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What’s it? Government revenue is money earned by the government for carrying out its activities. Taxes are the main source. The government also derives its revenue from non-tax sources, such as contributions from state-owned enterprises and proceeds from privatization.
Unlike business, the government is not profit-oriented. Thus, when government revenues exceed spending, we call it surplus, not profit. On the other hand, when revenue is less than expenditure, we call it a deficit, not a loss.
The government allocates its revenues to expenditures such as government operations, public services, and infrastructure spending. Therefore, when revenue is insufficient, the government must borrow to cover the shortfall. Usually, the government issues debt securities to do so. In classification, debt securities are divided into three categories based on their maturity: bills for the short term, notes for the medium term, and bonds for the long term.
Importance of government revenue
The government collects revenue to finance its expenditures. This becomes important for several reasons. First, the government uses its spending to provide public services. For example, health, education, and infrastructure budgets are vital to support not only economic activity but also prosperity. In addition, budgets such as defense are important to maintain national security. The government can provide it all by being financed from its revenue.
Second, the government uses changes to the revenue budget to influence the economy, primarily through taxes. For example, when a recession occurs, the government cuts taxes to stimulate economic activity. Lower taxes encourage consumption and investment. Conversely, when inflation is high, the government raises taxes to avoid overheating the economy.
Third, government revenue is important to fulfill its redistributive role. The government collects revenue and distributes it back to society, for example, through welfare programs. If done right, this will reduce inequality, poverty, and prosperity.
Government revenue and the economic cycle
Government revenue is closely related to the economic situation. For example, during expansion, government revenues tend to increase. This was because the economy was prosperous during this period. Businesses face high-profit prospects as demand for goods and services is strong. Meanwhile, households are also more optimistic about their income and employment because many jobs are available. Finally, the government can collect more revenue from businesses and households.
On the other hand, during a recession, tax revenues usually fall. The outlook for household income and business profits is deteriorating. Businesses face declining demand for goods and services, depressing their profitability. Meanwhile, households face pressure on income as their jobs are lost. During this period, the unemployment rate was high. As a result, less tax is collected.
Fiscal policy tools
Fiscal policy relates to changes in the government’s budget. In other words, the policy uses changes in government spending and revenues to influence the economy. Changes in government revenue are related to changes in taxes.
The government changes taxes for different purposes. For example, it raised them to reduce inflationary pressures, but they were lowered to encourage economic growth.
During high inflation, the government raises taxes to dampen the pace before it harms the economy. We call this policy contractionary.
An increase in taxes reduces the rate at which aggregate demand increases. This is because higher taxes leave less money for household consumption or business investment. So as the impact, the demand for goods and services weakens. And it pushes down the price level.
However, contractionary policies can hurt economic activity. As demand for goods and services weakens, businesses reduce their production and may reduce some employees. Economic growth weakens, and the unemployment rate increases due to tax increases. Then, if the policy is too aggressive, it could lead the economy into contraction.
The opposite policy is expansionary fiscal policy. The government implements this policy when the economy is weak or in recession. To stimulate economic activity, the government lowers taxes, hoping to boost aggregate demand and stimulate production activity.
Lower taxes leave households and businesses with more money for consumption and investment. Thus, their demand for goods and services increases. As a result, it will stimulate increased production in the economy.
Faced with stronger demand, businesses increase their output. At first, they maximize their existing production capacity and workforce. A further increase in demand will encourage them to invest in capital goods to increase production. In addition, they recruit more workers. As a result, the unemployment rate decreased. Households face improving job and income prospects, prompting them to increase consumption.
Where does government revenue come from
The government derives revenue from various sources. Taxes are usually the main source. However, which taxes contribute the most can vary between countries or over time.
Tax revenue
The government collects various taxes, including:
Income tax: This is the most significant source of tax revenue for many governments. It’s a levy on the income earned by individuals and businesses. Income tax structures can vary, with some being progressive (higher earners pay a larger share) and others being flat (everyone pays the same percentage).
Corporate profit tax: Businesses also contribute through taxes levied on their profits. This ensures that corporations share a portion of their success with the nation.
Consumption taxes: These taxes are collected on the sale of goods and services. Here’s a breakdown of some common types:
- Value-added tax (VAT): A widespread tax applied at each stage of production and distribution. The final consumer shoulders the VAT when purchasing a product.
- Sales tax: This tax is levied directly on the retail sale of goods and services, typically at the point of purchase. Unlike VAT, it’s usually a one-time tax.
- Excise tax: This tax targets specific goods or services, often those considered non-essential or “sinful,” such as cigarettes, alcohol, or gasoline. These taxes can discourage consumption while generating revenue.
International trade taxes:
- Customs duties (tariffs): Taxes imposed on imported goods, potentially raising their price for consumers and protecting domestic industries.
Wealth transfer taxes: These taxes capture revenue from the transfer of wealth between individuals.
- Inheritance tax: This tax applies to assets inherited from a deceased person.
- Gift tax: This tax is levied on the transfer of assets (money or property) while the donor is still alive.
Property tax: This tax is based on the assessed value of real estate or land ownership. Governments use it to generate revenue from property ownership.
Capital gains tax: This tax is imposed on the profit earned from selling assets like stocks, real estate, or investments. It captures a portion of the gains individuals or businesses make on these transactions.
Non-tax revenue sources
While taxes are the primary source of government revenue, there are additional income streams to consider:
- Asset sales/privatization: When governments sell off state-owned assets, they generate a one-time injection of revenue. This can be used for specific projects or to reduce debt.
- Foreign aid: International organizations or foreign governments may offer grants for specific purposes, providing additional resources for the government.
- Dividends from state-owned companies: Profits generated by government-controlled companies can be directed towards government spending. For example, a national oil company might contribute a portion of its profits to the national budget.
Investment funds (Sovereign Wealth Funds): Some governments establish sovereign wealth funds to manage their financial assets. These funds can generate income through investments, providing a long-term revenue stream. - Resource extraction fees: Governments may charge fees to companies extracting resources like oil, gas, or minerals from their territory.
- Public service fees: Certain government services, such as road tolls or business permits, may have associated user fees.
- Fines and confiscated assets: Penalties imposed for violations of laws and regulations generate revenue for the government. Confiscated assets from criminal activity can also be sold and contribute to government coffers.
Government budget and spending
Understanding how governments allocate their resources is crucial. Let’s explore the different scenarios that play out in a government budget and the types of spending that make up the equation.
Government budget
A government budget reflects its planned spending and revenue for a specific period, typically a year. Three main scenarios can emerge:
- Fiscal deficit: When expenditures exceed government revenue, the government must borrow to cover the shortfall. The current government debt is an accumulated deficit over time minus what is due or redeemed.
- Balanced fiscal. Expenditure equals government revenue, so no need for the government to borrow. This scenario may rarely be adopted in the real world.
- Fiscal surplus: Government revenue exceeds expenditures. The government may use the surplus to pay off debt as it matures or withdraw debt early. It may also be used as an investment, for example, managed through sovereign wealth funds (SWFs).
The scenario above is usually related to economic conditions and the government’s policy stance. For example, the government intends to run a budget deficit during a recession to stimulate economic growth. Thus, the government increases its budget and lowers taxes to increase aggregate demand and get the economy out of recession.
Meanwhile, during expansion, the government budget may lead to a surplus. On the one hand, a prosperous economy allows the government to collect more taxes and other revenues. On the other hand, certain expenditure items, such as unemployment benefits, are reduced because the unemployment rate is lower and society is more prosperous.
Government expenditures
In simple terms, the government uses its revenues to finance its expenditures, such as capital expenditures, routine expenditures, and transfer payments. The budget for infrastructure is an example of capital expenditure. The government builds airports, roads, railways, and ports. They are all productive spending because they produce long-term benefits. Moreover, in the short term, such expenditures create jobs and income for society.
Meanwhile, routine expenditures include current government spending, salary expenditures, and expenditures to purchase goods and services for operational activities or public services.
Finally, transfer payments cover government expenditures without directly exchanging goods and services as compensation. Examples are spending on unemployment benefits, student grants, pension payments, and social security.
