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 17.2 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 services  e.g. VAT, duty on alcohol  Wealth taxes – capital transfer tax, tax on property 17.7 Employers pay the green area, and workers the blue. A tax on wages Hours worked W a g e L 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. 17.8 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 P r i c e 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*. 17.10 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 T a x r e v e n u e [...]...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 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. 2 Government. 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. 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