“The Magic Money Tree”

This is an extra blog post – it doesn’t fit into the regular flow of 500-word Friday blog posts explaining how the economy works and how we could begin creating an economy that provides enough for everyone.

But I’ve heard so much nonsense on the news about “the magic money tree” that I had to post something explaining why this buzzphrase is misleading.  Typically, the comment is thrown at Labour plans to fund improved public services or pay increases for public sector workers such as nurses, so I want to make it clear that I am not endorsing Labour’s specific policies in this respect, nor the Labour party in general.

This post focuses solely on the “there is no magic money tree” response.  The mission of this blog is to educate on how the economy actually works, so that opinions on economic life are based on reality.  This issue is a perfect opportunity to demonstrate how understanding the detail of the economy can enable us to have greater insight into such issues.  For regular readers, they will see the application of the concepts I have been introducing to a practical issue, but the post stands on its own – you won’t need to have been following the blog to understand it (I hope).

So let’s get started: when the Government spends its new expenditure on the salaries of Government workers, instantly 20% of that expenditure returns to the Government as income tax (less the personal allowance where this expenditure has involved employing new staff rather than increasing salaries of existing staff).

These workers will then spend their salaries, and where that expenditure is subject to VAT, another 20% (of that expenditure) returns to the Government.

This expenditure then becomes income for the recipient companies, and likewise when new Government expenditure is spent on private sector goods and services (rather than public sector salaries) those companies will see their incomes rise.  And all these companies will either spend the increased income on salaries, use it to pay other companies, or record it as profit.  In the first case there is more income tax for the Government, in the third there is corporation tax, and in the second this expenditure becomes income for a new set of companies, and so the same three options apply again.

What I hope you can see is that as this money flows round the economy it gets taxed as either VAT, income or corporation taxes, and eventually much, possibly even most, of this expenditure will return to the Government in the form of taxes.  How long this takes depends on who receives the new income and what they spend it on, and how these new recipients then use their new income, and so on and so forth through continuous iterations.  Given a set of reasonable assumptions it would be possible to model this – it would be a big task, but not that difficult.

Yes, the Government has to borrow to finance the expenditure in the first place, but there is every possibility of recovering a large proportion of that borrowing within a year.  In an earlier post I explained the essential nature of credit to an economy, and this has been a repeated theme of the blog since then.  Credit is nothing to be afraid of if the new expenditure stimulates the economy.

However, not all of the spending would return to the Government – there would be two areas of “leakage”:  saving and imports.

Saving

Whenever an individual or company “saves”, the new money in the economy would stop flowing (regular readers of the blog will be well familiar with this dynamic, the paradox of thrift).  Don’t think in terms of saving accounts: for individuals, the only economically significant form of saving is pension funds (contributions to which are not taxed).  And in any case, the most significant form of saving in the economy is by companies.

But neither pension funds nor institutional savings are left sitting in bank accounts – they are spent on financial assets.  These assets intermediate the savings back into the real economy – a dynamic explained over the last 3 weeks’ posts on financial assets.  As this funding is spent back into the real economy, it can be taxed!

Imports

Where individuals or companies are spending on imports, the money flows to overseas individuals, out of the reach of our taxes.  The same is true when saving is spent on overseas financial assets.  However, some of these overseas recipients will then spend their income on British exports, so some of that spending will flow back.  Nevertheless, as Britain has a balance of payments deficit, ultimately it would be impossible for the Government to recoup all the increased expenditure through taxation.  What we have here is something called the “balance of payments constraint” (or Thirlwall’s Law), which is perhaps the most significant constraint on economic growth for a nation.  This is incredibly significant to the overall theme of this blog, but we haven’t talked about foreign exchange at all yet.  It will be the subject of a series of posts in the future.

So these are the factors that limit how much of its new expenditure ends up returning to the Government in tax:

• The proportion of income from that expenditure that is saved rather than being spent back into the economy;
• How this is saving is used (e.g. whether it is intermediated back into the national economy via domestic financial assets);
• What proportion of income from this expenditure is spent on imports or overseas assets, balanced against any increase in exports resulting from the increased income overseas.

And again, all of this could be modelled, given a reasonable set of assumptions.  It would be complicated, but it wouldn’t be difficult (the biggest difficulty would probably be finding data on which to base the assumptions so that they are well-grounded).

So when people say “where will the money come from”, the answer is that the money will come from the increased tax revenues as this new expenditure flows continually around the economy, being taxed as it is spent and as it is earned.  We don’t need a “magic money tree”, we just need to understand how the economy works.

There will be leakage as new income is saved and as it flows overseas, so there will be some increase in national debt, and this has to be weighed against the benefits achieved in terms of economic growth.

But these benefits could be significant.  In a country operating near full productivity such a policy would simply cause inflation, but in an economy with low productivity, where wages are stagnant and small businesses in particular are struggling, such a policy is likely to stimulate growth far more than inflation.  Increased government expenditure, either on better salaries for existing workers or new employment, will translate into increased demand in all local economies where public sector workers live (that’s everywhere, by the way).  So the next people who see the benefit will be the local shops and trades people – and as their incomes increase, they will spend it in their local economies, and so on and so on.

As stated, there will be an increase in national debt, but this increase will be far less than the actual increase in Government expenditure (estimating how much it would increase would require some robust modelling).  That debt will need to be serviced, for example through tax increases or by clamping down on tax evasion and tax avoidance, and every individual will have a different point of view on what the right trade off is between the increase in national debt and the increase in economic growth, income and employment.  I am therefore not endorsing any particular policy or course of action, but I am saying that if you want your personal point of view to be informed and intelligent, then you should base it on a basic understanding of how the economy works, and how a large proportion of increased expenditure by the Government will flow back in the form of increased tax revenues.

In two weeks the blog is going to start looking at how money and banking works, a theme which will shed much light on the issues discussed here.  But first, this Friday’s post will be a summary of everything on the blog so far, which would be a good time for new readers to join in.