Edexcel International Advanced Level Economics: Public expenditure and taxation (YEC11) – Revision Notes

Use these notes after the study guide, which has the full explanations and worked examples. They cover the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics specification (Issue 2, June 2018), section 4.3.5 items 1 and 2. In the specification, Units 1 and 2 are the International AS content and Units 3 and 4 are the extra International A2 content; Unit 4 is labelled an IAL compulsory unit, so this topic is for the full International A Level only.

Next: the practice questions, the course hub, the checklist and the free diagnostics. All numbers are invented for illustration.

Key definitions

Term	Meaning
Current expenditure	Spending on running public services now (wages, supplies)
Capital expenditure	Spending on lasting assets (roads, schools, hospitals)
Transfer payments	Money moved from taxpayers to recipients, with no output bought in return
Direct tax	Charged on income, profit or wealth; paid by the person or firm taxed
Indirect tax	Charged on spending; legal payer is the seller, burden is shared
Average tax rate	Tax / income
Marginal tax rate	Tax on the next unit of income
Crowding out	Fall in private spending caused by public spending or borrowing
Laffer curve	Relationship showing tax revenue first rising, then falling, as the rate rises

1: Public expenditure

1a: Types

• Transfers are not part of G in aggregate demand, because they buy no output. They still raise consumption.
• Capital spending adds to the capital stock and can raise potential output. Current spending mostly does not.

Reminder. Public expenditure is 36bn and GDP is 120bn. Expenditure/GDP = 36 / 120 = 30.0%. If 28% of the 36bn is transfers, G in the GDP identity is 72% of 36 = 25.9bn.

1b: Reasons for change

Reason	Chain
Changing incomes	Higher incomes, more demand for merit goods (health, education), share of GDP rises if spending grows faster than income; fewer qualify for means-tested benefits
Changing age distribution	More older people, more pensions and health; more children, more schooling
Changing expectations	Voters expect better services and compare with other countries; governments respond; expectations can also fall

Reminder. A country of 3m people has 20% aged 65 or over, which is 0.6m people. At 8,000 each, pension cost is 4.8bn.

International comparisons: differences in expenditure/GDP come from income, age structure, history and what each society expects the state to do. Say which of these applies to the countries in the data.

1c: Significance of expenditure/GDP

Effect	Key points
Productivity and growth	Depends on composition: capital and training spending can shift long-run aggregate supply right; transfers and waste may not; high taxes can blunt incentives
Crowding out	Financial: borrowing raises interest rates, private investment falls. Resource: competition for labour and materials near full capacity. Weaker with spare capacity; “crowding in” if public spending lifts private returns
Levels of taxation	Higher spending/GDP needs higher taxes or borrowing

Method for crowding out. Net injection = spending − fall in private investment. Output change = net injection × multiplier. Offset = fall in investment / spending.

Reminder. The state spends an extra 40bn, the multiplier is 1.5 and private investment falls by 10bn. With no crowding out, output rises by 40 × 1.5 = 60bn. With it, the net injection is 30bn and output rises by 30 × 1.5 = 45bn. Offset = 10 / 40 = 25.0%.

2: Taxation

2a: Direct versus indirect

Direct	Indirect
Income tax, corporation tax, capital gains tax, inheritance tax	Value added or sales tax, excise duties, import duties

Incidence of an indirect tax depends on elasticity: the more inelastic demand, the more falls on buyers.

2b: Progressive, proportional, regressive

Type	Average rate as income rises	Example
Progressive	Rises	Income tax with a tax-free allowance and higher bands
Proportional	Constant	A flat rate on all profit
Regressive	Falls	A fixed licence fee; sales tax measured against income

Reminder. Allowance 10,000, then 25% above it. On 20,000: tax 2,500, average rate 12.5%. On 50,000: tax 10,000, average rate 20.0%. The marginal rate is 25% in both cases, but the average rate rises, so the tax is progressive.

2c: Effects of tax changes

Method in steps for any tax-change question:

1. State the direction of the change and the group affected.
2. Give the first effect (disposable income, costs or post-tax profit).
3. Link to a macro variable (AD, AS, prices, imports, FDI).
4. Qualify: size, elasticity, spare capacity, time.
5. Make a judgement.

Variable	Income tax rate falls	Indirect tax rate rises
Incentives to work	Substitution effect: work more; income effect: may work less	Little direct effect on hours; real pay falls as prices rise
Tax revenue	Depends on position on Laffer curve	Depends on elasticity and avoidance
Income distribution	Often favours higher earners if the tax was progressive	Often regressive
Real output and employment	AD up via the multiplier if spare capacity; may lift supply	AD down; costs up
Price level	Demand-pull if capacity is short	Cost-push: SRAS shifts left
Trade balance	Imports rise with income; exports may gain from lower costs	Export prices may rise; imports may fall
FDI	Little direct effect unless corporation tax also falls; skilled staff keep more pay	Little direct effect

Work incentive reminder. A gross wage of 9 an hour faces a marginal rate that rises from 25% to 35%. The net wage falls from 6.75 to 5.85, a fall of 13.3%. Leisure has become cheaper (substitution effect, work less), but a worker with a target income must work more (income effect). The net result is uncertain.

Laffer reminder. Revenue = rate × base. At 30% with a base of 400, revenue is 120. At 45% with a base of 240, revenue is 108. The higher rate reduced revenue, so the economy was past the peak on that evidence. Without the base figures, you cannot say.

Price reminder. A sales tax rises from 12% to 18%. A good priced 100 before tax goes from 112 to 118, a rise of 5.4%.

FDI reminder. Profit of 40 on capital of 200. At 25% tax, post-tax profit 30, return 15.0%. At 15% tax, post-tax profit 34, return 17.0%.

Evaluation toolkit

Use these to finish any tax or spending answer:

• Size and speed: a small change may do little; effects arrive with lags.
• Spare capacity: with slack, demand changes move output; near full capacity, they move prices.
• Elasticity: of labour supply, of demand for the taxed good, of exports.
• Use of funds: spending on infrastructure and training can raise supply; spending on transfers mainly supports demand.
• Funding: higher spending needs higher taxes or borrowing; borrowing may crowd out.
• Context: compare countries by income, age structure and expectations.

Must-know distinctions

• Total public expenditure versus G in aggregate demand: transfers are the difference.
• Average rate versus marginal rate.
• Progressive tax versus a high tax. A tax can be high and proportional.
• Fall in tax rate versus fall in tax revenue.
• Direct tax cut (raises AD) versus indirect tax cut (lowers costs and prices).
• Financial crowding out versus resource crowding out.

Quick self-test

1. Classify unemployment benefit as current, capital or transfer.
2. Total public expenditure is 90bn and GDP is 360bn. Find expenditure/GDP.
3. Name two direct taxes and two indirect taxes.
4. A tax takes 600 from an income of 10,000 and 4,000 from an income of 40,000. Classify it.
5. Why do transfers not count in G?
6. Revenue is 150 at a rate of 25%. What is the base?
7. A sales tax moves from 8% to 10%. Find the percentage rise in the price of a good priced 200 before tax.
8. State the income effect of a higher income tax rate on hours worked.
9. Government spends 20bn extra, private investment falls by 5bn, multiplier 1.6. Find the rise in output.
10. Give one reason a lower corporation tax rate may raise FDI.
11. Give one reason why a country’s spending on pensions rises over time.

Answers

1. Transfer payment.
2. 90 / 360 = 25.0%.
3. Direct: income tax, corporation tax. Indirect: sales tax, excise duty.
4. Average rates: 600 / 10,000 = 6.0%, 4,000 / 40,000 = 10.0%. The rate rises, so progressive.
5. They buy no output; they move income between households.
6. 150 / 0.25 = 600.
7. Price goes from 216 to 220. Rise = 4 / 216 = 1.85%.
8. Take-home pay falls, so people may work more to keep their living standard.
9. Net injection = 20 − 5 = 15bn. Output rises by 15 × 1.6 = 24bn.
10. The post-tax return on the investment is higher.
11. Ageing population: more people qualify.

Where marks are usually lost

• Counting transfers in G, or leaving them out of total public expenditure.
• Saying a tax is progressive because the marginal rate is high, with no average rates.
• Treating the Laffer curve as proof that a country should cut taxes.
• Forgetting the income effect when explaining work incentives.
• Stating crowding out without a chain through interest rates or resources.
• Calling every tax cut inflationary, with no mention of spare capacity.
• Ignoring elasticity when analysing indirect tax incidence or export effects.
• Listing effects with no judgement at the end.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2, June 2018, Pearson Education Limited, section 4.3.5 items 1 and 2.