Unit 5 Role of government
in an economy
Unit 5 Role of government in an economy
Activities: Guidance and answers
Activity 5.1 Being instrumental
Article
Government objective
Economic policies used
Sweden to cut taxes again
To boost consumer demand
and employment
Cutting income tax
Higher taxes on car imports to
curb trade deficit
To reduce demand for
imports; to reduce balance of
payments deficit
Increasing tariffs on imported goods
Venezuela to increase public
spending…
To boost economic growth
and employment
Public spending on new schools, roads and
other infrastructure
Taiwan cuts interest rates to
boost exports
To increase consumer spending
and investment to boost output,
employment and growth
Cutting interest rates to reduce the cost of borrowing
India raises interest rate…
To reduce consumer spending to
control price inflation
Raising interest rates to make borrowing more
expensive
China launches tax reforms…
To encourage firms to invest in
new productive assets to boost
economic growth
Reducing taxes on profits, smaller businesses and the
self-employed
Germany wants a million electric
vehicles on the road by 2020
To increase employment and
economic growth
Increasing government spending and financial
support for firms investing in new green technologies
Activity 5.2 Can increased public expenditure create jobs?
Your explanation should describe how the building of the new hospitals creates
jobs and incomes for construction workers, and thereafter for doctors, nurses and
other hospital workers once it is operational. All the employees will spend their
incomes buying other goods and services, thereby providing additional revenues
for firms who may increase their output as a result, creating additional jobs and
incomes for other people. That is, public spending has a multiplier effect on
private spending in the economy.
If the increase in public spending is paid for through increased taxes this may
have the impact of reducing consumer spending and new investment by firms
unless people and firms reduce their savings or increase borrowing to maintain
their levels of spending. If savings are reduced to pay the increased taxes, which
are subsequently spent by government, this can boost employment and output in
the economy. If the tax revenue is spent on capital goods rather than consumer
goods this can also help to grow the productive potential of the economy.
If consumer demand falls it will have a negative impact on firms producing
consumer goods and services. In response, firms manufacturing and selling consumer
products may reduce their output and employment. However, if many consumer
goods are imported the fall in demand will help improve the balance of trade.
An increase in interest rates may encourage people and organizations to save
more, including buying interest bearing government bonds. The increase in
interest rates may therefore crowd out private sector spending.
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Unit 5 Role of government in an economy
Activity 5.3 A walk on the supply side
Supply-side instrument
Likely impact
Milk market deregulation
Simplifying or removing old and
unnecessary regulations
Reducing costs of compliance on businesses
allowing them to increase their productivity
New tax incentives
Tax credit for film industry
Providing an incentive to film companies to increase
their investment and output in the sector
Pakistan Telecommunications
Authority
Price controls on company
abusing its market power
Reducing the ability of large firms with powerful
market positions to force up market prices
UK plans skills academies
Free vocational training
To teach people new skills for modern expanding
industries. They will be unable to expand unless
there is a suitable supply of labour
Privatization in Romania
Sale of state-owned energy
providers to private sector
Transferring energy supply to more efficient private
sector suppliers who may be able to produce power
at a lower average cost per unit, thereby benefiting
both the sector and many other firms
Trade unions protest
Laws to control the ability of
trade unions to take strike action
Constraining the ability of trade unions to
disrupt production and forcing up wages without
improvements in labour productivity
Activity 5.4 Public or private provision?
1
Privatization is the transfer of public sector activities to private firms because
it is thought they will be able to provide them more efficiently than public
sector organizations.
2
Lee will pay a private company to supply water and sewerage services.
3
Arguments for privatization: a private company will have a profit motive and
will therefore do more than a public sector organization to reduce costs and
improve services to earn additional revenue and profits.
Arguments against privatization: workers may lose their jobs as the private
company will want to reduce costs; the private firm may also cut service
levels and reduce health and safety to save costs to improve its profits.
4
If privatization improves efficiency and service levels local taxpayers will
benefit because the public sector will save money providing water and
sewerage services through the private supplier and local customers will also
benefit from lower prices and improved services. However, some former
public employees may lose their jobs as the private firm seeks to cut its costs.
It may also cut pensions and other benefits for those employees it retains.
5
(This is your own research on examples of privatization in your country.)
Activity 5.5 Policy conflicts
1
US economic growth in real output was positive throughout most of the
1990s and first decade of the new millennium, but turned sharply negative
in 2009 due to the global financial crash and recession. However, even over
these two decades annual growth rates were variable and there is clear
cyclical pattern in growth rates.
Annual inflation rates have been variable but came down from over 5%
in 1990 to between 2% to 4% over the next two decades until 2008 when
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Unit 5 Role of government in an economy
inflation fell sharply and there was a short-lived period of deflation, again
during the global recession.
The deficit on the US balance of trade has grown steadily over time only
recovering during 2008 and 2009 as US consumers cut back their sending on
imported goods during the economic downturn.
The US unemployment rate fell steadily during most of the 1990s from a peak
in 1993 of just under 8% of the US workforce to 4% by 2000, but thereafter
began to increase again, rising sharply to 10% by 2009.
Overall therefore, while the US government clearly had some success in
achieving its macroeconomic aims during the 1990s and early part of the
following decade, the recession in the global economy hit the US particularly
hard during 2008 and 2009.
2
At least between 1993 and 2002 the US economy experienced a period of
relatively high positive economic growth at the same time as falling rates of
inflation and workforce unemployment. Growth in the economy slowed in
2002 and 2003 as inflation and unemployment rose.
However, there appeared to be a clear conflict between economic growth
and the balance of trade over the same period. The deficit on the balance of
trade steadily worsened during a period when the US economy, and therefore
consumer incomes and spending, were growing. Although the unemployment
rate and inflation rate fell together, particularly over the period 1993 to 2000,
unemployment rose sharply in 2008 and 2009 as inflation fell rapidly due to
the impact of a deep and widespread recession.
3
(This is your own research comparing and contrasting the US economic
experience with that of your own country.)
Activity 5.6 Why have taxes?
Image 1: The government might impose taxes to finance public expenditure, for
example for the provision of a police service.
Image 2 : Taxes might be imposed to help control aggregate demand, for example,
by raising the overall level of taxation to reduce inflationary pressures
Image 3 : The government might want to influence the behaviours of consumers
and producers, for example to reduce pollution by taxing petrol and vehicles
that produce significant emissions more heavily than other vehicles or forms of
transport, to encourage consumers to switch their consumption.
Image 4 : The aim might be to reduce inequalities in incomes by taxing high
incomes proportionally more than low incomes.
Activity 5.7 When is a tax a good tax?
A height tax is not very fair. It does not meet the principle of equity
between taxpayers.
A high tax on overtime would reduce employee incentives to work overtime and
therefore reduce the productive potential of many firms and the economy, i.e. the
tax would be distortionary.
Moving from PAYE income tax to lump sum payments every two years will
increase administrative costs and reduce the certainty of tax flows to government
to pay for recurrent public expenditures. People and firms would also have
to work out how much they every two years and keep sufficient cash over
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Unit 5 Role of government in an economy
time to pay their tax demands. Such a move lacks simplicity and would not be
very convenient.
If a tax costs a government more to collect than it raises in revenue it is
administratively inefficient.
A lump sum tax of $2,000 per adult would be simple and cheap to collect for
government and taxpayers, and would not distort behaviours, but it may not be very
fair to charge people on very low incomes the same as people who are very rich.
Activity 5.8 Window tax: daylight robbery
or a smashing idea?
Your report may cover the following arguments.
•
Fairness: although it is not directly related to ability to pay a window tax
is likely to tax rich households more than poor households because rich
households tend to live in larger houses.
•
The effect on consumption expenditure, output and employment: the tax
would reduce after tax incomes and therefore will tend to reduce consumer
spending on many goods and services. In response to falling demand, firms
may cut back output and employment. However, the tax may also create
distortions because it can be avoided simply by removing or bricking-up
windows. Manufacturers of window frames will suffer a big fall in demand
for their products while demand for the services of builders and bricklayers
may rise as householders and firms seek to remove or cover their windows to
avoid tax. Consumption of electricity to indoor lights may then rise as a result
because natural light entering properties will be restricted.
•
The cost of collection: it should be reasonably cost effective to collect this tax
if the number of properties and windows is known. However, as more people
and firms brick-up windows to reduce their tax burdens, revenues will start
to fall, and more collectors may be needed to monitor changes in the tax base,
i.e. the number of windows.
•
The ease with which the tax payable can be calculated: it depends on how a
window is defined or whether the window tax is set per window or per unit
of area of window such as per cm2, such that the larger the window the more
tax is payable.
Activity 5.9 : Tax systems
1
1 = progressive tax; 2 = proportional tax; 3 = regressive tax.
2
Tax system 1
Tax system 2
Tax system 3
Annual income
% tax rate
Annual income
% tax rate
Annual income
% tax rate
$5,000
30%
$10,000
10%
$8,000
40%
$15,000
30%
$16,000
15%
$12,000
30%
$25,000
30%
$30,000
22%
$20,000
20%
Tax system 1 is proportional; tax system 2 is progressive; tax system 3 is regressive.
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Unit 5 Role of government in an economy
Activity 5.10 Taxing USA
1
A single person with an annual income of:
a $20,000 will pay $1,725 in income tax (an average tax rate of 8.6%)
b $500,000 will pay $151,464 in income tax (an average tax rate of 30.3%).
A married couple with an annual income of:
a $150,000 will pay $28,370 (an average tax rate of 18.9%)
b $800,000 will pay $248,171 (an average tax rate of 31%).
2
The first slice of income for all households is tax free in the US income tax system.
People on the lowest incomes therefore pay no or very little tax. The US income
tax system then applies rising marginal rates from 10% up to a top rate of 35%
to progressively higher slices of income. The top rate of tax applies to any income
over $379,150 per year. This means that people who earn the very highest
incomes, for example $1 million per year, will pay an average rate of tax near to
35%. That is, the US income tax system becomes more like a proportional tax on
very high incomes.
Activity 5.11 A taxing problem
The monthly earnings of a footballer
Income tax
A gift of $1 million
Wealth tax
A gain in the value of company shares realized when they
are sold
Capital gains tax
Machinery imported from an overseas manufacturer
Import duty or tariff
A fee charged per vehicle to use a new publicly funded
motorway
User charge
A bottle of wine
Excise duty, sales tax or VAT
The purchase of a meal from a restaurant
Sales tax or VAT
The annual profits of a large company
Corporation tax
A fixed charge per flight on aircraft passengers
User charge
Activity 5.12 Greece lightning
1
A budget deficit is a financial situation in which a government plans to spend
more than it expects to receive from tax revenue over the coming financial
year. If tax revenues turn out to be less than expected and/or spending higher
than planned, then there will be an actual budget deficit.
2
Public spending in Greece, especially on public sector wages, increased at a
much faster rate than tax revenues. There was also widespread tax evasion at
the same time that reduced tax revenues below what they should have been.
3
Public borrowing increased significantly.
4
Greece did not have enough money to meet public debt repayments and
interest charges, and was unable to borrow any more money to do so from
banks and other lenders.
5
Unless Greece cuts its public spending and increases tax revenues it will
continue to have a budget deficit and have to borrow more money. However,
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Unit 5 Role of government in an economy
if the government cannot borrow more then it will be unable to pays its bills
and will be bankrupt. To avoid this, public spending must be cut and taxes
must rise. However, this may result in many public sector workers losing
their jobs and many others also as consumer spending falls. A deep economic
recession could result.
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