Public Finance: Taxation, Budget Policy and the Role of the State
Government and the budget
Understand the functions of the state: allocation (public goods, externalities), redistribution (taxes and transfers), stabilisation (fiscal policy). Public goods are non-rival and non-excludable; merit goods are under-consumed if left to the market. The budget shows revenues and expenditures; a deficit is financed by borrowing, which raises public debt. Distinguish primary deficit (excluding interest) from overall deficit.
Taxation
Classify taxes as direct (income, corporate) and indirect (VAT, customs). Principles: ability to pay and benefit principle. Taxes are progressive (average rate rises with income), proportional, or regressive (average rate falls). Indirect taxes on essentials are often regressive. The Laffer curve suggests revenue may fall beyond an optimal rate.
Fiscal policy
Expansionary fiscal policy (higher G, lower T) raises aggregate demand via the multiplier; contractionary policy cools inflation but may crowd out private investment. Automatic stabilisers (unemployment benefits, progressive taxes) dampen cycles.
Traps
- Calling VAT progressive because the rate is uniform - it is usually regressive in effect.
- Confusing deficit (flow) with debt (stock).
- Assuming all public spending is wasteful; distinguish capital from current spending.
- Mixing crowding out with the multiplier effect.
Worked example
Income tax: 5% on first 1,000, 15% above. On income 3,000, tax = 50 + 0.15 × 2,000 = 350; average rate = 11.7%, marginal rate = 15%. Since average rate rises with income, the tax is progressive.