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What’s it? Government expenditures refer to money the government spends on goods and services or other items. Examples are expenditures on operational activities and investments in public services such as defense, education, social protection, and health care. In addition, some expenditures may not involve the exchange of goods and services, such as transfer payments.
Under a fiscal deficit, government expenditures exceed government revenue. On the other hand, if government revenue exceeds government expenditures, the government runs a fiscal surplus. When expenditures equal revenue, we call it a balanced fiscal.
Government expenditure is vital in influencing the economy. It forms aggregate demand in addition to household consumption, business investment, and net exports. Thus, the changes will affect the economy. When it increases, aggregate demand increases, and we expect the economy to grow higher. Conversely, when the government cuts its spending, aggregate demand declines, and so does the economy.
Why government expenditure matters
Government spending is essential to the economy. There are several reasons for this. First, providing public services in which the private sector is unwilling or commercially unfit to engage is vital. Services like defense are a good example.
The government provides affordable public services because, unlike businesses, it is not profit-oriented. For example, government hospitals and schools exist to provide services and reach those who cannot afford to access expensive private health and education.
Second, government spending is essential to support those who are economically disadvantaged. An example is social security benefits. Unemployment benefits are another example. These items contribute to sustaining a decent life for the needy.
Third, government spending becomes a fiscal tool to influence the economy. Changes in the spending budget can have an impact on short-term economic growth. Increased spending encourages the economy to grow higher. The opposite effect applies when governments cut spending – to avoid overheating the economy.
Fourth, government spending is important to increase the economy’s productive capacity. Capital spending on infrastructure increases capital accumulation, which increases the economy’s potential output.
Components of government expenditures
Government spending can be categorized into several groups. For example, it is divided into government consumption, transfer payments, and interest payments. Then, another classification, and the main one, divides it into three:
- Current expenditure
- Capital expenditure
- Transfer payments
Current expenditure represents routine expenditure for operational and administrative activities. Spending on civil servants’ salaries is an example. Another example is goods and services for office equipment and public services. This expenditure is routine and paid for by the government regularly.
Capital expenditure represents productive government spending. Sometimes, we call it fixed capital formation. An example is spending on infrastructure such as roads, bridges, ports, railways, and airports.
Capital expenditure is essential for increasing the capital stock in the economy. Moreover, it creates future benefits by increasing the economy’s productive capacity, allowing it to produce more output. For example, road construction not only absorbs labor but increases the mobility of goods and services. But, it also stimulates business activity to increase and reduce logistics costs.
Transfer payments are monetary payments to the private sector that do not involve the exchange of goods and services. Examples are unemployment benefits, scholarship grants, and social security benefits. Because no goods and services are exchanged—and therefore do not represent expenditures for production—this component is excluded from the GDP calculation under the expenditure approach.
Government expenditure’s impact on the economy
Government spending contributes to increasing potential GDP. For example, investment in infrastructure creates a multiplier effect on the economy by stimulating business activity and the mobility of goods and services. Finally, such investments also increase the economy’s productive capacity in the long run.
Then, by changing its spending, the government affects indicators such as economic growth, inflation, and the unemployment rate. As Keynesian economists advocate, government intervention is the key to influencing the economy. By changing the fiscal budget (spending and taxes), the government can minimize or prevent the economy from bad economic cycles such as recession and an overheated economy.
For example, the government increases its spending to prevent or bring the economy out of recession. Increased spending stimulates higher aggregate demand, prompting businesses to increase production and absorb more labor. As a result, the economy grew higher (real GDP rose). Moreover, when production expands, it helps reduce the unemployment rate.
On the other hand, when the economy overheats, inflationary pressures spike. So the government cut its spending to prevent a worse effect (i.e., hyperinflation). Lower spending reduces aggregate demand – and so does inflationary pressure. The side effect is lower economic growth.
Some expenditures provide monetary income for households, such as unemployment benefits and other social security benefits. They help the unemployed or the underprivileged maintain a minimum standard of living, and ultimately, such spending helps reduce extreme poverty.
Government expenditure as a fiscal policy tool
Government spending is a fiscal tool other than taxes. The government uses both to influence economic activity. When it intervenes in the economy, the government can change its spending and taxes or combine the two.
When governments adopt expansionary policies, they increase spending. Conversely, they reduce spending in a contractionary policy.
Expansionary fiscal policy
Expansionary fiscal policy revives economic growth, usually during a recession. Higher spending leads to increased demand for goods and services in the economy.
Higher demand stimulates businesses to increase their production and recruit new workers. As a result, the economy grows, and the unemployment rate falls.
A growing economy leads to better prospects for household income. Because they have more money, they should spend more on goods and services. Again, it encourages businesses to increase production. This process continues, and as a result, increases in government spending have a multiplier effect on the economy’s output.
During a recession, it is difficult for the economy to rely on the households and businesses (private sector) to recover. Assuming they are rational economists, they will not increase investment or consumption during this period. In contrast, households consume fewer goods and services and save more as their income and employment prospects deteriorate. Meanwhile, businesses are reluctant to invest as their profits are depressed and they face weak demand. For this reason, relying on the government is the way to get out of a recession, as Keynesian economics advocates.
Contractionary fiscal policy
Contractionary fiscal policy aims to contract or weaken economic growth. The government pursued this policy during the late expansion period when inflationary pressures were too high, and the economy overheated. If not prevented, it could lead to hyperinflation, threatening economic stability.
To reduce inflationary pressures, the government cut its spending. Such cuts reduce aggregate demand. In the face of a decline in aggregate demand, the price level is slowly falling, and the inflation rate is moving more moderately.
However, as aggregate demand declines, it also weakens economic growth. Businesses face a weaker demand outlook, prompting them to cut output. As a result, this policy not only reduces inflationary pressures but also weakens economic growth. If done too aggressively, it could lead to a decline in the economy’s output (a recession) and an increase in the unemployment rate.
Automatic stabilizer
In some cases, government spending works on a counter-cyclical basis. And it doesn’t take any deliberate government action to change it. Rather it changes automatically and in the opposite direction to the current economic cycle.
Take unemployment benefits as an example. When the economic cycle is expanding, they decrease, and conversely, during a recession, they rise.
During the expansion, the economy prospered, improving the outlook for income and household work. In addition, the unemployment rate was low because businesses needed many workers to meet strong demand. As a result, payments for unemployment benefits were also low.
In contrast, the outlook for income and household work deteriorates during a recession. Economic output falls, businesses fire their workers, and the unemployment rate rises. During this period, payments for unemployment benefits will increase. Although rising, this spending is essential to helping the unemployed maintain their demand for goods and services. Thus, aggregate demand does not fall deeper, and the recession does not get worse.
Crowding out effect
Fiscal deficits do not always result in higher economic growth. It depends on how much government spending has a multiplier effect on the economy’s output. In economics, we measure the economy’s output through the gross domestic product (GDP). Under the expenditure approach, economists define it as follows:
- GDP = C + I + G + NX
Where:
- C: Household consumption
- I: Gross investment of business
- G: Government spending
- NX: Net exports
When real GDP increases, the economy’s output increases. Conversely, when it goes down, output goes down. And we can see that government spending is not the only contributor to GDP. So, although government spending increases, other components may decrease more significantly, which does not result in an increase in GDP. Instead, it lowers GDP.
Well, we will discuss the effect of government spending on gross investment by the private sector.
Back again to the fiscal deficit. When running a deficit, the government’s revenue is insufficient to finance its spending. So, the government has to borrow to cover the shortfall. The most common way to borrow is to issue debt securities.
Increasing the fiscal deficit may not effectively stimulate economic growth when government debt has accumulated. An additional deficit increases debt and reduces the government’s ability to repay. In other words, the default risk increases.
Faced with a higher risk of default, investors will demand a higher premium to be willing to lend money to the government. They face higher uncertainty. And their money may not come back due to the higher default risk. So, when it wants to increase the deficit, the government must offer high interest rates to attract investors to buy debt securities.
Since government bonds are the benchmark in financial markets, high interest rates affect borrowing in the economy. For example, companies must pay higher coupons when issuing debt securities because they carry a higher risk than government bonds. So, long story short, borrowing costs have become more expensive for businesses.
The business sector may have responded to higher borrowing costs by delaying investment, which resulted in lower business investment.
The crowding-out effect is when a rising government deficit reduces private investment. The net effect on the economy depends on which one has a more significant effect on aggregate demand. For example, suppose the decline in private investment is much more significant than the increase in government spending. In that case, a higher fiscal deficit weakens economic growth, not the other way around.
Fiscal deficits and national debt
Imagine a country spending more than it earns, year after year. This gap between spending and revenue is called a fiscal deficit. To cover this gap, the government borrows money by issuing bonds. The total amount of borrowed money that hasn’t been repaid is the national debt.
The high and ever-growing national debt can lead to economic instability. Here’s why:
- Higher interest rates: As the national debt rises, the government needs to borrow more money. This increased demand can push up interest rates. Businesses and individuals also face higher borrowing costs, potentially discouraging investment and economic activity.
- Crowding out effect: When the government borrows heavily, it competes with private businesses for loanable funds. This can lead to a situation where businesses have to pay higher interest rates or even struggle to get loans at all. As a result, private investment may decline, hindering economic growth.
- Loss of confidence: A ballooning national debt can signal to investors and international markets that the government is struggling to manage its finances. This can lead to a loss of confidence in the economy, potentially weakening the currency and triggering inflation.
It’s important to remember that debt is not inherently bad. Responsible governments can use debt strategically to invest in infrastructure, education, and other areas that promote long-term growth. The key lies in managing the debt level sustainably and ensuring economic growth is strong enough to handle the debt burden.
Government spending plays a crucial role in the economy. However, it’s a balancing act. Excessive spending can lead to deficits and debt accumulation, potentially triggering the negative consequences mentioned above. Conversely, insufficient spending can stifle economic growth. The goal is to find the right balance between stimulating the economy and ensuring long-term fiscal health.
