The Role of Government in an Economy
Chapter 7
The Role of Government in an Economy
Part 1
Government Objectives & Policies
Government Objectives Most national governments have four main economic objectives for their national economies. These are: • To achieve a low and stable rate of inflation in the general level of prices • To achieve a high and stable level of employment, and therefore a low level of unemployment • To encourage economic growth in the national output and income • To encourage trade and secure a favorable balance of international transactions.
A government may also have additional objectives which aim to improve the economic welfare of people in the economy, including: • To reduce poverty and reduce inequalities in income and wealth • To reduce pollution and waste, and therefore encourage more sustainable economic growth. If government can achieve these aims it will creates a favorable economic climate for business and improve people's living standards. For example, when prices are rising rapidly, consumers may not be able to keep up and may have to cut their demand for goods and services. As a result firms may cut back production and their demand for labour. Unemployment and the loss of wage income may cause hardship for many families. In addition, exports from the economy will become less competitive because of high prices and the balance of trade may become unfavorable and cause the exchange rate to fall.
What is the Macroeconomy? Macroeconomics is the study of how a national economy works with a view to understanding the interaction between growth in national income, employment and price inflation. In contrast, macroeconomics examines the economic behavior of individual consumers, household and businesses and how individual markets work.
Total demand and supply in a simple macroeconomy . The total output of goods and services is paid for by the total expenditure of consumers, firms and government. Workers and owners of land and capital supply their resources to private firms and public sector organizations to produce those goods and services. In return they are paid income; their total income is therefore the national income.
Total expenditure or aggregate demand in a macroeconomy is therefore the sum of: • Consumers' expenditure on goods and services • Investment expenditure by firms on new plant and machinery • Government expenditure on goods and services • Spending from overseas on exports of goods and services from the economy
Total expenditure in an economy is therefore spent on the total or aggregate supply of all goods and services in the economy. This is the sum of all goods and services provided by private firms and public sector organizations in the economy. You will note that in a macroeconomy, government is both a produce, organizing land, labour and capital to provide goods and services such as healthcare, defence, roads and street lighting, and also a consumer of goods and services produced by private firms, including computers, paper and furniture for government offices.
Policy Instruments: Governments can use different policy instrument, including taxes and regulations, to help achieve their objectives through their impact on the actions of producers and consumers. 1. Fiscal Policy:- Fiscal Policy Involves varying total public sector expenditure and/or the overall level of taxation to influence the level of demand in an economy.
Expansionary Fiscal Policy:- Expansionary fiscal policy may be used during an economic recession to boost demand for goods and services through tax cuts or increased public sector spending. Firms may respond by hiring more labour and increasing output. However, increasing demand can force up market prices and involve spending more on imported goods and services from overseas. Increasing imports will have a negative impact on the balance of payments. Increasing government spending and/or cutting taxes to boost aggregate demand, output and employment in an economy is known as expansionary fiscal policy. An expansionary fiscal policy usually means running or increasing a budget deficit. The budget refers to the amount a government has spend each year relative to the amount of revenue it raises from taxation. If government spending exceeds tax revenues in any year the budget will be in deficit. An expansionary fiscal policy that increases public expenditure and/or lowers taxes will therefore increase the budget deficit. To pay for the deficit a government will have to borrow money. Fiscal policy may also be used to redistribute incomes between rich and poor people in an economy. For example, taxes may be raised on people with high incomes and the money used to fund benefits and public services for people on low incomes, or those unable to work because they are old, sick or unemployed. Contractionary Fiscal Policy: Contractionary fiscal policy may be used to reduce prices inflation. It involves reducing demand in an economy through tax increases or cuts in public sector spending. However, firms may respond to falling demand by cutting their output and reducing employment. Increased taxes may also reduce work incentives and therefore productivity.
Fiscal Policy instruments:-
|Fiscal policy instruments |Impacts on consumers |Impact on producers |
|Increase income taxes |Disposable income is reduces and |Market prices and profits fall as consumer |
| |consumer spending falls |demand falls, firms cut output and employment |
|Reduce income taxes |Disposable incomes and consumer |Market prices and profits to rise so firms |
| |spending rise |expend output and employ more labour |
|Increase taxes on profits |Consumers are not directly affected but|After-tax profit fall. Firms may increase their |
| |may pay higher prices if firms cut |prices and/or cut output in response |
| |output | |
|Cut taxes on profits |Consumers may benefit from reduced |After-tax profits rise. firms may expand their |
| |prices as output rises |output and employment |
|Increase indirect taxes on goods and |Consumers on low incomes may be hit |Consumer demand may contract and profits fall. |
|services |hardest by price rises because they |Firms may cut output and reduce their demand for|
| |spend all or most of their incomes |labour |
|Cut indirect taxes on goods and |Consumers may expand their demand for |Expanding demand will boost profits which are an|
|services |goods and services as after-tax prices |incentive to firms to raise their output and |
| |fall |demand more labour |
|Raise public expenditure |Public sector workers could be paid |Firms supplying goods and services to government|
| |more. Low income families may receive |will enjoy increased revenues and profits, and |
| |more benefits. More public services |may expand their output and employment |
| |could be provided for free | |
|Cut public expenditure |Public sector workers could suffer pay |A cut in public spending on capital projects, |
| |cuts or be made unemployed. Welfare |such as road and school building, will cause |
| |benefits may be reduced |cutbacks in the construction industry. Subsidies|
| | |paid to other firms may be cut |
Problems with Fiscal Policy: 1. Fiscal policy is cumbersome to use It is difficult for a government to know precisely when and by how much to expand public spending or cut taxes in a recession, or cut spending and raise taxes during a boom. Boosting aggregate demand by increasing public spending and/or cutting taxes may cause an economy to 'overheat'. That is demand may rise too much and too quickly. if the supply of goods and services to buy does not rise as quickly as demand there will be demand-pull inflation. On the other hand, a government may cut spending and raise taxes by too much following a period of high inflation and cause unemployment to rise.
2. Public spending crowds out private spending To finance an increase in public spending and/or cut in taxation a government may borrow the money from the private sector. The more money the private sector lends to a government the less it has available to spend itself. This is called crowding out. To encourage people, firms and the banking system to lend money to the government it may raise interest rates. However, higher interest rates may discourage other people and firms from borrowing money to spend on consumption and investment. Reducing investment in modern and more productive equipment can reduce economic growth.
3. Raising taxes on incomes and profits reduce work incentives, employment and economic growth If taxes are too high, people and firms may not work as hard. This reduces productivity, output and profits. As productivity falls firms' costs increase and they are less able to compete on product price and quality against more efficient firms overseas. As a result demand for their goods and services may fall and unemployment may rise.
4. Expansionary fiscal policy increases expectations of inflation As a result, people will push for higher wages to protect them from higher prices in the future. Rising wages increases production costs and reduces the demand for labour. This in turn causes cost-push inflation and rising unemployment. 2. Monetary Policy:- What is monetary policy? Monetary policy refers to actions taken by a government to try to control either the supply of money in the economy or the price of money. Interest rates are the price of borrowing money, or the reward for lending money.
Monetary policy involves varying the interest rate charged by the central bank for lending money to the banking system in an economy.
Why use monetary policy? 1. Growth in the money supply can cause inflation If the supply of money increases people will have more to spend on goods and services. If the output of goods and services available to buy does not rise as fast as the money supply, the increase in demand will cause demand-pull inflation.
2. Changes in interest rates cause changes in aggregate demand Interest rates are the price of money. If interest rates fall, people and firms will find it cheaper to borrow, while others will be less willing to save money and will spend it instead. that is, as interest rates fall more people will want to spend more money.
Consumer expenditure and firms' investment in new machines and buildings will rise. Increased aggregate demand helps to create jobs and reduces unemployment. Increased investment helps to create economic growth as firms will be able to produce more output in total.
However, it may be difficult to encourage consumers and firms to spend more by lowering interest rates if there is a deep economic recession when unemployment is rising and incomes falling. People may not want to get into debt in case they too lose their jobs, and firms may not want to invest in new productive capacity if there is falling demand.
3. Interest rates can be used to affect the exchange rate Interest rates can be raised to help increase the value of the national currency compared to other countries' currencies.
For example, if interest rates are higher in the UK than other countries, wealthy foreigners will peter to keep their saving in the UK and so earn high rates of interest on their money. However, to put their money in the UK, overseas residents must buy the UK currency, sterling, with their currencies. This increase in demand for sterling will cause its price, or value, to rise in terms of other currencies.
This can help to reduce imported inflation but will also increase the foreign currency prices of UK exports. As a result, consumer demand overseas for exports of goods and services from the UK may fall.
Monetary policy therefore involves influencing the supply of money and interest rates to control the level of inflation, unemployment, economic growth and the exchange rate.
Contracting Monetary Policy:- Contracting monetary policy may be used reduce price inflation by increasing the interest rate.
Because banks have to pay more to borrow from the central bank they will increase the interest rates they charge their own customers for loans to recover the increased cost. Banks will also raise interest rates to encourage people tp save more in bank deposit accounts so they can reduce their own borrowing from the central bank.
As interest rates rise, consumers may save more and borrow less to spend on goods and services. Firms may also reduce the amount of money the borrow to invest in new equipment. A reduction in capital investment by firms will reduce their ability to increase output in the future. Higher interest rates may therefore reduce economic growth and increase unemployment.
Expantionary Monetary Policy:- Expantionary monetary policy may be used during an economic recession to boost demand and employment by cutting interest rates. However, increasing demand can push up prices and may increase consumer spending on imported goods and services.
Monetary Policy Instruments:-
|Monetary policy |Impacts on consumers |Impacts on producers |
|instruments | | |
|Raise interest rates |Spending falls as consumers save more and borrow less |Firms cut output and employment in response |
| | |to falling demand |
| |The foreign exchange rate of the national currency may| |
| |rise. This will reduce the prices of impacts |Firms borrow less to invest in new capital |
| | |equipment, which may harm economic growth |
| |Consumers may buy more imports instead of | |
| |home-produced goods and services |Prices of exports sold overseas will rise if|
| | |the exchange rate increase. Exporting firms |
| | |may suffer falling demand and profits |
|Cut interest rates |Spending rises as saving becomes less attractive and |Firms increase output and demand more labour|
| |borrowing less expensive |as demand rises |
| | | |
| |The exchange rate may fall causing imported inflation |Firms may increase investment |
| | |Prices of exports sold overseas may fall if |
| | |the exchange rate rises. Demand for exports |
| | |may rise |
3. Supply Side Policy:- Supply side policies are aimed at increasing economic growth by raising the productive potential of an economy. An increase in the aggregate supply of goods and services will required more labour and other resources to be employed, help reduce pressure on prices, and-provide more goods and services available for export.
Supply-side policy instruments are aimed at reducing barriers to increased employment and higher productivity in domestic and international markets, and at creating the right incentives for firms and workers to increase their output. Policy instruments can include:
1. Tax incentives High rates of tax on incomes may reduce incentive to work hard or even seek paid employment. Similarly, high rates of tax on profits can reduce entrepreneurs' incentives to start new businesses, and invest in new products and production methods if additional profits are highly taxed. Cutting taxes on incomes and profits can therefore have a direct impact on the productive efforts of workers and firms. Tax relief may also be given to firms investing significantly in building new plants and equipment, and in new technologies.
2. Selective Subsidies Subsidies are grants of money provided by a government often to selected business organizations to simulate or protect productive activity. They can be used to help new businesses that might otherwise lack the finance they need to start up, and to reduce the cost of investing in research and development by existing firms in new production methods, machines, materials and products. Technological advance can increase the efficiency of production, lower costs and create new markets for new products.
3. Improving Education and Training In order for firms to be successful when competing in international markets it is essential they have access to a high trained and skilled workforce. Skill needs in industry are rising as the pace of change in competition and technology increases. A well-educated and trained workforce can raise labour productivity and will be better able to adapt to new production methods and technologies. A government can assist firms by helping them design and finance training programmes, funding universities and providing access for more people to attend colleges and higher education. 4. Labour Market Reforms Legislation can be used to curb the power of trade unions to call strikes and other disruptive industrial actions. Some powerful unions may also use their power to force up the wages of members, which may simply reduce the demand for labour and raise unemployment. They may also resist attempts to introduce new, more efficient production and working methods. Reforms have often brought protest from trade unions.
A number of governments have also introduced minimum wage laws to protects low-paid workers from being exploited by some employers, and also to encourage more people into work. In contrast, employers often argue that raising minimum wages will reduce the demand for labour.
High social security benefits may also discourage some people from seeking paid employment. In some countries, benefits paid to the unemployed have therefore been lowered, are time limited and/or linked to evidence a person is actively seeking work in order to encourage them back into paid employment and not to rely on benefit payments. This, however, may conflict with a government's aims to reduce hardship and poverty which may often be the result of long periods of unemployment.
5. Competition Policy Some firms may be large enough to exercise control over the supply of a particular good or service to a market. They may use this power to restrict competition, charge consumers high prices and reduce the quality of products. Competition policy concerns the removal of such barriers to help stimulate competition, expend output and lower prices.
6. Removing International Trade Barriers In much the same way as a monopoly, a national government may seek to protect its domestic firms and employment from competition from overseas by using barriers against free trade. Some goods and services may be produced much more efficiently and at a far lower cost by firms overseas. However, a government may tax imports or simply restrict their entry into a country to protect their national firms producing the same goods and services even if they do so at a higher cost. By removing these barriers to trade, firms in other countries can expend by selling to many more consumers lower-priced goods and services, and use their own resources more efficiently to produce others.
7. Deregulation Deregulation involves removing or simplifying old, unnecessary or over-complex rules and regulations on what businesses can or cannot do. For example, reforms might include removing restrictions on opening hours and Sunday shopping, reducing product information and labeling requirements, reducing the burden of health and safety inspections and much more. The removal of such restrictions should help cut business costs, increase competition and help firms increase output and lower prices.
8. Privatization Privatization involves the transfer or sale of public sector activities to the private sector. It is argued that private sector firms will run these activities more efficiently because they have a profit motive to do so, and therefore both consumers and the taxpayer will benefit. We will consider privatization in more detail in the next section because it has become an important supply-side policy in many developed and developing countries, especially as many former planned economies such as China and Russia transform their economies into market economies.
Privatization Public Ownership In many countries, entire industries are owned and controlled by the government. They may include public utilities such as electricity and water supplies, bus and train services, the health service, postal services, or even the national airline. Industries owned and controlled by government are called nationalized industries.
Why were industries nationalized? Governments have in the past taken into public sector ownership entire industries for the following reasons: • To control natural monopolies In some industries firms need to grow very large in order to take full advantage of the cost saving large-scale production can bring. However, this can result in one very large firm becoming the only supplier of a product to a market and, if unchecked, it could take advantage of this market power to charge high prices to consumers. To prevent this, natural monopoly providers of gas, water, electricity and railway supply networks are in some countries controlled by government.
• For safety Some industries, such as nuclear energy, are thought to be too dangerous to be controlled by private entrepreneurs.
• To protect employment Some firms were nationalized because they faced closure as private sector loss-making organizations. For example, in 1975 the UK government reduced British Leyland to protect the jobs of car services.
• To maintain a public service Nationalized industries can provide services even if they make a loss, such as postal deliveries and rail services in rural areas. Private firms seeking to make profit would not operate these services.
What is privatization? Privatization involves private sector firms taking over public sector activities in the following ways: • The sale of public sector assets This involves a government selling shares in the ownership of government-owned industries to private firms and individuals. For example, in 1986 the UK government sold British Gas for £ 6 billion. The gas network and all gas suppliers in the UK are now all private firms.
• Joint ventures with private with firms This can involve public sector organizations and private firms working together to supply a public service. For example, in the UK the London underground train service is still government-owned but services are operate in 'public-private partnership' with private train operators.
• Contracting out This involves a government awarding contracts to private firms to provide services it formerly provided. For example, this may include a private firm collecting household refuse, road sweeping, the management and upkeep of public parks, catering services in public schools and hospitals, parking enforcement and even running prisons.
• Removing barriers to competition By allowing private firms to compete with public sector organizations, for example, in the provision of postal services and bus services.
Arguments for & against privatization:- The main economic arguments used in favour of privatization concern efficiency and competition. Unlike the public sector, private firms aim to make profits and they do this by using resources more efficiently and reducing costs. Secondly, nationalized industries are large monopolies which mean there is no competition to supply consumers. Privatization opens up the market to new competition and consumers will benefit from firms competing with each other to supply them with new and better quality products at lower prices. However, others argue that because privatized firms want to make profits the prices they charge will be higher and their quality of service lower. They will also cut their costs by laying off workers, which conflicts with aims to reduce unemployment.
|Those in support privatization argue: |Those against privatization argue: |
|If these industries are forced to compete for profit they |Many privatized industries still dominate the markets they supply|
|will become more competitive, import their product quality, |and have been able to raise their prices and cut services. For |
|and lower prices |example, private rail and water companies are local monopoly |
|Whereas there used to be only one nationalized supplier, |suppliers. |
|consumers will be able to chose from a wide variety of goods|Private sector organizations will not protect public services. |
|and services from different producers. For example, there |For example, many fear private sector firms providing railway |
|are now many rival suppliers of communication services to |services will cut services and raise fares in the long run. |
|British Telecom. |Complaints about rail services are rising all the time. |
|The sale of shares in these industries raises revenue for a |Most of the shares in privatized organizations have been bought |
|government which can be used to lower taxes. |by large financial organizations such as banks and insurance |
|Private individuals can own shares in these organizations |companies who are interested only in making big profits. |
|and vote on how they should be run. | |
Policy Conflicts: The various aims of governments might be difficult to achieve all at once. In some cases policy aims might conflict. For example • , boosting aggregate demand during an economic recession might help raise output and employment in an economy but may also increase demand for imports and make the trade balance less favorable. Increasing demand may also increase pressure on prices to rise while higher levels of output may create more pollution and waste.
• Similarly, raising taxes or interest rates, and cutting public expenditure to reduce price inflation by lowering total demand, may result in lower output and more unemployment. The impact of higher taxes and lower government spending may also fall heavily on people on lower incomes in an economy, especially if social security benefits from government are cut back.
• In the same way, policies that directly aim to redistribute income may also conflict between different groups in society. for example, taxes on high-income households may be raised and the tax revenues used to pay for increased benefits to very low-income families. Alternatively, taxes on business profits could be raised but this may conflict with an aim of encouraging more people to start their own business and the aim of attracting overseas firms to locate in the economy.
• However, not all economists accept there will always be trade-offs between government objectives. That is, they see no reason why low taxes, low rates of unemployment and high economic growth can only be achieved at the expense of achieving low price inflation, a favorable international trade balance and reduced poverty in society. • Government policy, the argue, can and should be designed to achieve all these aims at the same time. • Their argument runs as follows. If price inflation can be reduced to a low stable rate then low unemployment, faster economic growth and a favorable balance of payments will follow. Rising national income and employment also means people will become better off thereby helping to reduce poverty. Rising incomes will also mean tax revenues collected by the government from wages and profits will be increasing and can be used to schools, and other public expenditures that benefit the economy.
• Reducing inflation will help make domestically produced goods and services more competitive. Demand for them will tend to rise at home and overseas. This will help to improve the balance of trade. Firms will respond by increasing output and their demand for labour. Firms will also want to invest in new machinery and production facilities as the economy expends. This is because they will be more confident that their investments will make a good return, and any money they may have borrowed to fund them can be repaid from increased revenues. Further, if people expect price inflation to remain low and stable then they will not push for such high wage rises in future that would otherwise increase production costs and reduce profits.
Part 2
Public Sector Finance
Section 1
Public Expenditure
Current and capital expenditures Public sector spending, or public expenditure, can be divided up into a number of different categories.
One method is to distinguish between current expenditure and capital expenditure. Current expenditure covers public sector workers' wages and salaries, social security benefits paid to the unemployed and those on low incomes, and spending on consumable goods such as medicines for public healthcare services, and paper, pens and electric power suppliers for government offices. That is, current expenditure tends to cover the day-to-day running expenses of the public sector. In contrast, capital expenditures involves government investments in new roads, school buildings, sea defence and military defence equipment.
Transfer payments Another way is to distinguish between public expenditure to purchase goods and services that contribute to the productivity of the public sector and the economy, and transfer payments to other people.
A large amount of public expenditure in many countries is not spent by government but is given to people in the form of cash benefits such as pensions, unemployment insurance and other social security payments the people who receive these benefits can use the money to buy the goods and services the need and want. They are called transfer payments because a government is simply transferring money collected through taxes from people in work to those who are not able to be productive.
Reasons for Public Spending
There are a number of reasons why governments spend money.
1. To provide public goods Some goods, known as public goods, cannot be provided profitably by private firms. For example, private firms would find it difficult to collect revenue from people in payments for street lighting, a policy force or national defence system. This is because once they have been provided it is difficult to exclude people from benefiting from these public goods simply because they haven't paid directly for the amount they have used. These public goods are nevertheless of great value to people and an economy, and so the public sector provides them.
2. To provide merit goods Governments also spend money on the provision of merit goods. These are gods or services a government thinks everyone should benefit from, whether they can afford to pay for them or not. Such merit goods can include state schools and a public healthcare service. An economy will benefit from an educated and healthy workforce. If people did have to pay for them directly then they might not consume as much as they should.
3. To reduce inequalities and help vulnerable people People on very low incomes, including elderly and disabled people, the unemployed and homeless, single-parent families and the long-term sick, often need help with living expenses, or finding and affording accommodation. The public sector can provide a safety net for poor and vulnerable people through the provision of social security benefits, low-cost social housing, free healthcare, free bus passes and other welfare benefits.
4. To invest in the economic infrastructure A modern economy needs a modern infrastructure such as road and railways, public buildings, parks, waterways, and much more. The investment required to provide these can cost many billions of dollars, but they benefit both individuals and firms and help economic growth.
5. To support agriculture and industry Grants and subsidies are often paid to farmers and owners of firms to help them increase production and employment, invest in new plant and machinery, and pay for new research and development. This can help to boost output and economic growth in an economy . however, other countries might argue that such subsidies are unfair and that they protect inefficient domestic firms from products imported from more efficient producers overseas.
6. To control the macroeconomy The public sector in many countries is a very big spender, raising large amounts of money through taxation to pay for it all. A change in the amount of public expenditure or taxation can therefore have a big effect on the total level of demand in an economy and therefore on the level of output, employment, prices and national income. A government can therefore use its spending and taxation policies to help it achieve its macroeconomic objectives. This is called fiscal policy.
7. To give overseas aid Some public spending may be paid overseas to help countries in need because they have suffered wars or natural disasters such as droughts, earthquakes and tsunamis. Overseas aid can help provide food and medicine and pay for new roads and schools.
Section 2
Financing Public Expenditure
Sources of revenue The public sector in an economy raises revenue to pay for its public expenditure in a number of ways: • Borrowing money from the general public • Interest payments on loans of money made to individuals and private sector firms, and overseas governments. • Rent from publicly owned buildings and land, and any admission charges, for example, from museums and national monuments. • Revenues from government agencies and public corporations that sell goods or services . • Proceeds from the sale (or privatization) of government-owned industries and other publicly owned assets, such as land public buildings. • Taxes on incomes, wealth and expenditures.
Tax burden By far the most revenue is raised from taxation. In some countries governments tax as much as half of all their national income or GDP. For example, in 2005 Sweden taxed over 51 per cent of its national income. In contrast, the total tax from GDP in Mexico in the same year was just 19 per cent.
The proportion of tax taken from national income in a country measures the total tax burden in that national economy. Individuals and firms also have personal or corporate tax burdens measured by the amount of tax they each have to pay as a proportion of their incomes. Tax burdens can vary greatly between different individuals and firms depending on the design of the tax system in a country.
Tax evasion and avoidance Taxes are compulsory payments backed by laws. Non-payment of tax or tax evasion is a punishable offence.
Some taxes can, however, be divided legally. For example, taxes on cars or petroleum can be avoided by not owing or dividing a car. Wealthy people, pop stars, and so on, can also avoid tax in one country by moving their wealth to a country with low tax rates.
What are taxes for? Many taxes were first introduced many hundreds of years ago by kings or governments to pay for wars. For example, the US federal government in 1862 introduced an income tax for the first time to pay for the Civil War. It was 3 per cent of incomes above $ 600, rising to 5% for incomes above $ 10000. Today, the reasons for taxes are far more complex: 1. Taxes are the main way of raising money to finance public sector spending.
2. Taxes can be used to discourage consumption, for example by imposing tariffs on imported goods to protect domestic firms from, overseas competition, or by raising the price of harmful products such as alcohol and tobacco.
3. Taxes can be used to reduce incomes and wealth inequalities. Revenues from high taxes on people with high incomes or significant wealth can be used to fund benefits and services for people on low incomes.
4. Taxes can be used to help protect the environment. They are used to encourage people and firms to change their behavior to avoid the tax. For example, raising taxes on petroleum makes car use more expensive and so may help to cut car use and harmful exhaust emissions. Taxes on landfill can encourage firms to recycle more of their waste by making dumping waste in landfill sites more expensive.
5. Taxes can be varied by a government to help achieve its macroeconomic objectives. For example, a Contractionary fiscal policy involves raising taxes to reduce total demand in an economy and demand-pull inflation. Cutting taxes during an economic recession can help boost demand, and therefore output and employment .
What is a good tax? A good tax must possess the following qualities: 1. Fairness taxes must be fair. If most people think that a tax is unfair, they are unlikely to pay it. For example a tax based on height would be very unfair.
2. Must not discourage people from working a tax should not discourage people from working. If taxes are too high, then people may decide that it is not worth trying to earn more.
3. Cheap to collect there is little point introducing a tax if it costs more money to collect than it earns in revenue for a government. For example, a tax costing $10 million to collect but only bringing in $3 million in revenue would be pointless and a waste of public money.
4. Convenience imagine how inconvenient it would be if tax-payers were expected to work out their own tax bills and then had to keep enough money back to pay them once every two years. People who are not very good at managing their own money would find themselves in trouble when called to pay their taxes. For this reason it is important that taxes are easy to pay and easy to understand. A government will also need to raise tax revenues regularly to pay for its expenditures.
Section 3
Tax Systems
THE IMPACT OF A TAX ON INCOME CAN BE PROGRESSIVE, REGRESSIVE OR PROPORTIONAL
Taxes are paid either directly or indirectly from incomes. The effective tax rate is the production of income paid in tax.
|Annual incomes $ |Progressive % tax rate |Regressive % tax rate |Proportional % tax rate |
|$ 5,000 |0% |30% |20% |
|$20,000 |10% |25% |20% |
|$50,000 |20% |20% |20% |
|$100,000 |40% |15% |20% |
If a tax is a progressive tax the effective tax rate rises with income. A person with a high income will pay proportionally more of their income in tax than a person on a low income.
If a tax is a regressive tax the effective rate of tax falls with income. The tax will impose a higher relative tax burden on people with low incomes.
If a tax is a proportional tax everyone, rich or poor, pays the same effective tax rate.
The total tax burden of a tax system is the proportion of the national income taken in tax. For example, in 2007 the tax burden in Denmark was just under 50% of its national income.
Diagram
Direct & Indirect Tax
1. Direct tax: Direct taxes are taken directly from a person or firm and their incomes or wealth. They include income taxes, corporation taxes on company profits, capital gains taxes on property and other valuable assets, and inheritance taxes.
Types of direct tax 1. Income tax Income tax is a tax levied on an individual's earnings. Most countries allow people to earn a certain amount of income tax free, usually known as a personal allowance. For example, in the UK in 2007/8 a single person could earn up to £5225 each year, or up to £ 7550 if aged between 65 and 74, or £7690 if over 75, before becoming liable to pay income tax.
Exactly how much tax a person pays in income tax will depend on how much they earn and I some cases their personal circumstances, for example, whether they are single, married, with or without children, old and retired. Income tax in most countries is a progressive tax. That is, higher marginal tax rates are usually applied to progressively higher parts of a person's income. They may also differ for different groups of people. Allowances and marginal rates of tax tend to be more generous for old people and for people with children so that they pay less tax overall than a person who earns the same amount but is single and has no children.
2. Corporation tax This is a tax on company profits, and may also be called a profits tax. Sometimes a government may also impose a one-off windfall tax on the profits of a company either thought to be a monopoly and making very significant profits, or benefiting from world events that boosted their profits. For example, the UK has from time to time imposed a windfall tax on the often huge profits of oil companies that have benefited simply as a result of a rise in world oil prices over which they have no direct control.
To encourage new business to start up, corporate tax rates on relatively small profits of smaller companies are less, even zero, in some countries, than tax rates on larger companies. Corporation tax rates often rise with the scale of profits.
3. Capital gains tax It is possible to make profits from the sale of shares, famous paintings, jewellery and other valuable assets that have increased in value over time. Profits made in this way are called capital gains and may be taxed by a government. Sometimes allowances are made, such as for the length of time someone has held an asset so that the longer someone has held it the lower the tax they pay. For example, in Canada, only 50% of a capital gain is classed as taxable income.
4. Wealth taxes These might include taxes on the value of residential and commercial property. Wealth taxes can also include inheritance taxes on the transfer of wealth from one person to another upon their death. When an individual dies and leaves their house, savings and/or other valuable possessions to someone else, inheritance tax might be payable on the total value inherited. For example, in the UK in 2007/8 inherited wealth up to a value of £300000 was tax free, but any wealth inherited over and above this sum was taxed at 40 per cent.
Advantages of direct taxes 1. Revenue The chief advantages of direct taxes, like income tax and corporation tax, are that they have a high yield of revenue compared with their cost of collection. The total amount of money collected can be estimated with reasonable accuracy in advance, which is of great help to a government when planning how much it can spend.
2. Redistribution The progressive nature of many direct taxes means that wealthier members of society are taxed more heavily than poorer groups to help reduce income inequalities.
3. Ability to pay Direct taxes are constructed so that they take account of firms' and people's ability to pay tax. Family commitments, dependants, etc., are taken into consideration and a system of tax allowances can be used to reflect these responsibilities.
Disadvantages of direct taxes 1. Work incentives A high rate of tax on income may cause people to work less hard because they know that the more they earn the greater the proportion of their income they will have to pay in tax.
2. Enterprise Corporation tax on a firm's profits reduces the incentive for entrepreneurs to start up firms to earn a profit. It also means that a firm will have less profits to re-invest in their business.
3. Tax evasion High tax rates increase the advantages of evading taxes and finding loopholes in tax laws. As a result, revenues are lower and the trouble of trying to catch up with tax evaders increases a government's costs.
Summary:
|Advantages of direct taxes |Disadvantages of direct taxes |
|They are a major source of tax revenue |Income taxes can reduce work incentives |
| | |
|Many are progressive and help to reduce inequalities in |Taxes on profits reduce profit available to entrepreneurs to |
|incomes after tax |re-invest in their businesses |
| | |
|They take account of people's ability to pay. |High tax rates can cause tax evasion. |
Types of indirect tax:- Indirect taxes include tariffs and excise duties added to the prices of goods and services. They are normally imposed on producers who will then pass on as much of the tax as they can to consumers through higher prices. 1. Value added tax An ad valorem tax or value added tax (VAT) is a tax on goods and services levied as a percentage of their selling price. It is normally a fixed rate but some goods and services may be taxed at a lower rate, or even zero-rated if their consumption is encouraged or because they are things which people on low incomes often buy. For example, many foods, medicines, books and public transport fares are zero rated, or example from VAT, in the UK.
VAT is a regressive tax because it is a fixed percentage rate and because people on low incomes tend to spend all or most of their incomes on goods and services. For example, if an unemployed man receiving $50 per week in benefits buys pair of jeans for $20 and pays 20 per cent or $4 in VAT on top, then this tax will represent 8 per cent of his income. If a lawyer earning $500 a week buys the same pair of jeans, the VAT she pays will take only 0.8 per cent or her income.
2. Tariffs A tariff also called a customs duty or an impost, is a tax levied on the price of goods imported from overseas as they enter a country. Tariffs are used to discourage people from buying imports in an attempt to protect domestic industries. High tariffs can encourage illegal smuggling and so governments that impose tariffs may use part of the revenue they raise to pay for police and navy border patrols.
3. Excise duties Excise duties are taxes placed on certain goods based on the quantity, not the value, of product purchased. Examples include duties o fuel; vehicles, tobacco and alcohol. They are used not only to raise revenue but also to discourage the consumption of certain products such as cigarettes and alcohol that can be damaging to health.
Excise duties are also increasingly being used to discourage activities that harm the environment and to encourage the consumption of those that do not. These are becoming known as 'green taxes'. Examples of such taxes in the UK include fuel duties and vehicle excise duties which are in part designed to stop people buying and driving big cars which produce more emissions than smaller vehicles or to (a fixed charge per person, and in this case also per flight) designed to raise the price of air travel and so discourage flying which also causes harmful air pollution.
4. User taxes or charges These are just another type of excise duty linked to specific goods or activities. For example, they include toll charges to use major bridges or roads and pay for their upkeep. London and other major cities around the world have also introduced congestion charges that charge vehicle drivers a fixed amount to enter these cities. Some of the revenue raised from these charges is used to pay for better public transport.
A tax on a specific good or activity used to raise revenue for a specific purpose, such as paying for road or public transport improvements rather than simply adding to total tax revenue, is called a hypothecated tax.
Advantages of indirect taxes
1. Cost of collection
2. Wider tax base
3. Selective aims
4. Tax alternations
The Role of Government in an Economy
Part 1
Government Objectives & Policies
Government Objectives Most national governments have four main economic objectives for their national economies. These are: • To achieve a low and stable rate of inflation in the general level of prices • To achieve a high and stable level of employment, and therefore a low level of unemployment • To encourage economic growth in the national output and income • To encourage trade and secure a favorable balance of international transactions.
A government may also have additional objectives which aim to improve the economic welfare of people in the economy, including: • To reduce poverty and reduce inequalities in income and wealth • To reduce pollution and waste, and therefore encourage more sustainable economic growth. If government can achieve these aims it will creates a favorable economic climate for business and improve people's living standards. For example, when prices are rising rapidly, consumers may not be able to keep up and may have to cut their demand for goods and services. As a result firms may cut back production and their demand for labour. Unemployment and the loss of wage income may cause hardship for many families. In addition, exports from the economy will become less competitive because of high prices and the balance of trade may become unfavorable and cause the exchange rate to fall.
What is the Macroeconomy? Macroeconomics is the study of how a national economy works with a view to understanding the interaction between growth in national income, employment and price inflation. In contrast, macroeconomics examines the economic behavior of individual consumers, household and businesses and how individual markets work.
Total demand and supply in a simple macroeconomy . The total output of goods and services is paid for by the total expenditure of consumers, firms and government. Workers and owners of land and capital supply their resources to private firms and public sector organizations to produce those goods and services. In return they are paid income; their total income is therefore the national income.
Total expenditure or aggregate demand in a macroeconomy is therefore the sum of: • Consumers' expenditure on goods and services • Investment expenditure by firms on new plant and machinery • Government expenditure on goods and services • Spending from overseas on exports of goods and services from the economy
Total expenditure in an economy is therefore spent on the total or aggregate supply of all goods and services in the economy. This is the sum of all goods and services provided by private firms and public sector organizations in the economy. You will note that in a macroeconomy, government is both a produce, organizing land, labour and capital to provide goods and services such as healthcare, defence, roads and street lighting, and also a consumer of goods and services produced by private firms, including computers, paper and furniture for government offices.
Policy Instruments: Governments can use different policy instrument, including taxes and regulations, to help achieve their objectives through their impact on the actions of producers and consumers. 1. Fiscal Policy:- Fiscal Policy Involves varying total public sector expenditure and/or the overall level of taxation to influence the level of demand in an economy.
Expansionary Fiscal Policy:- Expansionary fiscal policy may be used during an economic recession to boost demand for goods and services through tax cuts or increased public sector spending. Firms may respond by hiring more labour and increasing output. However, increasing demand can force up market prices and involve spending more on imported goods and services from overseas. Increasing imports will have a negative impact on the balance of payments. Increasing government spending and/or cutting taxes to boost aggregate demand, output and employment in an economy is known as expansionary fiscal policy. An expansionary fiscal policy usually means running or increasing a budget deficit. The budget refers to the amount a government has spend each year relative to the amount of revenue it raises from taxation. If government spending exceeds tax revenues in any year the budget will be in deficit. An expansionary fiscal policy that increases public expenditure and/or lowers taxes will therefore increase the budget deficit. To pay for the deficit a government will have to borrow money. Fiscal policy may also be used to redistribute incomes between rich and poor people in an economy. For example, taxes may be raised on people with high incomes and the money used to fund benefits and public services for people on low incomes, or those unable to work because they are old, sick or unemployed. Contractionary Fiscal Policy: Contractionary fiscal policy may be used to reduce prices inflation. It involves reducing demand in an economy through tax increases or cuts in public sector spending. However, firms may respond to falling demand by cutting their output and reducing employment. Increased taxes may also reduce work incentives and therefore productivity.
Fiscal Policy instruments:-
|Fiscal policy instruments |Impacts on consumers |Impact on producers |
|Increase income taxes |Disposable income is reduces and |Market prices and profits fall as consumer |
| |consumer spending falls |demand falls, firms cut output and employment |
|Reduce income taxes |Disposable incomes and consumer |Market prices and profits to rise so firms |
| |spending rise |expend output and employ more labour |
|Increase taxes on profits |Consumers are not directly affected but|After-tax profit fall. Firms may increase their |
| |may pay higher prices if firms cut |prices and/or cut output in response |
| |output | |
|Cut taxes on profits |Consumers may benefit from reduced |After-tax profits rise. firms may expand their |
| |prices as output rises |output and employment |
|Increase indirect taxes on goods and |Consumers on low incomes may be hit |Consumer demand may contract and profits fall. |
|services |hardest by price rises because they |Firms may cut output and reduce their demand for|
| |spend all or most of their incomes |labour |
|Cut indirect taxes on goods and |Consumers may expand their demand for |Expanding demand will boost profits which are an|
|services |goods and services as after-tax prices |incentive to firms to raise their output and |
| |fall |demand more labour |
|Raise public expenditure |Public sector workers could be paid |Firms supplying goods and services to government|
| |more. Low income families may receive |will enjoy increased revenues and profits, and |
| |more benefits. More public services |may expand their output and employment |
| |could be provided for free | |
|Cut public expenditure |Public sector workers could suffer pay |A cut in public spending on capital projects, |
| |cuts or be made unemployed. Welfare |such as road and school building, will cause |
| |benefits may be reduced |cutbacks in the construction industry. Subsidies|
| | |paid to other firms may be cut |
Problems with Fiscal Policy: 1. Fiscal policy is cumbersome to use It is difficult for a government to know precisely when and by how much to expand public spending or cut taxes in a recession, or cut spending and raise taxes during a boom. Boosting aggregate demand by increasing public spending and/or cutting taxes may cause an economy to 'overheat'. That is demand may rise too much and too quickly. if the supply of goods and services to buy does not rise as quickly as demand there will be demand-pull inflation. On the other hand, a government may cut spending and raise taxes by too much following a period of high inflation and cause unemployment to rise.
2. Public spending crowds out private spending To finance an increase in public spending and/or cut in taxation a government may borrow the money from the private sector. The more money the private sector lends to a government the less it has available to spend itself. This is called crowding out. To encourage people, firms and the banking system to lend money to the government it may raise interest rates. However, higher interest rates may discourage other people and firms from borrowing money to spend on consumption and investment. Reducing investment in modern and more productive equipment can reduce economic growth.
3. Raising taxes on incomes and profits reduce work incentives, employment and economic growth If taxes are too high, people and firms may not work as hard. This reduces productivity, output and profits. As productivity falls firms' costs increase and they are less able to compete on product price and quality against more efficient firms overseas. As a result demand for their goods and services may fall and unemployment may rise.
4. Expansionary fiscal policy increases expectations of inflation As a result, people will push for higher wages to protect them from higher prices in the future. Rising wages increases production costs and reduces the demand for labour. This in turn causes cost-push inflation and rising unemployment. 2. Monetary Policy:- What is monetary policy? Monetary policy refers to actions taken by a government to try to control either the supply of money in the economy or the price of money. Interest rates are the price of borrowing money, or the reward for lending money.
Monetary policy involves varying the interest rate charged by the central bank for lending money to the banking system in an economy.
Why use monetary policy? 1. Growth in the money supply can cause inflation If the supply of money increases people will have more to spend on goods and services. If the output of goods and services available to buy does not rise as fast as the money supply, the increase in demand will cause demand-pull inflation.
2. Changes in interest rates cause changes in aggregate demand Interest rates are the price of money. If interest rates fall, people and firms will find it cheaper to borrow, while others will be less willing to save money and will spend it instead. that is, as interest rates fall more people will want to spend more money.
Consumer expenditure and firms' investment in new machines and buildings will rise. Increased aggregate demand helps to create jobs and reduces unemployment. Increased investment helps to create economic growth as firms will be able to produce more output in total.
However, it may be difficult to encourage consumers and firms to spend more by lowering interest rates if there is a deep economic recession when unemployment is rising and incomes falling. People may not want to get into debt in case they too lose their jobs, and firms may not want to invest in new productive capacity if there is falling demand.
3. Interest rates can be used to affect the exchange rate Interest rates can be raised to help increase the value of the national currency compared to other countries' currencies.
For example, if interest rates are higher in the UK than other countries, wealthy foreigners will peter to keep their saving in the UK and so earn high rates of interest on their money. However, to put their money in the UK, overseas residents must buy the UK currency, sterling, with their currencies. This increase in demand for sterling will cause its price, or value, to rise in terms of other currencies.
This can help to reduce imported inflation but will also increase the foreign currency prices of UK exports. As a result, consumer demand overseas for exports of goods and services from the UK may fall.
Monetary policy therefore involves influencing the supply of money and interest rates to control the level of inflation, unemployment, economic growth and the exchange rate.
Contracting Monetary Policy:- Contracting monetary policy may be used reduce price inflation by increasing the interest rate.
Because banks have to pay more to borrow from the central bank they will increase the interest rates they charge their own customers for loans to recover the increased cost. Banks will also raise interest rates to encourage people tp save more in bank deposit accounts so they can reduce their own borrowing from the central bank.
As interest rates rise, consumers may save more and borrow less to spend on goods and services. Firms may also reduce the amount of money the borrow to invest in new equipment. A reduction in capital investment by firms will reduce their ability to increase output in the future. Higher interest rates may therefore reduce economic growth and increase unemployment.
Expantionary Monetary Policy:- Expantionary monetary policy may be used during an economic recession to boost demand and employment by cutting interest rates. However, increasing demand can push up prices and may increase consumer spending on imported goods and services.
Monetary Policy Instruments:-
|Monetary policy |Impacts on consumers |Impacts on producers |
|instruments | | |
|Raise interest rates |Spending falls as consumers save more and borrow less |Firms cut output and employment in response |
| | |to falling demand |
| |The foreign exchange rate of the national currency may| |
| |rise. This will reduce the prices of impacts |Firms borrow less to invest in new capital |
| | |equipment, which may harm economic growth |
| |Consumers may buy more imports instead of | |
| |home-produced goods and services |Prices of exports sold overseas will rise if|
| | |the exchange rate increase. Exporting firms |
| | |may suffer falling demand and profits |
|Cut interest rates |Spending rises as saving becomes less attractive and |Firms increase output and demand more labour|
| |borrowing less expensive |as demand rises |
| | | |
| |The exchange rate may fall causing imported inflation |Firms may increase investment |
| | |Prices of exports sold overseas may fall if |
| | |the exchange rate rises. Demand for exports |
| | |may rise |
3. Supply Side Policy:- Supply side policies are aimed at increasing economic growth by raising the productive potential of an economy. An increase in the aggregate supply of goods and services will required more labour and other resources to be employed, help reduce pressure on prices, and-provide more goods and services available for export.
Supply-side policy instruments are aimed at reducing barriers to increased employment and higher productivity in domestic and international markets, and at creating the right incentives for firms and workers to increase their output. Policy instruments can include:
1. Tax incentives High rates of tax on incomes may reduce incentive to work hard or even seek paid employment. Similarly, high rates of tax on profits can reduce entrepreneurs' incentives to start new businesses, and invest in new products and production methods if additional profits are highly taxed. Cutting taxes on incomes and profits can therefore have a direct impact on the productive efforts of workers and firms. Tax relief may also be given to firms investing significantly in building new plants and equipment, and in new technologies.
2. Selective Subsidies Subsidies are grants of money provided by a government often to selected business organizations to simulate or protect productive activity. They can be used to help new businesses that might otherwise lack the finance they need to start up, and to reduce the cost of investing in research and development by existing firms in new production methods, machines, materials and products. Technological advance can increase the efficiency of production, lower costs and create new markets for new products.
3. Improving Education and Training In order for firms to be successful when competing in international markets it is essential they have access to a high trained and skilled workforce. Skill needs in industry are rising as the pace of change in competition and technology increases. A well-educated and trained workforce can raise labour productivity and will be better able to adapt to new production methods and technologies. A government can assist firms by helping them design and finance training programmes, funding universities and providing access for more people to attend colleges and higher education. 4. Labour Market Reforms Legislation can be used to curb the power of trade unions to call strikes and other disruptive industrial actions. Some powerful unions may also use their power to force up the wages of members, which may simply reduce the demand for labour and raise unemployment. They may also resist attempts to introduce new, more efficient production and working methods. Reforms have often brought protest from trade unions.
A number of governments have also introduced minimum wage laws to protects low-paid workers from being exploited by some employers, and also to encourage more people into work. In contrast, employers often argue that raising minimum wages will reduce the demand for labour.
High social security benefits may also discourage some people from seeking paid employment. In some countries, benefits paid to the unemployed have therefore been lowered, are time limited and/or linked to evidence a person is actively seeking work in order to encourage them back into paid employment and not to rely on benefit payments. This, however, may conflict with a government's aims to reduce hardship and poverty which may often be the result of long periods of unemployment.
5. Competition Policy Some firms may be large enough to exercise control over the supply of a particular good or service to a market. They may use this power to restrict competition, charge consumers high prices and reduce the quality of products. Competition policy concerns the removal of such barriers to help stimulate competition, expend output and lower prices.
6. Removing International Trade Barriers In much the same way as a monopoly, a national government may seek to protect its domestic firms and employment from competition from overseas by using barriers against free trade. Some goods and services may be produced much more efficiently and at a far lower cost by firms overseas. However, a government may tax imports or simply restrict their entry into a country to protect their national firms producing the same goods and services even if they do so at a higher cost. By removing these barriers to trade, firms in other countries can expend by selling to many more consumers lower-priced goods and services, and use their own resources more efficiently to produce others.
7. Deregulation Deregulation involves removing or simplifying old, unnecessary or over-complex rules and regulations on what businesses can or cannot do. For example, reforms might include removing restrictions on opening hours and Sunday shopping, reducing product information and labeling requirements, reducing the burden of health and safety inspections and much more. The removal of such restrictions should help cut business costs, increase competition and help firms increase output and lower prices.
8. Privatization Privatization involves the transfer or sale of public sector activities to the private sector. It is argued that private sector firms will run these activities more efficiently because they have a profit motive to do so, and therefore both consumers and the taxpayer will benefit. We will consider privatization in more detail in the next section because it has become an important supply-side policy in many developed and developing countries, especially as many former planned economies such as China and Russia transform their economies into market economies.
Privatization Public Ownership In many countries, entire industries are owned and controlled by the government. They may include public utilities such as electricity and water supplies, bus and train services, the health service, postal services, or even the national airline. Industries owned and controlled by government are called nationalized industries.
Why were industries nationalized? Governments have in the past taken into public sector ownership entire industries for the following reasons: • To control natural monopolies In some industries firms need to grow very large in order to take full advantage of the cost saving large-scale production can bring. However, this can result in one very large firm becoming the only supplier of a product to a market and, if unchecked, it could take advantage of this market power to charge high prices to consumers. To prevent this, natural monopoly providers of gas, water, electricity and railway supply networks are in some countries controlled by government.
• For safety Some industries, such as nuclear energy, are thought to be too dangerous to be controlled by private entrepreneurs.
• To protect employment Some firms were nationalized because they faced closure as private sector loss-making organizations. For example, in 1975 the UK government reduced British Leyland to protect the jobs of car services.
• To maintain a public service Nationalized industries can provide services even if they make a loss, such as postal deliveries and rail services in rural areas. Private firms seeking to make profit would not operate these services.
What is privatization? Privatization involves private sector firms taking over public sector activities in the following ways: • The sale of public sector assets This involves a government selling shares in the ownership of government-owned industries to private firms and individuals. For example, in 1986 the UK government sold British Gas for £ 6 billion. The gas network and all gas suppliers in the UK are now all private firms.
• Joint ventures with private with firms This can involve public sector organizations and private firms working together to supply a public service. For example, in the UK the London underground train service is still government-owned but services are operate in 'public-private partnership' with private train operators.
• Contracting out This involves a government awarding contracts to private firms to provide services it formerly provided. For example, this may include a private firm collecting household refuse, road sweeping, the management and upkeep of public parks, catering services in public schools and hospitals, parking enforcement and even running prisons.
• Removing barriers to competition By allowing private firms to compete with public sector organizations, for example, in the provision of postal services and bus services.
Arguments for & against privatization:- The main economic arguments used in favour of privatization concern efficiency and competition. Unlike the public sector, private firms aim to make profits and they do this by using resources more efficiently and reducing costs. Secondly, nationalized industries are large monopolies which mean there is no competition to supply consumers. Privatization opens up the market to new competition and consumers will benefit from firms competing with each other to supply them with new and better quality products at lower prices. However, others argue that because privatized firms want to make profits the prices they charge will be higher and their quality of service lower. They will also cut their costs by laying off workers, which conflicts with aims to reduce unemployment.
|Those in support privatization argue: |Those against privatization argue: |
|If these industries are forced to compete for profit they |Many privatized industries still dominate the markets they supply|
|will become more competitive, import their product quality, |and have been able to raise their prices and cut services. For |
|and lower prices |example, private rail and water companies are local monopoly |
|Whereas there used to be only one nationalized supplier, |suppliers. |
|consumers will be able to chose from a wide variety of goods|Private sector organizations will not protect public services. |
|and services from different producers. For example, there |For example, many fear private sector firms providing railway |
|are now many rival suppliers of communication services to |services will cut services and raise fares in the long run. |
|British Telecom. |Complaints about rail services are rising all the time. |
|The sale of shares in these industries raises revenue for a |Most of the shares in privatized organizations have been bought |
|government which can be used to lower taxes. |by large financial organizations such as banks and insurance |
|Private individuals can own shares in these organizations |companies who are interested only in making big profits. |
|and vote on how they should be run. | |
Policy Conflicts: The various aims of governments might be difficult to achieve all at once. In some cases policy aims might conflict. For example • , boosting aggregate demand during an economic recession might help raise output and employment in an economy but may also increase demand for imports and make the trade balance less favorable. Increasing demand may also increase pressure on prices to rise while higher levels of output may create more pollution and waste.
• Similarly, raising taxes or interest rates, and cutting public expenditure to reduce price inflation by lowering total demand, may result in lower output and more unemployment. The impact of higher taxes and lower government spending may also fall heavily on people on lower incomes in an economy, especially if social security benefits from government are cut back.
• In the same way, policies that directly aim to redistribute income may also conflict between different groups in society. for example, taxes on high-income households may be raised and the tax revenues used to pay for increased benefits to very low-income families. Alternatively, taxes on business profits could be raised but this may conflict with an aim of encouraging more people to start their own business and the aim of attracting overseas firms to locate in the economy.
• However, not all economists accept there will always be trade-offs between government objectives. That is, they see no reason why low taxes, low rates of unemployment and high economic growth can only be achieved at the expense of achieving low price inflation, a favorable international trade balance and reduced poverty in society. • Government policy, the argue, can and should be designed to achieve all these aims at the same time. • Their argument runs as follows. If price inflation can be reduced to a low stable rate then low unemployment, faster economic growth and a favorable balance of payments will follow. Rising national income and employment also means people will become better off thereby helping to reduce poverty. Rising incomes will also mean tax revenues collected by the government from wages and profits will be increasing and can be used to schools, and other public expenditures that benefit the economy.
• Reducing inflation will help make domestically produced goods and services more competitive. Demand for them will tend to rise at home and overseas. This will help to improve the balance of trade. Firms will respond by increasing output and their demand for labour. Firms will also want to invest in new machinery and production facilities as the economy expends. This is because they will be more confident that their investments will make a good return, and any money they may have borrowed to fund them can be repaid from increased revenues. Further, if people expect price inflation to remain low and stable then they will not push for such high wage rises in future that would otherwise increase production costs and reduce profits.
Part 2
Public Sector Finance
Section 1
Public Expenditure
Current and capital expenditures Public sector spending, or public expenditure, can be divided up into a number of different categories.
One method is to distinguish between current expenditure and capital expenditure. Current expenditure covers public sector workers' wages and salaries, social security benefits paid to the unemployed and those on low incomes, and spending on consumable goods such as medicines for public healthcare services, and paper, pens and electric power suppliers for government offices. That is, current expenditure tends to cover the day-to-day running expenses of the public sector. In contrast, capital expenditures involves government investments in new roads, school buildings, sea defence and military defence equipment.
Transfer payments Another way is to distinguish between public expenditure to purchase goods and services that contribute to the productivity of the public sector and the economy, and transfer payments to other people.
A large amount of public expenditure in many countries is not spent by government but is given to people in the form of cash benefits such as pensions, unemployment insurance and other social security payments the people who receive these benefits can use the money to buy the goods and services the need and want. They are called transfer payments because a government is simply transferring money collected through taxes from people in work to those who are not able to be productive.
Reasons for Public Spending
There are a number of reasons why governments spend money.
1. To provide public goods Some goods, known as public goods, cannot be provided profitably by private firms. For example, private firms would find it difficult to collect revenue from people in payments for street lighting, a policy force or national defence system. This is because once they have been provided it is difficult to exclude people from benefiting from these public goods simply because they haven't paid directly for the amount they have used. These public goods are nevertheless of great value to people and an economy, and so the public sector provides them.
2. To provide merit goods Governments also spend money on the provision of merit goods. These are gods or services a government thinks everyone should benefit from, whether they can afford to pay for them or not. Such merit goods can include state schools and a public healthcare service. An economy will benefit from an educated and healthy workforce. If people did have to pay for them directly then they might not consume as much as they should.
3. To reduce inequalities and help vulnerable people People on very low incomes, including elderly and disabled people, the unemployed and homeless, single-parent families and the long-term sick, often need help with living expenses, or finding and affording accommodation. The public sector can provide a safety net for poor and vulnerable people through the provision of social security benefits, low-cost social housing, free healthcare, free bus passes and other welfare benefits.
4. To invest in the economic infrastructure A modern economy needs a modern infrastructure such as road and railways, public buildings, parks, waterways, and much more. The investment required to provide these can cost many billions of dollars, but they benefit both individuals and firms and help economic growth.
5. To support agriculture and industry Grants and subsidies are often paid to farmers and owners of firms to help them increase production and employment, invest in new plant and machinery, and pay for new research and development. This can help to boost output and economic growth in an economy . however, other countries might argue that such subsidies are unfair and that they protect inefficient domestic firms from products imported from more efficient producers overseas.
6. To control the macroeconomy The public sector in many countries is a very big spender, raising large amounts of money through taxation to pay for it all. A change in the amount of public expenditure or taxation can therefore have a big effect on the total level of demand in an economy and therefore on the level of output, employment, prices and national income. A government can therefore use its spending and taxation policies to help it achieve its macroeconomic objectives. This is called fiscal policy.
7. To give overseas aid Some public spending may be paid overseas to help countries in need because they have suffered wars or natural disasters such as droughts, earthquakes and tsunamis. Overseas aid can help provide food and medicine and pay for new roads and schools.
Section 2
Financing Public Expenditure
Sources of revenue The public sector in an economy raises revenue to pay for its public expenditure in a number of ways: • Borrowing money from the general public • Interest payments on loans of money made to individuals and private sector firms, and overseas governments. • Rent from publicly owned buildings and land, and any admission charges, for example, from museums and national monuments. • Revenues from government agencies and public corporations that sell goods or services . • Proceeds from the sale (or privatization) of government-owned industries and other publicly owned assets, such as land public buildings. • Taxes on incomes, wealth and expenditures.
Tax burden By far the most revenue is raised from taxation. In some countries governments tax as much as half of all their national income or GDP. For example, in 2005 Sweden taxed over 51 per cent of its national income. In contrast, the total tax from GDP in Mexico in the same year was just 19 per cent.
The proportion of tax taken from national income in a country measures the total tax burden in that national economy. Individuals and firms also have personal or corporate tax burdens measured by the amount of tax they each have to pay as a proportion of their incomes. Tax burdens can vary greatly between different individuals and firms depending on the design of the tax system in a country.
Tax evasion and avoidance Taxes are compulsory payments backed by laws. Non-payment of tax or tax evasion is a punishable offence.
Some taxes can, however, be divided legally. For example, taxes on cars or petroleum can be avoided by not owing or dividing a car. Wealthy people, pop stars, and so on, can also avoid tax in one country by moving their wealth to a country with low tax rates.
What are taxes for? Many taxes were first introduced many hundreds of years ago by kings or governments to pay for wars. For example, the US federal government in 1862 introduced an income tax for the first time to pay for the Civil War. It was 3 per cent of incomes above $ 600, rising to 5% for incomes above $ 10000. Today, the reasons for taxes are far more complex: 1. Taxes are the main way of raising money to finance public sector spending.
2. Taxes can be used to discourage consumption, for example by imposing tariffs on imported goods to protect domestic firms from, overseas competition, or by raising the price of harmful products such as alcohol and tobacco.
3. Taxes can be used to reduce incomes and wealth inequalities. Revenues from high taxes on people with high incomes or significant wealth can be used to fund benefits and services for people on low incomes.
4. Taxes can be used to help protect the environment. They are used to encourage people and firms to change their behavior to avoid the tax. For example, raising taxes on petroleum makes car use more expensive and so may help to cut car use and harmful exhaust emissions. Taxes on landfill can encourage firms to recycle more of their waste by making dumping waste in landfill sites more expensive.
5. Taxes can be varied by a government to help achieve its macroeconomic objectives. For example, a Contractionary fiscal policy involves raising taxes to reduce total demand in an economy and demand-pull inflation. Cutting taxes during an economic recession can help boost demand, and therefore output and employment .
What is a good tax? A good tax must possess the following qualities: 1. Fairness taxes must be fair. If most people think that a tax is unfair, they are unlikely to pay it. For example a tax based on height would be very unfair.
2. Must not discourage people from working a tax should not discourage people from working. If taxes are too high, then people may decide that it is not worth trying to earn more.
3. Cheap to collect there is little point introducing a tax if it costs more money to collect than it earns in revenue for a government. For example, a tax costing $10 million to collect but only bringing in $3 million in revenue would be pointless and a waste of public money.
4. Convenience imagine how inconvenient it would be if tax-payers were expected to work out their own tax bills and then had to keep enough money back to pay them once every two years. People who are not very good at managing their own money would find themselves in trouble when called to pay their taxes. For this reason it is important that taxes are easy to pay and easy to understand. A government will also need to raise tax revenues regularly to pay for its expenditures.
Section 3
Tax Systems
THE IMPACT OF A TAX ON INCOME CAN BE PROGRESSIVE, REGRESSIVE OR PROPORTIONAL
Taxes are paid either directly or indirectly from incomes. The effective tax rate is the production of income paid in tax.
|Annual incomes $ |Progressive % tax rate |Regressive % tax rate |Proportional % tax rate |
|$ 5,000 |0% |30% |20% |
|$20,000 |10% |25% |20% |
|$50,000 |20% |20% |20% |
|$100,000 |40% |15% |20% |
If a tax is a progressive tax the effective tax rate rises with income. A person with a high income will pay proportionally more of their income in tax than a person on a low income.
If a tax is a regressive tax the effective rate of tax falls with income. The tax will impose a higher relative tax burden on people with low incomes.
If a tax is a proportional tax everyone, rich or poor, pays the same effective tax rate.
The total tax burden of a tax system is the proportion of the national income taken in tax. For example, in 2007 the tax burden in Denmark was just under 50% of its national income.
Diagram
Direct & Indirect Tax
1. Direct tax: Direct taxes are taken directly from a person or firm and their incomes or wealth. They include income taxes, corporation taxes on company profits, capital gains taxes on property and other valuable assets, and inheritance taxes.
Types of direct tax 1. Income tax Income tax is a tax levied on an individual's earnings. Most countries allow people to earn a certain amount of income tax free, usually known as a personal allowance. For example, in the UK in 2007/8 a single person could earn up to £5225 each year, or up to £ 7550 if aged between 65 and 74, or £7690 if over 75, before becoming liable to pay income tax.
Exactly how much tax a person pays in income tax will depend on how much they earn and I some cases their personal circumstances, for example, whether they are single, married, with or without children, old and retired. Income tax in most countries is a progressive tax. That is, higher marginal tax rates are usually applied to progressively higher parts of a person's income. They may also differ for different groups of people. Allowances and marginal rates of tax tend to be more generous for old people and for people with children so that they pay less tax overall than a person who earns the same amount but is single and has no children.
2. Corporation tax This is a tax on company profits, and may also be called a profits tax. Sometimes a government may also impose a one-off windfall tax on the profits of a company either thought to be a monopoly and making very significant profits, or benefiting from world events that boosted their profits. For example, the UK has from time to time imposed a windfall tax on the often huge profits of oil companies that have benefited simply as a result of a rise in world oil prices over which they have no direct control.
To encourage new business to start up, corporate tax rates on relatively small profits of smaller companies are less, even zero, in some countries, than tax rates on larger companies. Corporation tax rates often rise with the scale of profits.
3. Capital gains tax It is possible to make profits from the sale of shares, famous paintings, jewellery and other valuable assets that have increased in value over time. Profits made in this way are called capital gains and may be taxed by a government. Sometimes allowances are made, such as for the length of time someone has held an asset so that the longer someone has held it the lower the tax they pay. For example, in Canada, only 50% of a capital gain is classed as taxable income.
4. Wealth taxes These might include taxes on the value of residential and commercial property. Wealth taxes can also include inheritance taxes on the transfer of wealth from one person to another upon their death. When an individual dies and leaves their house, savings and/or other valuable possessions to someone else, inheritance tax might be payable on the total value inherited. For example, in the UK in 2007/8 inherited wealth up to a value of £300000 was tax free, but any wealth inherited over and above this sum was taxed at 40 per cent.
Advantages of direct taxes 1. Revenue The chief advantages of direct taxes, like income tax and corporation tax, are that they have a high yield of revenue compared with their cost of collection. The total amount of money collected can be estimated with reasonable accuracy in advance, which is of great help to a government when planning how much it can spend.
2. Redistribution The progressive nature of many direct taxes means that wealthier members of society are taxed more heavily than poorer groups to help reduce income inequalities.
3. Ability to pay Direct taxes are constructed so that they take account of firms' and people's ability to pay tax. Family commitments, dependants, etc., are taken into consideration and a system of tax allowances can be used to reflect these responsibilities.
Disadvantages of direct taxes 1. Work incentives A high rate of tax on income may cause people to work less hard because they know that the more they earn the greater the proportion of their income they will have to pay in tax.
2. Enterprise Corporation tax on a firm's profits reduces the incentive for entrepreneurs to start up firms to earn a profit. It also means that a firm will have less profits to re-invest in their business.
3. Tax evasion High tax rates increase the advantages of evading taxes and finding loopholes in tax laws. As a result, revenues are lower and the trouble of trying to catch up with tax evaders increases a government's costs.
Summary:
|Advantages of direct taxes |Disadvantages of direct taxes |
|They are a major source of tax revenue |Income taxes can reduce work incentives |
| | |
|Many are progressive and help to reduce inequalities in |Taxes on profits reduce profit available to entrepreneurs to |
|incomes after tax |re-invest in their businesses |
| | |
|They take account of people's ability to pay. |High tax rates can cause tax evasion. |
Types of indirect tax:- Indirect taxes include tariffs and excise duties added to the prices of goods and services. They are normally imposed on producers who will then pass on as much of the tax as they can to consumers through higher prices. 1. Value added tax An ad valorem tax or value added tax (VAT) is a tax on goods and services levied as a percentage of their selling price. It is normally a fixed rate but some goods and services may be taxed at a lower rate, or even zero-rated if their consumption is encouraged or because they are things which people on low incomes often buy. For example, many foods, medicines, books and public transport fares are zero rated, or example from VAT, in the UK.
VAT is a regressive tax because it is a fixed percentage rate and because people on low incomes tend to spend all or most of their incomes on goods and services. For example, if an unemployed man receiving $50 per week in benefits buys pair of jeans for $20 and pays 20 per cent or $4 in VAT on top, then this tax will represent 8 per cent of his income. If a lawyer earning $500 a week buys the same pair of jeans, the VAT she pays will take only 0.8 per cent or her income.
2. Tariffs A tariff also called a customs duty or an impost, is a tax levied on the price of goods imported from overseas as they enter a country. Tariffs are used to discourage people from buying imports in an attempt to protect domestic industries. High tariffs can encourage illegal smuggling and so governments that impose tariffs may use part of the revenue they raise to pay for police and navy border patrols.
3. Excise duties Excise duties are taxes placed on certain goods based on the quantity, not the value, of product purchased. Examples include duties o fuel; vehicles, tobacco and alcohol. They are used not only to raise revenue but also to discourage the consumption of certain products such as cigarettes and alcohol that can be damaging to health.
Excise duties are also increasingly being used to discourage activities that harm the environment and to encourage the consumption of those that do not. These are becoming known as 'green taxes'. Examples of such taxes in the UK include fuel duties and vehicle excise duties which are in part designed to stop people buying and driving big cars which produce more emissions than smaller vehicles or to (a fixed charge per person, and in this case also per flight) designed to raise the price of air travel and so discourage flying which also causes harmful air pollution.
4. User taxes or charges These are just another type of excise duty linked to specific goods or activities. For example, they include toll charges to use major bridges or roads and pay for their upkeep. London and other major cities around the world have also introduced congestion charges that charge vehicle drivers a fixed amount to enter these cities. Some of the revenue raised from these charges is used to pay for better public transport.
A tax on a specific good or activity used to raise revenue for a specific purpose, such as paying for road or public transport improvements rather than simply adding to total tax revenue, is called a hypothecated tax.
Advantages of indirect taxes
1. Cost of collection
2. Wider tax base
3. Selective aims
4. Tax alternations
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