3.2.5.1 - Public expenditure and taxation

Types and purposes of public expenditure

Public expenditure buys services, builds assets and transfers purchasing power, with different effects on the economy.

Current expenditure pays for continuing services, such as nurses' wages, medicines and maintaining schools. Capital expenditure creates or improves long-lived assets, such as a hospital building or railway. These categories describe the use of spending: a school needs both a building and teachers. Capital spending is not automatically productive, and current spending on education can improve future human capital.

Transfer payments, such as pensions and benefits, redistribute income without purchasing newly produced output in return. They are public expenditure but are not directly included in the government-purchases component of aggregate demand. If recipients spend them, consumption may rise. Debt-interest payments also use public funds without buying current public services.

Governments provide public goods that markets would underprovide, support merit goods with external benefits, redistribute income, protect people against risks and stabilise economic activity. Infrastructure may reduce firms' costs; healthcare may improve labour participation. Each use also has an opportunity cost: the workers, materials and money could support another public service or private activity. A larger spending budget alone does not tell us whether benefits exceed those costs.

Why taxes are levied and who pays

Taxation raises revenue and changes incentives, so the tax base and the economic burden both matter.

Governments tax to finance services and transfers, redistribute income and wealth, influence aggregate demand and discourage activities with external costs. Taxes can also encourage substitution: a levy linked to sugar content can make reformulation attractive to a drinks producer. Borrowing can finance spending temporarily, but creates future financing obligations; it does not remove the need to consider revenues and expenditure.

A direct tax is levied on income, profits or wealth: UK Income Tax, Corporation Tax and Inheritance Tax are examples. An indirect tax is levied on expenditure or transactions in goods and services: VAT and excise duties are examples. Direct/indirect describes the tax base, not whether the burden is progressive or whether the payer can pass it on.

The person legally responsible for paying a tax need not bear its entire economic incidence. A producer paying a duty may raise prices; a company paying Corporation Tax may alter dividends, wages or investment. As in the indirect-tax lesson, relative demand and supply elasticities influence how a tax burden is shared. Saying “businesses pay” is therefore insufficient to establish the distributional effect.

Progressive, proportional and regressive taxes

Classify a tax by how the proportion of income paid changes as income rises, rather than by the cash payment alone.

The average tax rate is total tax divided by income. A progressive tax takes a rising proportion as income rises; a proportional tax takes a constant proportion; a regressive tax takes a falling proportion. The marginal tax rate is the proportion of an additional unit of income taken in tax. A higher marginal rate on the next band does not apply retrospectively to every pound earned.

Consider this illustrative income-tax system: the first £10,000 is untaxed, the next £20,000 is taxed at 20%, and income above £30,000 at 40%. These are invented bands, not current UK rates.

At £40,000, tax is $0.20\times £20{,}000+0.40\times £10{,}000=£8{,}000$. Its average rate is $£8{,}000/£40{,}000\times100=20\%$, while the marginal rate on another pound is 40%. Both households pay more cash at higher income, but the rising average rate is what establishes progressivity.

A fixed annual £600 charge would take 3% of £20,000 and 1.5% of £40,000: it is regressive relative to income. VAT can be proportional to taxable expenditure yet regressive relative to income if poorer households spend a larger income share on taxed goods. Zero rates on some necessities and the wider tax-benefit system affect the overall result. Always state the denominator and distinguish a tax's own burden from the net effect of all taxes and transfers.