Tax and spending GapFill

Taxation and government expenditure represent the overwhelming source of revenue and costs respectively for the government. It is important to know the key economic reasons for different levels of taxation and expenditure.

In terms of government expenditure, we can identify five key reasons for variation. Firstly,  debt interestpublic expectationdemographicsincome level influences the level of spending, such as increased spending on healthcare for an ageing population. Secondly,  debt interestpublic expectationsdemographicsincome levels will determine the level of demand for public services, and by extension the extent of resources required for their functioning. Thirdly,  income levelspublic expectationsdemographicsdebt interest as a result of rising standards of living or technological advances may increase the level of spending required on public services. Finally,  debt interestpublic expectationincome leveldemographics has begun to take up a larger proportion of government spending in recent years, and in particular after the 2007−08 financial crisis.

In terms of taxation, we can identify five key reasons for variation. Firstly,  wealth/income redistributionbalance of tradeeconomic performanceforeign direct investment will influence levels of taxation. Because taxation leads to a decline in aggregate demand, tax relief may be necessary when the economy is suffering from low output or high unemployment. Similarly, tax increases on duties or VAT will contribute to inflationary pressure by increasing prices. Secondly,  economic performancewealth/income redistributionforeign direct investmentbalance of trade may be a primary cause of variation in taxation, depending on the levels of poverty and/or inequality in society. Thirdly, low levels of  balance of tradeforeign direct investmenteconomic performancewealth/income redistribution may lead to reductions in corporation tax to attract greater investment. Fourthly, the level of income tax will affect the  work disincentivisationbalance of tradepublic expectationsforeign direct investment as tax increases will reduce aggregate demand and thus demand for imports.

According to the Laffer curve model, tax revenues increase as taxes rise only up to a certain point, after which tax revenues begin to fall again. According to this model, when taxes are too high, factors such as  foreign direct investmenteconomic performancework disincentivisationwealth/income redistribution and tax evasion result in a reduction in tax revenues. The Laffer curve is often criticised for being overly simplistic, however, and not taking into account crucial factors such as growth, incomes and different systems of taxation.