Spending by the public sector can be broken down into three main areas:
Transfer Payments: Transfer payments are government wellbeing payments made on hand through the social security system including social welfare programs such as social security, old age or disability pensions, student grants, unemployment compensation, etc. These transfer payments are not included in the calculation of gross national product because there is no exchange of money with product or services.
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Current Government Spending: Current Government spending i.e. spending on the goods and services provided by the states on state-provided goods & services which are provided on regular basis. Current spending is made on regular basis because these services have to be provided day to day all over the country.
Capital Spending: Capital spending would include infrastructural spending such as spending on new motorways and roads, hospitals, schools and prisons. This investment spending by the government adds to the economy’s capital stock and clearly can have important demand and supply side effects in the medium to long term.
Government spending is defensible on economic and societal grounds as well as the desire to correct for perceived market failure when the market mechanism might be unsuccessful to supply enough public and merit goods for social wellbeing to be maximized.
Therefore we justify government spending on these grounds:
To supply a socially efficient level of public goods and merit goods.
To supply a safety-net system of welfare benefits to supplement the incomes of the poorest in society.
To provide necessary infrastructure via capital spending on transport, education and health facilities.
Automatic stabilizers and discretionary changes in fiscal policy:
Discretionary fiscal changes are deliberate changes in direct and indirect taxation and government spending. Automatic stabilizers include those changes in tax revenues and government spending that comes about automatically as the economy moves through different stages of the business cycle.
Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which takes money out of the circular flow of income and spending
Welfare spending: A growing economy means that the government does not have to spend as much on means-tested welfare benefits such as income support and unemployment benefits
Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of money from the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a larger budget deficit.
In taxation government takes certain amount of money from the people to raise the funds to provide services to the public like safety and security etcâ€¦ There are number of taxation systems but one important difference to make is between direct and indirect taxes.
Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, national insurance contributions, capital gains tax, and corporation tax.
Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many different goods and services.
Also the biggest source of income for the government is income tax.
Progressive, proportional and regressive taxes:
With a progressive tax, the marginal rate of tax rises as income rises. I.e. as people earn more income, the rate of tax on each extra pound earned goes up. This causes a rise in the average rate of tax (the percentage of income paid in tax).
With a proportional tax, the marginal rate of tax is constant.
With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate of tax is lower for people of higher incomes.
Fiscal Policy and Aggregate Supply
Changes to fiscal policy can affect the supply-side capacity of the economy and therefore contribute to long term economic growth.
Labor market incentives: Cuts in income tax might be used to improve incentives for people to actively seek work and also as a strategy to boost labor productivity. Some economists argue that welfare benefit reforms are more important than tax cuts in improving incentives – in particular to create a “wedge” or gap between the incomes of those people in work and those who are in voluntary unemployment.
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Capital spending: Government capital spending on the national infrastructure (e.g. improvements to our motorway network or an increase in the building program for new schools and hospitals) put in to an increase in investment across the whole economy.
Entrepreneurship and new business creation: Government spending might be used to subsidize a development in the rate of new small business start-ups
Research and development and innovation: Government spending, could be used to encourage an increase in private business division research and development.
Human capital of the workforce: Government spending on education and training (designed to boost the human capital of the workforce) and increased investment in healthiness and transport can also have significant supply-side economic effects in the long run.
However targeted government spending and tax decisions can have a positive impact even though fiscal policy reforms take a long time to feed through. The key is to help provide the right incentives for individuals and businesses – for example the incentives to find work and incentives for businesses to increase employment and investment.