What is capital expenditure in the context of public expenditure?

Capital expenditure, in the context of public expenditure, is government expenditure on long-term investments and physical assets, where the benefits of this expenditure come about over a long time period. This includes spending on roads, bridges and hospitals.

What is current expenditure in the context of public expenditure?

Current expenditure, in the context of public expenditure, encompasses the normal, recurrent, short-term government spending, such as spending on wages.

What are transfer payments in the context of public expenditure?

Transfer payments, in the context of public expenditure, are payments made by the government to economic agents with no corresponding output being associated with these payments. A primary example is welfare payments. The main aim of transfer payments is to provide a basic floor of income or standard of living.

What are some global trends in the size and composition of public spending? 

The size of public spending in countries normally depends upon the health and state of the economy. During periods of low or negative economic growth, government spending is likely to rise considerably, as the government is likely to spend more on areas such as unemployment-related benefits due to slowing growth.

The demographic of a country will also affect where the government spends its money. For example, a government in a country with an ageing population is likely to be spending a high proportion of its money on healthcare and pensions, whereas a government in a country with a youthful population is likely to spend a lower proportion on healthcare and pensions. 

Moreover, government spending is likely to rise significantly when there is an external shock to the economy. For example, in the midst of the COVID-19 pandemic, most governments had to spend huge amounts on healthcare, but also on the economy in general to keep the economy afloat.

What is the impact of different levels of government spending as a proportion of GDP on productivity and growth?

Higher spending as a proportion of GDP on public institutions may lead to them becoming inefficient and not productive if they become overly reliant on funding from the government. This is because profit maximisation is not a key objective, so they have no incentive to improve efficiency. This is likely to result in falling productivity, falling output and falling economic growth.

However, higher spending as a proportion of GDP on areas such as education and healthcare is likely to help to boost productivity, as spending on education helps to improve human capital, and spending on healthcare is likely to improve the physical and mental health of workers, leading to increased productivity. This increase in productivity is likely to lead to more output being produced and hence more economic growth.

What is the impact of different levels of government spending as a proportion of GDP on living standards?

An increase in government spending as a proportion of GDP on areas such as welfare payments and healthcare will likely lead to a largely positive effect on individuals and living standards. This is because a generous welfare state may provide unemployed individuals with a basic income which allows them to search for a job where they won't be underemployed, and welfare payments help to reduce absolute poverty. Moreover, spending on healthcare is likely to improve the physical and mental well-being of individuals in the economy.

What is the impact of different levels of government spending as a proportion of GDP on crowding out?

An increase in government spending as a proportion of GDP is likely to crowd out the private sector. This is because, when governments spend, they often borrow in order to finance this spending. This borrowing leads to an increase in demand for loanable funds, leading to an increase in the interest rate. This increase in the interest rate will reduce private sector investment, as it has become more costly for firms in the private sector to invest. Hence, higher government spending crowds out the private sector.

What is the impact of different levels of government spending as a proportion of GDP on taxation? 

It is likely that when government spending as a proportion of GDP is high, taxation will also be high to finance this spending.

What is the impact of different levels of government spending as a proportion of GDP on equality?

High government spending as a proportion of GDP on welfare payments such as higher welfare payments on unemployment-related benefits is likely to improve equality as it gives individuals a basic income and standard of living which they otherwise may not have had. 

What is a progressive tax?

A progressive tax is a tax where the marginal rate of tax rises as income rises. An example is income tax.

What is a regressive tax?

A regressive tax is a tax where the rate of tax falls as income rises. An example is VAT.

What is a proportional tax? 

A proportional tax is a tax where the marginal rate of tax is constant. 

What are the economic effects of changes in direct and indirect tax rates on incentives to work?

Low income tax rates (income tax being a direct tax), are likely to increase the incentive to work as individuals pay less as a proportion in tax on their earnings when they work. High VAT rates (an indirect tax) may lead to individuals not being incentivised to participate in the formal economy, but rather in the informal economy.

What are the economic effects of changes in direct and indirect tax rates on tax revenues?

The Laffer curve can be used to show the effects of changes in direct and indirect tax rates on tax revenues.

As shown by the above Laffer curve, when either direct or indirect tax rates are too high or too low, the government will not be maximising tax revenue. Thus, there is an optimal rate of taxation which is not too high or too low, where the government can maximise tax revenue, as shown in the diagram above.

What are the economic effects of changes in direct and indirect tax rates on income distribution?

A progressive income tax system is likely to help improve income equality as a progressive income tax system takes a larger proportion in tax the higher the income, whereas a regressive income tax system is likely to exacerbate income inequality. A rise in indirect taxes (which are usually regressive) is likely to exacerbate income inequality. 

What are the economic effects of changes in direct and indirect tax rates on real output and employment?

A rise in both direct and indirect tax rates is likely to lead to a rise in the withdrawals from the circular flow of national income. This may lead to a reduction in aggregate demand. This is likely to lead to a fall in real output, and as there is less output being produced, there is likely to be a fall in employment as there is less derived demand for labour in the economy.

What are the economic effects of changes in direct and indirect tax rates on the price level?

A rise in both direct and indirect tax rates may lead to a net leakage from the circular flow of national income and a fall in aggregate demand, leading to a fall in the price level. However, a rise in some indirect taxes may lead to cost-push inflation which could lead to a rise in the price level.

What are the economic effects of changes in direct and indirect tax rates on the trade balance?

A rise in import taxes (tariffs) is likely to lead to a reduction in imports as imports become more expensive. This is likely to lead to an improvement in the trade balance due to the fall in imports. Higher direct and indirect taxes may also reduce disposable incomes, leading to a further reduction in imports as consumers have less money to spend on imports, leading to a further improvement in the trade balance.

What are the economic effects of changes in direct and indirect tax rates on FDI flows?

Lower direct and indirect tax rates are likely to lead to an increase in FDI flows into the country as businesses are likely to benefit from a higher rate of return as they pay less in taxes.

What are automatic stabilisers and what is discretionary fiscal policy?

Automatic stabilisers are mechanisms that automatically adjust transfer payments and taxes during economic fluctuations. They help to stabilise the economy without any direct intervention from the government.

Whereas, discretionary fiscal policy is where the government actively decides and implements policy changes. 

What is a fiscal deficit and what is the national debt?

A fiscal deficit is the amount by which government expenditure exceeds government revenue over a year. The national debt is the accumulation of all the fiscal deficits over the years.

What is a structural deficit and what is a cyclical deficit?

The structural deficit is the part of the fiscal deficit not related to the state of the economy. The structural deficit will not disappear when the economy recovers. The cyclical deficit is the part of the fiscal deficit related to the state of the economy. The cyclical deficit will disappear as the economy recovers.

What are the factors affecting the size of a fiscal deficit?

One factor could be a recession. A recession is likely to lead to a rise in the unemployment rate due to falling output and thus falling derived demand for labour. A rise in unemployment will likely lead to more individuals claiming unemployment-related benefits, and there will be less tax revenue received in the form of income tax as there are fewer workers employed. This worsens a fiscal deficit. 

Rising interest rates may also lead to more money being spent on servicing the national debt, increasing government expenditure, and potentially worsening a fiscal deficit. 

A fall in the profitability of firms may also lead to rising unemployment, which likely leads to the government spending more on unemployment-related benefits and the government receiving less income tax, worsening a fiscal deficit.

What are the factors influencing the size of national debts? 

Continuous budget deficits are likely to lead to a rise in the size of the national debt. An ageing population will likely lead to a large national debt as fiscal deficits are likely to build up over time due to low tax revenues as not many individuals are working, and large expenditure on pensions.

What is the significance of the size of fiscal deficits and national debts?

A large fiscal deficit is representative of large amounts of borrowing. When there are large amounts of borrowing there is likely to be a higher interest rate which is likely to crowd out private investment. Moreover, when there are large amounts of borrowing there is likely to be a large increase in aggregate demand, potentially leading to large increases in the price level as the economy approaches full employment, leading to large levels of inflation. However, this boost in aggregate demand is also likely to lead to large increases in economic growth and employment.

A large national debt will likely mean that a government will spend a large proportion of money on debt interest payments. This creates an opportunity cost as the government could be spending this money on areas such as healthcare or education rather than spending it on servicing the national debt. Moreover, a large national debt may lead to a fall in a government's credit rating.

How can policies reduce the size of fiscal deficits and the national debt? 

The government can employ contractionary fiscal policy which involves increasing taxes and reducing expenditure. This will help to reduce a fiscal deficit as the government begins to receive more in taxes than it spends.

Moreover, a government may choose to employ expansionary fiscal policy which involves lowering taxes and increasing expenditure. In the short run, this is likely to increase the size of a fiscal deficit, however, if the employment of expansionary fiscal policy leads to lots of job creation and future economic growth, this future rise in national income may eventually lead to a fiscal surplus and the eventual reduction of the national debt. Interest rates could also be lowered to help increase consumption and investment, leading to greater aggregate demand and potentially more economic growth, likely leading to higher tax revenues, leading to a fall in the size of fiscal deficits and the national debt over time.

The government could also employ supply-side policies by investing in areas such as infrastructure. This may help to improve the attractiveness of the country for the purposes of FDI, leading to increased investment within the country, leading to higher tax revenues and hence a fall in the size of a fiscal deficit and the national debt. The government could also devalue its currency, stimulating exports and leading to a fall in imports, improving the trade balance, leading to a boost in aggregate demand, leading to a higher national income, and potentially leading to higher tax revenues which can help reduce the size of a fiscal deficit and the national debt.

How can policies reduce poverty and inequality? 

The introduction of a national minimum wage acts as a price floor for which wages must be paid above. This helps to correct the market failure where market wage rates are too low to sustain a sustainable standard of living. This helps to provide workers with a basic income and standard of living, reducing poverty and inequality.

The government could also spend more on education to try and reduce absenteeism and make education accessible to all. This means that even those from low-income backgrounds can build their human capital, potentially meaning that they can gain the qualifications necessary to enter a high-paid job, reducing poverty and inequality.

Currency devaluation may help boost exporting industries, creating more job opportunities, potentially meaning that unemployed workers can find work and earn a good income, reducing poverty and inequality. Moreover, cutting interest rates may stimulate investment, potentially leading to increases in employment opportunities, meaning unemployed workers can find work and earn an income, reducing poverty and inequality.

How significant is a change in interest rates and the money supply?

A central bank can manipulate interest rates and hence the money supply to achieve macroeconomic objectives. Lowering interest rates can help to stimulate investment within the domestic economy and devalue the currency as it is likely that there will be a fall in hot money flows into the country and an increase in hot money flows out of the country as the rate of return on saving in the country has fallen. Central banks have also used quantitative easing during a liquidity trap, such as after the 2008 financial crisis.

How can policies be used to improve international competitiveness?

The government can reduce corporation tax which means that firms can keep more of the profit they have made. Firms can then invest this profit to improve how price and non-price-competitive their products are on the international markets, meaning that the country becomes more internationally competitive.

The government can also invest in areas such as education and healthcare. This helps to improve the productivity of the workforce, potentially leading to higher quality and lower cost goods and services. leading to an improvement in the international competitiveness of the country.

Interest rates can also be lowered to stimulate investment, this may lead to higher quality and lower cost goods and services, improving international competitiveness.

Competitive devaluation of the currency is also another option, making a country's exports relatively cheaper, and improving international competitiveness.

How can macroeconomic policies be used to respond to external shocks and what are the impacts of these policies?

External shocks are unexpected events that originate from outside of an economy but have a very large impact on the economy. A good example is the COVID-19 pandemic. The UK government responded with a furlough scheme in order to protect the incomes of workers who were unable to go to work due to the pandemic. This also helped companies to retain workers.

During a financial crisis, a government may use expansionary fiscal and monetary policy to help boost the economy. For example, following the 2008 financial crisis, interest rates plummeted extremely low, but quantitative easing was also required to help boost liquidity.

What is transfer pricing and how is it regulated? 

Transfer pricing is a method transnational companies employ to reduce their tax burden and maximise profits. 

Transfer pricing normally works by a company producing a good in Country A and then transferring it to Country B where it transforms the good into another good. In this example, Country A has higher taxes than Country B. Thus, the company sets a low price on the goods sold in Country A and a high price on the goods sold in Country B. This is because the company wants to make most of its profit in the low-tax country (Country B) rather than the high-tax country (Country A) in order to maximise profits.

The OECD introduced transfer pricing guidelines in 1995 in an attempt to prevent transnational companies from exploiting transfer pricing. The underlying philosophy was that the prices that the transferred resources should be priced at are the prices that these resources would be priced at if parts of the company weren't connected.

What are the limits to the government's ability to control global companies?

Companies often invest in countries that have low operating costs, low corporation tax rates and few regulations. Some countries are heavily dependent upon this investment from global companies. This may mean that, even if the governments of these countries would like to increase regulatory pressure or increase the corporation tax rate, they may not do so for fear of the global companies leaving their country which is likely to have a very large negative effect on their economy. Hence, these countries may not be able to effectively control global companies.

How is inaccurate information a problem for policymakers?

Policymakers aren't likely to have perfect information when they create policies. This may lead to some policies being implemented, even though policymakers may not be fully aware of their potential effects. Often, a full cost-benefit analysis is required when creating policies. However, these cost-benefit analyses are often very time-consuming and expensive, and it is unlikely that a government can gain every single bit of information they require.

How are risks and uncertainties a problem for policymakers?

Policies can often be very easily undermined, which may make government policies more expensive to implement.

How are external shocks a problem for policymakers?

Policymakers aren't always able to find the best solution to unexpected external shocks such as the 2008 financial crisis. During the 2008 financial crisis, interest rates fell extremely low, however, this failed to stimulate that much economic activity as consumers were unwilling to spend and banks were unwilling to lend.