Public Expenditure and Finance in the UK Economy
1
Public-sector expenditure
1.1
Public-sector expenditure is the name given to spending by central
government, local government and public corporations, e.g. the Post Office,
the BBC. Plans for public-sector spending are published annually along with
the Budget. These plans show intended spending for the coming 3 years.
1.2
Types of public-sector spending
• Capital spending. This helps to create productive capacity, e.g. hospitals,
urban renewal and transport infrastructure.
• Current spending. This covers day-to-day running costs of government,
e.g. the pay of public-sector workers.
• Transfer payments. A transfer payment is defined as a payment to an
individual or firm for which there is no economic b enefit given in return,
e.g. pensions, unemployment benefit, child benefit, grants and subsidies.
They are called transfer payments because money is transferred from
taxpayers to those who qualify for benefit.
The distinction between types of spending is important because capital and
current spending diverts resources from the private sector; whereas transfer
payments do not absorb resources but redistribute income and spending power
within the private sector.
Most of the Government’s capital and current expenditure is on public and
merit goods and services.
1.3
A public good or service is one which benefits everyone in society, e.g.
defence, street-lighting. A public good cannot be provided by the private
sector because of the difficulty in getting all its consumers to pay.
Government, therefore, has to provide public goods and raise the required
revenue from general taxation.
1.4
Merit goods or services, e.g. healthcare, education, are considered to be
socially desirable but would be under produced if left to private enterprise.
Merit goods or services are given to those people who merit (i.e. need) them,
either free or at reduced prices. These are paid for out of taxation and in some
cases, e.g. medical prescriptions, by charging consumers a proportio n of the
price.
1.5
Trends in public-sector expenditure
Changing total
In recent years there has been an increase in Government expenditure in the
economy. This has been due mainly to increases in spending on health,
education and transport.
Changing pattern
Increases in spending on health and education have been proportionately
greater than on other programmes. Defence spending has fallen because of the
end of the ‘cold war’, which has given us a ‘peace dividend’.
Social security spending has increased because the ageing population has led
to more spending on retirement pension.
However, there have been reductions in areas such housing where – as part of
its privatisation policy – government has limited its spending on building new
council houses. Spending on support for industry has also become less
important.
There is strong debate among economists and politicians about the merits of
public-sector expenditure.
1.6
Case for reducing growth in public spending
• Income tax can be reduced which will increase incentives and increase
consumers’ freedom to choose how to spend their incomes.
• Government borrowing can be reduced.
• Resources can be released for use by the private sector. It is thought by
some that the private sector uses resources more efficiently.
1.7
Case against cuts in growth of public spending
• Most public-sector spending is on UK-produced output which creates
employment in the UK. If given back to consumers by reducing tax, it may
be spent on imports.
• Capital spending is the easiest for government to cut but this reduces the
country’s infrastructure, which in turn reduces the efficiency of the
economy, e.g. there have been major cuts in recent years in housing.
• Resources released from the public sector are not automatica lly taken up by
the private sector. They may remain unemployed.
• Lower-income groups are the most dependent on public spending, not only
on benefits but also on services such as housing and public transport.
2
Taxation
2.1
Types of taxation
Direct taxes
Direct taxes are defined as those taxes which are taken directly from
individuals and firms. They are levied by the Inland Revenue department.
They are mainly taxes on income and wealth, e.g.:
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income tax
national insurance contributions – although not called a tax, in fact it is
corporation tax – levied on company profits
council tax – levied on the value of a householder’s house
capital gains tax – levied on the increase in value of assets
inheritance tax – levied on a deceased person’s estate
stamp duties – levied on the change of ownership of houses and land.
Indirect taxes
Indirect taxes are levied indirectly, i.e. the payer of the tax to government
passes on the burden of the tax, usually to a customer. These are collected by
the Customs and Excise Department. They include:
• Value Added Tax (VAT) – levied on a wide range of goods and services.
Some goods, e.g. children’s clothes, books and basic foodstuffs are zero rated
• customs duties – taxes on imports
• excise duties – taxes on petrol, tobacco and alcohol
• petrol revenue tax – tax on North Sea oil companies
• motor vehicle duties.
2.2
What makes a good tax?
Adam Smith, the famous eighteenth-century Scottish economist laid down four
principles (or ‘canons’, as he called them) for a good tax.
(a)
Equity. Taxes should relate to the taxpayer’s ability to pay.
(b)
Efficiency. Taxes should be reasonably inexpensive to collect, i.e. the
cost of collection should form a small percentage of the revenue
collected and they should not have negative side-effects such as reducing
work incentives for individuals.
(c)
Certainty. The taxpayer should be clearly aware how much is due, and
when and where to pay.
(d)
Convenience. Taxes should be payable at a time and place that suits the
taxpayer.
Not all taxes levied in the UK adhere to these principles.
2.3
Progressive and regressive taxes
A progressive tax is one which takes account of people’s ability to pay, i.e. it
follows Smith’s principle of equity. A progressive tax takes a larger
percentage of income as income rises. Most direct taxes are of this type.
A regressive tax takes no account of people’s ability to pay. Lower -income
earners pay a higher percentage of their income in tax. Most indirect taxes are
regressive, e.g. duties on alcohol, petrol, road tax are fixed amounts of money
which are the same for everybody. VAT, although an indirect tax, takes some
account of ability to pay in that some essential items such as food, children’s
clothes and shoes, which account for a large proportion of a low income
earner’s spending, are zero rated and household fuel is rated at 5%.
Nevertheless VAT is a regressive tax.
2.4
Trends in taxation
Cuts in business taxes, e.g. corporation tax and business rates
The aim has been to allow firms to earn higher profits and so encourage
investment. The UK now has lower business taxes than most other European
countries, which helps to attract inward investment.
Shift from direct to indirect tax
In the 1980s Conservative Governments star ted to restructure taxation by
shifting the balance away from direct taxation towards indirect taxation and
this policy was continued in the 1990s. The restructuring was done by
simplifying and reducing rates of income tax. The Conservatives believed that
lowering rates of income tax would encourage enterprise and effort. The top
rate has been cut from 83% in 1979 to 40%; standard rate from 33% to 22%.
There is also now a starting rate of 10%. The share of income tax in total tax
revenue has fallen from 45% to 25%. The loss in revenue from income tax cuts
was largely recouped from VAT which has been raised and extended to a
wider range of goods and services. Excise duties on tobacco, alcohol and
motoring have been increased by more than inflation. The effect of the
restructuring has been to tilt the balance of taxation away from earning to
spending and to make the tax system more regressive. A further effect has
been a widening of the gap between rich and poor. The Labour Government
elected in 1997 gave a promise that it would not raise income tax nor extend
VAT. However, it has started to narrow the rich –poor gap by a reform of other
taxes.
2.5
Case for cuts in income tax
• Tax revenue may increase. High rates of income tax encourage people to
exploit every possible loophole to avoid tax and they encourage some
people to break the law in order to evade tax. Cutting rates may remove this
evasion.
• Incentives are increased. If marginal rates of tax are reduced then people
will be able to keep more of any additional income they earn. This may act
as an incentive to work harder or to seek promotion. Lower tax rates may
also encourage some of the voluntary unemployed to work.
As people work harder and earn more, the tax revenue in total may rise.
The potential revenue from income tax cuts can be illustrated by the Laffer
curve (Laffer is a US economist). Since no revenue can be expected from tax
rates of 0%, the curve of tax revenue rises as tax rates rise but eventually falls
because of disincentives, evasion and avoidance, until at 100% rates tax
revenue would return to zero. The difficulty for a Government is knowing
which tax rate would yield the highest tax revenue.
Tax revenue
Tax rate
2.6
Case against cuts in income tax
• Some economists argue that tax revenue may not increase. A higher
disposable income from working the same or fewer hours may encourage
people to take more leisure time.
• The demand side of the economy may be over stimulated . This leads to
inflation.
• Inequalities are likely to widen. Since income tax is progressive, cuts are
likely to favour those on higher incomes while those on low incomes who
are not liable to income tax will gain no benefit. If, as has been the case,
government switches to more taxes on expenditure, which tend to be
regressive, then those on low incomes are further disadvantaged.
3
Public Sector Net Cash Requirement (PSNCR)
3.1
PSNCR. The PSNCR is defined as the borrowing of the public sector, i.e.
central government, local authorities and public corporations. There is a need
for the public sector to borrow if its expenditure is greater than its income.
The main factor in this is usually a central government budget deficit. The
PSNCR is measured in £ billion and as a percentage of GDP. It is financed by
selling bonds, gilt-edged securities and
treasury bills to financial institutions and to citizens. In some years the
PSNCR may be negative. In this case the government is running a budget
surplus and is then able to repay debt.
3.2
The Budget. A Government must plan what it wants to spend and how it is
going to finance its expenditure. This plan is usually done once a year and is
presented to parliament as the Budget. However, the Budget may be used for
purposes other than just a financial plan. This is covere d in Topic 4
Government Economic Policies.
Budget deficit
If central government income is less than central government spending, this is
called a budget deficit.
You should note that the Budget is as much a political exercise as an
instrument of economic policy. For example, in the run-up to an election
measures in the Budget may be taken to win political support which may be
against the interest of the economy at that time.
3.3
National debt. The national debt is the total amount of accumulated debt , i.e.
the total amount which the public sector owes to those who have loaned it
money. If in one year there is a PSNCR, then the national debt will increase. A
budget surplus will reduce the national debt.
3.4
Why government needs to control the PSNCR. A high PSNCR may cause
the following problems:
• ‘Crowding out’ – high Government borrowing may starve the private
sector of funds for investment.
• Interest rates may have to rise to encourage lenders to lend to
Government. The UK Government usually has l ittle difficulty in borrowing
money because lenders have confidence in its ability to repay. However,
when the borrowing requirement is large it may have to offer higher rates
of interest to attract extra funds. This also increases the cost of borrowing
for the private sector.
• Inflation. Monetarists believe that if Government borrowing is financed by
borrowing from banks then the money supply increases and causes
inflation.
• National Debt is increased – this leads to higher repayments of debt
interest in the future which have to be financed by higher taxes or
reductions in other spending programmes.
• EMU. A condition for membership of Economic and Monetary Union
(EMU) in Europe is that in any year the PSNCR should be no more than 3%
of GDP and the national debt should be no more than 40% of GDP.
Government therefore has to try to stick to these requirements.
3.5
Difficulties in controlling Government borrowing . It is difficult for
governments to control their borrowing because of the difficulty in pred icting
the economic cycle. The amount of money the government spends and receives
from taxation fluctuates with the economic cycle. In periods of economic
growth and rising employment spending on benefits decreases while tax
revenues increase from higher incomes, consumer spending and business
profits. The opposite happens during a recession!
3.6
UK trends
The recession of 1990–2 had increased the PSNCR. Tax revenues fell but
public expenditure on unemployment benefits and social securi ty payments
increased. The government could have increased tax rates to reduce the Public
Sector Borrowing Requirement (PSBR) but the economy was too weak to
stand this.
From 1994 to 1997, the PSBR fell. As the economy recovered from recession,
tax revenues increased as GDP increased and government felt able to increase
taxes.
The new Labour Government of 1997 set a tough target for government
borrowing and intended to achieve it by maintaining strict control of public sector spending, and raising some taxes (although it had a commitment not to
raise income tax or extend VAT). It restored the ‘golden rule’ of fiscal policy.
Golden Rule of Fiscal Policy
The golden rule is that in the long run government borrowing should only
be allowed to finance capital expenditure rather than current
expenditure. The thinking is that capital spending, such as new hospitals
and roads, will benefit present and future generations and should be paid
for by those who benefit now and in the future.
Current spending, such as teachers’ salaries, school books, etc. should
be paid for now by taxing the generation who benefit from this spending.
The Chancellor has modified this by stating that borrowing to fund
current spending should be neutral over the economic cycle , i.e. it may
need to borrow during years of recession but that this should be repaid
out of budget surpluses in years of growth.
The 1997 and 1998 Budgets were both tight, i.e. taxes were higher than
spending. The public finances improved to the exte nt that instead of having to
borrow the Government was able to repay debt. In 1999 and 2000 public
finances continued to improve and the Chancellor was able to reduce tax
receipts in the Budget of 1999 without having to borrow.
Since 2001 public borrowing has grown as the economy and tax revenues have
not grown as fast as the Chancellor predicted and because of very large
increases in capital spending in health and education. Note that although the
figures are very large, they are a small percentage of GD P, e.g. the national
debt of the UK will be 35% of GDP in 2005, compared with 50% in the USA
and Germany and 80% in Japan.