25.

The Government as a producer and an employer

The govt. as a producer:

A government may produce products which it believes are of national importance or the products
that are produced by a natural monopoly, or those which it thinks are essential and hence should
be available to all. Also, it may produce those commodities which the private sector may under-
produce or not.

Natural Monopolies:

Natural monopolies, such as all rail infrastructure, may be run by the government. This is to
prevent consumers being exploited by a private sector firm charging a high price. Also to
produce at a low AC a high output may be required and at an output, loss may be incurred.

Essential Products:

Most governments produce at least some goods and services that they think are essential. In
some countries, governments provide affordable housing to rent. Besides housing, education and
health care are also seen as essential services and some governments produce them and provide
them to people free of cost or at subsidised prices.

Merit goods;

Besides being essential products, education and health care are also merit goods. Merit good is
one whose benefit to consumers and others is undervalued by them. To stimulate the
consumption of merit goods, governments also pay private sector firms to produce them, provide
information about their benefits and in some cases make their consumption compulsory.

Public goods:

There are some products that private sector firms have no incentive to produce. This is not
because people do not want them but because they know that if they are provided, they can
consume them without paying. For example, it is not possible to exclude someone from enjoying
the benefits of defence and street lighting even if they are not prepared to pay them directly. This
is why governments produce them or pay private sector firms to make them and raise finance
through taxation. It is also interesting to note that public goods are non-rivalled.

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 The government as an Employer

The government employs workers and managers to operate its sate owned enterprises.
Employing people helps a government to achieve some of its aims for the economy. To reduce
unemployment, the government can employ more workers. To control rises in prices, the
government can limit the wage rises of its own workers and the prices charged by its enterprises.
It can also set an example of in terms of employment practice by providing its workers with good
quality training, preventing discrimination and ensuring good pensions to its workers.

Ø Aims of Government

The macroeconomic aims of a government are;

Full employment, price stability, economic growth, redistribution of income and stability of
BOPs.

Full employment:

Most governments try to achieve full employment. This means that people who are willing and
able to work can find employment. It includes only the active work force excluding children, the
retired, students, home makers, sick and disabled.

The unemployment rate is calculated as a percentage of the labour = (UNEMPLOYED/

LABOUR FORCE) X100

Most economies think that full employment is not actually 0% unemployment. They usually put
the figure at approximately 3%. This is because of cyclical and frictional unemployment.

Price Stability:

Governments aim for price stability because it ensures greater economic certainty and prevents
the country’s products from losing international competitiveness. The governments do not aim
for 0% of price change. A common target is a stable inflation rate of 2%. Because a slight
inflation is an incentive for the economic agents to engage in production process.

2
Economic growth:

When an economy is experiencing economic growth, there is an increase in its output in the short
run (actual economic growth). In the long run, for an economy to sustain its growth, the
productive potential of the economy has to be increased. Such an increase can be achieved as a
result of a rise in the quantity and/or quality of factors of production.

The difference between actual growth and potential growth can be shown on a PPC. The
movement from point A to B represents actual economic growth- more capital and consumer
goods are produced. The shift outwards of the PPC from YY to ZZ represents potential economic
growth – the economy is capable of producing more.

Redistribution of Income:

A government may seek to redistribute income from the rich to the poor. The government
redistribute income by taxing and spending. The rich are taxed more than the poor. Some of the
money raised is spent directly on the poor by means of benefits such as housing benefit and
employment benefit. Other forms of government’s expenditure, such as that on education and
health, particularly benefit poor.

Governments are unlikely to aim for a perfectly equal distribution of income. This is because
taxing the rich too heavily and providing too generous benefits may act as a distinctive to effort
and enterprise.

Balance of payments stability:

Over the long run, most governments want the value of their exports to equal the value of their
imports. If expenditure on imports exceeds revenue from exports for a long period of time, the
country will be living beyond its means and will get into debt. If export revenue is greater than
import expenditure, the inhabitants of the country will not be enjoying as many products as
possible.

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 The governments influence on Private producers

Governments Macroeconomic Policies:

The three main types of government macroeconomic policies are fiscal policy, monetary policy
and supply side policy.

a) Fiscal Policy: FP refers to changes in government expenditure and taxation.

Governments spend money on a variety of items including benefits, education,
healthcare, transport, defense, and interest on national debt.
A government sets out the amount it plans to spend and raise in tax revenue in a budget
statement. A budget deficit is when the government’s expenditure is higher than its
revenue. In this case the government will have to borrow finance some of its expenditure.
A government may alter its expenditure or tax revenue to influence economic activity. If
a government wants to raise AD in order to increase economic growth and employment,
it will increase its expenditure and/or cut taxation by lowering tax rates, reducing the
items taxed or raising tax thresholds.
b) Monetary Policy:
Monetary policy includes changes in money supply, the rate of interest and the exchange
rate, although some economists treat changes in the exchange rate as a separate policy.
The main monetary policy measure, currently used in most countries, is changes in the
rate of interest. A rise in the rate of interest helps implement a deflationary monetary
policy. It will be likely to reduce AD by lowering consumption and investment.
Households will spend less due to availability of less income, expensive borrowing and
greater incentive to save. Firms will invest less as they will expect consumption to be
lower. Also the opportunity cost of investment will have risen and borrowing will have
become expensive. A higher interest rate may also reduce AD by lowering net exports.
Changes in the money supply, as changes in the interest rates, are implemented by the
central banks on behalf of governments. If the money supply is increased by the Bank
printing more money, buying back government bonds or encouraging commercial banks
to lend more, the AD increases. On the other hand, a decrease in the money supply
reduces AD.

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 c) Supply Sided Policy: SSP measures are designed to increase AS and hence increase
productive potential. Such policies seek to increase the quantity and quality of resources
and raise the efficiency of markets. These include improving education and training,
cutting direct taxes and benefits, reforming trade unions and privatization. The training
improves productivity and cutting direct taxes encourages employment.

Microeconomic Policies (measures):

There are a range of policy measures which are specifically microeconomic in nature that is they
concentrate on particular industries and products. These include subsidies, indirect taxes,
competition policy, price controls, environmental policies and regulation.

(a) Subsidies and taxes: Government subsidies affect the output of some firms only. The
effect of subsidy given to producers is influenced by the size of the subsidy and the price
elasticity of demand. A subsidy being an extra payment to producers, shifts the supply
curve to the right. The larger the subsidy, the more increase there is in supply. It is
represented by the distance the two supply curves.

Fig.

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 In fig. the subsidy per unit is SY. If all the subsidy is passed on to consumers, the price
would fall to P2. As demand is inelastic, producers have to pass on most of the subsidy
encourage an extension in demand. Price actually falls to P1, with consumers receiving
most of the benefit (PSXP10 and the producers keeping the rest (P1XYP2).
If demand is elastic, a subsidy will have more impact on the quantity sold and less on the
price. In this case, the producers can keep more of the subsidy as shown in fig.3
In deciding whether to grant subsidy, government has to consider the opportunity cost as
the money which could have been used for another purpose.
All firms are affected by taxes in some way. The impact of tax is again influenced by the
size of the tax and the price elasticity of demand. The higher the tax, the greater is the
impact. A tax on a product with inelastic demand would have a greater effect on price
than the quantity sold. In the case of product with elastic demand, it is the other way
round. If a government wants to raise revenue, it should tax products with inelastic
demand. This is because the quantity sold will not fall by much.

(b) Competition Policy: This policy seeks to promote competitive pressure and prevent firms
from abusing their market power. Government uses the ways like prevention of mergers,
removal of barriers of entry and exit, regulation of monopolies and prohibition of
uncompetitive practices.

(c) Environmental Policies: Firms can be affected by a range of policies, designed to

improve environmental conditions. A government may place restrictions on the amount
of pollutants emitted by firms in to the air, sea and rivers. It may then fine any firms
which exceed these limits. Another policy, which has become more popular in recent
years, is tradable permits. This involves a government issuing permits to firms allowing
them to pollute up to ascertain limit and to sell part of their allocated limit, and to sell
part of their allocated limit, if they pollute less. The idea is that the cleanest firms will be
able to sell most of their permits. This will have to buy more of their firms, whilst raising
the costs of the cleanest firms. As a result the cleanest firms. As a result the costs of the
worst polluting firms. As result the cleanest firms should capture a higher market share
and consequently, pollution should fall.

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(d) Price controls: A government may limit firm’s ability to set their own prices by imposing
price controls. A government may set a maximum ceiling on the price in order to enable
the poor afford basic necessities. To have any impact, a maximum price being set below
the equilibrium price. Fig. 4 shows maximum price being set at pox’ below the
equilibrium price of P. some people will now be able to purchase the product at a lower
price. The problem is however, that a shortage will be created as at this lower price the
quantity demanded exceeds the quantity supplied. To prevent the development of an
illegal market in the product, some method of its allocation will have to be introduced.
This might be through queuing, rationing or even a lottery.

To encourage production of a product a government of a product a government may set a

maximum price (PX). To have an impact on a market, this will have an impact on a
market, this will have to be set above the equilibrium price as shown fig 5.
Fig.
This time the problem created is surplus, with the quantity supplied being greater than the
quantity demanded? To prevent the price being driven down, surplus will have to be
bought up by government or some other official body
A minimum price may also be set on the price of labour in the form of a minimum wage.
Regulation: Regulation includes the rules and laws which place restrictions on the
activities of the firms. Besides setting price controls government applies uncompetitive
policies, pollution control and regulating the target audience for the product.

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 Conflicts between Government aims.
When the government tries to achieve certain macro-economic aims, it may pave the way
for conflict between some of the objectives. It can be discussed as follows.
(a) Unemployment and inflation: Some of the policy measures designed to reduce
unemployment may increase inflation. For example, an increase in the government
expenditure on pensions would raise consumption. This raise would encourage firms
to expand their output and take on more workers. The higher AD may raise price
level (inflation).
(b) The BOP and Economic Growth: Policy measures to reduce expenditure on imports
may reduce economic growth. A raise in income tax, designed to reduce household’s
expenditure on imports would also reduce spending on domestically produced
products. This fall in demand would reduce the country’s output or at least slow down
the economic growth.
(c) Government aims and AD: Unemployment and economic growth tend to benefit from
expansionary fiscal and monetary policies. In contrast, deflationary fiscal and
monetary policies are more likely to reduce inflation and expenditure on imports.
(d) Government aims And supply-side policy: In the long run, all the government
macroeconomic aims have the potential to benefit from supply side policy. Increasing
AS enables an economy to continue to grow in a non-inflationary way. Fig.1 shows
AS rising in line with Ad. Such a combination enables output and employment to
increase, without inflation.
(e) Improving education and training is likely to increase AD, as it will probably involve
an increase in govt. expenditure. Also, it will be likely to reduce unemployment in by
making workers more productive and occupationally mobile.
(f) Increasing productive potential and efficiency can improve economy’s BOP
positions. Producing better quality and cheaper products can increase exports and
reduce imports.
It has to be reduced that besides a time lag before the effect of some supply side
policy, some of the measures can be expensive while some might not work. For
instance, the govt. may spend more on education but if subjects’ thought are not in dd
in the future, it may reduce employment.

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 26. Fiscal Policy

Types of Taxation

1. What is meant by tax?

A tax (from the Latin taxo; "rate") is a financial charge or other levy imposed upon a taxpayer
(an individual or legal entity) by a state. Taxes consist of direct or indirect taxes .

2. Aims of tax

(a) To redistribute income: An important aim of tax is redistribution of income from the rich to the
poor. Higher income groups pay more in tax than the poor and some of the revenue raised is used
to pay benefits to the poor.

(b) To discourage consuming demerit goods: Another aim of tax is to discourage the consumption of
demerit goods. These are products which government considers more harmful to consumers than
they realise, for example, cigarettes and alcohol.

(c) To reduce externality from private firms: Tax aims to raise the costs of firms that impose costs on
others (society or to third party), for instance, causing pollution.

(d) To discourage imports: The tax aims discouraging the consumption of imports and hence protect
domestic industries. By placing tariffs on rival imported products, the country’s inhabitants may
buy less from foreign and more domestic products.

(e) To influence economic activity: Fiscal policy, which uses tax as an instrument, can be used to
change aggregate demand. If an economy is experiencing rising unemployment, its government
may cut taxes to stimulate an increase in consumption and investment.

3. Direct and Indirect taxes

Direct taxes are levied on a person’s or a firm’s income or wealth. They are called direct taxes
because the people or firms responsible for paying the tax have to bear the burden of the tax.
Indirect taxes (expenditure or outlay taxes) differ from direct taxes in two ways; (i) they are
levied on spending. (ii) The firms actually make the tax payment to the government may pass on
(at least some of the burden) to other people.

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4. Types/kinds of taxes:

A. Direct Taxes

(a) Income tax

This is a tax on income that people receive form their employment and investment income.
People are given a tax allowance, which is an amount of income they earn free of tax. Income
above this level is referred to as taxable income. Personal income tax is often collected on a pay-
as-you-earn basis, with small corrections made soon after the end of the tax year.

Negative income tax-In economics, a negative income tax (abbreviated NIT) is a progressive
income tax system where people earning below a certain amount receive supplemental pay from
the government instead of paying taxes to the government.

(b) Corporate tax

This is the tax on profits earned by firms. Corporate tax refers to income, capital, net worth, or
other taxes imposed on corporations.

(c) Capital gains tax

This is a tax on profit made on assets when they are sold. A capital gain can be made, for
instance, by shareholders selling shares for more than what they paid for them. When capital
gains tax is imposed exemptions are usually made. These normally include any money made on
the sale of people’s main residence.

(d) Inheritance Tax:

This is a tax on wealth above a certain amount which is passed on to other people when a person
dies. Inheritance tax, estate tax, and death tax or duty are the names given to various taxes which
arise on the death of an individual. In United States tax law, there is a distinction between an
estate tax and an inheritance tax: the former taxes the personal representatives of the deceased,
while the latter taxes the beneficiaries of the estate.

(e) Property Tax

A property tax (or millage tax) is an ad valorem tax levy on the value of property that the owner
of the property is required to pay to a government in which the property is situated. Multiple
jurisdictions may tax the same property. There are three general varieties of property: land,
improvements to land (immovable man-made things, e.g. buildings) and personal property
(movable things). Real estate or realty is the combination of land and improvements to land.

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B. Indirect Taxes

(a) Sales tax

Sales taxes are levied when a commodity is sold to its final consumer. People with higher
incomes spend a lower proportion of them, so a flat-rate sales tax will tend to be regressive. The
main type of sales tax is value Added tax (VAT). This is levied on the value added by firms at
the different stages of the production process. Firms can usually get back the VAT paid by them
on the products they have purchased.

(b) Excise Duties:

These are taxes charged on certain domestically produced goods, most commonly on alcoholic
drinks, petrol and tobacco. They are charged in addition to VAT. Excise taxes are based on the
quantity, not the value, of product purchased. For example, in the United States, the Federal
government imposes an excise tax of 18.4 cents per U.S. gallon (4.86¢/L) of gasoline, while state
governments levy an additional 8 to 28 cents per U.S. gallon.

(c) Customs duties/ tariff:

These are taxes on imports and are also called tariffs. An import or export tariff (also called
customs duty or impost) is a charge for the movement of goods through a political border. Tariffs
discourage trade, and they may be used by governments to protect domestic industries.

(d) Licenses:

A license may be needed to use a range of products including a car and a gun. Occupational
taxes or license fees may be imposed on businesses or individuals engaged in certain businesses.
Many jurisdictions impose a tax on vehicles.

(e) Poll Tax:

A poll tax, also called a per capita tax, or capitation tax, is a tax that levies a set amount per
individual. It is an example of the concept of fixed tax

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5. Nature of taxation:

Proportional, progressive, regressive, and lump-sum

An important feature of tax systems is the percentage of the tax burden as it relates to income or
consumption. The terms progressive, regressive, and proportional are used to describe the way
the rate progresses from low to high, from high to low, or proportionally. The terms describe a
distribution effect, which can be applied to any type of tax system (income or consumption) that
meets the definition.

• A progressive tax is a tax imposed so that the effective tax rate increases as the amount to
which the rate is applied increases.
• The opposite of a progressive tax is a regressive tax, where the effective tax rate decreases as
the amount to which the rate is applied increases. This effect is commonly produced where
means testing is used to withdraw tax allowances or state benefits.
• In between is a proportional tax, where the effective tax rate is fixed, while the amount to
which the rate is applied increases.
• A lump-sum tax is a tax that is a fixed amount, no matter the change in circumstance of the
taxed entity. This in actuality is a regressive tax as those with lower income must use higher
percentage of their income than those with higher income and therefore the effect of the tax
reduces as a function of income.
Incidence and impact of taxation

1. Tax base:
Tax base is the source of tax revenue, which is what is taxed.
Total of taxable assets, income, and assessed value of property within the tax jurisdiction of
a government.
The assessed value of a set of assets, investments or income streams that is subject to
taxation, or the assessed value of a single asset that is subject to taxation. Anything that can
be taxed has a tax base.
(a) Wide tax base: It means that a large range of items and people are taxed.
(b) Narrow tax base: It means that a small range of items and people are taxed.
There can be a link between tax rates and the tax burden. A wide tax base may enable tax
rates to be relatively low. High tax rates, particularly corporate tax rates, can reduce the
tax base. This because they may cause firms to move out of the country.

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2. Tax burden:
TB relates to the amount of tax paid by people and firms. It is sometimes expressed as a
percentage of the country’s total income (GDP). The higher the tax burden, the greater the
percentage of people’s and firm’s income taken through tax.
3. Incidence of taxation:
It refers to the distribution of the burden of an indirect tax, shared between consumers and
producers. In the case of products with inelastic demand, consumers bear most of the tax.
This is because the producers can pass on a high proportion of the tax in the form of a higher
prices as they know it will not reduce the demand significantly.
In contrast, if products have elastic demand, it is producers who bear most of tax. This is
because they know that they cannot pass on much of the tax to consumers as such a move
would bring down sales significantly.

13
 The tax shifts the supply curve to the left by the amount the tax. The total revenue is P1TXZ.
The proportion of tax borne by consumers is represented by the change in price multiplied by
the quantity sold, PP1TA. The proportion borne by producers, is the amount by which the
price producers receive after tax is below the original market price, multiplied by the quantity
sold, i.e, PAXZ. Elasticity of supply also influences the incidence of taxation. The more
inelastic supply is, the more the tax borne by the suppliers. In contrast, if supply is elastic,
more of the tax will be borne by consumers.

4. The Qualities of a Good Tax:

The important qualities of a good tax are;
(a) Equity: This means fairness in the sense that the amount of tax people and firms have to
pay, should be based on their ability to pay. A rich person has a greater ability to pay tax
than a poor person.
(b) Certainty: A tax should be easy to understand and households and firms should be able to
calculate the amount of tax required to be paid by them.
(c) Convenience: A tax should be easy to pay
(d) Economy: The cost of collecting a tax should be considerably less than the revenue it
generates.
(e) Flexibility: It should be possible to change the tax if economic activity changes or
governments aims change. The revenue from some taxes changes automatically to offset
economic booms and slumps. For instance, tax, revenue rises from income tax and sales
tax, without any change in the rates, when there is an economic boom. This is because
more people will be employed, incomes will rise and people will spend more. Such a rise
in tax revenue may slow down the rise in AD and prevent inflationary pressure building
up.
(f) Efficiency: A tax should improve the performance of markets or at least, not significantly
reduce the efficiency of markets. For instance, an extra one-off tax, sometimes called a
windfall tax imposed on high supernormal profits of banks may encourage banks to
reduce the charges they impose on consumers. A tax on pollution may result in a cleaner
environment. Income tax rates should not be set so high that they discourage effort.

14
 5. The impact of Direct Taxes:
It may discourage effort, enterprise and saving. Higher income tax may stop some people
from working overtime and taking promotion and prevent some people entering the labour
force. Higher corporation tax will discourage entrepreneurs from expanding their firms and
investing in new markets.
Direct taxes may create disincentives to postpone consumption through saving and also for
firms to invest in new capital inputs
6. The impact of Indirect tax:
Arguments For Using Indirect Taxation Arguments Against Using Indirect Taxation
Changes in indirect taxes can change the pattern of demand by Many indirect taxes make the distribution of
varying relative prices and thereby affecting demand (e.g. an income more unequal because indirect taxes are
increase in the real duty on petrol) more regressive than direct taxes

They are an instrument in correcting for externalities – indirect Higher indirect taxes can cause cost-push inflation
taxes can be used as a means of making the polluter pay and which can lead to a rise in inflation expectations
“internalizing the external costs” of production and
consumption

Indirect taxes are less likely to distort the choices that people If indirect taxes are too high – this creates an
have to between work and leisure and therefore have less of a incentive to avoid taxes through “boot-legging” –
negative effect on work incentives. e.g. the booze cruises to France where duty on
alcohol and cigarettes is much lower.

Indirect taxes can be changed more easily than direct taxes – Revenue from indirect taxes can be uncertain
this gives policy-makers more flexibility. Direct taxes can only particularly when inflation is low or there is a
be changed once a year at Budget time recession causing a fall in consumer spending

Indirect taxes are less easy to avoid, often people are unaware There is a potential loss of welfare from duties
of how much in duty and other spending taxes they are paying e.g. loss of producer & consumer surplus

Indirect taxes provide an incentive to save savings help to Higher indirect taxes affect households on lower
provide finance for capital investment incomes who are least able to save

Indirect taxes leave people free to make a choice whereas Many people are unaware of how much they are
direct taxes leave people with less of their gross income in paying in indirect taxes – they may be taxed by
their pockets stealth – this goes against one of the basic
principles of a tax system – that taxes should be
transparent

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 27. Monetary Policy

The money supply is the total value of money available in an economy at a point of time. The
government can control money supply through a variety of tools including open market operations
(buying and selling of government bonds) and changing reserve requirements of banks.

The interest rate is the cost of borrowing money. When a person borrows money from a bank,
he/she has to pay an interest (monthly or annually) calculated on the amount he/she borrowed.
Interest is also be earned on the money deposited by individuals in a bank.
(The interest on borrowing is higher than the interest on deposits, helping the banks make a
profit).
Higher interest rates will discourage borrowing and therefore, investments; it will also encourage
people to save rather than consume (fall in consumption also discourage firms from investing
and producing more).
Lower interest rates will encourage borrowing and investments, and encourage people to
consume rather than save (rise in consumption also encourage firms to invest and produce more).
The monetary authority of the country cannot directly change the general interest rate in the
economy. Instead, it changes the interest rates of borrowing between the central bank and
commercial banks, as well as the interest on its bonds and securities. These will then influence
the interest rate provided by commercial banks on loans and deposits to individuals and
businesses.

Monetary policy:
MP is a government policy controls money supply (availability and cost of money) in an
economy to attain growth and stability. It is usually conducted by the country’s central bank
and usually used to maintain price stability, low unemployment and economic growth.

a. Expansionary monetary policy is where the government increases money supply by

cutting interest rates. Low interest rates will mean more people will resort to spending
rather than saving, and businesses will invest more as they will have to pay lower interest on
their borrowings. Thus, the higher money supply will mean more money being circulated
among the government, producers and consumers, increasing economic activity. Economic
growth and an improvement in the balance of payments will be experienced
and employment will rise.

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b. Contractionary monetary policy is where the government decreases money supply by increasing
interest rates. Higher interest rates will mean more people will resort to saving rather than spending,
and businesses will be reluctant to invest as they will have to pay high interest on their borrowings.
Thus, the lower money supply will mean less money being circulated among the government,
producers and consumers, reducing economic activity. This helps slow down economic growth
and reduce inflation, but at the cost of possible unemployment resulting from the fall in output.

17