4.3.5 - The role of the state in the macroeconomy

Public expenditure can purchase long-lived productive assets, pay for the government's continuing activities, or transfer purchasing power without buying current output. The economic effect depends on which category changes.

Capital and current purchases directly count within government consumption or investment in aggregate demand. Transfer payments do not count directly because no output is purchased; they affect aggregate demand when recipients spend their disposable income.

The size and pattern of public expenditure change as national income, population structure and public expectations alter demand for services and the government's capacity to finance them.

Countries differ in income, demographics, political choices, private provision and administrative capacity, so equal expenditure-to-GDP ratios need not buy the same services. A rise in the ratio can occur because nominal spending grows, real spending grows, GDP falls, or spending falls more slowly than GDP.

Public expenditure as a proportion of GDP shows the relative scale of government spending, but its significance depends on composition, financing and spare capacity rather than the ratio alone.

If GDP falls faster than expenditure, the ratio rises even without a real spending expansion. Conversely, a growing economy can accommodate higher real spending with a stable ratio.

A direct tax is levied directly on a person's or organisation's income, profit or wealth. An indirect tax is levied on expenditure or production and is collected from the seller, which may pass some or all of the burden to buyers through prices.

Who sends the payment to government is not necessarily who bears the economic burden. The incidence of an indirect tax depends on demand and supply elasticities; a direct business tax can also affect owners, workers or customers over time.

Tax structures are classified by how the average tax rate changes as income rises. The average rate is total tax paid divided by income; it is different from the marginal rate on the next unit of income.

If a household earning $20,000 pays$2,000 and one earning $100,000 pays$20,000, their average rates are 10% and 20%, so the schedule is progressive. A fixed amount per unit of fuel can be regressive when lower-income households spend a larger share of income on it.

Tax-rate changes alter disposable income, prices, incentives and revenue. Their macroeconomic effects depend on the tax, its incidence and behavioural responses.

Fiscal terms separate an annual flow from an accumulated stock and separate built-in budget responses from deliberate policy choices.

A recession can create a cyclical deficit as tax receipts fall and benefit payments rise. Recovery reverses that component automatically. A structural deficit persists without policy or supply-side change and therefore adds to debt across the cycle.

A fiscal deficit changes with revenue, expenditure and the economic cycle; national debt changes through accumulated borrowing, repayment and the cost of servicing existing liabilities.

Debt sustainability also depends on debt relative to GDP: growth in nominal GDP can lower the ratio even when the cash stock rises, while currency depreciation raises the domestic burden of foreign-currency debt.

The significance of fiscal deficits and national debt depends on their size relative to GDP, duration, financing cost, ownership and what the borrowing funds.

External or foreign-currency debt adds exchange-rate and foreign-currency risk. Persistent structural deficits can weaken confidence and credit ratings; cyclical borrowing may support output and automatically shrink during recovery.

Governments combine fiscal, monetary, exchange-rate and supply-side policies with direct controls because each objective has different causes and trade-offs.

Diagnosis comes first: demand restraint cannot produce missing energy, while a subsidy cannot permanently offset an economy-wide demand boom. Time lags often make a coordinated short-run and long-run package stronger than one instrument.

The 2008 global financial crisis damaged bank balance sheets, credit and confidence, causing consumption and investment to fall. Governments and central banks used expansionary demand-side policies to limit the resulting contraction in aggregate demand.

With private demand collapsing and inflation pressure weak, expansion reduced the risk of a deeper recession. International spillovers mattered because one country's imports support another's exports.

Tax avoidance uses legal arrangements to reduce tax liability, while evasion illegally conceals liability. A transnational company can shift reported profit between jurisdictions through prices charged in transactions among companies in the same group.

A single government is constrained by mobile capital, information gaps, legal appeals, bargaining over investment and competition from other jurisdictions. Joint rules reduce opportunities to move profit without matching real activity.

A policy change begins with the people, firms and markets directly affected, then spreads through national income, prices, finance and international trade. The same policy can create gains at one scale and costs at another.

A subsidy to a domestic industry may preserve jobs in one region and raise national output, yet increase taxes, divert resources from other sectors and lower foreign producers' sales. If partners retaliate, trade and efficiency can fall globally.

Trace incidence, multiplier and spillover effects; then compare short-run adjustment with long-run productivity. Size, openness, exchange-rate regime, mobility of labour and capital, and coordination with other countries determine how far effects travel.

Policymakers choose instruments before the economy's current state, future shocks and behavioural responses are known with certainty. A policy can therefore be correctly aimed yet mistimed or produce a different magnitude from that expected.

Recognition, decision, implementation and impact lags can allow conditions to change before a policy takes full effect. For example, tightening demand against a temporary supply shock may lower inflation only after output and employment have already weakened.

Use scenario ranges, timely indicators, automatic stabilisers, targeted temporary measures and coordinated policies, then revise as evidence improves. These reduce error but cannot eliminate uncertainty.