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Chapter 14 Government spending and revenue

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1 Chapter 14 Government spending and revenue
©McGraw-Hill Companies, 2010

2 Government spending, % of GDP
Sources: World Bank, World Development Report; OECD, Economic Outlook. ©McGraw-Hill Companies, 2010 2

3 ©McGraw-Hill Companies, 2010
Government spending We may justify government spending on two grounds: Equity a progressive tax and transfer system redistributes income from rich to poor Efficiency correction of market failure may improve resource allocation ©McGraw-Hill Companies, 2010 3

4 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 Companies, 2010 4

5 ©McGraw-Hill Companies, 2010
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 Companies, 2010 5

6 ©McGraw-Hill Companies, 2010
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 Companies, 2010 6

7 ©McGraw-Hill Companies, 2010
A tax on wages With no tax, the labour market is in equilibrium at wage W, hours L. 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. Wage SS The orange area is a welfare loss for society. W It falls partly on firms who pay a higher wage and partly on workers who receive a lower wage. DD L Hours worked ©McGraw-Hill Companies, 2010 7

8 ©McGraw-Hill Companies, 2010
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 Companies, 2010 8

9 A tax to offset an externality
A tax of E*F enables this optimum to be reached. F SS' Given private demand DD and supply SS, free market equilibrium is at Q. SS Price DD' E* Q* But if there is a negative consumption externality (e.g. from smoking), the social optimum is at Q*. DD Q Quantity ©McGraw-Hill Companies, 2010 9

10 ©McGraw-Hill Companies, 2010
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. Tax revenue t* 100% Tax rate ©McGraw-Hill Companies, 2010 10

11 ©McGraw-Hill Companies, 2010
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 Companies, 2010 11

12 ©McGraw-Hill Companies, 2010
The median voter 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. Median voter £0 £250 £500 £750 £1000 Preferred expenditure ©McGraw-Hill Companies, 2010 12

13 ©McGraw-Hill Companies, 2010
Some maths Two firms, A and B. Firm A pollutes the lake used by firm B for fishing. The cost function of firm A is , TCA = TCA(QA, PA) where QA is the quantity produced by A and PA 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 Companies, 2010 13

14 ©McGraw-Hill Companies, 2010
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 Companies, 2010 14

15 ©McGraw-Hill Companies, 2010
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 Companies, 2010 15

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