A Perfectly Regressive Tax – a guest post by Michael Green

Economists and politicians get worked up about the peril of Public Sector Debt, but seem far less worried about Private Sector Debt.  This is surprising, because Private Debt should be at least as dangerous.  It seems subject to far less scrutiny, even though it is subject to constant selective pressure towards instability. 

Here, I will argue that Private Debt and Banks provide the formal equivalent of a perfectly regressive tax system.  The less money you have, the higher your rate of tax.

 “Thin Air” Money

   We know from Modern Monetary Theory (MMT) that Governments create money out of thin air.   (Where else did the pound in your pocket originate?)

Governments next spend the money that they have created.  I would argue that they “invest” it, either wisely or otherwise, and that taxes can be thought of as “dividends” on their investments.

MMT proponents sometimes argue that when Governments recoup as tax the thin air money they have created, they turn it back into thin air.  In reality, as fast as a Government collects money as tax, it spends it again.  There is effectively no cancelling out.

So why does the amount of money in the economy not increase endlessly?  Quite simply, there are other processes that turn thin air money back  into thin air.  One of these is via Private Debt and the Banking System.

The role of banks

   It is now recognised that, just like governments, banks can make loans with money they create out of thin air.

  But wherever the money the bank lends comes from, there are three components to the repayment:

The loan itself is repaid.  If the bank has created the loan with “thin air” money, it is indeed cancelled out – a closed system. 

The interest on the loan, however, must have come from elsewhere.  If bank lending is a closed system, it cannot have been created by the bank.  It has to be money that was created earlier by the Government and was invested in the wider economy. 

There are two components to bank interest.  Part is the Bank’s profit, Government-created money comes out of the economy and (in theory) goes back into the wider economy.

However, part of the interest on the loan is “insurance” against the loan going bad.  The “insurance” on loans that are successfully repaid is used to cover the cost to the bank of loans that default.  It is regarded as natural that the worse the credit risk, the higher the “insurance” component of the interest.

This makes Private Sector Debt and the Banking System a potent driver of inequality.  Banks cover the cost of bad loans by preferentially draining Government-created money from that part of the economy where there is least money to start with.  Those with the least pay the most.  The equivalent of a perfectly regressive tax system.

(In contrast, with Public Sector Debt, it is regarded as natural that when the Government “invests” in the economy and receives its “dividends” as tax, those best able to pay should pay a higher rate of tax.  Potentially a progressive tax system.)

Finally:

Question 1:  Why are Governments criticised for creating more money than they collect as tax, when they may simply be replacing the money drained from the system by Private Sector Debt?

Question 2:  Does the money lost to bad debt really disappear?  If not, where is the money that vanished in 2008?  My suggested explanation is that when banks lend to buy an asset, they increase competition for that asset and push up its price.  This falsely increases the apparent security of the loan, which encourages more lending against that class of asset, while in reality increasing its risk.  Worse, ”thin air” lending against an asset blurs the distinction between money and assets, turning money into a highly unstable form, which can appear or disappear at will.  In a rational world, Private, rather than Public Sector Debt would be regarded as the menace.

Comments

  1. simon gray -

    Government debt can be seen as a means of controlling the money supply rather than as debt. When a government issues bonds it receives cash usually from a source that needs to make payments at a future time such as pension funds. This reduces the money supply as the pension fund pays cash to the government for the bond and creates an obligation on the state to pay in the future. There is no obligation on the government to spend that cash in the economy. Just as with tax it can cancel the cash. When the repayment comes due the government can create the cash and repay the pension provider who uses the cash to pay the beneficiaries at that point. This is why it is incorrect to suggest that government debt is putting future generations in a position to repay the debts of the “Father”. The debt is actually used to pay future generations.
    Government spending is a different mechanism. Government can create cash via an accounting entry between the central bank and the treasury. Government doesn’t require private debt to spend in the economy although it can use private debt to balance the supply of cash. Government spending can be used to reallocate resources to projects especially where there is spare capacity. Government spending is not debt as no one needs to be repaid.

    1. Michael Green -

      This is a really good point. Government borrowing cannot add to the amount of money in the system. The money the Government borrows has to be money that it created previously. So that Government borrowing can either temporarily remove money from circulation, as Simon suggests, or it can redirect its flow, by spending the money immediately.

  2. Peter May -

    While I agree that bank interest and charges does help to drain money from the economy and increase poverty, I’m not at all sure we should go along with the idea that Government doesn’t destroy money that it collects – (something which, after all, it licences the banks to do). This suggests we are back to tax and spend, which logic dictates is not the case.

    And when the government takes about a third of GDP as tax http://www.progressivepulse.org/economics/basic-econimics/the-logic-of-spend-and-tax the banks would have to be charging stupendous interest to be able to syphon this sort of figure out of the economy.
    So, whilst I’m willing to be corrected if the statistics can be pointed out the answer to the question: ‘So why does the amount of money in the economy not increase endlessly? ‘ is, I think, still going to be tax.

    1. Michael Green -

      Peter, I’m a biologist, not even an amateur economist, but I do think this can be a blind spot. The money the Government spends is going to be of the same order as the money it collects as tax (though not identical). If the Government cancels out the pounds that it collects via tax, then it has to create a similar number of identical pounds to fund its expenditure. When two very large processes cancel out, what is left may be a very different picture. The amount of money that banks drain from the system may be trivial compared to the amount collected as tax, but it may well be significant after cancelling out. And cleverer people than me may see other important processes that have been hidden in plain sight.
      The other key corollary is that almost the entire function of tax is not to cancel money but to redirect its flow. Tax takes money from one part of the economy and places it in another. If your figure of tax as one third of GDP is correct, Government spending decisions must be far and away the most important factor directing the economy.

      1. Peter May -

        I suggest Government spending decisions are indeed the most important for the economy. Which is why austerity has been such an economic disaster – both in the UK and the EU. As for tax redirecting the flow of money – that implies we’re back to tax first and spend after. We cannot possibly pay our taxes in Sterling – and that after all, is the only way we can pay them – unless the government first creates £ sterling with which to pay them.

  3. Michael Green -

    A completely unrelated subject, also involving cancelling out.
    I have a bee in my bonnet about pensions. At any one time, workers are contributing to pensions, and retirees are receiving them. Overall, these two processes largely cancel each other out, but the whole pensions industry is predicated on ignoring this.
    University lecturers are on strike, among other reasons, because their employer wants to worsen their pensions.
    Rough figures: A year ago, their pension scheme USS had assets of about £60 billion and was deemed to have a deficit of £15 billion. This deficit probably increased by £4-£5 billion in the last week. (As far as I know, the actuary takes the simple market value of the assets and works out the income that this would generate if held in Government bonds). So that, if the stock market falls by 10% and the £60 billion becomes, say, £55-£56 billion, then the deficit rises accordingly.
    However, at the same time the scheme receives about £2 billion per year in contributions, and should have an income of £1-£2 billion from its investments. It pays out about £2 billion a year in pensions.
    Peter may know better than me, but it is unusual for a business to require a cash injection of £15 billion when it has a predictable income of £3-£4 billion and predictable outgoings of £2 billion. You would need to be an actuary, or the master of an Oxbridge college to explain it.

    1. Peter May -

      Or just accidentally – or purposely – mislead people….

    2. Christopher Steane -

      Isn’t that how Ponzi schemes operate?

      There is a decent argument that the discount rate applied by the actuaries should not be the gilt rate, but then someone has to assume the risk that the projected investment returns are inadequate to meet the expectations of the pensioners.

      As various public sector pension schemes indicate, if you run a pay as you go scheme and you do not receive contributions which adequately reflect the value of the future benefits, eventually it will become a transfer of resources from taxpayers to recipients of gold plated index linked pension benefits, which can be both unfair and regressive.

  4. Michael Green -

    Christopher Steane, apologies for being slow replying.
    1) If you take pensions as a whole, I don’t think pay as you go creates a Ponzi scheme, because the number of people paying into pensions and receiving pensions should be fairly predictable.
    2) There are always likely to be universities, though some may expand and others go to the wall. Similarly, there should always be companies, though any individual company is unlikely to be around long enough to continue to make contributions to offset its pension payments. If I think full funding is inefficient and probably harmful, it is up to me to suggest an alternative.
    3) I am lucky (and hypocritical) enough to enjoy an index-linked final salary pension, but I have to agree that they are inherently unfair. At the other end of the scale, the same National Insurance contribution might buy you an index-linked state pension, a flat-rate state pension, or nothing at all.
    4) My fear is that the requirement for full funding creates a mountain of money. A fair amount goes to investment managers playing zero sum games, but most of it achieves little or nothing. Richard Murphy writes well on the subject. To my mind, this is much closer to a Ponzi scheme, pushing more and more money into assets that aren’t really there. What happens if the bubble is pricked?
    5) My suggestion is a hybrid of pay-as-you-go and the Green New Deal. Instead of issuing bonds, the Government accepts a sum of money. In return, it promises to pay an index-linked pension in the future. This could be flexible, the later you leave it, the higher the pension you receive. To keep the in-out balance, pension schemes could buy in on the same terms, to offset their pensions-in-payment.
    6) It all would need a lot more thought and work, but the general aim would be to move from fragmented company schemes, which have to be fully funded, to an overall scheme which could be pay as you go.

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