Cambridge O Level Economics: Government budget, spending and taxation (2281)

This guide covers the Cambridge O Level Economics 2281 syllabus for examination in 2026, statements 4.3.1 to 4.3.6. Topics: what a government budget is, public spending, why tax is raised, how taxes are classified, what makes a tax good and what taxes do to people and firms. There is no tiering. Statements 4.3.7 to 4.3.9 are covered in a different unit. All names and figures here are made up for illustration and are not real statistics.

Practise with the practice questions and recap with the revision notes. Course links: the Cambridge O Level Economics hub, the printable checklist and the free 10-minute diagnostics. For taxes and subsidies used to intervene in markets, read the mixed economic system and government intervention. For elasticity, see price elasticity of demand.

What you must be able to do

Statement	Outcome
4.3.1	State what a government budget is
4.3.2	Name the main areas of public spending, then give reasons for it and its effects
4.3.3	Show why tax is the biggest source of government revenue and why it is levied
4.3.4	Give examples of each class of tax: progressive, regressive, proportional, direct, indirect
4.3.5	Judge a tax against the qualities of a good tax
4.3.6	Trace what a tax does to buyers, firms, the government and the wider economy

4.3.1 What the budget is

A government budget is a plan of how much it expects to spend and how much it expects to raise in revenue over a set period, usually one year. Spending is set out by area. Revenue is set out by source, with taxation the largest.

Three words describe how the two sides compare. A balanced budget has planned revenue equal to planned spending. A deficit means spending is larger. A surplus means revenue is larger. Calculating the size of a deficit or surplus belongs to the fiscal policy unit, so this guide stays with the plan itself.

4.3.2 Government spending

The syllabus asks for the main areas of spending, the reasons for them and their effects. Here is an invented budget for Country Delta, in billions of currency units (illustrative figures).

Area	Spending	Share of total
Social protection	96	24.0%
Health	72	18.0%
Education	64	16.0%
Infrastructure	48	12.0%
Other	44	11.0%
Interest on past borrowing	40	10.0%
Defence	36	9.0%
Total	400	100%

The share is area ÷ total × 100. For health: 72 ÷ 400 × 100 = 18.0%.

Area	Main reasons	Likely effects
Health	Merit good: people may underuse it and it has external benefits. Aims to raise the quality and length of working life	Healthier, more productive workers. Costs rise as populations age
Education	Merit good. Raises skills and earning power	More skilled labour over time. The benefit appears years later
Defence and law and order	Public goods: the private market will not supply them because people cannot be excluded	Security that supports every other activity. Resources are not available for other uses
Infrastructure	Roads, ports and power networks are costly and benefit many users	Lower business costs and easier trade. Large projects need long planning
Social protection	Redistribution of income and support for those unable to work	Less poverty and more spending power for poorer households. A heavy cost if numbers claiming grow
Subsidies	Lower the price of a good with external benefits, or protect a key industry	More output at lower prices. Cost to taxpayers

Every pound or dollar spent has an opportunity cost, because it must be paid for from taxes or borrowing.

Worked example. Country Delta moves 10 from defence to health. Health becomes 82 ÷ 400 × 100 = 20.5% of the budget. Defence becomes 26 ÷ 400 × 100 = 6.5%. The total is unchanged at 400. The change favours health users and gives up some security, so the opportunity cost is the defence output given up.

4.3.3 Why governments tax

Tax is the biggest single source of government revenue. Other sources exist, such as charges for services, profits of state-owned firms and borrowing, but tax is the largest. A tax is a compulsory payment to the government that gives no direct service in return.

Governments levy tax for these reasons:

• Funding: it pays for the areas of spending listed above.
• Fairness: taking more from high earners lets the state support lower earners.
• Demerit goods: a tax on tobacco, say, raises its price so that less is bought.
• Home industry: duties on imports make foreign goods dearer than local ones.
• Behaviour: lower tax for firms that train workers rewards what the government wants.

Here is Country Delta’s revenue (illustrative, billions).

Source	Amount	Type
Income tax	120	Direct
Corporation tax	60	Direct
Sales tax	130	Indirect
Import duties and excise duties	50	Indirect
Other revenue	20	Not tax
Total	380

Direct taxes are 120 + 60 = 180 and indirect taxes are 130 + 50 = 180. Each is 180 ÷ 380 × 100 = 47.4% of revenue. The other 5.3% is not tax. Tax is therefore 360 ÷ 380 × 100 = 94.7% of all revenue, which is what “main source” means here.

4.3.4 Classification of taxes

There are two separate ways to classify a tax. Do not mix them up.

Direct or indirect: who pays and how.

• A direct tax is collected from the person or firm that earns the income or owns the wealth. Examples: income tax, corporation tax, inheritance tax.
• An indirect tax is placed on spending. The seller collects it in the price and passes it on. Examples: sales tax, excise duties, import duties.

Progressive, regressive or proportional: what happens to the tax rate as income rises. Use the average tax rate, which is tax paid ÷ income × 100.

• Progressive: the average rate rises as income rises.
• Regressive: the average rate falls as income rises.
• Proportional: the average rate is unchanged whatever the income.

Worked example: progressive. Country Delta charges 0% on income up to 12,000, 15% on the part between 12,000 and 36,000, and 30% on the part above 36,000.

Income	Working	Tax	Average rate
9,000	below the first threshold	0	0%
24,000	(24,000 − 12,000) × 15%	1,800	7.5%
60,000	(36,000 − 12,000) × 15% + (60,000 − 36,000) × 30% = 3,600 + 7,200	10,800	18%

The average rate climbs from 0% to 7.5% to 18%, so the tax is progressive. Each rate applies only to the slice of income inside its band.

Worked example: regressive. A vehicle licence costs a fixed 300 per year. Owner X earns 6,000 and owner Y earns 30,000. X pays 300 ÷ 6,000 × 100 = 5%. Y pays 300 ÷ 30,000 × 100 = 1%. The rate falls as income rises, so the licence fee is regressive.

Worked example: proportional. A flat 12% on all income takes 720 from 6,000 and 3,600 from 30,000. Both are 12%, so the tax is proportional.

Indirect taxes are often regressive in effect even when the rate is the same for all. Suppose an 8% tax applies to goods. A low-income household spends 90% of its income on taxed goods, so it pays 90% × 8% = 7.2% of income. A high-income household spends 50% on taxed goods and pays 50% × 8% = 4.0% of income. Poorer households give up a larger share of income.

4.3.5 Qualities of a good tax

The syllabus asks for the qualities of a good tax. This is the standard textbook list, which grows out of Adam Smith’s four canons with efficiency or flexibility added.

Quality	Meaning	Test question
Equity (fairness)	The burden matches ability to pay	Does the richer taxpayer pay a fair share?
Certainty	Taxpayers know what, when and how much to pay	Can a taxpayer work out the bill in advance?
Convenience	Easy to pay	Is payment simple and at a suitable time?
Economy	Cheap to collect compared with the revenue raised	Is a small part of revenue spent on collection?
Efficiency or flexibility	Raises the revenue wanted, with little damage to work or output, and can be changed when needs change	Does it avoid large side effects?

No tax scores top on every quality. A flat fee per adult is certain, cheap to collect and easy to pay, but it is not equitable because it is regressive. A steeply progressive income tax is equitable but costs more to administer and may weaken the incentive to earn more. Judge a tax by deciding which qualities matter most for its purpose.

4.3.6 Impact of taxation

Consumers

A direct tax lowers disposable income, so consumers can buy less. An indirect tax raises prices, so they buy less of the taxed good and may switch to untaxed substitutes. If tax falls on a demerit good, lower consumption may improve health.

Producers

An indirect tax raises costs or cuts the price the seller keeps. Sales fall and so may profit and output. Corporation tax cuts profit after tax. If a firm has profit of 200,000 and pays 25% corporation tax, the tax is 50,000 and the firm keeps 150,000. Less retained profit can mean less investment.

Who bears an indirect tax

The tax is split between consumers and producers, depending on how responsive buyers and sellers are to price. In Country Delta’s market for notebooks (illustrative), Qd = 1,000 − 50P and Qs = −200 + 100P.

1. Equilibrium: 1,000 − 50P = −200 + 100P, so 1,200 = 150P, P = 8 and Q = 600.
2. Impose a tax of 3 per unit. Sellers now receive P − 3, so Qs = −200 + 100(P − 3) = −500 + 100P.
3. New equilibrium: 1,000 − 50P = −500 + 100P, so 1,500 = 150P, P = 10 and Q = 1,000 − 500 = 500.
4. Consumers pay 10 instead of 8, a rise of 2. Sellers receive 10 − 3 = 7, a fall of 1.
5. Government revenue is 3 × 500 = 1,500. Consumers bear 2 × 500 = 1,000 of it and producers bear 1 × 500 = 500.

Consumers bear two thirds because their demand responds less to price than supply does. At the first equilibrium, price elasticity of demand is −50 × 8 ÷ 600 = −0.67, which is inelastic. Whichever side reacts less to a price change carries more of the burden.

The government

Tax raises revenue, but how much depends on elasticity. Take a good that sells 1,000 units at 10, where a tax of 2 lifts the price by 20%.

• If demand is inelastic with PED = −0.4, quantity falls by 0.4 × 20% = 8% to 920. Revenue is 2 × 920 = 1,840.
• If demand is elastic with PED = −1.5, quantity falls by 1.5 × 20% = 30% to 700. Revenue is 2 × 700 = 1,400.

This simple figure assumes the whole tax is passed on in the price. It shows why governments raise most indirect tax revenue from goods with inelastic demand, and why a tax on a demerit good raises revenue and cuts consumption together only if demand is not too inelastic.

The economy as a whole

• Redistribution: progressive taxes narrow the gap between rich and poor.
• Work incentives: very high tax rates may reduce the reward for extra work or effort.
• Prices: indirect taxes can raise the general price level.
• Black market: very high taxes may encourage tax evasion and an unrecorded economy.

Explain these effects through incomes, prices, costs, jobs and output.

Common errors

• Treating a tax as progressive just because richer people pay more money. Compare average rates.
• Charging the highest rate on all income rather than only on the top slice.
• Writing “indirect taxes are paid by firms”. Firms collect them, but the burden can pass to consumers.
• Saying a tax is regressive because it is unfair. Regressive is a mathematical description, not an opinion.

Official syllabus

Aligned to the Cambridge O Level Economics 2281 syllabus for examination in 2026, published by Cambridge University Press and Assessment (Cambridge International), subject content statements 4.3.1 to 4.3.6.