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The Role of Taxation in the UK

In a nutshell

In the UK, taxes do not provide the money for public services. The government, through the Bank of England, creates new money when it spends, a process we explored in the “Self-Financing State” document. The real purpose of taxes is to give value to the pound. By requiring us to pay taxes in the currency it issues, the government ensures that its money is in constant demand. Taxes also act as a crucial tool for managing the economy and to make room for the provision of public services paid for with new money created by the state.

The Full Explanation

This is a fundamental shift from the common belief that tax revenue funds spending, which can lead to confusion, political debate and dangerous limitations on the state’s willingness to provide for the people, known as austerity. Here’s a more detailed look at the true functions of taxation.

  • Creating Demand for the Currency: The government, as the sole issuer of the pound, needs to create a demand for its currency. It does so by levying a tax liability which can only be paid in pounds. This legal requirement creates a constant demand for the pound, giving state money its value and creating willing sellers of goods and services, including labour, in exchange for state money from the government. The private sector needs to earn state money to both pay its taxes and to buy goods and services (the state money remaining in the system after taxes have been paid equals private sector net saving). This process explains how the public sector provisions itself.

  • Controlling Inflation: After the government spends new money into the economy, taxes collect a portion of it back, effectively destroying that money. This is a powerful way for the government to manage the total amount of money in circulation. If spending from both the public and private sectors exceeds the economy’s ability to produce goods and services, this can generate inflationary pressure. When planning its budget, the government sets out the level of taxes required to reduce private sector spending, freeing up resources for the government to buy at market prices to serve public purpose. Raising taxes ‘after the fact’ to control inflation is not a desirable policy (the best counter-inflation policy is to use a buffer stock approach, i.e. a Job Guarantee programme).

  • Reorganising the Economy: The tax system is a powerful tool for social and economic policy. Taxes on high incomes or certain types of wealth can be used to redistribute money more equitably and address inequality. Higher inequality tends to reduce sustainable growth and has serious political consequences as the super-rich can exert pressure which undermines democracy. The super-rich can also command a large portion of scarce resources; their spending patterns can reduce resource availability for lower-income households.

  • Repricing Goods and Services: Taxes can be used to influence public behaviour and consumption. For example, a tax on carbon-intensive activities, like a fuel duty or landfill tax, makes those activities more expensive. This incentivises people and businesses to make more environmentally friendly choices, effectively “repricing” certain goods and services to reflect their true social and environmental costs. A lower tax or a subsidy can be used to incentivise activities seen as socially desirable.

  • Raising Democratic Representation: There is evidence to suggest that people who pay taxes, especially income taxes, are more likely to hold their government to account for how money is spent. This strengthens the social contract between the state and its citizens and encourages greater democratic participation.

Frequently Asked Questions (FAQ)

  • Why does the government say taxes are to pay for public services, like the NHS? The idea that taxes fund public services is a deeply held belief and a useful metaphor for political and social purposes. It’s often used to justify the government’s role in providing public services. However, the operational reality is that tax revenue which flows into the Consolidated Fund is not used for future spending. The money to pay for the NHS is created when it is needed, on Parliament’s order.

  • Isn’t collecting taxes a waste of time and resources if they don’t fund spending? No. The tax system is essential for a stable economy. Without taxes to create demand for the currency and manage the money supply, the government’s ability to spend new money would lead to uncontrolled inflation. Taxes also serve the crucial social purposes of redistribution and behavioural change, making them a fundamental part of a fair and functioning society.

  • This is just a cynical view of tax. It ignores the idea of the social contract where we pay taxes to get public services in return. The social contract is a powerful idea, and the reality of how the system works doesn’t undermine it, it reframes it. The government’s ability to create money allows it to guarantee that it can provide public services, and taxes are the vital tool that makes this all possible without causing inflation. The true social contract is that the government uses its power to create money to ensure public provision, and we, as citizens, accept its currency and its obligation to pay taxes, which enables the system to work.

  • If taxes are meant to control inflation, why did we have high inflation in the UK when taxes were also high? Inflation is a complex issue and can be caused by many things other than government spending. Nearly all inflationary events in our lifetimes have been caused by the increases in the cost of imported energy and food, not ‘too much government spending’. Supply chain disruptions, energy crises, and global events can all cause prices to rise. While taxes are a tool to fight inflation, they are not a magic bullet. The idea that taxes are the only way to fight inflation is a misconception. The government must also consider other factors and adjust its policies accordingly to get the desired result, for example, buffer stock policies, selective price controls and investment in improved infrastructure.

  • If taxes are used for redistribution and not funding, why do political parties always argue about tax cuts and tax rises? The political arguments over tax are crucial because they determine who benefits from public spending and who bears the burden of managing the economy. A government can choose to take money out of the economy from the rich through higher taxes on wealth or from the poor through higher taxes on consumption. These choices have significant social consequences, even if they don’t change the operational reality that tax revenue does not fund government spending.