The Role of Government

The public sector in every economy plays a major role, as a producer and employer.
Governments work locally, nationally and internationally. Here are the roles they play in the
economy:

• As a producer, it provides, at all levels of government:

❖merit goods (educational institutions, health services etc.)

❖public goods (streetlights, parks etc.)

❖welfare services (unemployment benefits, pensions, child benefits etc.)

❖public services (police stations, fire stations, waste management etc.)

❖infrastructure (roads, telecommunications, electricity etc.).

• As an employer, it provides at all levels of government, employment to a large

population

• Manage the macroeconomy in terms of prices, employment, growth, income redistribution

etc.

• Governments also manage its trade in goods and services with other countries by

negotiating international trade deals.

Government Macroeconomic Aims

The government’s major macroeconomic objectives are:

• Economic Growth: economic growth refers to an increase in the gross domestic product

(GDP), the amount of goods and services produced in the economy, over a period of
time. More output means economic growth. But if output falls over time (economic
recession), it can cause:

❖fall in employment, incomes and living standards of the people

❖fall in the tax revenue the govt. collects from goods and services and incomes,

which will, in turn, lead to a cut in govt. spending

 ❖fall in the revenues and profits of firms

❖low investments, that is, people won’t invest in production as economic

conditions are poor and they will yield low profits.

• Price Stability: inflation is the continuous rise in the average price levels in an economy

during a time period. Governments usually target an inflation rate it should maintain in a
year, say 3%. If prices rise too quickly it can negatively affect the economy because it:

❖reduces people’s purchasing powers as people will be able to buy less with the

money they have now than before

❖causes hardship for the poor

❖increases business costs especially as workers will demand higher wages to

support their livelihood

❖makes products more expensive than products of other countries with low

inflation. This will make exports less competitive in the international

market.

• Full Employment: if there is a high level of unemployment in a country, the following may

happen:

❖the total national output (goods produced) will fall

❖government will have to give out welfare payments (unemployment benefits) to

the unemployed, increasing public expenditure while income taxes fall –

causing a budget deficit

❖large unemployment causes public unrest and anger towards the government.

• Balance of Payments Stability: economies export (sell) many of their products to

overseas residents, and receive income and investment from abroad; they also
import (buy) goods and services from other economies, and make investments in
other countries. These are recorded in a country’s Balance of Payments (BoP).
Exports > Imports = Surplus in BoP
Exports < Imports = Deficit in BoP
 • Income Redistribution: to reduce the inequality of income among its citizens, the

government will redistribute incomes from the rich to the poor by imposing taxes on the
rich and using it to finance welfare schemes for the poor. All governments struggle with
income inequality and try to solve it because:

❖widening inequality means higher levels of poverty

❖poverty and hardship restricts the economy from reaching its maximum

productive capacity.

Conflict of Macroeconomic Aims

When a policy is introduced to achieve one macroeconomic aim, it tends to conflict with one or
more other aims. In other words, as one aim is achieved, another aim is undone. Let’s look at
some conflicts of government macroeconomic aims.

Full Employment v/s Price Stability:

Low rates of unemployment will boost incomes of businesses and workers. This rise in incomes,
mean higher demand and consumption in the economy, which causes firms to raise their prices
resulting in inflation. This is probably the most prominent policy conflict in the study of
Economics.

Economic Growth & Full Employment v/s BoP Stability:

Once again, as incomes rise due to economic growth and low unemployment, people will import
more foreign products and consume relatively less domestic products. This will cause a rise in
imports relative to exports and a deficit may arise in the balance of payments.

Economic Growth v/s Full Employment:

In the long run, when economic growth is continuous, firms may start investing in more capital
(machinery/equipment). More capital-intensive production will make a lot of people
unemployed.
Government spending
Governments spend on all kinds of public goods and services, not just out of political and social
responsibility, but also out of economic responsibility. Government spending is a part of the
aggregate demand in the economy and influences its well-being. The main areas of government
spending includes defence and arms, road and transport, electricity, water, education, health,
food stocks, government salaries, pensions, subsidies, grants etc.

Reasons governments spend:

1) To supply goods and services that the private sector would fail to do, such as public
goods, including defence, roads and streetlights; merit goods, such as hospitals and
schools; and welfare payments and benefits, including unemployment and child
benefits.
2) To achieve supply-side improvements in the economy, such as spending on education
and training to improve labour productivity.
3) To spend on policies to reduce negative externalities, such as pollution controls.
4) To subsidise industries which may need financial support, and which is not available
from the private sector, usually agriculture and related industries.
5) To help redistribute income and improve income inequality.
6) To inject spending into the economy to aid economic growth.
Tax
Governments earn revenue through interests on government bonds and loans, incomes from
fines, penalties, escheats, grants in aid, income from public property, dividends and profits on
government establishments, printing of currency etc; but its major source of revenue comes
from taxation.

Taxes are a compulsory payment made to the government by all people in an economy.

There are many reasons for levying taxes from the economy:

1) It is a source of government revenue: if the government has to spend on public goods

and services it needs money that is funded from the economy itself. People pay taxes
knowing that it is required to fund their collective welfare.
2) To redistribute income: governments levy taxes from those who earn higher incomes
and have a lot of wealth. This is then used to fund welfare schemes for the poor.
3) To reduce consumption and production of demerit goods: a much higher tax is levied
on demerit goods like alcohol and tobacco than other goods to drive up its prices and costs
in order to discourage its consumption and production. Such a tax on a specific good is
called excise duty.
4) To protect home industries: taxes are also levied on foreign goods entering the
domestic market. This makes foreign goods relatively more expensive in the domestic
market, enabling domestic products to compete with them. Such a tax on foreign goods
and services is called customs duty.
5) To manage the economy: as we will discuss shortly, taxation is also a tool for demand
and supply side management. Lowering taxes increase aggregate demand and supply in
the economy, thereby facilitating growth. Similarly, during high inflation, the government will
increase taxes to reduce demand and thus bring down prices.
Classification of Taxes

Taxes can be classifies into direct or indirect and progressive, regressive or proportional.

Direct Taxes are taxes on incomes. The burden of tax payment falls directly on the person or
individual responsible for paying it.

1) Income tax: paid from an individual’s income. Disposable income is the income left after
deducting income tax from it. When income tax rise, there is little disposable income to
spend on goods and services, so firms will face lower demand and sales, and will cut
production, increasing unemployment. Lower income taxes will encourage more spending
and thus higher production.
2) Corporate Tax: tax paid on a company’s profits. When the corporate tax rate is
increased, businesses will have lower profits left over to put back into the business and
will thus find it hard to expand and produce more. It will also cause shareholders/owners
to receive lower dividends/returns for their investments. This will discourage people from
investing in businesses and economic growth could slow down. Reducing corporate tax
will encourage more production and investment.
3) Capital gains tax: taxes on any profits or gains that arise from the sale of assets held for
more than a year.
4) Inheritance tax: tax levied on inherited wealth.
5) Property tax: tax levied on property/land.

Advantages:

1) High revenue: as all people above a certain income level have to pay income taxes, the
revenue from this tax is very high.
2) Can reduce inequalities in income and wealth: as they are progressive in nature –
heavier taxes on the rich than the poor- they help in reducing income inequality.

Disadvantages:

• Reduces work incentives: people may rather stay unemployed (and receive govt.

unemployment benefits) rather than be employed if it means they would have to pay a
high amount of tax. Those already employed may not work productively, since for any
extra income they make, the more tax they will have to pay.
 • Reduces enterprise incentives: corporate taxes may demotivate entrepreneurs to set

up new firms, as a good part of the profits they make will have to be given as tax.

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• Tax evasion: a lot of people find legal loopholes and escape having to pay any tax. Thus

tax revenue falls and the govt. has to use more resources to catch those who evade
taxes.

Indirect Taxes are taxes on goods and services sold. It is added to the prices of goods and
services and it is paid while purchasing the good or service. It is called indirect because it
indirectly takes money as tax from consumer expenditure.
Some examples are:
1) VAT: these are included in the price of goods and services. Increasing these indirect

taxes will increase the prices of goods and services and reduce demand and in turn
profits. Reducing these taxes will increase demand.
2) Customs duty: includes import and export tariffs on goods and services flowing between
countries. Increasing tariffs will reduce demand for the products.
3) Excise Duty: tax on demerit goods like alcohol and tobacco, to reduce its demand.

Advantages:

• Cost-effective: the cost of collecting indirect taxes is low compared to collecting direct

taxes.

• Expanded tax-base: directs taxes are paid by those who make a good income, but

indirect taxes are paid by all people (young, old, unemployed etc.) who consume goods
and services, so there is a larger tax base.

• Can achieve specific aims: for example, excise duty (tax on demerit goods) can

discourage the consumption of harmful goods; similarly, higher and lower taxes on
particular products can influence their consumption.

• Flexible: indirect tax rates are easier and quicker to alter/change than direct tax rates.

Thus their effects are immediate in an economy.

Disadvantages:

1) Inflationary: The prices of products will increase when indirect taxes are added to it,
causing inflation.
2) Regressive: since all people pay the same amount of money, irrespective of their income
levels, the tax will fall heavily on the poor than the rich as it takes more proportion of their
income.
3) Tax evasion: high tariffs on imported goods or excise duty on demerit goods can
encourage illegal smuggling of the good.

Progressive Taxes are those taxes which burdens the rich more than the poor, in that the rate
of taxation increases as incomes increase. An income tax is the perfect example of
progressive taxation. The more income you earn, the more proportion of the income you have to
pay in taxes, as defined by income tax brackets.

Regressive Taxes are those taxes which burden the poor more than the rich, in that the rate
of taxation falls as incomes increase. An indirect tax like GST is an example of a regressive
tax because everyone has to pay the same tax when they are paying for the product, rich or
poor.
The burden on the poor is higher than on the rich, making its regressive.

Proportional Taxes are those taxes which burden the poor and rich equally, in that the rate of
taxation remains equal as incomes rise or fall. An example is corporate tax. All companies
have to pay the same proportion of their profits in tax.

Qualities of a good tax system (the canons of taxation):

1) Equity: the tax rate should be justifiable rate based on the ability of the taxpayer. 2)
Certainty: information about the amount of tax to be paid, when to pay it, and how to pay it
should all be informed to the taxpayer.
3) Economy: the cost of collecting taxes must be kept to a minimum and shouldn’t exceed
the tax revenue itself.
4) Convenience: the tax must be levied at a convenient time, for example, after a person
receives his salary.
5) Elasticity: the tax imposition and collection system must be flexible so that tax rates can
be easily changed as the person’s income changes.
 6) Simplicity: the tax system must be simple so that both the collectors and payers
understand it well.

Impacts of taxation:

Taxes can have various direct impacts on consumers, producers, government and thus, the
entire economy.

• The main purpose of tax is to raise income for the government which can lead to higher spending

on health care and education. The impact depends on what the government spends the
money on. For example, whether it is used to fund infrastructure projects or to fund the
government’s debt repayment.

• Consumers will have less disposable income to spend after income tax has been deducted.
This is likely to lead to lower levels of spending and saving. However, if the government spends
the tax revenue in effective ways to boost demand, it shouldn’t affect the economy.

• Higher income tax reduces disposable income and can reduce the incentive to work. Workers

may be less willing to work overtime or might leave the labour market altogether. However,
there are two conflicting effects of higher tax:

• Substitution effect: higher tax leads to lower disposable income, and work becomes

relatively less attractive than leisure – workers will prefer to work less.

• Income effect: if higher tax leads to lower disposable income, then a worker may feel

the need to work longer hours to maintain his desired level of income – workers feel
the need to work longer to earn more.

• The impact of tax then depends on which effect is greater. If the substitution effect is

greater, then people will work less, but if income effect is greater, people will work
more.

• Producers will have less incentive to produce if the corporate taxes are too high. Private firm aim
on making profits, and if a major chunk of their profits are eaten away by taxes, they might not
bother producing more and might decide to close shop.
Fiscal Policy
Fiscal policy is a government policy which adjusts government spending and taxation to
influence the
economy.
It is the budgetary policy, because it manages the government expenditure and revenue.
Government aims for a balance budget and tries to achieve it using fiscal policy.

A budget is in surplus, when government revenue exceed government spending. While this is
good it also means that the economy hasn’t reached its full potential. The government is keeping
more than it is spending, and if this surplus is very large, it can trigger a slowdown of the
economy.

When there is a budget surplus, the government employs an expansionary fiscal

policy where govt. spending is increased and tax rates are cut.
A budget is in deficit, when government expenditure exceeds government revenue. This is
undesirable because if there is not enough revenue to finance the expenditure, the government
will have to borrow and then be in debt.
When there is a budget deficit, the government employs contractionary fiscal policy,
where govt. spending is cut and tax rates are increased.
Fiscal policy helps the government achieve its aim of economic growth, by being able to
influence the demand and spending in the economy. It also indirectly helps maintain price
stability, via the effects of tax and spending.

Expansionary fiscal policy will stimulate growth, employment and help increase prices.
Contractionary fiscal policy will help control inflation resulting from too much growth. But
as we will see later on, controlling inflation by reducing growth can lead to increased
unemployment as output and production falls.

The money supply is the total value of money available in an economy at a point of time.
The government can control money supply through a variety of tools including open market
operations (buying and selling of government bonds) and changing reserve requirements of
banks. (The syllabus doesn’t require you to study these in depth)
The interest rate is the cost of borrowing money. When a person borrows money from a
bank, he/she has to pay an interest (monthly or annually) calculated on the amount he/she
borrowed. Interest is also be earned on the money deposited by individuals in a bank. (The
interest on borrowing is higher than the interest on deposits, helping the banks make a
profit).

Higher interest rates will discourage borrowing and therefore, investments; it will also
encourage people to save rather than consume (fall in consumption also discourage firms from
investing and producing more).
Lower interest rates will encourage borrowing and investments, and encourage people to
consume rather than save (rise in consumption also encourage firms to invest and produce
more).

The monetary authority of the country cannot directly change the general interest rate in the
economy. Instead, it changes the interest rates of borrowing between the central bank and
commercial banks, as well as the interest on its bonds and securities. These will then influence
the interest rate provided by commercial banks on loans and deposits to individuals and
businesses.

Monetary Policy
Monetary policy is a government policy controls money supply (availability and cost of
money) in an economy in order to attain growth and stability. It is usually conducted by the
country’s central bank and usually used to maintain price stability, low unemployment and
economic growth.

Expansionary monetary policy is where the government increases money supply by

cutting interest rates. Low interest rates will mean more people will resort to spending rather
than saving, and businesses will invest more as they will have to pay lower interest on their
borrowings. Thus, the higher money supply will mean more money being circulated among the
government, producers and consumers, increasing economic activity. Economic growth and
an improvement in the balance of payments will be experienced and employment will
rise.
Contractionary monetary policy is where the government decreases money supply by
increasing interest rates. Higher interest rates will mean more people will resort to saving rather
than spending, and businesses will be reluctant to invest as they will have to pay high interest on
their borrowings. Thus, the lower money supply will mean less money being circulated among the
government, producers and consumers, reducing economic activity. This helps slow down
economic growth and reduce inflation, but at the cost of possible unemployment resulting from
the fall in output.

Supply side policies are microeconomic policies aimed at increasing supply

and productivity in the economy, to enable long-term economic growth.

Some of these policies include:

1) Public sector investments: investments in infrastructure such as transport and
communication can greatly help the economy by making the flow of resources quick and
easy, and facilitate faster growth.
2) Improving education and vocational training: the government can invest in education
and skills training to improve the quality and quantity of labour to increase productivity.
3) Spending on health: accessible, affordable and good quality health services will
improve the health of the population, helping reduce the hours lost to illnesses and
increasing productivity.
4) Investment on housing: as more housing spaces are built, the geographical mobility of
the population will increase, helping increase output.
5) Privatization: transferring some public corporations to private ownership will increase
efficiency and increase output, as the private sector has a profit-motive absent in public
sector.
6) Income tax cuts: reducing income tax will increase people’s willingness to work more
and earn more, helping increase the supply in the economy.
7) Subsidies are financial grants made to industries that need it. More subsidies mean more
money for producers to produce more, thereby increasing supply.
8) Deregulation: removing or easing the laws and regulations required to start and run
businesses so they can operate and produce more output with reduced costs and hassle,
encouraging investments.
9) Removing trade barriers: the govt. can reduce or withdraw import duties, quotas etc. on
imports so that more resources, goods and services may be imported to increase
productivity and efficiency in the domestic economy. It can also reduce export duties to
increase export of resources, goods and services to other nations, thereby encouraging
domestic firms to increase production.
 10) Labour market reforms: making laws that would reduce trade union powers would
reduce business costs and increase output. Minimum wages could be reduced or done
away with to allow more jobs to be created. Welfare payments like unemployment
benefits could be reduced so that more people would be motivated to look for jobs rather
than rely on the benefits alone to live. These will not only increase the incentive to work
but also increase the incentive to invest.

Economic growth is an increase in the amount of goods and services produced per
head of the population over a period of time.

GDP (Gross Domestic Product): the total market value of all final goods and services provided
within an economy by its factors of production in a given period of time.
Causes of Economic Growth:

1) Discovery of more natural resources: more resources mean more the production
capacity. The discovery of oil and gas reserves have enabled a lot of economies (Norway,
Saudi Arabia, Venezuela etc.) to grow rapidly.

2) Investment in new capital and infrastructure: investment in new machinery, buildings,

technology etc. has enabled firms and economies to expand their production capacities.
Investment in modern infrastructure such as airports, roads, harbours etc. have improved
access and communication in economies, helping in achieving quicker and more efficient
production.
3) Technical progress: New inventions, production processes etc. can increase the
productivity of existing resources in industries and help boost economic growth.
4) Increasing the quantity and quality of factors of production: A larger and more
productive workforce will increase GDP. More skilled, knowledgeable and productive human
resources thus help increase economic growth. Similarly, good quality capital, use of better
natural resources, innovative entrepreneurs all aid economic growth in the long run.
5) Reallocating resources: Moving resources from less-productive uses to more-productive
uses will improve economic growth.
The benefits of economic growth:

1) Greater availability of goods and services to satisfy consumer wants and needs.
2) Increased employment opportunities and incomes.
3) In underdeveloped or developing economies, economic growth can drastically improve
living standards and bring people out of poverty.
4) Increased sales, profits and business opportunities.
5) Rising output and demand will encourage investment in capital goods for further
production, which will help achieve long run economic growth.
6) Low and stable inflation, if growth in output matches growth in demand.
7) Increased tax revenue for government (as incomes and spending rise) that can
be invested in public goods and services.

The drawbacks of economic growth:

1) Technical progress may cause capital to replace labour, causing a rise in

unemployment. This will be disastrous for highly populated underdeveloped and
developing economies, pulling more people into poverty
2) Scarce resources are used up rapidly when production rises. Natural resources may get
depleted over time.
3) Increasing production can increase negative externalities such as pollution,
deforestation, health problems etc. Climate change is a consequence of rapid global
economic growth.
4) If the economy produces over its productive capacity and if the growth in demand
outstrips the growth in output, economic growth may cause inflation
5) Economic growth has also been accused of widening income inequalities in developing
economies, because rich investors and businessmen gain more than the working class
and poor during growth – the benefits of growth are not evenly distributed. This will cause
relative poverty to rise.
Recession
Recession is the phase where there is negative economic growth, that is real GDP is falling.
This usually happens after there is rapid economic growth. High inflation during the boom period
will cause consumer spending to fall and cause this downturn. Workers will demand more wages
as the cost of living increase, and the price of raw materials will also rise, leading to firms cutting
down production and laying off workers. Unemployment starts to rise and incomes fall.

Causes of recession:

1) Financial crises: if banks have a shortage of liquidity, they reduce lending and this
reduces investment.
2) Rise in interest rates: increases the cost of borrowing and reduces demand.
3) Fall in real wages: usually caused when wages do not increase in line with inflation
leading to falling incomes and demand.
4) Fall in consumer/business confidence: reduces both supply and demand.
5) Cut in govt. spending: when government cuts spending, demand falls.
6) Trade wars: uncertainty in markets, and thus businesses will be reluctant to invest during
a trade war, causing supply to fall.
7) Supply-side shocks: e.g. rise in oil prices cause inflation and lower purchasing power.
8) Black swan events: black swan events are unexpected events that are very hard to
predict. For example, COVID-19 pandemic in 2020 which disrupted travel, supply chains
and normal business activity, as well consumer demand, has caused recessions in many
countries.
 Policies to promote economic growth.
Expansionary fiscal and monetary policies (demand-side policies) and supply-side
policies described in the previous sections can be employed to promote economic growth,
depending on the nature of the problems that are holding back the economy from growing. For

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example, if it is the poor quality of human capital (labour) that is preventing the economy from
achieving its maximum productive capacity, the government should invest in education and
vocational training centres to improve the quality of the labour force and increase productivity. If
it is a lack of effective demand causing slow growth, the government should focus on cutting
income taxes, indirect taxes and interest rates to boost spending.

Labour force – the working population of an economy, i.e. all people of working age who are
willing and able to work.

Dependent population – people not in the labour force and thus depend on the labour force to
supply them with goods and services to fulfill their needs and wants. This includes students in
education, retired people, stay at home parents, prisoners or similar institutions as well as those
choosing not to work.

Employment is defined as an engagement of a person in the labour force in some occupation,

business, trade, or profession.

Unemployment is a situation where people in the labour force are actively looking for jobs but
are currently unemployed.
All governments have a macroeconomic objective of maintaining a low unemployment rate.

Full Employment is the situation where the entire labour force is employed. That is, all the
people who are able and willing to work are employed – unemployment rate is 0%.