ECO152: Macroeconomics

Chapter 3: The government and fiscal policy

In this chapter…
• Explain why government participates in economic affairs
• Explain the meaning of fiscal policy
• Discuss government spending and the financing of such spending
• Discuss the criteria for a good tax
The government (or public sector)
The public sector consists of the following:
A. Central government – mainly deals with national issues, e.g. defence.
B. Regional/provincial government – mainly deals with regional issues, e.g.
housing.
C. Local government – deals with local issues, e.g. sewerage and waste services.
D. Public corporations – and state owned enterprises (SOEs) like Eskom, Transnet.

A + B + C = general government
A + B + C + D = Public sector

*Note that often we use government and public sector interchangeably.

The composition of the
public sector (Fig. 3-1)
1 2 3
The interaction between
government, households
and firms (Fig. 3-2)
Government participation in the economy
1. Private initiative and market forces are generally more efficient than
government.
2. Government must provide an appropriate environment (e.g. legal
framework) in which markets can operate.
3. Markets sometimes fail.
4. Markets produce efficient, but not necessarily equitable outcomes.
5. Markets tend to generate instability through business cycles.

Both government and markets are needed in economy.

How does government intervene?
1. Public provision of goods and services
2. Government as a market participant
3. Government spending
4. Taxation
5. Regulation
Fiscal policy and the budget
Definition of fiscal policy:
• Level and composition of government spending, taxation, and government
borrowing.
• The main instrument of fiscal policy is the annual budget.
• This is a reflection of political decisions on how much to spend, what to spend
on, and how to finance the expenditure.
• However, the macroeconomic effects of the public sector budget cannot be
ignored.
• Fiscal policy is viewed as a more direct intervention than monetary policy
when applying business-cycle countermeasures.
Government response to business cycles
• Recession • Expansionary phase
Expansionary fiscal policy Contractionary fiscal policy
Government spending increases Government spending reduced
And/or And/or
Taxes decrease Taxes increase
Budget deficit increases Budget deficit decreases
Fiscal policy and the budget
• Main instrument: budget .
• Main variables: taxation and government spending.
• Spending plans for the year ahead: reflection of political decisions.
• Budget year runs from 1 April to 31 March.
• Medium term budget (presented in October) offers longer term view
of fiscal policy.
• Other instrument: monetary policy (chapter 2)
Budget speech 2021
• “…our public finances are dangerously overstretched…We owe a lot
of people a lot of money,”
1. Expenditure amounts to R2 trillion, mostly on social services.
2. Budget speech emphasised the need for infrastructure investment.
3. Introduction of ‘zero based budgeting’ to promote efficiency in
expenditure.
4. Addressing crime and corruption mentioned in the budget.
SA: Government revenue and expenditure
Government budget 2021
projection
-14%
Government spending (G)
• Table 3-1
Year Final consumption Total spending by general
expenditure by general government (% of GDE)
government (% of GDE)
1960 9.8 12.7
1970 11.5 18.8
1980 14.1 17.6
1990 19.5 22.6
2000 18.9 21.6
2010 20.5 23.3
2017 21.2 24.4
Explanations for trends in government
spending post World War 2
• Political and other shocks
• Redistribution of income
• Population growth and urbanisation
Table 3-2 Functional composition of budget
expenditure
Function Percentage of total expenditure
1990 2000 2010 2016
General public services 27.8 28.7 21.6 24.6
Of which, public debt transactions 12.4 16.8 6.6 8.5
Defence 12.8 4.5 3.4 2.9
Public order and safety 6.8 9.7 11.2 9.9
Education 17.7 20.3 19.6 18.8
Health 8.9 9.8 11.5 11.4
Social protection 6.3 11.4 14.2 13.4
Housing and community amenities 4.4 2.3 4.4 4.6
Recreation, culture and religion 1.3 1.6 3.0 2.4
Economic affairs 14.0 9.8 10.4 11.2
Environmental protection n.a. 1.9 0.8 0.8
Government spending financed by:
• Income from property
• Taxes
• Borrowing
• Domestic capital markets (government bonds)
• International capital markets (government bonds)
• Central Bank (SARB – inflationary financing)
• Borrowing increases public debt and interest on public debt (see next
slide).
Revenue and debt service cost
Criteria of good taxes
• Neutrality
• Should have minimum possible effect on relative prices
• Equity
• Ability to pay principle
• Horizontal equity – people with the same incomes pay the same taxes.
• Vertical equity – people with higher incomes pay more taxes than those with lower
incomes
• Benefit principle – recipients of benefits generated by government
expenditure should pay for such goods and services (electricity, transport).
• Administratively simple
• Compliance costs and administrative costs to be kept as low as possible.
• Tax avoidance vs tax evasion
Different types of taxes
• Direct taxes: Ievied on persons, specifically on wealth and income
• Indirect taxes: Income on goods and services, levied on transactions
• General taxes: levied on most goods and services
• Specific taxes: levied on selected goods and services

A tax can cut across these categories, for example:

VAT is an indirect tax and a general tax
Progressive, proportional and regressive taxes
• Progressive
• The higher your income, the larger the percentage of income paid
in tax.
• Proportional
• Tax ratio is the same for all levels of income.
• Regressive
• Takes a larger percentage of poorer individuals’ or households’
income in tax.
Personal income tax
• The most important form of direct taxation in SA and also the most
important single source of revenue
Levied on taxable income (tax base)
Marginal tax rate and average (or effective) tax rate
Includes capital gains tax
Progressive tax
Company tax
• Company profits (tax base)
• Proportional tax
Value-added tax (VAT)
• Indirect tax
• Regressive tax
• 15% in South Africa
• Some products exempted:
dried beans, samp, maize meal, rice, brown bread, vegetables, fruits,
vegetable oil, mealie rice, pilchards in tins, edible legumes and pulses
of leguminous plants, eggs, milk, dried mealies, dairy powder blend,
lentils, cultured milk, milk powder, brown wheaten meal
Thank you for your attention.