Unit 5 : THE ROLE OF GOVERNMENT IN AN ECONOMY

Govt as a producer of goods and services, takes responsibility for production due to:

1. To produce essential goods and services

2. To supply merit goods
3. To supply public goods
4. To control natural monopolies
5. To invest in national infrastructure
6. To support agriculture and key industries
7. To manage the macroeconomy
8. To reduce inequities in incomes and help vulnerable people

Govt as an employer :

 Major employer in public sector

 In public goods

Govt policy : Full Employment

Full employment may be defined as the situation where everyone willing to work at the going
wage rate is able to get a job. Economists state that there are enough people out of work to
prevent wages to starting to rise at an increasing rate.

Unemployment Rate = (Number of unemployed/labour force) * 100

Why the govt seeks to achieve full employment:

 Unemployment is a waste of human resources

 Tax revenue is lost
 Spending on unemployed increases
 Rise in social unrest and crime

Dealing with unemployment:

1. Temporary – publicise job vacancies

2. Seasonal – if employees can find a second job, then not a problem
3. Technological – education and training to upgrade skills
 4. Frictional – training in job areas where supply shortages exist, providing informational
through employment agencies
5. Structural – encourage people and business to move to growth areas of economy, regions,
occupations
6. Cyclical, demand deficient – increase in Govt spending at the time of recession

Govt policy : Price stability

Inflation : Inflation is a quantitative measure of the rate at which the average price level of a
basket of selected goods and services in an economy increases over a period of time. Often
expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation's
currency.

 Average prices are measured by Govt using the Consumer Price Index (CPI)
 Inflation doesn’t mean price of every single commodity will rise
 Small increases in general prices are not bad. Rather they provide an incentive for
producers to increase supply.
 Price stability enables businesses to carry out their business with more certainty

Govt policy to create price stability :

1. Direct control of prices

a. Set prices for goods
b. Impose limits on wage increases of public sector employees

Drawback : Price mechanism not operating freely. There may be conflicts between Govt
and businesses, and Govt and Trade unions.

2. Reduced Govt spending and increased taxes (Fiscal policy)

3. Controlling the quantity of money available for spending in the economy (Monetary
policy)
Govt policy : Economic Growth

Economic growth is an increase in the capacity of an economy to produce goods and services,
compared from one period of time to another. It can be measured in nominal or real terms, the
latter of which is adjusted for inflation.

Economic growth is the increase in the inflation-adjusted market value of the goods and
services produced by an economy over time. It is conventionally measured as the percent rate of
increase in real gross domestic product, or real GDP.

Rising GDP per head means :

 Incomes within a country are rising

 Standard of living is rising
 Govt’s tax revenue is rising

Sustainable economic growth occurs when the pace of growth is maintained over a period of
time. An important aspect of sustained growth is that there is investment for future generations.

Trade cycle : The business cycle, also known as the economic cycle or trade cycle, is the
downward and upward movement of GDP around its long-term growth trend. The length of a
trade cycle is the period of time containing a single boom and contraction in sequence. These
fluctuations typically involve shifts over time between periods of relatively rapid economic
growth (expansions or booms), and periods of relative stagnation or decline
(contractions or recessions).

Growth can be encouraged by:

1. Making it easier to conduct business (reduced taxes, reduced regulations)

2. Providing incentives for businesses to set up in growing industries
3. Employing people in public sector
4. Encouraging investment (both public and private sector)
Govt policy: Redistribution of income

Economic inequality is the unequal distribution of income and opportunity between different
groups in society. It is a concern in almost all countries around the world and often people are
trapped in poverty with little chance to climb up the social ladder.

Poverty is a state or condition in which a person or community lacks the financial resources and
essentials for a minimum standard of living.

Methods of redistributing income :

1. Govt spending (Tax revenue can be spent on goods and services that benefit poor more
than rich)
2. Subsidies (A subsidy is a benefit given to an individual, business or institution, usually by
the government. It is usually in the form of a cash payment or a tax reduction)
3. Taxation (progressive taxation, higher taxes on luxury goods)

Govt policy : Balance of Payments Stability

The balance of payments is a statement of all transactions made between entities in one country
and the rest of the world over a defined period of time, such as a quarter or a year.

Problems of having a deficit balance :

1. It is unsustainable
2. Its an indication of unbalanced economy
3. Its an indication of uncompetitive economy
4. Risk of currency depreciation

Conflicts between Govt Aims

 Spending more money to stimulate growth can lead to rising prices (inflation)
 If the govt strives for full employment, labour may become expensive and scarce
  If govt tries to redistribute income by having progressive taxes, it may act as a
disincentive for rich to work hard (might lead to brain drain)

Types of Taxation

Reasons for taxation :

1. To raise revenue
2. To discourage certain activities
3. To discourage the import of goods
4. To redistribute income from rich to the poor

Direct taxes : Those taxes the burden of which falls on the person paying it. Eg. Income tax,
corporate tax, capital gains tax, wealth tax.

Indirect taxes : These are taxes which are imposed by Govt on goods and services, but are
eventually paid by consumers rather than by the businesses that collect the tax for the govt in the
first instance. Eg. Excise duties, import tariffs, user charges, GST, VAT (value added tax)

Progressive tax : A progressive tax is a tax that imposes a lower tax rate on low-income earners
compared to those with a higher income, making it based on the taxpayer's ability to pay. That
means it takes a larger percentage from high-income earners than it does from low-income
individuals.

Regressive tax : A regressive tax is a tax which takes a higher percentage of tax revenue from
those on low incomes.

Proportional tax : Refers to a situation in which tax rises in proportion to the income of the
taxpayer.

Advantages of direct taxes :

1. High revenue yield

2. Can be used to reduce inequalities of income and wealth
3. They are based on ability to pay

Disadvantages of direct taxes:

1. They can reduce work incentives

 2. They can reduce enterprise incentives
3. Tax evasion

Advantages of indirect taxes:

1. They are cost effective

2. They expand the tax base
3. They can be used to target specific products and activities
4. They are flexible

Disadvantages of indirect taxes:

1. They are inflationary

2. They are regressive
3. Revenues are less certain and predictable
4. They can encourage tax evasion

Govt influence on private producers : Regulation

Regulations are rules governing the conduct of business. They can be backed by penalties in case
of non-compliance.

Benefits of regulation:

1. Govt may use regulation to improve efficiency

2. Used to redistribute income
3. To regulate monopoly powers
4. To limit the negative effects of externalities eg. pollution
5. Used in industries where public interest needs to be protected eg. Banking

Disadvantages of regulation :

1. Raise business costs

2. Time consuming
3. May raise corruption
4. Countries with high level of regulations lose competitiveness
Govt influence on private producers : Subsidy

Subsidy may be defined as sums of money provided by govt to a producer or supplier for a
specific purpose.

Subsidies may be provided for reasons like :

1. To encourage the production of goods of national importance

2. To encourage the development of new products and industries
3. To provide support for industries that are in decline and that are major employers of
labour
4. To protect domestic industries against foreign competition

When a supplier receives a subsidy it will be encouraged to produce more for the market. (Dia –
rightward shift of supply curve, increased supply at lower prices)

Govt influence on private producers : Taxes

Taxes act in opposite way to subsidies. Govt may use them to discourage production of certain
goods and services as well as to raise revenue.

Eg. Taxes on liquor, cigarettes, casinos

The incidence of sales taxes and price elasticity of demand:

 The price elasticity of demand determines how much tax revenue the givt can collect
from indirect sales taxes
 Incidence of tax means who bears the major burden of tax – producer or consumer
 If demand is elastic, producers bear greater burden of tax (diagram)
 If demand is inelastic, consumers bear greater burden of tax (dia)

Effective taxes:
 Should focus on producing desirable goods and services
 Should discourage businesses from carrying out undesirable activities
 Should not discourage effort and initiative
 Should also provide revenue to govt
 Should be simple to understand and operate