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FORM 5 ECONOMICS NAME: ________________

TOPIC: GOVERNMENT EXPENDITURE AND INCOME

THE CIRCULAR FLOW OF INCOME

THE GOVERNMENT ROLE

More complete and realistic circular flow models are more complex including the roles of government and
financial markets, along with imports and exports.
 LEAKAGE OCCURS WHEN FIRMS AND HOUSEHOLD PAY TAXES TO THE GOVERNMENT
 INJECTION OCCURS WHEN THE GOVERNMENT SPENDS ON INFRASTRUCTURE,
SCHOOLS, HEALTH CARE ETC

Government is an institution that is charged with making certain decisions for the betterment of a country.
The government sector includes central government, local government and public companies. Central
government is run by the prime minister and all the cabinet ministers. Local government is run by elected
councilors. Public companies are owned by the government but most times run by a Board of Director
appointed by the government. The roles of the government are:
 Security of the state
 Protection and general welfare of citizens
 Job security and severance benefits to the workers
 Protection of the environment
 Maintenance of a safe environment for investors
 Managing the economy

ECONOMIC POLICY- REFERS TO THE ECONOMIC OBJECTIVES OF THE GOVERNMENT AND

THE WAYS IN WHICH HE TRIES TO ACHIEVE THEM.

ECONOMIC OBJECIVES OF THE GOVERNMENT

1. HIGH AND STABLE LEVEL OF EMPLOYMENT-the government tries to create a situation where
people who are willing and able to work are able find employment/jobs.
2. RELATIVELY STABLE PRICE LEVEL- They try to keep inflation under control to achieve this.
Governments aim for price stability because it ensures greater economic certainty and prevents the
country’s products from losing international competitiveness.
3. SATISFACTORY BALANCE OF PAYMENT POSITION-If a country persistently spends more on
foreign goods (imports) than it is earning from selling goods to other countries (exports) then they will
be in debt with those countries. Economic policies try to prevent this from happening in order to have a
balanced Balance of Payment (imports =exports). Governments also seek to avoid sudden changes in
other parts of the balance of payments. This is because they can prove to be disruptive for the economy.
For instance, there may be a sudden and unexpected movement of money out of the country’s financial
institutions into financial institutions of other countries. Such a movement can have an adverse effect not
only on the banks of a country but also on the country’s exchange rate and eventually on the price of the
country’s imports. .
4. A RISING STANDARD OF LIVING: This happens as a result of steady economic growth (increase
in production) where real income per person increases. Persons can now afford better housing,
improved education, more modern hospitals etc due to higher wages.
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5. MORE EQUAL DISTRIBUTION OF WEALTH AND INCOME-when this is achieved persons will
be able to have a better standard of living. A government may seek to redistribute income from the rich
to the poor. Governments redistribute income by taxing and spending. The rich are taxed more than the
poor. Some of the money raised is spent directly on the poor by means of benefits such as housing
benefit and unemployment benefit. Other forms of government expenditure, such as that on education
and health, particularly benefit the poor.
6. ECONOMIC GROWTH: When an economy experiences economic growth, there is an increase in its
output in the short run. This is sometimes referred to as actual economic growth. In the long run, for an
economy to sustain its growth, the productive potential of the economy has to be increased. Such an
increase can be achieved as a result of a rise in the quantity and/or quality of factors of production.

INSTRUMENTS OF ECONOMIC POLICIES

These are the methods which the government uses to try to achieve its economic objectives.
1. Fiscal policy- is the means by which a government adjusts its spending levels and tax rates to monitor
and influence a nation's economy. The main instrument of fiscal policy is the Budget.
2. Monetary policy- is the macroeconomic policy laid down by the central bank. It involves management of
money supply and interest rate by the government of a country to achieve macroeconomic objectives
like inflation, consumption, growth and liquidity. It influences the ability of banks to make loans.
3. Direct Controls- Government place legal controls on wages, prices, rents and dividends. They can also
use their power to grant planning permission to control the number, type and location of all kinds of
buildings. The government can also use rationing.
4. Public ownership- taking over of private companies so that they can create more jobs and reduce the
cost of production to lower prices.

There are two types of public expenditures, real spending and transfer payments.
 Real spending is when goods and services are bought by central government and
local authorities. The payments for services of civil servants, teachers, police men and nurses represent real
spending. These also include medicines purchased for use in hospitals, textbooks and equipment for schools.
 Transfer payments consist of transfers of money in the form of grants from the
government to households and firms. They are not payments for goods and services or for work done.
Unemployment benefits and child benefits are examples.

REASONS FOR GOVERNMENT EXPENDITURE

 To provide Merit goods: These are goods that provide benefits to both individuals and society as a
whole. These include education and health care.
 To provide public goods: These are goods that are non-excludable, that is, no one can be prevented
from using the good. Example: street light, defense and light houses.
 To redistribute income and wealth: the government may spend money on projects to create employment
for the unemployed.
 To control economic activities: Government spending affects employment, prices and output. They
control the economy by manipulating their spending. This is called fiscal policy.

SOURCES OF GOVERNMENT REVENUE

 Taxes
 Profits from public owned companies
 Public Sector borrowing
 Fines and levies
 Sales of government assets
 Foreign aid.

TAXATION
A tax is a compulsory payment made by individuals or corporations to the government from which they receive
no direct benefit.

THE PURPOSES/REASONS FOR TAXATION

 The main purpose of taxation is to provide the government with the money it needs to pay for the many
services it provides.
 To control the amount of spending in the economy. This is most likely when excess demand is causing
prices to rise.
 To reduce in equalities in the distribution of income. The higher income groups can be made to pay
higher rates of tax narrowing the gap between the rich and the poor.
 To protect local industries from foreign competition. Tariffs are levied on goods coming in.

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 It may also be used to discourage the consumption of some commodity. The government for example
may impose a higher GCT on tobacco and alcohol to reduce the consumption.

TYPES OF TAXES

THERE ARE TWO TYPES OF TAXES: DIRECT AND INDIRECT

DIRECT TAX: This is where the burden of the tax and the payment falls on the same individual. These taxes
are placed on income and wealth. Examples: PAYE (pay as you earn – income tax), Corporation taxes, Capital
Gains tax and Inheritance taxes.
INDIRECT TAX: This occurs when the burden of the tax and payment falls on different individuals. This tax
is placed on spending. These include: Value added tax (VAT), Customs duties, Tariffs, Property tax and GCT.

INCIDENCE OF TAX: When a tax is placed on a good or service someone must bear the burden of paying
that tax. The burden is called the incidence of tax. This incidence of tax must either be borne by the supplier or
the buyer or they may share the burden. This depends on the nature of the good.

FORMS OF TAX
A tax can take three forms: Regressive, Proportional or Progressive.
Regressive: A regressive tax is one in which as income increases a smaller and smaller percentage is taken out
in taxation. Persons with lower incomes pay a larger percentage of their income in tax vice versa. An example
is airport tax which is 100 dollars per person regardless of their income.

Income Tax rate Tax paid

$ 1 000 10% $100
$ 2 000 5% $100
$ 3 000 3.3% $100

Regressive tax 

Proportional Tax: A tax is proportional when all tax payers pays the same proportion of their income in tax.
The tax rate remains constant but the amount paid in tax increase as income increases. Below the rate of tax is
25% and as income rises a constant 25% is paid in tax.
Income Tax rate Tax paid
$ 1 000 25% $250
$ 2 000 25% $500
$ 3 000 25% $750

Proportional tax

Progressive Tax: A tax is progressive when those with higher incomes pay a larger percentage of their income
in tax. As income increase the percentage of income paid in taxes increases.

Progressive tax

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Example of Progressive Tax:

Taxable Income ($) Rate of Tax

0 - 10 000 30%
10 001 – 20 000 40%
20 001 – 30 000 50%

A person with a taxable income of $8 000 will pay tax equal to:
30% of $8 000 = $2 400
A person with a taxable income of $14 000 will pay tax equal to:
30% of $10 000 plus 40% of $4 000 = $3 000 plus $1 600= $4 600

Question: How much will be paid by a person with a taxable income of $ 25 000?

PRINCIPLES OF TAXATION
 It must be equitable: The burden of the tax should be more or less the same for each tax payer. The
sacrifice should be similar.
 It must be convenient: This means that the taxes should also be made at a time and in a manner
that is agreeable to the tax payer.
 It must be economical: This means that the taxes should not be expensive to collect and administer.
 It must be certain: All should know that such taxes will be levied and the amount to be paid should be
clear to the persons who have to pay them.
ECONOMIC EFFECTS OF TAXATION
 Taxes on income: Progressive tax reduces the inequality in the distribution of income. This is because
those with higher income pay a larger portion of their income as tax.
 Taxes on Expenditure: tax on items such as gas, tobacco and alcohol raises large sums for the
government. The demand for these commodities is inelastic, so an increase in the tax rate does not
affect the amount purchased. The problem with expenditure taxes is the fact that an increase in the rate
raises prices. This could cause a demand for increase wages which might lead to an increase in the rate
of inflation.
 Taxes on wealth and capital: Taxing wealth may cause persons to want to spend rather than save.

NATONAL BUDGET

The National Budget: This is an estimate of the government’s spending and revenue for the next financial
year. This is presented in parliament each year. The main objectives of the budget are to:
 Announce the government’s plan for spending and revenue collection
 Influence the state of the economy through fiscal policy

When the government’s revenue from taxation is more than its expenditure, there is a budget surplus. If the
government’s revenue from taxation is less than its expenditure, there is a budget deficit. If the government’s
revenue from taxation is equal to its expenditure, there is a balanced budget.

GOVERNERNMENT BORROWING: PUBLIC SECTOR BORROWING REQUIREMENT

If the government spends more than it receives in revenue, it will have to borrow to make up for the short fall.
The amount the government needs to borrow in a given period of time is called the PUBLIC SECTOR
BORROWING REQUIREMENT (PSBR). This can be met by:
 The central bank printing more money
 The government borrowing from local and overseas sources
 The central bank selling government treasury bills, notes or bonds.

NATIONAL DEBT
This is also known as public sector debt and is accumulated by the government overtime. It represents the total
amount owed by the government to its citizens, which is domestic debt as well as the amount owed to
foreigners, which is external debt.

Public debt: 123.6% of GDP (2013 est.)

132.9% of GDP (2012 est.)
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Country 2004 2005 2006 2007 2008 2009 2010 2011

Jamaica 146.1 128.7 133.3 126.5 109.6 124.4 123.2 125.5

Definition and explanation of the following terms and concepts:

(a) national budget;

(b) national income;
(c) disposable income;
(d) national debt;
(e) fiscal policy;
(f) fiscal deficit;
(g) monetary policy; (h) economic growth;
(i) economic development;
(j) developing economy; (k) developed economy;
(l) balance of payments;
(m) GDP;
(n) GNP;
(o) employment;
(p) unemployment;
(q) inflation;
(r) deflation;
(s) savings;
(t) investment; and,
(u) closed and open economies.