Public Expenditure and Fiscal Policy (Edexcel A-Level Economics A): Revision Notes

Public Expenditure and Fiscal Policy

Introduction to fiscal policy

Fiscal policy refers to the range of government decisions concerning public spending, taxation, and borrowing. It is one of the main policy tools available to governments to influence the macroeconomy and achieve key objectives such as economic growth, low inflation, and reduced inequality.

The effectiveness of fiscal policy depends on the overall economic environment in which it operates. It works alongside monetary policy (controlled by the Bank of England) and supply-side policies to influence economic performance.

Types of public expenditure

Governments undertake spending in several key areas, each serving different purposes:

Current expenditure

Government consumption expenditure (also called current or revenue expenditure) represents day-to-day spending on goods and services. This includes:

• Salaries and wages for public sector workers such as teachers, nurses, and civil servants
• Running costs of public services
• Spending on education and healthcare

Capital expenditure

Government capital expenditure involves spending on infrastructure and long-term projects that will benefit the economy in the future. Examples include:

• Building roads and transport networks
• Constructing hospitals and schools
• Investing in public facilities

Capital spending creates assets that can improve productivity and economic growth over many years.

Transfer payments

Transfer payments are payments made to provide protection for vulnerable households. These may be:

• Universal - paid to everyone (such as child benefit)
• Means-tested - paid only to those on low incomes

Transfer payments can take the form of cash benefits or payments in kind (such as free education or healthcare provision). They redistribute income within society without directly purchasing goods or services.

The changing size and composition of public expenditure

Trends in UK government spending

Government spending as a proportion of GDP has fluctuated significantly over time in the UK. During the 1980s under Conservative governments, there was a gradual downward trend as the public sector reduced its share of the economy. This trend halted after Labour came to power in 1997, and following the 2010 coalition government, the downward trend resumed until spending began to increase again around 2019.

International comparisons

The role of government varies considerably between countries. Denmark, Sweden, and Greece have relatively high government consumption expenditure (over 25% of GDP), reflecting the greater role that government plays in providing services such as education and healthcare. In contrast, countries like Switzerland and the USA have much lower government consumption (around 15% of GDP or less), with the private sector taking a greater role, often through insurance markets.

Factors driving changes in public expenditure

Several factors have influenced the size and composition of public expenditure over time:

Demographic changes: Many developed countries have experienced ageing populations and increased life expectancy. This has resulted in:

• Higher dependency rates
• Greater demand on healthcare systems (such as the NHS in the UK)
• Increased pension obligations

Rising expectations: Even before the COVID-19 pandemic, the NHS was under pressure due to the development of new treatments, which raised public expectations about the standard of healthcare that should be provided.

Technological changes: Advances in technology have created demands for investment in infrastructure such as improved equipment in schools and colleges.

The significance of high public expenditure

Why does it matter if government expenditure is high relative to GDP? There are important considerations on both sides of this debate.

Crowding out

If the economy is operating at full employment, then an increase in the size of the public sector can only occur at the expense of the private sector. This happens through two main channels:

This process is known as crowding out - where increased government expenditure 'crowds out' private sector activity by raising the cost of borrowing.

Productivity concerns

A second consideration relates to the relative efficiency of public versus private sectors. The public sector does not need to maximise profits or face competition, so the incentives to become efficient may not be as strong as in the private sector. This suggests that the public sector may be less efficient in its use of resources than private enterprise.

A switch in the balance of activity towards the public sector may therefore reduce the overall level of productivity in the economy. However, this argument has been contested, and the evidence is not conclusive.

National debt

An increase in the stock of public sector debt means an increase in future interest payments on that debt. This means that resources that could have been devoted to spending on public services must instead be used for repaying debt. High levels of national debt can become a burden on future generations who must service this debt through taxation.

The upside

Despite these criticisms, it is important to remember that there may also be benefits to government expenditure:

Infrastructure investment: If spending is on projects that improve the country's infrastructure, then this will promote efficiency and economic growth in the longer term. Improved transport and communication links can reduce vital parts of the costs faced by firms.

Human capital: Similarly, spending on healthcare and education has beneficial effects not only on the standard of living but also on productivity. It may improve the distribution of income and welfare, thus reducing inequality.

Taxation

Public expenditure must be financed in some way. The revenue side of government finances is just as significant as the expenditure side. Taxation serves multiple purposes:

• Financing government expenditure
• Acting as a weapon against market failure
• Influencing the distribution of income

The choice between using direct or indirect taxes has important implications for these objectives.

Direct and indirect taxes

Direct taxes are taxes levied on income of various kinds, including:

• Personal income tax
• Corporation tax
• Capital gains tax

Direct taxes are designed to be progressive - they can be effective in redistributing income. For example, a higher income tax rate can be charged to those earning high incomes, taking a larger proportion of income from the wealthy.

Indirect taxes are taxes on expenditure, such as:

• Value Added Tax (VAT)
• Excise duties on specific goods (petrol, alcohol, tobacco)

The effects of changes in taxes

Incentive effects

When Margaret Thatcher came to power in 1979, one of her first actions was to introduce a switch away from direct taxation towards indirect taxes.

VAT was increased and the rate of personal income tax was reduced. The argument was that if an income tax scheme becomes too progressive, it can provide a disincentive towards work effort. If people feel that a high proportion of their income is being taken in tax, their incentives to provide work effort are weak.

Taxes and inequality

Perhaps the most important effect of a direct tax such as income tax is that it redistributes income from those on relatively high incomes to those on lower incomes. This occurs when the revenue raised is used to benefit lower-income groups through the provision of education and healthcare, or through social security payments for those in need.

Foreign direct investment

The relative level of corporation tax in the domestic economy compared with elsewhere may influence the direction of flows of foreign direct investment (FDI). Transnational companies may be looking to minimise their tax liabilities when deciding where to locate their investment.

Having a high rate of corporation tax may deter foreign firms from investing in the domestic economy, or encourage domestic firms to invest elsewhere. Many transnational companies have been able to negotiate tax holidays, leaving them free of taxation for a period after they bring in their investment.

Real output, employment and the balance of trade

High taxation may influence aggregate demand by reducing the disposable income of consumers. This could benefit the current account of the balance of payments by reducing the demand for imports. However, the potential multiplier effects of a reduction in income may result in lower real output and employment. This is a costly way of tackling a current account deficit.

The rate of indirect taxes such as VAT can also have an impact on the economy. When the UK economy faced recession in 2008, one of the steps taken to mitigate its effects was to reduce the rate of VAT (albeit temporarily). Steps were also taken to reduce the burden of VAT payments on the hospitality sector during the COVID-19 pandemic.

Tax revenue and the Laffer curve

Does an increase in the tax rate necessarily lead to a rise in tax revenue? Arthur Laffer argued that the answer to this was 'no'.

Laffer pointed out that changes in tax rates have two effects on tax revenue:

1. The arithmetic effect: An increase in the tax rate will increase the tax revenue
2. The economic effect: As tax rates rise, incentive effects come into play, tending to work against the arithmetic effect, as people have less incentive to supply labour at higher tax rates

Public sector finances

In terms of the impact that fiscal policy can have on aggregate demand, both expenditure and revenue are important. The key measure is the difference between them - the government budget deficit (or surplus).

Key definitions

Government budget deficit (surplus): The difference between government expenditure and government revenue. A deficit occurs when expenditure exceeds revenue.

Fiscal deficit: Occurs when government outlays exceed government receipts. This happens when the revenues raised through taxation are not sufficient to cover the government's various types of expenditure.

National debt: The total amount of government debt, based on accumulated previous deficits and surpluses. It represents the stock of accumulated past borrowing.

Cyclical deficit: A budget deficit that occurs during the downturn of the business cycle, but disappears in the upturn.

Structural deficit: A deficit that persists even when the economy is at full employment.

A fiscal deficit and the national debt

The way in which fiscal policy is conducted has implications for the overall size of the public sector in the economy. Traditionally, fiscal policy was used to affect the level of aggregate demand in the economy, influenced by Keynesian thinking.

The overall balance between government receipts and outlays affects the position of the aggregate demand curve, which is reinforced by multiplier effects. When government outlays exceed government receipts, the result is a fiscal deficit. The national debt is the accumulation of past borrowing resulting from these deficits.

Structural and cyclical deficits

Notice that as the economy goes through a business cycle, the deficit will tend to fluctuate:

This cyclical element to the size of the deficit is known as a cyclical deficit, which fades away as the economy returns to its trend.

The fiscal deficit and fiscal policy

The overall size of the fiscal deficit may act as a constraint on the government's actions in terms of fiscal policy. In addition, the overall pattern of revenue and expenditure has a strong effect on the overall balance of activity in the economy.

A neutral government budget can be attained either with:

• High expenditure and high revenues, or
• Relatively low expenditure and low revenues

Such decisions affect the overall size of the public sector relative to the private sector. Over the years, different governments in the UK have taken different positions on this issue, and different countries throughout the world have adopted different approaches.

Aggregate demand and supply and the government budget deficit

An important question concerns the extent to which a government budget deficit can be used to stabilise the macroeconomy by influencing aggregate demand.

The AD/AS model revisited

To analyse the impact of public expenditure on aggregate demand, we return to the model of aggregate supply and aggregate demand (AS/AD).

A shift in aggregate demand from $AD_0$ to $AD_1$ results in an increase in both real output and the price level as the economy moves to a new equilibrium - a movement along the short-run aggregate supply curve (SRAS). However, the SRAS is called a 'short-run' aggregate supply curve for a reason, and there is no guarantee that the equilibrium shown can be sustained.

Different views on aggregate supply

The monetarist/classical view: There was a natural rate of output, corresponding to full employment. The economy would adjust rapidly to this equilibrium position, so the authorities would not need to intervene. With this view, the aggregate supply curve is vertical, and policies affecting aggregate demand have an impact only on prices, leaving real output unaffected.

The Keynesian view: The economy could get caught in an equilibrium position below full employment, and adjustment back to full employment could be slow. This difference of opinion was reflected in the shape of the long-run aggregate supply curve, which in the Keynesian view slopes upwards over a range.

The impact of a budget deficit

Shifting the aggregate demand curve affects only the overall price level in the economy when the aggregate supply curve is vertical. With a Keynesian aggregate supply curve, a key issue for a government considering the use of fiscal policy is knowing whether there is spare capacity in the economy. Otherwise, an expansion in aggregate demand from increased government spending will push up prices but leave real output unchanged.

In terms of the AD/AS diagram, the existence of the multiplier means that if there is an increase in government expenditure, the AD curve moves further to the right than it otherwise would have done. However, this does not mean that equilibrium income will increase by the full multiplier amount.

Fiscal policy and crowding out

Looking more closely at what is happening, you can see that there are some forces at work that are acting to weaken the multiplier effect of an increase in government expenditure.

One way in which this happens is through interest rates. If the government finances its deficit through borrowing, a side-effect is to put upward pressure on interest rates. This may cause private sector spending - by households on consumption and by firms on investment - to decline, as the cost of borrowing has been increased.

When crowding out occurs, the public sector is effectively displacing private sector activity, so it affects the relative size of the public and private sectors.

Automatic and discretionary fiscal policies

It is important to distinguish between automatic and discretionary changes in government expenditure.

Automatic stabilisers

Some items of government expenditure and receipts vary automatically with the business cycle. They are known as automatic stabilisers.

Discretionary fiscal policy

More important is the question of whether the government can or should make use of discretionary fiscal policy in a deliberate attempt to influence the course of the economy.

For example, the collapse of the economy of Zimbabwe was accompanied by inflation at such a high level that the printing presses could not keep up with the need for banknotes. Inflation in Zimbabwe peaked in November 2008, when some estimates put the annual inflation rate at almost 100% per day. By the early 2010s, inflation had settled down, but the World Bank recorded an annual inflation rate of 557% in 2020.

Balance between the public and private sectors

An important theme that runs through much economic analysis is that governments may be justified in intervening in the economy in order to correct market failure. Some of this intervention requires the use of fiscal policy.

Infrastructure and market failure

Take infrastructure as an example. Infrastructure covers a range of goods that are crucial for the efficient operation of a market economy:

• Businesses need good transport links and good communication facilities
• Households need good healthcare, education and sanitation facilities
• These are needed not only for a good standard of life, but also to create a productive labour force

This may be especially important for developing countries.

The dangers of excessive intervention

On the other hand, too much government intervention may also be damaging. One of the most compelling arguments in favour of privatisation was that when the managers of public enterprises are insufficiently accountable for their actions, X-inefficiency becomes a major issue. Public sector activity tends to be less efficient than private sector enterprise.

Income distribution and inequality

Another key role for fiscal policy is in affecting the distribution of income within society. Taxes and transfers can have a large effect on income distribution and inequality. This in turn may have an impact on the economy by affecting the incentives that people face in choosing their labour supply.

Achieving a balance of taxation between direct and indirect taxes is an important aspect of the government's redistributive policy. A switch in the balance from direct to indirect taxes will tend to increase inequality in a society.

It may be important to avoid over-stressing the likely impact of these incentive effects. In her brief ill-fated spell as prime minister, Liz Truss argued that the route to economic growth was to cut taxes in order to improve incentives and fuel economic growth. Her focus on cutting taxes (alongside spending cuts) was to reduce taxes in a way that mainly benefited the better-off.

The policy may have affected economic growth in the long run, but in the midst of rising national debt and a cost of living crisis, there was a negative reaction from the public and from financial markets, leading to a rapid U-turn in the policy and Truss's demise as prime minister.

The role of the government in different countries

In an international context, there are significant differences between countries in relation to the role of the government in the economy. Political ideology plays a part in this - countries with socialist governments tend to see a stronger role for the state in intervening in the economy. However, this is not the only important factor.

Challenges for developing countries

For many developing countries, tax collection is a challenge, with no effective administrative system in place. The situation is compounded when many people in the country are living on low incomes or in absolute poverty. Furthermore, where subsistence activity is significant, taxation cannot be effectively implemented.

The figure shows tax revenue as a percentage of GDP for selected countries around the world, ranked in descending order of GDP per capita in PPPs. Some important patterns emerge:

Lower-income countries: Display relatively low tax revenue relative to GDP. This is important because if the government has a limited capacity to raise tax revenue, this may limit the extent to which it is able to introduce policies to combat poverty, or to provide social infrastructure needed to encourage economic growth.

The UK and USA difference: Notice the difference between the UK and the USA. The UK collects around 27% of GDP in tax revenue, while the USA collects only around 20%. This reflects different attitudes towards the role of government in the economy.

Corporate tax competition

Governments have also been aware that transnational companies may take account of relative tax rates in different countries when deciding where to locate their investment. Countries that are keen to attract foreign direct investment may feel pressured to keep corporate tax rates relatively low in the hope of attracting inflows of investment.

Indeed, many transnational companies have been able to negotiate tax holidays, leaving them free of taxation for a period after they bring in their investment.

Sustainability of fiscal policy

Another important issue that came to the fore during the 1990s concerned the sustainability of fiscal policy. This is wrapped up with the notion that current taxpayers should only have to fund expenditure that benefits their own generation. Future taxpayers should make their own decisions, and not have to pay for past government expenditure that has been incurred for the benefit of earlier generations.

The concept of sustainability

In this context, what is significant is the overall balance between receipts and outlays through time. If outlays were always larger than receipts, the spending programme could be sustained only through government borrowing, thereby shifting the burden of funding the deficit to future generations. This could be a problem if:

• It made it more difficult for the private sector to obtain funds for investment
• It added to the national debt

The Golden Rule of fiscal policy

The Labour governments of 1997-2010 introduced a so-called Golden Rule of fiscal policy, which stated that, on average over the economic cycle, the government should borrow only to invest and not to fund current expenditure.

The need to bail out commercial banks in order to safeguard the financial system rendered the Golden Rule impossible to follow. The further increases in government spending during the COVID-19 pandemic kept the Golden Rule well out of reach.

Managing the economic cycle

If receipts and outlays more or less balance over the economic cycle, the economy is not in a position whereby the current generation is forcing future generations to pay for its consumption. However, as the economy does go through a business cycle, it is not practical to impose this rule at every point in time. The so-called Golden Rule was intended to apply over the cycle as a whole.

The financial support offered to Northern Rock and other banks in the bailout of 2008 had a noticeable effect on public sector net debt. Even without the financial sector interventions, net debt rose over the 40% mark in the last quarter of 2008 and kept rising thereafter. This reflected other measures taken by the government to try to mitigate the effects of the recession.

One example was the reduction in the rate of VAT from 17.5% to 15%. This is tantamount to a fiscal expansion, but when it was introduced, it was made clear that it was intended as a temporary boost for a specified period. This statement enabled the government to maintain that it was not breaching its long-term fiscal commitment. The rate of VAT returned to 17.5% in January 2010, and was increased to 20% in January 2011.

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