Government revenues come mainly from direct taxes on personal
incomes and company profits, indirect taxes on purchases
of goods and services and contributions to state-run social
security schemes. Government spending comprises government purchases
of goods and services and transfer payments.
Governments intervene in a market economy in pursuit of distributional
equity and allocative efficiency. A progressive tax-and-transfer system
takes most from the rich and gives most to the poor. The UK system is mildly
progressive. The less well off get transfer payments and the rich pay the
highest tax rates. Although some necessities, notably food, are exempt from
VAT, other goods intensively consumed by the poor, notably cigarettes and
alcohol, are heavily taxed.
Externalities are cases of market failure where intervention
may improve efficiency. By taxing or subsidizing goods that involve externalities,
the government can induce the private sector to behave as if it takes account
of the externality, eliminating the deadweight burden arising
from the misallocation induced by the externality distortion.
A public good is a good for which one person’s consumption
does not reduce the quantity available for consumption by others. Together
with the impossibility of effectively excluding people from consuming it,
this implies all individuals consume the same quantity, but they may get different
utility if their tastes differ.
A free market will undersupply a public good because of the free-rider
problem. Individuals need not offer to pay for a good that they can
consume if others pay for it. The socially effcient quantity
of a public good equates the marginal social cost of production to the sum
of the marginal private benefits over all people at this output level. Individual
demand curves are vertically added to get the social demand or marginal benefit
curve.
Except for taxes to off set externalities, taxes are distortionary.
A wedge between the sale price and purchase price prevents
the price system equating marginal costs and marginal benefits. The size of
the deadweight burden is higher the higher is the marginal
tax rate and the size of the wedge, but also depends on supply and demand
elasticities for the taxed commodity or activity. The more inelastic are supply
and demand, the less the tax changes equilibrium quantity and the smaller
is the deadweight burden.
Tax incidence describes who ultimately pays the tax. The
more inelastic is demand relative to supply, the more incidence falls on buyers
not sellers.
Rising tax rates initially increase tax revenue but eventually lead to
such large falls in the equilibrium quantity of the taxed commodity or activity
that revenue falls. Cutting tax rates will usually reduce the deadweight tax
burden but might increase revenue if taxes were initially very high. Few economies
are in this position. Lower tax rates usually reduce tax revenue.
The economic sovereignty of nation states is reduced by
cross-border mobility of goods, capital, workers and shoppers. Policy co-ordination
may increase efficiency by making decisions reflect previously neglected policy
spillovers.
Political economy examines political equilibrium and incentives
to adopt particular policies.
When all those voting have single-peaked preferences, majority voting achieves
what the median voter wants.
