Government Income and Expenditure

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:

• 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.

Figure 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. Distribution of income: public expenditure is used to influence the distribution of income and create a more equitable society.

3. 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.

4. 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.

5. 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.

6. 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, 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.

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.