Chapter 5:

Government

Expenditure
and
Revenue
by
Ooi Soon Beng
After studying this chapter, you should be able to
understand:
 Public Budget
 Budget Deficits and Surplus
 Expansionary and Contractionary Fiscal Policy
 Discretionary and Automatic Fiscal Policy
 National Debts and Its Issues and
Misconceptions
 Problems with Fiscal Policy
According to Keynes,
government has to
intervene to stabilize the
economy.
Stabilization can be
achieved by
manipulating the Public
Budget to increase
output and employment
or to reduce inflation.
The Budget outlines the government’s taxation and
expenditure plans for the coming fiscal year.
The Ministry of Finance are responsible for the
preparation of the budget.
Sources of Revenues:
 Direct taxes on individuals and companies
 Indirect taxes on goods and services (gasoline,
alcohol, tobacco, etc)
 Non-tax revenue (stamp duty, licenses, permits,
etc)
 Malaysia: Sources of Revenue (in RM)
1990 2013 2019
Direct Taxes 35.2% 56.5% 51.5%
Indirect Taxes 36.7% 16.6% 16.9%
Non-Tax Revenue 28.0% 26.9% 31.6%
Total Revenue 29,521m 207,913 263,300m
m
Source: Ministry of Finance
Categories of Expenses:
 Operating Expenditure (emolument,
pensions, debt servicing, grant to states,
subsidies, supplies, scholarships, etc)
 Development Expenditure (security, social
services, economic services, expenditure
on goods and services).
 1990 2012 2019
Operating Expenditure 70.3% 81.4% 83.0%
Development Expenditure 29.7% 18.6% 17.0%
Total Expenditure 35.62bn 252.5bn 315.96bn
Source: Ministry of Finance
Malaysia recorded a
budget deficit of
3.70% of GDP in
2018. The deficit
reached a record of
6.70% of GDP in
2009.
Fiscal policy is carried out primarily by:
A. the Federal government.
B. state and local governments working
together.
C. state governments alone.
D. local governments alone.
1) Discretionary Fiscal Policy
Deliberate manipulation of government spending and
taxes by government to influence real
domestic output and employment, and to control
inflation.

2) Automatic Fiscal Policy

A change in fiscal policy that is triggered
automatically by the state of the economy (without
any explicit policy action by the government).
There are two discretionary policy tools: government
expenditure (G) and taxes (T).
 If G > T , budget is deficit and fiscal policy is
expansionary.
 If G < T, budget is surplus and fiscal policy is
contractionary.
 If G = T, budget is balanced.
If real GDP is below potential
GDP (recessionary gap), an
expansionary fiscal policy
could be used.
Government increases its
expenditures or cut taxes, or
do some of both.
Aggregate demand increases,
and through the multiplier
effect narrow the recessionary
gap.
 Increase in government
expenditures or tax
125 cut
Multiplier Potential
SAS0
115 effect GDP
Price level (GDP

C
105
B
deflator)

100
A
85 AD1
AD0 + E
AD0
0 800 900 1,000 1,100
Real GDP (billions)
If real GDP is above potential
GDP (inflationary gap), a
contractionary fiscal policy could
be used.
Government decreases
expenditures or raises taxes or
do some of both.
Aggregate demand decreases,
and through the multiplier
effect narrow the inflationary
gap.
 Potential Decreases in government
125 GDP expenditures or tax
increase
SAS0
115 B A
Price level (GDP

Multiplier
105 effect
C
deflator)

95 AD0

85 AD0 - E
AD1

0 800 900 1,000 1,100

Real GDP (billions)
Socialist economists Classical economists
who are concerned who think that
about unmet social government is too large
needs or infrastructure and inefficient tend to
tend to favor : favor:
(i) higher G (i) lower T during
during recessions, and
(ii) recessions, and
higher T during (ii) lower G during
inflationary periods. inflationary
periods.
Suppose the MPC is 0.8 and the inflationary GDP
gap is a negative $100 billion.
To achieve full-employment output, government
should decrease its spending by $ billion or
raise taxes by $ billion.
To remove inflationary gap , we use contractionary
fiscal policy by decreasing G or increasing tax.

∆ GDP = k x ∆ in initial spending

$100 bn = 5 x ∆ in initial spending
∆ in initial spending = $100bn/5 = $20 bn
(decrease G)
Tax multiplier; KT=
∆ GDP = k x (MPC x ∆ in tax) -MPC/MPS

$100 bn = 5 x (0. 8 x ∆ in tax)

$100 bn = 4 x ∆ in tax)
 Which tool A $5 billion tax cut
represents a or a $5 billion
more increase in
expansionary government
spending?
fiscal policy?
 Most countries in the world have budget
deficits.
 Norway, Macau, Kuwait, Qatar, Hong Kong,
Singapore and Norway are the few countries
having budget surpluses.
 For most of the 1970s, 1980s, and 1990s, the
Malaysia budget was in deficit.
In the event of deficit budget, financing come
from:
 Seigniorage, the benefit from printing
money
 Domestic borrowings
 External borrowings
 Drawing from fiscal reserves
 Sale of fixed assets (shares in government-
linked companies, land)
U.S. has the highest public debt (US$25.6 trillion) in
2020.
But, the correct way to look at the health of an
economy is by using the debt-to-GDP ratio.
A low debt-to-GDP ratio indicates an economy that
produces a large number of goods and services
and probably are able to pay back debts.
Economic growth usually begins to suffer when debt-
to-GDP ratio exceeds 90%.
US, Europe, Japan Face Massive Debts!
Malaysia’s debt-to-GDP ratio averaged 47% in the 70s,
exceeded 100% in 1986-87, and progressively reduced to its
lowest level at 31.9% in 1997.
Following the 1997 Asian Crisis, 9/11 incident, dot-com
crash in 2001, the Iraq War and SARS syndrome, the
Malaysian government embarked on expansionary fiscal
policy. Debt-to-GDP ratio rose to average 42.2% between
2002 and 2007.
Following the subprime crisis in the U.S., the Malaysian
government introduced two stimulus packages and this
worsen the debt-to-GDP ratio to 54.8% in 2013.
Malaysia recorded a government debt equivalent to 51.80%
of GDP in 2018.
 Negative aspects of borrowings
 Repayment of the debt increases income inequality.
Working taxpayers will be paying interest to the wealthier
groups who hold the bonds.
 National debt and its interest charges must be paid out of
government revenues. Increase tax burden may
decrease incentives to work, save and invest for taxpayers.
 If a higher proportion of the debt is owed to foreigners,
payments leave the country.
 Some economists believe that public borrowing crowds
out private investment.
 Positive aspects of borrowings
 If borrowing is for public investment that causes
the economy to grow more in the future, the burden
on future generations can be less than if the
government had not borrowed.
 Public investment makes private investment more
attractive. For example, new good highways
help private shipping, etc.
1) Can the
federal
government
go bankrupt?
2) Does debt
impose a
burden on
future
generations?
There are reasons why it is
not easy to go bankrupt.
1. The government can
issue new bonds to
refinance maturing
bonds.
2. The government has the
power to tax, which
businesses and
individuals do not have
when they are in debt.
1. No. Public debt is a public credit. Your
grandparents may own the bonds.
Some day, you may inherit those bonds.
The true burden is borne by those who
pay taxes or lend government money
today.
2. No. Borrowing allows growth to occur
when it is invested in productive capital.
It will enhance future earning power and
could reduce the size of the debt relative
to future GDP.
Discretionary fiscal policy is seriously hampered
by :
1. Problem of timing lag
2. Political business cycle
3. State and local finance budget
4. Crowding out
5. Expectation complications
Problem of Timing Lag
Recognition Lag
It takes time to assess the current state of the economy,
and realise the occurrence of recession or inflation.
Law-making Lag
It takes time for the Parliament to pass the laws needed
to change taxes or spending after the problem has been
recognised.
Impact Lag
It takes time from the implementation of the policy to
impact real GDP.
 Problem of Timing
Lag
Apply
contractionary
policy

May Aug Nov Feb

• Political business cycle. During election years, politicians cut
tax and increase spending to please voters even though this may
fuel inflation.

• State and local finance policies are often pro-cyclical to

balance their budgets. They depend on funds allocated by the
federal government. During recession, they cut spending because
of small allocation, making the recession worse.
During economic boom, they increase spending because
of higher allocation, making inflation worse.

• Crowding out may occur. Government deficit spending

requires big borrowing which will push up domestic interest rate,
reduce private investment, and offset the stimulus of fiscal
policy.
A change in fiscal policy that is triggered
automatically by the state of the economy
(without any explicit policy action by the
government).
The economy can automatically trigger a change
in fiscal policy through welfare payment and
induced taxes.
Example: Welfare payments.
 During recession:
An increase in unemployment triggers an
increase in welfare payments to the unemployed.
People have money to spend (expansionary).
 During boom:
A decrease in unemployment triggers a decrease
in welfare payments to the unemployed. People
have less money to spend (contractionary).
Example: Induced taxes.
 During recession:
Progressive tax automatically decrease and this
increases disposable income (expansionary).

 During boom:
Progressive tax automatically increase and this
reduces disposable income (contractionary).
Automatic fiscal policy help to reduce instability,
but does not eliminate economic instability.
 In a recession, taxes fall, spending rises and
the budget deficit grows.
 In an expansion, taxes rise, spending falls
and the budget deficit shrinks.
Which is an example of an automatic stabilizer?
As real GDP decreases, income tax revenues:
A. Increase and transfer payments decrease
B. Decrease and transfer payments increase
C. Decrease and transfer payments decrease
D. Increase and transfer payments increase
 Some economists oppose the use of fiscal policy,
believing that monetary policy is more effective or that
the economy is sufficiently self-correcting.
 Most economists support the use of fiscal policy to
help “push the economy”, and monetary policy for “fine
tuning.”
 Economists agree that the potential impacts of fiscal
policy on long-term productivity growth should be
evaluated along with the short-run cyclical effects.