Government expenditure is a crucial component of aggregate demand, influencing economic activity, stabilisation policies, and long-term growth through strategic fiscal interventions.
What is government spending?
Government spending refers to the total amount of money that the public sector uses to fund goods and services in the economy. It plays a central role in macroeconomic management and the provision of public services. Spending decisions are often shaped by the government’s political priorities, economic objectives, and the broader economic climate.
Government spending can influence economic growth, inflation, employment levels, and income distribution. It also determines how resources are allocated between different sectors, such as healthcare, education, defence, and infrastructure.
Capital and current government spending
Government spending is categorised into two main types: capital spending and current spending.
Capital spending:
This includes expenditure on physical assets that have long-term benefits for the economy.
Examples include the construction of new hospitals, roads, railway lines, and public housing.
Capital spending enhances the productive capacity of the economy, supporting long-term growth and efficiency.
Often seen as an investment in future prosperity.
Current spending:
This includes day-to-day operational expenditure required to keep public services running.
Covers wages and salaries for public sector workers such as teachers, nurses, and civil servants.
Also includes spending on consumables like medicines in the NHS or school supplies.
Unlike capital spending, current spending does not add to the capital stock but ensures ongoing delivery of services.
In summary, capital spending is growth-oriented and long-term, while current spending is necessary for the maintenance and delivery of essential services. The balance between the two depends on policy priorities, fiscal space, and the stage of the economic cycle.
What influences government expenditure?
Government spending is shaped by a variety of economic, political, and institutional factors. The main macroeconomic influence comes from the trade cycle, while decisions on fiscal policy also play a key role.
The trade cycle and spending decisions
The trade cycle, also known as the business cycle, refers to the fluctuations in economic activity over time. These cycles influence the level and composition of government expenditure.
Spending during a recession
When an economy experiences a recession, economic growth slows or becomes negative, unemployment rises, and consumer demand falls. In such situations, governments typically increase spending to support demand and reduce the impact of the downturn.
There are two ways this can occur:
Automatic stabilisers:
These are built-in features of the fiscal system that automatically increase spending or reduce tax revenues during a downturn.
For example, unemployment benefits rise when more people lose their jobs.
They help smooth out fluctuations in the economy without the need for new legislation.
Discretionary fiscal stimulus:
This involves deliberate decisions by the government to increase spending or cut taxes.
Examples include new infrastructure projects or temporary tax reliefs to boost consumption.
The aim is to inject demand into the economy and shorten the recession.
Spending during a boom
When the economy is in a boom phase, demand is high, employment levels are strong, and inflation may become a concern. In such conditions, governments might reduce or slow the growth of spending to prevent the economy from overheating.
Automatic stabilisers work in reverse: tax revenues increase and welfare spending falls as incomes and employment rise.
Governments may also run a budget surplus, using the extra revenue to pay off debt or save for future downturns.
Example
During the 2008 Global Financial Crisis, the UK government introduced a fiscal stimulus package which included increased capital spending and expanded welfare payments. These actions, both automatic and discretionary, aimed to mitigate the effects of falling private sector demand.
Fiscal policy and government spending
Fiscal policy refers to the use of government spending and taxation to influence the level of economic activity. Governments can use fiscal policy to manage demand, control inflation, stabilise the economy, and achieve long-term growth goals.
There are two main types of fiscal policy:
Expansionary fiscal policy
This involves increasing government spending or reducing taxes.
The objective is to boost aggregate demand and stimulate economic activity.
Particularly useful during recessions or periods of weak growth.
Spending increases may be directed towards infrastructure, healthcare, education, or job creation programmes.
Expansionary policy often works through the multiplier effect. This is the process by which an initial increase in spending leads to a greater final increase in national income. For example, government spending on road construction generates income for workers, who then spend their earnings, creating further rounds of demand.
If the marginal propensity to consume (MPC) is 0.8, then the fiscal multiplier is calculated as:
Multiplier = 1 / (1 - MPC)
Multiplier = 1 / (1 - 0.8) = 5
This means every £1 spent by the government could generate up to £5 in total income.
Contractionary fiscal policy
This involves reducing government spending or increasing taxes.
Used when inflation is high or when the government wants to reduce budget deficits.
Aims to cool down demand, slow the economy, and restore fiscal sustainability.
However, contractionary policies can have negative side effects, such as reduced public services, slower growth, and higher unemployment, particularly if implemented too aggressively or during weak economic conditions.
Implementation lags
One key challenge in using fiscal policy is the time lag between identifying a problem, designing a response, and seeing the results. Fiscal measures often require parliamentary approval, procurement, and implementation stages, which can delay their impact.
Discretionary vs non-discretionary spending
Understanding the distinction between discretionary and non-discretionary (automatic) spending is crucial for assessing the government’s ability to respond to economic conditions.
Discretionary government spending
Discretionary spending refers to deliberate decisions made by the government about how much to spend and where. This is typically reviewed annually in the budget process.
Examples:
Launching new infrastructure programmes.
Increasing NHS funding as a policy choice.
Expanding defence spending or education budgets.
Discretionary spending is flexible and reflects current political and economic priorities. However, it is also subject to political negotiations, public scrutiny, and potential delays.
Advantages:
Can be tailored to specific economic needs or social objectives.
Enables government to respond dynamically to new challenges.
Disadvantages:
Vulnerable to political cycles and short-termism.
Can be delayed by administrative or legislative processes.
Non-discretionary government spending
Non-discretionary spending occurs automatically, often as a result of existing laws or entitlements. It is sometimes referred to as mandatory spending.
Examples:
State pensions (based on eligibility).
Jobseeker’s Allowance and other welfare payments.
Interest payments on national debt.
These spending items are less flexible but act as automatic stabilisers, helping the economy adjust without the need for new policies.
Advantages:
Provides stability and certainty for recipients.
Automatically supports demand during downturns.
Disadvantages:
Limits the flexibility of government budgets.
Can grow rapidly due to demographic changes or rising debt.
Real-world fiscal policy examples
To better understand how theory applies in practice, here are key examples of fiscal policy responses from recent history.
UK Government – COVID-19 pandemic (2020–2021)
In response to the unprecedented economic disruption caused by the COVID-19 pandemic, the UK implemented an expansionary fiscal policy on a large scale.
Key measures:
Furlough scheme: Government paid up to 80% of workers’ wages to prevent mass unemployment.
One-off grants to businesses forced to close.
Increased NHS spending for testing, treatment, and vaccine distribution.
Expansion of Universal Credit and housing support.
These were examples of discretionary policies, though they also triggered non-discretionary spending via increased benefit claims.
UK Austerity Period (2010–2015)
Following the 2008 financial crisis and rising public debt, the UK government under Chancellor George Osborne pursued a programme of fiscal consolidation, often termed austerity.
Key features:
Cuts to public sector budgets.
Reduction in welfare spending.
Public sector pay freezes.
Limited capital investment.
This was a contractionary fiscal policy designed to reduce the budget deficit. While it helped control borrowing, critics argue that it slowed the recovery and increased inequality.
US Infrastructure Investment and Jobs Act (2021)
Though from outside the UK, this American example illustrates large-scale capital spending through discretionary fiscal policy.
Over $1 trillion invested in transport, broadband, and clean energy infrastructure.
Aimed to create jobs, modernise ageing systems, and stimulate post-pandemic recovery.
Shows how fiscal policy can support long-term supply-side improvements.
Eurozone fiscal responses
In the aftermath of the Eurozone debt crisis, countries like Greece, Spain, and Italy were forced to adopt strict fiscal rules.
Spending cuts and tax hikes were imposed to meet EU deficit and debt criteria.
These measures led to deep recessions and social unrest in some countries.
Highlights the constraints on fiscal policy under a monetary union without a shared fiscal authority.
These examples demonstrate how government spending decisions reflect economic theory, political values, institutional rules, and external shocks.
FAQ
Economists who favour government spending over tax cuts during recessions argue that direct spending injects demand into the economy more immediately and predictably. When the government builds infrastructure or hires workers, the money directly enters the circular flow of income, stimulating demand for goods, services, and labour. In contrast, tax cuts rely on households or firms choosing to spend the additional disposable income, which may not happen during periods of economic uncertainty. For instance, in a recession, people might save tax cuts or use them to pay off debts, limiting the fiscal multiplier effect. Government spending also allows targeted intervention—funding sectors with the highest potential impact on jobs and demand. Moreover, spending can address supply-side weaknesses, such as outdated transport networks or underfunded schools, supporting long-term growth alongside short-term stimulus. While both tools can be useful, many economists believe that well-planned government expenditure delivers more reliable and larger boosts to economic activity in downturns.
A government's political ideology significantly shapes its spending priorities, size of public sector involvement, and views on redistribution. Left-leaning governments, typically aligned with social democratic or socialist principles, are more likely to favour higher levels of public spending, especially on welfare, healthcare, education, and infrastructure. They tend to see government intervention as a means of promoting equality, reducing poverty, and correcting market failures. In contrast, right-leaning or conservative governments often advocate for limited government intervention, prioritising balanced budgets, low taxation, and private sector-led growth. They may view high public spending as inefficient, distortionary, or inflationary. This ideological divide can lead to stark differences in budget composition, responses to economic shocks, and fiscal policy objectives. For example, a left-leaning government might respond to a recession with large-scale stimulus packages, while a right-leaning one might emphasise tax incentives for businesses. Ultimately, ideology influences both the scale and focus of government expenditure.
Government spending can become inefficient due to poor planning, misallocation of resources, bureaucratic inefficiencies, corruption, or lack of accountability. Inefficiency arises when spending does not lead to intended outcomes or when the cost of achieving those outcomes is unnecessarily high. For example, infrastructure projects may run over budget or fail to deliver promised productivity gains. Similarly, excessive administrative costs can reduce the amount of funding reaching frontline services. Inefficient spending can result in low fiscal multipliers, meaning the boost to aggregate demand is minimal relative to the money spent. Over time, inefficiency can undermine public trust in the government and lead to higher public debt without corresponding improvements in growth or welfare. It may also crowd out private sector investment if interest rates rise due to large deficits. To prevent this, governments must apply rigorous cost-benefit analyses, ensure transparency, and use performance-based budgeting to enhance the effectiveness of public expenditure.
Demographic trends, especially ageing populations and changes in birth rates, have a profound impact on government expenditure. As populations age, there is increased pressure on pensions, healthcare, and social care services. In countries like the UK, where the state pension system is pay-as-you-go, a rising proportion of retirees relative to the working population increases the fiscal burden. Healthcare spending also rises with age, as older individuals require more frequent and expensive treatments. At the same time, declining birth rates reduce school-age population numbers, potentially decreasing education spending but also shrinking the future workforce. This demographic shift can lead to structural deficits, where government revenues fall short of rising obligations. To address this, governments may need to reform pension systems, raise retirement ages, encourage immigration, or shift spending priorities. Long-term planning is essential to maintain the sustainability of public finances while continuing to meet the needs of changing population structures.
International borrowing allows governments to finance spending beyond their domestic revenue capacity, particularly during crises or major investment programmes. By issuing bonds purchased by foreign investors or securing loans from institutions like the International Monetary Fund (IMF), governments can access capital to fund infrastructure, social programmes, or economic stimulus measures. However, reliance on international borrowing carries significant risks. It exposes the country to exchange rate volatility—if debt is denominated in foreign currency, a depreciation can increase repayment costs. Large external debts may also reduce investor confidence, pushing up interest rates and making future borrowing more expensive. Additionally, excessive borrowing can lead to a loss of fiscal sovereignty if lenders impose conditions on spending or structural reforms. For example, during the Eurozone debt crisis, countries like Greece faced austerity measures as conditions for international assistance. Therefore, while international borrowing can support government expenditure, it must be managed prudently to avoid long-term financial instability.
Practice Questions
Explain how discretionary and non-discretionary government spending respond differently to changes in the trade cycle.
Discretionary government spending involves deliberate fiscal policy decisions, such as increased infrastructure investment or tax changes. During a recession, governments may raise discretionary spending to stimulate aggregate demand. In contrast, non-discretionary spending adjusts automatically to economic changes. For example, in a downturn, welfare benefits like unemployment payments rise without new policy action, acting as automatic stabilisers. While discretionary spending requires active government intervention and often takes time to implement, non-discretionary spending provides immediate support. Both forms help smooth fluctuations in the trade cycle, but only discretionary spending reflects current political decisions and budgetary priorities.
Assess the possible impact of increased government capital spending on long-term economic growth
Increased government capital spending, such as investment in transport, healthcare, or education infrastructure, can enhance the economy’s productive capacity, supporting long-term growth. Improved infrastructure reduces costs for firms and increases efficiency, attracting investment and boosting productivity. Additionally, better education and health outcomes raise human capital, leading to a more skilled workforce. However, the effectiveness depends on the quality of the investment and efficient allocation of resources. Poorly targeted spending may lead to waste or crowding out of private sector investment. In the long term, sustained and strategic capital spending is likely to promote higher potential output and living standards.
