This article was compiled by Dr W A Wijewardena.

Dr W A Wijewardena is an independent economic analyst and presently serves as a visiting lecturer at several Sri Lanka and regional universities in economic issues.

Contrary to modern governments, ancient kings ran surplus budgets

            Citizens of modern states are worried about the taxes they must pay to governments. There is a valid reason for such worries. That is because any tax they pay is a loss to them in terms of their current or future welfare. It could be a loss of current consumption or a future income earning opportunity or a mixture of both. Hence, high taxes, whether they are direct or indirect, have been a worrisome feature for them. This is perfectly correct for the fiscal policies adopted by ancient monarchs. In the absence of a readily available capital market to borrow to fund the budgets, those monarchs had to finance them entirely through taxes levied on people. As the Indian economics Guru Kautilya had recommended to his king, those monarchs had to build a strong Treasury to maintain their power. It involved running a budget surplus by spending less than what they got as tax revenue. Hence, the total taxes they paid, in kind, cash, and human labour, was a burden to them.

Modern governments run deficit budgets by borrowing and printing money

            Today’s fiscal systems are different. Governments can run deficit budgets by borrowing from the markets – both domestic and foreign – and printing money. When a government makes a foreign borrowing, there is an inflow of resources from the rest of the world raising the welfare of people for the time being. But when that debt is repaid, there is an outflow of resources reducing that welfare. While the present generation enjoys the increased welfare, the future generation will have to sacrifice their welfare levels. But when the governments borrow from the domestic markets to finance the high government expenditure levels, for long, economists had believed that it did not involve a burden because such borrowings were simply an instance of people owing to themselves. Hence, at the aggregate level, a domestic borrowing meant people’s changing the form of asset holding from cash to bonds. At the time of repayment, people had to pay taxes and therefore, it was simply a redistribution of assets from taxpayers to bondholders. Therefore, it was believed that there was no burden involved in domestic financing. Money printing became a mode of budget financing after the governments started issuing paper currency of which the cost of printing was less than the face value of the note concerned. For instance, if the printing cost of a 5000-rupee note is Rs 20, for every note issued by the government generated a super profit of Rs 4980/- called seigniorage by economists. Since there was no visible burden involved, it was also believed that financing the budget deficits did not impose any burden to citizens. In fact, it is this logic which is being presented by those who advocate Keynesianism as a policy guide for governments to run budget deficits.

Ricardian equivalence: no difference between tax financing and bond financing

            Long before money printing became a mode of budgetary financing and when only bond financing was available for running budget deficits, English economist David Ricardo established in 1818 that there was no difference between tax financing and bond financing as for assessing the burden of the budget. This law, known as Ricardian Equivalence, said that people bear the burden of taxes today. But bonds must be repaid in the future and at that time, people will have to pay higher taxes to repay those bonds. Hence, it was established that what should be worried was not only the current taxes paid but also the future taxes that should be paid. But today when the governments use their money printing power also to run budget deficits, there is another type of burden being borne by current as well as the future generations. That burden arises from inflation and hence, known as the inflation tax.

Inflation tax: involuntary transfer of resources from citizens to governments

            How the inflation tax operates can be explained by a simple example as follows. Suppose the government gets the central bank to print a 5000-rupee note and uses it to buy the services of a teacher for one month. The teacher sacrifices her real labour for this 5000-rupee note but the government sacrifices only the printing cost, say Rs 20, in real terms. Hence, it is an unequal exchange in which the teacher makes a bigger real sacrifice than the real sacrifice made by the government. But why should the teacher agree to this unequal exchange? That is because she is told by the government that with this 5000-rupee note she can command a basket of real goods from the market. For simplicity, let’s assume that there is only one real good and that real good is milk food. If a kilogram of milk food costs Rs 5000, this teacher exchanges one month’s real labour not for a piece of paper but for a kilogram of milk food. But if the government has given these 5000-rupee notes to others also – which is the case always – they also go to the market to buy milk food raising their price to say Rs 10000 a kilo. Now the teacher can buy only half a kilo of milk food for her 5000-rupee note. The other half of a kilo she has lost is a tax she has paid to the government. Since it arises from inflation, it is known as inflation tax.

Increase in the level of CCPI has cut real purchasing power of a family by half

            Let’s take an example to illustrate this point. In terms of the new series of the Colombo Consumers’ Price Index or CCPI, in January 2021 when the CCPI was 100, it cost a family of 3.8 members Rs 91880 to buy the basket of real goods and services involved. In January 2024 when CCPI has increased to 200.6, the family should spend Rs 184311 to buy the same basket of real goods and services. That has increased the cost of living by 100%. If a family has the same income level as in January 2021, it amounts to cutting their real purchasing power by a half. This is an inflation tax which Sri Lankans have been paying over the period.

Gross expenditure in Budget 2024 is 35% of estimated GDP

              Hence, it is not the current tax burden only that people should worry about. It is the total government expenditure, known as the gross expenditure, about which they should be worried. If the government expenditure level is high and it is financed by taxing people, borrowing from both domestic and foreign sources, and printing money leading to inflation, people are forced to bear a burden. Hence, higher the government expenditure, greater the burden being borne by people. For instance, the Budget 2024 envisages to raise Rs 3.8 trillion by way of taxes and another Rs 307 billion as other incomes. But the total government expenditure that includes the repayment of both domestic and foreign debt as well has been estimated at Rs 11.7 trillion or 35% of estimated GDP. It has generated a gross financing requirement of Rs 7.4 trillion or 22% of GDP. Since the new Central Bank Act has prohibited the direct money printing to finance the budget, the entirety of the gross financing requirements should be financed by borrowing from the domestic and foreign sources and from commercial banks. The last item is money creation and, therefore, it leads to an inflation tax imposed on citizens.

            This total gross expenditure level is the one which should be kept in check if people are to reduce their burden arising from running a big government.