The state in the economy: taxes, budgets and the welfare state

Think about your journey to school this morning: the road, the pavement, the street lighting, perhaps the bus – and at the end, a school building with teachers. You did not pay for any of that today. And in the market you know from “Supply and demand”, “Price formation and market equilibrium” and “Competition: monopoly and competitive markets”, most of it would never be provided.

Why not? Take street lighting: if a private company put up lamps and asked for money, who would pay? The light shines for everyone – nobody can be excluded from benefiting. So everyone waits for someone else to pay – and in the end, it stays dark, even though everyone wants the light. The market fails to provide such public services: without shared funding, roads, schools, the police, the fire service or flood protection would not exist, or would only be available to a few people.

That is why the state plays a part in the economy – you already know it as a participant in the circular flow of the economy (“Economic activity: households, businesses and the state” and “The extended circular flow of the economy: the state, banks and the rest of the world”). It has three main tasks:

1. Provide what the market does not deliver: roads, schools and security.
2. Set rules: Fair competition needs rules – for example, rules against collusion and the abuse of monopoly power (“Competition: monopoly and competitive markets”). And from “What is politics?”, you know that this is precisely what politics means: negotiating shared, binding rules.
3. Protect vulnerable people: People who are old, ill or disabled should not be left without support – more on this later when we look at the welfare state.

That leaves the crucial question: Where does the state get the money for all this?

The answer is on every till receipt and every payslip: taxes. A tax is a compulsory payment to the state with no direct service in return. ‘No direct service in return’ means you do not get a receipt for a particular service in exchange for your taxes – they go into a large shared pot that pays for roads, schools and everything else.

You should be able to distinguish between three basic types:

• Income tax: People who work and earn money pay part of their income to the state – once a year through their tax return. The more someone earns, the more they pay.
• Value added tax (VAT): It is included in the price of almost everything you buy – from a sandwich to a mobile phone. You pay it without noticing; the shop passes it on to the state. Because it is charged on consumption and is not collected directly from you, it is called an indirect tax – income tax, by contrast, is a direct tax.
• Corporation tax: Companies pay tax on their profit – what is left after all costs have been deducted. If a company makes no profit, it pays no tax on profits.

Two distinctions matter: fees are not taxes – you receive a direct service in return, such as a new passport or a parking space. And the AHV and IV deductions on your payslip (“Personal Finance I: Budgeting, Saving and Payslips”) are not taxes either: they are insurance contributions – we will look more closely at what they are for in a moment.

Politicians constantly debate how high taxes should be – here, we are only looking at the principle: without taxes, there can be no state that provides services, sets rules and offers protection.

A useful introduction is the explainer video ‘Steuern in Deutschland einfach erklärt’ by the channel explainity (3:21). It uses Germany as an example to show why the state collects taxes and what it uses them for – the same principle applies here, even if some names and figures differ. The video is not embedded here – you will find the link in the sources and materials at the bottom of this module.

Keep two questions in mind as you watch: (1) What does the state spend tax revenue on in the video – and which of these areas will you see again in this module's budget diagram? (2) The video distinguishes between direct and indirect taxes: which of these two types do income tax and VAT belong to?

In “Personal Finance I: Budgeting, Saving and Payslips”, you drew up your personal budget: comparing income and expenses so you would not be short of money at the end of the month. A government budget works on exactly the same principle – only with much larger figures and one important difference: the government's budget is decided through politics, because it determines how shared money is used.

You need three terms to understand any budget headline:

• Surplus: Revenue is higher than spending. The state can build up its cushion – its reserves – or reduce debt.
• Deficit: Spending is higher than revenue. The state has to fill the gap – usually by borrowing money.
• Government debt: If a state keeps borrowing money over many years, its debts grow. As with any loan (“Banks: their roles, loans and interest”), borrowed money has to be repaid with interest – and that interest leaves less room in future budgets.

A purely descriptive look at a neighbouring country: Liechtenstein has run budget surpluses for years, built up reserves and is virtually debt-free – something that is rare internationally. Many other countries, by contrast, carry high levels of debt.

Does this mean debt is always bad? It is not that simple: if a state borrows money to build a school, for example, the building also benefits the generations who will help pay for it later. Persistent deficits to cover day-to-day spending, on the other hand, leave less and less room to manoeuvre. How much debt makes sense is therefore a real political debate – with good arguments on both sides.

That leaves the state's third task: protecting vulnerable people. You already know the basic idea – it is the insurance principle from “Insurance: useful or unnecessary?”: many people regularly pay a small contribution into a shared pot, and anyone who suffers a loss receives help from it.

The welfare state applies this principle to the major risks in life that can affect anyone: old age (eventually you can no longer work), disability (an accident or illness makes work impossible), illness and unemployment. The state organises large compulsory insurance schemes to cover these risks – in Liechtenstein as in Switzerland, examples include AHV (old-age and survivors' insurance) and IV (disability insurance), whose deductions you know from the payslip in “Personal Finance I: Budgeting, Saving and Payslips”. You start paying contributions quite early, by the way: from 1 January of the year in which you turn 18, as soon as you are in paid work.

Two features distinguish the welfare state from private insurance:

• Everyone takes part – it is compulsory, not a choice. If everyone could decide for themselves, many healthy and young people would not pay in, and the scheme would no longer add up. In the end, the very people who needed protection most would be left without it.
• Today's contributions pay for today's pensions. AHV is essentially a pay-as-you-go scheme: the contributions of today's workers fund the pensions of today's pensioners – your money is not saved in a personal account. When you retire later, the people working then will pay for your pension.

And where does the budget fit in? The state also supports the welfare state with tax revenue – shown in the budget diagram under ‘Social welfare’. That brings this module full circle: taxes fill the coffers, the budget allocates the money, and the welfare state provides protection that the market alone does not.