Public expenditure is an important tool that governments can use to achieve their economic objectives. Government spending includes the expenses of national or local governments and is often used to fund national services like health, infrastructure, welfare benefits, or security. Government spending is especially important for fiscal policy and goes hand-in-hand with taxation. Taxation raises government revenue, which is then used to finance public expenditure. This process provides the basis for fiscal policy.
Factors that affect government spending
There are numerous factors that may affect the level of government spending. Some key factors that impact how much the government spends include:
The country's population
A country with a large population will have higher government spending levels than a smaller country. Additionally, the structure of a country's population can impact government spending. For example, an aging population implies that there are more people claiming state-funded pensions. Older people also have a higher demand for healthcare services, which the government funds.
Fiscal policy measures
Governments can use fiscal policy measures to address some economic problems.
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 reduce a negative output gap. During these periods the level of government spending is generally higher than during periods of economic contraction.
Other government policies
Governments may also impose various policies to encourage income equality and income redistribution.
The government might spend more on welfare benefits to redistribute income in society.
What are some types of government spending to address the poverty level?
Governments often use fiscal policy to reduce the poverty level. A government can address poverty in several ways.
Increasing spending on transfer payments
Spending on unemployment benefits, state pension, or disability support helps those who are unable to work or to find work. This is a form of income redistribution, which can help reduce absolute poverty in the country.
A transfer payment is a payment for which no goods or services are provided in return.
Providing goods and services for free
Publicly funded services like education and healthcare are accessible for free in most countries. This makes them accessible for everyone, particularly those who would otherwise not be able to access them. Providing these services for free helps reduce the impacts of poverty. This way, the government is indirectly investing in the economy's human capital, which can increase productivity in the economy in the future.
Educated and skilled workers may find jobs more easily, reducing unemployment and increasing overall productivity in the economy.
Progressive taxation
This form of taxation allows for the redistribution of income in society by reducing income inequality. The government may 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. The government can also use the tax revenue received to fund welfare payments.
For further insight into how the progressive taxation system is used in the UK, check out our explanations on Taxation.
Increase and decrease in government spending
Every national government receives income (from taxation and other sources) and spends on public services. The way these sources of revenue and expenditure are managed can cause budget deficits and surpluses in a given period. If these accumulate over time, there are many possible consequences.
A budget deficit occurs when the current expenses are higher than the current income received through standard operations.
A budget surplus occurs when the current expenses are lower than the current income received through standard operations.
Problems of a budget deficit
Running a budget deficit has numerous impacts on macroeconomic activity. Firstly, additional borrowing leads to an increase in public sector debt.
The national debt is the accumulation of budget deficits in the long term over multiple periods.
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.
Another main concern of a budget deficit is demand-pull inflation due to the increase in the money supply caused by increased borrowing. This means that there is more money in the economy than what can be matched by the national output.
Additionally, increasing borrowing leads to higher levels of debt interest payments. Debt interest can be defined as the interest payments the government has to make on the money it previously borrowed. In other words, it is the cost of servicing the national debt which needs to be paid at regular time intervals. As the government runs a deficit and borrows even more causing an increase in already accumulated debt, the amount of interest paid on borrowings rises.
Similarly, interest rates on government borrowing are also likely to rise, as the government has to attract new lenders. One method of attracting new lenders is by offering higher interest rate payments on the amount borrowed. Higher interest rates can discourage investment and make the national currency appreciate (rise in value). This is problematic as it may lead to less competitive exports, harming the country's balance of payments.
As a reminder, take a look at StudySmarter's explanations on exchange rates and the balance of payments.
Problems of budget surplus
Although running a budget surplus might sound ideal as the government has more financial resources to spend on public services, it can actually lead to various problems. To achieve a budget surplus, government spending, government revenue, or both, have to be manipulated.
A government can achieve a budget surplus by decreasing government spending as a result of budget cuts in the public sector. However, this will only occur if government revenue is higher. This means that the government will have to decrease investment in certain areas of the public sector like housing, education, or health while increasing taxation. Lower investment in public services can have a negative impact on the future productivity and efficiency of the economy.
Government revenues can increase due to higher taxation on household income, excise duties, and corporation taxes, or higher human capital employment levels in the economy. This can have several impacts, like decreased disposable income in the case of individuals, or lower profits to use for investment in the case of businesses.
If higher tax rates are levied on individuals’ income, a larger percentage of that income is spent on taxes. This reduces their disposable income and thus their ability to spend more on other goods and services.
Higher taxation can also 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.
Finally, a strong fiscal position, like a budget surplus, can be the result of sustained economic growth. However, the opposite may also take place. If the government is forced to increase taxation and decrease public expenditure to achieve a budget surplus, low levels of economic growth may occur due to the policy's effects of suppressing aggregate demand.
Review of government spending
Recent rule-based fiscal policy in the UK can be broken down into two specific types:
- The deficit rule aims to get rid of the structural part of the budget deficit.
- The debt rule aims to make sure that debt is decreasing as a certain share of the GDP.
Governments can use fiscal rules to avoid overspending. An example of a fiscal rule is the UK government's implementation of the golden rule.
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 must maintain the current budget position in a surplus or a balance.
These types of fiscal rules prevent governments from overspending when attempting to encourage growth. Overspending can lead to high levels of inflation and increasing national debt. As a result, fiscal rules help governments maintain economic and inflationary stability.
They can also increase consumer and firms' confidence in the economic environment. Economic stability might encourage firms to invest more, as they perceive the economic environment to be promising. Similarly, consumers might be encouraged to spend more, as their fears of inflation decrease.
Government Spending - Key takeaways
- Public expenditure is an important tool that governments can use to achieve their economic objectives.
- Some key factors that impact how much the government spends include:
- The country's population
- Fiscal policy measures
- Policy measures to redistribute income
- Governments often use fiscal policy to reduce the poverty levels. Addressing poverty in a country can be done by:
- Increasing government spending on transfer payments
- Providing goods and services for free
- Progressive taxation
- A budget deficit implies that government revenues are lower than government spending.
- A budget surplus implies that government revenues are higher than government spending.
- Some problems associated with running a budget deficit include demand-pull inflation, an increase in public sector debt, debt interest payments, and higher interest rates.
- Some problems associated with a budget surplus include high taxation, higher household debt, and lower economic growth.
- Governments can use fiscal rules in order to avoid overspending.
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