Chapter Overview
- The Government Budget: How government revenue and spending relate — balanced budgets, deficits, and surpluses explain why governments borrow
- Taxation: Two types of tax (direct and indirect), three tax systems (progressive, regressive, proportional), and principles that make a tax system 'good'
- Fiscal Policy Measures: How governments use spending and tax changes to stimulate or slow the economy, with clear trade-offs between competing economic goals
- The Chain Reaction: Changing one tax rate or spending amount affects consumption, investment, employment, and inflation in predictable ways
1. The Government Budget
What Is a Government Budget?
A government budget is an annual financial plan showing government revenue (money coming in) and government expenditure (money going out). The relationship between these two numbers determines whether the budget is balanced, in deficit, or in surplus.
Three Budget Scenarios:
Balanced Budget: Government Revenue = Government Expenditure (income and spending match)
Budget Deficit: Government Revenue < Government Expenditure (spending exceeds income; must borrow)
Budget Surplus: Government Revenue > Government Expenditure (income exceeds spending)
Key point: When a government runs a deficit, it borrows money (public sector borrowing). This borrowing gets added to the public debt — the total amount the government owes. Public debt is cumulative, so each year's deficit adds to the overall debt mountain.
Three Types of Government Spending
1. Current Expenditures
Daily payments needed to run the government and public sector. Examples: wages for teachers, police, doctors, and civil servants; medicines for hospitals; electricity bills for government buildings.
Think of it: The cost of keeping government operations running day-to-day.
2. Capital Expenditures
Investments in infrastructure and long-term assets. Examples: building new hospitals, schools, roads, railways, bridges, or aircraft carriers.
Think of it: Money spent to create assets that will produce value for years to come.
3. Transfer Payments
Money redistributed from one group to another, with no goods or services exchanged. Examples: unemployment benefits, disability allowances, pensions, subsidies to farmers or businesses.
Critical: These do NOT count towards GDP because no new production happens. Income simply moves from taxpayers to recipients.
Why Do Governments Spend Money?
Public expenditure is a major component of aggregate demand (total spending in the economy). When the government spends, it creates jobs, buys goods from businesses, and supports households. This is why fiscal policy is such a powerful tool.
Practice Question
Classify each of the following as current, capital, or transfer expenditure:
(a) Building a new motorway; (b) Paying a teacher's salary; (c) Unemployment benefits; (d) Purchasing military aircraft.
2. Taxation
Why Do Governments Tax?
Taxation is a form of government intervention in a mixed economy. Governments tax for several interrelated reasons:
Six Reasons for Taxation:
1. Earn revenue — fund public services, merit goods, public goods
Correct market failures
Promote equity
Support firms
Reduce externalities