Topic 6 Government and the economy

Notes compiled by: Richard Zhou

Topic 6 Government and the economy

• Context rate of government in a mixed economy combination

• Mixture of government intervention and market freedom

Government intervention

1. market failure (failure to properly provide goods and services or provide certain good and

services- parks and defence)

2. lack of allocative efficiency

(everyone benefits from goods or services eg. Medicare )

Limitations in the operation of the free market

The rationale for government intervention in a market economy is based on the argument of market

failure.

Market failure refers to the shortcoming or inadequacies of the market system of economic

organisation in achieving an efficient allocation of resources in all circumstances.

Market price is Pe1 government intervenes to increase to pe1 to pe to compensate for externalities

(cost beared by 3rd party,eg community)

Poverty trap- cycle of low income, leads to low levels of education and health


How does the government intervene ?

1. compulsory/ free schooling and opportunities for apprenticeship

2. social welfare/ security to help low income earners

3. free health care eg. medicare

Limitations in the operation of the free market

• Provision of goods and services, public goods, merit goods

• Inequality in the distribution of income – disadvantaged groups, relative poverty

• Externalities and the environment – pollution, climate change

• Monopoly power – the formation of monopolies, government-owned monopolies,

privatisation, corporatisation and competition

• Fluctuations in economic activity – the business cycle and the adverse effects of booms and

recessions

Provision of goods and services, public goods, merit goods

The market may fail to provide certain necessary goods and services, or it may be more

desirable that they are not provided by the private sector.

Public goods are non-excludable and non-rival.

Non-excludable: once provided, it is difficult to prevent anyone from using it,

regardless of whether they pay for it – i.e. it attracts free riders (and hence there is

no incentive for the market to produce it, so the government must provide it), e.g.

street lighting, public parks, clean air, national defence, ABC TV and radio, etc.

Non-rival: one person’s enjoyment of a public good does not diminish the potential

for others to enjoy the good, e.g. if you went for a run in a public park, this does not

prevent another person from running in the park in the future.

Note that not all collective goods provided by the government are public goods, e.g. public

transport – you have to pay for public transport, therefore making it excludable.

Merit goods are not produced in sufficient quantity by the private sector because private

individuals do not place sufficient value on them, e.g. health care, ballet. The governments

intervene to provide the good directly (e.g. hospitals) or provide funding (e.g. to the arts).

Demerit goods are items that cause harm to the community and are produced in too large a

quantity by the private sector, e.g. tobacco, alcohol, addictive drugs and gambling. The

government intervenes to restrict their production and sale by requiring licenses, charging

taxes or placing bans.


Natural monopoly

Governments sometimes provide goods by operating as a natural monopoly.

Natural monopoly: goods can only be efficiently produced by one supplier, usually because

an enormous investment in infrastructure is required, so it would be inefficient for

competition to operate, e.g. rail networks.

Governments may maintain ownership of these monopolies because of concerns that

private owners of such enterprises would have monopoly power, leaving consumers with

little choice but to pay whatever price the monopolist sets for their good or service.

Governments that operate natural monopolies generally try to set a fair price that ensures

that consumers cover the costs of providing the good or service but are not exploited by

excessive prices.

1. Inequality in the distribution of income

Inequality in the distribution of income in Australia and other market economies is an outcome the

market system disturbing factor incomes according to the relative marginal productive of the factors

of production

Income inequality problem – the market economy is the outcome of distributing factor incomes

according to productivity of worker

How long you work = return/ income

But what about those who can’t work or are low skilled / low productivity

2. Scope of inequality of the income in Australia

Income- top 20% have 15times more than bottom 20%

Wealth- top 20% earn 70 times more than bottom 20%

Reasons for some people not earning incomes above poverty line

-duration of unemployment

-sole parent families

-people reliant on government wealth payments

Inequality in the distribution on income- disadvantaged groups, relative poverty

- Government intervenes through a progressive tax system, providing a free education and a

welfare state

-Government provides welfare state- many benefits/ payments like pensions / unemployment

benefits

Government intervention in sustainable ecological development

1. goal of ecological sustainability

-environment resources to be conserved or enhanced for now and the future

using, conserving and enhancing the community's resources so that ecological processes, on which

life depends, are maintained, and the total quality of life, now and in the future.


Externalities and the environment

Negative externalities may arise in private production because most environmental resources are

not priced in the market, so producers do not pay for the resources they use, and are able to pass on

the cost of using resources to an unwilling third party which may be the community at large.

1. positive externalities – benefits to 3rd parties , eg. Ecotourism business clean up a polluted river

in order to offer white water rafting

Negative externalities- harm society and the economy- pollution arises as a consequence of

production and reduces air quality

Negative externalities

Positive externalities


Externalities and the environment

Examples of negative externalities in Australia include:

Contribution to increased carbon dioxide and global warning caused by the burning of fossil

fuels, such as from coal-fired power stations and more vehicles

The transformation of land that occurs because of land clearing

Land degradation through increased soil salinity and soil erosion, which are major problems

for regional Australia

Water pollution, resulting from the use of detergents and industrial output

Tragedy of commons

-unrestricted access to common property, eg. Clean air or water, may lead to over exploitation and

eventual depletion of some natural resources

Government intervention with big businesses and economic activity

Monopoly power

Because of the costs involved in producing, distributing and marketing goods & services in some

markets, only a number of firms will survive.

This may create a market structure where there is imperfect competition – oligopoly or monopoly.

In this market situation, the market will produce a smaller quantity of goods at a higher price

1. the problems of big businesses

Many businesses -> markets allow for a small number of firms to survive (competition) -> small

number of firms become larger -> oligopoly + monopoly in an industry -> market situation at a

limited supply of a higher/ highest price

Examples of monopolies and oligopoly in Australia:

• Sydney Airport

• Coles and Woolworths

• Australia Post

• Banks


Issues with large firms/ monopolies

• Price discrimination occurs when a firm sells the same type of good or service in different

markets at different prices, e.g. early-bird pricing for flights, concession prices for movie

tickets for students.

Set prices at different levels in different places

• Exclusive dealing occurs when firms set conditions for supply that exclude retailers from

dealing with other competitors (prohibited under the Competition and Consumer Act 2010).

Exclusive dealing- firms set conditions for supply that exclude other firms/ competitors

• Collusion and market sharing occur when firms get together and agree on pricing and

market-sharing arrangement (cartel) that reduces effective competition between them, and

tends to inhibit the entry of new competition into the market (also prohibited under the

Competition and Consumer Act 2010), e.g. cardboard box case.

Firms get together and agree on pricing or market sharing

• Swaying politics/ democracy eg. Murdoch swaying ideological world view

Government and big businesses

• Privatisation: selling off government business enterprises to the private sector, e.g.

Medibank Private, the Commonwealth Bank, QANTAS, Telstra, etc.

• Corporatisation: government enterprises are forced to act as private business enterprises

with no government interference (although they are still government owned), e.g. Australia

Post.

• Competition: the government encourages competition in the market to produce a more

efficient use of resources, lower production costs, lead to product innovation and lower

prices for consumers.

Government intervention

The Australian Competition & Consumer Commission (ACCC) promotes competition and fair

trade in markets to benefit consumers, businesses, and the community.

Their primary responsibility is to ensure that individuals and businesses comply with Australian

competition, fair trading, and consumer protection laws - in particular the Competition and

Consumer Act 2010.

How does this help?

• Regulate prices

• Encourage competitive behaviour

• Prevent anti-competitive behaviour

• Protect consumers from deceptive or misleading conduct


The role of government

Functions of the three levels of government, Constitutional powers, size of the public sector

Functions of the three levels of government

Commonwealth (Federal) government: overall responsibility for the economy, foreign

affairs, defence, currency. Revenue comes from income tax, customs duty, superannuation

tax, etc.

State (6) and territory (2) governments: develop infrastructure (e.g. roads) transport,

utilities (electricity, water) deliver government services (e.g. health, education, police) and

foster regional planning. Revenue comes from redistribution of GST from Commonwealth

govt, stamp duty taxes, payroll tax, gambling taxes and land ownership taxes, and funding

also comes from the federal government.

Local governments (565): responsible for local planning and development decisions,

community facilities and local services (e.g. rubbish collection, parks, libraries). Revenue

comes from council rates, fees, licenses and fines and they also get funding from federal and

state governments.

Constitutional powers

The Australian Constitution sets out the law-making powers of the Commonwealth and state

governments.

It sets out the absolute limits on what governments are able to do.

Separation of powers – parliament, executive, judiciary

Division of powers – between the Commonwealth and State government


Size of the public sector

Public sector: the parts of the economy that are owned or controlled by the government. It includes

all tiers of the government (Federal, State, Local) as well as government enterprises (Australia Post,

Sydney Water, etc.). [business or employees that are owned or controlled by the government]

Taken as a percentage of GDP, total public sector outlays shows the proportion of total annual

expenditure by all levels of government compared with the expenditure for the economy as a whole.

Total public sector outlays as a percentage of GDP increased steadily in the second half of the

twentieth century (following World War Two).


4. Public sector outlays have been within the range of 35-42% of GDP during the past three decades.

5. Public sector outlays typically increase in response to downturns in economic activity.

6. Over time, governments have tended to spend less on infrastructure and more on social welfare

payments and community services such as health care.

Another measure of the overall size of the public sector is the proportion of Australian employees

who work in the public sector.

Employment in the public sector grew in line with public sector outlays, peaking at 25.5% of the total

number of workers in 1985.

Since 1985, employment levels in the public sector have declined even though public sector outlays

have remained at around the same proportion of GDP, partly because governments have been

contracting out many of their activities to the private sector.


Relocation of resources- taxation

1. direct taxation- paid by individuals or business on which they are levied

taxation influencing the patterns demand or indirectly change resource

2. indirect taxation- attached to a good or service, rather than to an individual or company- they

are levied on induvial and business firm but can be passed on to someone else eg. Gst

Reallocation of resources- spending

Government spending attempts to redress a failure of the market to provide an allocation of

resources that fits with community broader needs and wants

1. funding or the as- (merit goods) as they are unprofitable

Grants- start up business or new growth industries that, without a proven financial track

record , might lack access to finance

Subsidies- for telecommunication companies such as Telstra to provide broadband services

to regional areas

Reallocation of resources- government provision of goods and services

Provisions of infrastructure- railways and public transport

Electricity distribution, postal services, telecommunications networks

Government enterprises have largely been privatised

Redistribution of income

-the main way that the government redistribute income is through taxation system and welfare

payments


Gross income inequality is severe prior to government intervention with the highest 20% of

income earners receiving almost half of total private income

As income rises, so too does level of taxation. However, lowest 40% have a proportionately high tax

burden, reflecting the impact of indirect consumption of taxes not related to income

Redistribution of income – Taxation

• Tax base: the items that are taxed. There are three main bases for the imposition of taxes –

income, wealth and consumption. In Australia, income is the main tax base.

• Average rate of tax (ART) – the proportion of total income earned that is paid in the form of

tax.

• Marginal rate of tax (MRT) – the proportion of any increase in income that must be paid as

tax. It represents how many cents in every extra dollar earned that must be paid to the

government.

How the average rate of tax changes as an individual’s income increases indicates whether the tax is

a:

Progressive tax: higher income earners pay a greater proportion of their income as tax than lower

income earners (ART rises as an individual’s income increases), e.g. personal income tax in Australia.

Regressive tax: higher income earners would pay a smaller proportion of their income as tax than

lower income earners (ART falls as an individual’s income increases), e.g. GST.

Proportional tax: all income earners pay the same proportion of their income as tax (ART remains

constant as an individual’s income increases), e.g. company tax in Australia.

Average tax rate

Marginal tax rate


• Australia’s progressive income tax system (PAYG) is the main taxation tool used to

redistribute income.

• Under PAYG, tax payments are regularly deducted from employees’ wages, and includes tax

paid in advance by self-employed persons and individuals who derive a significant

proportion of their income from investment.

• The tax-free threshold (the income level below which no tax is paid) is $18,200.

Social welfare payments –

The Commonwealth government redistributes its taxation revenue to lower income earners via

social welfare payments.

Payments are often means tested, meaning that people on high incomes (or those with a large

amount of assets) may be ineligible to receive specific benefits.

Payments include unemployment benefits, family benefits, aged pensions, disability pensions, etc.

Fiscal policy

What is fiscal policy ?

Fiscal Policy is the use of changes in the level and direction of government spending (G) and

revenue (T) to influence

-income distribution,

-resource allocation (public/ merit goods)

-the level of economic activity (for example increase government spending, less tax to

stimulate spending)

-The main instrument of Fiscal Policy is the Commonwealth Government Budget. It is an

announcement of the planned levels of G and T for the financial year.

-The Budget Papers set out the government expenditure (G) as Expenses and government

receipts (T) as Revenue.

Possible budget outcome

There are 3 possible budget outcomes. They are:

• a Balanced Budget, G = T

• a Surplus Budget, T > G (goal is by 2022)

• a Deficit Budget, G > T

Australian Governments over much of the last 30 years have run Budget Deficits.

This has often been done in an attempt to reduce the level of unemployment or as a result of the

level of unemployment, in Australia.


Underlying budget balances

Tax cut 24% earning up to 45000 pay 19c

45001-200000 70% of people pay 30c

200000+ 6% of people pay 45c

1billion tax avoidance taskforce- for companies such as google

3.9 billion for emergency relief

2billion dollar rail for Melbourne to geelong

2billion climate solution

Budget components

There are 2 parts of the budget to consider to determine the Fiscal Stance. They are the:

-Cyclical component

This is the part of the budget that changes with the level of economic activity in the

economy. As the economy approaches full employment of resources, the lower the cyclical

component of the budget will be.

If income in the economy declines, the cyclical component will rise and lead to a larger

budget deficit.

Similarly rising income will increase the level of the fiscal balance.

Natural changes in government spending due to economic growth


-Structural Component.

The structural budget balance is the budget outcome that would occur if there was full

employment of resources.

The structural component of the budget is deliberate policy decisions of the government to

effect the level of national income and thus economic activity.

The structural component of the budget and its comparison to the previous year is an

indication of the government’s fiscal stance.

Deliberate changes in spending

How does Australia debt compare

Selected Industrial Nations Public Sector Net Debt as a Percentage of GDP (2014)

How does budget affect the economy?

The Government’s Fiscal Stance refers to whether it is trying to increase growth

(expansionary policy) or slow the rate of growth in the economy (contractionary policy).

This is not simply a matter of having a budget deficit or surplus. When the economy is

growing this automatically reduces G and increases T (less spending on welfare and more tax

revenue, due to lower unemployment levels).


The Budget has a number of effects on the economy.

Initially changes in G will affect the level of aggregate expenditure and aggregate demand and thus

income in the economy.

-The income change will be magnified by the multiplier effect.

- Any increase in income generates increased employment and economic growth, while reductions

in income do the opposite.

Fiscal policy is a macroeconomic policy that involves the use of taxation and spending

powers through the Commonwealth Budget in order to achieve certain economic objectives.

Possible fiscal policy stances

Expansionary – Reduction in tax or increase in spending to stimulate growth. This will lead

to either a bigger deficit or a smaller surplus.

Contractionary – Increase in tax or decrease in spending to slow growth. This will lead to

either a smaller deficit or a bigger surplus.

Neutral – No intentional change on last year’s budget. Implies a balanced budget where

G=T.

Fiscal policy- commonwealth federal budget stabilise economy

During upswing/ excessive growth

-increase tax and decrease spending- slow down growth


HOW DOES THE BUDGET AFFECT THE ECONOMY?

1. The Government’s Fiscal Stance refers to whether it is trying to increase growth

(expansionary policy) or slow the rate of growth in the economy (contractionary policy).

2. This is not simply a matter of having a budget deficit or surplus. When the economy

is growing this automatically reduces G and increases T (less spending on welfare and more

tax revenue, due to lower unemployment levels).

3. The Budget has a number of effects on the economy.

4. 4. Initially changes in G will affect the level of aggregate expenditure and aggregate

demand and thus income in the economy.

5. 5. The income change will be magnified by the multiplier effect: refers to an economic

factor that, when increased or changed, causes increases or changes in many other related

economic variables. In terms of gross domestic product, the multiplier effect causes gains in

total output to be greater than the change in spending that caused it.

6. 6. Any increase in income generates increased employment and economic growth, while

reductions in income do the opposite.

-any initial changes sch as increasing government spending is an injection

-multiplying effect

1. Howard’s political stance:

1st term - Reductions in spending

2nd term - increases in spending, introduction of GST, welfare benefits increased.

3rd/4th terms - Modest budget surpluses due to rising commodity prices, sustained

economic growth allowed for decreases to personal tax.

2. Rudd’s political stance:

In 2007-08 mildly expansionary

In 2008-09 mildly contractionary moving back out to 1.8%. This was due to the increasing

need to manage inflation. The reality was a huge deficit as the GFC hit.

2009-10 – Expansionary – the government attempted to ensure stability of the economy.

Mass increases to building and infrastructure spending and increased reliance on welfare

due to increasing unemployment.

2010-11 – Attempts to get back to surplus within 3 years as the economy saw a resurgence.


Currently Australian context (2019)

• Economic growth 1.8% (should be 3-4%)

• Inflation 1.6% (should be 2-3%)

• Wage 2.3%(problem with wage growth and unemployment)

• Unemployment rate- 5.2%

• Household saving rate 2.8%

• $1 to 68c US

Monetary – using the central bank to control/manage money supply and cash/ interest rate

Effects of MP

Tightening of monetary policy Loosening of monetary policy

RBA sells securities RBA buys securities

Shortage of borrowable funds Excess of borrowable funds

Cash rate increases Cash rate falls

To maintain margins, banks increase market

interest rates

To maintain margins, banks decrease market

interest rates


Consumers and businesses have to pay more on

existing debts and new borrowers find it harder

to borrow funds

Consumers and businesses have to pay less on

existing debts and new borrowers find it easier to

borrow funds

Consumption and investment spending decreases Consumption and investment spending increases

Economic activity decreases Economic activity increases

• Transmission mechanism – explains how changes in the stance of monetary policy pass

through the economy to influence economic objectives such as economic growth and

inflation.

• There is a time lag of 6-9 months between a change in monetary policy stance and the

ultimate effect on spending, output, employment and prices.

Fiscal Policy is the use of changes in the level and direction of government spending (G) and

revenue (T) to influence

1. income distribution,

2. resource allocation and

3. the level of economic activity.

There are 3 possible budget outcomes. They are:

a Balanced Budget, G = T

a Surplus Budget, T > G


Budget components

There are 2 parts of the budget to consider to determine the Fiscal Stance. They are the:

Cyclical component: This is the part of the budget that changes with the level of economic

activity in the economy. As the economy approaches full employment of resources, the

lower the cyclical component of the budget will be.

Structural Component: The structural component of the budget is deliberate policy

decisions of the government to effect the level of national income and thus economic

activity.

Fiscal policy: against- takes 6-12months – time lag

-political red tape (must go through parliament)

Documents

Topic 6 Government and the economy