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Government Income and Expenditure

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Government Income and Expenditure

Have you ever wondered how governments spend and receive money? Where do the funds come from? and why is it so important to spend them? This explanation will outline the basis of government revenue and expenditure.

Governments collect taxes primarily to finance their spending. They can also use taxes to manipulate the relative pricing of goods and services to influence consumption. However, the main reason why governments use taxation is to manage macroeconomic goals and achieve fiscal objectives. Based on fiscal economics, the main reason behind government spending and taxation include:

  1. Allocation: this includes influencing prices and consumption. For example, demerit goods are taxed heavily in an attempt to discourage their consumption. Meanwhile, merit goods are often subsidized to encourage their consumption.

  2. Distribution: Taxation and government spending are also used to redistribute income in society in case the distribution of income under free market forces is inequitable.

Government income and expenditure: revenue

Let's take a closer look at government revenue.

Main sources of government revenue

The main source of government revenue is taxation. Figure 1 below outlines the different types of public sector receipts in the UK and the majority of them are various forms of taxes.

UK’s government income

We can see that the largest factor of government revenue is income tax. Income taxes and national insurance contributions make up almost half of government revenue. Most of the tax revenue comes from direct taxes, including income tax, corporation tax, national insurance contributions, council tax, etc. However, indirect taxes like VAT and excise duty all form part of government tax revenues, in addition to other non-tax receipts.

Government Income and Expenditure Public Sector Revenue 2021 22 StudySmarter OriginalsFigure 1. Public Sector Revenue 2021–22, StudySmarter Originals. Source: Office for Budget Responsibility, obr.uk

Principles of taxation

Adam Smith proposed the principles or guidelines of taxation, which serve as criteria for evaluating the effectiveness of a tax system.

Adam Smith's principles of taxation suggest that taxation should be:

  1. Equitable: the tax system should be fair.
  2. Convenient: the tax should be convenient for taxpayers to pay.
  3. Economical: the tax should be cheap to collect relative to the revenue it yields.
  4. Certain: taxpayers should be certain of the amount of tax they need to pay.
  5. Efficient: the tax should be able to achieve its desired objectives.
  6. Flexible: taxes should be easy to change when circumstances change.

The idea behind the concept is that an 'ideal' tax should meet all of these criteria. However, realistically, this rarely happens due to trade-offs and conflicts.

A trade-off happens when there are two or more mutually exclusive objectives, meaning that both of them cannot be achieved synchronously. In this case, it is the extent to which one principle, for instance, certainty, has to be sacrificed in order to meet another principle: flexibility.

The effects of taxation on economic activity

Taxation has numerous effects on economic activity:

  • Redistribution of income: certain types of taxation (i.e. progressive taxes) can have a positive and more equitable impact on the distribution of income in society.

  • Labour supply: on the other hand, high taxation rates can disincentivise people from working more which decreases the supply of labour.

  • Consumption of goods: taxes like excise duties can influence the consumption of certain goods that are deemed to be harmful to health and/or the environment. For example, demerit goods are taxed heavily in order to disincentivize their consumption.

  • Environmental impact: increasing taxes for companies on carbon emissions will have a positive impact on the environment, as higher taxes will increase the cost of production for producers and potentially disincentivize them from increasing their emissions. This can lower the effect of negative externalities (i.e. pollution).

  • Government spending: higher taxation means that governments have more funds to spend on public services. Increased public expenditure can result in economic growth.

It is important to keep in mind that taxation may also impact microeconomic activity. For instance, taxes are imposed on demerit goods like tobacco or junk food to discourage their consumption. Taxes are also imposed on firms that produce high amounts of CO2 emissions, to reduce negative externalities. On the other hand, merit goods like healthcare are often heavily subsidised by the government to encourage their consumption.

Government income and expenditure: spending

Public expenditure is an important tool that governments can use to achieve their economic objectives.

Main types of government spending

Government spending can be divided into different categories. The three main types of government expenditure include spending on health, education, defence, and social protection (public services); transfer payments; and debt interest.

Expenditure on public services also includes spending on capital expenditure and current expenditure.

Capital expenditure involves government spending on fixed, or existing, assets like schools, hospitals, roads, bridges, etc. Current expenditure includes spending on goods and services that are consumed over a shorter period of time. This could include salaries of public sector teachers, doctors, or heating costs of hospitals.

UK’s government expenditure

Figure 2 below provides a breakdown of public sector expenditure on services in the UK between 2021–22.

Government Income and Expenditure Public Service Expenditure 2021 22 StudySmarter OriginalsFigure 2. Public Service Expenditure 2021–22, StudySmarter Originals. Source: gov.uk

General public expenditure also includes debt interest payments. Public sector debt interest accounted for £ 41.5 billion of total public expenditure on services between 2020–21. Debt interest is composed of payments made by the government to those that have allowed the government to borrow money from them: interest payments on the national debt.

The effects of spending on economic activity

The purpose of government spending is to influence economic activity. The effects of spending include:

  1. Supply-side improvements: public spending is used to achieve certain supply-side policy objectives. For example, spending on education and skill training programs to improve labour output and productivity in the economy.

  2. Public goods: governments spend money to provide goods and services which would otherwise not be provided by the private sector. Examples of such goods and services include defence, roads, bridges, street lighting, and other infrastructure.

  3. Merit goods: public expenditure is also spent on merit goods, which are goods that the government thinks people might underconsume if they were not free or subsidized. Health programs, education programs, and libraries are examples of merit goods.

  4. Subsidies: governments provide subsidies in industries that are beneficial to society but may lack funding. An example of this would be agriculture or transport infrastructure.

  5. Boosting aggregate demand: government spending is used to inject income into the economy to boost aggregate demand and other economic activities like investment.

We can conclude from Figure 2 that total expenditure in the UK in 2021–22 is expected to reach £999.7 billion. Figure 1 shows that total public sector income is expected to be around £862.0 billion. As a result, the budget deficit for this year is expected to be £137.7 billion.

One of the factors which may have recently contributed to the budget deficit includes the high levels of spending on health and the overall uncertainty in the economic climate due to the Covid-19 pandemic. The budget deficit may be indicative of a cyclical deficit, whereby the deficit may decrease once the national economy recovers.

Transfer payments

Transfer payments also make up a large part of public expenditure. Transfer payments are payments for which no goods or services are traded in return. Instead, they are just a transfer of money. These include unemployment benefits, disability support, state pensions, or social security payments. These payments represent a redistribution of income and spending power from taxpayers to the individuals receiving welfare payments. Transfer payments are excluded from a country's GDP as they are not part of national income or output: no goods or services are exchanged in return for the payment.

Transfer payments are payments for which no goods or services are traded in return.

Transfer payments, or spending on social protection, tends to make up the largest fraction of public sector expenditure (£ 297.2 billion between 2020–21). By excluding this figure, along with debt interest, from public spending, government spending relative to GDP decreases. This represents a more accurate measure of national output created by the government to produce public goods and services like hospitals, schools, etc., which governments finance from tax revenues.

Government income and expenditure: the national budget

It is important to distinguish between the national debt and a government budget deficit. A budget deficit comes from the difference between government revenue from taxes and government spending on public services. When public expenditure is higher than tax revenue, the government is running a budget deficit. This is something the national economy experiences in the short term.

To raise capital and continue operating this way under a budget deficit, the government has to borrow money. This can either be done by borrowing money from another country or, more commonly, by issuing treasury bonds and bills.

A government bond is an agreement between an individual and the government, whereby the individual lends a certain amount of money to the government (for a certain period of time). The government will then pay a certain amount of interest at regular time intervals until the bond expires, which is when the individual will be repaid for the original amount of money they loaned.

To learn more about government bonds and yields check our explanation on the Capital Market.

By issuing these types of securities the government can continue to provide public services even when they do not earn enough tax revenues in a certain period. The accumulation of yearly budget deficits is known as the national debt. This is something the national economy experiences in the long term.

Other effects of taxes and spending

Let's take a look at further effects of government spending, taxation, and debt on the macroeconomic factors.

Debt interest includes interest payments on the national debt - government borrowing from previous years added to borrowing in the current year. Debt interest tends to increase when interest rates are high and decrease when interest rates are low.

The bank rate influences these interest payments. If the national debt decreases faster than nominal GDP, debt interest relative to real GDP will also decrease if the rate of interest does not increase. The reverse is also true if national debt increases faster than nominal GDP.

Finally, it is also important to note the debt to GDP ratio, which is the national debt as a percentage of nominal GDP and serves as an indicator of the impacts of debt on the economy. At times, GDP may grow faster than the national debt, meaning that although national debt could be increasing, the national debt relative to nominal GDP could be decreasing. This can happen either because a country's economy is prospering, which leads to economic growth, or due to inflation, which might present a problem to the national economy.

Government Income and Expenditure - Key takeaways

  • Governments collect taxes to finance government spending.
  • The main reason why governments spend and use taxation is to manage macroeconomic goals and achieve fiscal objectives, including the allocation and distribution of resources.
  • The main source of government revenue is taxation, including revenue from both direct and indirect taxes.
  • Adam Smith's principles of taxation suggest that taxation should be economical, equitable, convenient, certain, efficient, and flexible.
  • Taxation has effects on the redistribution of income, the labour supply, externalities, and consumption.

  • Expenditure on public services includes both capital and current expenditure.

  • A budget deficit is a short-term economic consequence whereas the national debt influences the economy in the long term.

Frequently Asked Questions about Government Income and Expenditure

In the year 2021–22 total government revenue in the UK was around £820 billion. Total expenditure in 2020–21 was around £999 billion.

Government spending can be divided into different categories. The three main types of government expenditure include spending on health, education, defence and social protection (public services); transfer payments; and debt interest.

Income and expenditure refer to the ways in which governments make money and spend it. 

Expenditure includes spending on capital expenditure and current expenditure. Capital expenditure involves government spending on fixed, or existing, assets like schools, hospitals, roads, bridges, etc. Current expenditure includes spending on goods and services that are consumed over a shorter period of time. This could include salaries of public sector teachers, doctors or heating costs of hospitals.

They are opposites. Government revenue is the money that a government receives (for example from taxes), while expenditure is the money a government spends (for example on public goods like education and healthcare).

Final Government Income and Expenditure Quiz

Question

What are the two main reasons for government spending and taxation?

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Answer

Allocation and distribution of wealth.

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What is the primary reason governments collect taxes?

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To finance government spending.

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What are the main sources of government revenue?

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Direct and indirect taxes.

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Who argued for the principles of taxation?

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Adam Smith.

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Taxation should be:

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All of the above answers are correct

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Which criteria should the 'ideal' tax meet?

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Equitable, efficient, economical, flexible, convenient and certain.

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How does taxation impact the distribution of income?

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Certain types of taxation (i.e. progressive taxes) can have a positive and more equitable impact on the distribution of income in society.

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How does taxation impact consumption?

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Taxes like excise duties can influence the consumption of certain goods that are deemed to be harmful to health and/or the environment. For example, demerit goods are taxed heavily in order to disincentivize their consumption.

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What is public expenditure?

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Public expenditure is an important tool that governments can use to achieve economic objectives.

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What are the three types of public expenditure?

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The three main types of government expenditure include spending on health, education, defense and social protection (public services); transfer payments; and debt interest.

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What is capital expenditure?

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Capital expenditure involves government spending on fixed, or existing, assets like schools, hospitals, roads, bridges, etc.

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What is current expenditure?

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Current expenditure includes spending on goods and services that are consumed over a shorter period of time. This could include salaries of public sector teachers, doctors or heating costs of hospitals.

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What are transfer payments?

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Transfer payments are payments for which no goods or services are traded in return. Instead, they are just a transfer of money like unemployment benefits, disability support, state pensions or social security payments.

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What is the national debt?

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The accumulation of yearly budget deficits.

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What is a budget deficit?

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A budget deficit comes from the difference between government revenue from taxes and government spending on public services. When public expenditure is higher than tax revenue, the government is running a budget deficit.

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What is government spending?

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A public sector spending on goods and services like education or healthcare.

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Name one factor that can influence the levels of government spending.

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The country's population.

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How can a country's population impact government spending?

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A country with a large population will have higher levels of government spending, compared with a smaller country.

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Outline how fiscal policy measures can impact government spending.

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During a recession, the government may pursue an expansionary fiscal policy. This would allow for an increase in the levels of government spending to boost aggregate demand and close a negative output gap. During these periods the level of government spending is higher than during periods of economic contraction.

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How can an increase in transfer payments impact poverty in a country?

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Spending on unemployment benefits, state pension, or disability support helps those that are unable to work or to find work. This is a form of redistribution of income, which can help reduce absolute poverty in the country.

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Describe how providing certain goods and services for free can impact the macroeconomy.

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Publicly funded services like education and healthcare are accessible for free in most countries. This allows for everyone to access these services, including those who would otherwise not be able to access them. This helps reduce the impacts of poverty. By providing these goods and services to everyone, the government is indirectly investing in the economy's human capital, which can increase productivity in the economy.

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How can progressive taxation influence poverty?

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It can reduce poverty levels by attempting to close the gap between low and high-income earners, as high-income earners pay progressively more taxes than low-income earners. 

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What is a budget deficit?

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A budget deficit occurs when current expenses are higher than current income received through standard operations.

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What is a budget surplus?

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A   budget surplus occurs when current expenses are lower than the current income received through standard operations.

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What happens when the government is running numerous budget deficits?

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If the government is running numerous budget deficits, it will have to increase borrowing even further to finance its activities. This further contributes to increasing the national debt.

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Define debt interest.

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The interest payments the government has to make on the money it previously borrowed.

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How can a budget surplus be achieved?

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By decreasing government spending and/or increasing taxation.

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How can higher taxation influence household debt?

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Higher taxation can lead to higher household debt if households are forced to borrow to finance their consumption. This leads to lower levels of spending and individual saving in the economy, as consumers are focused on paying off their debt.

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What are the two main rule-based fiscal policies in the UK?

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The deficit rule and the debt rule.

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Describe the UK government's implementation of the golden rule.

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The golden rule follows the idea that the public sector should only borrow to fund capital investments (like infrastructure) that encourage future growth. In the meantime, it cannot increase borrowing to fund current spending. As a result, the government has to maintain the current budget position in a surplus or a balance.

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Define taxation.

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Taxation is when a government imposes a compulsory levy on its residents and citizens to pay for its activities.

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What is taxation used for?

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Funding public expenditure and the redistribution of income in society.

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What is direct taxation?


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Direct taxes are taxes imposed on income and wealth.

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Name two types of direct taxes.


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Income tax and corporate tax.

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Which of the following is not a direct tax?


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Value-added tax

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What is corporate tax?

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They are taxes companies pay on their earned profits.

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What is indirect tax?


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A tax imposed by the government on spending.

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What is the current VAT rate in the UK?


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20%

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What is excise duty?

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Excise duty is a form of tax paid on certain goods that the government considers harmful for consumption or the environment.

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Name an example of a good excise duty to be charged upon.


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Tobacco.

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What is a progressive tax system and what are its consequences?


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A system in which higher tax rates are imposed on higher-income earners. This means that higher earners take on more of the tax burden.

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What is a regressive tax system?


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Regressive taxation takes a larger percentage of income from lower earners than from higher earners, meaning lower-income earners take on more of the tax burden.

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Describe the proportional taxation system.

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It is a system in which the same percentage of tax is levied on everyone's earnings no matter their income.

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What is a flat rate?


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It is a certain percentage that is levied as a tax to all earners in a proportional taxation system.

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A government can address poverty by ___________

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Increasing spending on transfer payments

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A budget deficit occurs when the current expenses are ___________ than the current income received through standard operations.

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higher

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A budget surplus occurs when the current expenses are lower than the current income received through standard operations.

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True

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The main concern of a budget deficit is ___________


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demand-pull inflation

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A government can achieve a budget surplus by decreasing government spending as a result of budget cuts in the public sector.


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True

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Higher taxation can lead to ___________


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household debt

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