Government Budget: Components, Types, and Fiscal Policy

What’s it: A government budget is a government’s planned expenditures and revenues over a specific period, usually one year. Government revenue can come from taxes or other sources such as contributions from government-owned enterprises and asset sales. Meanwhile, government spending includes routine expenditures, capital expenditures, and transfer payments.

The government may prefer to run a budget surplus, where planned revenues exceed expenditures. Or the government plans to spend more than it earns under a budget deficit. Alternatively, the government runs a balanced budget where income equals expenditure.

Government decisions about the budget can affect the economy. For example, the government adopts a budget deficit to stimulate economic growth through lower taxes and greater spending, such as on infrastructure.

What is government spending for?

The government spends its money to provide public services. Spending on defense, social protection, education, and health care are examples. In general, government spending falls into three categories:

• Current expenditure
• Capital expenditure
• Transfer payment

Current government expenditure includes spending on goods and services for recurring and regular provision. An example is a budget for health and education. Such expenditures are vital for improving the quality of human resources and labor productivity.

Capital expenditure includes infrastructure spending such as roads, ports, airports, and railways. This investment is essential to build the economy in the long term by increasing capital accumulation. Apart from creating jobs and income in the economy, infrastructure also contributes to increasing the economy’s productive capacity.

Transfer payments are money payments without involving the direct exchange of goods and services, including welfare assistance, financial assistance, and social security. Unemployment benefits and income support for poor families are examples. These expenditures are among avenues for redistributing income in the economy to its citizens. Thus, those who are poor can maintain their lives and have the opportunity to improve their future.

Then, in another classification, government spending can be divided into categories:

• Discretionary spending – intentional and planned by the government but not legally required to do so. Military spending, education, and health are examples.
• Mandatory spending – spending on programs mandated by law. The Social Security and Medicare programs are good examples.
• Net interest – expenditures related to government debt. A budget deficit requires the government to finance it through debt, giving rise to paying principal and interest expenses.

Reason for government spending

Several reasons justify government spending. First, government capital spending contributes to building the economy and supporting economic growth. For example, infrastructure spending creates jobs and income for households. In addition, it also creates a multiplier effect by increasing economic activity and lowering logistics costs.

Second, government spending is an important tool for maintaining economic stability. The government changes its spending to influence economic growth, inflation, and the unemployment rate. For example, during a recession, the government raises its spending to stimulate economic growth.

Third, the government provides vital public services such as defense, education, and health services. These expenditures support not only national security but also the quality of human resources. For example, educational services enable citizens to improve their knowledge and skills.

Fourth, the government redistributes income and wealth in the economy to citizens through its spending. For example, the government provides food stamps, unemployment compensation, housing assistance, and child care assistance to those who are entitled. If done right, such spending reduces poverty and inequality and increases opportunities for improving living standards.

Fifth, the government intervenes in the economy to remedy market failures. For example, the government provides subsidies and other incentives to encourage businesses to invest in environmentally friendly technologies.

Where does government revenue come from?

The government’s revenue comes mostly from taxes. In general, taxes are categorized into two:

• Direct tax
• Indirect tax

The government levies direct taxes on income, wealth, and profits. Examples include personal income tax, corporate tax, and capital gains tax. Meanwhile, indirect taxes are levied on expenditures for goods and services. Examples of indirect taxes are value added tax, excise duty, and fuel tax.

Meanwhile, non-tax sources can come from mineral resource compensation fees and grants. Other sources are contributions from state-owned enterprises and asset sales.

Reasons to collect taxes

Taxes are a mandatory levy, and at first glance, they are burdensome. For example, we have to set aside dollars to pay for it. And our burden becomes higher when the government raises tax rates. In addition, tax rates also make the goods and services we consume more expensive, making us have to spend fewer dollars on shopping.

However, taxes are essential to finance government spending to provide public services such as education, health, and infrastructure. And such services provide great benefits to our daily life. For example, we can access health services and education cheaper. Or we enjoy the roads built by the government.

Then, there are several other reasons to justify taxation. First, it is to help redistribute income and wealth in the economy. The government collects taxes to redistribute it through programs such as unemployment compensation, which is important to support the unemployed to maintain their livelihoods while not finding work.

Second, taxes are a tool to limit harmful products such as tobacco and alcohol. In addition, taxes reduce negative externalities, which the government imposes when economic activities incur additional costs such as pollution. Imposing taxes increases production costs, hoping to suppress such negative effects.

Third, taxes become a tool for economic policy. For example, the government lowers taxes to stimulate aggregate demand and economic growth. Lower taxes leave households and businesses with more dollars to spend and invest. Finally, it increases the demand for goods and services, encouraging businesses to increase production and absorb more labor.

Fourth, taxes help to protect the economy and domestic producers from foreign competition. For example, the government imposes import tariffs on dumped goods. It protects domestic producers from unfair competition by foreign companies.

What are the three types of government budgets?

Government budgets are divided into three types based on the balance between revenues and expenditures. They are:

• Budget surplus – the government’s revenue exceeds its spending.
• Balanced budget – the government’s revenue equals its spending.
• Budget deficit – government spending exceeds its revenues.

The government budget surplus represents public savings. And if we add it to private savings, it forms national savings, representing the total loanable funds provided by the domestic economy.

On the other hand, public savings are negative when the government runs a budget deficit (public dissavings). This is because the government spends more than it earns. Thus, the government must finance it through debt, usually by issuing debt securities. Therefore, the longer and bigger the government runs a budget deficit, the government debt will accumulate.

And when the government’s debt is too large, beyond its capacity to collect revenue, it becomes a big problem. Government fiscal becomes unsustainable because debt grows faster than government revenue. As a result, principal and interest expenses accumulate. As a result, the default risk increases and causes high-interest rates in the economy.

Then, the government should take austerity measures to avoid default. And those austerity policies can hurt the economy. For example, the government takes the following options:

• Raise taxes
• Reduce spending

Both options, if not executed carefully, could weaken economic growth. An increase in taxes and a decrease in government spending reduces aggregate demand, which can cause the economy to crash and lead to a recession. As a result, the economy’s output falls, the unemployment rate rises, and the income outlook worsens.

What is the relationship between government budgets and fiscal policy?

Fiscal policy uses changes in the government’s budget to influence the economy. As Keynesian economists view, changes in spending and taxes affect aggregate demand, output, and employment.

Fiscal policy is divided into two categories based on its objectives. They are:

• Expansionary or loose fiscal policy to stimulate economic growth.
• Contractionary or tight fiscal policy to try to control inflation.

Both policies affect output, unemployment, and inflation through their effects on aggregate demand. For example, the government wants to stimulate economic growth by taking expansionary fiscal policies, involving lowering taxes or increasing government spending. Both options will drive aggregate demand.

Say, personal income tax goes down. It increases disposable income. Because households have more money to spend, it increases their demand for goods and services. Increased demand pushes prices up. It stimulates businesses to increase production to reap more profits. They then recruit more labor and invest in capital goods. As a result, the economy’s output increases, unemployment decreases, and inflation rise.

Another option might be to lower indirect taxes and corporate taxes. Lower indirect taxes increase real income as prices of goods and services fall, driving more demand. Meanwhile, an indirect tax cut boosts corporate profits, prompting them to set aside more dollars to invest. And increased investment boosts aggregate demand in the economy.

Then, stimulating aggregate demand can also be by increasing government spending. Please remember that aggregate demand is the sum of household consumption, business investment, government spending, and net exports. Thus, when infrastructure spending increases, it increases the economy’s demand for goods and services.

Like a decrease in taxes, increased demand pushes the price level up. This situation is an opportunity for businesses to increase output and recruit workers. Eventually, the economy grows higher, unemployment lowers, and inflation rises.

Infrastructure spending has a multiplier effect. For example, it reduces unemployment and creates income for households. Finally, they shop for more goods and services, increasing aggregate demand. Moreover, in the long term, infrastructure contributes to long-term growth. For example, building roads lowers logistics costs and stimulates the economic activity of local residents.

What to read next

• Automatic Stabilizer: Meaning, Types, How It Works
• Autonomous Expenditure: Formula, Components, Determinants
• Balanced Budget: Why It Matters, The Multiplier Effect
• Budget Deficit: Formulas, Causes, and Effects
• Budget Surplus: Why It Occurs and Its Effects
• Cyclical Budget Deficit: Causes, How it Works, Impacts
• Discretionary Fiscal Policy: How it Works, Types, Effects
• Government Budget: Components, Types, and Fiscal Policy
• Government Capital Expenditures: Examples, Why It Matters
• Government Current Expenditure: Example, Calculation in GDP
• Government Discretionary Spending: What Is It? What are some examples?
• Government Expenditure: Components and Effects on the Economy
• Government Revenue: Types and Why Does It Matter?
• Induced Expenditure: Examples, Formula
• Induced Tax: Examples, How they Work, Effects on the Economy
• National Debt: What is it and What Are the Implications?
• Net Tax in Macroeconomics: Formula, Effects on the Economy
• Structural Budget Deficit: How it Works and Its Implications
• Tax: Types and Its Impact on the Economy
• Transfer Payments: Importance, Types, and Criticism