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The Government
5. Role of the government in the economy
| Term | |
|---|---|
| Economic Objectives of the Government | keep inflation under control, maintain a low level of unemployment, achieve a high level of economic growth rate, and maintain a healthy balance of payments. |
| Why does the government spend money? | to provide public goods, to provide merit goods, to maintain and promote economic growth, and ensure welfare of the state |
| Tax | financial charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state |
| Purposes of Taxation | financing government spending, reduce gap between rich and poor, reduce consumption of demerit goods, control inflation, balance of payments, and protecting local industries |
| financing government spending | Taxes are justified as they fund government expenditure and activities that are necessary and beneficial to society. |
| reduce gap between rich and poor | Progressive taxation can be used to reduce inequality in a society. Progressive tax system where higher income groups have to pay more tax is an effective way of reducing inequality of income. |
| reduce consumption of demerit goods | Taxes can be used as an effective tool to reduce the consumption of demerit goods like alcohol and tobacco. Higher taxes on these goods reduce the consumption. Examples include cigarette tax and excise duty. |
| control inflation | One of the causes of inflation is ‘too much money chasing too few goods’. Government can take away the extra disposable income of the people through higher taxes and thus reduce the aggregate demand in the economy and resulting in low inflation rate. |
| balance of payments | Tariffs are taxes on imports. Government can correct an unfavourable balance of payment situation by increasing the tariffs. This will result in imports becoming expensive and will cause a fall in demand for the imported goods |
| protecting local industries | Government uses taxes as a mean to protect local/infant industries. Increasing tariffs on imports and charging lower taxes to local/infant industries may boost the demand for goods and services produced by domestic industry. |
| Classification of taxes | Progressive taxes, Regressive Tax, and Proportional Tax |
| Progressive taxes | A progressive tax is a tax imposed so that the tax rate increases as the amount subject to taxation increases. In simple terms, it imposes a greater burden (relative to resources) on the rich than on the poor. |
| Regressive Tax | The opposite of a progressive tax is a regressive tax, where the tax rate decreases as the amount subject to taxation increases. It imposes a greater burden (relative to resources) on the poor than on the rich. |
| Proportional Tax | A proportional tax is one that imposes the same relative burden on all taxpayers—i.e., where tax liability and income grow in equal proportion. In simple terms, it imposes an equal burden (relative to resources) on the rich and poor. |
| Types of Direct taxes | Income tax, Corporation tax, Petroleum revenue tax, Capital gains tax, Property Tax, and Stamp duty |
| Stamp duty | Stamp duty is a form of tax that is levied on documents relating to immovable property, stocks and shares. |
| Income tax | Income tax is collected on all incomes received by private individuals after certain allowances are made. In most of the economies Income tax is a major source of Government revenue. |
| Corporation tax | This tax is levied on profits earned by companies. It is a proportional tax which is levied at the constant rate. |
| Petroleum revenue tax | It is a tax levied on the profits of companies involved in drilling of oil and gas. This tax may or may not exist in other countries. |
| Capital gains tax | Capital gains tax is charged on the profit realized on the sale of a non-inventory asset that was purchased at a lower price. |
| Property Tax | Many countries have Property tax, or millage tax. It is the tax which the owner pays on the value of the property being taxed. |
| Direct taxes | Taxes which are collected directly from income and wealth are known as direct taxes. |
| Indirect Taxes | Indirect tax (such as sales tax, value added tax (VAT), or goods and services tax (GST)) is a tax collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the customer). |
| Types of Indirect Taxes | Value added Tax, and Excise duties |
| Excise duties | Excise duty is a type of indirect tax charged on goods produced within the country. Lists of such goods are readily provided by governments. |
| Value added Tax | Value added tax (VAT), or goods and services tax (GST), is a consumption tax levied on value added. |
| Fiscal Policy | Fiscal policy refers to government policy that attempts to influence the direction of the economy through changes in government taxes or through some spending. The two main instruments of fiscal policy are government spending and taxation. |
| Changes in the level and composition of taxation and government spending can impact on the following variables in the economy | Aggregate demand and the level of economic activity, the pattern of resource allocation, and the distribution of income. |
| During high rate of Inflation… | Government will use deflationary fiscal policy. On the other hand, Government may increase the tax rates. An increase in tax rates will take away the extra disposable income out people’s pocket resulting in a lower demand. |
| During low rate of Inflation… | The Government will increase the public spending resulting in a rise in aggregate demand. Government may reduce the tax rates so that people have more disposable income to spend and instigate demand in the economy. |
| Problems with Fiscal Policy | Reduce incentive to work, Adverse effect of lowering Public Spending, ‘Crowding out’ effect, Inaccurate forecasting, and Implementation of the Policy |
| Reduce incentive to work | Raising taxes on income and profits reduce work incentives, employment and economic growth. An effort to reduce aggregate demand may cause disincentives to work, if this occurs there will be a fall in productivity and Aggregate supply could fall. |
| Adverse effect of lowering Public Spending | Reduced govt spending to Increase Aggregate demand could adversely affect public services such as public transport and education causing market failure and social inefficiency. |
| ‘Crowding out’ effect | With an increase in government expenditure, there will be greater competition for limited resources. This will offset private investments resulting in shrinking of the private sector. |
| Inaccurate forecasting | If the Government’s estimate or forecasting is wrong or inaccurate the Fiscal policy will suffer. For example, if a recession is expected and the government practises deficit budget, and yet the recession turns out to be a boom, this will cause inflation. |
| Implementation of the Policy | Planning for the spending is done once by most of the governments. If there is a delay in the implementation of the fiscal policy, it might reduce the effectiveness of the policy. Thus the time lag is important. |
| Monetary Policy | Monetary policy is the process by which the government, central bank, or monetary authority of a country controls the supply of money, availability of money, and cost of money or rate of interest |
| expansionary policy | increases the total supply of money in the economy and is traditionally used to combat unemployment in a recession by lowering interest rates. |
| Contractionary policy | decreases the total money supply and involves raising interest rates in order to combat inflation. |
| Increasing the interest rates | An increase in the interest rates will reduce the demand for borrowing from customers and firms. If they borrow less money, they will have less money to spend and the aggregate demand will fall or rise more slowly. |
| Reducing the interest rates | Reducing the interest rates will encourage people and firms to spend more money. As loans become cheaper, more people will be interested in taking loans and purchasing houses and cars. |
| How Government controls the money supply? | Open market operations, and Variation of legal reserve requirements |
| Variation of legal reserve requirements | When the Central Bank wants to reduce money supply it will increase the limit of the deposit kept by the banks. The commercial banks are left with less money to lend to their customers. |
| Open market operations | Government usually sells treasury bills and bonds to raise money. Private individuals invest in these bonds and bills in order to get a healthy rate of interest. This reduces the deposits with banks and the money supply. |
| Supply side Policies | Privatisation, Deregulation, Increased education and training, and Labour Markets reforms |
| Labour Markets reforms | By controlling the actions of the trade unions the Government can ensure that there is least disruption in the business activities. |
| Increased education and training | Improving the level of education, training and skills of the workforce will raise the labour productivity and increase the aggregate supply. |
| Deregulation | Deregulation involves reducing barriers to entry in order to make the market more competitive. It does away with unnecessary rules and regulations on business which results in reduced cost, increased output and lower prices. |
| Privatisation | Privatisation is the selling of state owned businesses to private individuals and groups. This increases the efficiency of these organisations as they face more competition. |
| Privatisation | Privatisation is the selling of state owned businesses to private individuals and groups. This increases the efficiency of these organisations as they face more competition. |
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