3.2.3
Note

Effects of Taxation and Government Expenditure

3.2.3 Macro policies

Idea

Beyond financing the budget, taxation and government expenditure are themselves instruments with microeconomic and macroeconomic consequences. The same tax that raises revenue also changes relative prices, the distribution of income, and incentives to work and invest; the same expenditure that delivers services also corrects market failure and steers aggregate demand.

Mechanism

Effects of taxation.

  • Allocative efficiency. Taxes can price in negative externalities and correct imperfect information, raising the price of demerit goods and reducing their over-consumption — moving the market towards a more efficient allocation.

  • Equity. Progressive taxes generate more equitable outcomes, since the better-off pay proportionately more; regressive taxes worsen inequality, as they take a larger share of a poorer household’s income.

  • Work effort. A rise in income tax has two opposing pulls. Through the income effect, workers wanting to protect their standard of living work harder to restore lost disposable income; through the substitution effect, the lower net return on an extra hour makes leisure relatively more attractive, so some work less. Which dominates varies across workers.

  • Consumption, savings and investment. Higher personal income tax lowers disposable income and so consumption; higher corporate tax lowers after-tax profit and so firms’ ability and willingness to invest.

Government expenditure. Spending divides into government consumption (recurrent spending, e.g. public-sector wages) and government investment (capital spending, e.g. building a hospital). It is directed at three ends: servicing national debt (interest and principal); microeconomic aims — subsidies for public and merit goods to improve allocation, and transfers to low-income households to improve equity; and macroeconomic aims — adjusting the level of expenditure to manage aggregate demand, which is where public finance becomes fiscal policy.

Considerations

  • A progressive income tax improves equity, but set too high it can erode an economy’s competitiveness for foreign talent and investment, so that less wealth flows in — a point that cuts against pushing rates up indefinitely.

  • The two effects of taxation on work effort run in opposite directions, so the net impact on labour supply is genuinely ambiguous and depends on the composition of the workforce.

  • Expenditure and taxation both carry an opportunity cost: funds committed to one programme, or revenue forgone through a tax cut, are unavailable elsewhere — the binding constraint behind most fiscal judgement.

Context

Singapore’s tax structure is deliberately progressive at the personal level — those earning below roughly $20,000 a year pay no income tax — which improves equity, while a relatively low headline corporate-tax rate is used to keep the economy attractive to foreign investment. The tension between the two is the practical form the equity–competitiveness trade-off takes.