What’s it: Government revenue is money earned by the government for carrying out its activities. Taxes are the main source. In addition, 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, the government must borrow to cover the shortfall when revenue is insufficient. Usually, the government will issue 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.
Why is revenue important to the government?
The government collects revenue to finance its expenditures. It 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. And 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, it will reduce inequality, reduce poverty and promote prosperity.
How are government revenues related to economic activity?
Government revenue is closely related to the economic situation. For example, during expansion, government revenues tend to increase. It was because, during this period, the economy was prosperous. 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. In particular, changes in revenue are related to changes in taxes.
The government changes taxes for different purposes. For example, the government raised it to reduce inflationary pressures. But instead, the government lowered it to encourage economic growth.
During high inflation, the government will raise taxes to dampen the pace before it harms the economy. We call this policy contractionary policy.
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. In addition, they may reduce some employees. As a result, economic growth weakened, and the unemployment rate increased 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.
Facing a stronger demand, businesses increase their output. At first, they maximized their existing production capacity and workforce. And a further increase in demand will encourage them to invest in capital goods to increase production. In addition, they also recruit more workers. As a result, the unemployment rate decreased. And households face improving job and income prospects, prompting them to increase consumption.
The government budget
The government runs the following three scenarios in its budget:
- Fiscal deficit. Expenditure is greater than revenue. As a consequence, the government needs to borrow to cover the shortfall. And we can say the current government debt is an accumulated deficit over time minus what is due or redeemed.
- Balanced fiscal. Expenditure equals revenue. No need for the government to borrow. This scenario may rarely be adopted in the real world.
- Fiscal surplus. The government’s revenues exceed its expenditures. The government may use the surplus to pay off debt as it matures or withdraws debt early. Or the government uses it 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.
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.
The government collects various taxes, including:
- Income tax
- Corporate profit tax
- Capital gains tax
- Property tax
- Inheritance tax
- Gift tax
- Value-added tax
- Sales tax
Then, in addition to taxes, government revenue sources also come from asset sales or privatization, foreign aid, and dividends from government-owned companies. Other sources are revenue from investment funds such as sovereign wealth funds (SWFs), concessions and royalties for resource extraction contracts, fees for public services and facilities, fines, and confiscated assets.
What is the government used for?
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 expenditure includes current government spending. It includes salary expenditures and expenditures to purchase goods and services for operational activities or for 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.
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