Lesson preview · What governments do
The government's budget, and two levers for steering the economy
~8 min · Free to read
Imagine you run a country’s budget for a year. You must pay for hospitals, schools, pensions and roads, and decide who pays. In 2023, governments in OECD countries (a group of mostly rich countries) spent, on average, an amount equal to about 44% of their country’s GDP. GDP is the value of all the final goods and services a country produces in a year.
Most of that money comes from taxes: payments the law says people and firms must make. The three main kinds are taxes on pay and income, on spending (added to the prices of things you buy) and on company profits. In many countries, taxes on pay include social security contributions: charges on wages that help pay for pensions and benefits.
Key Term
Direct and indirect taxes
A direct tax is charged on what a person or firm earns or owns. Income tax and company tax are direct. The tax is theirs to pay, even when an employer sends income tax in for them.
An indirect tax is charged on spending. The seller adds it to the price, then pays it to the government. VAT (value added tax), GST (goods and services tax) and sales tax are indirect. So are excise duties (extra taxes on goods such as fuel or tobacco) and customs duties (taxes on goods brought in from abroad).
Ana earns 20,000 dollars a year and pays 10% of it in income tax. Ben earns 100,000 dollars and pays 30%. That tax is progressive: it takes a bigger percentage of income from people who earn more. Most income taxes work this way. A regressive tax takes a bigger percentage from people who earn less.
Progressive taxes and benefits (payments such as pensions and help for families or the unemployed) move money from richer households to poorer ones. This is redistribution.
So pensions, benefits and health take about half of government spending. And most tax money comes from people’s pay and spending, not from company profits.
Say a government spends 500 billion dollars this year but collects only 480 billion. The 20-billion-dollar gap is a budget deficit, which it borrows to cover. (Collecting more than it spends gives a surplus.) The government debt is the total still owed from past borrowing. A deficit is one year’s gap; the debt is the pile.
Key Term
Two levers for steering the economy
Two levers can warm up a slumping economy (falling spending, lost jobs) or cool racing prices.
- Lever 1: the government’s budget (fiscal policy). In a slump, the government spends more itself, or cuts taxes so people keep more of their income. Either way, total spending rises. When prices race, it does the reverse. Changes usually need a vote by lawmakers, which can take months.
- Lever 2: the central bank’s interest rate (monetary policy). A central bank, such as the US Federal Reserve, is the bank that looks after a currency. Its rate steers what banks charge for loans. A cut makes borrowing cheaper, so spending rises. A higher rate does the reverse, so spending slows and prices rise more slowly. In many countries the central bank decides on its own, with no vote by lawmakers, and meets about eight times a year. So this lever can usually be changed faster.
Pushing spending up is expansionary policy; holding it back is contractionary.
The problem sets the direction: warm up a slump, cool down racing prices. The situation picks the lever. In 2020, interest rates had almost no room left to fall, so government budgets did the main work. In 2022, central banks raised rates to cool prices, since keeping price rises slow is part of their job. European governments, meanwhile, spent more on energy help. In 2024, several European governments were told to cut their deficits, so rate cuts did the warming.
Trap · Common Misconception
"A government must balance its budget every year, like a family"
In a slump, tax money falls and benefit spending rises by itself, so a deficit appears. Cutting spending to close it would drain more money from a weak economy.
Unlike a family, a government has no end date: it can repay old loans by borrowing again. And as the economy grows, old debts shrink compared with the government’s tax income. But the government must pay interest, and lenders may charge more if its debt looks too big.
Check yourself · no marks
A government’s deficit shrinks every year for five years: 50, 40, 30, 20, then 10 billion dollars. Is its debt shrinking?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 6
Which of these is a direct tax?
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