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.

Figure 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.

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:

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

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. Public Service Expenditure 2021–22, StudySmarter Originals. Source: gov.uk

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

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.

Government income and expenditure: the national budget

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.

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.