1.6.1 - Government spending and taxation

Public services and business activity

Public spending pays for services that support everyday life and the conditions in which businesses operate.

Examples include education, healthcare, policing and transport facilities. These are public services because government arranges or finances their provision for the population. A public service need not be delivered entirely by government employees: a government can pay a private building firm to construct a school. The payment is still public spending; the building firm is a supplier earning revenue.

Education can give a bakery access to workers who can read instructions and handle money accurately. Health services can help workers recover and return to work. Policing and reliable transport can make deliveries safer and more predictable. These links explain how spending can improve business activity even when a business receives no direct payment from government.

Spending can also create demand directly. In an illustrative business scenario, a government orders uniforms from a local clothing manufacturer. The order raises the manufacturer's sales and may justify recruiting more machinists. Benefits depend on which service is funded, how effectively it is delivered and whether the particular business uses it. Spending on a distant hospital will not automatically produce a new order for every nearby retailer.

Taxation and its business effects

Taxation raises government revenue but can change the money available to customers and businesses.

Direct taxes are charged on income or profit. If a customer's income tax rises while their gross income stays the same, their income after tax falls. They may reduce purchases of optional items, weakening sales for businesses such as leisure centres. Essential purchases are often less easily postponed, so the effect varies between products and customers.

A tax on business profit reduces the profit available after tax for owners to receive or for the business to retain. This can restrict money for future equipment or expansion. It does not mean that the business's revenue has fallen: tax on profit and customer spending affect different stages of the business's finances.

Indirect taxes are charged on spending on goods and services. A higher tax on a product can raise its selling price if the business passes the tax on to customers. Some customers may then buy less. If the business absorbs some of the tax to protect demand, the amount it keeps from each sale falls, putting pressure on profit. Whether it can raise prices depends on competition and how sensitive its customers are to price.

These are mechanisms, not predictions that every tax increase has the same result. Governments may use tax revenue for services that help the very businesses paying taxes. Tax names, rates, exemptions and arrangements differ between countries and dates; the examples here describe general effects rather than current national rules.

Constraints and spending choices

A government has to choose between competing uses of limited funds.

Tax revenue depends partly on incomes, profits and spending in the economy. If businesses close and unemployment rises, less income and profit may be available to tax just as more people need public support. Raising tax rates can raise revenue, but it can also discourage spending or investment; the amount collected does not necessarily rise in proportion to the rate.

Borrowing can help pay for spending before sufficient tax revenue is available. However, borrowing creates obligations to repay and service debt. Interest payments use money that could otherwise fund services, and lenders may limit what they will provide. Borrowing is therefore a way to finance spending, not an unlimited supply of free funds.

In an illustrative country, the government must decide whether to improve a road or expand healthcare with its available budget. Better roads might reduce firms' delivery delays; healthcare might reduce illness-related absence. Funding one project can delay the other: this is an opportunity cost, the next best use of resources given up. A business should ask which service addresses its real constraint, rather than assuming that all extra spending benefits it equally.

Government objectives might include better health, improved employment or stronger economic activity. Spending and taxation are tools used to pursue those objectives. Resources, borrowing commitments and competing needs constrain the tools. A useful judgement weighs the service's benefit against its financing cost and the alternatives forgone.