Government expenditure plays an important role in determining the changes in the level of national income; providing the right needs for potential output and sustaining the welfare of the economy. Government spending can determine the changes in the level of national income to a desired national output or to a new equilibrium of economic growth, however on the contrary, can shift the equilibrium of economic growth lower to one that fulfills the capacity of national income.
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Government spending on goods and services contribute to the productive potential of an economy. One form is through ‘transfer payments’, which include unemployment benefits, state pensions and CAP subsidies in the EU(i.e. agricultural). This alters the distribution of income through transferring the “purchasing power output” (Chrystal and Lipsey, 2007) from higher level to lower income groups. However, transfers of payment do not add to the national income, nevertheless, help distribute the balance of payments and the power to consume goods and services. Another form is spending on public goods such as education, healthcare, infrastructure, which enriches the economy and productive output. Educational expenditure is similar to investing in the quality of labor for future purposes. Educational experiences ensure an enhanced quality of skills and knowledge for young people to enter the labor force (Blink and Dorton, 2007), and through the increased availability of provided education, more people can yield productive output. Another leading contribution in expenditure is investment in capital stock such as improvements made in infrastructure like better transportation links and telecommunications. Capital goods open a pathway to increased efficiency and productive capacity (Carlin and Soskice, 2006), facilitating improved services, as well as new incomes and employment for firms and households. Government expenditure can enhance the ability of the economy to perform through the value of the public goods, and hence influence a change in production level and national income.
The circular flow of income helps identify the key relationship of government expenditure towards household and domestic firms, which is when “income rises, spending rises, and when spending rises, output rises which [then again] gives rises to incomes” (Chrystal and Lispey 2007, p.340)- providing growth in national income. Households, firms, and foreign sectors (on exports) pay taxes with their incomes, which generate overall revenue for government expenditure (Bradford, 2002). A rise in national income is attributed from an injection of government spending on goods and services (e.g. subsidy grants), which enables firms to produce greater output and provide more income to households (i.e.in wages, rent, interest, profit). Firms receive greater propensity to invest in the factors of production through the higher levels of aggregate demand, and households are able to consume at a greater capacity due to rises in income (Bradford, 2002). This circular flow helps illustrate the importance of government expenditure in fostering a positive national output and economic growth.
However, government spending is autonomous, and therefore will spend regardless of the size of revenue, (Cullis and Jones, 2009) emphasizing potential leakages in the circular flow of income and the changing pace of economic growth. For example, tax revenues do not equal government spending in public goods. Some revenue may be set aside for savings or used to pay back bonds to reduce national debt (Carlin and Soskice, 2006). This presents a leakage in the circular flow, as incomes generated do not finance current goods and services. Furthermore, taxes reduce the disposable incomes in households and profit in firms (Cullis and Jones, 2009) presenting a withdrawal in the flow. When leakages are greater than injections, the “national output will fall to a new equilibrium, as there will be less income circulating” (Blink and Dorton 2007, p.150) and change the pace of economic growth. On the other hand, when government injections rise, national output will move to a new equilibrium (Blink and Dorton, 2007). Therefore, injections must equal leakages for an economy to be in equilibrium (Blink and Dorton, 2007), emphasizing the different positions of equilibrium growth and the varying conditions. National income will vary correspond to the pace of the growth and the shift of equilibrium in national output. This highlights the power of government expenditure in manipulating the economic activity level with how they choose to spend relative to tax revenue, and thereby changing the productive capacity of an economy and the corresponding national income.
Moreover, the Multiplier Effect demonstrates the magnitude of these changes in GDP as a result of autonomous government expenditure (Chrystal and Lipsey, 2007). Autonomous spending encourage a rise in aggregate demand, and high levels of aggregate demand lead an economy to achieve higher levels of output (Carline and Soskice, 2006). For example, when the government injects $100 million for a school project, this provides labor for the architecture, plumbers, electricians and more. The sources of raw material for capital also receive income. If 20% of the incomes received are spent on tax, 10% on savings and the other 10% on imports of goods and services, this leaves 60% of spending to domestic goods and services, presenting the marginal propensity to consume as 0.6. According to [1/(1-mpc)], in this example, the multiplier is 2.5. Therefore, the amount of $100 million is now 2.5 times greater, amounting to $250 million of final addition to national income (Blink and Dorton, 2007). Assuming a constant price level, this reveals that an “increase desire of aggregate spending increases equilibrium GPD by a multiple of the initial increase in autonomous spending” (Chrystal and Lipsey 2007,p.376) and illustrates the magnifying change government spending has towards national income.
Therefore, as a result of government expenditure, many opportunities are created to reach the productive potential of an economy and foster growth of national income. Government expenditure is important in stimulating aggregate demand to stimulate productive output, increasing induced consumption spending and providing opportunity for higher disposable incomes. Nevertheless, the balance between injections and leakages in the economy may shift equilibrium to a lower position dependent on the net output and ultimately, what the government decides to do with the revenue. The government expenditure can determine changes in the level of national income through their influence in aggregate demand.
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Bradford, J. (2002) Macroeconomics. New York: McGraw-Hill Companies, Inc
Carlin, W. and Soskice, D. Macroeconomics: Imperfection, Institutions & Policies. New York: Oxford University Press, Inc.
Chrystal, A. and Lipsey, R. (2007) Economics. 11th Ed. New York: Oxford University Press Inc.
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Parkin, M. (2003). Economics. 6th Ed. United States of America: Pearson Education
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Government Expenditure Multiplier of National Income. (2019, Mar 28). Retrieved from https://phdessay.com/what-is-the-importance-of-government-expenditure-in-determining-changes-in-the-level-of-national-income/