Economics - Understanding The Government

Understanding The Government Page | 1 Public expenditure can be divided into two categories – operating and development. Ways to use Government Expenditure: 1. 2. 3. 4.

Resource allocation by diverting resources Reduce inequity Economic growth (income, employment and output) Fiscal tool

Sources of Government Revenue 1. 2. 3. 4. 5.

Taxes Income from public assets, services, fines and fees, etc Loans Issue of new money Grants and gifts from other countries

Purpose of Taxation 1. 2. 3. 4. 5.

Source of revenue Economic management tool Reduce income inequality Correct market failures Attraction for foreign labour

Characteristics of a Tax System 1. 2. 3. 4.

Income equality Clarity and certainty Convenience Economical

Types of Taxes 1. 2.

Direct taxes Indirect taxes a. Ad Valorem taxes b. Specific taxes

Rates of Taxation 1.

Marginal Tax Rate (MTR)

a. Change in tax rateChange in total incomeX 100 2.

Average Tax Rate (ATR)

a. Total taxTotal incomeX 100 Impact of Taxation 1. 2. 3.

Proportional tax (ATR constant) Progressive tax (ATR rises) Regressive tax (ATR falls)

Effects of Taxation Positive 1. 2. 3.

Income equality Discourage demerit goods Fiscal policy to affect AD

Negative 1. 2. 3. 4.

Lower desire to work Less savings and investment Higher prices, may lead to inflation Distort demand and supply interaction

The Laffer Curve

The Laffer Curve illustrates that excessive tax rates will have a dampening effect on national income and tax revenue. Strategy in Collecting Taxes 1. 2.

Reducing direct taxes Widening the tax base

Evaluation of Direct Taxes Merits 1. 2. 3.

Clarity and certainty No shifting of tax burden Progressive in nature, able to improve income equality

Demerits 1. 2. 3.

Disincentive effect on production Less savings and investments Loopholes for tax dodging

Evaluation of Indirect Taxes Merits 1. 2. 3. 4. 5.

Substantial revenue at relatively low rates Tax burden is hidden No direct effect on savings and investment Few loopholes for tax dodging Can be used to discourage demerit goods

Demerits 1. 2. 3. 4. 5.

Producers shift burden of tax to consumer Prices higher, lower real income Negative effect on exports and tourism Discourage investment due to higher production costs Regressive in nature, worsening inequity

Impact – who pays the tax first Incidence – who eventually pays the tax Budget Types 1. 2. 3.

Surplus - Contractionary fiscal policy Deficit – Expansionary fiscal policy Balanced – Overall still expansionary, used to stabilise and maintain

Factors Determining a Country’s Budget Policy 1. 2. 3.

Achieving monetary stability (full employment with price stability) Rate of economic development intended State of economy

Evaluating Balanced Budget Positive 1. 2. 3.

Government is well-disciplined in its fiscal policy Monetary stability Government does not spend more than what it collects

Negative 1. 2. http://education.helixated.com An Open Source Education Project

Aggravates inflation and deflation Unfeasible on the long term economic planning of a country

2 | Page Financing Budget Deficits Internal sources 1. 2. 3.

General public Central bank or commercial banks Print new notes

External sources 1. 2.

Loans from other countries International financial institutions (eg. World Bank, IMF)

Reasons of Budget Deficits 1. 2. 3.

Expansionary fiscal policy (stimulate AD) Economic development in a poor country Finance a war

Public Debt 1. 2. 3.

Productive purposes, it has no real burden and may confer a benefit Unproductive purposes, it will impose burdens External burden poses higher welfare loss to society as interest payment flows out