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Question 4: Government expenditure has tended to grow rapidly in most advanced
industrialised economies. Explain why some ...
The Theory: Economics of Government Spending

       Diagram 1 suggests that there is an optimal & modest level of governm...
2. Displacement of scarce resources
     Government spending displaces private-sector activity. Every dollar that the
undermines the critical role of competitive markets, causing significant inefficiency in
   health care and education sect...
4. Privatisation of major projects to private sector that could performed better
   Malaysia is very successful in impleme...
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Govt expenditure


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Govt expenditure

  1. 1. Question 4: Government expenditure has tended to grow rapidly in most advanced industrialised economies. Explain why some believe that is important to restrict the growth in public expenditure. Suggest how public expenditure might be controlled. Introduction Government spending or government expenditure is classified by economists into three main types. Government purchases of goods and services for current use are classed as government consumption. Government purchases of goods and services intended to create future benefits, such as infrastructure investment or research spending, are classed as government investment. Government expenditures that are not purchases of goods and services, and instead just represent transfers of money, such as social security payments, are called transfer payments. Government spending can be financed by seignior age, taxes, or government borrowing. Policymakers are divided as to whether government expansion helps or hinders economic growth. Some claim that government programs provide valuable goods such as education and infrastructure. These government spending would help in bolster economic growth by putting money into people’s pockets. Another group provides different point of view. They explain that government is too big with higher spending undermines economic growth by transferring additional resources from the productive sector of the economy to government that apparently uses the resources less efficiently. Industrialized economics tend to have high government spending as one of the major portion contributing to the nation’s GDP. Table 1 reveals a number of features about the government sectors of the industrialized market economies. All these countries have sizable government sectors, particularly for many European governments that have extremely large public welfare. 2007 GDP Govt GS of Countries (USD bil) Spending (bil) nation's GDP Sweden 453.84 244.17 53.8% France 2,593.78 1,377.30 53.1% Denmark 310.50 157.42 50.7% Italy 2,117.52 1,024.88 48.4% Belgium 459.03 221.71 48.3% Spain 1,439.98 681.11 47.3% United Kingdom 2,803.40 1,250.32 44.6% Germany 3,320.91 1,471.16 44.3% USA 13,807.55 5,164.02 37.4% South Korea 1,049.32 332.63 31.7% Japan 4,384.38 1,354.77 30.9% Table 1: General Government Spending (% of GDP) in year 2007 1
  2. 2. The Theory: Economics of Government Spending Diagram 1 suggests that there is an optimal & modest level of government spending which maximises the rate of economic growth. There will be very little economic growth if government spending is zero. Government spending is essential and plays an active role in enforcing contracts, protecting property and developing infrastructure and facilities for the people. In other words, some government spending is necessary to bolster the economic growth. Economic activity is very low or nonexistent in the absence of government, but it jumps dramatically as core functions of government are financed. Downward sloping curve in Diagram 1 shows that economy shrinks when government grows too large that would cause higher spending. Economists will generally agree that government spending become a burden at some point, either because government becomes too large or because outlays are misallocated. From The Rahn curve, we found that the more government spending as percentage of GDP will bring negative impact to the economic growth rate. In such cases, the cost of government exceeds the benefit. Diagram 1: The Rahn Curve: Impact of government spending on Nation’s GDP Some negative impacts of large government spending as follows: 1. Extraction Cost Government spending requires costly financing resources. All options used by the government to increase revenue before spending have negative consequences. Higher taxes rate on personal income, saving and investment has discouraged productive behaviour. Extracting consumes capital that otherwise would be available for private investment may lead to higher interest rates and eventually will increase the inflation rate. 2
  3. 3. 2. Displacement of scarce resources Government spending displaces private-sector activity. Every dollar that the government spends necessarily means one less dollar in the productive sector of economy. Capital and financial resources that supposing been used for private investment activity has been diverted into other sectors as the politicians and bureaucrats decide on the usage of fund and financial resources. In short, government do not use resources efficiently, resulting in less economic output. 3. Inefficiency in public services Government spending is a less effective way to deliver services. Government directly provides many public services and activities such as education, airports, utilities and postal services. Private sector could provide these important services at a higher quality and lower cost. In some cases, privatisation of airport and postal services has improved the quality of services while enhancing efficiency of works. 4. Encouragement of wrong behaviour and mindset Government spending encourages destructive choices. Many government programs subsidise economically undesirable decisions. Public welfare programs encourage people to choose leisure over works. Unemployment insurance programs in most of the industrialised countries provide an incentive to remain unemployed. All these programs have reduced the economic growth and diminish national output because of misallocation or underutilisation of resources. 5. Discourage productive alternatives Government spending discourages productive choices and desirable decisions. Saving is important to help to promote capital for new investment, yet the incentive to save money has been undermined by government programs that subsidise retirement, housing and education. Good public welfare encourages people to depress their incomes artificially and misallocate their wealth as they know they will be taken care well. 6. Distort resource allocation Government spending distorts resource allocation. Buyers and sellers in competitive markets determine prices in a process that ensures most efficient allocation of resources, but some government programs interfere with competitive markets. In both health care and education, government reduces out-of-pocket expenses have created “third-party payer” problem. Individuals become less concerned about the cost and price of the public services that subsidised by the government. This 3
  4. 4. undermines the critical role of competitive markets, causing significant inefficiency in health care and education sectors. Government programs also lead to misallocation of resources where individuals spend time, energy and money seeking either to take advantage of the government subsidies or avoid sharing the cost of government. 7. Inhibit innovation & creativity Because of competition and the desire to increase income, individuals and entities in the private sector constantly search for new alternatives and opportunities. Greater economic growth is enhanced by the discovery process of “creative destruction.” Government programs are inherently inflexible because of centralisation and bureaucracy. As the result of inflexibility, the economy will become stagnant due to lack of innovation and creative solutions. Below are some alternatives to control government expenditure: 1. Reduce the size and scope of government Downsizing exercise could be implemented to reduce the size and scope of government. Restructuring of abundant government agencies and reduce the number of exceed manpower in some government agencies could help to reduce unnecessary expenditure. A smaller government will lead to better economic performance and it also is the only pro-growth way to deal with the politically sensitive way of budget deficits. 2. Re-inventing the public sector The government should think of ways to restructure and re-invent the public sector in order to improve efficiency and quality of works. Delivery systems of public services need to be enhanced and improved. This would help to encourage a more efficient use of resources within public sector while upgrading the quality of public services to general public. 3. Devolve federal programs to state and local governments In general cases, the federal government do not know what policies are best for every state and locality. One-size-fits-all federal mandates rarely succeed as well as the flexible programs designed by state and local officials who are closer to the people affected. The federal government can promote accountability, flexibility, and local control by eliminating many of the mandates on how state and local governments address their own issues, and by letting them raise their own revenues and create their own programs. 4
  5. 5. 4. Privatisation of major projects to private sector that could performed better Malaysia is very successful in implementing “Privatisation” concept to devolve the major infrastructure developments to private sector, such as highways, utilities services and education. Private Funding Initiatives (PFI) Public-Private Partnerships (PPPs) are ways to encourage more economy activities in private sector while reducing the burden of government in developing the country. Privatisation can lead to increased efficiency, more consumer choice, better use of scarce resources and lower prices. 5. Building a knowledge-based system One of the best ways to improve efficiency of public sector is to build and setup a knowledge-based system. Investment in human capital, human resource training, upgrade of technology and equipment are necessary to transform the labour- intensive to knowledge-intensive public sector. 6. Terminate unnecessary welfare programs and reform wasteful programs Reduction of outdated and duplicative programs could help the government to save cost for giving subsiding unnecessary welfare programs. Eventually it could use the savings to reduce income taxes across the board. This would help to increase household income and encourage more spending in the private sector. 7. Remove procedural barriers and simplify regulatory policy Bureaucracy and red tape have a considerable effect on a country’s economy Deregulated markets encourage the efficient allocation of scarce resources since decisions are based on economic factors. Excessive regulation can result in unnecessary high costs and inefficient behaviour. By removal of procedural barriers, it will save the taxpayer money, increase the efficiency of works and eventually attracts foreign direct investment (FDI) into the country. 8. Low tax policy The tax system has a pronounced impact on economic performance. Lower tax rates will reduce barriers to working, saving, and investing, and therefore promote long- term economic growth. For instance, Hong Kong has a low-rate flat tax that generally does not penalise saving and investment, it raises revenue in a much less destructive manner. 5