Impose Taxes

Governments pay for the goods they buy and for the transfer payments they make by levying taxes or by borrowing. Taxes raised at national level, such as income tax or VAT, are usually supplemented by local taxes assessed on property values or household size.

Spending, Taxes, and Deficits Table 3-2 shows that the scale of government activity has risen over a long period. For much of this time, governments have been reluctant to meet this extra cost in full by raising taxes. They have run budget deficits financed by borrowing. Budget deficits add to the government's debt. Table 3-3 shows how government debt has changed over the 1980s. Only in the UK has the debt-income ratio fallen during the 1980s.

Table 3-2. Government spending, as percentage of national income.

	1880	1929	1960	1985
Japan	11	19	18	33
USA	8	10	28	37
Germany	10	31	32	47
UK	10	24	32	48
France	15	19	35	52
Sweden	6	8	31	65
Source World Bank. World Development Report. 1908

Table 3-3. Government debt as a percentage of national income, 1980-89.

	1980	1989
USA	37.9	51.2
Japan	52.0	65.1
Germany	32.5	43.8
France	37.3	43.8
Italy	58.5	96.7
UK	54.6	40.1
Sweden	44.8	53.0
Netherlands	45.9	82.5
Ireland	78.0	132.2

In countries like Italy and Ireland it has now grown to very high levels indeed. In later chapters we shall address several questions. Will government spending continue to increase? Should it? Can government debt be allowed to increase indefinitely?

Try to Stabilize the Economy

Every market economy suffers from business cycles. The business cycle consists of fluctuations of total production, or GDP, accompanied by fluctuations in the level of unemployment and the rate of inflation.

Governments, through their control of taxes and government spending and through their ability to control the quantity of money in the economy, often attempt to modify fluctuations in the business cycle. The national government may reduce taxes in a recession in the hope that people will increase spending and thus raise the GDP. The central bank (in the UK the Bank of England), which controls the quantity of money, may increase the quantity of money more rapidly in a recession to help bring the economy out of the recession. When inflation is high, the central bank may reduce the rate of money growth with the aim of reducing inflation.

These are macroeconomic policies through which the government attempts to stabilize the economy, keeping it as close as possible to full employment with low inflation.

Affect the Allocation of Resources

By spending and taxing, the government of course plays a major part in allocating resources in the economy. In terms of what, how, and for whom, government chooses much of what gets produced, from defence expenditures to education to its support for the arts. It affects how goods are produced through regulation and through the legal system. It affects for whom goods are produced through its taxes and transfers, which take income away from some people and give it to others.

Beyond these direct effects, the government also affects the allocation of resources indirectly through taxes (and subsidies, which are negative taxes) on the price and level of production in individual markets. When government taxes a good, such as cigarettes, it generally reduces the quantity of that good produced; when it subsidizes a good, such as milk, it generally increases the quantity of the good produced.

The power to tax is thus the power lo affect the allocation of the economy's resources, or to change what gets produced. By taxing cigarettes, the government can reduce the amount of cigarettes smoked and thereby improve health. By taxing income earned from work, the government affects the amount of time people want to work. Because they affect the allocation of resources indirectly, through their effects on relative prices, as well as directly, taxes loom large in the workings of the market system and have a profound effect on the way society allocates its scarce resources.

Exercise 1. Find the English equivalents of the following word-combinations:

распределять ресурсы; устанавливать юридические нормы; покупать товары и услуги; финансировать себя посредством налогообложения и займов; оказывать влияние на цены, процентные ставки и уровень производства; получать в виде налогов; влиять на функционирование экономики; размах деятельности государства; владение собственностью; ограничение права собственности; регулировать экономическую деятельность; предоставлять бесплатно; находиться в государственной собственности; осуществлять трансфертные платежи; расходы государства; облагать налогами, взимать налоги; подоходный налог; НДС (налог на добавленную стоимость); сталкиваться с дефицитом бюджета; бизнес-цикл; уровень безработицы; уровень инфляции; контролировать количество денег в экономике; снижать налоги; экономический спад; вывести экономику из состояния спада; стабилизировать экономику; полная занятость при низкой инфляции.

Exercise 2. Answer the following questions:

1. How does the author prove that governments play a major role in Western economies?

2. What do we need to do in order to understand the operation of the modern economy?

3. How did the government’s share in the economy change in the 20^th century?

4. What kinds of regulations can governments issue?

5. What kinds of goods and services are usually provided by governments?

6. In what ways are governments similar to business firms?

7. What is a transfer payment? Give your own examples of transfer payments.

8. What does government spending include?

9. What are the main sources of government income?

10. How did the government debt change in the 1980s in most countries?

11. What are the main elements of the business cycle?

12. What is a recession?

13. How can the government stabilize the economy?

14. How do government policies affect the answers to the main economic questions (what, how and for whom to produce)?

15. How can the government influence the quantity of the goods produced?

16. Prove that the power to tax is the power to affect the allocation of resources.

Exercise 3.

Define the following terms in English: GNP, GDP, income tax, VAT, the business cycle, transfer payments, market failure

Exercise 4. Summarize each subsection of the text (orally):

1. Create Laws, Rules and Regulations

2. Buy and Sell Goods and Services

3. Make Transfer Payments

4. Impose Taxes

5. Try to Stabilize the Economy

6. Affect the Allocation of Resources

Exercise 5. Listening from Guide to economics, unit 10 – “Government spenging”, track 30

The pie chart below shows how the UK government spends its revenue. Each segment of the pie (A to H) shows a different area of spending. Some labels are missing. Which of these areas do you thing they are?

• Education

• Defence

• Environment

• Health care

• Transport

Listen and complete the chart.

Exercise 6. Translate into English:

Размах экономической деятельности государства зависит от типа экономической системы. Все государства устанавливают юридические нормы, покупают и продают товары и услуги, осуществляют трансфертные платежи и собирают налоги.

При командно-административной экономической системе государство распределяет ресурсы, ограничивает право собственности и регулирует экономическую деятельность на всех уровнях. Большая часть предприятий находится в государственной собственности, а владение частной собственностью едва ли возможно.

В экономических системах смешанного типа государство оказывает косвенное влияние на цены, процентные ставки и уровень производства и таким образом воздействует на функционирование экономики. Правительства делают это в основном путем взимания налогов, например, налога на добавленную стоимость.

Государство финансирует себя при помощи налогообложения и займов. Часть денег, полученных в виде налогов, возвращается к гражданам в форме трансфертных платежей и социальных услуг, предоставляемых бесплатно.

Если расходы государства превышают его доходы, государство сталкивается с дефицитом бюджета. Если правительство увеличивает количество денег в экономике, чтобы справиться с дефицитом бюджета, это приводит к повышению уровня инфляции. Однако повышение количества денег – не единственный способ вывести экономику из состояния спада. Чтобы стабилизировать экономику, многие западные правительства снижают налоги.

Государство в условиях экономики смешанного типа пытается достичь полной занятости при низкой инфляции. Но уровень безработицы и уровень инфляции постоянно изменяются на протяжении бизнес-цикла.

IV–2. The Role of Government

Having mentioned the effect of government tax policy on the income distribution, we now examine in greater detail the role of the government in society. In every society governments provide such services as national defense, police, firefighting services, and the administration of justice. In addition, governments make transfer payments to some members of society.

Transfer payments are payments made to individuals without requiring the provision of any service in return.

Examples are social security, retirement pensions, unemployment benefits, and, in some countries, food stamps. Government expenditure, whether on the provision of goods and services (defense, police) or on transfer payments, is chiefly financed by imposing taxes, although some (small) residual component may be financed by government borrowing.

Table 1 compares the role of the government in four countries. In each case, we look at four measures of government spending as a percentage of national income: spending on the direct provision of goods and services for the public, transfer payments, interest on the national debt, and total spending. Italy is a 'big government' country. Its government spending is large and it needs to raise correspondingly large tax revenues. In contrast, Japan has a much smaller government sector and needs to raise correspondingly less tax revenue. These differences in the scale of government activity relative to national income reflect differences in the way different countries allocate their resources among competing uses.

Table 1
Government spending as a percentage of national income in 1985
Country	Purchase of goods and services	Transfer payments	Debt interest	Total
	%	%	%	%
UK	23.0	17.2	5.1	45.3
Japan	14.9	12.7	4.6	32.2
United States	20.1	12.2	4.8	37.1
Italy	27.0	23.0	9.2	59.4
Source: IMF, World Economic Outlook, 1986.

Governments spend part of their revenue on particular goods and services such as tanks, schools, and public safety. They directly affect what is produced. Japan's low share of government spending on goods and services in Table 1 reflects the very low level of Japanese spending on defense. Governments affect for whom output is produced through their tax and transfer payments. By taxing the rich and making transfers to the poor, the government ensures that the poor are allocated more of what is produced than would otherwise be the case, and the rich get correspondingly less.

The government also affects how goods are produced, for example through the regulations it imposes. Managers of factories and mines must obey safety requirements even where these are costly to implement, firms are prevented from freely polluting the atmosphere and rivers, offices and factories arc banned in attractive residential parts of the city.

The scale of government activities in the modern economy is highly controversial. In the UK the government takes nearly 40 per cent of national income in taxes. Some governments take a larger share, others a smaller share. Different shares will certainly affect the questions what, how, and for whom, but some people believe that a large government sector makes the economy inefficient, reducing the number of goods that can be produced and eventually allocated to consumers.

It is commonly asserted that high tax rates reduce the incentive to work. If half of all we earn goes to the government, we might prefer to work fewer hours a week and spend more time in the garden or watching television. That is one possibility, but there is another one: if workers have in mind a target after tax income, for example to have at least sufficient to afford a foreign holiday every year, they will have to work more hours to meet this target when taxes are higher. Whether on balance high taxes make people work more or less remains an open question. Welfare payments and unemployment benefit are more likely to reduce incentives to work since they actually contribute to target income. If large-scale government activity leads to important disincentive effects, government activity will affect not only what, how, and for whom goods are produced, but also how much is produced by the economy as a whole.

This discussion of the role of the government is central to the process by which society allocates its scarce resources. It also raises a question. Is it inevitable that the government plays an important role in the process by which society decides how to allocate resources between competing demands? This question lies at the heart of economics, and we return to it shortly when we examine the role of markets in economic life.

First, however, we must refine our notion of scarce resources. To do so, we introduce a useful tool of economic analysis, the production possibility frontier.

Check your understanding.

1. Find the terms in the text which describe the following:

   • money paid to people without asking for a service in return

   • money paid to people when they stop working

   • money paid to people who have no work

   • money owed by the government of a country

   • the money received by governments from taxation

   • money a worker keeps after paying taxes

2. Now look at these statements. Using the information in the text, say if they are correct or incorrect.

• Governments do not make free transfer payments.

• Food stamps are an example of a transfer payment.

• Most government income comes from borrowing.

• Japan raises more taxes than Italy.

• Japan spends very little on defence.

• The poor get more of what is produced through taxation and transfer payments.

• Governments do not affect how goods are produced.

• Nobody questions the scale of government economic activity.

• Many people believe that high taxes result in people not wanting to work so hard.

• The production possibility frontier is a tool to examine the role of government in the economy.

3. Summarize in your own words the arguments for and against high taxes. Then express your own opinion on whether taxes should be high or low.

4. Comment on the quotations:

   1. The office of government is not to confer happiness, but to give men the opportunity to work out happiness for themselves. (W.E. Channing)

   2. If the Government is big enough to give you everything you want, it is big enough to take away everything you have. (Gerald R. Ford)

   3. Most bad government has grown out of too much government. (Thomas Jefferson)

   4. Every cook has to know how to govern the state. (V.Lenin)

IV-3. What Should Governments Do?

Why should governments intervene in a market economy? Adam Smith, the father of economics, argued in his 1776 classic, The Wealth of Nations, that people pursuing their own interests are led as if by 'an invisible hand' to promote the interests of society. If there is an invisible hand, if markets allocate resources efficiently so that consumers' wants are satisfied at minimum cost, why should governments intervene in the economy at all?

In this section we discuss theoretical justifications for government intervention in market economy. The general argument for government intervention is market failure. Sometimes markets do not allocate resources efficiently, and government intervention may improve economic performance. Economic theory identifies six broad types of market failure, which we describe below.

Very few economists dispute the idea that the government could in theory improve the allocation of resources by correcting market failures, but many dispute the idea that government in fact improves the allocation of resources. Conservative economists, including Nobel Prize winners Milton Friedman of the Hoover Institution and James Buchanan of George Mason University, argue that in practice the government is even more likely to fail to allocate resources efficiently than are markets. We take up their arguments in Part 3, but first we discuss the six reasons why government intervention may, at least in principle, improve the allocation of resources.

The Business Cycle

The business cycle has many external causes, from wars or oil price changes to bursts of new inventions. Government policies also affect the business cycle. Increases in taxes and reductions in government spending generally reduce GNP; increases in the money stock increase GNP and Prices. Government policy can make the business cycle worse, lengthening recessions and creating inflation, or it can reduce economic fluctuations.

There are major controversies in macroeconomics over whether and to what extent the government can stabilize the economy. Obviously, the government cannot control the economy perfectly or we would not have severe recessions and inflation. But since the government does control a large share of total spending and the quantity of money, it must make its decisions with their effect on the business cycle in mind. And it does: taxes may be cut when the economy is in a recession, and the growth rate of money may be reduced when the inflation rate is too high or be increased when the economy is in a recession.

Public Goods

Most of the goods supplied by businesses and demanded by consumers are private goods. A private good is a good that, if consumed by one person, cannot be consumed by another. Ice cream is a private good. When you eat your ice cream cone, your friend doesn't get to consume it. Your clothes are also private goods. When you wear them, everyone else is precluded from wearing them at the same time.

But there are goods we can all consume simultaneously, without anyone's consumption reducing anyone else's. These are called public goods. A public good is a good that, even if it is consumed by one person, is still available for consumption by others. Clean air is a public good. So is national defense, or public safety. If the armed forces are protecting the country from danger, your being safe in no way prevents anyone else from being safe.

It is no coincidence that most public goods are not provided in private markets. Because of the free-rider problem, private markets have trouble ensuring that the right amount of a public good will be produced. A free-rider is someone who gets to consume a good that is costly to produce without paying for it. The free-rider problem applies particularly to public goods because, if anyone were to buy the good, it would then be available for everyone else to consume.

For instance, suppose a market were set up for national defense. Even if each of us felt that we needed defense, we would not have the right incentives to buy our share of defense. Since the amount of national defense I will have is the same as the amount everyone else has, I have a strong incentive to wait for someone else to buy it rather than contribute my fair share. I will have a free ride on everyone else's purchases. But of course, if everyone is waiting for someone else to buy national defense, there will be no defense.

To get around the free-rider problem, the country has to find some way of deciding together how much to spend on defense. Governments are set up to make such collective decisions. Many of the goods provided by the government are in fact public goods. National defence and police services are certainly public goods. National parks are a mixed case, since the views in the parks are a public good, at least until congestion sets in, but use of the eating facilities is not.

It may seem from this discussion that the government should produce public goods and should not produce any other goods. Neither conclusion is correct. The government does not have to produce public goods; it only has to specify how much of each should be produced. It may rely on private contractors to do the actual production, as it does, say, with regard to defence equipment. Indeed, it used to be common for countries to have private con­tractors provide armies on a commercial basis. It is increasingly common for municipalities to hire private contractors to remove the rubbish.

On the other hand, there is no general economic reason why governments should not produce private goods. There are government-owned firms or nationalized industries in most countries. Some government enterprises appear to be commercially successful and efficient. None the less, experience suggests that in many circumstances the government is less likely to produce efficiently than is the private sector.

Externalities

Markets work well when the price of a good equals society's cost of producing that good and when the value of the good to the buyer is equal to the benefit of the good to society. However, the costs and benefits of production are sometimes not fully reflected in market prices.

Consider the problem of pollution. A firm produces chemicals and discharges the waste into a lake. The discharge pollutes the local water supply, kills fish and birds, and creates an offensive smell. These adverse side effects represent costs to society of producing the chemical, and they should accordingly be reflected in its market price — but they may not be. Unless the chemical company is charged for the damages caused by its pollution, the market price of its output will understate the true cost of production to society. In this case there is an externality in the production of the chemical.

An externality exists when the production or consumption of a good directly affects businesses or consumers not involved in buying and selling it and when those spillover effects are not fully reflected in market prices.

Externalities are not all negative. The homeowner who repaints her house provides spillover benefits for the neighbours; they no longer have to look at a peeling or dilapidated house. In all externalities, there exists something that affects firms' costs or consumers' welfare (such as pollution or views of newly painted houses) but is not traded in a market. Economists often speak of externalities as caused by 'missing markets'.

When externalities are present, market prices do not reflect all the social costs and benefits of the production of a good. Government intervention may improve the functioning of the economy, for example by requiring firms to treat their waste products in certain ways before dumping them. Since externalities involve missing markets, they can also be handled in principle by market-type solutions. The government might charge firms (an estimate of) the damages their pollution causes, or might permit a certain amount of total pollution and allow firms to buy and sell rights to pollute.

The presence of externalities can provide the justification for a number of government activities besides pollution control. Examples range from control of broadcasting (interference is an externality) to various restrictions on land use.