CHAPTER 14 Government spending and revenue ©McGraw-Hill Education, 2014

Government spending, % of GDP ©McGraw-Hill Education, 2014

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: ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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 ©McGraw-Hill Education, 2014

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 dark blue 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. It falls partly on firms who pay a higher wage and partly on workers who receive a lower wage. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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*. ©McGraw-Hill Education, 2014

The Laffer curve 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 ©McGraw-Hill Education, 2014

Economic sovereignty Increasing integration of countries in the world economy reduces the economic sovereignty of individual nations. International capital is now highly mobile across countries. Suppose the UK government tries to levy a large tax on capital in Britain. Lots of capital will quickly move elsewhere to escape the high taxes. In contrast, people are much less mobile across national boundaries. The tax base for taxing workers’ incomes in Britain is much less sensitive to tax rates than the tax base for capital taxes. ©McGraw-Hill Education, 2014

The median voter model of choice ©McGraw-Hill Education, 2014 Each dot represents the preferred expenditure of 17 voters. The outcome under majority voting will be the level preferred by the median voter. Everyone to the left will prefer the median voter’s position to any higher spending level. Everyone to the right will prefer it to any lower level. The median voter’s position is the only one that cannot be outvoted.

Some maths (1) Two firms, A and B. Firm A pollutes the lake used by firm B for fishing. The cost function of firm A is, TC A = TC A (Q A, P A ) where Q A is the quantity produced by A and P A is the level of pollution of firm A. Costs increase with the output produced: and decrease with the level of pollution: Firm B’s cost function has the following properties: and ©McGraw-Hill Education, 2014

Some maths (2) The optimal level of pollution chosen by firm A satisfies the condition : That is marginal cost of pollution equals to marginal revenue of pollution (zero in this case). Firm A is polluting more than it should, so we can tax firm A in such a way that the socially efficient level of pollution is reached. Those kinds of taxes are also called Pigouvian taxes. ©McGraw-Hill Education, 2014

Some maths (3) When firm A has to pay a tax for its polluting activity, the profit function of firm A becomes: Where t is the tax rate and p is the market price for the output of firm A. Now the optimal level of pollution (the one that maximizes firm A profits) is: The tax simply increases the marginal cost of polluting. Now the level of pollution that maximizes the profits is lower than before since must be equal to t and t is greater than zero. ©McGraw-Hill Education, 2014

Concluding comments (1) Government revenues come mainly from direct taxes on personal incomes and company profits, indirect taxes on purchases of goods and services, and contributions to state-run social security schemes. Government spending comprises government purchases of goods and services and transfer payments. ©McGraw-Hill Education, 2014

Concluding comments (2) A progressive tax-and-transfer system takes most from the rich and gives most to the poor. Externalities are cases of market failure where intervention may improve efficiency. A public good is a good for which one person’s consumption does not reduce the quantity available for consumption by others. ©McGraw-Hill Education, 2014

Concluding comments (3) Except for taxes to offset externalities, taxes are distortionary. Tax incidence describes who ultimately pays the tax. When all those voting have single- peaked preferences, majority voting achieves what the median voter wants. ©McGraw-Hill Education, 2014