Economic growth and development are the major concerns of every government. There is a need to have a system of operation that measures how much the economy has grown and how it can be kept upward. And in this case, public finance plays an important role. Public finance can be a study of government activities, which include but are not limited to government spending, deficit, and taxation. It seeks to answer the questions, of when, how, and why the government should get involved in the current economy. Apart from this, public finance seeks to understand the possible effects of making changes in a given market. Public finance can also touch on issues that are not directly linked to the economy, like accounting, law, and public finance management.
A student of economic studies will need to understand the role of the government and the changes that can affect the general economy. It is among several roles that public finance professionals play as they seek to advise policymakers and governments on what to do during a certain period in the business cycle. Government intervention in the economy can come in different ways, three of which are economic efficiency, distribution of income, and stabilization of macroeconomics. In everything, the government always has to understand the different issues that can impact the economy’s growth.
Economic efficiency is the standard used by economists use to evaluate different resources. This can be derived with a general formula of different ratios and generated outcomes. One must understand the differences between technical efficiency and economic efficiency. It all comes down to the relationship of values people place on different things. In technical efficiency, the value may be subjective from one individual to another, where what one finds valuable may not be what another person may want to have. On the other hand, economic efficiency seeks to get rid of waste to offer as much value as possible. Technical efficiency aims at the maximization of value, even by sacrificing as much as is necessary to come up with a perfect initiative.
Distribution of income stands for the calculation of the wealth and income of a nation after it has been divided by its total population. A series of statistical studies can be sued in evaluating the overall distribution. Also, it is important to understand the difference between wealth and income. Wealth means the overall value of physical possessions held by the entire population, whereas income is the exact monetary value of a population’s net intake over a specified period of time. Collecting information on a country’s wealth can be a resourceful source of data when seeking to answer different questions in the political, social, and economic realms.
Macroeconomic stabilization is another aspect of public finance that affects the economy directly. It is the process by which the growth of an economy is monitored by creating fiscal and monetary policies, laws, and various regulations. An economy cannot grow with stabilization, which is why this aspect is very crucial. But then, stabilization cannot be achieved if there is no balance between government budgeting, domestic commerce, banking operations, international trade, and governing institutions. And once stability has been achieved in the current macroeconomic environment and an optimal level of efficiency, there is a need to maintain this status. This management can be done to ensure interest rates, business cycles, and demand within the economy are kept on a steady trend.
All of these factors can be summarized in government spending. Governments use the money on different projects that keep the economy on an upward growth trend. Various government institutions are mandated to keep government expenditure on these processes well met. But we cannot talk about government spending before understanding public finance because this is where the government gets the money to spend on various things. Taxation is the main method that many governments use to collect revenues for their smooth operation.
What is government spending?
Now that you understand the role of the government in economic development, we can now go ahead to look at what government spending means. This is a process that includes all the government’s consumption, investment, and transfer of payments. Government final consumption is a situation in national income accounting that forms a classification of the acquisition of goods and services for current use by governments of goods. Government acquisition of goods and services for future benefits, including things like investing in infrastructure or spending on research, can be classed under government investment – the government gross capital formation. When final consumption and capital formation are put together, they form what is known as the growth of domestic products. In other words, government spending plays a vital role in growing the country’s GDP in different aspects of the economy.
Another important question that falls under government spending is, where does the money come from? Two major methods are used to fund government spending, namely, borrowing and taxes. Taxes are a way of ensuring every person in the economy gets involved in its growth and development. Economic growth is the measure of how well people are perceived to be leading a happy life, where the government is able to offer all or most of the resources they need. Before a government can spend this money, it has to develop a clear budget indicating where most expenditure is expected and how much investment is needed. A surplus is generated when the government spends less than what it had planned. Hence, the difference between expenditure and the current budget. Sometimes, however, the government may spend more than what was budgeted for, in which case, a deficit is created. When money is borrowed, it leads to government debt, otherwise known as public debt. A huge public debt could be an indication that the economy is a growing factor, and the government is expected to spend even more. Any change in government spending creates a major component of fiscal policy, which is used in the stabilization of the macroeconomic business cycle.
Government spending is an important aspect of economic development. Consider the 2008-2009 Great Recension and its aftermath that caused many markets to fall, for instance. It began with a failure in the financial markets, which then spread into the other markets. Policymakers rushed to create different policies to restore the economy and shield markets from its worst effects. Among these steps, there was investing money in collapsing markets through bonds, reducing lending rates and taxes. Governments were forced to spend more because it was necessary at the time to put more money into the economy.
Fiscal policy in macroeconomic economics
Government spending is necessary and a crucial tool in dealing with different economic issues. Fiscal policy can be defined as the use of government spending to influence the growth of the economy. There are two main categories of fiscal policies used based on the current situation of the economy.
Contractionary fiscal policy
This is where the government increases spending or increases taxation. This comes up when the economy is facing a bubble (an unhealthy upward growth trend). Here, the government needs to develop policies to increase taxes and commodity prices to discourage too much supply of goods. If not, there is a huge chance of inflation. Increasing the interest rate reduces the chances of too much borrowing, ensuring that only the desired amount for safe growth of the economy is achieved. There is an increase in government spending with the aim of increasing public debt. The expansionary fiscal policy comes up during a bubble to help the government to put a brake on negative economic growth. For instance, governments can decrease spending directly to influence an increase in the demand for goods and services.
Expansionary fiscal policy
During a recession, the government comes up with this policy to boost the economy. During a downturn, the government can increase spending, reduce lending rates, and reduce taxes on different goods. This is the time when more schools could be built, and more investment infrastructure was witnessed.
Economic downturns can either be short-term or long-term. During short term recessions, the government can change its spending through automatic stabilization. This is when the current policies are automatically applied to change government spending or taxes as a response to certain changes in the economy. It does not require passing another law or making other changes to the existing ones to meet these changes. For instance, unemployment insurance is used as an automatic stabilizer, whereby financial assistance is given to workers who are currently not employed.
Contrary to these short-term solutions, there is discretionary stabilization, where the government takes action to spend or change taxing as a response to changes in an economy. For example, the government can use a discretionary fiscal policy to increase government spending where a long-term recession is witnessed. In discretionary stabilization, the government has to pass a new law in making changes in expenditure.
Government deficit spending is where the government has to borrow funds from other internal and external sources to meet certain needs in the economy. John Maynard Keynes was the first economist to advocate for this type of spending to be included in the fiscal policy response to a contraction in the economy. When there is an increase in government spending, it causes an increase in aggregate demand. There is more money in the economy, which incentivizes producers to reduce the prices of their goods, which in turn leads to increased consumption. More spending means more production and a quicker recovery from a recession. On the other hand, we have classical economists, who believe that increasing government spending can exacerbate an economic contraction because resources are shifted from the private sector, which to them, is more productive, to the public sector, considered unproductive. When there is a ‘shifting’ of resources from the private to the public sector due to increased deficit spending, economists term this as crowding out. Government spending can be used to boost the economy. Whether it is through crowding out or other means, it is still crucial to ensure better growth of the economy.
But not every economist agrees with the explanation above. Different other models have been designed to explain government spending’s potential effects, helping governments and policymakers find alternative ways of dealing with economic shocks.
The explanation we have used above on the impact of government spending on an economy is taken from conventional, orthodox economics. This set of theories failed to predict the Global Financial Crisis, which was the biggest in the past 80 years. It could not also predict the sub-prime mortgage derivatives meltdown, and therefore, it is understandable that some experts may say this method should not be applied when dealing with serious economic issues. Economics is well known to provoke controversy, and therefore this is not something new. However, empirical evidence exists to prove that orthodox economics can be used as a valid approach to the current economic situation. A good example is Steve Keen’s “Debunking Economic: The Naked Emperor Dethroned.” Even though this book presents the orthodox approach as questionable, it can still help you understand some aspects of this model that may not be clear yet.
Another economist who is against orthodox economics is Matte Stoller, who says that this approach is best used to “create a language and methodology that hides political assumptions from the public.” Besides, calling this a “science creates a sense of questions. Questionable things promoted by orthodox economists, like crowding out, don’t seem to make a lot of sense to other economists.
Government spending is a wide subject of discussion. By the end of your course, and when you start practising, you will gain more understanding of this vital aspect of economic growth and development. Even with the contradicting idea above, we can still conclude that the government plays a huge role in economic development. And government spending is still an approach used by many countries to change markets. It’s still an open subject with many varying views, and under public finance, one that should be studied carefully.