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Chapter 17Taxes and government spending
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
17.2
Government spending in the UK
0
10
20
30
40
50
% of GDP
UK
Government spending
1956 1976 1999
The scale of government spending has changed over the past four decades.
It is now running at just under 40%.
17.3
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:
17.4
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
There are strong externalities associated with public goods, so government intervention may be justified to ensure appropriate provision.
17.5
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 recognizes that otherwise individuals act in a way they will subsequently regret.
17.6
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
servicese.g. VAT, duty on alcohol
Wealth taxes– capital transfer tax, tax on property
17.7
Employers pay the greenarea, and workers the blue.
A tax on wages
Hours worked
Wa
ge
L
W
DD
SS
With no tax, the labourmarket is in equilibrium at wage W, hours L.
L'
SS'
W'
W''
With a tax, labour supplyis effectively at SS',workers receive W'',but firms pay W', thedifference being the tax.
The red area is a welfare loss for society.
17.8
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.
17.9
A tax to offset an externality
Quantity
Pri
ce
DD
SS
Given private demand DDand supply SS, free marketequilibrium 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 negativeconsumption externality(e.g. from smoking), thesocial optimum is at Q*.
17.10
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
Ta
x r e
ven
u e
17.11
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.
