The Government in the economy
From ZuluNotes - Free Leaving Cert Notes
How is the state involved in the Economy?
• Levying tax- redistribution of wealth. • Giving social welfare benefits and subsidies • Running Government Departments. • Running Semi-State bodies, for example, ESB. • Passing legislation.
Arguments in favour of Government Involvement
• State provides essential services The public relies on the state for many services which may otherwise not be provided, for example, health, water, education, transport, defence.
• State provides Employment The Government is the largest single employer in Ireland. It creates jobs in Government Departments, Semi-State Bodies etc.
• State develops industries unsuited to Private Enterprise The State develops enterprise which may not be suited to private entrepreneurs. Some industries may require large capital investment ( air/rail transport) and may make them more suitable for state investment.
• State stops monopolies The State, through legislation and regulation, can stop the development of monopolies (an industry with only one firm and therefore no competition.) Monopolies result in higher prices and less choice for consumers.
• Economic Growth through Government Initiatives The Government provides grants and subsidies to encourage enterprise and job creation. This generates growth in the economy.
Arguments against Government Involvement
• Inefficiency State tends to be inefficient- it often faces no competition so there is no instinct to reduce costs/prices or increase quality/speed.
• Burden on the Taxpayer Many semi-state bodies are unprofitable and the losses are borne by the taxpayer, leading to higher taxes.
• Growth of Private Sector is Restricted If the state increases its role in areas of the economy, there are less opportunities open to private entrepreneurs.
• Bureaucracy/Red Tape State departments and semi state bodies tend to be organised in a very complicated way. This increases the costs of running them and makes access for consumers difficult.
• Industrial Relations Problems Many state employees feel protected from the harsh realities of the private sector. They may be more likely therefore to become involved in disputes or strikes. The effects of this are felt right through the economy.
Privatisation
Privatisation refers to the sale or transfer of a semi-state body into the private sector. For example: Telecom Eireann Eircom Irish Sugar Company Greencore plc B & I Line Irish Ferries.
Arguments in favour of Privatisation
1) Results in Large Capital Sum(Revenue) for the Government This can be used to repay the National Debt or re-invest in the economy.
2) Burden on Taxpayer Some Semi-State bodies are a burden on the taxpayer. Semi-States that perform poorly are often subsidised by the Government through tax revenue.
3) Private Individuals become Shareholders Privatisation leaves opportunities for private individuals to become shareholders in a company that was previously controlled by the state.
4) Increased Competition Privatisation would result in an increase in competition in the industry. Competition would lead to greater efficiency, lower prices etc.
5) Greater scope to raise finance The company itself, once privatised, has greater scope to raise finance in the private sector and will also have to become more efficient to survive.
Arguments against Privatisation
1) Loss of Future Revenue If the semi-state company has been profitable in the past there is a loss of future revenue for the government
2) Unprofitable but Socially Desirable services discontinued In the private sector, companies may discontinue unprofitable services although these services may be socially desirable, for example Aer Lingus discontinuing Shannon-Heathrow.
3) Loss of Valuable state Assets Loss of valuable state assets which were built up using taxpayers money over the years. Future profits will go to the shareholders not the taxpayer.
4) Control possibly out of state If shares are purchased by foreign investors, control of the company may be out of the state. Decisions may be made which impact heavily on people living in Ireland.
B) THE BUDGET
GOVERNMENT CURRENT BUDGET
• Outlines the governments planned/expected current revenue and current expenditure for the forthcoming year. • A current receipt is one which arises within one year and is usually received on a continuous basis. Examples include tax revenue (VAT, PAYE), repayments of interest on Local Authority loans. • A current expense is an expense whose benefit is felt witin one year and is paid out on a continuous basis. Examples include teacher’s salaries, social welfare payments.
CURRENT BUDGET SURPLUS
Current Budget Surplus is where planned Current Receipts are greater than planned Current Expenses. This means that the Government is planning to take in more money from the economy than it is investing into it. A current budget surplus has a deflationary effect on the economy ( no pressure on prices to rise)
Positive Consequences of Current Budget Surplus
1) Deflationary Effect Less pressure on prices as government is collecting more money than it is spending.
2) Good Financial Planning Current Budget Surplus indicates prudent financial planning by the government. This means that the National Debt will not be increased and there is no need to borrow.
3) Potential for Tax Reform A Current Budget Surplus gives the government scope to reduce taxes in the future.
4) Stability Current Budget Surplus means that the Government is keeping within EU guidelines, which are to encourage stability in the Eurozone.
Negative Consequences of a Current Budget Surplus
1) Pressure on Social Partnerships Current Budget Surplus may put pressure on social partnership as some of the social partners, for example unions, feel that the government is taking too much money out of the economy.
2) Not enough money spent on Public Services Current Budget Surplus may indicate that there is not enough money spent on Public Services, for example, health, justice, transport.
3) Taxpayers may look for tax reductions Taxpayers may feel that they are financing this surplus and may look for tax-reductions, especially those on low incomes.
4) Possibly leads to Wage demands Current Budget Surplus may lead to wage demands, especially from Public Sector workers who feel that a wage increase may be possible.
CURRENT BUDGET DEFICIT
This is where the Government planned current expenses are greater than planned Current Receipts. The Govt. is putting more money into the economy (spending) than it is taking out of it (revenue).
Positive consequences of Current Budget Deficit
1) Current Budget Deficit may reflect extra spending on public services. This means that services such as health, education etc may improve in the coming year.
2) Current Budget Deficit means that the Govt is injecting extra money into the economy. This increases the circular flow of income and increases aggregate demand for goods and services. This should lead to an increase in Economic Growth.
3) Current Budget Deficit gives the Govt. bargaining power in Social Partnership. The Govt can argue that it has a shortage of current funds and so cannot increase wages.
4) If the extra funds are invested in enterprise ( through grants) more entrepreneurs may set up businesses and therefore more jobs are created. This may lead to more tax revenue in the future.
Negative Consequences of Current Budget Deficit
1) A Current Budget Deficit will have to be financed through Govt borrowing. This increases the National Debt. Future Govt funds will have to be used to repay the interest and the capital.
2) The repayment of a Current Budget Deficit places a burden on future taxpayers which may be unfair as they may not feel the benefits of the money borrowed ( its effect will only be felt in the current year).
3) A Current Budget Deficit is inflationary- the extra funds lead to an increase in Aggregate Demand which pushes up prices. If inflation goes up, the cost of living goes up, particularly for those with fixed incomes.
4) A Current Budget Deficit may indicate that the Govt is not keeping within EU guidelines on Fiscal Policy. This could lead to a sanction/fine by the EU.
CAPITAL BUDGET
• Capital Receipt A Capital receipt is a lump sum received by the Government during the present year. Examples include: EU grant, Repayment of Local Authority loans, Surplus from Current Budget.
• Capital Expense Capital Expense is spending of a lump sum by the Government where its effect will be felt will be felt into the future. Examples include: Road construction, repayment of National Debt, Development of Airports.
• The Capital Budget can also have a surplus or deficit.
• A deficit will have to be financed through further borrowing which will increase the National Debt.
LOCAL AUTHORITY BUDGET
An example of Local Authority Budget is Wexford County Council.
Current Budget: Current Receipts: Rates on Commercial Premises Parking Fines Motor Tax
Current Expenses: Local Authority Wages Maintenance of Roads Running of local library, fire station etc.
Can be surplus or deficit. Capital Budget: Capital Receipts: Grants from Central Govt Loans from Central Govt Surplus from Current Budget
Capital Expenses: Developing Infrastructure (roads, ports etc) Expanding services (Hospitals, schools etc) Loan Repayments.
RELATIONSHIP BETWEEN CURRENT BUDGET DEFICIT AND THE NATIONAL DEBT
The Central Govt borrow for two reasons: • Current Budget Deficit • Borrowing for Capital Budget
The two combined are called Exchequer Borrowing Requirement, or E.B.R. To this we must add any borrowing by local authorities and Semi- State bodies. The total is called the Public Sector Borrowing Requirement, or PSBR. Some of this will be raised through non-monetary sources( eg post office savings). The remainder will be raised through monetary sources ( for example, borrowing from domestic banks, abroad, or the sale of Govt bonds to non-nationals).
To Sum Up:
Current Budget Deficit
+ Borrowing for Capital a/c = EBR + Borrowing by local authorities + Semi- State Bodies = PSBR
THE NATIONAL DEBT
The National Debt is defined as the total outstanding debt owed by the Irish nation. It is made up of two parts, internal and external.
Internal: Money owed to Irish Citizens (Govt stocks/bonds)
External: Money owed to non-residents, foreign governments, and foreign financial institutions.
The National Debt is managed by the National Treasury Management Agency. The Agency manages the National Debt under the supervision of the Minister for Finance, and tries to reduce the overall cost of financing the debt. It does this by:
• Changing the mix of currencies, by paying back a loan where the euro has a poor exchange rate in favour of a new loan where there is a better rate.
• Replacing old loans with high interest rates to ones with low rates.
• Trying to shorten loans ( maturity dates).
Positive Consequences of National Debt
1) Productive Investment Borrowed funds may be invested in projects that in the future will generate enough income to cover costs.
2) Economic Growth Borrowed funds are invested in the economy, causing a rise in Aggregate Demand, which creates a rise in job creation, which increases Economic Growth.
3) Socially Desirable Projects Money may be invested in schools, hospitals, public services. In the long run this may lead to a happier, healthier population, and they will go to work.
4) Improvements in Infrastructure If money is invested in roads, ports, airports, telecommunications etc, it generates more trade, expressed in terms of exports and generate more tax revenue for the Govt.
Negative Consequences of the National Debt
1) Deferred Taxation Increasing the National Debt means that the Govt has decided not to raise the current tax rates to finance its activities but rather to place the burden on future tax payers.
2) Govt Borrowing from Domestic Sources
This may lead to an increase in interest rates (as demand for borrowed funds goes up). If interest rates rise, repayments will also rise.
3) Govt Borrowing from External Sources This is especially negative from non- Euro countries, as it can leave the government open to Exchange rate risks. In the future, if the alue of the euro falls, the repayments may rise.
4) Loss of Income Repayment of external debt leads to a loss of income from the country. Repayments are a leakage from the circular flow of income. When this falls, the Aggregate Demand also falls.
C) TAXATION
Principles/Canons of Taxation (Adam Smith 1776)
1) Equity The tax system should take into account the persons ability to pay, ie, it should take a higher proportion of tax as income rises, for example, in Ireland, as income rises, taxpayers move onto a higher rate (PAYE).
2) Certainty The amount paid should be clear and the taxpayer should be able to estimate the amount due. This benefits both the taxpayer and the Govt in terms of financial planning.
3) Convenience The method and timing of the collection of tax should suit the taxpayer. In the PAYE system, collection of tax is convenient as it is paid in instalments as income is earned. It is deducted at source.
4) Economy The cost of assessing and collecting the tax should be small in proportion to the amount collected.
Other characteristics that a “good” taxation system should have are:
5) Work The tax system should not act as a disincentive to work, i.e. the tax rates should not be as high as to prevent people from taking up employment.
6) Investment It should not act as a disincentive to investing or saving money i.e. the tax on the interest earned should be reasonable (DIRT)
TYPES OF TAXATION
DIRECT TAX
This is a tax on income/profits. It is paid directly to the Revenue Commissioners. It is described as a Progressive tax as it takes into account your ability to pay. Examples of Direct Taxes include PAYE and Corporation Tax.
Advantages of Direct Taxes
1. They are progressive, i.e. , they take into account your ability to pay. High earners pay a higher proportion in income tax
2. It is convenient for the taxpayer, for example, PAYE is deducted at source and it is paid regularly as you earn it.
3. Direct Taxes allow the taxpayer to estimate the tax due in advance of payment. This gives the taxpayer some degree of certainty.
4. Economy: The Costs of assessment and collection for the state is low as the responsibility for this lies mainly with employers.
Disadvantages of Direct Taxes
1. High rates may act as a disincentive to work. This can lead to a scarcity of labour in certain sectors and also increase the burden of Social Welfare payments.
2. High rates may encourage growth of the “Black Economy” where people engage in economic activity but evade payment of income tax, for example, working “off the books”.
3. It puts pressure on the National Wage Agreement as high rates lead to wage demands by workers. If wage increases are given then firms lose competitiveness.
4. High rates of Direct tax may discourage saving/investment as people’s disposable income is reduced. A fall in savings will lead to a reduction in the availability of credit, causing investment to fall.
INDIRECT TAXES
Indirect Taxes are taxes on spending which are paid through retailers to the state. They are said to be regressive as they do not take into account your ability to pay. Examples include VAT, Excise Duty ( Alcohol, tobacco, petrol) and Import Duty.
Advantages of Indirect Taxes
1. Indirect taxes do not act as a disincentive to work, as consumers may not link spending to income.
2. Burden of assessing and collecting indirect taxes is on retailers, not the state.
3. Convenient for taxpayers as the payment is at irregular intervals and in small amounts.
4. Indirect taxes are a valuable source of revenue for the Govt, especially during a boom in the economy when Aggregate Demand is rising.
5. Government can use indirect taxes to change consumer’s expenditure patterns and reduce the consumption of harmful products, for example, cigarettes.
Disadvantages of Indirect Taxes
1. It is inequitable as it does not take into account your ability to pay (regressive). Lower income families pay proportionately more of their income in tax than higher earning families.
2. Increases in Indirect taxes may fuel inflation as these increases will take the form of higher prices. This could lead to Irish goods losing competitiveness on foreign markets.
3. Uncertainty: For both taxpayers and the government there is uncertainty. It is difficult to estimate in advance how much will be paid/collected in indirect taxes. This hinders financial planning.
4. Employment: When indirect taxes rise they force up business costs, for example, electricity services, telephone. When costs rise, businesses will try to reduce costs in other areas, for example, wages. In this way, jobs may be lost.
“Tax increases are subject to the Law of Diminishing Marginal Returns”
True or False?
Direct taxes: True
If you increase income tax initially each taxpayer will pay more tax and the Govt will collect more tax overall. However, eventually, some tax payers may give up work (burden of tax) and so less tax may be collected overall.
Indirect taxes: True If Indirect taxes are increases the Govt may initially collect more tax overall but eventually consumers may reduce consumption of these products and so tax revenue will fall.
TAX DEFINITIONS
• Progressive tax One which takes into account your ability to pay, i.e. a person on a higher income will pay proportionately more of their income in tax. For example, Direct taxes ( PAYE).
• Regressive Tax One which does not take into account your ability to pay, i.e. everyone pays the same regardless of income levels. However, lower income families pay proportionately more of their income. For example, indirect taxes ( VAT).
• Fiscal Policy This refers to any action taken by the Govt which influences the timing, size and structure of current revenue and expenditure.
• Impact of Taxation This refers to the individual, firm or good or service on which the tax is levied.
• Incidence of Taxation This refers to the individual who actually bears the burden of the tax ( pays it). Whether the impact and the incidence are the same or different depends on the Price Elasticity of Demand and Supply for the Good or Service.
• Tax Avoidance This refers to arranging your finances within the law so as to minimize the amount of tax to be paid. For example, if you do not smoke, you avoid paying Excise Duty.
• Tax Evasion This is reducing your tax liability by making false returns or no returns. For example, working but not declaring it to the Revenue Commissioners.
• Revenue Buoyancy This term is describing a situation where the actual tax revenue collected is greater than the amount estimated in the current budget at the beginning of the year.
• Fiscal Drag In a time of revenue buoyancy, when revenue is greater than expected, government expenditure may remain at the same level. Revenue > Expenditure causes a decrease in income and a deflationary effect on the economy.
