taxes and government spending

Private and public goods A private good – if consumed by one person, cannot be consumed by another person.. dental treatment  A public good – even if consumed by one person, can stil

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

Government spending in the UK

 It is now running at just under 40%.

Government spending

 EQUITY

– a progressive tax and transfer system

redistributes income from rich to poor

 EFFICIENCY

– correction of market failure may

improve resource allocation

We may justify government spending on two grounds:

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

There are strong externalities associated with public goods,

so government intervention may be justified to ensure

appropriate provision.

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

compulsory education or compulsory

vaccination because it recognizes that

otherwise individuals act in a way they will

subsequently regret.

Varieties of taxes

 Direct taxes

– taxes on earnings from labour, rents,

dividends and interest.

e.g income tax, corporation tax

Employers pay the green area, and workers the blue.

The red area is a welfare loss for society.

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.

A tax to offset an externality

Q

A tax of E*F enables this optimum to be reached.

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* Tax rate 100%

Industrial policy and

Competition Policy

 Competition policy

– aims to enhance economic efficiency by promoting or safeguarding competition between firms.

 Industrial policy

– aims to offset externalities that affect

production decisions by firms

Industrial policy

 Inventions and the patent system

– designed to provide a sufficient

incentive for invention without

suppressing competition for ever

 Research and Development (R&D)

– the social return on risky projects may exceed the private return

 Dynamic change

– coping with sunset and sunrise

industries

Consider the demand curve D

and suppose price is at P with quantity demanded being Q.

P represents the value placed

on the good by the marginal consumer

so D can be seen to

represent marginal social benefit

With all consumers paying the same price P for the good, the

triangle APC represents consumer surplus – benefit received

by consumers in excess of the amount they need to pay.

A

C

– as shown by the rectangle.

Consumer surplus is the area of the big green triangle.

The social cost of monopoly:

comparing perfect competition and monopoly

Under perfect competition, long-run equilibrium would

be with industry output

Qc selling at price Pc.

and the red triangle shows the welfare loss – the

social cost of monopoly

The monopoly receives producer surplus (profit)

of the blue rectangle.

Consumer surplus is now the smaller green triangle.

The social cost of monopoly:

comparing perfect competition and monopoly

must be balanced against the gains from efficiency

(the pink rectangle).

In comparing the two situations, the loss of consumer

surplus under monopoly (the red triangle)

Perfect competition and monopoly under differing cost conditions

Counting the cost of monopoly

 The size of the social cost of monopoly is difficult

to evaluate

– in part it depends upon the elasticity of demand

– which influences the size of the ‘red triangle’ of welfare loss

 Furthermore, firms may use up resources to

defend their monopoly position

– implying that costs are higher than under perfect

competition

– there may also be X-inefficiency under monopoly

competition.

Competition law in the UK

 The Competition Commission (formerly

the Monopolies and Mergers Commission)

is the body responsible for administering competition policy in the UK.

 A company can be referred to the

Commission if it supplies more than 25%

of the total market for a good

– or where there is collusion between firms

 The Commission is charged to investigate whether or not the monopoly acts against the public interest.

Mergers and acquisitions

 Firms can grow through merger and acquisition (M&A) activity

 Size may enable:

– economies of scale

– competition on a global scale

 The late 1990s saw record levels of

M&A activity.