What’s it: Government sector includes all institutional units consisting of the central government, state governments, and local governments. Several independent institutions, such as the Central Bank and the Financial Services Authority, also fall into this category.
The government sector excludes state-owned companies. Even though the government owns their shares, they operate like private companies. They do not rely on taxes to finance operations. Instead, they generate income by producing goods or providing services.
The government sector has a vital role in economic activities. The government and its institutions act as regulators. They issue various regulations and policies to influence economic activity. These interventions may directly or indirectly impact the private sector (business sector and the household sector).
The difference between the government sector and the public sector
Both the government sector and the public sector consist of units controlled by the government. However, both have slightly different definitions.
The government sector consists of units that are financed through taxes or compulsory social contributions. They do not produce private goods and services to sell in the market and are not profit-oriented.
Meanwhile, the public sector consists of the government sector, plus state-owned companies. The company produces market output and is profit-oriented. They usually operate in strategic sectors such as utilities, energy, and financial sectors.
Government sector budget
The primary source of government sector revenue is taxes. The government collects it from the household and business sector. The two main types of taxes are:
- Direct tax. The government imposes it on company revenues, wealth, and profits. Examples are income tax, corporate tax, and capital gains tax.
- Indirect taxes. The government imposes it on goods and services instead of directly to the taxpayers. Examples of indirect taxes are value-added tax and excise.
The government uses tax revenues for various purposes. The government provides public services and goods. They also buy goods and services from the business sector. In general, government spending falls into three main categories:
- Current expenditures. It consists of routine expenditures on goods and services such as spending on health, education, and defense programs. Payments for government employees’ salaries also fall into this category.
- Capital expenditures. It consists of spending on economic capital, such as spending on infrastructure. This component makes an essential contribution to increasing the capital stock and productive capacity of the economy.
- Transfer payment. This category includes expenses that do not involve the exchange of goods and services. Examples of transfer payments are unemployment benefits and income allowances for poor families.
In running the budget, the government has three options:
- Balanced budget, where revenue equals spending.
- Budget deficit, where government spending exceeds revenue.
- Budget surplus, where revenue exceeds government spending.
Surplus acts as public savings. It represents a supply of loanable funds on financial markets, apart from private savings, and lent to financial markets.
Conversely, a deficit means negative national saving (public dissavings). To finance the deficit, the government borrows from financial markets or from the external sector. One of the main options is to issue debt securities.
Debt securities investors come not only from within the country but also abroad. They usually consist of large institutional investors, such as pension funds and insurance companies.
Government bonds are considered safer than corporate bonds. Investors and analysts usually consider government bond yields to represent the risk-free rate. For this reason, they often use it as a benchmark in determining corporate bond yields and the cost of capital using the weighted average cost of capital (WACC) method.
How the government sector affects the economy
Keynesians believe that government has a substantial impact on the economy. Its fiscal policy affects aggregate demand, impacting the economy’s level of prices, output, and employment.
Taxes and government spending are two tools of fiscal policy. The government uses both to influence economic activity. Both can impact economic variables such as economic growth, the inflation rate, and the unemployment rate.
The two categories of fiscal policy are:
- Expansionary fiscal policy. The government adopts this policy to stimulate economic growth and to get out of recession. The options are to increase government spending and lower taxes.
- Contractionary fiscal policy. The aim of this policy is to reduce high inflationary pressures and avoid an overheated economy. To do this, the government reduces spending and raises taxes.
Take expansionary as an example. When the government increases spending, the demand for goods and services increases. This will stimulate businesses to increase production. The same effect also applies when the government reduces the tax rate.
Lower tax rates increase disposable income. Households set aside less money to pay taxes. Instead, they have more money to spend on goods and services. It stimulates demand, prompting an increase in output by businesses.
Budget deficit effect
When implementing expansionary policies, the government increases the budget deficit. Or, they move from budget surplus to budget deficit.
If successful, deficits stimulate economic growth. The prospects for business profits and household income are improving. That allows the government to collect more taxes and cover the deficit.
However, if the deficit persists and lasts a long time, it can hurt the economy in the long run. Government debt builds up, increasing interest expense and the risk of default. A build-up of debt can cause crowding out effect.
What is the crowding-out effect?
The crowding-out effect occurs when an increase in government borrowing causes an increase in interest rates. Higher interest rates cause private sector investment and consumption to fall.
The impact of falling consumption and investment is more significant than the effects of the budget deficit. As a result, a budget deficit weighs on economic growth, rather than stimulating economic growth.
How could that be?
The high deficit forces the government to borrow more. If it continues over time, it results in a build-up of debt. High debt increases interest expense and the risk of default.
Investors will ask for a higher premium to compensate for the increased risk. On the other hand, to apply for new debt and attract investors, the government will offer higher interest rates.
As a result, deficits lead to persistently high-interest rates. That causes the cost of funds to be more expensive.
For the business sector, which also needs funds, the high cost of funds makes them suffer. Because they usually finance capital investment through loans, the investment costs are high and make the investment less viable. Consequently, they are reluctant to invest.
On the other hand, the household sector relies on loans to purchase several items, especially durable goods such as cars and houses. When interest rates are high, they prefer to delay applying for new loans and purchasing goods.
Reduced investment and consumption undermines aggregate demand. Even if the government uses money in productive ways (such as infrastructure development), the impact may be less significant than the reduction in investment and consumption. Since these two expenditures form a component of the gross domestic product (GDP), the deficit negatively impacts. It reduces GDP at the expense of economic growth instead of stimulating economic growth, as is the goal of expansionary fiscal policy.
What to read next
- Circular Flow of Income: Types and Descriptions
- Economic Actors: Types and Roles
- Macroeconomic Sector: Types, Roles
- Government Sector: Meaning, Budget, and Impact on the Economy
- Household Sector: Definition and Role in the Economy
- Business Sector: Meaning, Types of Companies
- External Sector: Its Effect on the Economy
- 4 Types of Business Sector You Need to Know
- How Does the Government Play A Role In the Economy?