Taxes and government spending

EQUITY – a progressive tax and transfer system redistributes income from rich to poor  EFFICIENCY – correction of market failure may improve resource allocation

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Chapter 17 Taxes and government spending David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 17.1 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%. 17.2 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: 17.3 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. 17.4 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. 17.5 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 17.6 Employers pay the green area, and workers the blue. A tax on wages Hours workedL W DD SS 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. The red area is a welfare loss for society. 17.7 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. 17.8 A tax to offset an externality Quantity 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*. 17.9 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 17.10 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. 17.11 Chapter 18 Industrial policy and competition policy David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 18.13 Industrial policy and Competition Policy  Competition policy – aims to enhance economic efficiency by promoting or safeguarding competition between firms.  Industrial policy – aims to offset externalities that affect production decisions by firms 18.14 Industrial policy  Inventions and the patent system – designed to provide a sufficient incentive for invention without suppressing competition for ever  Research and Development (R&D) – the social return on risky projects may exceed the private return  Dynamic change – coping with sunset and sunrise industries 18.15 Consumer surplus D Q P Quantity Consider the demand curve D and suppose price is at P with quantity demanded being Q. P represents the value placed on the good by the marginal consumer so D can be seen to represent marginal social benefit With all consumers paying the same price P for the good, the triangle APC represents consumer surplus – benefit received by consumers in excess of the amount they need to pay. A C 18.16 Producer surplus D LAC = LMC QuantityQ P Producer surplus is the excess of total revenue over total costs – as shown by the rectangle. 18.17 Consumer surplus is the area of the big green triangle. The social cost of monopoly: comparing perfect competition and monopoly D LAC = LMC Qc Pc Quantity For simplicity, suppose as industry with horizontal long-run average and marginal costs. Under perfect competition, long-run equilibrium would be with industry output Qc selling at price Pc. 18.18 and the red triangle shows the welfare loss – the social cost of monopoly The monopoly receives producer surplus (profit) of the blue rectangle. Consumer surplus is now the smaller green triangle. The social cost of monopoly: comparing perfect competition and monopoly D LAC = LMC Qc Pc Quantity MR Qm Pm If taken over by a monopolist, profit maximization is at the lower output Qm and higher price Pm. 18.19 must be balanced against the gains from efficiency (the pink rectangle). In comparing the two situations, the loss of consumer surplus under monopoly (the red triangle) Perfect competition and monopoly under differing cost conditions D Quantity Suppose that monopoly enjoys lower cost conditions than under perfect competition Qc Pc LRSSpc Under perfect competition equilibrium is at Pc, Qc. LAC = LMC MR Pm Qm Compared with Pm, Qm under monopoly 18.20 Counting the cost of monopoly  The size of the social cost of monopoly is difficult to evaluate – in part it depends upon the elasticity of demand – which influences the size of the ‘red triangle’ of welfare loss  Furthermore, firms may use up resources to defend their monopoly position – implying that costs are higher than under perfect competition – there may also be X-inefficiency under monopoly  if incentives to be cost-efficient are lower in the absence of competition. 18.21 Competition law in the UK  The Competition Commission (formerly the Monopolies and Mergers Commission) is the body responsible for administering competition policy in the UK.  A company can be referred to the Commission if it supplies more than 25% of the total market for a good – or where there is collusion between firms  The Commission is charged to investigate whether or not the monopoly acts against the public interest. 18.22 Mergers and acquisitions  Firms can grow through merger and acquisition (M&A) activity – horizontal mergers mergers between firms at the same stage of production in the same industry – vertical mergers mergers between firms at different stages of production in the same industry – conglomerate mergers  a way for firms to diversify into a new activity 18.23 M&A  Size may enable: – economies of scale – competition on a global scale  The late 1990s saw record levels of M&A activity.
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