The Role of Government Chapter 14 LIPSEY & CHRYSTAL ECONOMICS 12e

Learning Outcomes Governments have objectives for stability, growth, and equity, as well as for efficiency Equity, efficiency, and growth objectives may often conflict Tools of government policy include taxation and spending, the law, and regulation, as well as public production of goods and services

Learning Outcomes Government interventions usually involve both direct costs of administration and indirect costs associated with interference with the price mechanism. The incentives facing specific governments may deviate from those needed to deliver economic efficiency.

INTRODUCTION - THE ROLE OF GOVERNMENT Government Objectives Governments seek to protect life and property, improve economic efficiency, protect individuals from others and [sometimes] from themselves, influence the rate of economic growth, and stabilize the economy against fluctuations in national income and the price level. Policies for equity include making the distribution of income and wealth somewhat less unequal.

INTRODUCTION - THE ROLE OF GOVERNMENT Government Objectives Equity, efficiency, and growth often come into conflict. Policies to increase equity can reduce efficiency and/or growth, while policies to increase efficiency or growth can make some situations less equitable.

INTRODUCTION - THE ROLE OF GOVERNMENT Tools and Performance Governments may seek to achieve their policies using the tools of taxes, expenditure, rules and regulations, and public ownership.

INTRODUCTION - THE ROLE OF GOVERNMENT The Costs of Government Intervention Government activity incurs many types of cost. Internal costs refer to the government’s own costs of administering its policies. Direct external costs refer to the costs imposed on those directly affected by these policies in such terms as extra production costs, costs of compliance, and losses in productivity. Indirect external costs refer to the efficiency losses that spread throughout the whole economy as a result of the alteration in price signals caused by government tax and expenditure policies.

INTRODUCTION - THE ROLE OF GOVERNMENT Government Failure As well as showing the potential for benefits to exceed costs in a world where the government functioned perfectly, it is necessary to consider the likely outcome in the imperfect world of reality.

INTRODUCTION - THE ROLE OF GOVERNMENT Government Failure Government failure - not achieving some possible gains - can arise because of rigidities causing a lack of adequate response of rules and regulations to changing conditions, poorer foresight on the part of government regulators compared with private participants in the market, and government objectives - such as winning the next election - that conflict with objectives such as improving economic efficiency.

Income Taxes With Different Progressivities - Proportional 30 [i]. Proportional 25 20 Tax paid [£000] 15 10 5 10 20 30 Income [£000] Income [000]

Income Taxes With Different Progressivities - Progressive 30 [2] [ii]. Progressive 25 20 Tax paid [£000] 15 [1] 10 5 10 20 30 Income [£000]

Income Taxes With Different Progressivities - Regressive [iii]. Regressive 30 25 [3] 20 15 [4] Tax paid [£000] 10 5 10 20 30 Income [000]

Income Taxes With Different Progressivities Part (i): This proportional tax’s average and marginal rates remain unchanged at 50 per cent as income changes.

Income Taxes With Different Progressivities Part (ii): Tax (1) has a constant marginal rate of 50 per cent. But the average rate rises with income, being zero at income £10,000, 25 per cent at income £20,000, and 33 per cent at income £30,000. With tax (2) both the marginal and the average tax rates rise as income rises.

Income Taxes With Different Progressivities Part (iii): Tax (3) has a constant marginal rate of 50 per cent. But the average rate falls as income rises, being 150 per cent at £10,000, 100 per cent at £20,000, and 83.3 per cent at £30,000. With tax (4) both the marginal and the average rates fall as income rises.

The Inefficiency of Free Goods Price E0 2 p0 1 q1 Quantity q0

The Inefficiency of Free Goods Competitive equilibrium is at E0. Price is p0, and quantity q0. At a zero price q1 is consumed. Since each extra unit that is produced adds its marginal cost to the total cost of production, total costs rise by the area under the industry’s marginal cost curve (its supply curve). The two shaded areas 1 and 2 show this extra cost of production. The additional consumers’ surplus is given by the medium blue shaded area 1. So the efficiency loss is the dark shaded area 2.

The Efficiency Loss From an Indirect Tax Price Quantity

The Efficiency Loss From an Indirect Tax Price p0 E0 D q0 Quantity

The Efficiency Loss From an Indirect Tax Price Tax p0 E0 D q0 Quantity

The Efficiency Loss From an Indirect Tax Price Tax E1 p0 p0 E0 p0 D q1 q0 Quantity

The Efficiency Loss From an Indirect Tax The original curves are S and D. Equilibrium is at E0 with price p0 and quantity q0. The tax shifts the supply curve to ST. Equilibrium moves to E1 . Market price is p1, and quantity q1. Consumers pay p1, while the after-tax receipts of producers are p2.

The Efficiency Loss From an Indirect Tax The government gains tax revenue equal to the light yellow area, which is p1 minus p2 multiplied by q1. Part of this revenue comes from producers and part from consumers. Consumers also lose surplus of the dark yellow area. Producers also lose surplus of the medium shaded area. Since no one gets the surpluses that consumers and producers lose, they are the deadweight losses of the tax.

An Income Tax and the Work-leisure Choice 24 20 G E1 18 E0 16 15 E2 Leisure [hours/days] 10 5 120 240 320 480 840 960 Daily income [£]

An Income Tax and the Work-leisure Choice This person earns £40 an hour. His budget line runs from 24 hours (no work) to £960 (no sleep!). He maximizes utility at E0. Here he takes 16 hours of leisure and works 8 hours to gain an income of £320 per day. Income tax: An income tax of 50 per cent shifts his after-tax budget line to run from 24 hours to £480 (no sleep!) He maximizes utility by moving to E1 with 18 hours of leisure (6 hours of work) and a gross pay of £240. This yields him an after-tax income of £120.

An Income Tax and the Work-leisure Choice An alternative tax: The government raise its £120 through a tax that did not alter the income-leisure trade-off, say a poll tax. The after-tax budget line then shifts inward to 21 hours (the tax is the equivalent of 3 hours work) and £840. The individual now moves from E0 to E2. He consumes 15 hours of leisure (working 9 hours) and £240 worth of goods. E2 is superior to E1 because it lies on a higher indifference curve.

Dis-incetives of Welfare Schemes 24 E0 19 a Leisure [hours] E1 16 I0 I1 25 40 Income [£] 120

Dis-incetives of Welfare Schemes The individual is not employed but is receiving benefits of £25 per day from some income-related scheme. This puts him at point E0, consuming 24 hours of leisure and receiving £25 pounds of income. He is now offered work at £5 per hour, presenting him with a budget line that ends at £120 (for 24 hours’ work). In the absence of the benefit he would locate at E1. He would then consume 16 hours of leisure (working 8 hours) and earning £40 of income.

Disincetives of Welfare Schemes But for every £1 he earns he loses £1 of benefit, so the budget line starts at E0 and is vertical to point a. At a he is working 5 hours and still getting £25 but now all from work. Further work nets him £5 an hour, so the budget line has its normal slope below a. Since the indifference curve through E1, is lower than the curve through E0, his rational choice is not to work.

Government Failure MC2 MC1 £ MB 10 1.6 4 1.6 4 Pollution abatement [millions of tonnes]

Government Failure Each tonne of pollution imposes a social cost of £10. Thus the marginal social benefit of abatement is £10 per tonne as shown by the MB line. The most efficient method of control is assumed to have a marginal cost curve of MC1. It is now socially optimal to prevent 4 million tonnes of pollution. Now assume that the government misguidedly chooses an abatement procedure that has a marginal cost curve of MC2. Optimal abatement is now only 1.6 million tonnes.

Government Failure Now assume that the government insists on having 4 million tonnes abated. There is now a loss of the light shaded area above marginal benefit curve and below the MC2 curve. That loss may exceed the benefit which is given by the dark shaded area between the b MB and the MC2 curves below 1.6 millions tonnes of abatement. If so the programme causes a net social loss. Having no programme would then be better than having the inefficient one imposed at too high a level of abatement.