New government spending is an injection into an economy, and, like all injections, it will have a multiplier effect on national income.
Governments spend money for three main reasons:
- Most government spending is to compensate for market failures, such as providing public goods like street-lighting, policing and defence. Public goods are usually funded by government because they are not likely to be funded through the private sector. Merit goods, such as education and healthcare are also provided by governments. Merit goods are partly funded by the government because the private sector is unlikely to allocate sufficient resources to establish an effective infrastructure for their supply: a situation referred to as an incomplete market.
- Government also provides welfare benefits, which help ensure a minimum standard of living. The private sector is unlikely to provide a guarantee of work for everyone, or to guarantee that those who cannot work are provided for. Welfare benefits in the UK include unemployment benefit (Job Seeker’s Allowance), income guarantees, child allowances and pensions.
- Government may also deliberately manipulate the macro-economy through fiscal policy. Spending is an injection of demand into the economy and governments can spend more to compensate for a decline in the other components of national income. For example, if consumer or investment spending by the private sector falls, then aggregate demand can be boosted by an additional injection of public spending.
Central and local government must raise revenue in order to meet its spending commitments. Revenue is raised from a number of sources including:
- Taxation – direct taxes are taxes on incomes, including income tax and corporation tax. Indirect taxes are taxes on spending, including Value Added Tax (VAT).
- Charges – both central and local government can charge for using resources under their control, such as parking charges, prescription charges and TV licences.
- Privatisation – the sale of state-owned assets, such as public utilities like gas, water and electricity.
- The sale of property rights – government can sell off the right to use a resource owned or controlled by the State. For example, the UK government has raised substantial revenue by selling licences to broadcasters and to mobile phone companies for the right to use the public ‘airwaves’.
- Borrowing – if a government does not have enough revenue to fund its spending plans it may borrow from the commercial banks, from the public, or from overseas lenders, such as the International Monetary Fund. Both central and local government may need to borrow from time to time to fund spending commitments.