Government Spending

Article byPrakhar Gajendrakar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Government Spending?

Government spending refers to the spending from the government side to achieve specific objectives such as developing and providing public goods. It is an example of an expansionary fiscal policy formulated to increase aggregate demand.

Government Spending

It is one of the components of GDP. GDP is obtained by adding consumption, investment, government spending, and exports minus imports. Therefore, a fall in government spending without a corresponding change in other variables like consumption or investment can reduce employment opportunities, income growth, and inflationary pressure. At the same time, the demand, production, and employment will all rise with increased spending.

Key Takeaways

  • Government spending refers to the spending by the government to benefit the common people and promote economic growth.
  • There are different types of classifications for it. Generally, it is divided into government consumption, transfer payment, government investment, and interest payment.
  • Tax collection and borrowing are the two main sources of fund collection for spending.
  • It helps countries overcome recessions and financial crises. But, at the same time, it is also criticized for causing inflation in an economy.
  • It may differ from one country to another depending on the needs, demand, and supply of goods and services. 

Government Spending Explained

Government spending is the expenses that government incurs in providing goods and services essential for society’s growth. Several departments are run and maintained by the government. Apart from it, many facilities and schemes are initiated for the citizens, like free education, night schools, public hospitals, community halls, roads, and dams. Furthermore, it is also called public spending in many countries.

An increase in public spending helps countries fight financial crises and long periods of recession because government induces funds in the market, which can regulate the demand and supply. As a result, it may look like the best option and overall good for the people. However, some economists believe that the spending technique can trigger inflation, which is a major drawback.

Another important concept is the government spending multiplier. The multiplier effect occurs when public spending that stimulates the economy enhances private spending and further boosts the economy. It also points to the fact that the private sector is an important element in a growing economy, contributing to employment and innovations. However, the significant outcome of the multiplier phenomenon does not always happen. Rising public spending can decrease private sector spending; in other words, the crowding-out effect occurs.

The U.S. government spending chart or the federal spending pie chart discloses that the government spends significantly on healthcare, pensions, education, and welfare. In the financial year 2021, The CBO projection suggests that debt may climb to 110 percent of GDP from the measurement of 98% of GDP in 2022, mostly but not entirely due to huge increases in Social Security and Medicare brought on by the inevitable aging of the Baby Boomers. The CBO estimates that by 2032, the national debt will be $40 trillion.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Types

Let us look at different types of government spending:

#1 – Government Consumption

The expenditure made by the government for the direct and immediate consumption of goods and services. Such expenses are to offer the present use of goods and services to handle and satisfy the population, in other words, the population’s collective needs. It is also known as government final consumption expenditure (GFCE) or current expenditures. 

#2 – Government Investment

These are purchases made for future investment for the welfare and growth of the people and the whole country. Such investments are mainly made in infrastructure, government schemes, healthcare programs, and education. Construction of roads, airports, community centers, and research spending are common examples of government investment.

#3 – Transfer Payments

It involves the expenditure consisting of fund flow for events like pension, foreign aid, and unemployment benefits rather than the usage for purchasing goods and services.

#4 – Interest Payments

The expenditure is primarily for the interest payments to the holders of government bonds.

Sources

The two main sources of government funds are –

1. Tax Revenue

The revenue earned through tax collection is one of the primary sources of public spending. Every country has its own set of rules and tax slabs based on the income brackets of its citizens. The citizens, according to their income, pay taxes annually. Furthermore, the government can increase taxes to collect more revenue.

2. Borrowing

When the expenditure crosses the income, the government resorts to borrowing to fix the deficit. In such cases, the government borrows or issues securities like Treasury bills and bonds to collect money. In addition, countries can take financial assistance from institutions like IMF, World Bank, etc.

Example

The main road network in ABC village is poorly constructed and always muddy. Moreover, during the rainy season, the situation worsens, affecting the smooth delivery of farm inputs and decreasing agricultural production and distribution. The farmers, saddened by this, formed a committee, visited the responsible government offices, and demanded that they do something about it.

They wrote applications and followed the legal process. Soon the responsible government entity responded to their request. The government investigators analyzed the need for reconstruction, and within the next three months, the road reconstruction was completed satisfactorily. It is a simple government spending example where the government spends on the roads. 

Frequently Asked Questions (FAQs)

Does government spending cause inflation?

There is mixed opinion about public spending’s role in causing inflation. Some economists believe that it causes inflation. There is a chance that when consumers have more money and spend more and in such situation, sellers may raise prices to manage demand. At the same time, based on specific historical records, some advocate that spending does not cause inflation.

What happens when government spending increases?

When spending increases, it creates a huge demand for goods and services. In other words, it increases consumption and aggregate demand. It can help economies overcome recessions and periods of a financial crisis. An increase in spending replicates the fact that the government is infusing funds into the market.

How does government spending affect the GDP?

It plays an archetypal role in the gross domestic product of any country, irrespective of country size and other factors. An increase in spending contributes to an increase in the GDP. Conversely, low spending means less consumption, less production, and a negative impact on the GDP.

This article is a guide to What is Government Spending & its definition. Here, we explain it in detail, along with its types, sources, and an example. You can also go through our recommended articles on corporate finance –