Chapter 17 Taxes and government spending David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation.

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Presentation transcript:

Chapter 17 Taxes and government spending David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

17.1 Government spending in the UK n The scale of government spending has changed over the past four decades. n It is now running at just under 40%.

17.2 Government spending n EQUITY – a progressive tax and transfer system redistributes income from rich to poor n EFFICIENCY – correction of market failure may improve resource allocation We may justify government spending on two grounds:

17.3 Private and public goods n A private good – if consumed by one person, cannot be consumed by another person. á e.g. dental treatment n A public good – even if consumed by one person, can still be consumed by other people. á e.g. street lighting There are strong externalities associated with public goods, so government intervention may be justified to ensure appropriate provision.

17.4 Merit goods and bads n Merit goods (bads) – goods (bads) that society thinks everyone ought to have (ought not to have) regardless of whether they are wanted by each individual. á e.g. Education, health services, cigarettes – The government may spend money on compulsory education or compulsory vaccination because it recognizes that otherwise individuals act in a way they will subsequently regret.

17.5 Varieties of taxes n Direct taxes – taxes on earnings from labour, rents, dividends and interest. á e.g. income tax, corporation tax n Indirect taxes – taxes levied on expenditures on goods and services á e.g. VAT, duty on alcohol n Wealth taxes – capital transfer tax, tax on property

17.6 Employers pay the green area, and workers the blue. A tax on wages Hours worked Wage L W DD SS With no tax, the labour market is in equilibrium at wage W, hours L. L' SS' W' W'' With a tax, labour supply is effectively at SS', workers receive W'', but firms pay W', the difference being the tax. The red area is a welfare loss for society.

17.7 The incidence of a tax n Who pays a tax depends upon the elasticity of demand and supply for the product. n This also affects the size of distortion caused by the imposition of a tax.

17.8 A tax to offset an externality Quantity Price DD SS Given private demand DD and supply SS, free market equilibrium is at Q. Q A tax of E*F enables this optimum to be reached. F SS' DD' E* Q* But if there is a negative consumption externality (e.g. from smoking), the social optimum is at Q*.

17.9 The Laffer curve shows how much tax revenue is raised at each possible tax rate. Beyond t*, higher tax rates reduce revenue because of disincentive effects. t* 100% Tax rate Tax revenue

17.10 Economic sovereignty n Increasing integration of countries in the world economy reduces the economic sovereignty of individual nations. n Co-operation is needed to cope with transnational externalities.