Governments all around the world have a strong impact on the economy via taxation and spending, but does it make sense to treat them as one government in Earth Economics? At the end of the video, you will be able to argue when the analysis of Earth economic government makes sense and you will be able to analyze global government spending and identify different forms of taxation and their impact. Now, the fact that we have national governments is probably the most important reason why Earth Economics is not yet practiced everywhere. Governments pursue national interests and a model that focuses on the system as a whole overlooks interactions amongst its constituencies. So for Earth Economics, it is important that aggregate behavior works into the same direction. Sometimes, a fuzzy picture emerges when countries follow contradictory policies so that on average, the impulse from world government at the world level is zero. As you can see on this graph, recently, economic policy uncertainty has increased, that started a few years ago. Thus we are getting less and less sure about what we can expect from government. Good thinking, there are many causes. For me, the outbreak of the Great Recession in 2008 is one of the most crucial events. It has led to a powerful domino effect in global political and economic systems and threatens to break down coherence and coordination. Earth Economics, however, argues that governments often move in the same direction. In the golden age of the 1950's and 1960's, policies where by and large Keynesian. The oil crises of 1973 and 1980's led to stagflation and gave rise to monetarism. Ultimately, stagflation provides the basis for structural reforms and The Washington Consensus. Look at the graph again. In the period before the outbreak of the Great Recession, you will recognize this consensus as a low level of policy uncertainty. The initial response to the Great Recession is a key example of the case of national policies suddenly moving together in the same direction. Monetary policy, as we will discuss later in the course, became expansionary and a very large majority used fiscal stimulus by reducing taxes and/or increasing government spending. This marked a clear break in policies that previously aimed at reducing the budget deficit. Indeed, for a long time, stabilization or Keynesian demand management policies were "politically incorrect" around the globe. So my point is that we have instances in history where governments all around the world act as if they were one, because all policy instruments are used in the same direction. Remember the three M's, math, manner, meaning. The analysis of government changes the equilibrium condition. The left-hand side describes what goods are produced, everything the consumer buys, government expenditure, and private investment. The right-hand side of the definition equation describes how income is spent. Everybody first has to pay taxes and the money that is not spent on consumption is saved. Now, subtract C from both sides of the definition equation and a new equation emerges, I + G = S + T We can rewrite this equilibrium condition, of course, also as S - I = G - T This helps us to see that investment can now exceed private saving in the world economy. This is, for example, the case when taxes exceed government expenditure. There is yet another formulation, I = S + T - G. This directly clarifies that investment equals private saving plus public saving, and public saving equals tax receipts minus expenditure. If public saving is positive, we have a budget surplus, and otherwise, we have a deficit. Government spending does not create new analytical difficulties. It is an exogenous variable, and a change of exogenous govern spending G works in the same way as investment. Alternatively, we could study a particular kind of govern behavior in which the government always keeps the budget balanced, that is, spending equals taxation. Taxation can be constant as in a lump-sum, proportional to income, or progressive taxes. So we can distinguish three cases. First, lump-sum taxes that do not depend on the level of income, for example, a land tax. Second, proportional taxes increase with income. Third, progressive taxes have a tax exemption where people do not have to pay taxes if they are below a certain income level. Now, often people think that progressive taxation is an invention of the socialists and that is a misconception. Let me explain this. One of the oldest, still surviving, and very stable systems of taxation is Zakat, a religious Islamic tax. It was installed by the Prophet in the seventh century. Zakat has many properties of progressive taxation. The tax rate is low, at 2.5 percent, and it is applied to most forms of monetary wealth and earned income, but with many clear and regulated exemptions regarding the nisad. The nisad is the tax exemption. The nisad, for example, specifies the number of camels and goats that one can hold tax-free. This helps us to recap the earlier discussion. A proportional tax is a fixed percentage of income. The marginal and average tax rates are identical. The lump-sum tax has no relationship with income, so the marginal tax rate is zero. If you get more income, you do not pay more tax. The average tax rate is the amount of tax divided by income. At a low income, the lump-sum tax carries a higher weight than at the higher income. Now, let's take a look at progressive taxation. Initially, you do not pay tax until you pass the tax exemption. This is where the graph jumps to the level of the marginal tax and then you pay a fixed percentage of your additional income. The average tax rate starts at zero until you reach the income threshold and from then on, the rate increases. This increase explains why the tax is called progressive. There remains one thing to be done, and that is we need to make sure that the tax is paid in our equations. So we work with disposable income, and that is defined as the net income after taxes, and we make consumption a function of disposable income. Professor Peter, I now have a good understanding of taxation and government spending in the Earth economy, but I have no clue, whatsoever, how government spends all money and what it spends on. You're right. There is a good way to find out. Let's make that the topic of today's exercise. Well, spending usually is closely linked to taxation. So I guess we also have to touch upon this topic. Don't you think so? That's a very good idea. Yes, we need to take a look at the budget deficit and how that fits into public debt. Let's investigate that issue next time.