Chapter Notes: The Government Budget & Fiscal Policy
Hey everyone! Ever wondered where the government gets its money to build new MTR lines or run public hospitals? And how do its financial decisions affect our daily lives and the economy as a whole? That's exactly what we're going to explore in this chapter. We'll look at the government's financial plan, called the budget, and how it uses it as a powerful tool to manage the economy. Don't worry if it sounds complicated; we'll break it all down step-by-step. Let's get started!
What is the Government Budget and Fiscal Policy?
Think of a government like a huge household. It has income (money coming in) and expenses (money going out). The government budget is simply its annual plan for all this money.
Fiscal Policy is the use of government spending and taxation to influence the economy. The budget is the main tool for carrying out fiscal policy.
The Three States of a Budget
A government's budget can be in one of three states at the end of the year:
Balanced Budget: Government Revenue = Government Expenditure. (It spends exactly what it earns.)
Budget Deficit: Government Revenue < Government Expenditure. (It spends MORE than it earns. It has to borrow money to cover the difference.)
Budget Surplus: Government Revenue > Government Expenditure. (It spends LESS than it earns. It has money left over, which can be saved or used to pay off old debts.)
Quick Review Box
Deficit = Spending is Dangerously high!
Surplus = There's a Surprising amount of cash left!
Balanced = Everything is in Balance.
Key Takeaway
The government budget is a plan of its income (revenue) and spending (expenditure). The relationship between these two determines if there is a surplus, deficit, or a balanced budget. This plan is the core of fiscal policy.
Where Does the Government's Money Come From? (Revenue)
The main source of government revenue is taxation. A good tax system should follow some basic principles.
Adam Smith's Principles of a Good Tax System
A famous economist, Adam Smith, suggested four key principles (canons) for good taxes. Let's remember them as CECE:
Certainty: The amount, timing, and way to pay the tax should be clear and certain to the taxpayer. (No nasty surprises!)
Economy: The cost of collecting the tax for the government should be as low as possible. (It shouldn't cost $50 to collect a $100 tax.)
Convenience: It should be easy and convenient for people to pay the tax. (Think online tax filing.)
Equity: The tax should be fair. This usually means people should pay according to their ability to pay (richer people pay more).
Taxation Principle in Hong Kong
Hong Kong follows a very specific principle:
The Territorial Source Principle: This is a very important concept! It means that tax is only charged on income or profits that are generated WITHIN Hong Kong. If you earn income from another country, even if you are a Hong Kong resident, you generally don't pay Hong Kong tax on it.
Example: An engineer who lives in Hong Kong but works on a project in Singapore for a Singaporean company would likely NOT have to pay HK Salaries Tax on that income because its source is outside Hong Kong.
Classification of Taxes
We can classify taxes in two main ways:
1. Direct vs. Indirect Taxes
This is all about whether the tax burden can be passed on to someone else.
Direct Tax: A tax where the burden cannot be shifted to others. The person or company who receives the tax bill is the one who pays it.
Examples in HK: Salaries Tax (you can't make your friend pay your income tax!), Profits Tax (a company pays tax on its own profits).
Indirect Tax: A tax where the burden can be shifted to others. It's usually levied on a good or service, and the seller passes the cost on to the buyer in the form of a higher price.
Examples in HK: Stamp duty on property (the seller might increase the property price to cover it), Bets and Sweeps Tax (the Jockey Club passes this cost to bettors).
2. Progressive, Proportional, and Regressive Taxes
This classification is based on the relationship between the tax rate and a person's income.
Progressive Tax: The average tax rate (percentage of income paid as tax) increases as income increases. This is based on the 'equity' principle - higher earners pay a larger percentage of their income in tax.
Example: HK's Salaries Tax. It has different tax bands. The first part of your income is taxed at 2%, the next part at 6%, and so on. So, a high-income earner's overall average tax rate is higher than a low-income earner's.
Proportional Tax: The average tax rate remains constant regardless of income. Everyone pays the same percentage. This is also known as a 'flat tax'.
Example: HK's Profits Tax. All companies, big or small, pay the same rate (e.g., 16.5%) on their profits.
Regressive Tax: The average tax rate decreases as income increases. This means lower-income individuals end up paying a larger percentage of their income than higher-income individuals. This is often seen as unfair.
Example: A fixed car license fee of $5,000 per year. For someone earning $200,000, this is 2.5% of their income. For a CEO earning $5,000,000, it's only 0.1% of their income. The burden is heavier on the lower-income person.
Key Takeaway
The government earns money mainly through taxes, which are classified as direct/indirect and progressive/proportional/regressive. Hong Kong's unique 'Territorial Source Principle' means it only taxes income generated locally.
How Does the Government Spend Its Money? (Expenditure)
Public expenditure is what the government spends money on to provide public services and run the city.
Classification of Public Expenditure by Function
In Hong Kong, government spending is divided into several key areas. Think about what services you see around you every day:
Social Welfare: Providing a social safety net, like payments to the elderly and those in need (e.g., Comprehensive Social Security Assistance, CSSA).
Education: Funding for public schools, universities, and student grants.
Health: Running public hospitals and clinics (e.g., Queen Mary Hospital).
Infrastructure: Building and maintaining roads, bridges, ports, and public transport systems.
Security: Funding for the Police Force, Fire Services, and correctional services.
How Big is the Government's Role?
To measure the size of the public sector (i.e., the government's economic role), we often use this ratio:
Size of Public Sector = $$ \frac{\text{Total Public Expenditure}}{\text{Gross Domestic Product (GDP)}} \times 100\% $$
This tells us what percentage of the entire country's economic activity is accounted for by government spending.
Socio-Economic Implications of Spending
Where the government chooses to spend money has big consequences:
Spending more on education can lead to a more skilled workforce and higher economic growth in the long run.
Spending more on social welfare can reduce income inequality and poverty.
Spending more on infrastructure can improve business efficiency and connectivity.
Key Takeaway
The government spends money on essential services like health, education, and social welfare. These spending choices have a huge impact on both society and the economy.
The Budget's Impact on the Economy (Fiscal Policy in Action!)
This is where it all comes together! How does the government use the budget to steer the economy? It uses two main strategies. Don't worry if this seems tricky at first, we'll use the AD-AS model to make it clear.
1. Expansionary Fiscal Policy
When is it used? During a recession or economic slowdown, when unemployment is high and businesses are struggling.
What is the goal? To "expand" or boost the economy by increasing aggregate demand (AD).
What are the tools?
- Increase government spending (G ↑)
- Decrease taxes (T ↓)
This usually leads to a budget deficit (G > T).
How it works with the AD-AS model:
Increasing G (e.g., building a new bridge) or decreasing T (e.g., giving everyone a tax rebate) gives people and firms more money to spend. This increases consumption (C) and government spending (G), shifting the AD curve to the right.
Result: In the short run, the price level rises (P↑) and real output increases (Y↑). This means more jobs and economic growth!
2. Contractionary Fiscal Policy
When is it used? When the economy is "overheating" and there is high inflation (prices are rising too fast).
What is the goal? To "contract" or slow down the economy to control inflation by decreasing aggregate demand (AD).
What are the tools?
- Decrease government spending (G ↓)
- Increase taxes (T ↑)
This usually leads to a budget surplus (G < T).
How it works with the AD-AS model:
Decreasing G (e.g., cancelling a big project) or increasing T (e.g., raising the profits tax rate) takes money out of the economy. This reduces consumption (C) and government spending (G), shifting the AD curve to the left.
Result: In the short run, the price level falls (P↓) and real output decreases (Y↓). This helps to bring inflation under control.
Did you know?
In Hong Kong, the Financial Secretary traditionally carries a red briefcase when delivering the annual budget speech, a tradition inherited from the UK.
What about a "Balanced Budget" Change?
What if the government increases spending and taxes by the exact same amount (e.g., G↑ by $10bn and T↑ by $10bn)? You might think the effect is zero, but it's not! This action is actually slightly expansionary.
Simple Explanation: The $10bn increase in G boosts AD by the full $10bn. However, the $10bn tax increase reduces people's spending by *less than* $10bn, because people would have saved a portion of that money anyway. So, the positive effect from G is stronger than the negative effect from T, leading to a small increase in AD.
Effects of Taxation on Individuals and Firms
Let's quickly summarize how taxes affect us:
On Individuals: Taxes reduce our disposable income, which affects how much we can save and spend. They can also affect our incentive to work (very high taxes might discourage people from working overtime).
On Firms: Taxes like the Profits Tax reduce a company's after-tax profit, which can affect their decisions to invest in new machinery or hire more staff.
Key Takeaway
Fiscal policy is the government's secret weapon for managing the economy. It uses expansionary policy (cutting taxes, increasing spending) to fight recessions and contractionary policy (raising taxes, cutting spending) to fight inflation. These actions directly shift the Aggregate Demand curve.