Government Spending (Cambridge (CIE) A Level Economics): Revision Note

Types of government spending

• Government spending is the total expenditure by the public sector on goods, services and transfer payments

  • It is one of the four components of aggregate demand: AD = C + I + G + (X-M)

• Government spending is classified into two broad types: capital spending and current spending

1. Capital spending (investment spending)

• Capital spending is expenditure on long-lived assets that increase the productive capacity of the economy

  • It adds to the stock of physical capital available to the public sector

  • It generates benefits over many years beyond the period in which the spending occurs

• Examples include:

  • Building new roads, railways, bridges and ports

  • Construction of hospitals, schools and universities

  • Investment in renewable energy infrastructure

  • Digital infrastructure such as broadband networks

2. Current spending

• Current spending is day-to-day expenditure on the ongoing provision of public services

  • It does not create long-lived assets

  • It must be repeated each year to maintain the existing level of public services

• Examples include:

  • Wages and salaries of public sector workers such as teachers, nurses and police officers

  • Purchasing medicines, equipment and consumables for hospitals

  • Running costs of government departments and administration

  • Transfer payments - payments made by the government to individuals without any good or service being produced in return, such as unemployment benefit, state pensions and child benefit

The distinction between capital and current spending

• Cutting current spending reduces the quality of existing services immediately, while cutting capital spending damages the economy's future productive capacity - both have costs but over different time horizons

• Transfer payments are included in current spending but are not counted in GDP - they are a redistribution of income rather than payment for output produced

Reasons for government spending

• Taxation and government spending are the two instruments of fiscal policy and often work together to achieve the same objectives

  • The reasons for each can appear similar

To provide public goods

• Markets fail to provide public goods because they are non-excludable and non-rivalrous - the free rider problem means private firms cannot charge for them profitably

  • Government must provide them directly, funded through taxation

  • Examples include national defence, street lighting and flood defences

To correct market failure

• Government spending can correct under-provision of merit goods such as healthcare and education, where the free market produces less than the socially optimal quantity due to imperfect information

  • Subsidies to producers or direct provision shifts supply rightward, increasing consumption towards the socially optimal level

To redistribute income and wealth

• Transfer payments such as unemployment benefit, state pensions and housing benefit redistribute income from higher-income taxpayers to lower-income households

  • This reduces income inequality and supports a minimum standard of living for the most vulnerable

To achieve macroeconomic objectives

• Expansionary fiscal policy - increasing G shifts AD rightward, raising real output, reducing unemployment and stimulating economic growth

• Government investment in infrastructure and human capital (education and training) shifts LRAS rightward over time, increasing potential output

• During a recession, automatic stabilisers such as unemployment benefit increase government spending automatically, cushioning the fall in AD without requiring a policy decision

To support strategic industries

• Governments may subsidise industries considered strategically important - such as defence manufacturing, technology or agriculture - where reliance on foreign supply would create national security or food security risks

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