Chapter 3: Fiscal Policy – Taxation and Government Spending
The role of the government is to provide goods and services which the private market fails to adequately supply. To accomplish this, the government needs revenue. The government has recourse to only three main sources of funds. The first is taxation, the second is borrowing or bond sales, and the third is the printing of money. There are other minor sources of revenue, such as user and licensing fees, fines, income on government assets, foreign aid, and lotteries. However, over the long run, the government really has only three reliable sources of funds – taxes, bonds, and money. Public economics or public finance is concerned with the raising of government revenue and the implementation of government spending programs. Fiscal policy is concerned with the design of public tax and spending programs to achieve some specific set of social goals.
By far, the most important source of funds for a government is taxation. Taxation is a very important topic. The American Revolutionary War was fought because of "taxation without representation"; the American colonists were taxed, but they did not have any representatives in the British government. They felt this was unjust. In Mainland China today, tax collectors are routinuely killed trying to collect taxes. In response, the Chinese government has recently created a special police force to help protect tax collectors. In Taiwan, some people have suggested that individuals be taxed who do not marry. Apparently, these people believe that the tax system should be used for social engineering. There is an old saying in economics—"if you want less of something, tax it and if you want more of something, subsidize it".
Taiwan has fourteen types of taxes. The individual and corporate income taxes, value added tax, and tariffs are the most important types of taxes in Taiwan. Direct taxes involve taxing individuals. The burden cannot be shifted to someone else. Indirect taxes involve taxing possessions and transactions. The income tax is an example of a direct tax. By contrast, the burden of indirect taxes can be shifted, at least somewhat. The VAT and tariffs are examples of indirect taxes. Economists believe that direct taxes are better than indirect taxes, since they do not explicitly involve a change in the relative prices of goods and services.
Some economists have argued that taxes should be reduced during times of recession and raised during times of overheated expansion. When taxes are cut, people find they have greater disposable income and this increases their spending. When government raises taxes, then consumers have less disposable income and therefore spending falls. Research has shown that a tax cut can be stimulative, if it is considered a long lasting tax cut. A short run tax cut tends to be saved by households, rather than spent. This is because people base their spending decisions on their permanent income, rather than their current level of income. A short run tax cut does not affect peoples' permanent income and cannot have a significant impact on their consumption.
Government raises revenue in order to finance its expenditures. Total government expenditure is equal to government spending and the payment of interest on government debt. We can summarize the government budget with the following equation:
rB + PG = PY + B + M
where r = average interest rate on government debt, PG = nominal government spending, PY = nominal government taxes (income taxes only here for simplicity), B = the change in government debt outstanding, M = the change in money issued by the government, Y = real income and P = average price level. The left side of the equation is government expenditure, while the right side shows the three sources of revenue.
To evaluate the fiscal condition of a country, we often look at two statistics. The first is the deficit/GDP ratio and the second is the debt/GDP ratio. In terms of our equation above, the first can be written as (B/PY), while the second ratio can be written as (B/PY). A general rule of thumb is that the first ratio should not exceed 3-5% while the second should not exceed 50-60%. Taiwan's deficit-GDP ratio is currently about 4-5% and its debt to GDP ratio is rougly 25-30%.
Taiwan's external debt is rather low compared to other countries, which means that Taiwan's government and private sector borrows most of its funds domestically and does not rely on foreign lenders. This is not true of certain other countries, such as Argentina, Indonesia, South Korea, etc. Borrowing from abroad exposes the country to the risk of defaulting on its international debts – what is sometimes called sovereign risk. This can have a serious impact on the currency of the country.
There is nothing wrong with a country borrowing reasonable amounts from abroad. In fact any country which is running a trade deficit, and which is on flexible exchange rates, MUST be borrowing from abroad. The US is a good example of this.