Economic neo-liberals tend to think that having a balanced budget, or a much reduced deficit, is easy enough, at least in principle. Just reduce government spending and increase taxation. Deficits will fall and the financial markets will react by rewarding a ‘prudent’ government. Right? Well, no. That’s where they always get it wrong and they never learn from their mistake. That kind of austerity economics is always just going to send the economy into a downward spiral of recession and increased unemployment as we’ve seen happen in the Eurozone. Governments there have sought, in vain, to balance their budgets in accordance with EU rules. They are actually ‘allowed’ a 3% GDP maximum deficit.

When sovereign governments spend they simply credit bank accounts as we know from MMT. Much of their spending is on wages and salaries. Straightaway about 30% or so comes back in tax and other Government deductions, like National insurance in the UK. The remainder gets spent and respent. After a few respendings there’s not much left after the government has taken its cut at each stage. 20% VAT, fuel duty, corporation tax etc etc and yet more income tax. So, it’s important for Governments to recognise that the level of taxes overall doesn’t have a 1:1 level on the tax take or anything like it. But the level of spending does have close to a 1:1 effect. Of course, raising one tax will increase the revenue raised by that particular tax but reduce the revenue raised by other taxes, simply because once money is removed from the economy, by one tax, it becomes unavailable to be removed by a subsequent tax. Eventually nearly all spending goes back to government as taxes regardless of the level at which they are set, providing they are finite. It just takes longer if taxes are lower.

Just think of it as water being pumped from a bucket and returned to the same bucket via a hosepipe. Once the system has settled down the amount of water returning to the bucket will be same as the amount leaving regardless of the time it takes to complete its journey, which is determined by the length of the hosepipe.

Warren Mosler likes to make the point that all money to pay taxes, and buy government securities, comes from Government spending. We can go further and say that all money to pay taxes (inc buying government securities) and to support the profits, wages and salaries of the private sector comes from Government spending. The lower the level of taxes, the longer the money stays in the economy to benefit the private sector, but it doesn’t just magically appear from nowhere as the more vitriolic of libertarians tend to suggest when they attack all government spending as wasteful.

There are two exceptions to the rule that issued money always comes back to government. Money which is saved by individuals and private companies, and money which is net spent on imports. The taxman can’t get that back. That is the source of the deficit. So, we can say:

Government Deficit = Savings of the Private Domestic Sector + External Deficit

This equation can easily be shown from a consideration of sectoral balances too.

So, if government, in its wisdom (or folly?), does decide the deficit needs to be cut in a recessionary period, it should forget about spending cuts and tax rises. What needs to happen is for saving to be discouraged and, of course, having interest rates very low helps do that. Then imports have to be cut and/or exports increased as well. Of course that’s very difficult to do in a free society where individuals wish to purchase goods and services from anywhere in the world and save money in whatever is their currency of choice. However, if neo-liberals argue this is impossible they must also necessarily concede that running a government surplus, or even a reduced deficit, is sometimes impossible too.

So, is there any truth at all in the conventional wisdom that cutting spending and raising taxes is the way to reduce a government’s deficit? Just a grain! It could send the economy into such a downward spiral that everyone becomes so poor they can neither afford to save nor buy imported goods from abroad. But, if that is the plan, then politicians arguing for a balanced budget should say so in advance to give us the chance of voting for someone else.