The Role of the State in the Macroeconomy
The Role of the State in the Macroeconomy
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A government spends money in three different ways, and they are told apart by what the money buys.
Rensa is a country that imports its oil and exports copper. In one year, its government pays for a new port, a teacher's monthly salary and a pension (a regular payment after someone stops work) for a retired copper miner. All three are paid for by the public sector (the government and the organisations it owns or funds).
Public expenditure: spending by central and local government and the organisations they fund.
Put simply, public expenditure is all the money the state, meaning the government and the public sector, spends, whatever it spends it on. It is split into three types.
Capital expenditure: long-term investment expenditure by the government on capital projects, such as new roads or hospitals.
Put simply, capital expenditure buys something Rensa will still use for many years, such as the new port.
Current expenditure: the government's day-to-day expenditure on goods and services, such as the wages of public sector workers and medicines for public hospitals.
Put simply, current expenditure keeps services running now. The teacher is paid this month, and must be paid again next month.
Transfer payments: payments made by the state to individuals without any exchange of goods or services, so there is no production in return for these payments.
Put simply, a transfer payment moves money from the state to a person, such as the retired miner. The state receives nothing back for it.
So the key difference is what the money buys: something that lasts for many years (an asset, such as the port), something used up this year, or nothing at all.
So for every $100 of output that Rensa produces in a year, its state spends $40.
Why does the type matter? Aggregate demand is the total spending on a country's output. Government spending on goods and services is part of it, because that spending pays for production. A transfer pays for no production, so it is not government spending on goods and services. It is still public expenditure, because the state pays it out. The pension adds to aggregate demand only when the miner spends it, for example on food.
As a country's income rises, its people want more of the services that the state provides.
Imagine a country where average income doubles over twenty years. Families who once needed only basic schooling now want their children to finish school and go to university. They want better hospitals too. In this country the state provides much of this education and health care, so the government pays for it.
Why does public spending then grow faster than income? Demand for education and health care is income elastic. This means that demand for these services rises by a larger percentage than income: if income rises by 10%, demand rises by more than 10%. Put simply, as households get richer, they want to spend a larger share of their income on education and health care.
This is why public spending's share of GDP rises, not only its amount in dollars. If spending grew at the same rate as GDP, its share would stay the same. Because spending on these services grows faster than GDP, its share of GDP rises.
Rising incomes also help the state to pay for this. The tax base is the total income and spending a tax is charged on. As people earn and spend more, the tax base grows. The same tax rates then raise more revenue (the money the government collects), and the state can spend it on schools and hospitals.
Falling incomes reverse these changes. When a country's income falls year after year, demand for education and health care falls by a larger percentage than income. The tax base shrinks too, so the state has less to spend on schools and hospitals. Public spending can then fall faster than GDP, so its share of GDP falls. In a recession, when output falls for some months, the first effect is different: more people lose their jobs and claim benefits, so transfer payments rise.
The mix of young and old people in a country changes what its government spends money on.
Picture two countries. In the first, almost half of the people are children. In the second, one person in four is over 65. Their governments need to spend on very different services, because each age group uses different public services.
A population's age distribution means the share of the population in each age group. When it changes, the pattern of public expenditure, meaning what the money is spent on, changes too. Its size can change as well, because the number of people who use each service changes.
Ageing affects the budget in two ways at once. Spending on pensions and health care rises. At the same time, the share of people of working age (usually 15 to 64) falls. Most income tax is paid by people in work, so there are fewer taxpayers for each pensioner. The income that tax is charged on then grows more slowly than the pension and health bills it must pay for.
As a country's population changes from young to old, it meets both patterns, one after the other. Some schools may close, while spending on pensions and hospitals grows. A pension is paid for many years, so a promise of pensions made today commits spending far into the future.
Real Example: In 2023, 29.1% of Japan's people were aged 65 or over. In Nigeria, about 40% of people were under 15 in 2025. The same reasoning points Japan's spending pressure towards pensions and health care, and Nigeria's towards schools and child health.
Exam Matters: In an Explain answer, say which age group is changing and which public services that group uses most. Then use the case's figures to say how the pattern of spending changes.
What people believe the state should provide can rise over time, and public spending may rise to meet it.
Imagine a country where, a generation ago, families accepted a long wait to see a hospital doctor. Today their children expect a short wait and the newest treatment, even though incomes have hardly changed. What has changed is their idea of a good public service.
These beliefs are called expectations: what people believe the state should provide, and to what standard. They rise in several ways.
New technology raises expectations too. When new scanners and medicines become available, patients expect state hospitals to offer them.
Why can expectations rise when incomes do not? Expectations depend on more than income. They also depend on what people see in other places, and on what politicians promise them. A disaster or an election can change them within a year, while incomes usually change slowly.
When expectations rise, voters ask the state for more and better services. A government that wants to keep voters' support may then spend more to meet them. If this spending grows faster than GDP, public spending's share of GDP rises, even though incomes have not changed. Expectations can also fall, for example when a government persuades voters to accept less. Then less spending is needed to meet them, so public spending can grow more slowly than GDP, and its share can fall.
Real Example: In 2002, Thailand launched its Universal Coverage Scheme, paid for from the national budget. People could see a doctor for 30 baht a visit, about one US dollar. This shows wider coverage in practice: the state paid for the care, and each visit cost the patient very little.
Exam Matters: In an Explain question, decide first which reason the case shows: changing incomes, changing age distributions or changing expectations. Then explain the link from that reason to the spending, using the case's own facts.
A high share of public spending can raise or lower productivity (output per worker), depending on what the money buys.
Two countries each spend 40% of their GDP through the state. Over the next decade, one grows quickly and the other hardly grows. Their shares are the same, so the share alone cannot explain the difference. What the money buys, and how well it is used, can.
How a higher share can raise productivity. Productivity is output per worker. Roads, ports and power supplies lower firms' costs. Schools and universities raise workers' skills, and health care keeps workers fit and at work. Each lets the same workers produce more. This raises long-run aggregate supply, the most the economy can produce when all its resources are used, so the curve shifts to the right and the economy can grow faster.
How a higher share can lower productivity. A private firm has the profit motive, meaning the wish to earn profit, which pushes it to cut costs. If it wastes money, its profit falls, and a rival may take its customers. A state service often faces neither of these pressures. Its managers may gain nothing from cutting its costs, and its users may have no other provider to go to. So it has a weaker incentive (a reason to act) to cut costs and improve. It may then use more workers and money to produce the same output, so output per worker is lower. Long-run aggregate supply then shifts to the right by less than it would if the service were run well, so the economy grows more slowly.
Some spending also adds little. Subsidies (payments from the state) that keep loss-making firms open use workers and money that could produce more elsewhere. A loss-making firm is one whose costs are higher than its revenue. A new road that few people use is capital expenditure, but it adds almost nothing to output.
A higher share must also be paid for: by higher taxes, which can weaken incentives to work and invest, or by borrowing (taking loans), which can raise interest rates, so that firms invest less.
So the size of the share does not decide the result on its own. What matters is what the spending buys, how well it is run and how it is paid for.
When a government borrows to spend more, spending by firms and households can fall, so total spending rises by less.
Rensa's government wants to spend an extra $20bn on hospitals without raising taxes. When spending is greater than tax revenue, the government usually borrows the gap. It does this by selling bonds, which are promises to repay a loan with interest. Interest is the extra amount a borrower pays a lender, and the interest rate is that amount as a percentage of the loan each year.
The savings available for others to borrow are called loanable funds. Firms and households borrow from the same savings. Each part of an economy is called a sector, and firms and households together form the private sector (the part of the economy the state does not own). The part the state owns or funds is the public sector, also called the state sector. An economy is at full employment when almost everyone who wants a job has one. It is then at or close to full capacity: almost all its workers and machines are already in use.
Crowding out: the reduction in private sector spending caused by an increase in public spending.
Put simply, the state's extra spending is partly cancelled by a fall in what firms and households spend, so total spending rises by less than the state spends.
Resource crowding out: when the economy is operating at full employment and the expansion of the public sector means that there is a shortage of resources in the private sector.
Put simply, if almost every worker already has a job, the new hospitals can usually hire nurses only by taking them from private firms. Those firms are then left with fewer workers and can produce less.
Financial crowding out: when the expansion of the state sector is financed by increased government borrowing, which increases the demand for loanable funds, drives up interest rates and crowds out private sector investment.
Put simply, the state and private firms compete for the same savings, and firms lose some of them, so they invest less: they spend less on machines, buildings and projects. Step by step:
Total spending on Rensa's output is its aggregate demand. On the diagram, the extra public spending shifts aggregate demand from AD₀ to AD₁, and the lost private investment shifts it back to AD₂. Real output, on the horizontal axis, rises along the short-run aggregate supply curve, SRAS, from Y₀ to Y₂. It does not reach Y₁, the output that AD₁ alone would give, because total spending rises by less than $20bn.
Crowding out is most likely near full employment. Then few workers are idle (without work), and most savings are already being borrowed. It is least likely in a deep recession. Then savings lie idle because few firms want to borrow, so the state can borrow them without pushing the interest rate up much.
A government that spends a high share of GDP may, in the long run, have to raise a high share of GDP in tax.
Rensa spends $160bn, 40% of its $400bn GDP, but raises only $144bn in tax, 36% of GDP. It borrows the $16bn gap by selling bonds.
Can Rensa borrow the gap every year? Each year's borrowing adds to what the government owes, and interest must be paid on all of it. That interest is paid from future tax revenue, the money the government collects in tax. So borrowing does not remove the need for tax. It only delays the tax until later years.
This is why, in the long run, a government may have to raise taxes to fund its spending. To close its gap without spending less, Rensa would need tax revenue of $160bn: 40% of GDP instead of 36%.
High taxes have three main costs:
Which people pay the higher tax depends on which tax the government raises. A tax on spending at one rate usually takes a larger share of a poor family's income than of a rich family's, because a poor family spends a larger share of what it earns. A tax on income can be set to take a larger share from people who earn more, so people on high incomes pay more of the extra tax.
Real Example: In 2023, France's government spent 57.3% of GDP, and taxes took 43.5% of GDP. These taxes include social contributions, which are payments for pensions and health care charged on wages. A state that spends a large share of GDP raised a large share in tax, although its tax share was still below its spending share.
Governments tax what people earn and what people spend, and the two kinds of tax are charged on different things.
In Rensa, a shop assistant pays income tax: part of her wage goes to the government before she is paid. At work she sells a radio, and the shop adds a sales tax to its price. The shop then pays that tax to the government.
Both are taxes, charged on different things.
Direct tax: a tax on income, such as income tax, corporation tax or capital gains tax.
Put simply, a direct tax takes part of what a person or a firm earns, and they pay it to the government themselves. Corporation tax is charged on a firm's profit, and capital gains tax on the gain a person makes by selling an asset, such as land, for more than it cost.
Indirect tax: a tax on expenditure on goods and services, such as VAT, excise duty or a sales tax.
Put simply, an indirect tax is a tax on expenditure, meaning spending: it is added to the price of what people buy. VAT (value added tax) is charged on most goods and services, and an excise duty (a tax on each unit of one particular good) on a few, such as fuel. The seller collects the tax from the buyer and pays it to the government.
So the key difference is what the tax is charged on: income for a direct tax, spending for an indirect tax.
Corporation tax can look like an indirect tax, because a firm pays it. But it is charged on the firm's own income, its profit. It is not charged on what the firm's customers spend, so it is a direct tax.
It also affects how easily each tax is collected. A street trader in the informal sector (work that is not registered with the government) may never report her income, so income tax is hard to collect from her. But when she buys fuel, she pays the indirect tax in the price. So a government may rely more on indirect taxes where many people work in the informal sector, because it can collect them through prices, even from people whose income it cannot see.
Exam Matters: When you explain the difference, name one tax of each kind and say what each is charged on, income or spending. That is more precise than saying who pays it.
As income rises, a tax can take a larger share of income, the same share or a smaller share.
Rensa's government wants to know which households carry most of each tax. Counting the dollars each household pays does not answer this. Richer households pay more dollars of almost any tax, even a tax that takes a smaller share of their income. What matters is the share of income each household pays.
Average rate of tax: the total tax paid as a percentage of income.
Put simply, the average rate is how many dollars of every $100 of income go in this tax.
Progressive tax: a tax where, as income rises, a larger percentage of income is paid in tax.
Proportional tax: a tax where the percentage of income paid in tax is constant, no matter what the level of income.
Regressive tax: a tax where, as income rises, a smaller percentage of income is paid in tax.
Put simply, a progressive tax takes a larger share from richer households, a proportional tax the same share from everyone, and a regressive tax a larger share from poorer households. A flat 15% tax on all income would be proportional.
Rensa charges nothing on the first $10,000 of income, 20% on income from $10,000 to $30,000, and 40% on income above $30,000.
Marginal rate of tax: the percentage of an extra dollar of income that is paid in tax.
Put simply, the marginal rate is the tax on the next dollar earned. At $100,000 it is 40%, above the average rate of 32%. The average is lower because the first $10,000 is not taxed and the next $20,000 is taxed at only 20%.
Rensa also has a 10% sales tax, an indirect tax added to the price of what people buy. Every household pays the same rate on what it buys, but each spends a different share of its income.
The richer household pays more dollars. But those dollars are a smaller share of its income, so the sales tax is regressive. A poorer household spends almost all its income, so almost all of it is taxed. A richer household saves more, and its savings pay no sales tax.
Exam Matters: In a Calculate question, find the tax on each band (each slice of income taxed at one rate), add them, and divide by the whole income, not by the income in the top band. Give the answer as a percentage.
A higher tax on extra pay can make an extra hour of work less worthwhile, so some people choose to work less.
A nurse in Rensa is offered extra shifts at the weekend. Before she agrees, she asks how much of the extra pay she will keep. The answer depends on her marginal rate, the tax on her next dollar, not on her average rate.
Suppose she already earns more than $30,000, so her extra pay is taxed at Rensa's top rate. Rensa raises this top rate of income tax from 40% to 50%. Of an extra $1,000 she earns, she now keeps $500 instead of $600. The tax on the rest of her income does not depend on the extra shifts, so only the marginal rate matters for this choice.
The lower reward weakens her incentive (her reason to act) to work more. Across the economy, it can reduce work in several ways:
But some people do the opposite. A worker may have a target income (an amount she aims to have left after tax, such as her children's school fees). If tax takes more of each hour's pay, she needs more hours to reach that amount. So she may work more, not less.
A rise in an indirect tax also lowers the reward for work. Sellers add the tax to their prices, so prices rise and each hour's pay buys fewer goods.
So the overall effect depends on which workers face the higher rate. Second earners can most easily choose whether to work. Many full-time workers cannot choose their hours at all, so their hours may not change.
Raising a tax rate does not always raise revenue, because people may earn and report less income that is taxed.
Rensa's government wants to know how much its income tax could raise. At a rate of 0%, the tax collects nothing. At 100%, the government takes every dollar of taxed income. Almost no one then has a reason to earn taxed income, so revenue is close to nothing.
Tax base: the total amount of income, spending or wealth on which a tax is charged.
Put simply, the tax base is everything the tax is charged on. For Rensa's income tax, it is all the income that people earn and report.
Revenue is the tax rate multiplied by the tax base. A higher rate takes more from each dollar, but it can also shrink the base, because people earn or report less income. For a small rise in the rate, revenue falls if the base falls by a larger percentage than the rate rises, and revenue rises if the base falls by a smaller percentage.
Laffer curve: a curve showing how tax revenue changes as the tax rate rises from 0% to 100%.
Put simply, the curve starts at zero, rises to a peak and falls back to almost zero. The rate at the peak is called the revenue-maximising rate, because no other rate collects more.
Suppose the curve for Rensa's income tax peaks at 50%, a figure that only illustrates the idea. At low rates, people keep most of each extra dollar, so a higher rate changes their choices only a little. Below 50%, the tax base then shrinks by a smaller percentage than the rate rises, so revenue rises. At high rates, people keep little of each extra dollar, so a further rise makes many of them work less, hide income or leave. Above 50%, the base shrinks by a larger percentage than the rate rises, so revenue falls. The base shrinks for three reasons:
So if a rate is above the revenue-maximising rate, a cut reverses these steps: for a small cut, the base grows by a larger percentage than the rate falls, and revenue rises, as long as the new rate is not below the peak. The limit is that no one can measure exactly where the peak is. It differs between taxes and countries, and it can move over time.
Real Example: In 2001 Russia replaced its income tax rates with a single rate of 13%, which cut the higher rates. Real revenue from income tax rose by about 26% the next year. A study by the IMF (the International Monetary Fund, which lends to governments) found no strong sign that people worked more. It estimated that compliance (people paying what they owed) improved by about a third, but it could not tell whether the single rate or stricter enforcement caused this. So a rise in revenue after a cut may come from less evasion, not only from more work.
Exam Matters: In an Analyse answer, a sketch of the Laffer curve helps: mark 0%, 100% and the peak, and say which side of the peak the country's rate is on.
A tax change can widen or narrow the gap between rich and poor, depending on whose share of income it changes most.
Take two households in Rensa, one on $20,000 a year and one on $100,000. Income distribution means how income is shared between households like these. A tax change alters it when it takes a different share of each household's income. Their disposable incomes (income after taxes, plus benefits such as pensions and payments to the unemployed) then move further apart or closer together. In this part, the gap between two incomes means how many times larger the richer one is.
Why does the rich household pay more dollars, while the poor one loses a larger share? The rich household spends more dollars, so it pays more tax. But it spends a smaller share of its income, and that is why the sales tax is regressive. So the extra tax is a larger share of the poorer household's income, 4.5% against 2%, and its disposable income falls by a larger percentage. The richer income becomes a larger multiple of the poorer one. The gap widens, even though the richer household loses more dollars.
A rise in the top rate of income tax moves the gap the other way. It takes more only from the highest incomes, so the richer income becomes a smaller multiple of the poorer one, and the gap narrows.
A higher tax-free allowance (the income a person can earn before any income tax is charged) helps the lowest earners most. Rensa's first $10,000 is tax-free. Raising this to $15,000 means the next $5,000 of income is no longer taxed, and it was taxed at 20%. So every taxpayer earning above $15,000 saves $1,000. The dollars are the same, but they are 5% of a $20,000 income and only 1% of $100,000.
A government can also remove the sales tax from basic foods. Poorer households spend a larger share of their income on food, so the saving is a larger share of their income, and the gap narrows. A tax is also only one side of the budget. A progressive tax narrows the gap between disposable incomes, but it makes poorer households better off only if the revenue is spent in ways that help them, such as free schooling. Free schooling saves a poor family the fees it would otherwise pay, and that saving can be a larger share of its income than a sales tax takes. So even a regressive sales tax can leave poorer households better off overall, if it pays for free schooling.
Exam Matters: Say first whether the tax being changed is progressive or regressive, then whose share of income changes most. End with what the revenue is spent on.
A cut in income tax leaves households more to spend, and the extra spending can raise output and jobs.
Suppose Rensa's government cuts income tax. Households keep more of their pay, so their disposable income rises. They spend most of the extra income, which starts a chain:
The first rise in spending also starts further rounds. The shops' extra sales become extra income for their workers, who spend part of it too. This process is called the multiplier. Because of it, the final rise in real output is larger than the first rise in spending.
On the diagram, the cut in income tax shifts aggregate demand from AD₀ to AD₁. Real output, the quantity of goods and services produced, rises from Y₀ to Y₁, and the price level rises from P₀ to P₁.
A rise in income tax reverses each step. Tax is a leakage (income that is not spent on the country's output). A higher tax leaves households less to spend, so consumption falls. AD shifts to the left, firms produce less, and unemployment may rise.
How much of the change is in output depends on spare capacity (workers and machines that are not being used). In a recession there is plenty, so firms meet extra demand by producing more. Close to full capacity, firms cannot produce much more. So the extra demand mostly raises the price level (the average level of prices) instead of output.
Two other leakages weaken the effect. Some of the extra income is saved, and some is spent on imports, which adds to output abroad, not in Rensa. Each round of spending at home is then smaller, so the multiplier is smaller.
A tax cut may also work on the supply side, meaning the economy's ability to produce. Lower marginal rates can raise the incentive to work and to invest. Over time this shifts long-run aggregate supply, the most the economy can produce when all its resources are used, to the right.
Exam Matters: In an Analyse answer, draw AD shifting right and read off both real output and the price level. Then use the case's evidence on spare capacity to say which rises more.
A rise in an indirect tax pushes prices up once, and it is likely to cause lasting inflation only if wages follow.
Suppose Rensa raises its sales tax from 10% to 15%. Firms now pay more tax on each sale, so their cost of selling each unit rises and they raise prices.
Short-run aggregate supply (SRAS) is the total output firms are willing to supply at each price level in the short run. Because costs have risen, firms need a higher price to supply each level of output, so SRAS shifts to the left. The price level rises and real output falls. Inflation is the rate at which the price level rises over a year, and a rise in the price level caused by higher costs is cost-push inflation. Here the rise happens once.
On the diagram, the rise in the sales tax shifts short-run aggregate supply from SRAS₀ to SRAS₁. The price level rises from P₀ to P₁, and real output falls from Y₀ to Y₁.
The tax makes prices jump once. If nothing else changes, they stay at their new level, so a year later the tax no longer adds to inflation.
Inflation is likely to continue only if the tax rise starts a wage-price spiral. This means higher prices lead workers to demand higher wages, which raise firms' costs and prices again:
A direct tax works on the demand side instead: an income tax cut raises AD. Near full capacity, firms cannot produce much more, so the higher AD mostly pushes up the price level (demand-pull inflation).
A cut in an indirect tax lowers firms' costs, so SRAS shifts to the right and the price level falls once. A government may do this when inflation is high, though it loses revenue.
Real Example: Japan raised its consumption tax, a sales tax, in April 2014. Its core inflation rate, which leaves out the prices of fresh food, rose to 3.2% that month. The Bank of Japan, its central bank, estimated that about 2 points of it came from the tax. By April 2015 the rate was 0.3%. The tax had raised the price level once, so a year later it no longer added to inflation.
Exam Matters: In an Analyse answer, show an indirect tax rise as a leftward shift of SRAS, not of AD, and label the higher price level and the lower real output.
A cut in income tax raises spending, and part of that extra spending goes on goods from abroad.
Rensa imports its oil and many consumer goods. Its trade balance means its exports minus its imports of goods and services. A tax change moves the trade balance in two ways: through incomes and through costs.
A cut in income tax raises disposable income, and households spend most of it. Why does only part of that spending go on imports? Households spend much of their income on things made at home, such as rent, haircuts and local food. The marginal propensity to import is the share of each extra dollar of income that is spent on imports.
A rise in income tax reverses each step. If Rensa raised income tax by $30bn, disposable income would fall by $30bn, so households would spend less, including on goods from abroad. Imports would fall by $30bn × 0.3 = $9bn, and the trade balance would improve by $9bn if exports did not change. A government with a trade deficit (imports greater than exports) may raise income tax for this reason, although lower spending also reduces output and jobs at home.
Some taxes are costs for firms, such as taxes on fuel or other inputs (the materials and services firms use to make their products). A rise in these taxes raises exporters' costs. Exporters are firms that sell abroad, so they charge higher prices to foreign buyers. Their exports become less competitive, meaning less attractive than rivals' goods, so the quantity of exports sold may fall and the trade balance may worsen. A cut in these taxes helps exporters.
Exam Matters: Name the channel first. An income tax change works through disposable income and imports; a tax on firms' costs works through export prices.
A firm investing abroad compares the profit it keeps after tax in each country, so tax rates can change where it invests.
A transnational corporation (TNC), a firm that produces in more than one country, is choosing where to build a copper smelter (a plant that heats rock to take the copper out of it). Building or buying productive assets, such as factories, machines and land, that a firm controls in another country is foreign direct investment (FDI). One thing the TNC compares is the return after tax in each country: the profit it keeps after tax, as a percentage of what it invests.
Why does a higher return attract investment? If a rival country offers 16% on the same project, the cut moves Rensa from second place to first. A TNC invests only if the return is high enough to be worth the risk, so a project that was not worth doing in Rensa at 15% may be worth doing at 17%.
A tax holiday (a period of years in which a new investor pays no tax on its profits) works in the same way: it raises the return after tax on a new factory.
But tax is one factor among many. TNCs also weigh market size, skills, roads and power, and political stability. A factory cannot run without reliable power. So a low tax rate is unlikely to attract a factory to a country where the power often fails. A cut also loses revenue on investment that would have come anyway. And if every country in a region cuts its rate, returns are level again and none gains much.
Exam Matters: In an Examine answer, work out a return after tax if the question gives figures. Then weigh tax against the other location factors, the reasons a firm chooses one country over another, to reach a judgement.
In any one year, a government may spend more than it collects in taxes, or less.
Each year, the government of Rensa, a country, plans its spending and the revenue, mostly taxes, it expects to collect. This yearly plan is called the budget.
Fiscal deficit: when government spending exceeds tax revenue.
Put simply, the government pays out more than it collects, so it must borrow the difference. It usually borrows by selling bonds, which are loans it promises to repay with interest.
Fiscal surplus: when tax revenue exceeds government spending.
Put simply, the government collects more than it pays out, and it can use the extra to repay past borrowing or save it.
The key difference is which of the two totals, spending or tax revenue, is larger. If the two are exactly equal, the government has a balanced budget.
Rensa's base year, the year its figures start from, is a normal year, with the economy at full capacity: it uses all its workers and machines.
Why use a share of GDP? $16bn would be a large deficit for a small economy and a small one for a very large economy. As a percentage of GDP, deficits of different countries or years can be compared.
A deficit is not a failure in itself. It is the gap between two totals, so it can widen because revenue falls, not only because spending rises. When incomes fall, people pay less tax, and the deficit can widen with no new spending. Borrowing to build a port that lasts for decades can also be sensible, because the port is used for decades while the loan is repaid.
Exam Matters: In a Calculate question, divide the deficit, not total spending, by GDP, and give your answer with its % sign.
Each year's deficit is borrowed, and the borrowing is added to what the government already owes.
Think of a water tank. The water running in each hour is a flow, measured over a period of time. The water in the tank is a stock, measured at one moment. The flow adds to the stock.
A fiscal deficit is a flow: what the government borrows in one year. Each year's borrowing is added to what it already owes, a stock, so the total builds up over the years.
National debt: the cumulative total of past government borrowing.
Put simply, the national debt is all the past borrowing not yet repaid. Cumulative means added up over time: each deficit adds to it, and a surplus used to repay debt reduces it.
Why does a smaller deficit still add to the debt? Suppose Rensa halves its deficit the next year, from $16bn to $8bn. It still spends $8bn more than it collects, so it must borrow $8bn, and the debt still rises. A smaller deficit only slows the rise. The debt falls in dollars only in a year with a fiscal surplus.
The debt as a share of GDP can behave differently. If GDP grows by a larger percentage than the debt, the debt becomes a smaller share of the economy, even while it rises in dollars. For example, if the debt rises by 2% in a year and GDP rises by 5%, the debt is a smaller share of GDP at the end of the year.
Real Example: In 2024, the IMF (the International Monetary Fund, which lends to governments) put Japan's government debt at about 214% of its GDP: the government owed more than twice the value of a year's output. A debt this large is not built by one deficit. It is the sum of the borrowing of many years.
Exam Matters: In an Explain question on the two, use the words flow and stock, and show the link: each year's deficit is added to the debt.
Some changes in taxes and government spending happen by themselves when output falls; others need a decision.
Output grows fast in some years and falls in others. This rise and fall over time is called the economic cycle, and a recession is a period when output falls.
Suppose Rensa enters a recession, and its government changes no tax rate and no spending plan. What happens to its budget?
Automatic stabilisers: government spending and taxation that vary automatically over the course of the economic cycle.
Put simply, automatic stabilisers are the existing tax and benefit rules. Nobody votes for the change: the amounts change because incomes and jobs change.
Why are they called stabilisers? A worker who loses a job pays less tax and receives a benefit. So disposable income (income after taxes and benefits) falls by less than earnings. Households spend out of their disposable income, so their spending falls by less than it would without these rules. Total spending in the economy falls by less, so the fall in output is smaller and the recession is less deep. Now take the opposite case, a boom, a period when output and incomes rise quickly. The same tax rates then collect more, and fewer people claim benefits, so the deficit narrows with no decision. Disposable income also rises by less than earnings, which slows the rise in spending.
A government can also choose to change taxes or spending to reach its objectives (the goals it aims for). Rensa could cut its sales tax rate or build new roads.
Discretionary fiscal policy: the deliberate alteration of government expenditure and taxation designed to achieve the government's economic objectives.
Put simply, discretionary fiscal policy is a choice: someone decides to change a tax rate or a spending plan.
The key difference is the decision. Automatic stabilisers work at once but only soften a recession. Discretionary policy can be larger and aimed at one problem, but it takes time to plan, approve and deliver, so it may arrive after the recession ends.
Part of a deficit disappears when the economy recovers, but part of it remains even in a normal year.
In its base year, Rensa was at full capacity (using all its workers and machines), and its deficit was $16bn. In the recession, the automatic stabilisers widened it by $12bn, to $28bn. When the economy recovers, how much of the $28bn will disappear?
A downturn is a period when output falls, as in a recession. Output grows faster in some years and slower in others, and its average rate of growth over many years is called the trend growth rate. An economy producing at full capacity, using all its workers and machines, is operating at its full potential, and its output is then on its trend path. When output returns to that path, tax receipts rise again and benefit claims fall, so the extra deficit caused by the recession disappears.
Cyclical deficit: the part of a fiscal deficit that occurs during a downturn, because tax revenues fall and government expenditure on benefits rises; it should disappear when the economy returns to its trend growth rate.
Put simply, the cyclical deficit is the part the recession caused, and recovery removes it without any decision.
Structural deficit: the part of a fiscal deficit that remains even when the economy is operating at its full potential.
Put simply, the structural deficit is the part that remains in a normal year, because the government's spending plans are larger than what its tax rates raise at full capacity.
The key difference is what removes each part. Recovery removes the cyclical part, but not the structural part, which is there even at full capacity.
Recovery removes the $12bn cyclical part. So if Rensa only waits for recovery, its deficit falls back to $16bn, not to zero. Closing the structural $16bn needs a decision to raise taxes or cut spending.
The split decides the policy response. Raising taxes in a recession to close a cyclical deficit reduces disposable income, so spending and output fall further, just when they are already falling. A decision on the structural part can be timed for the recovery, when it does less harm than it would in the recession.
The split is an estimate, because full-capacity output cannot be observed directly.
Exam Matters: In an Examine question on a deficit, say which part of it the policy would close, then judge whether its timing suits the stage of the cycle.
A deficit or a debt can grow because of events a government did not choose, not only because of its decisions.
A deficit is the gap between spending and revenue, so anything that raises spending or lowers revenue widens it, and the extra borrowing adds to the national debt. Some causes are decisions. Others happen to the government.
Why does a falling currency raise a debt? Some governments borrow in US dollars but collect their taxes in their own currency. If the home currency falls against the dollar, each dollar costs more of it. The debt in dollars is unchanged, but repaying it, and paying its interest, now takes more of the home currency.
The debt as a share of GDP also depends on nominal GDP. Nominal GDP is GDP measured at current prices, so it rises when output rises and when prices rise. Higher inflation (a faster rise in the price level) can therefore make the same debt a smaller share of the economy, even if none of it is repaid.
Exam Matters: When an extract describes a rising deficit, name its cause: the cycle, a policy choice, interest costs or an event. This helps you judge whether the deficit is likely to last: a cyclical cause may fade, but a policy choice or high interest costs may not.
The more a government owes, and the higher the interest rate, the more of its revenue is spent on interest each year.
When a government runs a large deficit, it must sell many bonds each year (loans it promises to repay with interest). To persuade enough lenders (people and firms that lend money, such as banks) to buy them, it may have to offer a higher interest rate, especially if lenders start to doubt that they will be repaid in full.
Lenders can choose between lending to the government and lending to firms and households. If the government pays more, the others must offer more too, so interest rates can rise across the economy, on loans to firms and households as well. Firms may then borrow and invest less. This is financial crowding out: government borrowing raises interest rates and so reduces private investment.
Debt servicing: paying the interest on the national debt.
Put simply, debt servicing is the yearly cost of owing money. The government pays it every year, even in a year when it repays none of the debt itself.
Why does a higher interest rate make the same debt cost more? The debt is still $240bn, but each dollar owed now costs twice as much interest. The rise comes gradually. Each year some old bonds are repaid, and the government sells new bonds at the higher rate to repay them.
Every dollar of interest is a dollar Rensa cannot spend on schools or hospitals, or return to households in lower taxes. If interest takes a large share of revenue, a government may borrow just to pay it, and the debt then grows even though the government has bought nothing new.
Real Example: Egypt's budget for 2024/25 expected interest on its debt to cost about 91% of the tax revenue it expected to collect. If this plan held, almost all of the tax revenue it expected would be spent on interest, leaving little for schools, hospitals or roads unless it borrowed more.
Borrowing now can leave later generations to pay, and whether that is fair depends on what the money bought.
A generation is a group of people born at about the same time. When Rensa's government borrows, today's generation gets the spending now. The debt is serviced and repaid later, partly by taxpayers who are children today or not yet born.
Intergenerational equity: fairness in how the costs and benefits of government decisions are shared between generations.
Put simply, it asks whether each generation pays for what it gets. When the national debt rises, future generations bear the cost of repaying it. They may then pay for benefits that an earlier generation enjoyed.
Is that unfair? It depends on what the borrowing pays for. Capital spending buys assets, things of value that last for many years, such as a railway or a port. Current spending is used up within the year, such as this year's wages for teachers.
Why can borrowing for a railway be fair to the people who repay it? Suppose Rensa borrows to build a railway that will run for fifty years. The taxpayers who repay the debt in twenty years' time also travel on it, and their firms use it to carry copper to the port. So they pay part of the cost of something they also use: they share the benefit as well as the cost.
Borrowing to pay higher wages this year is different. The benefit is used up now, so a later generation pays and gains nothing lasting in return.
Borrowing can also protect the future. If it prevents a deep recession, it may save years of lost jobs and investment, and the next generation gains from that too.
Exam Matters: In an Analyse question on fairness between generations, say what the borrowing buys, who gains from it and when, and who repays.
A government has five kinds of policy, and each one changes the economy through a different route.
Imagine Rensa's government faces three problems in one year. Prices are rising fast, the budget is short of money, and many families are poor. One decision cannot deal with all three. The government chooses from five kinds of policy, and each works through its own channel: the route by which it changes what people and firms do.
Exchange-rate policy: the use of interest rates or the central bank's buying and selling of currency to influence the value of the currency.
Put simply, the central bank tries to raise or lower the value of its currency, the country's money, against other currencies. A stronger currency makes imports cheaper at home. A weaker one makes exports cheaper abroad.
Direct controls: forms of control which work outside the market system, such as maximum prices, minimum prices and wage controls.
Put simply, a direct control is a rule. A maximum price on bread means no shop may charge more than a set amount for a loaf.
Why does a direct control work differently? The other four kinds of policy change prices, incomes or what the economy can produce, such as the cost of a loan or the price of imports (goods bought from abroad). People and firms then choose how to respond, for example by borrowing less when a loan costs more. A direct control sets the outcome by law instead. It can work quickly. But if the law sets a price below the market price, the price buyers and sellers would agree on their own, buyers want more than sellers will supply at that price, so there is a shortage.
Most aims need several kinds of policy at once, and a policy that helps one aim can harm another. A higher interest rate can slow inflation, but it also raises the interest the government pays on its debt.
Real Example: Singapore's central bank uses the exchange rate, not an interest rate, as its main tool for keeping prices stable. Singapore buys a large share of its goods from abroad, so a stronger Singapore dollar makes imports cheaper at home. This shows exchange-rate policy used as the main tool, not only as a support.
Cutting public spending reduces a fiscal deficit, but usually by less than the cut, because it also shrinks the economy.
Rensa has a fiscal deficit of $16bn a year (its government spends $16bn more than it collects) and a national debt of $240bn (the total it owes from past borrowing). Its government wants both to be smaller. Each kind of policy can help:
Why might a spending cut not save its full amount? Public spending is part of aggregate demand. When the state spends less, firms sell less, so output and incomes fall. Lower incomes cut tax receipts and raise benefit claims, with no decision (the automatic stabilisers), so the deficit widens again. When output and incomes grow, the same steps work the other way: tax receipts rise, benefit claims fall, and the deficit narrows.
The cut still reduces the deficit, but the smaller economy takes back $4bn of the saving. This is why the timing and the mix of cuts matter as much as their size. A cut made in a recession reduces output when it is already falling. If output falls far enough, the debt can even grow as a share of GDP, because GDP, the figure the debt is divided by, falls while the debt does not.
The best policy against inflation depends on its cause: too much spending, or higher costs of production.
The world price of oil doubles. Rensa imports its oil, so firms' fuel and transport costs rise, and they raise their prices. Inflation, the rate at which the price level rises, goes up to 8%. Rensa's inflation target, the rate of inflation the central bank is asked to aim for, is 3%. Which policy should it use?
It depends on the cause. Demand-pull inflation comes from too much spending: aggregate demand grows faster than the economy can produce. Cost-push inflation comes from higher costs of production, which shift short-run aggregate supply (SRAS) to the left, from SRAS₀ to SRAS₁. Rensa's inflation is cost-push. The tools against inflation are:
Why is cost-push inflation harder to control? A higher interest rate works by reducing aggregate demand. Against demand-pull inflation, a fall in aggregate demand removes the cause. Against Rensa's oil price rise, it does not: oil is still expensive. Prices rise more slowly only because firms sell less. With fewer buyers, firms raise their prices less, and they also cut output, so jobs are lost. Output has already fallen once, because the higher oil price shifted SRAS to the left. So the central bank must weigh a faster fall in inflation against a deeper fall in output.
A government may instead act on the fuel price itself, because the oil price is the cause. A temporary fuel price cap or a fuel tax cut lowers what buyers pay for fuel without reducing aggregate demand. But a cap can cause a shortage and a tax cut reduces tax revenue, so each is used only for a short time.
Exam Matters: In an Examine answer, say first whether the inflation is demand-pull or cost-push, because that decides whether a higher interest rate removes the cause or only reduces output.
Some events abroad change a country's spending, and others change its costs, and each needs a different response.
In one year, two things happen outside Rensa that its government cannot prevent. A recession abroad, a fall in output there, reduces the demand for Rensa's copper. And the world price of oil doubles. Events like these are called external shocks.
External shock: an event outside a country's control that changes its economy, such as a sharp change in world oil or commodity prices, a major financial crisis or a political crisis abroad.
Put simply, an external shock starts abroad but is felt at home. Commodities are raw materials such as oil and copper, and their prices can change sharply. An open economy, one that trades a large share of its output, feels it most.
Shocks to trade and prices come in two kinds, and the kind decides the response. A demand-side shock changes spending on a country's output, such as its exports or the spending of tourists who visit it. A supply-side shock changes firms' costs of production. When SRAS shifts left, from SRAS₀ to SRAS₁, firms supply less at every price level, so output falls and the price level rises at the same time.
Why not use stimulus after the oil shock too? Stimulus raises aggregate demand. After an oil shock, prices are already rising because costs rose. More spending pushes prices up further, so inflation gets worse. Stimulus would raise output but make inflation worse. Supply-side policies raise aggregate supply, so they can lift output without raising prices, but they take years.
A shock can also start with money. If foreign investors suddenly withdraw their money, which is a capital outflow, they sell the country's currency to buy other currencies, so the demand for it falls and its value falls fast. The central bank may sell its foreign currency reserves (the dollars and other currencies it holds) to buy its own currency, which raises the demand for it. It may raise interest rates, which gives investors a higher return for keeping their money in the country. Or it may limit, for a time, how much money can leave the country. A country that keeps its debt low and its reserves large in good years has room to borrow and to defend its currency.
Real Example: In September 1998, during the Asian financial crisis, Malaysia limited money leaving the country and fixed the ringgit against the US dollar. Its aim was to stop the falling currency from deciding its interest rates. This shows a direct control used against a shock that started with money flowing out.
Poverty and inequality are different problems, so a policy can reduce one without reducing the other.
Poverty means having too little income to meet basic needs, such as food, housing and clothing. Inequality means that income is shared unequally between the rich and the poor. If every income in a country doubles, fewer people are poor. But each household's share of total income does not change, so inequality does not fall, although the gap in dollars between rich and poor doubles.
Why does taxing the rich not always reduce poverty? A higher tax on top incomes takes a larger share from the rich, so income after tax is shared less unequally, and inequality falls. But no poor family is any richer yet. Poverty falls only when the revenue, the money the tax raises, reaches the poor, through benefits or services, or when growth creates jobs for them.
Each tool has a cost. High tax rates can weaken incentives to work, and benefits that stop as income rises can make a better-paid job hardly worth taking.
Real Example: Brazil's Bolsa Família pays poor families a monthly cash payment, on condition that their children attend school and have their vaccinations. The payment reduces poverty now. The conditions build the children's skills and health, which can reduce poverty in the future too.
Exam Matters: In an Explain question, say whether the policy works on poverty, on inequality or on both, and show the step that links it to the one the question asks about.
In 2008, spending fell in many countries at once, and governments and central banks acted together to raise it.
The global financial crisis of 2008 began with losses on housing loans in the US. Many banks around the world held these loans, so the losses spread. Banks that had lost money had less to lend, and they no longer trusted that other borrowers would repay, so they stopped lending to each other and to firms. Without loans, firms invested less and households spent less. Aggregate demand fell in many countries at once, and world trade fell sharply.
Governments answered with demand-side policies: fiscal and monetary policy used to change aggregate demand. Here, the aim was to raise it.
Why act together? When one country's spending rises, part of it buys imports. So part of its stimulus raises demand abroad, not at home. When the large economies all acted at once, one country's spending on imports was another country's exports. So the spending that left one country returned to the others as demand for their exports.
There were costs. National debts rose sharply, partly because stimulus was paid for by borrowing and partly because the recession cut tax receipts. From 2010, several euro-area governments (countries that use the euro) faced debt crises: lenders charged them far more to borrow, so they had to cut their spending.
A firm that works in many countries can lower its tax bill legally by recording its profit where tax rates are low.
A transnational corporation (TNC) is a firm that produces in more than one country. It usually runs its business in each country through a subsidiary, a company that the TNC owns. Each subsidiary pays tax on the profit it records, in the country where it records it. So a TNC can lower its total tax bill by recording more of its profit where tax rates are low.
Tax avoidance: legally arranging affairs so as to pay less tax.
Put simply, tax avoidance uses the rules: a TNC that records its profit in a low-tax country is breaking no law.
Tax evasion: illegally not paying tax that is owed.
Put simply, tax evasion breaks the rules, for example by hiding sales from the tax authority, the government office that collects tax. Because avoidance uses the rules, governments fight it by changing the rules, not by taking firms to court.
Which profit is easiest to move? A copper mine must stay where the copper is. Profit from a brand (a firm's name and logo), an idea or software is different. The TNC can register its brand with a company in a tax haven, a country with very low or no tax on profit. Its other subsidiaries then pay that company to use the brand. Each payment is a cost for the subsidiary that pays and income for the company in the tax haven, so profit moves with each payment.
Governments use several measures, each against one route:
Real Example: Ireland has long charged 12.5% tax on company profits. Under the global minimum tax, it now raises the tax of large groups to 15%, while most smaller firms still pay 12.5%. This shows a low-tax country changing its own rules to fit an agreement between many countries.
When one part of a TNC sells to another, the price it chooses decides in which country the profit is taxed.
Ostra is a mining TNC. It mines copper in Rensa, where tax on profit is 25%, at a cost of $60m. It sells the copper to its own trading company in Pelmo, a country where tax on profit is 5%. The trading company sells it to outside buyers for $100m. Both belong to Ostra, so Ostra sets the price one charges the other.
Transfer pricing: the pricing policies adopted by groups of companies for transactions between companies in the group, such as the sale of goods or the provision of services.
Put simply, transfer pricing is how a TNC sets the prices its own companies charge each other. The price Ostra's mine charges its trading company is called a transfer price.
Why does the transfer price matter? The mine's profit is the transfer price minus its $60m cost. The trading company's profit is $100m minus the transfer price. Together they always make $40m. The transfer price only decides where that profit is recorded, and so which country taxes it.
So a low transfer price, charged by the mine in Rensa to its trading company in Pelmo, moves the profit to the country with the lower tax. If the buying company were in the higher-tax country, Ostra would set a high transfer price instead, and the profit would move the other way.
Arm's-length principle: the rule that a price charged between two parts of the same group must be the price two independent firms would agree.
Put simply, the tax authority asks what an independent buyer would have paid. Copper has a world price, the price independent buyers and sellers pay for it around the world, and here outside buyers pay $100m. So Rensa can compare Ostra's $60m with that $100m, and tax Ostra as if the price had been $100m.
A brand or a patent (the legal right to be the only producer of an invention) often has no market price, a price agreed between independent firms, to compare with, so the check is harder. And one country cannot check what happens in another. Transfer pricing is hard to control without international agreements, and the agreements work only if each country enforces the agreed rules.
One government acting alone finds a TNC hard to control, because the TNC can move and knows more.
Suppose Rensa raises its tax on the profits of large firms. Can it be sure the TNCs in Rensa will pay more? Not always. Its power is limited in several ways:
Agreements between countries limit a government too. Under the World Trade Organization (WTO), the agreement on trade-related investment measures (TRIMs) stops a member country from requiring a foreign firm to buy local products, for example its parts from local suppliers. So a government cannot make a TNC buy local parts to create local jobs.
Why do several governments acting together do better? A TNC escapes one country's rule by moving its profit or its factory to another. If every country it could move to applies the same rule, moving no longer helps. This is why a global minimum tax needs many countries to join.
The same policy can help a country as a whole while it hurts one region, or other countries.
A policy change can have different effects at three levels. A local economy is the economy of one town or region. A national economy is the whole country's economy. The global economy is all the world's economies, linked by trade and flows of money.
Rensa's government removes a fuel subsidy that cost $5bn a year. The subsidy paid part of the price of every litre, so fuel was cheap. Now buyers pay the full price.
Why can the same policy help the nation and hurt a region? The saving goes into the whole budget and helps all taxpayers a little, while the cost falls on the people who use the most fuel. So a policy can improve the national budget while it lowers living standards in one region. In the same way, a large economy's policy can suit it at home while it causes problems for smaller economies.
Exam Matters: In an Analyse answer on a policy's impact, write a separate chain for each level the question names, and say who gains or loses at that level.
Policymakers must decide using figures that may later turn out wrong, about effects that no one can know in advance.
In Rensa, the first estimate says the economy grew by 3% last year. That looks fast, and inflation could follow, so the central bank raises interest rates. Months later the figure is revised, meaning corrected, to 1%. The economy was already weak, and the higher interest rate slows it further.
Why not wait for the correct figure? It can take months to arrive, and there are time lags: the time between a policy decision and its effect. A change in interest rates can take a year or more to affect inflation, so a bank that waited would act even later. So a central bank must act on forecasts, estimates of where the economy will be, and those forecasts rest on figures that may be wrong.
Policymakers face two problems of knowledge. Inaccurate information means the figures themselves may be wrong or late:
Risks and uncertainties mean that, even with correct figures, the effect of a policy is hard to predict:
So the key difference is this: inaccurate information is about the figures, while risks and uncertainties are about how and when the economy will respond.
Exam Matters: In an Examine question on problems for policymakers, name each problem and show what it did to the policy's effect, not how the policy works. End with a judgement on which problem mattered more and why.
A government can prepare for events abroad, but it cannot stop them, so a sound plan can still fail.
Many policies are planned on assumptions about the world economy: the price of oil, the growth of its trading partners (the countries it trades with), the flow of money from abroad. An external shock, an event abroad that the country cannot control, can overturn those assumptions in weeks.
Suppose Rensa plans to cut its deficit over three years. Then its main copper buyers abroad fall into a slump and order less. Exports and incomes fall, so tax receipts fall and benefit spending rises. The deficit widens instead of shrinking. The plan was sound when it was made, and it failed because of an event the government had no power to prevent.
The more closely countries are linked by trade and money, the harder it is to protect one of them from a shock abroad. Small, open economies are more exposed. An economy whose exports are a large share of GDP, which imports most of its fuel and food, or which relies on one commodity, such as copper or cocoa, feels a shock abroad as a large shock at home.
A government can prepare, but it cannot prevent. Large foreign currency reserves let the central bank defend the currency, and low debt lets the government borrow when tax receipts fall. Selling a wider range of exports means a fall in one price, or in one buyer's orders, hits only part of its export income. When the shock comes, it must still respond to events it did not choose.
Exam Matters: When an extract mentions events abroad, use them to evaluate: the policy's success depended on conditions the government could not control. Then name one way it could have prepared.
A government spends money in three different ways, and they are told apart by what the money buys.
As a country's income rises, its people want more of the services that the state provides.