IV–2. The Role of Government

Having mentioned the effect of government tax policy on the income distribution, we now examine in greater detail the role of the government in society. In every society governments provide such services as national defense, police, firefighting services, and the administration of justice. In addition, governments make transfer payments to some members of society.

Transfer payments are payments made to individuals without requiring the provision of any service in return.

Examples are social security, retirement pensions, unemployment benefits, and, in some countries, food stamps. Government expenditure, whether on the provision of goods and services (defense, police) or on transfer payments, is chiefly financed by imposing taxes, although some (small) residual component may be financed by government borrowing.

Table 1 compares the role of the government in four countries. In each case, we look at four measures of government spending as a percentage of national income: spending on the direct provision of goods and services for the public, transfer payments, interest on the national debt, and total spending. Italy is a 'big government' country. Its government spending is large and it needs to raise correspondingly large tax revenues. In contrast, Japan has a much smaller government sector and needs to raise correspondingly less tax revenue. These differences in the scale of government activity relative to national income reflect differences in the way different countries allocate their resources among competing uses.

Table 1
Government spending as a percentage of national income in 1985
Country	Purchase of goods and services	Transfer payments	Debt interest	Total
	%	%	%	%
UK	23.0	17.2	5.1	45.3
Japan	14.9	12.7	4.6	32.2
United States	20.1	12.2	4.8	37.1
Italy	27.0	23.0	9.2	59.4
Source: IMF, World Economic Outlook, 1986.

Governments spend part of their revenue on particular goods and services such as tanks, schools, and public safety. They directly affect what is produced. Japan's low share of government spending on goods and services in Table 1 reflects the very low level of Japanese spending on defense. Governments affect for whom output is produced through their tax and transfer payments. By taxing the rich and making transfers to the poor, the government ensures that the poor are allocated more of what is produced than would otherwise be the case, and the rich get correspondingly less.

The government also affects how goods are produced, for example through the regulations it imposes. Managers of factories and mines must obey safety requirements even where these are costly to implement, firms are prevented from freely polluting the atmosphere and rivers, offices and factories arc banned in attractive residential parts of the city.

The scale of government activities in the modern economy is highly controversial. In the UK the government takes nearly 40 per cent of national income in taxes. Some governments take a larger share, others a smaller share. Different shares will certainly affect the questions what, how, and for whom, but some people believe that a large government sector makes the economy inefficient, reducing the number of goods that can be produced and eventually allocated to consumers.

It is commonly asserted that high tax rates reduce the incentive to work. If half of all we earn goes to the government, we might prefer to work fewer hours a week and spend more time in the garden or watching television. That is one possibility, but there is another one: if workers have in mind a target after tax income, for example to have at least sufficient to afford a foreign holiday every year, they will have to work more hours to meet this target when taxes are higher. Whether on balance high taxes make people work more or less remains an open question. Welfare payments and unemployment benefit are more likely to reduce incentives to work since they actually contribute to target income. If large-scale government activity leads to important disincentive effects, government activity will affect not only what, how, and for whom goods are produced, but also how much is produced by the economy as a whole.

This discussion of the role of the government is central to the process by which society allocates its scarce resources. It also raises a question. Is it inevitable that the government plays an important role in the process by which society decides how to allocate resources between competing demands? This question lies at the heart of economics, and we return to it shortly when we examine the role of markets in economic life.

First, however, we must refine our notion of scarce resources. To do so, we introduce a useful tool of economic analysis, the production possibility frontier.

Check your understanding.

1. Find the terms in the text which describe the following:

· money paid to people without asking for a service in return

· money paid to people when they stop working

· money paid to people who have no work

· money owed by the government of a country

· the money received by governments from taxation

· money a worker keeps after paying taxes

2. Now look at these statements. Using the information in the text, say if they are correct or incorrect.

· Governments do not make free transfer payments.

· Food stamps are an example of a transfer payment.

· Most government income comes from borrowing.