The Role of Government Chapter 14

1
The Role of GovernmentChapter 14

• LIPSEY CHRYSTAL
• ECONOMICS 12e

2
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

3
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.

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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.

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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.

6
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.

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INTRODUCTION - THE ROLE OF GOVERNMENT

• The Costs of Government Intervention
• Government activity incurs many types of cost.
  Internal costs refer to the governments 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.

8
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.

9
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.

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Income Taxes With Different Progressivities -
Proportional
30
i. Proportional
25
20
15
Tax paid 000
10
5
10
20
30
Income 000
Income 000
11
Income Taxes With Different Progressivities -
Progressive
30
2
ii. Progressive
25
20
Tax paid 000
15
1
10
5
10
20
30
Income 000
12
Income Taxes With Different Progressivities -
Regressive
iii. Regressive
30
25
3
20
15
4
10
Tax paid 000
5
10
20
30
Income 000
13
Income Taxes With Different Progressivities

• Part (i)
• This proportional taxs average and marginal
  rates remain unchanged at 50 per cent as income
  changes.

14
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.

15
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.

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The Inefficiency of Free Goods
D
S
Price
E0
2
p0
1
Quantity
q1
q0
0
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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 industrys
  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.

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The Efficiency Loss From an Indirect Tax
Price
0
Quantity
19
The Efficiency Loss From an Indirect Tax
S
Price
p0
E0
D
q0
0
Quantity
20
The Efficiency Loss From an Indirect Tax
S
Price
Tax
p0
E0
D
q0
0
Quantity
21
The Efficiency Loss From an Indirect Tax
S1
S
Price
Tax
E1
p0
p0
E0
p0
D
q1
q0
0
Quantity
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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.

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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.

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An Income Tax and the Work-leisure Choice
24
20
G
E1
18
E0
16
15
E2
Leisure hours/days
10
5
Daily income
840
960
480
320
240
120
0
25
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.

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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.

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Dis-incetives of Welfare Schemes
24
E0
19
a
Leisure hours
E1
16
I0
I1
25
40
Income
120
0
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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.

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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.

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Government Failure
MC2
MC1

MB
10
4
1.6
Pollution abatement millions of tonnes
0
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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.

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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.