Government Spending: Definition, Types & Examples (2022)

Public expenditure is an important tool that governments can use to achieve their economic objectives. Government spending includes the expenses of national or local governments and is often used to fund national services like health, infrastructure, welfare benefits, or security. Government spending is especially important for fiscal policy and goes hand-in-hand with taxation. Taxation raises government revenue, which is then used to finance public expenditure. This process provides the basis for fiscal policy.

Factors that affect government spending

There are numerous factors that may affect the level of government spending. Some key factors that impact how much the government spends include:

  1. The country's population

    A country with a large population will have higher government spending levels than a smaller country. Additionally, the structure of a country's population can impact government spending. For example, an aging population implies that there are more people claiming state-funded pensions. Older people also have a higher demand for healthcare services, which the government funds.

  2. Fiscal policy measures

    Governments can use fiscal policy measures to address some economic problems.

    During a recession, the government may pursue an expansionary fiscal policy. This would allow for an increase in the levels of government spending to boost aggregate demand and reduce a negative output gap. During these periods the level of government spending is generally higher than during periods of economic contraction.

  3. Other government policies

    Governments may also impose various policies to encourage income equality and income redistribution.

    (Video) Government Spending I A Level and IB Economics

    The government might spend more on welfare benefits to redistribute income in society.

  1. Increasing spending on transfer payments

    Spending on unemployment benefits, state pension, or disability support helps those who are unable to work or to find work. This is a form of income redistribution, which can help reduce absolute poverty in the country.

    A transfer payment is a payment for which no goods or services are provided in return.

  2. Providing goods and services for free

    Publicly funded services like education and healthcare are accessible for free in most countries. This makes them accessible for everyone, particularly those who would otherwise not be able to access them. Providing these services for free helps reduce the impacts of poverty. This way, the government is indirectly investing in the economy's human capital, which can increase productivity in the economy in the future.

    Educated and skilled workers may find jobs more easily, reducing unemployment and increasing overall productivity in the economy.

  3. Progressive taxation

    (Video) EC1002 Chapter 10 Lesson 3 - Government Spending Function & Activities [Full]

    This form of taxation allows for the redistribution of income in society by reducing income inequality. The government may reduce poverty levels by attempting to close the gap between low and high-income earners, as high-income earners pay progressively more taxes than low-income earners. The government can also use the tax revenue received to fund welfare payments.

    For further insight into how the progressive taxation system is used in the UK, check out our explanations on Taxation.

Increase and decrease in government spending

Every national government receives income (from taxation and other sources) and spends on public services. The way these sources of revenue and expenditure are managed can cause budget deficits and surpluses in a given period. If these accumulate over time, there are many possible consequences.

A budget deficit occurs when the current expenses are higher than the current income received through standard operations.

A budget surplus occurs when the current expenses are lower than the current income received through standard operations.

Problems of a budget deficit

Running a budget deficit has numerous impacts on macroeconomic activity. Firstly, additional borrowing leads to an increase in public sector debt.

The national debt is the accumulation of budget deficits in the long term over multiple periods.

If the government is running numerous budget deficits, it will have to increase borrowing even further to finance its activities. This further contributes to increasing the national debt.

(Video) TYPES OF GOVERNMENT EXPENDITURE

Another main concern of a budget deficit is demand-pull inflation due to the increase in the money supply caused by increased borrowing. This means that there is more money in the economy than what can be matched by the national output.

Additionally, increasing borrowing leads to higher levels of debt interest payments. Debt interest can be defined as the interest payments the government has to make on the money it previously borrowed. In other words, it is the cost of servicing the national debt which needs to be paid at regular time intervals. As the government runs a deficit and borrows even more causing an increase in already accumulated debt, the amount of interest paid on borrowings rises.

Similarly, interest rates on government borrowing are also likely to rise, as the government has to attract new lenders. One method of attracting new lenders is by offering higher interest rate payments on the amount borrowed. Higher interest rates can discourage investment and make the national currency appreciate (rise in value). This is problematic as it may lead to less competitive exports, harming the country's balance of payments.

As a reminder, take a look at StudySmarter's explanations on exchange rates and the balance of payments.

Problems of budget surplus

Although running a budget surplus might sound ideal as the government has more financial resources to spend on public services, it can actually lead to various problems. To achieve a budget surplus, government spending, government revenue, or both, have to be manipulated.

A government can achieve a budget surplus by decreasing government spending as a result of budget cuts in the public sector. However, this will only occur if government revenue is higher. This means that the government will have to decrease investment in certain areas of the public sector like housing, education, or health while increasing taxation. Lower investment in public services can have a negative impact on the future productivity and efficiency of the economy.

Government revenues can increase due to higher taxation on household income, excise duties, and corporation taxes, or higher human capital employment levels in the economy. This can have several impacts, like decreased disposable income in the case of individuals, or lower profits to use for investment in the case of businesses.

If higher tax rates are levied on individuals’ income, a larger percentage of that income is spent on taxes. This reduces their disposable income and thus their ability to spend more on other goods and services.

(Video) Understand Federal Spending in 8 Minutes

Higher taxation can also lead to higher household debt if households are forced to borrow to finance their consumption. This leads to lower levels of spending and individual saving in the economy, as consumers are focused on paying off their debt.

Finally, a strong fiscal position, like a budget surplus, can be the result of sustained economic growth. However, the opposite may also take place. If the government is forced to increase taxation and decrease public expenditure to achieve a budget surplus, low levels of economic growth may occur due to the policy's effects of suppressing aggregate demand.

Review of government spending

Recent rule-based fiscal policy in the UK can be broken down into two specific types:

  • The deficit rule aims to get rid of the structural part of the budget deficit.
  • The debt rule aims to make sure that debt is decreasing as a certain share of the GDP.

Governments can use fiscal rules to avoid overspending. An example of a fiscal rule is the UK government's implementation of the golden rule.

The golden rule follows the idea that the public sector should only borrow to fund capital investments (like infrastructure) that encourage future growth. In the meantime, it cannot increase borrowing to fund current spending. As a result, the government must maintain the current budget position in a surplus or a balance.

These types of fiscal rules prevent governments from overspending when attempting to encourage growth. Overspending can lead to high levels of inflation and increasing national debt. As a result, fiscal rules help governments maintain economic and inflationary stability.

They can also increase consumer and firms' confidence in the economic environment. Economic stability might encourage firms to invest more, as they perceive the economic environment to be promising. Similarly, consumers might be encouraged to spend more, as their fears of inflation decrease.

Government Spending - Key takeaways

  • Public expenditure is an important tool that governments can use to achieve their economic objectives.
  • Some key factors that impact how much the government spends include:
    • The country's population
    • Fiscal policy measures
    • Policy measures to redistribute income
  • Governments often use fiscal policy to reduce the poverty levels. Addressing poverty in a country can be done by:
    • Increasing government spending on transfer payments
    • Providing goods and services for free
    • Progressive taxation
  • A budget deficit implies that government revenues are lower than government spending.
  • A budget surplus implies that government revenues are higher than government spending.
  • Some problems associated with running a budget deficit include demand-pull inflation, an increase in public sector debt, debt interest payments, and higher interest rates.
  • Some problems associated with a budget surplus include high taxation, higher household debt, and lower economic growth.
  • Governments can use fiscal rules in order to avoid overspending.

FAQs

What are the types of government spending? ›

Federal government spending pays for everything from Social Security and Medicare to military equipment, highway maintenance, building construction, research, and education. This spending can be broken down into two primary categories: mandatory and discretionary.

What are two types of government spending explain or define each? ›

Mandatory spending is simply all spending that does not take place through appropriations legislation. Mandatory spending includes entitlement programs, such as Social Security, Medicare, and required interest spending on the federal debt. Mandatory spending accounts for about two-thirds of all federal spending.

What are three examples of government spending? ›

What is Government Spending?
  • Tax collections by the government. Direct taxes. Indirect taxes.
  • Government borrowing. Borrowing money from its own citizens. Borrowing money from foreigners.
28 Apr 2022

What are the four main categories of government spending? ›

The four main areas of federal spending are national defense, Social Security, healthcare, and interest payments, which together account for about 70% of all federal spending. When a government spends more than it collects in taxes, it is said to have a budget deficit.

What is meant by government spending? ›

Public expenditure is an important tool that governments can use to achieve their economic objectives. Government spending includes the expenses of national or local governments and is often used to fund national services like health, infrastructure, welfare benefits, or security.

What is the importance of government spending? ›

Government expenditures serve a wide range of purposes, such as providing health care, education and justice services to the population, and maintaining public order and safety. looking at expenditures by function can show government's priorities and challenges, as well as track their evolution over time.

Which is an example of discretionary spending? ›

Discretionary spending is what the President and Congress must decide to spend for the next fiscal year through annual appropriations bills. Examples include money for such programs as the FBI, the Coast Guard, housing, education, space exploration, highway construction, defense, and foreign aid.

What factors determine government spending? ›

The studies have identified income per capita, dependency ratio, population, urbanisation, trade openness, foreign aid, and inflation, among others as the determinants of government expenditure.

What is an example of mandatory spending? ›

Outlays for the nation's three largest entitlement programs (Social Security, Medicare, and Medicaid) and for many smaller programs (unemployment compensation, retirement programs for federal employees, student loans, and deposit insurance, for example) are mandatory spending.

What are examples of government purchases? ›

Governments make direct purchase of goods and services. The federal government, for example, buys guns, bullets, tanks, and uniforms, etc. and pays soldiers to supply the national defense. Governments also make “transfer payments” such as welfare, Social Security, Medicare, Medicaid, and unemployment insurance.

Where is government spending money? ›

More than half of FY 2019 discretionary spending went for national defense, and most of the rest went for domestic programs, including transportation, education and training, veterans' benefits, income security, and health care (figure 4).

What are the 5 major sources of revenue for the government? ›

The 5 major sources of revenue for the Government are Goods and Services Tax (GST), Income tax, corporation tax, non-tax revenues, union excise duties .

How does government spending affect the economy? ›

If the government spending causes the unemployed to gain jobs then they will have more income to spend leading to a further increase in aggregate demand. In these situations of spare capacity in the economy, the government spending may cause a bigger final increase in GDP than the initial injection.

What is government spending GDP? ›

Government Spending in the United States increased to 44 percent of the GDP in 2020 from 35.68 percent in 2019.

How does government spending affect GDP? ›

If the “G” portion—government spending at all levels—increases, then GDP increases. Similarly, if government spending decreases, then GDP decreases.

What is the difference between government spending and government expenditure? ›

Answer and Explanation:

Thus, the difference between the government expenditure and government purchases is the inclusion of government transfer payments in government expenditure, which isn't included in government purchases.

What is an example of taxation? ›

Examples include general and selective sales taxes, value-added taxes (VAT), taxes on any aspect of manufacturing or production, taxes on legal transactions, and customs or import duties. General sales taxes are levies that are applied to a substantial portion of consumer expenditures.

How does the government spend tax? ›

The rest includes investing in education, investing in basic infrastructure such as roads, bridges, and airports; maintaining natural resources, farms, and the environment; investing in scientific and medical research; enforcing the nation's laws to promote justice, and other basic duties of the federal government.

Why does government spending increase? ›

When the government innovates more and more methods of taxation and resource mobilisation, its ability to finance public expenditure increases and the size of public expenditure grows. Public sector outlays could be increased by more taxation yields, public debt, foreign aid and deficit financing.

How can you reduce government spending? ›

Time to Be Bold
  1. Build a constituency for limited government and lower taxes. ...
  2. Turn local programs back to the states. ...
  3. Privatize activities that could be performed better by the private sector. ...
  4. Terminate irrelevant programs and reform wasteful programs. ...
  5. Terminate corporate welfare and other mistargeted programs.
12 Feb 2003

What are some examples of mandatory and discretionary spending? ›

For example, the administrative expenses associated with running the Social Security Administration generally are funded with discretionary spending, but the benefit checks sent to retirees and disability recipients enrolled in Social Security programs are classified as mandatory spending.

What is a deficit budget? ›

What Is a Budget Deficit? A budget deficit occurs when expenses exceed revenue and can indicate the financial health of a country. The term is commonly used to refer to government spending rather than businesses or individuals.

What is the difference between discretionary and non-discretionary spending? ›

Understanding Discretionary Expenses

In simpler terms, non-discretionary expenses are those that are necessary to be incurred, also called as needs such as utilities, groceries, mortgage, taxes, etc. Discretionary expenses are those that one can do without and are beyond the needs of a person.

How does government spending affect inflation? ›

Historical studies on government spending and inflation

Louis Federal Reserve found that government spending has little to no impact on inflation. In fact, a 10% increase in government spending may lead to a 0.08% decline in inflation.

What happens when government spending decreases? ›

Decreasing government spending tends to slow economic activity as the government purchases fewer goods and services from the private sector. Increasing tax revenue tends to slow economic activity by decreasing individuals' disposable income, likely causing them to decrease spending on goods and services.

What are the 2 largest categories of state government spending? ›

In the United States, the two major categories of spending of the state and local government are- Education and Healthcare.

What is non discretionary government spending? ›

Within the U.S. budget, non-discretionary spending is referred to as mandatory spending and includes spending on social service programs, such as social security, Medicaid and Medicare. Funding for research and defense is considered discretionary spending.

What's the difference between mandatory spending and discretionary spending? ›

Simply put, there are two main types of government spending: mandatory vs discretionary spending. Mandatory spending is determined by pre-determined laws or regulations. It cannot be changed without an act of Congress. Discretionary spending, on the other hand, is set by Congress and can be changed at any time.

What are the 5 major sources of revenue for the government? ›

The 5 major sources of revenue for the Government are Goods and Services Tax (GST), Income tax, corporation tax, non-tax revenues, union excise duties .

What are the three types of expenditure? ›

Types of expenditures
  • Capital expenditure. A company incurs a capital expenditure when it buys an asset that has a life of more than one year (non-current asset). ...
  • Revenue expenditure. This type of expenditure refers to when a company spends money on a short-term benefit (less than one year). ...
  • Deferred revenue.

What does the government spend the most money on? ›

The official source of government spending data
  • $234.81 Billion. on Transportation.
  • $232.52 Billion. on Veterans Benefits.
  • $39.00 Billion. on Agriculture.

What is included in government spending in GDP? ›

Consumption expenditures and gross investment are the measures of government spending included in calculations of gross domestic product, or GDP. Government current expenditures include consumption expenditures, plus spending on social benefits and other transfers, interest payments, and subsidies to businesses.

What is expenditure example? ›

Expenditure – This is the total purchase price of a good or service. For example, a company buys a $10 million piece of equipment that it estimates to have a useful life of 5 years. This would be classified as a $10 million capital expenditure.

What is the example of capital expenditure? ›

Examples of CapEx include the purchase of land, vehicles, buildings, or heavy machinery.

What do governments pay for? ›

Mandatory. Mandatory spending consists primarily of Social Security, Medicare, and Medicaid. Several welfare programs are smaller items, including food stamps, child tax credits, child nutrition programs, housing assistance, the earned income tax credit, and temporary assistance for needy families.

Where does government money come from? ›

The federal government collects revenue from a variety of sources, including individual income taxes, payroll taxes, corporate income taxes, and excise taxes. It also collects revenue from services like admission to national parks and customs duties.

Why does the government need taxes? ›

The country's budget

All citizens must pay taxes, and by doing so, contribute their fair share to the health of the government and national economy. The federal taxes you pay are used by the government to invest in technology and education, and to provide goods and services for the benefit of the American people.

What is an example of GDP? ›

If, for example, Country B produced in one year 5 bananas each worth $1 and 5 backrubs each worth $6, then the GDP would be $35. If in the next year the price of bananas jumps to $2 and the quantities produced remain the same, then the GDP of Country B would be $40.

How does government spending affect the economy? ›

If the government spending causes the unemployed to gain jobs then they will have more income to spend leading to a further increase in aggregate demand. In these situations of spare capacity in the economy, the government spending may cause a bigger final increase in GDP than the initial injection.

How do you calculate government spending? ›

What is the GDP Formula?
  1. Expenditure Approach. The expenditure approach is the most commonly used GDP formula, which is based on the money spent by various groups that participate in the economy. GDP = C + G + I + NX. ...
  2. Income Approach. This GDP formula takes the total income generated by the goods and services produced.
7 May 2022

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