1. Chapter 14 Government spending and revenue
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2. Government spending, % of GDP
Sources: World Bank, World Development Report; OECD, Economic Outlook.
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Government spending
We may justify government spending on two grounds:
Equity
a progressive tax and transfer system redistributes income from rich to poor
Efficiency
correction of market failure may improve resource allocation
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4. Private and public goods
A private good
if consumed by one person, cannot be consumed by another person.
e.g. dental treatment
A public good
even if consumed by one person, can still be consumed by other people.
e.g. street lighting
The strong externalities associated with public goods, mean that government intervention may be justified to ensure appropriate provision.
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Merit goods and bads
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.
e.g. Education, health services, cigarettes
The government may spend money on compulsory education or compulsory vaccination because it recognises that otherwise individuals act in a way they will subsequently regret.
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Varieties of taxes
Direct taxes
taxes on earnings from labour, rents, dividends and interest.
e.g. income tax, corporation tax
Indirect taxes
taxes levied on expenditures on goods and services
e.g. VAT, duty on alcohol
Wealth taxes
capital transfer tax, tax on property
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A tax on wages
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.
Wage SS
The orange area is a welfare loss for society. W
It falls partly on firms who pay a higher wage and partly on workers who receive a lower wage. DD L
Hours worked
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The incidence of a tax
Who pays a tax depends upon the elasticity of demand and supply for the product.
This also affects the size of distortion caused by the imposition of a tax.
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9. A tax to offset an externality
A tax of E*F enables
this optimum to be
reached. F
SS'
Given private demand DD
and supply SS, free market
equilibrium is at Q. SS
Price
DD' E* Q*
But if there is a negative
consumption externality
(e.g. from smoking), the
social optimum is at Q*. DD Q
Quantity
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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.
Tax revenue t*
100%
Tax rate
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Economic sovereignty
Increasing integration of countries in the world economy reduces the economic sovereignty of individual nations.
International capital is now highly mobile across countries. Suppose the UK government tries to levy a large tax on capital in Britain. Lots of capital will quickly move elsewhere to escape the high taxes.
In contrast, people are much less mobile across national boundaries. The tax base for taxing workers’ incomes in Britain is much less sensitive to tax rates than the tax base for capital taxes.
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The median voter
Each dot represents the preferred expenditure of 17 voters. The outcome under majority voting will be the level preferred by the median voter.
Everyone to the left will prefer the median voter’s position to any higher spending level. Everyone to the right will prefer it to any lower level.
The median voter’s position is the only one that cannot be outvoted.
Median voter £0
£250
£500
£750
£1000
Preferred expenditure
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Some maths
Two firms, A and B. Firm A pollutes the lake used by firm B for fishing.
The cost function of firm A is , TCA = TCA(QA, PA) where QA is the quantity produced by A and PA is the level of pollution of firm A.
Costs increase with the output produced:
and decrease with the level of pollution:
Firm B’s cost function has the following properties:
and
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Some maths (2)
The optimal level of pollution chosen by firm A satisfies the condition:
That is marginal cost of pollution equals to marginal revenue of pollution (zero in this case).
Firm A is polluting more than it should, so we can tax firm A in such a way that the socially efficient level of pollution is reached. Those kinds of taxes are also called Pigouvian taxes.
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Some maths (3)
When firm A has to pay a tax for its polluting activity, the profit function of firm A becomes:
Where t is the tax rate and p is the market price for the output of firm A. Now the optimal level of pollution (the one that maximizes firm A profits) is:
The tax simply increases the marginal cost of polluting. Now the level of pollution that maximizes the profits is lower than before since must be equal to t and t is greater than zero.
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