Quiz : Special Topic 1 Government Spending and Taxation


Government expenditure is financed through taxes, borrowings or user charges. Borrowings are future taxes. Therefore, a major source of government earnings is taxes. Taxes also impose an extra burden on the society and reduce the economic efficiency. The taxes reduce economic efficiency because of two reasons: 1. Collecting taxes and enforcing the tax law requires huge resources. The opportunity cost of these resources is greater than the benefit government draws from the tax. This is marked as waste to the society and hence, reduces the economic efficiency. 2. The taxes create deadweight losses which is measured as the difference between lost in consumer surplus due to taxation and gain in producers' surplus plus tax revenue. These deadweight losses create a difference between the price seller receive and the amount consumer pays. This difference distorts the efficiency of production and represents loss in economic efficiency.25

The GDP per-capita measures the standard of living in a country. It is given by the nominal GDP divided by the total no of people in a country. Government expenditure is financed through taxes, borrowings or user charges. Borrowings are future taxes. Therefore, a major source of government earnings is taxes. One important function of government is redistribution of income and providing public good to its citizens. Government raises revenue through taxes and spends in various purposes including transfer payments and health care. During last four decade the spending on defense has sharply decreases. Since the spending on transfer payment and health care has increased, it means that the composition of the government spending has changed. The government spending is component of GDP and changing the composition of government spending does affect the living standards of the people. With a high share of budget devoted to income transfers ad health care, the citizens will experience an increase in the standards of living owing to better living conditions in the society. For e.g. the society will have more hospitals and would be disease free. Therefore, as the government spends more on transfer payment and health care instead of defense, it implies a greater standard of living for its citizens.

The progressive income taxation implies that a high income person will face higher tax rate and low income person will face lower tax rate. This implies that as the economy grows, government will take a larger share of income given that the tax rate remains unchanged. This also implies that the government shares in the economy will continue to grow with increasing growth rate. According to some economists the expansion of government beyond a particular limit decreases government efficiency as the government enters the sectors that are unfit for political decision. If the government expand beyond its original functions the growth rate of the economy decreases. If the government takes an action based on its productive capacity the economy will grow. Any additional expenditure beyond its limit will decrease the growth rate of the economy. Therefore, if government spends what it earns and a progressive taxation at higher growth rate means higher revenue, the growth of the economy will decrease eventually. This is why the progressive tax system is not an attractive feature of the economy.

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