Sources (and Distortions) of Government Revenue

After my post on The Truth About Austerity and hearing some great feedback from Peter in the comments, I deemed it necessary to dedicate a post to explaining the basics of public finance. We at Hans try to make basic economics accessible to all readers, so I will aim to keep it simple and limit our discussion to the fundamentals. Namely, I will compare and contrast the government’s three measures of raising revenue (taxation, debt, and inflation) and how they affect you personally.

1: Taxation

Taxation is a source of government revenue that we are all well aware of. I was not so well aware of it before holding a job, but now, as an adult citizen, I have the privilege of seeing part of my income doled out to Uncle Sam every year, especially come April.

Although probably the most frustrating and painstaking form of government revenue for you, the individual income earner, taxation is actually the most economically sound way for governments to raise revenue. This is because we actually see the dollars transfer from our bank account to the public purse. We are personally involved in the process. Therefore we know how much less money we have to spend and can reallocate our resources accordingly.

Economic exchange is able to continue most smoothly with the incidence of taxation relative to debt and inflation. Whether it is just or not is another issue.

2: Debt     

Government borrowing is a worse alternative than taxation. When the government borrows money, it decreases the amount of available funding to private borrowers.

In a financially sound economy, when the government decides to borrow more, there is less money available to fund capitalists and entrepreneurs, the very people who are best equipped to see to the well-being of the economy by improving the capital structure.Government borrowing decreases the amount of private investment projects that can be carried out. By crowding out the availability of funds to the private sector, government indebtedness redirects credit away from its most efficient uses to the uses deemed necessary by Uncle Sam.

3: Inflation 

Inflation is the most destructive form of public financing. Government inflates the money supply by having a central bank print more money which the government then uses to finance its projects.

When the central bank begins printing new money, people see no reason to change the way they use their money. Unaware of what’s going on behind the scenes, citizens do not observe that government has made a decision which should change their expenditures. Once the new money has reached the hands of individuals, the purchasing power of the dollar decreases.

Thus you and I are no longer able to buy as much as we could have with our money before the government revved up the printing press. We are not able to plan for the effect of the inflation because it is impossible to predict exactly how it will affect prices.

What we do know is that inflation will encourage prices to rise. What prices will rise or to what extent we cannot know. Therefore inflation makes it much more difficult than taxation (in which we see the money come out of our account) or government debt (in which we know that we cannot obtain the loan which the government has taken) to allocate the money we do have in the way we would like to. The nuisance is especially apparent to businesses trying to maximize their bottom line. Uncertainty about future prices makes it particularly hard for them to make decisions.

In summary, none of these do any good for the private sector. Inflation has the most harmful effects followed by debt while taxation does the least damage for the aforementioned reasons. Hopefully this gives you a basic understanding of how the government fattens the public purse and its effect on you. I encourage any comments either cheering me for diagnosing the ills of public finance or jeering me for not giving government ample praise for the benefits(?) of public finance. 

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One Response to Sources (and Distortions) of Government Revenue

  1. beniyam kebede October 22, 2013 at 8:21 am #

    thank you Jdellape, I have got a clear understanding especially on inflation and debt. but my question is that in countries that uses their own currency for domestic transactions and use dollar for international transactions and at the same time the input for their projects is by hard currency from international markets, how money printing would cause inflation. I do agree that money printing is the main cause of inflation. but with this scenario I couldn’t understand its effect.

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