Government budget

Q: What is fiscal policy, and how does the government use it?

Fiscal policy is the use of government spending ( (G\)) and taxation ( (T\)) to influence aggregate economic activity and achieve macroeconomic goals such as price stability, economic growth, and full employment.

Q: What are the three possible states of a government budget balance?

The three states are a balanced budget ( (G = T\)), a budget deficit ( (G > T\)), and a budget surplus ( (T > G\)).

Q: What are Adam Smith's four canons of taxation (CECE)?

The four canons of taxation are Certainty , Economy , Convenience , and Equity .

Q: What is Hong Kong's Territorial Source Principle of taxation?

Under the Territorial Source Principle , tax is levied only on income, profits, or gains arising in or derived from Hong Kong, while foreign-sourced income is generally exempt regardless of residency status.

Q: What is the difference between direct taxes and indirect taxes?

A direct tax is paid by the statutory taxpayer who bears the burden and cannot shift it (e.g., Salaries Tax), whereas an indirect tax can be shifted to other parties through price adjustments (e.g., tobacco duties).

Q: How are progressive, proportional, and regressive taxes defined in terms of Average Tax Rate (ATR)?

A tax is progressive if ATR rises as income increases, proportional if ATR remains constant, and regressive if ATR falls as income increases.

Practice

Economics · Senior Secondary (HKDSE) · 6 min read · Updated: 23 Aug 2026

Chapter Notes: The Government Budget & Fiscal Policy

Ever wondered where the government gets its revenue to build new infrastructure or run public hospitals? And how do its financial decisions affect our daily lives and the overall economy? That's exactly what we explore in this chapter. We will examine the government's financial plan, called the budget, and how it uses fiscal policy to stabilize and steer the macroeconomy.

What is the Government Budget and Fiscal Policy?

Think of a government like a huge household. It has revenue (money coming in) and expenditure (money going out). The government budget is its annual financial plan of revenue and spending.

Fiscal Policy is the use of government spending and taxation to influence aggregate economic activity and achieve macroeconomic goals (such as price stability, economic growth, and full employment).

The Three States of a Budget

A government's budget balance can be in one of three states:

Balanced Budget: Government Revenue $=$ Government Expenditure. (Spending equals revenue.)
Budget Deficit: Government Revenue $<$ Government Expenditure. (Spending exceeds revenue. The shortfall must be financed through fiscal reserves or borrowing.)
Budget Surplus: Government Revenue $>$ Government Expenditure. (Revenue exceeds spending. Surplus funds accumulate in fiscal reserves or are used to repay public debt.)

Financing a Budget Deficit

When the government runs a budget deficit, it can finance it by:

Drawing down accumulated fiscal reserves: Using past savings.
Borrowing / Issuing government bonds: Issuing debt securities. If the government borrows heavily from domestic financial markets, it may increase interest rates and crowd out private investment (known as the crowding-out effect).

Quick Review Box

Deficit = Expenditure exceeds Revenue ($G > T$)
Surplus = Revenue exceeds Expenditure ($T > G$)
Balanced = Revenue equals Expenditure ($G = T$)

Where Does the Government's Money Come From? (Revenue)

Government revenue in Hong Kong is categorized into operating revenue (recurrent income such as direct and indirect taxes, fees and charges) and capital revenue (non-recurrent income such as land premia from land sales and loan repayments).

Adam Smith's Principles of a Good Tax System

Adam Smith proposed four classical canons of taxation (remember as CECE):

Certainty: The tax liability (amount, payment method, and timing) must be clear, transparent, and certain to the taxpayer.
Economy: The administrative cost of tax collection incurred by the government should be minimized relative to the revenue raised.
Convenience: The tax payment procedure and schedule should be convenient for taxpayers to comply with.
Equity: The tax burden should be distributed fairly among citizens based on ability to pay.

Taxation Principle in Hong Kong

Hong Kong adheres strictly to the Territorial Source Principle:

Tax is only charged on income, profits, or gains that arise in or are derived from Hong Kong. Income originating outside Hong Kong is generally not subject to Hong Kong taxation, regardless of residency status.

Example: A Hong Kong resident who earns salary solely from employment exercised outside Hong Kong for an overseas firm is generally exempt from HK Salaries Tax on that income.

Classification of Taxes

Taxes are classified in two major ways for HKDSE Economics:

1. Direct vs. Indirect Taxes

This distinction depends on whether the legal tax burden (incidence) can be shifted:

Direct Tax: A tax where the statutory taxpayer bears the tax burden directly and cannot shift it to others.

Examples in HK: Salaries Tax, Profits Tax, Property Tax, Stamp Duty.
Indirect Tax: A tax where the burden can be shifted to buyers or sellers via price adjustments. It is levied on goods, services, or transactions.

Examples in HK: Duties on specific commodities (tobacco, liquor, hydrocarbon oil), Motor Vehicles First Registration Tax, Air Passenger Departure Tax, General Rates.

2. Progressive, Proportional, and Regressive Taxes

This classification is based on how the Average Tax Rate (ATR) changes as income (tax base) increases:

Progressive Tax: The average tax rate increases as income increases ($\text{Marginal Tax Rate} > \text{Average Tax Rate}$).

Example: HK's Salaries Tax progressive rate structure, where higher income slices face progressively higher marginal tax rates.
Proportional Tax: The average tax rate remains constant regardless of income level ($\text{Marginal Tax Rate} = \text{Average Tax Rate}$).

Example: A flat-rate tax system where all taxpayers pay an identical fixed percentage of their taxable income or profits.
Regressive Tax: The average tax rate decreases as income increases ($\text{Marginal Tax Rate} < \text{Average Tax Rate}$).

Example: A fixed lump-sum license fee (e.g., \$5,000 per vehicle per year). A \$5,000 fee accounts for 2.5% of an annual income of \$200,000, but only 0.1% of an annual income of \$5,000,000.

How Does the Government Spend Its Money? (Expenditure)

Public expenditure is divided into operating expenditure (recurrent daily operational expenses, civil servant salaries, subventions) and capital expenditure (infrastructure projects, capital works, equipment purchases).

Classification of Public Expenditure by Function

Key policy areas include:

Social Welfare: Providing social safety nets (e.g., Comprehensive Social Security Assistance (CSSA), Old Age Living Allowance).
Education: Funding subsidized primary, secondary, and tertiary education institutions.
Health: Operating public healthcare facilities and subsidized hospital services.
Infrastructure: Constructing and maintaining transport networks, bridges, and public utilities.
Security: Maintaining law and order via the Police Force, Fire Services, and customs control.

Measuring the Public Sector Size

The economic footprint of the government is measured as:

$\text{Size of Public Sector} = \frac{\text{Total Public Expenditure}}{\text{Gross Domestic Product (GDP)}} \times 100\%$

Fiscal Policy in Action (AD-AS Analysis)

The government uses fiscal policy to influence aggregate demand (AD) and output.

1. Expansionary Fiscal Policy

Application: During economic recessions when aggregate output is below capacity and unemployment is high.
Policy Tools: Increase government spending ($G \uparrow$) and/or reduce taxes ($T \downarrow$).
Mechanism: Direct injection from higher $G$ and higher disposable income increasing consumption ($C \uparrow$) shift the Aggregate Demand curve to the right ($AD \uparrow$).
Macroeconomic Impact: In the short run, aggregate output increases ($Y \uparrow$), unemployment falls, and the general price level rises ($P \uparrow$).

2. Contractionary Fiscal Policy

Application: During an economic boom when the economy overheats with high demand-pull inflation.
Policy Tools: Decrease government spending ($G \downarrow$) and/or increase taxes ($T \uparrow$).
Mechanism: Reduced public purchases and lower disposable income (lowering $C$) shift the Aggregate Demand curve to the left ($AD \downarrow$).
Macroeconomic Impact: In the short run, the price level falls or inflation eases ($P \downarrow$), while output decreases ($Y \downarrow$).

Balanced Budget Multiplier Concept

When the government increases spending and taxes by the exact same amount ($\Delta G = \Delta T$), the net effect is still expansionary. Because consumers fund part of the tax payment from savings, aggregate demand increases by the initial increase in government expenditure.

Limitations of Fiscal Policy

In practice, fiscal policy encounters several constraints:

Time Lags: Recognition lags, administrative/legislative decision lags, and implementation/impact lags may delay effects until economic conditions have already shifted.
Crowding-out Effect: Deficit spending financed by heavy public borrowing can bid up interest rates, discouraging private investment.
Structural Deficits: Persistent deficits caused by structural imbalances (e.g., an ageing population) cannot be sustainably solved by short-term fiscal adjustments alone.

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What is fiscal policy, and how does the government use it?

Fiscal policy is the use of government spending ( (G\)) and taxation ( (T\)) to influence aggregate economic activity and achieve macroeconomic goals such as price stability, economic growth, and full employment.

What are the three possible states of a government budget balance?

The three states are a balanced budget ( (G = T\)), a budget deficit ( (G > T\)), and a budget surplus ( (T > G\)).

How can a government finance a budget deficit, and what is the crowding-out effect?

A budget deficit can be financed by drawing down fiscal reserves or by borrowing (issuing bonds); heavy borrowing may raise domestic interest rates and reduce private investment, causing a crowding-out effect.

What are Adam Smith's four canons of taxation (CECE)?

The four canons of taxation are Certainty, Economy, Convenience, and Equity.

What is Hong Kong's Territorial Source Principle of taxation?

Under the Territorial Source Principle, tax is levied only on income, profits, or gains arising in or derived from Hong Kong, while foreign-sourced income is generally exempt regardless of residency status.

What is the difference between direct taxes and indirect taxes?

A direct tax is paid by the statutory taxpayer who bears the burden and cannot shift it (e.g., Salaries Tax), whereas an indirect tax can be shifted to other parties through price adjustments (e.g., tobacco duties).

How are progressive, proportional, and regressive taxes defined in terms of Average Tax Rate (ATR)?

A tax is progressive if ATR rises as income increases, proportional if ATR remains constant, and regressive if ATR falls as income increases.

How is the size of the public sector measured relative to the overall economy?

The size of the public sector is calculated as (\text{Size of Public Sector} = \frac{\text{Total Public Expenditure}}{\text{Gross Domestic Product (GDP)}} \times 100\%\).

How does expansionary fiscal policy affect aggregate output, employment, and the price level?

By raising government spending ( (G \uparrow\)) or cutting taxes ( (T \downarrow\)), aggregate demand shifts rightward ( (AD \uparrow\)), increasing output ( (Y \uparrow\)), reducing unemployment, and raising the price level ( (P \uparrow\)).

How does contractionary fiscal policy work, and when is it applied?

Applied during economic booms with high inflation, the government cuts spending ( (G \downarrow\)) or raises taxes ( (T \uparrow\)) to shift aggregate demand leftward ( (AD \downarrow\)), easing the price level ( (P \downarrow\)) and reducing output ( (Y \downarrow\)).

What are the main practical limitations of using fiscal policy?

The main limitations include time lags (recognition, decision, and implementation lags), the crowding-out effect, and persistent structural deficits.

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