Taxes and Public Spending

In most economies government revenues come mainly from direct taxes on personal incomes and company profits as well as indirect taxes levied on purchase of goods and services such as value added tax (VAT) and sales tax. Since state provision of retirement pensions is included in government expenditure, pension contributions to state-run social security funds are included in revenue, too. Some small component of government spending is financed through government borrowing.

Government spending comprises spending on goods and services and transfer payments.

Governments mostly pay for public goods, that is, those goods that, even if they are consumed by one person, can still be consumed by other people. Clean air, national defence, health service are examples of public goods. Governments also provide such services as police, fire-fighting and the administration of justice.

A transfer is a payment, usually by the government, for which no corresponding service is provided in return. Examples are social security, retirement pensions, unemployment benefits and. in some countries, food stamps. In most countries there are campaigns for cutting governments spending. The reason for it is that high levels of government spending believed to exhaust resources that can be used productively in the private sector. Lower incentives to work are also believed to result from social security payments and unemployment benefits.

Whereas spending on goods and services directly exhausts resources that can be used elsewhere, transfer payments do not reduce society’s resources. They transfer purchasing power from one group of consumers, those paying taxes, to another group of consumers, those receiving transfer payments and subsidies.

Another reason for reducing government spending is to make room for tax cuts.

Government intervention manifests itself in tax policy which is different in different countries. In the United Kingdom the government takes nearly 40 percent of national income in taxes. Some governments take a larger share, others a smaller share.

The most widely used progressive tax structure is the one in which the average tax rate rises with a person’s income level. As a result of progressive tax and transfer system most is taken from the rich and most is given to the poor.

Rising tax rates initially increase tax revenue but eventually result in such large falls in the equilibrium quantity of the taxed commodity or activity that revenue starts to fall again. High tax rates are said to reduce the incentive to work. If half of all we earn goes to the government we may prefer to work fewer hours a week and spend more time in the garden or watching television.

Cuts in tax rates will usually reduce the deadweight tax burden and reduce the amount of taxes raised but might increase eventual revenue.

If governments wish to reduce the deadweight tax burden and balance spending and revenue, they are supposed to reduce government spending in order to cut taxes.

2. Answer the questions to the test Taxes and Public Spending.

1. How is government spending financed?

2. What do governments pay for?

3. What are the three reasons for cutting government spending?

4. Which share of national income comes from taxes?

5. What are the characteristics of the progressive tax structure?

6. What may the result of very high tax rates be?

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