Government spending otherwise known as public expenditure helps governments in the production as well as the purchase of goods and services that are needed to fulfill the social and economic objectives of the government.
Governments around the world depend on the private sector to produce and manage the goods and services of the country as well as utilize their private partnerships to finance, build, design, and operate the projects of infrastructure.
A government spending and taxation policy to achieve macroeconomic goals is known as fiscal policy. Government expenditure is an important component of fiscal policy and works alongside taxation. This is because taxation boosts government revenue which the government uses to finance public expenditure. This means that over time, taxation has greatly increased government spending. It is this process that provides the basis for fiscal policy. Increased government spending to fight recessions is an expansionary fiscal policy.
The total change in aggregate spending generated by increased government spending is dependent upon the marginal propensity to consume. Therefore, a fiscal policy is when the government uses government spending and taxes to affect economic performance. This involves an increase or decrease in taxes or government spending in an effort to achieve economic stability.
When government spending increases and taxes are increased by an equal amount, interest rates tend to be stable.
In order to validate spending, the government spending bill is being passed. This bill is an appropriation as well as a proposed law authorizing the expenditure of government funds. Government spending as a percentage of GDP can either increase or decrease depending on the economic objectives, that is whether to increase or reduce economic activities. Therefore, discretionary government spending is public expenditure implemented through an appropriations bill.
Government spending definition
Government spending means the money that the public sector spends on the acquisition of goods as well as the provision of services such as social protection, education, healthcare, and defense. In the national income accounting, when the government acquires goods and services for current use in order to directly satisfy the community’s collective needs and requirements, we classify this as a government final consumption spending. On the other hand, if the government acquires goods and services for future purposes, we classify it as government investment. This encompasses public consumption and public investment as well as transfer payments that consist of income transfers.
As earlier pointed out, federal government spending is an important tool that governments can use in achieving their economic objectives. It has to do with the expenses of national or local governments and governments usually use it to fund national services such as health infrastructure, welfare benefits, or security. Changes in government spending and/or taxes as the result of the legislation are called discretionary fiscal policy. Government spending on social programs cut and income taxes lowered are critical in boosting an economy.
Every country has its government spending breakdown which shows detailed information with regard to the expenditure.
Before the 1994 midterm elections, issues of taxes and government spending on social programs were points of disagreement between democrats and republicans. This is because there is extreme dissatisfaction in the hearts of the American citizens with the governance of president Bill Clinton. Also, as a result of the cuts president ford made to government spending, unemployment increased.
President Reagan’s policies affected government spending by causing it to drop. His aim was to curb the ongoing recession. His philosophy was that the government was not the solution to the problem but rather the problem itself.
Sources of government spending
- Tax collections by the government
- Government borrowing
Tax collections by the government
Tax collections by the government involve direct and indirect taxes. Through these compulsory contributions levied, the government generates revenue to finance its projects.
Primarily, the government funds its spending through the revenues it earns from taxes. However, when this revenue becomes insufficient to fund those expenditures, it will resort to borrowing. It can borrow money from its own citizens or from other countries. This borrowing can be short-term or long-term and has to do with selling government bonds/bills. The government can issue Treasury bills in the money market to help in raising short-term funds. When the government borrows money, the transfer takes place from the lender to the government. This implies that the lender is exchanging his funds for government securities. The effect of this is that it reduces the lender’s liquidity, that is his command over cash, and this to an extent depends on the nature of the securities.
Reasons for government spending
- Economic welfare
- Provision of public and merit goods and services
- Reduce unemployment
- Reduction in crime wave
- Macroeconomic improvements
One of the reasons for government spending is to ensure the social and economic welfare of the citizens thereby improving the standard of living of its people. Social welfare is important for any economy as it is a sign that the economy is healthy.
The government spends in order to ensure the security of properties. Through the provision of social services such as defense, law, and order, fire service, etc, the government helps in protecting the life and property of its people.
To provide public goods
It is very expensive for the private sector to produce public and merit goods and services. This, therefore, becomes the responsibility of the government to make provision for these goods and services so that the gap between the rich and the poor can be bridged. In other words, the aim of government spending is to supply those goods and services that the private sector cannot supply such as roads, bridges, defense, schools, hospitals, and welfare payments such as unemployment benefits.
The government spends on some economic activities in order to reduce the rate of unemployment.
Reduction in crime wave
Another aim of public expenditure is to ensure that there is a reduction in the crime wave, that is to reduce the level of crime in the economy. With this, there will be social stability as well as economic growth and development.
The government incurs expenses in order to make provision for subsidies to industries that are in need of financial support for their operations as well as expansion. Oftentimes, the private sector is unable to meet the financial requirements, in this case, the public sector will play a critical role in lending necessary support. For example, the projects of transport infrastructure do not attract private finance unless the government spends on the industry.
The government spends to improve the supply side of the macroeconomy such as spending on education and labor for the improvement of labor productivity.
Types of government spending
- Current spending
- Capital spending
Current spending is short-term spending that takes place in the fiscal period in which the expense is incurred. They are for the short term and examples are wages, salaries, costs of raw materials, and administrative expenses.
This government spending lasts for a long term and does not need annual renewal. It has to do with spending on physical assets such as roads, bridges, hospitals, and equipment.
Factors affecting public expenditure
- The country’s population
- Fiscal policy measures
- Other government policies
- Increased spending on transfer payments
- Free provision of goods and services
- Progressive taxation
The above-mentioned are some of the factors that affect government spending. They are explained below;
The country’s population
The larger the population of a country, the higher will be the government levels. Also, a country’s population structure can have an impact on government spending. For example, a country with an aging population implies that more people are claiming pensions funded by the state. Also, older people have a higher demand for healthcare services which is funded by the government.
Fiscal policy measures
Governments make use of fiscal policy measures to address certain economic problems. During a recession, the government pursues an expansionary fiscal policy that has to do with tax cuts or an increase in government spending with the aim of boosting aggregate demand as well as reducing a negative output gap. In such periods, the level of government spending is generally higher than the contrary.
Other government policies
There are various policies that the government imposes in order to encourage income equality and redistribution. This may imply spending more on welfare benefits to redistribute income in society. Governments may as well impose various policies in order to encourage income equality and income redistribution among the people.
Increased spending on transfer payments
When the government spends on unemployment benefits, pensions, or disability supports, it is helpful to those who are not able to find work or not able to work. This forms a part of income redistribution which is helpful in reducing absolute poverty in the country. A transfer payment implies payments that are made for which no goods and services are provided in return.
Free provision of goods and services
In most countries, publicly funded services such as education and healthcare services are accessible. With this, those who initially could not access these services will now be able to. When they are being provided, the impact of poverty decreases. With this, the government is indirectly investing in the human capital of the economy. In turn, this will bring about an increase in the future productivity of an economy. This may make it easier for educated and skilled workers to find jobs more easily thereby reducing unemployment and increasing the overall productivity of the economy.
This is a form of taxation that allows a country to redistribute income in society by reducing income inequality. With this, there will be reductions in poverty levels through attempts to close the gap between low and high-income earners. This works as high-income earners progressively pay more taxes than low-income earners. It is from the tax revenue that the government funds welfare payments.
Demanding integrity in public expenditure
Integrity is important in government spending as this helps an economy to grow and develop. The aim of integrity policies is to prevent corruption and foster high standards of behavior. This helps in the reinforcement of the credibility and legitimacy of those that participate in policy decision-making. With this, public interests are being safeguarded thereby restoring confidence in the process of making policies.
Government spending by presidents demands high moral standards as integrity is a crucial factor that determines trust. Evidence brings about a suggestion of a link between trust in politicians both from the business community and citizens as well as the perception of corruption.
It is requested that government spending should be carried out with high moral standards and integrity and that embezzlement of funds is absent. There should be effective management of conflicts of interest, high behavioral standards in the public sector, adequate lobbying, and political finance regulation.
This factor is also important in reducing the likelihood of wasteful government spending where funds are being channeled wrongly. Wasteful government spending examples include fraud and duplicative programs.
Effect of increase and decrease in public expenditure
An increase in government spending will cause an increase in aggregate demand in an economy. Furthermore, an increase in government spending is likely to cause a hike in prices, leading to inflation. This shows a relationship between inflation and government spending. On the other hand, a decrease in government spending will cause aggregate demand to decrease. A reduction in government spending usually pushes interest rates lower and decreases the velocity of money. To explain further, An increase in government spending initially and primarily shifts the aggregate demand curve to the right which signifies an increase in aggregate demand. In the short run, the increase in government spending on infrastructure causes the price level to rise, and there will be higher growth.
On the supply side of the economy, higher government spending will have an impact and this depends on the area in which the government increases its spending. An increase in government spending on goods to build or repair infrastructure can bring about an increase in productivity as well as a growth in the long-run aggregate supply. Government spending on healthcare or welfare benefits may reduce inequality. However, it can crowd out more productive private sector investment. In other words, crowding out implies that the government spends more while the private sector spending reduces as a result. For instance, if the government borrows funds from the private sector, the private sector will be left with lower savings for private investment.
Some capitalists have argued that government spending has a significant potential of being more inefficient than private-sector spending. In the government sector, the problems of poor information and lack of incentives may be in place which in turn will bring about misallocation of resources.
Budget deficits and surpluses
As earlier pointed out, national governments receive their income from taxation and other sources and spend it on public services. The manner in which they manage these sources of revenue and expenditure can bring about budget deficits and surpluses over a given period of time. When these accumulate, there will be so many possible consequences.
Budget deficit and its impact
A budget deficit occurs when current government expenditure exceeds the current income received through standard operations. This has several impacts on a nation’s macroeconomic activities.
First of all, additional borrowing brings about an increase in public sector debt. The national debt implies the accumulation of budget deficits in the long term over multiple periods of time. If a country is in several deficits, then it will always lead to increased borrowing in order to finance its activities. This in turn will further increase the national debt.
Another major concern that is associated with a budget deficit is demand-pull inflation which results from the money supply that comes about due to increased borrowing. This implies that more money is in the economy than what can be matched by the national output.
Another impact is that an increase in borrowing brings about higher levels of debt interest payments. Debt interest means the payments that the government must make on the money it borrowed in the past. In other words, it means the cost of servicing the national debt which the government needs to pay at regular time intervals. As earlier stated, when a nation runs a deficit, its government borrows even more thereby increasing already accumulated debt. This further leads to an increase in the amount of interest paid on borrowings.
Similarly, there is a likelihood for the interest rates on government borrowing to rise because the government has to attract new lenders. Offering higher interest rates on borrowings is one method of attracting new lenders. Higher interest rates are bound to discourage investment as well as make the national currency appreciate. This may lead to less competitive exports which are harmful to a country’s balance of payments.
Budget surplus and its impact
A budget surplus comes in place when the current government expenditure is lower than the income received through standard operations. When tax revenue is greater than government spending which includes government purchases and transfer payments, there is a budget surplus. This economic condition may sound ideal because the government has more financial resources to spend on public services. However, it can lead to various problems. To achieve a budget surplus, there has to be a manipulation of government spending, government revenue, or both.
It is possible for a government to achieve a budget surplus by decreasing government spending through budget cuts in the public sector. However, this can only happen if government revenue is higher. By implication, the government has to reduce investment in certain areas of the public sector such as housing, education, healthcare, etc, while increasing taxation. Lower investment in public services can negatively impact an economy’s future productivity and efficiency.
While government revenue can increase due to higher taxation, disposable income and purchasing power on the other hand will decrease. Also, higher taxation can lead to higher household debt as this forces households to borrow so they can finance their consumption. With this, there will be lower levels of spending and individual saving in the economy because the focus of consumers is being diverted to paying off their debts.
A government can pursue a balanced budget in order to avoid the drawbacks of the budget deficit and surplus. A balanced budget means that government spending and taxes are equal.
Government spending multiplier
The government spending multiplier refers to the theory that government spending intending to stimulate the economy brings about an increase in private spending that additionally stimulates the economy. The theory in essence is that government spending provides additional income to households thereby leading to an increase in consumer spending.
In other words, it is the ratio of change in income to a change in government spending, symbolised by kG.
KG = ∆Y/∆G and ∆Y = KG. ∆G
We can say that an increase in government spending generates expansions of income. The level of income that would expand is dependent on the value of marginal propensity to consume (MPC) or marginal propensity to save (MPS).
Government spending multiplier formula
The government spending multiplier is expressed in a formula as;
KG = 1/1-MPC = 1/MPS
The above formula describes how to calculate the minimum change in government spending.
Does government spending cause inflation?
Whether government spending causes inflation is dependent upon the state of the economy as of the period in which the expenditure is taking place. An increase in government spending can cause a hike in prices that if left uncontrolled, can cause inflation.
What is the reasoning behind the multiplying effect of government spending?
The reasoning behind the multiplying effect of government spending is a relationship proposed in which government spending will bring about more growth in the economy than the amount of money that the government has spent.
How does government spending affect aggregate demand?
Government spending boosts aggregate demand in an economy thereby stimulating economic growth.
How does government spending affect the economy?
government spending influences the economy by increasing aggregate demand which in turn stimulates economic growth. Also in the economy, the effect of federal government spending on the national unemployment rate is that it reduces the natural unemployment rate. An increase in investment and government spending can be expected to shift the aggregate demand curve rightward. Through this, economic activities increase in a country.
Does government spending increase GDP?
As emphasized, an increase in government spending brings about an increase in aggregate demand. This in turn increases the real GDP which then results in a rise in prices.
What is the long-run effect of a permanent increase in government spending?
The long-run effect of a permanent increase in government spending is that the risk-free interest rate reduces. Also, the capital-labor ratio, productivity, and wages may reduce.
How do automatic stabilizers impact tax revenue and government spending during a recession?
During a recession, automatic stabilizers bring about a decrease in taxes and an increase in government spending.
Explain how government spending can trigger a chain of events that helps to improve the economy.
When the government spends or invests in businesses, schools, projects, transportation, etc., aggregate demand increases in an economy which in turn brings about economic growth. More jobs are then available for the people. It is an aspect of expansionary fiscal policy that the government adopts when the economy is in a recession.