We understand that money is an IOU of sovereign governments , or the State, as some prefer to say. When governments spend, they create money. When they tax they destroy it. Governments often like to pretend that the ideal state of affairs is to run a surplus, which means they are destroying more money than they are creating. This may be possible for a short time, but it is obviously impossible for governments to destroy more than they create overall. So, to that extent, they always have to be in debt in terms of their currency of issue. That’s the natural state of affairs.
Even if they are not running a surplus, Governments do seem to fret, usually unnecessarily, when a part of what they issue doesn’t come back quickly enough to be destroyed. Politicians are always worried that their deficits are too large. But why do they do silly things like raising taxes and cutting spending to shrink them? They are always surprised when that never seems to work but instead they end up with high levels of unemployment and business failure.
There’s a concept in Physics known as the half-life, which is commonly applied to the decay of radioactive materials. Say there are 1000 atoms of an unstable isotope, to start with, they will decay to 500 atoms after a time and release radioactive emissions in the process. Then, again after the same time, the 500 atoms will decay to 250. Then 125 and so on. The radioactivity is decaying over time, but never quite decays to zero. But mathematically we can say it tends to zero as time progresses. The shorter the half-life the quicker the decay.
This concept can be applied to the way taxes act on every financial transaction, starting when governments first spend their created money. If Income taxes are involved the rates can be very high. Up to 75% in France for example. On the other hand some transactions are tax free, (even in France!) and we have to consider a weighted average tax rate per transaction. If that average is 5% then it will take 14 transactions, per unit of issued currency, before half of it is returned to government and is therefore destroyed. Increase that to 7% and it becomes only 11 transactions. 10% takes 8 transactions, 20% takes just 5 transactions. 30% takes 3 transactions.
Providing the transactions keep occurring, governments will always get the same amount of revenue regardless of the level of taxes, so long as they are finite. Increasing taxes won’t therefore increase revenue in the way that may be initially supposed. Considerations by economists such as Arthur Laffer on what are the optimal level of taxes to maximise revenue can be seen to be unnecessary. Governments shouldn’t want all taxes to be optimised. Other, usually more social, considerations should apply. For example, cigarettes could be optimally taxed to maximise revenue or they could be highly taxed to discourage smoking. The less than optimal tax which is then raised from sales of cigarettes leaves more money in the economy to enable extra transactions to take place. Those transactions then yield the extra revenue that may appear to have been lost.
So, from a government’s perspective, increasing taxation, and/or reducing spending, should be associated with the need to reduce the amount of financial transactions which occur overall in the economy. If there are too many transactions, the real resources to support them may be insufficient and higher than acceptable levels of inflation will occur. Conversely, reducing taxes, and/or increasing spending, should be associated with the need to increase the number of transactions occurring, so increasing business activity and therefore reducing unemployment levels.