Download Session 8 The role of government

Module H4 Session 8
Economic Concepts for Statisticians
Session 8 The role of government
At the end of this session, students will have an understanding of:




Why governments are needed – the economics argument
Government accounts
Taxation
Fiscal policy
Why governments are needed
The main arguments for the existence of governments come from the field of political
philosophy, not from economics. However, economists have put forward three reasons
why governments are needed from the economics perspective:
1. Missing markets
2. Market failures
3. Equity issues
The missing markets argument is divided into two parts:
First, the existence of public goods. These are goods that, even if consumed by one
person, can still be consumed by other people (‘non-rivalry’) and it is only possible to
exclude other people from consuming them at a prohibitive cost (‘non-excludability’). They
will not be provided by private agents because they cannot be charged for, as so-called ‘free
riders’ could enjoy them without paying. So there are no markets for such goods. Examples
of pure public goods (and services) are defence, clean air and justice.
The second type of missing market has to do with externalities. An externality occurs
when there is a cost or benefit to society which cannot be captured by the price
mechanism: it is outside the market. For instance, society will benefit if all children are
vaccinated against major diseases, but the market will be in equilibrium at a point where
less than the entire population of children are vaccinated.
SADC Course in Statistics
Module H4 Session 8 – Page 1
Module H4 Session 8
The market failures argument has been touched on earlier (Sessions 1 and 5). The idea is
that the market does not in fact clear at the ‘competitive equilibrium’ ensuring maximum
efficiency, as orthodox economists predict. Instead, there are obstacles such as the market
power of monopolies, or a lack of reliable information to help consumers make rational
choices. These obstacles prevent markets from clearing: they represent failures in the
market mechanism.
The equity argument is that even where the market is quite efficient, there may be unfair
distribution of income/resources. Society may prefer a more equitable distribution than
that which market forces produces – for instance, it might want to create a safety net for
the poorest, or it might argue in favour of a national health service to ensure that rich and
poor alike can get access to medical treatment.
For these three reasons, economists argue that governments are needed to:



Provide public goods;
Introduce corrective measures to deal with externalities and market failures; and
Pursue income redistribution (if society wants it).
Government interventions in the economy
On a more practical level, the main areas of government intervention in relation to the
economy should be (as a minimum):




Investment in infrastructure
Providing incentives to the private sector (tax breaks, subsidies and other support)
Regulation of the private sector
Investment in human capital (e.g. education, health)


Redistribution to enhance social welfare (improve equity)
Fiscal policy interventions to smooth business cycles
Some economists argue that in addition to this, governments in developing countries
should take a more interventionist stance to promote growth. They should have industrial
development strategies involving intervention in key sectors/industries, support for
technological effort and provision of cheap credit (see Session 4).
SADC Course in Statistics
Module H4 Session 8 – Page 2
Module H4 Session 8
Government accounts
Table 1 shows how the government accounts are normally presented. This is the standard
format used by the IMF. On the one hand, the government receives revenue, mainly in the
form of taxes, and on the other, it incurs expenditure when it pays its employees, buys
goods and services, pays interest on government debt, and provides subsidies and grants to
businesses and social benefits to the unemployed, the elderly and the very poor.
The accounts show revenue minus expenditure as the ‘gross operating balance’. This is
added to the amount spent on non-financial asset purchases or received from sales of nonfinancial assets to give the total balance which needs to be financed. This is normally a deficit! In
the case of Mauritius in 1999-2000, the total deficit was 4,143 million rupees or 3.7% of
GDP. As a matter of interest, the accounts also show a ‘primary surplus or deficit’ which
consists of the gross operating balance minus the amount spent on interest payments.
Table 1: Mauritius Central Government Accounts, Financial Year 1999-2000
Millions of rupees
Revenue
% of GDP
23500
20.9
20373
18.1
Social contributions
120
0.1
Grants
161
0.1
2846
2.5
24777
22.1
Employee salaries & other payments
7763
6.9
Use of goods and services
2354
2.1
Interest
3856
3.4
Subsidies
2008
1.8
763
0.7
Social benefits
6891
6.1
Other
1141
1.0
-1277
-1.1
2866
2.6
-4143
-3.7
2580
2.3
Taxes
Other, incl. property income
Expenditure
Grants
Gross operating
balance1
(A)
Net acquisition of non-financial
assets2
Net lending/borrowing (equals A – B)
Primary
surplus/deficit3
(B)
Notes: 1 = revenue minus expenditure other than consumption of fixed capital. 2 = acquisitions minus
disposals and consumption of fixed capital. 3 = surplus/deficit excluding interest payments on debt.
Source: Adapted from IMF (2005), which uses as sources Mauritius authorities and IMF staff estimates.
SADC Course in Statistics
Module H4 Session 8 – Page 3
Module H4 Session 8
Another way of showing the government accounts is to break expenditure down into
‘capital’ and ‘current’ expenditure. This is helpful because it allows us to get an idea of what
proportion of the budget is spent on physical investment as opposed to recurrent costs
such as salaries and social benefits. The problem, however, is that ‘capital’ expenditure
normally includes only the initial investments – not the follow-up maintenance activities,
without which the initial investments will become worthless; and it does not include
investments in ‘human capital’ e.g. spending on health and education. Another approach
which does give some idea of how much money is spent in areas such as health and
education is to show a breakdown of expenditure by ministry (a functional classification).
Public expenditure management
In recent years, much effort has been put into trying to improve budgeting and public
expenditure management. The aim is to move away from a system where civil servants
simply repeat the same tasks year-in year-out and towards systems where objectives are
clearly stated in the budget, civil servants aim to deliver results, and the outcomes can be
measured and evaluated, feeding back into improvements in the next round of budgeting.
As part of this, the government’s performance in the areas of intervention discussed on
page 2 would be monitored. Public expenditure reforms tend to improve the image of
government with the general public. However, lack of resources and clear leadership have
often hindered the reform process in Africa and, in general, progress has been slow.
Taxation
It is sometimes said that only two things in life are inevitable: death and taxation! In
general, people do not like to be taxed. A government that raises taxes will be unpopular.
Nevertheless, taxation plays a very important role in the economy. As in Mauritius (Table 1
above, page 3), in most other countries, taxes make up the largest part – by far – of
government revenues. Without them, the government cannot intervene in the economy
and society in the way it needs to. If those who oppose taxation were to take their
arguments to the logical conclusion they would have to say that they do not want a stable
and growing economy, social welfare or national defence. What should be of more concern
than taxation is lack of ‘value for money’. Taxation is (by definition) a transfer to the
government without any specific benefit being provided. People want to get more in
return, and this is a reasonable expectation. If governments are not delivering, they should
be reformed so that they produce provide useful services to individuals and businesses. Tax
SADC Course in Statistics
Module H4 Session 8 – Page 4
Module H4 Session 8
systems themselves may also need to be reformed so that they are more efficient and
equitable (see page 7).
Types of taxation
Taxes can be divided into the following categories:

Direct (income) taxes
1. Personal income tax, which is levied on income from employment, pensions,
business profits, savings income and dividends, rental income, etc.
2. Corporate income tax, which is usually a flat rate tax applied to profits; different
rates may sometimes be applied to large and small/medium-sized companies and to
different sectors

Indirect taxes (domestic)
3. Sales tax or Value Added Tax (VAT), which are general taxes on consumption
4. Excises, which are selective consumption taxes e.g. on alcohol, tobacco and fuel

External trade taxes
5. Import taxes – both general tariffs which discourage imports and provide a general
level of protection, and specific duties designed to discourage the importing of
certain goods to provide protection for local producers
6. Export taxes – particularly on agricultural commodities and oil
Income tax contributes a substantial part of tax revenue in developed countries, but is
often hard to collect in developing countries. Companies, in particular, are adept at
avoiding income tax payments. In order to increase the ‘tax base’ (i.e. the number of
contributors), developing country governments have made a number of changes in recent
years such as reducing tax rates and deducting tax at source rather than relying on the filling
in of tax returns. Deductions at source also speed up the collection of taxes.
Many developing countries have introduced VAT to replace sales tax as part of reforms
promoted by the international financial institutions. VAT can contribute significant
amounts of tax to the government coffers, and should be levied on a broad base (large
SADC Course in Statistics
Module H4 Session 8 – Page 5
Module H4 Session 8
number of contributors). It should include imports but exclude exports. Certain products
such as food and medicine can be ‘zero-rated’ (i.e. pay no VAT) to help poor households.
Box 1 Advantages and disadvantages of VAT
VAT has two main advantages to the economy: it produces minimal economic distortions,
being levied at the same rate on all goods and services, and it avoids the cascading problem
of the old ‘turnover’ sales taxes. Cascading occurs when sales taxes are applied to output at
every stage of production. VAT applies instead to value added at each stage of production.
So, using the example of the brick industry from Session 2, if VAT is levied at 15%, the
amount paid is 15% of 30,000 kwacha, rather than 15% of 55,000 kwacha.
The advantages to the finance ministry are also considerable: it generates large amounts of
revenue with hardly any time lag, and the revenue effect of any rate change (e.g. from 12%
to 15%) is immediate and easy to calculate.
However, VAT has some disadvantages. It is more complex to administer than sales taxes
because it is based on value added. Normally the ‘subtraction method’ is used, whereby
taxes on purchases are credited against taxes on sales. This is not easy to understand!
VAT is also unpopular with the public. This is because it is perceived as a ‘regressive’ tax
(i.e. the poor pay more VAT in proportion to their incomes than the rich). Although this is
true in developed countries, studies suggest that it is not the case in Africa because the
poorest people (e.g. small farmers) escape the VAT net! Nevertheless, among those who do
pay VAT – principally urban consumers – the poor are hit harder than the rich.
Excises are used by governments to influence the pattern of consumption, discouraging
consumption of certain goods such as tobacco and alcohol. Economists see them as
making the people who consume them pay for part of the ‘externality’ costs associated with
their consumption (e.g. extra hospital beds for cancer patients). But tobacco, alcohol and
petroleum taxes are also convenient ‘tax handles’, i.e. easy ways to raise tax!
Trade taxes often account for a large part of tax revenue in developing countries.
However, export taxes are not normally a good thing, as they are paid by the exporter and
therefore discourage production – so efforts should be made to reduce them except where
there is a ‘windfall’ to exporters from a price increase (e.g. oil), or the government wishes
to discourage production of a particular type of export.
SADC Course in Statistics
Module H4 Session 8 – Page 6
Module H4 Session 8
Tax reform
At first glance, one might think that tax reform was about introducing VAT, or changing
the income tax rates to encourage more people and companies to pay. These are certainly
the types of reform that hit the newspaper headlines! However, tax reform is a complex
business which involves the whole system of taxation. In developing countries, reform is
generally considered necessary if:
1. There is a low tax take (taxation as a percentage of GDP), which prevents the
government from undertaking necessary expenditures
2. The tax system is regressive, representing an undue burden on the poor
3. The system leads to economic distortions which hamper growth
Such problems indicate a need for change. The main areas of reform are:

Making the system more effective, known as increasing the ‘administrative efficacy’
of the system, in order to increase the tax take. This might mean eliminating taxes
that are costly to collect, lowering rates of tax and broadening tax bases, reducing
dependence on trade taxes and relying more on domestic consumption taxes,
improving tax collection capacity and combating tax evasion.

Improving the equity (fairness) of the tax system, including making income tax
more ‘progressive’ (i.e. the rich should pay more tax in proportion to their incomes
than the poor) and zero-rating some basic needs items within the VAT regime.

Improving the economic efficiency of the system by reducing economic
distortions, providing the right incentives for savings, investment and growth,
replacing sales tax with VAT (zero rated for exports) and simplifying import tariffs.
Tax evasion
Tax evasion – when people and companies avoid paying taxes – is a serious problem for
governments. It affects all types of taxation, but is particularly widespread in relation to
trade taxes, ranging from smuggling to under-invoicing and bribery of customs officials.
Efforts to combat tax evasion in recent years have focused on:
SADC Course in Statistics
Module H4 Session 8 – Page 7
Module H4 Session 8






lowering rates of income tax in the top bands because high rates discourage
payment
reducing reliance on trade taxes
improving official tax collection capacity and improving the Treasury's public
image
introducing withholding taxes (credited against liabilities in income tax returns)
reducing time lags for payments and imposing tougher penalties for arrears
negotiating international tax treaties and improving exchange of information
Exercise 1
The tax take varies considerably between SADC countries, as the list below indicates. For
the purpose of comparison, the tax take in the US was 25.5% of GDP in 2004, while for
the UK it was 36% (OECD, 2006).
What are the reasons for the variations in tax takes in SADC countries? Do you think that
the tax take is too high or too low in any of these countries? Why?
Tax revenue as % of GDP, 1991-96 (average) from Ghura (1998):
Botswana
34.1
Mozambique
17.4
Swaziland
30.3
Lesotho
40.0
Namibia
33.3
Tanzania
12.0
Malawi
Mauritius
17.0
19.0
Seychelles
South Africa
32.4
25.0
Zambia
Zimbabwe
16.2
30.9
Exercise 2
Read and discuss the article by Tanzi and Zee (2001). How useful is it?
Fiscal policy
When we think of fiscal policy in developing countries, the words ‘fiscal deficit’ probably
come to mind. This is the difference between government revenue and expenditure, plus
net acquisition of non-financial assets. In the case of Mauritius in 1999-2000 (page 3), the
fiscal deficit was 4,143 million rupees or 3.7% of GDP.
SADC Course in Statistics
Module H4 Session 8 – Page 8
Module H4 Session 8
Fiscal policy does indeed cover the fiscal deficit and the borrowing needed to fill the gap.
We will look further at these issues in Session 9. But it is also about the government’s
policies on taxation and expenditure, and the impact that these policies have on the
economy. The government can use changes in its policies on taxation and expenditure to
smooth the business cycle. This is what economists normally mean by fiscal policy.
There are two main tools of fiscal policy which can be used to help raise output in a
recession: raising government expenditure and cutting taxes. Remember the equation
Y=C+I+G+X–M
(from Session 2)
This tells us that an increase in government expenditure, G, which is one of the
components of aggregate demand, will lead to an increase in output, Y.
Alternatively, a cut in taxes will also boost aggregate demand. For instance, a cut in income
taxes means that households will have more disposable income and will consume more, so
there will be an increase in C. Again, output will rise.
Keynes, who developed the idea that the government should use these tools to increase
aggregate demand in a recession, also argued that there would be a multiplier effect. For
instance, if the government spends more on products supplied by manufacturers, not only
will there be an increase in G, but the manufacturers – seeing demand for their products
rise – might invest in new machinery (an increase in I) and create more jobs, providing
incomes for workers who will consume more (an increase in C).
This type of ‘demand management’ is most commonly associated with recessions, but
governments can also cut spending or increase taxes during a boom to reduce aggregate
demand and slow down the economy.
There is continuing debate among economists about whether the Keynesian approach to
fiscal policy is a good idea. Keynesians argue that fiscal expansion in a recession, leading
to an increase in aggregate demand, may cause some inflation and draw in imports
(widening the current account deficit – see Session 10), but it will have a beneficial impact
on output and employment – which might otherwise be stuck in a low-level equilibrium
(see Session 5). Monetarists believe that in the long run it will only produce inflation.
SADC Course in Statistics
Module H4 Session 8 – Page 9
Module H4 Session 8
References
Anderton, A.G. (2000) Economics, 3rd edn. Causeway Press, Ormskirk, Lancashire, UK.
Ghura, D. (1998) ‘Tax Revenue in Sub-Saharan Africa: Effects of Economic Policies and
Corruption’, IMF Working Paper WP/98/135, International Monetary Fund (IMF),
Washington D.C.
IMF (2005) Using the GFSM 2001 Statistical Framework to Strengthen Fiscal Analysis in the Fund
Statistics and Fiscal Affairs Departments, IMF, Washington, D.C. Available at:
www.imf.org/external/np/pp/eng/2005/102505.pdf
OECD (2006) Revenue Statistics 2006, Organisation for Economic Co-operation and
Development, Paris, France. From: www.oecd.org/dataoecd/8/4/37504406.pdf
Tanzi, V. and Zee, H. (2001) Tax Policy for Developing Countries article available online at:
www.imf.org/external/pubs/ft/issues/issues27/index.htm
World Bank ‘Tax and Customs Policy and Administration’ website available at:
http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/EXTPUBLICSECTORAN
DGOVERNANCE/EXTPUBLICFINANCE/EXTTPA/0,,contentMDK:20261127~me
nuPK:2017195~pagePK:210058~piPK:210062~theSitePK:390367,00.html
SADC Course in Statistics
Module H4 Session 8 – Page 10