Understand the major components of government spending and sources of government revenues.

2. Define the terms budget surplus, budget deficit, balanced budget, and national debt.

Fiscal policy refers to the government’s efforts to keep the economy stable by increasing or decreasing taxes and government spending. High tax rates slow the economy because they take money out of the private sector and put it into the hands of government. They also discourage small businesses by decreasing profit margins. But high taxes also mean that more money is available in the budget to spend on education, health, defense, highways and social programs. In practice, most governments spend more than they collect in taxes, creating a national debt. Reducing this deficit is politically unpopular as it involves cutting public spending.

Types of taxes

In most economies government revenues come mainly from direct taxes on personal incomes and company profits (corporate taxes) as well as indirect taxes levied on purchase of goods and services. The examples of indirect taxes are value added tax (VAT) and sales tax sometimes called excise duties.

The composition of government revenues differs from country to country. Some governments take a larger share, others a smaller share. For example, in the United Kingdom the government takes nearly 40 percent of national income in taxes.

The most widely used progressive tax structure is the one in which the average tax rate rises with a person’s income level. As a result of progressive tax and transfer system most is taken from the rich and most is given to the poor. Sales tax is an example ofa regressive tax added to the price of goods at the time they are sold because this tax takes a higher percentage of a low income and a lower percentage of high income.

Higher tax rates initially increase tax revenue but eventually result in such large falls in the equilibrium quantity of the taxed commodity that revenue starts to fall again. High tax rates are believed to reduce the incentive to work. If half of all we earn goes to the government, we may prefer to work fewer hours a week and spend more time going out or watching television. This phenomenon is demonstrated by the Laffer curve. The Laffer Curve is a theory developed by supply-side economist Arthur Laffer to show the relationship between tax rates and the amount of tax revenue collected by governments. The curve is used to illustrate Laffer’s argument that sometimes cutting tax rates can increase total tax revenue and is favorable for businesses and production.

 

Cuts in tax rates will usually reduce the tax burden and reduce the amount of taxes raised but might increase eventual revenue. If governments wish to reduce the tax burden and balance spending and revenue, they can reduce government spending and cut taxes.

Taxes affect the relationship between real GDP and personal disposable income; they therefore affect consumption. They also influence investment decisions. Taxes imposed on firms affect the profitability of investment decisions and therefore affect the levels of investment firms will choose. Income taxes have an impact on employment and on the real wages earned by workers.

The bulk of tax revenues come from the personal income tax. State and local tax revenues are dominated by property taxes and sales taxes. The federal government, as well as local governments, also collects taxes imposed on business firms, such as taxes on corporate profits.

Government spending

Most government spending is financed by tax revenue. Some small component of government spending is financed through government borrowing. Government spending comprises spending on goods and services and transfer payments.

To understand government spending, we have to distinguish private goods and public goods. A private good, if consumed by one person, cannot be consumed by others. For example, a bar of chocolate is a private good. If you eat it, nobody else can eat that particular bar of chocolate. Most of the goods produced in the economy are private goods. A public good, if consumed by one person, can be consumed by others in exactly the same quantities. Governments mostly pay for public goods, i.e. the goods that would not be provided by a free market. Traffic lights, lighthouses and national defense are examples of public goods. The consumption of a public good by one does not reduce the consumption of it by someone else. Governments also provide such public goods as police, fire-fighting, courts of law, etc.

In addition to public goods, government spending includes various transfer payments. A transfer is a payment, usually by the government, for which no corresponding service is provided in return. Examples are social security, retirement pensions, unemployment benefits and, in some countries, food stamps, given to the poor to buy food. Transfer payments do not reduce society’s resources. They transfer purchasing power from one group of consumers, who pay taxes, to another group of consumers, who receive transfer payments.