What’s it: Government expenditure refers to the 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 expenditure exceeds government revenue. But on the other hand, if government revenue exceeds government expenditure, the government runs a fiscal surplus. And, when expenditure equals 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 is government expenditure important?
Government spending is essential to the economy. There are several reasons to explain it. 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.
Then, the government provides affordable public services because it is not profit-oriented, unlike business. 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.
How is government expenditure classified?
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 spending by the government. Sometimes, we call it fixed capital formation. An example is spending on infrastructures 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 and 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 without involving 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.
How does government expenditure affect 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.
Then, 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.
Effects of government expenditure as a fiscal 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, taxes, or combine the two.
When governments adopt expansionary policies, they will increase spending. Conversely, in a contractionary policy, they will reduce their spending.
Expansionary fiscal policy. This policy is to revive 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. They also started recruiting new workers. As a result, the economy grew, and the unemployment rate fell.
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. This 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, it also makes economic growth weaker. And if done too aggressively, it could lead to a decline in the economy’s output (a recession) and an increase in the unemployment rate.
Fiscal deficit effect and the 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. And 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
- 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, those 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 respond to higher borrowing costs by delaying investment. As a result, business investment fell.
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.
Automatic stabilizer effect
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, it decreases, and conversely, during a recession, it rises.
During the expansion, the economy is prospering. As a result, the outlook for income and household work is improving. In addition, the unemployment rate is low because businesses need many workers to meet strong demand. As a result, payments for unemployment benefits will also be low.
In contrast, the outlook for income and household work deteriorates during a recession. Economic output fell. Businesses fire their workers, and as a result, 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.
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