Economics

Governments have long recognized a need to protect poorly informed consumers from actions they would regret. Laws against fraud have been around for centuries. Modern governments generally regulate working conditions, inspect and grade foods, regulate the design and safety of consumer products, and require that certain products (such as foods and dangerous chemicals) have informative labels.

Monopoly and Market Power

Competitive markets generally work well, but markets where either buyers or sellers can manipulate prices generally do not. In particular, too little output will be produced and price will be too high in a market where a single seller controls supply.

A monopolist is the single seller of a good or service. Monopolists can earn high profits by restricting the quantity sold and raising the price. Because they are the only sellers, they have no fear of being undercut by competitors -- and consumers end up paying more than they should.

Some monopolies are almost unavoidable. Most public utilities (gas and electricity, for example) are potential monopolies. The government can regulate such companies by controlling the prices they are allowed to charge, or it may elect to supply the products involved itself. Other monopolies may be artificial, brought about through manipulation by firms. Here governments intervene with competition laws, seeking to make competition more vigorous and to prevent monopolies or other attempts to control supply.

Any buyer or seller who has the ability to affect market price significantly is described as having market power or monopoly power. Government intervention to limit market power, for instance by preventing firms with market power from charging high prices, can improve the allocation of resources.

Income Redistribution and Merit Goods

The distribution of income that is generated by free markets has no ethical claim to being just or fair. Depending on who starts out with what resources, private markets can produce many different final distributions - different 'for whoms' - of resources and welfare. Private markets may produce a distribution in which the top 1 per cent of income-earners receive 40 per cent of total income in the economy, or they may produce an even distribution of income. Either way, government may want to intervene to affect the distribution of income, by taxing some and giving to others.

In practice, modern governments engage in large-scale redistribution of income. The share of transfers in government spending has increased all over the world in the period since 1960. Government spending on transfer payments, shown in Table 3-1, represents government redistribution of income - towards the elderly (through social security), the unemployed (through unemployment benefits), farmers (through price supports), and other beneficiaries. The rapid growth of transfer spending has been a source of controversy, with critics arguing that many government welfare programmes have harmed the people they were designed to help.

There is a difference between government intervention to affect the distribution of income and intervention to ensure the right level of production of public goods or to make market prices reflect externalities. In the latter cases the government is taking actions that at least in principle can make everyone in society better off. But when the government intervenes to affect the income distribution, it makes some people better off by making others worse off.

Governments are concerned not just with the distribution of income, but also with the consumption of particular goods and services.

Merit goods are goods that society thinks people should consume or receive, no matter what their incomes are. Merit goods typically include health, education, shelter, and food. Thus we - society - might think that everyone should have adequate housing and take steps to provide it. Is there an economic justification for government intervention in regard to merit goods? In a sense there always is, because the sight of someone who is homeless creates an externality, making everyone else unhappy. By providing housing or shelter for those who would otherwise be on the streets, the government make the rest of us feel better.

Society's concern over merit goods is closely related to its concern over the distribution of income. The difference in the case of merit goods is that society wants to ensure an individual's consumption of particular goods rather than goods in general. Some of the goods provided by the government (such as health and education) are merit goods.

With merit goods, as with public goods, government concern with consumption does not justify government production. Economic theory justifies policies that ensure that individuals consume the specified amounts of merit goods. It does not say that the government should produce these goods itself, nor does it say exactly how the government should intervene. One way would simply be to require that the right amounts of the goods be consumed. In the case of education, everyone has to go to school up to a certain age. But nobody has to go to a state school; any accredited school will do. In the case of housing, the government can build low-income houses and rent them at a subsidized rate, provide rent supplements, or simply specify minimum housing standards.

The most difficult question that has to be answered in discussing both merit goods and the distribution of income is how society or the government decides who should get what. Any one person can have a perfectly sensible viewpoint on these issues -- for instance, that the more even the distribution of income the better, that the distribution of income we have is best, that people who work harder should be rewarded, that people who need more should get more, or that everyone should have decent housing and no one should starve. Translating these different opinions into a consistent view that is taken by the government and implemented in taxation and transfer policy is the impossible task of politics.

Recap

The discussion in this section provides some theoretical justification for government intervention in a market economy. However, governments do not make their tax and spending decisions on the basis of what economists say their role should be. Only by a huge stretch of the imagination could we say that in fact all government purchases of goods and services are purchases of public goods or merit goods, or that interventions in any particular market are designed only to remove externalities. It would take even more imagination to see government intervention that affects the distribution of income as resulting from a consistent view of the optimal distribution. We now discuss the mechanisms that democratic societies use to make their actual decisions about taxation and govern ment spending.

How Do Governments Decide?

The motivations economists ascribe to individuals and firms are simple. Firms are in business to make profits for their owners. Individuals are assumed to choose those combinations of goods that make them best off. These simple assumptions permit economists to explain most consumer and business decision-making.

Government decision-making cannot be explained so simply. Voters express their preferences by electing governments whose job is to make the basic decisions on spending and taxing, pass new laws, and establish new regulatory programmes. Thus, by voting, the electorate gets to express its preferences among alternative policy packages, though not on each issue.

The people who run the government - elected officials and civil servants - are not mere ciphers who simply do the bidding of society. They have their own objectives, in some sense trying like everyone else to maximize their own well-being. They may maximize their own well-being by doing what they believe is good for the public, or they may have much narrower goals, such as getting re-elected or advancing up the hierarchy. A well designed system is one in which the people who run the government are led to pursue the interests of society as they pursue their own goals, just as the invisible hand in competitive markets leads individuals pursuing their own interest to pursue society's interests.

Voting

If everyone were identical and of one mind, public decision-making would be easy. The most important problem that society solves through the political process is how to reconcile different views and different interests. In this section we discuss two features of majority voting.

The first is the paradox of voting, which concerns cases where majority voting will lead to inconsistent decision-making. The second is the median voter result, which shows how public choice will tend to avoid extreme outcomes.

The Paradox of Voting. Table 3-4 shows how voters 1, 2, and 3 rank three possible outcomes A, B, and C. For example, voter 1 likes A best, then B, then C. Let the group choose by majority vote between outcomes A and B. Voters 1 and 3 prefer A to В so the group will prefer A to В by two votes to one. Similarly, the group will vote two to one for outcome В rather than C. Since A is preferred to B and В preferred to C, you might expect the group to prefer A to C. But the first and third columns of Table 3-4 imply that the group would choose С rather than A by two voices to one. When individual preferences are as depicted in Table 3-4 majority voting will choose A over B, В over С; and С over A. Consistent decision-making will not be possible under majority voting.

This is a serious problem. Society cannot necessarily rely on majority voting to lead to consistent decision-making. It also means that the decisions taken by society may well depend on the order in which it votes on them.

Table 3-4. The paradox of

Figure 3-1. THE MEDIAN VOTER. Each dot represents the preferred expenditure of each of 17 voters. The outcome under majority voting will be the level preferred by the median voter. Everybody to the left will prefer the median voter's position to any higher spending level. Everybody to the right will prefer it to any lower spending level. The median voter's position is the only position that cannot be outvoted against some alternative. Hence it will be chosen.

The Median Voter. Majority voting does not always lead to inconsistent public choice. Figure 3-1 shows for 17 voters how much between ?0 and ?1000 each would like to spend on the police. Each dot represents an individual voter's preferred amount.

We also assume that each voter will vote for a spending level close to his or her own preferred amount rather than for one that is further away. A voter who wants to spend ?250 will prefer ?300 to ?400 and will prefer ?200 to ?100. Each person has single-peaked preferences, being happier with an outcome the closer it is to the peak or preferred level as judged by that individual.

Now suppose there is a vote on how much to spend on the police. A proposal to spend ?0 would be defeated by 16 votes to 1. Only the voter represented by the left-hand dot in Figure 3-1 would vote for ?0 rather than ?100. As we move to the right we get more people voting for any particular proposal. Figure 3-1 emphasizes the special position of the median voter. With 17 voters, the median voter is the person who wants to spend the ninth-highest amount on the police. There are 8 voters wanting to spend more and 8 wanting to spend less. The median voter is the person in the middle on this particular issue.

What is special about the median voter? Suppose the vote is between the amount the median voter wants to spend and some higher amount. The 8 people wanting less than either will vote for the median voter's proposal, and so will the median voter. There will be a majority against higher expenditure. Bу an identical argument there will be a 9-8 majority against lower expenditure when the alternative is the amount wanted by the median voter. Hence the median voter's preferred outcome will be the one that is chosen by majority voting.

Thus, majority voting works when each individual has single-peaked preferences. The paradox of voting arises in Table 3-4 precisely because preferences are not single-peaked. Suppose outcome A is low expenditure, В is moderate expenditure, and С is high expenditure on the police. Voter 1 prefers low to moderate and moderate to high. Voter 1 has single-peaked preferences. So does voter 2, whose peak is at moderate expenditure. But voter 3 prefers high to low and low to moderate expenditure, even though moderate expenditure is closer than low expenditure to the best outcome of high expenditure. Voter 3 does not have single-peaked preferences.

This is why majority voting is likely to get into trouble when individual preferences are not single-peaked. In contrast, with single-peaked preferences the outcome is likely to be that most preferred by the median voter. Consistent public choice under majority voting on particular issues is more likely the more each voter feels that the next best thing is an outcome close to that voter's preferred outcome. On issues where voters feel they must make an all-or-nothing choice between very different alternatives, intermediate positions are a complete waste of time. The failure of preferences to be single-peaked may result in inconsistent public choices.

Legislators

When preferences are single-peaked the median voter models helps us to understand how society makes decisions on particular issues, especially if there is a referendum on the issue. But the process of making decisions through legislative compromises is much more complicated. Decisions are not made issue by issue. There may be a trading of votes between different issues so that an individual gets a package that is preferred. Logrolling is one example.

Table 3-5 shows two issues, A and B, and three legislators, 1, 2, and 3. The value in pounds of each outcome to each individual is shown. These values are merely illustrative measures of how much each individual stands to gain or lose under each outcome. Suppose each person votes for a proposal only if the outcome is positive. Person 1 votes against A and B, person 2 against A but for B, and person 3 for A but against B. Both issues would be defeated on a majority vote.

Table 3 -5. Logrolling

Now suppose persons 2 and 3 do a deal and vote together. Suppose they decide to vote for A, which person 3 wants, and for B, which person 2 wants. Person 2 will make a net gain of ?1, gaining ?4 since В passes, and losing only ?3 when A passes. Person 3 gains a total of ?5, gaining ?6 since A passes and only losing ?1 when В passes. By forming a coalition they do better than they would have done under independent majority voting, when neither A nor В would have passed.

This kind of model helps us understand some behaviour by politicians, but they are subject to many other forces. They want to do good, to be powerful, to be popular, and above all to be re-elected. Even if society as a whole has consistent goals, it does not follow that politicians will act so as to reflect those goals as faithfully as possible.

Civil Servants

Civil servants influence public decision-making and its execution in two ways. They offer advice and expertise, which influence the government in deciding how laws and policies should be framed. They are also responsible for carrying out the enacted laws and stated policies and may have some discretion in how far and how fast to put into practice the directives with which they have been issued.

Civil servants also have vested interests. Those at the defence ministry are likely to try to persuade the government to expand defence activities. Those in education will press for higher spending on education. Although the final responsibility must be taken by elected politicians, governments sometimes argue that civil servants are quite skilled in obstructing policies that the civil servants do not like.

The main point of this section is that the process through which governments make spending and taxing decisions does not ma gically and automatically translate society's wishes into the appropriate action. Indeed, as the paradox of voting shows, it may be impossible for society always to express con sistent aims. The simple view that the government acts to maximize the public good is a convenient one on which we frequently fall back. But a complete understanding of how public choices are made, and could possibly be made, requires an extension of the ideas we have briefly examined in this section.

Summary

1. Governments play a major role in modern mixed economies. The scale of their activities is between a third and two-thirds of national income.

2. The role of government extends beyond purchasing goods and services, raising taxes, and making transfer payments. Governments also set the legal framework, regulate economic activity, and attempt to stabilize the business cycle.

3. Taxes affect the allocation of resources. Taxing a good raises the price to the buyers and lowers the price to the seller, thereby reducing the output of the good.

4. Government intervention in the economy can be justified on economic grounds by market failure. Stabilizing the business cycle, deciding on the amount of public goods, responding to externalities, correcting informational problems, preventing the exercise of market power, and creating a socially desirable distribution of income and merit goods are all economic grounds for a government role in the economy.

5. Government decisions should represent the interests of society, but society's true preferences may be hard to ascertain. A democratic society votes for legislators who make decisions that are carried out by civil servants under the supervision of the government.

6. Unless individual preferences are single-peaked, majority voting can lead to inconsistent public choices. With single-peaked preferences, majority voting will lead to consistent results. Society will tend to choose according to the median voter on any issue. Legislative decisions may reflect complex deals and vote-trading on different issues. There is no simple relation between the final choices of public servants and the underlying preferences of the voters who make up society.

Part V. Taxes

“But in this world nothing can be said to be certain, except death and taxes.” - Benjamin Franklin, 1789.

Few economic topics excite controversy more easily than taxes. Wile most would agree that neither government nor modern society could survive without them, taxes are more likely to be criticized than praised.

Why Do Governments Collect Taxes? Although the principal purpose of taxes is to pay for the cost of government, it is not the only function taxes serve.

Ш Sometimes taxes are levied to protect selected industries. For a number of years a tariff (a tax on imports) helped to protect American steel manufacturers by making imported steel more costly than it would have been otherwise.

Ш Taxes have also been used to discourage activities the government believes to be harmful. For example, taxes on cigarettes and liquor, so called “sin taxes”, have been levied both to raise money and to discourage people from smoking and drinking.

Ш Taxes have been used to encourage certain activities. In the 1980's, for example, the government wanted to encourage business to modernize plants and increase productivity. It did so, in part, by offering to reduce taxes of firms that purchased new machinery and equipment.

Ш The federal government can use its ability to tax to regulate the level of economic activity. The size of the economy is directly related to consumer and business spending. By increasing or decreasing taxes, government can directly affect the amount of money available to be spent.

Evaluating taxes. Most people would agree that some taxation is necessary, but the question of which taxes and in what amounts can lead to considerable disagreement. In comparing the merits of one tax to another, it is convenient to focus on the following questions:

Who ought to pay taxes?

What types of taxes are being considered?

Who will actually pay the taxes?

Who Ought to Pay Taxes?

The benefits-received principle of taxation states that those who benefit from a government program are the ones who ought to pay for it. Consider, for example, the case of a highway tunnel or bridge. In keeping with the benefits-received principle, motorists using these should have to pay for a toll.

Benefits-received works just fine when it comes to things like bridge and tunnel tolls or admission to a public beach, but it has its limitations. For example, is it fair to ask low-income families or the disabled to bear the cost of the programs designed to help them?

The ability-to-pay principle states that taxes ought to be paid by those who can best afford them, regardless of the benefits they receive. In arguing in favor of the ability-to-pay principle, economists often cite Engel's Law. It states that as income increases, the proportion spent on luxuries increases, while that spent on necessities decreases. It follows that taxing higher-income groups may deny them certain luxuries, but taxing the poor reduces their ability to buy necessities.

Also, some benefits are indirect. If Mr. And Mrs. Jones have children in the public school, they can see the direct benefit of their school taxes. But Mr. And Mrs. Smith may feel they get no benefit from the school because they have no children.

We all benefit from having an educated workforce, however. Thanks to education, the nation's productivity is higher, and we can all share in the additional output that results from it. If the Smiths own a business, they benefit from having workers who have been trained to read, write and solve mathematical problems.

Types of Taxes: Progressive, Proportional and Regressive

Most taxes can be classified as progressive, proportionate or regressive. A progressive tax takes a larger percentage of a higher income and a smaller percentage of a lower income. The federal income tax is the best known example of a progressive tax.

A proportionate tax takes the same percentage of all incomes, regardless of size. So, for example, a proportionate income tax of 10 percent would cost a person with a $10,000 income $1,000 in taxes, and a person with a $100,000 income $10,000 in taxes.

A regressive tax is one that takes a higher percentage of a low income and a lower percentage of a higher income. Although they are not based on a person's income, sales taxes have a regressive effect because they take a larger share of earnings from a low-income taxpayer than from a high-income taxpayer. For example, a low-income family and a high-income family buy $500 refrigerators with a sales tax of eight percent. They would both pay a $40 sales tax. But the $40 represents a higher percentage of the low-income family's total income than that of the high-income family.

Which tax is the fairest?

Few would argue that a regressive tax is fair. Those who favor the ability-to-pay principle would support a progressive tax, and possibly the proportionate tax. There are some, however, who argue that the proportional tax is not fair.

The proportional tax seems to be fair because everyone pays the same rate. Miss Rich, with her income of $100,000 pays 10 times as much as Mr. Poor who has an income of $10,000. Mr. Poor, however, can barely get by on $10,000; he needs every penny he earns. Miss Rich, on the other hand, can pay a tax of $10,000 and still have $90,000 left over - a very substantial sum! She can pay for all of her basic needs, enjoy main luxuries and still have money left to save or invest. Although her tax was 10 times as large as Mr. Poor's, she didn't suffer as much in laying it.

In analyzing the impact of taxes on individuals, economists often concentrate on discretionary income - the amount that a person has left buying necessities (food, clothing, shelter, medical care, transportation, etc.). Let's assume that Mr. Poor has $1,000 left after having met all his needs. By levying a tax of $1,000, the government has taken 100 percent of Poor's discretionary income. What about Miss Rich? Let's say that she needs $50,000 to meet all of her needs (as she defines “needs”), and that she has $50,000 left as her discretionary income. The government takes $10,000 of this, or only 20 percent. She still has $40,000 left for luxuries, savings and investments. If we look at the discretionary incomes of Mr. Poor and Miss Rich, we find that the proportional tax is really a regressive tax!

Who really Pays the Tax?

In evaluating a tax it is important to know who will really have to pay it, or, as economists put it, the incidence of tax. The burden of paying a tax can be avoided if one responsible for writing the check for taxes to the government can pass the cost to someone else. The process of passing the burden to someone else is known as tax-shifting. Taxes may be passed on to consumers, in which case they are said to be shifted forward. Similarly, taxes may be shifted backward as when suppliers or the workers who produced the products are forced to assume the burden.

Whether taxes are shifted forward, backward or not at all will depend upon the elasticity of demand and supply. When demand is relatively inelastic, it is easier for sellers to shift taxes to buyers. When supply is relatively elastic, the seller is more likely to assume the burden of taxes.

Suppose cigarettes cost ?1 a packet in the absence of a cigarette tax and the government imposes a tax of 50p per packet. Do cigarette smokers end up paying the tax or is it borne by manufacturers of cigarettes? It all depends on how much of the tax cigarette producers can pass on to the consumer. We now show that this depends on the slopes of the supply and demand curve.

In parts (a) and (b) of the figure we plot the (after-tax) price to the consumer on the vertical axis. DD' shows the demand curve, which depends on the price to cigarette smokers (consumers). Since the price received by the producer is the consumer price minus the 50p tax per packet, the effect of levying the tax is to shift the supply curve from SS to SS" in both diagrams. Each possible quantity supplied depends on the price received by the producer, which will be the same as before only if consumer prices are 50p higher; that is why we must shift the supply curve up by 50p.

In part (a), with a flat supply curve and steep demand curve, the tax is borne mainly by cigarette consumers. Point В is nearly 50p higher than point A. Since demand is inelastic, producers can pass on most of the tax in higher prices. Supply is elastic, so any significant drop in the price received by producers would lead to a large drop in the quantity produced. Consumers pay ?1.45 and producers get ?0.95 a packet. In part (b), with a flat demand curve and a steep supply curve, most of the tax is borne by cigarette producers. Demand is elastic, so attempts to pass on the tax in higher prices quickly lead lo a drop in the quantity of cigarettes sold. Supply is inelastic, and firms produce nearly as many cigarettes even though the price they receive (after tax) has fallen nearly 50p from point A lo point C. Consumers pay ?1.05 and producers get ?0.55 a packet.

Incidence refers to the individual or business that will bear the burden of a tax. For example, in many localities businesses have to pay a sales tax on their gross receipts. If, for example, your community charged a 5 percent sales tax, a store with $1,000 in sales would have to pay $50 in taxes. But sales taxes are normally added on to the selling price of a good or service. In other words, the incidence of a sales tax falls upon consumers.

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