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

This guide is aligned to the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics specification (Issue 2, June 2018, first teaching September 2018). It covers section 4.3.5, items 1 and 2: public expenditure and taxation. In the specification, Units 1 and 2 are the International AS content and Units 3 and 4 are the extra International A2 content. This topic sits in Unit 4, Developments in the global economy, which the specification describes as an IAL compulsory unit: it belongs to the full International A Level only, not the International AS.

Related pages: revision notes, practice questions, course hub, checklist, fiscal and monetary policy guide, multiplier guide and the free diagnostics. Deficits, debt and the wider policy problems have their own pages, so this one stays with spending and taxes.

Every figure below is invented for illustration. Country J, Country K, Country L and Country M are not real.

What you must be able to do

Spec item	You must be able to
1a	Distinguish capital expenditure, current expenditure and transfer payments
1b	Explain why the size and pattern of public expenditure change: incomes, age distribution, expectations
1c	Assess how public expenditure as a share of GDP affects productivity and growth, crowding out and tax levels
2a	Distinguish direct from indirect taxes, with examples
2b	Distinguish progressive, proportional and regressive taxes
2c	Analyse how changes in direct and indirect tax rates affect work incentives, revenue (Laffer curve), income distribution, output and employment, the price level, the trade balance and FDI

1a: Three kinds of public spending

• Current expenditure pays for running services now: wages of public employees, medicines, heating.
• Capital expenditure buys or builds assets that last: roads, schools, hospitals.
• Transfer payments move money from taxpayers to recipients without the state buying output in return: pensions, unemployment benefit, child benefit.

Worked example. Country K spends 230bn on current items, 60bn on capital and 210bn on transfers. GDP is 2,000bn.

1. Total public expenditure = 230 + 60 + 210 = 500bn.
2. Expenditure/GDP = 500 / 2,000 = 25.0%.
3. Shares of the total: current 46.0%, capital 12.0%, transfers 42.0%.
4. Transfers do not buy output, so they are not counted in the government spending (G) part of aggregate demand. G = 230 + 60 = 290bn, or 14.5% of GDP.

Transfers still matter: recipients spend them, so they raise consumption.

1b: Why the size and pattern change

Changing incomes

Richer households often demand more health care and education. If public spending on health rises faster than GDP, its share of GDP rises. In Country J, GDP rises from 1,000bn to 1,200bn (+20%) and health spending from 80bn to 108bn (+35%). The share moves from 8.0% to 9.0%, and 35 / 20 = 1.75. Meanwhile, higher incomes can cut spending on means-tested benefits, because fewer people qualify.

Changing age distribution

Different ages need different spending. Each country has 10m people and GDP of 200bn. A pension and care package costs 9,000 per person aged 65 or over; schooling costs 5,000 per child.

	Country L	Country M
Aged 65+	2.5m	0.8m
Children	1.5m	2.8m
Pensions and care	22.5bn	7.2bn
Schooling	7.5bn	14.0bn
Total	30.0bn	21.2bn
Share of GDP	15.0%	10.6%

An ageing population raises the size of spending and shifts the pattern from education towards pensions and health.

Changing expectations

Voters compare services with those at home in the past and in other countries. If they expect shorter waiting times or better pensions, parties promise them, and spending moves up. Expectations can also fall: if people expect to fund their own retirement, pressure on state pensions eases. International differences in expenditure/GDP therefore reflect incomes, age structure and what each society expects the state to provide.

1c: What spending as a share of GDP means

Levels of taxation

Spending has to be funded. Country K spends 500bn and collects 480bn in tax (24.0% of GDP), so its deficit is 20bn (1.0%). It wants spending of 600bn (30.0% of GDP) with a deficit no larger than 60bn (3.0% of GDP).

1. Tax needed = 600 − 60 = 540bn, or 27.0% of GDP.
2. That is 60bn more than now, a rise of 3.0 percentage points.

A higher spending share implies higher taxes, higher borrowing, or both.

Crowding out

Crowding out is a fall in private spending caused by public spending. Financial crowding out works through borrowing: if the state borrows more from a limited pool of savings, interest rates tend to rise, and private investment falls. Resource crowding out arises near full capacity, when the state competes for labour and materials.

Worked example. The multiplier in Country K is 2. The government spends an extra 60bn.

• With no crowding out, output rises by 60 × 2 = 120bn.
• Suppose private investment falls by 25bn. The net injection is 35bn, and output rises by 35 × 2 = 70bn.
• Crowding out has offset 25 / 60 = 41.7% of the stimulus.

Crowding out is weaker with spare capacity and low demand for loans. The spending may even raise private returns, which is “crowding in”.

Productivity and growth

The composition matters as much as the share. Capital spending on transport or on training can raise productivity and shift long-run aggregate supply right. A high share made up of transfers and waste may not. High taxes to fund it can weaken incentives. Evidence across countries is mixed, so judge each case by what the money buys.

2a: Direct and indirect taxes

	Direct	Indirect
Charged on	income, profit, wealth	spending
Examples	income tax, corporation tax, capital gains tax, inheritance tax	value added tax or sales tax, excise duties on fuel or tobacco, import duties
Who bears it	the person or firm that pays it	shared between buyer and seller

For an indirect tax the legal payer is the seller, but the burden depends on elasticity. Suppose a good sells at 10 and a tax of 2 per unit raises its price to 11.20. Buyers bear 1.20 (60%), and sellers bear 0.80 (40%). The more inelastic demand is, the more falls on buyers.

2b: Progressive, proportional, regressive

The average tax rate is tax / income. The marginal tax rate is the tax on the next unit of income.

• Progressive: average rate rises with income.
• Proportional: average rate stays the same.
• Regressive: average rate falls as income rises.

Worked example. Country K’s income tax has a tax-free allowance of 8,000, then 20% on income from 8,000 to 40,000 and 40% above 40,000.

Income	Tax	Average rate
10,000	400	4.0%
30,000	4,400	14.7%
60,000	14,400	24.0%

On 60,000: 32,000 × 20% = 6,400 and 20,000 × 40% = 8,000, so tax is 14,400. The average rate rises, so the tax is progressive.

Now a sales tax of 10% on goods. The 10,000 earner buys 8,000 of goods and pays 800 (8.0% of income). The 30,000 earner buys 18,000 and pays 1,800 (6.0%). The 60,000 earner buys 30,000 and pays 3,000 (5.0%). The tax is proportional to spending but regressive with respect to income, because richer households save more. A fixed 360 fuel licence is also regressive: 3.0% of 12,000 but 0.6% of 60,000.

2c: Effects of changing tax rates

Incentives to work

A higher income tax rate has two opposing effects. The substitution effect: leisure becomes cheaper relative to work, so people work less. The income effect: take-home pay falls, so people may work more to keep their living standard.

Worked example. A worker earns 20 an hour for 40 hours. The marginal rate rises from 20% to 40%. The net wage falls from 16 to 12 (−25%), and net weekly pay from 640 to 480 at 40 hours. To restore 640 she would need 640 / 12 = 53.3 hours (income effect). If she cuts hours instead, the substitution effect dominates.

Tax revenue and the Laffer curve

Revenue = rate × tax base, and a higher rate can shrink the base through less work, avoidance or evasion. Assume a base of 1,000 × (1 − rate).

Rate	Base	Revenue
20%	800	160
40%	600	240
50%	500	250
60%	400	240
80%	200	160

Revenue
  |        ***
  |      *     *
  |    *         *
  |  *             *
  +------------------- Tax rate
   0       t*       100%

Revenue rises to a maximum at t* then falls. Above t*, cutting the rate raises revenue and the base. The peak is not known in advance, and it differs by tax, country and time horizon. Do not assume a country is on the downward slope.

Income distribution

Using the three households (10,000, 30,000, 60,000), income tax leaves 9,600, 25,600 and 45,600. The top earner’s share of income falls from 60.0% to 56.4%. Adding the regressive sales tax (800, 1,800, 3,000) gives 8,800, 23,800 and 42,600. The top share becomes 56.65%, so the indirect tax takes back about 0.2 percentage points of the redistribution. Overall tax is still progressive: 12.0%, 20.7% and 29.0% of income.

Real output and employment

A tax cut raises disposable income, consumption and aggregate demand. Take a cut of 12bn with a marginal propensity to save of 0.10, to import 0.15 and to be taxed 0.20.

1. Multiplier = 1 / (0.10 + 0.15 + 0.20) = 2.22.
2. First-round domestic spending = 12 × (1 − 0.10 − 0.15) = 9bn.
3. Output rises by 9 × 2.22 = 20bn.
4. With output per worker of 80,000, jobs rise by 20bn / 80,000 = 250,000.

This needs spare capacity. A cut in marginal rates may also raise labour supply and capacity.

The price level

Indirect taxes raise firms’ costs and shift short-run aggregate supply left. If a sales tax rises from 10% to 15% and is fully passed on, a taxed item priced at 100 before tax goes from 110 to 115, a rise of 4.5%. If taxed goods are 60% of the basket, the price level rises by about 2.7%. A direct tax cut raises demand-pull pressure only if capacity is short.

The trade balance

A tax cut raises income and imports: in the example, imports rise by 0.15 × 20 = 3bn, which worsens the balance. Taxes on firms’ costs can raise export prices. Take exports of 300bn. A 5% price rise cuts quantity by 7% (elasticity 1.4), so value is 300 × 1.05 × 0.93 = 293bn. Lower direct taxes on firms can reduce costs and help competitiveness.

FDI flows

Foreign direct investment (FDI) responds to the post-tax return. A firm invests 100 and expects pre-tax profit of 18. At a 30% corporation tax, the return is 12.6%; at 20% it is 14.4%. The cut adds 1.8 percentage points. Other drivers still matter: market size, skills, infrastructure (paid for by taxes) and stability.

Evaluation points

• Size and timing of the change, and spare capacity.
• Elasticities: of labour supply, of demand, of exports.
• The use of the revenue: a tax rise spent on infrastructure may raise supply.
• Time lags and behavioural responses.

Common errors

• Counting transfers as part of G.
• Treating a progressive tax as one where the marginal rate alone rises.
• Calling every tax cut revenue-raising.
• Assuming indirect taxes always fall fully on buyers.

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.