1. © The McGraw-Hill Companies, 2008 Chapter 16 Government spending and revenue David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

2. © The McGraw-Hill Companies, 2008 Government spending

3. © The McGraw-Hill Companies, 2008 Government spending in the UK The scale of government spending has changed over the past four decades. It is now running at around 40%.

4. © The McGraw-Hill Companies, 2008 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:

5. © The McGraw-Hill Companies, 2008 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 The strong externalities associated with public goods, mean that government intervention may be justified to ensure appropriate provision.

6. © The McGraw-Hill Companies, 2008 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 –The government may spend money on compulsory education or compulsory vaccination because it recognises that otherwise individuals act in a way they will subsequently regret.

7. © The McGraw-Hill Companies, 2008 Varieties of taxes Direct taxes –taxes on earnings from labour, rents, dividends and interest. e.g. income tax, corporation tax Indirect taxes –taxes levied on expenditures on goods and services e.g. VAT, duty on alcohol Wealth taxes –capital transfer tax, tax on property

8. © The McGraw-Hill Companies, 2008 Employers pay the green area, and workers the blue. A tax on wages Hours worked Wage L W DD SS With no tax, the labour market is in equilibrium at wage W, hours L. The orange area is a welfare loss for society. L' SS' W' W'' With a tax, labour supply is effectively at SS', workers receive W'', but firms pay W', the difference being the tax.

9. © The McGraw-Hill Companies, 2008 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.

10. © The McGraw-Hill Companies, 2008 A tax to offset an externality Quantity Price DD SS Given private demand DD and supply SS, free market equilibrium is at Q. Q A tax of E*F enables this optimum to be reached. F SS' DD' E* Q* But if there is a negative consumption externality (e.g. from smoking), the social optimum is at Q*.

11. © The McGraw-Hill Companies, 2008 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* 100% Tax rate Tax revenue

12. © The McGraw-Hill Companies, 2008 Economic sovereignty Increasing integration of countries in the world economy reduces the economic sovereignty of individual nations. Co-operation is needed to cope with transnational externalities.