Unit 4
The Public Sector
Objectives
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Discuss the role of the public sector in the economy
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Discuss government spending and financing as fiscal instruments
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Discuss the different methods of taxation
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Explain the role of tax as fiscal policy instrument
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Explain the meaning of fiscal policy
1.
The Role of the Public Sector
There are various ways in which the government can intervene in the economy:
1. Ownership of firms
●To provide public goods and merit goods
●Nationalisation
2. Fiscal policy measures
●How the government raises money (taxes
●How the government spends money
Terms
Market failure
Market failure occurs when the market does not lead to a desired result and some needs of the community are not
satisfied. It is often used to justify government intervention in the economy.
Public goods
A public good is there for everybody to consume, regardless of who pays and who does not, e.g. defence, police
services and street lights.
Merit goods
These are generally services which are beneficial to the community but which may not be profitable for a business to
provide, e.g. education and inoculation against diseases.
The minister of finance is the head of the ministry of finance.
Fiscal objectives and plans are announced in the main budget every year and must be approved by the national
assembly
The functions of government
Establishing a stable and safe environment
The first duty of government is to provide:
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a safe environment in which society can function e.g. all the institutions and infrastructure we need to perform
economic activities and the laws and regulations required for carrying out these activities in an orderly
manner.
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courts of law and law enforcement officers
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protect the country against foreign aggression.
Combating externalities
Externalities can be defined as costs or benefits that are borne or enjoyed by parties not directly involved in an
activity. They are also called spill over effects.
Where there are external costs, we refer to negative externalities e.g. pollution or noise. Governments have the
responsibility to correct these negative externalities through legislation or taxes.
External benefits are called positive externalities e.g. the immunisation of babies against infectious diseases and the
aids awareness campaign.
Promoting competition
Government should ensure that markets are as competitive as possible. A free market could lead to the formation of
monopolies that may operate against public interest. The government can provide legislation that regulates the
formation of monopolies.
Promoting economic growth
The government can use expansionary fiscal policy measures such as increased spending when the economic
performance is poor. Restrictive measures such as reduced government spending or increased taxation can be used
to cool down the economy in inflationary conditions.
Social welfare
Government can provide basic social welfare programmes such as old age and disability pensions, basic education
and unemployment insurance.
Support the market mechanism
The government should support the market mechanism by providing public goods and merit goods.
A fair distribution of resources
The government should take measures to provide a fair distribution of income:
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Revenue side of the budget: this can be achieved through a progressive income tax system.
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Expenditure side of the budget: retirement pensions, sickness benefits, unemployment benefits, free primary
health care, free primary education or low cost housing.
2.
Government Expenditure
Government spending is one of the legs of fiscal policy. It has the following objectives
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To render essential services
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To be used as fiscal policy instrument
There are five expenditure categories in the Namibian Budget:
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Expenditure by vote: These are funds allocated to the different government ministries.
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Current expenditure: All personnel expenditures and the purchases of goods and services.
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Capital expenditure: Vehicle purchases and construction activities such as building roads, dams, schools,
etc.
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Statutory expenditure: To pay interest on loans.
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Development budget: This is the budget of the National Planning Commission where money is allocated to
development projects outlined in the National Development Plan.
3 Government Revenue
Government derives income in two main ways, namely, from taxes and from loans.
Taxation
Definition:
Taxation can be defined as the compulsory transfer of money from individuals or institutions to government.
Objectives of taxation:
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To finance government expenditure
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To be used as fiscal policy instrument
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To redistribute income
Types of taxation
Direct taxes:
Direct taxes are levied on the income and wealth of persons or organisations such as companies.
personal income tax, company tax and estate duty.
These taxes cannot be shifted.
Examples:
Indirect taxes:
Indirect taxes are levied on economic transactions and are paid by those who consume the goods and services.
Examples: value added tax (VAT), excise duties (sin taxes) and customs duties (tariffs).
These taxes can be shifted.
Tax shifting:
Tax shifting means to pass the tax burden from one taxpayer to another.
Methods of taxation
According to the method of calculation, a tax can be progressive, proportional or regressive. The distinction between
these methods is based on the percentage of our income that we pay.
Progressive taxation
Taxes are progressive if they take a larger percentage of income as income rises, e.g. personal income tax is an
example of a progressive tax. Table 1 shows a simplified example of a progressive tax.
Table 1: Progressive taxation
Income
Tax paid
Percentage of income
N$30 000
N$4 500
15% (4 500/30 000 x 100)
N$40 000
N$8 000
20% (8 000/40 000 x 100)
Progressive taxation can cause a phenomenon that is known as fiscal drag. We often receive salary increases to
keep up with inflation and to keep our purchasing power the same. The salary increases put us in higher tax
categories and that means we pay a larger percentage of income in tax. We therefore have very little advantage from
the salary increase.
Proportional taxation
Taxes are proportional if taxpayers pay a fixed percentage of their income regardless of the level of income, for
instance 10% of income. In other words, the tax rate is the same for all taxpayers.
Example: company tax. Table 2 shows a simplified example of a proportional tax.
Table 2: Proportional taxation
Taxpayer
Income
Tax paid
Percentage of income
Mr A
N$ 50 000
N$ 5 000
10% (5 000/50 000 x 100)
Mr. B
N$100 000
N$10 000
10% (10 000/100 000 x 100)
Regressive taxation
Taxes are regressive if they take a larger percentage of income as income falls and a lower percentage of income in
taxes as income rises. In other words, a regressive tax takes a larger percentage of the income of low-income
individuals than those with higher incomes.
VAT is an example of a regressive tax.
Suppose Mr A earned N$50 000 and Mr B earned N$100 000. Both of them bought goods for N$20 000 on which
15% VAT is levied. They would pay the following percentages of their income in tax:
Table 3: Regressive taxation
Taxpayer
Tax paid
Percentage of income
Mr A
15% of N$20 000 = N$3 000
N$3 000 of N$50 000 = 6%
Mr B
15% of N$20 000 = N$3 000
N$3 000 of N$100 000 = 3%
Activity 1
The table below shows the amount of tax paid by individuals in three different income categories. For each of the
three taxes, indicate whether the tax is progressive, proportional or regressive.
Income
% of income
Income N$40 000
N$20 000
% of income
Income N$60
000
Tax A
N$2 000
N$4 000
N$6 000
Tax B
N$1 400
N$2 600
N$3 600
Tax C
N$1 200
N$3 000
N$5 600
Tax A is:
Tax B is:
Tax C is:
% of income
Loans
If the government spends more than its revenue from taxes, there is a deficit budget. To take care of the excess
spending, the government must borrow money. These loans can be obtained from the private sector or from abroad.
Loans from the private sector
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Treasury bills: Treasury bills are short-term securities maturing after 3 months, 6 months or 12 months.
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Government bonds: Government bonds are long-term securities that are traded on the Namibian Stock
Exchange. They are identified as GC 15, GC24, etc.
Loans from abroad
The government can also borrow from foreign banks, governments, the World Bank or the International Monetary
Fund (IMF).
The World Bank gives loans for development projects such as roads and dams.
The IMF gives loans to countries with debt problems.
Interest has to be paid on all these loans. As a fiscal policy instrument loans can be used to stimulate the economy
and to develop the country.
Criteria for a good tax
Any tax should meet the following requirements:
Simplicity
A tax should be simple enough for the taxpayer to understand how much, where, when and how to pay.
Neutrality
Taxes should not discriminate between taxpayers by levying an extra tax on certain goods. However, excise taxes
discriminate against smokers because smoking is considered to be an undesirable and luxury habit.
Fairness
The tax burden should be spread as fairly as possible among the various taxpayers. The following two principles
apply:
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The benefit principle: Consumers should pay for the services they receive from government, for instance toll
on roads, taxes included in the price of petrol and airport taxes.
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The ability-to-pay principle: the greater a person’s income and ability to pay, the more tax should be paid, for
instance progressive income tax.
Terms:
Tax avoidance
Tax avoidance is legal and involves the exploitation of tax loopholes to pay as little tax as possible. Funds can be
applied where they will attract the least tax, or all allowable expenses can be deducted.
Tax evasion
Tax evasion occurs when people do not pay the taxes they are supposed to pay. For instance, they may not declare
taxable income or they may deduct expenses they did not actually have. Tax evasion is illegal.
Effect of a tax
Taxes increase the prices of goods resulting in a decrease in the quantity purchased of the good.
4.
The Budget
The budget is a statement showing the government’s planned expenditures and estimated revenues for some period,
usually one year.
Fiscal policy changes are also announced in the budget.
Deficit budget: Government expenditure is greater than the revenue from taxes. The deficit must be financed by
loans, for instance the issuing of treasury bills and government bonds.
Surplus budget: The revenue from taxes is greater than the government expenditure.
Balanced budget: The revenue from taxes is equal to government expenditure.
5.
Fiscal Policy
Definition:
Fiscal policy can be defined as deliberate changes in government expenditures and/or taxes to promote particular
macroeconomic goals such as full employment, stable prices and economic growth.
The aim of fiscal policy is to influence the national income by changing the total demand for goods and services. Total
demand consists of consumer expenditure, investment expenditure, government expenditure and net exports (Y =
C+I+G+X-M).
Instruments of fiscal policy:
●
Government expenditure
●
Taxes
Fiscal policy can be expansionary or restrictive (contractionary).
Expansionary fiscal policy
Expansionary fiscal policy increases production, employment and income and can be used to move the economy out
of a slump or recession or it can be used when unemployment is high.
Decrease taxes (T)
A decrease in tax rates will increase consumption (C) because consumers will have more money to spend.
Businesses will have a larger part of their profits to spend on capital goods and investment (I) will increase. If
consumption (C) and investment (I) increase, aggregate demand will increase.
Increase government spending (G)
The second option is to increase government spending (G). This will increase aggregate demand.
Restrictive (contractionary) fiscal policy
A restrictive fiscal policy decreases production, employment and income. It can be used to combat the problem of
inflation.
Increase taxes
Higher tax rates will decrease the disposable income of consumers and thus decrease consumption (C). Businesses
will pay a larger percentage of their profits as tax and will have less money for investment (I). Aggregate demand will
decrease.
Decrease government spending
A reduction in government expenditure (G) will also decrease aggregate demand. You should note, however, that it is
very difficult, perhaps impossible, for governments to decrease their expenditure
Activity 2
State whether fiscal policy is restrictive or expansionary in each of the following cases and how it will affect aggregate
demand:
1.
Personal income taxes are increased by 5% across the board.
2.
The government increases its expenditures on highways and bridges by N$10 billion.
3.
The government decreases tax rates for corporations.
4.
The government increases funding for unemployment insurance.
5.
Due to increased expenditures, the government’s budget shows a deficit.
6.
The government slashes national defence expenditures as peace spreads throughout Africa.
7.
Expenditures on the food-stamp programme are increased by 15% to help the poor.
Activity 3
1.
If the government decides today that aggregate demand is deficient and is causing a recession, what is it
likely to do?
2.
If the government decides today that aggregate demand is excessive and is causing inflation, what is it likely
to do?
Automatic stabilisers
The Minister of Finance cannot make decisions about everything in the economy and, therefore, certain measures are
built into the system that will not require decisions.
Automatic stabilisers consist of changes in government spending and taxes that occur automatically as the conditions
in the economy change.
The most important stabiliser is our progressive income tax system. Income tax adjusts automatically to changes in
personal income. If you earn more income, you pay more tax.
Unemployment insurance also serves as an automatic stabiliser. During times of economic growth when people have
jobs, money is paid into the system. During times of high unemployment, government will start making payments to
persons who lost their jobs. These payments will increase income and expenditure.
Shortcomings of fiscal policy
1.
Timing lags
Three timing lags restrict the application of fiscal policy. A lag means a delay.
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Recognition lag:
It refers to the time between the beginning of a recession or inflation and the recognition that it is actually
occurring. It may take up to three months before policy makers are sure that the problem is more than just a
disturbance.
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Administrative lag:
The way governments operate make quick action impossible. Fiscal policy changes need approval by the
national assembly before it can be implemented and the process can take months.
●
Operational lag:
This refers to the time it takes before the decision can be implemented. Changes in tax rates can be
implemented quickly, but increased spending on capital projects takes a long time.
2.
Irreversibility
It is difficult to reverse changes in tax rates. Once a tax is increased, the government is often reluctant to reduce that
tax as it provides additional revenue. Increased government spending is also difficult to reduce.
3.
Inflationary bias
Politicians tend to favour expansionary policies over restrictive policies. Because we elect politicians, they are not
keen to approve unpopular policies because they may not be re-elected. Restrictive policies such as higher taxes are
unpopular among voters.
4.
Crowding–out effect
Crowding-out occurs when government spending exceeds revenue from taxes, resulting in a budget deficit. With
crowding out, consumption and investment decrease as a result of increased government spending. The process is
simplified and mapped out in the diagram below.
The crowding-out effect
Government spending exceeds revenue from taxes, resulting in a
budget deficit.

The government enters the loanable funds market and issues more
securities.

As the demand for loanable funds rises, interest rates increase.

Firms and households buy fewer machines, equipment, cars and
houses. Thus government spending crowds out private sector
spending.