Mark Thoma Almost Gets It

Confusing the Size of the Deficit with the Size of Government

"But what Republicans have realized is that most people assess whether government is too big or too small using the deficit. If the government is running a deficit year after year, then it must be purchasing more than it can afford.

"The problem, I think, is a false analogy with a household. When a household is in deficit month after month after month, it is a sign that the household is overspending relative to its income. And, since in most cases income cannot be changed in the short-run, or even in the long-run, a household in budget trouble has little choice but to work on the spending side of the equation.

"However, the government's income is different from a households. The government has powers that households do not have, the power to change taxes. An increase in taxes will raise the government's income and help to solve the problem. The right has tried to convince us with Laffer curve nonsense that this margin cannot be adjusted, i.e. the false claim that tax increases will not increase revenues, and they have also made arguments about employment and economic growth. Or they have simply proclaimed, without justification, that tax increases are off the table.

"None of those argument withstand closer scrutiny, but they are an easy sell due to the willingness of households to project their own troubles with balancing their budgets onto the government...."

Congratulations to Prof. Thoma for pointing out that government budgets are not the same as household budgets. But he mistakes the difference as the power to tax in order to fund instead the power to issue currency to fund. Close but no cigar — yet. There's always hope.

A monetarily sovereign government that is the monopoly provider of a nonconvertible floating rate currency funds itself through currency issuance and neither taxing nor borrowing are required for funding. In a fiat system, taxes do not fund government. Issuance does. That's what "fiat" means.

Taxes serve two purposes. First, taxation gives the currency value because nongovernment needs the state's currency to meet its obligations to the state in the form of taxes, fees an fines. Secondly, taxes withdraw net financial assets from nongovernment, reversing the flow of net financial assets into nongovernment resulting from government expenditure.

Government expenditure (fiscal injection) is used to increase nongovernment net financial assets in order to offset demand leakage to saving and net imports, which would otherwise result in economic contraction, while taxation (fiscal withdrawal) is used to decrease nongovernment net financial assets to control inflationary pressure.

Moreover, Prof. Thoma does not seem to understand the rationale of the Laffer curve. Art Laffer understands monetary economics, and he correctly noted that lowering taxes will increase nongovernment net financial assets. But he was mistaken is in thinking that this increase in nongovernment NFA would automatically translate into effective demand, which would send a signal to invest in order to increase production.

Tax cuts go primarily to the wealthy, and they have a high propensity to save. Therefore, the multiplier from broad tax cuts to growth is small, since most of the cut is saved instead of being spent on either consumer goods or capital goods. The Laffer curve did not work then, and there is no reason think it will work now to stimulate demand and increase investment.