Government budget provides the projections of revenues to be received and expenses to be incurred by the government in a given financial year. The main sources of government revenue are levies, taxes, returns of government projects and fines. In many cases, the government budget is at a deficit because the amount of expenditure to be incurred is more that revenue projected revenue. Thus, the government has an option of financing the deficit through borrowing or applying austerity measures to cut down its projected spending. The government can also apply austerity measures when debt level reaches unmanageable high level. Everyone in the economy feels the imposition of austerity measures and the government budget position deteriorates more than the policymakers had expected (Anand, 2004).
These two measures reduce the amount of income received by households. Therefore, demand for goods by households in the economy falls drastically. This affects the level of investment because inventory levels will rise due to decreased market for output. In turn, investors cut down their level of production and retrench workers. Lying off of workers and declining returns reduce the income and corporate tax payable to the government. This increases the deficit.
The third measure involves cutting expenditure on a new government project. Some of the government projects include public works and infrastructure. Cutting down this spending reduces the employment opportunities for workers and market for capital goods. Moreover, the projected future inflow expected from the government project decreases. The increase in unemployment as a result of the freezing expansion of government projects reduces the income tax revenue. Moreover, it decreases the demand for goods by households. Thus, aggregate demand fall and the private sectors players are forced to reduce employment opportunities and tax payable. The deficit increases due to falling returns and tax revenue (Hubbard, 2009).
The third measure involves increasing corporate tax, capital gain tax, and income tax. The increase in cooperates tax has three effects. The first one is that it discourages entrepreneurship. The second one is discouraging foreign investors from investing in the country, and the third one is domestic investors opting to expand production in foreign countries and decrease local investment. The decrease in foreign direct investment affects GDP, level of employment and exchange rate while capital flights. The decrease in foreign investment and capital flight lowers the corporate and income tax receivable (Anand, 2004).
Thus, imagining the economy was in recession the austerity measures will put it in crisis. This is because the measures reduce aggregate demand at a time when the economy is not operating at full capacity. The reduction of aggregate demand will affect the level of investment as well as the household income. Thus, the government revenue obtained from taxing firms and household income will fall. This leaves the government in a worse situation than expected by policy makers. It is not recommendable to apply these measures to the economy will take quite long to recover from the recession (Anand, 2004).
Reference
Anand, A. (2004). Macro economics: Functions and policies. New Delhi: Mohit Publications.
Hubbard, R. G. (2009). Macro economics. Frenchs Forest, N.S.W.: Pearson Prentice Hall.
