🏛️ Types of Government Spending
Definition: Fiscal policy.
Government spending categories
- Current (recurrent) spending — day-to-day spending: wages of public employees, healthcare costs, welfare payments, defence.
- Capital spending — investment in infrastructure: roads, hospitals, schools, renewable energy projects.
- Transfer payments — payments where no good or service is received in return: pensions, unemployment benefits, subsidies. These redistribute income but are NOT counted in GDP (no output produced).
When we write G in the AD equation (C + I + G + (X − M)), we mean government spending on goods and services — NOT transfer payments. Transfer payments increase C when recipients spend them.
💰 Types of Taxes
Direct vs indirect taxes
- Direct tax.
- Indirect tax.
Progressive, regressive, and proportional
- Progressive tax — the tax rate rises as income rises. Higher earners pay a larger % of their income. Example: most income tax systems.
- Regressive tax — takes a larger % of income from lower earners. Example: flat-rate VAT — everyone pays the same rate, but it's a bigger share of a poor person's income.
- Proportional (flat) tax — same % regardless of income. Example: a flat 20% income tax.
In exams, link tax types to equity: progressive taxes reduce inequality (redistribute); regressive taxes worsen it.
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📊 Expansionary and Contractionary Fiscal Policy
Expansionary fiscal policy
- Increase government spending (G↑) and/or cut taxes (T↓).
- More disposable income → C rises. More G → AD shifts right.
- Used to close a deflationary (recessionary) gap — boost output and reduce unemployment.
- Leads to a budget deficit if spending exceeds tax revenue.
Contractionary fiscal policy
- Decrease government spending (G↓) and/or raise taxes (T↑).
- Less disposable income → C falls. Less G → AD shifts left.
- Used to close an inflationary gap — reduce demand-pull inflation.
- Makes the budget deficit smaller or creates a budget surplus.
Fiscal policy shifts AD — same as monetary policy. The difference: fiscal comes from the government; monetary comes from the central bank.