Effect of Government Expenditure on Production, Employment, Inflation, Income

Distribution and Economic Stabilization

A. Effect on Production

The effect of public expenditure on production can be examined with reference to its effects on
ability & willingness to work, save & invest and on diversion of resources.

i. Ability to work, save and invest: Socially desirable public expenditure increases
community's productive capacity. Expenditure on education, health, communication,
increases people's productivity at work and therefore their incomes. With rise in
income savings also increase and this in turn has a beneficial effect on investment and
capital formation.
ii. Willingness to work, save and invest: Public expenditure, sometimes, brings
adverse effects on people's willingness to work and save. Government expenditure on
social security facilities may bring such unfavorable effects. For example:
Government spends a considerable portion of its income towards provision of social
security benefits such as unemployment allowances old age pension, insurance
benefits, sickness benefit, medical benefit, etc. Such benefits reduce the desire to
work. In other words they act as disincentive to work.
iii. Effect on allocation of resources among different industries & trade: Many a
times the government expenditure proves to be an effective instrument to encourage
investment on a particular industry. For e.g. If government decides to promote
exports, it provides benefits like subsidies, tax benefits to attract investment towards
such industry. Similarly government can also promote a particular region by
providing various incentives for those who make investment in that region [vii].

B. Effect on Employment

Increased investments in infrastructure save or create millions of jobs in construction industry

and manufacturing. Upgrading roads, bridges, and other basic infrastructure not only creates jobs
or employment but also paves the way for businesses small, medium, and large to benefit.
Infrastructure investments lower the cost of doing business, make companies more competitive.
And they put people to work earning goods, middle-class incomes, which expand the consumer
base for businesses.

C. Effect on Inflation

Government spending is the total spending by government on all goods and services in a given
period of time. Inflation is the sustained increase in the general price level over a given period of
time. Higher government spending will lead to demand-pull inflation. This is because
government spending is a component of aggregate demand (AD). Assuming other determinants
of AD remain constant, an increase in government spending will increase the level of AD in the
economy. This means that the AD curve will shift to the right. This leads to an increase in the
price level, an extension along the aggregate supply (AS) curve, and an increase in real GDP.
Hence, a higher level of government spending has increased inflation, seen by the increase in the
price level. Higher government spending will lead to inflation due to the multiplier effect. The
multiplier effect occurs when an initial change in an injection into the circular flow of income
has a greater final impact on national income. Government spending is an injection into the
circular flow of income. The government spending filters through to firms and households (e.g.
through wages). They in turn spend a portion of this additional income, which flows from firms
to households, and vice versa (e.g. households purchase goods and services). This process carries
on with smaller and smaller amounts being added to national income as the money flows around
the economy. Each additional round includes consumer expenditure and investment, which,
being components of AD, shift the AD curve further right. This in turn leads to demand-pull
inflation. However, government spending will not increase inflation if there is spare capacity in
the economy. If there is a negative output gap, shifts to the right of the AD curve will mean that
unutilized factors of production will be used to increase real GDP, and there would be no
inflationary pressure. Whether or not higher government spending will always increase inflation
depends on which school of thought is adopted. In a Keynesian AD/AS model, spare capacity in
the long-run is possible, allowing for increases in AD without inflationary pressure. However,
neo-classical economists would argue that in the long-run, any increase in AD will always lead
to inflation, due to the nature of their AS curve being vertical. Ultimately, higher government
spending is very likely to result in demand-pull inflation, but will not necessarily ‘always’ do so
[vii].

D. Effects on Distribution

The primary aim of the government is to maximize social benefit through public expenditure.
The objective of maximum social welfare can be achieved only when the inequality of income is
removed or minimized. Government expenditure is very useful to fulfill this goal. Government
collects excess income of the rich through income tax and sales tax on luxuries. The funds thus
mobilized are directed towards welfare programs to promote the standard of poor and weaker
section. Thus public expenditure helps to achieve the objective of equal distribution of income
[vii].

E. Effects on Economic Stability

Economic instability takes the form of depression, recession and inflation. Public expenditure is
used as a mechanism to control instability. The modern economist Keynes advocated public
expenditure as a better device to raise effective demand & to get out of depression. Public
expenditure is also useful in controlling inflation & deflation. Expansion of Public expenditure
during deflation & reduction of public expenditure during inflation control money supply &
bring price stability [vii].

7. Wagner’s Law of Increasing State Activity

Wagner's law of state is known as the law of increasing state spending, is a principle named
after the German economist Adolph Wagner (1835–1917).He first observed it for his own
country and then for other countries. The theory holds that for any country, that public
expenditure rises constantly as income growth expands. The law predicts that the development of
an industrial economy will be accompanied by an increased share of public expenditure in gross
national product. The advent of modern industrial society will result in increasing political
pressure for social progress and increased allowance for social consideration by industry.
Wagner's law suggests that a welfare state evolves from free market capitalism due to the
population voting for ever-increasing social services as general income levels grow across broad
spectrums of the economy. In spite of some ambiguity, Wagner's statement in formal terms has
been interpreted by Richard Musgrave as follows:

As progressive nations industrialize, the share of the public sector in the national economy grows
continually. The increase in State Expenditure is needed because of three main reasons. Wagner
himself identified these as (i) social activities of the state, (ii) administrative and protective
actions, and (iii) welfare functions. There has been considerable increase in revenue to the
governments due to the economic developments over the years, thereby leading to a boost in
public expenditure. The government simply cannot ignore the demands that people make
regarding various services, especially when there is an increase in revenue collection at a
constant rate of taxation. During times of war tax rates are increased by the government to
generate more funds to meet the increase in defense expenditure. This is known as the
displacement effect. Such 'displacement effect' is created when the earlier lower tax and
expenditure levels are displaced by new and higher budgetary levels. But it remains the same
even after the war as people get used to them. Therefore, the increase in revenue results in rise in
government expenditure.

8. Wiseman-Peacock Hypothesis

Peacock and Wiseman conducted a new study based on Wagner's Law. They studied the public
expenditure from 1891 to 1955 in U.K. They found out that Wagner's Law is still valid.

Peacock and Wiseman stated that:

1. "The rise in public expenditure greatly depends on revenue collection. Over the years,
economic development results in substantial revenue to the governments, this enabled to
increase public expenditure".
2. There exists a big gap between the expectations of the people about public expenditure
and the tolerance level of taxation. Therefore, governments cannot ignore the demands
made by people regarding various services, especially, when the revenue collection is
increasing at constant rate of taxation.
3. They further stated that during the times of war, the government further increases the tax
rates, and enlarges the tax structure to generate more funds to meet the increase in
defense expenditure. After the war, the new tax rates and tax structures may remain the
same, as people get used to them. Therefore, the increase in revenue results in rise in
government expenditure [xi].