Main areas of government spending and the reasons for and effects of spending in these areas

Government and the Macro‑economy – Fiscal Policy

Learning Objective

Understand the main areas of government spending, the reasons for spending in each area, and the likely short‑run and long‑run effects on the economy. Relate these to the six macro‑economic aims (growth, full employment, low inflation, balance of payments, redistribution and environmental sustainability) and to the two fiscal‑policy levers – government spending and taxation.

1. What is Fiscal Policy?

  • Fiscal policy is the use of government spending and taxation to influence aggregate demand (AD), aggregate supply (AS) and, ultimately, the six macro‑economic aims.

  • Government budget – the annual plan that sets out total government revenue (mainly taxes) and total government expenditure (spending, transfers and interest payments). The budget can be in:

    • Surplus (Revenue > Expenditure)

    • Deficit (Expenditure > Revenue)

2. Fiscal‑policy Levers

  • Government spending – changing the level of current, capital or transfer payments.

  • Taxation – altering tax rates or the structure of taxes (progressive, regressive, proportional; direct or indirect) to affect disposable income and therefore consumption and investment.

Examples:

  • Expansionary: increase NHS capital funding by £5 bn; cut income‑tax rates by 2 %.

  • Contractionary: reduce defence spending by £3 bn; raise VAT from 20 % to 22 %.

3. Main Areas of Government Spending

Spending AreaDefinition (syllabus wording)Typical Examples
Current (recurrent) expenditureDay‑to‑day costs of running public services; the “recurrent” part of the budget.Salaries of civil servants, operating costs of hospitals, police and fire services, school running costs.
Capital expenditureSpending on long‑term assets that provide benefits for many years.Construction of roads, bridges, schools, hospitals, defence equipment, research facilities.
Transfer paymentsPayments made without any direct goods or services being received.State pensions, unemployment benefit, child benefit, welfare grants.
Interest payments (debt servicing)Payments made to service the national debt and maintain the government’s creditworthiness.Interest on Treasury bonds, repayments of principal (when included in the budget).

4. Reasons for Government Spending (syllabus list) and Link to the Six Aims

ReasonHow it helps the six macro‑economic aims
Provision of public goodsSupports growth (infrastructure), full employment (public‑sector jobs), and environmental sustainability (e.g., green public transport).
Redistribution of incomeImproves equitable distribution and can raise consumption by low‑income households, aiding growth and full employment.
Economic stabilisationCounter‑cyclical spending or tax cuts smooth business‑cycle fluctuations, protecting growth, employment and keeping inflation low.
Promotion of long‑term growthInvestment in education, health and R&D raises productivity → outward LRAS, supporting growth, full employment and a healthier balance of payments (more export‑competitiveness).
Political objectivesMeeting election promises can enhance public support; may target any of the six aims depending on the policy chosen.
Environmental sustainability (new 2027 emphasis)Green capital projects, subsidies for renewable energy, or carbon taxes help achieve environmental sustainability while also influencing growth and employment in new sectors.

5. Taxation – Purposes and Classifications

  • Purposes of taxation

    • Raise revenue for public spending.

    • Redistribute income (progressive taxes).

    • Influence behaviour (e.g., fuel duty to reduce carbon emissions).

  • Types of tax structures

    • Progressive – higher rates on higher incomes (e.g., UK income tax bands).

    • Regressive – lower‑income households pay a larger proportion of income (e.g., uniform sales tax).

    • Proportional (flat) – same rate for all (e.g., a flat 20 % income tax).

  • Direct vs. indirect taxes

    • Direct – levied on income or wealth (income tax, corporation tax).

    • Indirect – levied on consumption (VAT, excise duties).

Effect on AD: a tax cut raises disposable income → higher consumption → right‑ward shift of AD; a tax increase does the opposite.

6. Government Budget Position

  • Budget deficit – Expenditure > Revenue.
    Formula: Deficit = Expenditure – Revenue

  • Budget surplus – Revenue > Expenditure.
    Formula: Surplus = Revenue – Expenditure

Simple diagram (for revision): a box labelled “Government Budget” with arrows showing “Revenue” entering and “Expenditure” leaving; a plus sign on the expenditure side indicates a deficit, a plus on the revenue side a surplus.

7. Effects of Government Spending

7.1 Short‑run effects (AD side)

  • Aggregate demand – any increase in current, capital or transfer payments shifts AD rightward.

  • Fiscal multiplier – k = 1 / (1 – MPC). Larger when MPC is high; reduced in an open economy because part of the extra consumption is spent on imports.

  • Inflation – If the economy is near full capacity, a right‑ward AD shift can create demand‑pull inflation.

  • Crowding‑out – Borrowing to finance spending may raise interest rates, reducing private investment.

  • Balance of payments – Higher domestic demand can raise imports, widening the current‑account deficit.

7.2 Long‑run effects (LRAS side)

  • Capital expenditure improves infrastructure, education and health, raising productivity and shifting LRAS outward.

  • Transfer payments mainly affect distribution; they boost LRAS only if they enhance human capital (e.g., training schemes).

  • Interest payments divert resources from productive investment and may force future tax rises, dampening long‑run growth.

  • Environmental spending (e.g., renewable‑energy projects) can shift LRAS outward while also meeting sustainability targets.

7.3 Distributional effects

  • Targeted transfers raise the disposable income of low‑income households, who have a higher MPC → stronger multiplier and a reduction in poverty.

  • Progressive taxation combined with transfers narrows the income gap, helping the redistribution aim.

8. Effects of Fiscal Policy on the Six Macro‑economic Aims

Macro‑economic aimExpansionary fiscal policy (↑ spending / ↓ taxes)Contractionary fiscal policy (↓ spending / ↑ taxes)
Economic growthBoosts AD → higher output in the short run; capital spending can raise potential output.Reduces AD → lower output; may slow growth.
Full employmentHigher AD → firms hire more → unemployment falls.Lower AD → firms cut labour → unemployment rises.
Low inflationRisk of demand‑pull inflation if economy near capacity.Helps contain inflation by reducing AD.
Balance of paymentsHigher domestic demand can increase imports → current‑account deficit may widen.Lower demand reduces imports → current‑account improves.
RedistributionTransfer payments and progressive taxes increase equality.Higher taxes on high incomes can also improve equality, but cuts to transfers may worsen it.
Environmental sustainabilityGreen spending (e.g., renewable‑energy infrastructure) supports sustainability; tax incentives for low‑carbon technologies.Reduced green spending may hinder environmental goals; higher carbon taxes can improve sustainability while being contractionary for AD.

9. Diagrammatic Requirements (AO2)

  • Short‑run AD‑shift diagram – label AD1, AD2, LRAS (fixed), Y1, Y2, P1, P2. Show the multiplier chain (government spending → induced consumption → total AD increase).

  • Long‑run LRAS‑shift diagram – start with AD1 intersecting LRAS1 at Y1. Show an initial right‑ward AD shift (AD1→AD2) followed by a right‑ward LRAS shift (LRAS1→LRAS2) ending at a higher potential output Y2 with little change in price level.

  • Check‑list of labels: AD, LRAS, SRAS (optional), Y, P, multiplier arrows, “initial spending”, “induced consumption”.

10. Connections to Other Syllabus Topics

  • Monetary policy works alongside fiscal policy; e.g., an expansionary fiscal stance may be offset by a contractionary monetary stance (higher interest rates).

  • Supply‑side policies (e.g., deregulation, education reforms) complement capital spending by improving productivity.

  • Understanding the interaction of fiscal and monetary policy is essential for evaluating overall macro‑economic stability.

11. Summary Table – Linking Spending Areas, Reasons and Typical Effects

Spending AreaPrimary Reason(s) (syllabus)Typical Economic Effect(s)
Current (recurrent) expenditureProvision of public goods; maintain public‑sector employmentDirect increase in AD; modest long‑run growth impact; may raise public‑sector wages.
Capital expenditurePromotion of long‑term growth; provision of public goods (infrastructure)Initial AD boost + multiplier; later outward LRAS shift; lower future unemployment; can improve BOP via higher export capacity.
Transfer paymentsRedistribution of income; economic stabilisation (maintain consumption)Higher disposable income for recipients → higher consumption; strong multiplier when idle capacity exists; limited inflationary pressure.
Interest payments (debt servicing)Maintain creditworthiness; meet legal debt obligationsDiverts resources from other spending; may require higher taxes; can raise interest rates → crowding‑out of private investment.

12. Key Points to Remember

  • Fiscal policy works through two levers: government spending and taxation.

  • The size of the fiscal multiplier depends on the marginal propensity to consume (MPC) and on how open the economy is (imports reduce the multiplier).

  • Short‑run effects are shown by a right‑ward shift of AD; long‑run effects of capital spending are shown by a right‑ward shift of LRAS.

  • Persistent deficits increase the national debt, raise interest payments and can lead to crowding‑out or future tax hikes.

  • All spending decisions should be judged against the six macro‑economic aims, including the newer emphasis on environmental sustainability.

  • Remember the diagrammatic checklist for AO2 – a complete set of labels will secure marks.

  • Fiscal policy does not act in isolation; it interacts with monetary policy and supply‑side measures.