A budget is a financial plan detailing the planned revenue and expenditure in the coming fiscal year. It details the amount the government is expected to earn from different sources (tax, borrowing, sale of assets etc) as revenue and how it will be spent.
Governments aim for its budgets to be balanced (a situation where revenue equals expenditure) or surplus (a situation where revenue exceeds expenditure). In some cases, budget might be deficit (a situation where expenditure is more than revenue).
Reasons for government spending
Different government spend on different things which varies from health care to military to public expenditures. In all of these, government of every country spend base their spending on these objectives:
- To invest in social and economic infrastructure: These infrastructure could be roads, schools, hospitals, railway networks to enhance human and economic development within their country.
- To reduce inequalities in income and to help vulnerable people: Most government invest in welfare payment and unemployed benefits for the low income earners within their country. This support program can cater for the disabled, old-age pensions, child support, etc would help redistribute income.
- To provide public and merit goods: In a free market such goods will be under produced as it isn’t profitable for private firms.
- To boost key industries: government can also spend on key industries within their economy to help improve their output and increase employment. This assistance can be provided in form of subsidies to ease their cost of production while firms can invest in other key segment such as developing better products or processes.
- To manage the macro-economy: They use public spending and taxes to influence aggregate demand in order to maintain stable inflation, reduce unemployment and achieve economic growth.
Tax is a compulsory payment made to the government on income or expenditure. The tax is the government’s main source of income and it helps to boost their spending. Government levies taxes for the following reason:
- taxes on salaries and profits can be used to redistribute income and wealth in the economy
- taxes on goods and services can help reduce import goods which can boost local production, it can also reduce the consumption of demerits goods as they become more expensive.
- taxes can be use to manage the macroeconomy; this can be achieved in various ways as they can reduce taxes to increase aggregate demand for consumers and improve aggregate supply by producers or increase taxes to reduce demand during period of boom.
Classification of taxes
This type of tax is paid from income, wealth or profit of individuals or firms. Here are example of direct tax below:
- Income Tax: this is levied on personal incomes such as wages, interest rent and dividends. After this deduction is made, the money left is known as disposable income.
- Corporation Tax: this is a tax levied on profits of firms or businesses.
- Wealth Tax: Levied on the value of property that a person holds.
- Estate Duty: Paid by an individual in case of inheritance.
- Gift Tax: An individual receiving the taxable gift pays tax to the government.
These are taxes levied on the manufacture or sale of goods and services. These are initially paid to the government by an intermediary, who then adds the amount of the tax paid to the value of the goods / services and passes on the total amount to the end user. Here are examples of indirect tax below:
- Excise Duty: Payable by the manufacturer who shifts the tax burden to retailers and wholesalers.
- Sales Tax: Paid by a shopkeeper or retailer, who then shifts the tax burden to customers by charging sales tax on goods and services.
- Custom Duty: Import duties levied on goods from outside the country, ultimately paid for by consumers and retailers.
- Entertainment Tax: Liability is on the cinema owners, who transfer the burden to cinema goers.
- Service Tax: Charged on services rendered to consumers, such as food bill in a restaurant.
Key differences between Direct and Indirect Tax are:
- Direct tax is levied and paid for by individuals, firms, companies etc. whereas indirect tax is ultimately paid for by the end-consumer of goods and services.
- The burden of tax cannot be shifted in case of direct taxes while burden can be shifted for indirect taxes.
- Lack of administration in collection of direct taxes can make tax evasion possible, while indirect taxes cannot be evaded as the taxes are charged on goods and services.
- Direct tax can help in reducing inflation, whereas indirect tax may enhance inflation.
- Direct taxes have better allocative effects than indirect taxes as direct taxes put lesser burden over the collection of amount than indirect taxes, where collection is scattered across parties and consumers’ preferences of goods is distorted from the price variations due to indirect taxes.
- Direct taxes help in reducing inequalities and are considered to be progressive while indirect taxes enhance inequalities and are considered to be regressive.
- Indirect taxes involve lesser administrative costs due to convenient and stable collections, while direct taxes have many exemptions and involve higher administrative costs.
Taxes can also be classified according to whether they are progressive, regressive or proportional.
A progressive tax is a tax where the average tax rate, or the total amount of tax paid as a percentage of income, increases as the taxpayer’s income increases. A tax may be progressive if people with higher incomes pay a higher tax rate (e.g. the personal income tax). Alternatively, taxes can be progressive if the tax is levied on an action or purchase that is more common amongst wealthier people (e.g. the luxury car tax, or an inheritance tax).
A regressive tax is the opposite, where the average tax rate decreases with the increase of the taxpayer’s income. This type of tax places more burden on low-income demographics rather than the high-income population. The imposed burden is determined by the percentage of the tax amount relative to income. Examples of regressive tax are property tax, sin tax, sales tax.
A proportional tax lies between a progressive and a regressive tax, and collects a constant percentage of income in tax for all taxpayers.
Principles of Taxation
- Equitable: The type of tax imposed should present an equal burden on all taxpayers in the same economic condition. Further, the tax should not favor one group over another, so that one group receives a tax benefit at the expense of another group.
- Economical: The cost required to collect taxes should be as low as possible in order to maximise the yield.
- Convenience: taxation payment should be as simple as possible, so that a taxpayer will have little difficulty in complying with the tax payment requirements.
- Certainty: Tax payer should know what, when, where and how to pay the tax.
- Efficiency: the tax system should attempt to achieve its aims without any side effects. for example high taxes could result in a disincentive to work and hence slow down the economy and reduce long term tax revenue.
- Flexibility: A good tax system should be flexible in order to meet the needs of the society. it should easily adapt to a change in economic situation without re-writing the tax legislation.
Impact of Taxation
Taxes impact differently on economic agents (households, firms & government) depending on the type of tax
- An increase in tax reduces disposable income of earners leading to a reduction in spending ability and profit of firms. On the other hand, a cut in tax increases disposable income leading to increase in profit for firms and putting pressure on the economy which triggers inflation in the economy.
- An imposition of Indirect tax on demerit goods and services would shift the supply curve which can be attributed to higher cost of production. This increases the price of the product and reduces quantity demand for the product.
- An increase in tax might increase voluntary unemployment and reduce overall output produced in an economy. On the other hand, when it is reduced, it boost domestic spending thereby creating more job leading to an increase in output.
- An increase in corporation tax might discourage multinationals in setting up there by reducing foreign direct investment into the country. On the other hand, a reduction in corporation tax would attract investment and workers into the economy.
Fiscal policy is the use of taxation and government expenditure to influence macroeconomics objectives in an economy.
Fiscal policy can either be used to expand or contract the economic activity to achieve macroeconomic activities.
Expansionary fiscal policy can be used by increasing government spending and lowering taxes. This can easily help an economy in recession as the government could invest more funds into a special industry which can yield quick returns for them. This has a negative impact on the government as their revenues reduces as a result of reduction in taxes whilst there is an increase in government spending.
Contractionary fiscal policy is used to reduce the level of economic activity by decreasing government spending and increasing taxes. Contractionary policies are used to reduce inflationary pressures during an economic boom.
Effects of fiscal policy on government macroeconomic aims.
Inflation (Low & Stable): lower taxes and increased government spending can boost the productive capacity of the economy in the long run which is capable of keeping prices relatively low.
Employment(Low unemployment): A cut in income tax create incentives for people to seek employment and to be more productive. Government support through subsidies or selective taxes can motivate entrepreneurs there creating jobs and lowering unemployment.
Economic growth: Increased government spending on infrastructure can boost investment in the economy and attract multinationals thereby boosting economy’s output.
Balance on International Payment: Low taxes increase competition amongst domestic firms thereby increasing exportation of their goods. The government might also subsidise firms to improve their international competitiveness which ensures that they have a favourable balance of payment.