Role of Government in Economy

6 months ago

Atiqur Rahman

18 minutes

Introduction

The Market and the government are the two elements of an economic system. The individuals and institutions that are the owners of resources regulate markets.

A market is a system that coordinates the production and consumption of goods and services through a price mechanism. The transactions between the market participants are voluntary and are targeted to maximize individual objective functions.

The Classical school of thought had strongly argued for a price mechanism that, without government intervention, would ensure full employment through free-play market forces.

Now the question arises – If a price system is efficient, what role is there for government policy? It is important to remember that efficiency is not the only criterion by which an economic system may be judged.

Since the 1930s, there has been a profound change in how a government works. Apart from performing political and social activities, governments are expected to look into economic matters and ensure economic stability. In addition, a price system itself requires certain governmental action.

For this purpose, the government uses many policy instruments and allocates resources and redistributes income. A case can clearly be made for the government to redistribute incomes in the interest of equity. This article highlights the role of government in an organized society, and different perceptions of the role of government have evolved over time.

Role of Government in Organized Society

The fundamental question faced by many countries is what role the government should play in the economy relative to the markets. What service should it provide, and how should it be financed?

Over the period of time, the government’s role in an economy has been redefined. In some countries such as Norway, Sweden, Finland etc., governments are expected to provide a wide range of services, and in countries such as Sudan, Chad, and Somalia, governments have lost control.

The field of public finance answers these questions. As a field of economics, it is concerned with the financial activities of the government.

Musgrave (1959) describes public finance as “The complex of problems that center around the revenue- expenditure process of government is referred to traditionally as Public finance.”

In other words, the study is concerned with the method of raising government finances and the mode of spending them; this, in turn, is dependent upon the objectives of the government.

Despite many countries being market economies, governments across the country and around the world play a dominant role in society because markets do not efficiently allocate all, or even nearly all, of the output the economy produces. The government is involved in affecting the way income is produced and allocated.

Musgrave identified two distinctions between the analysis of the role played by the government- normative and positive. The normative analysis looks into the way things ought to be, that is, what government should do to correct market imperfections and maximize social-economic welfare, whereas the positive analysis is concerned with what government actually does.

For example, a positive analysis of poverty data of a country reflects a 20% poverty rate in a normative sense; however, we would be interested to know whether the poverty rate is too high.

The study of public taxation and expenditure structure falls under the realm of positive analysis (Actual behaviour). The study of the financial activities of the government according to the desired goals will fall into the normative analysis of public finance (desired behaviour).

In the ideal case, the two roles merge because the government would be carrying out its activities as desired. However, in the real world, the two roles tend to diverge. The divergence can be attributed to many reasons, such as a difference between the interest of various parties- for example, public interest and government interest.

Apart from it, rent-seeking and corruption, misconceptions on the part of policymakers, the influence of past programs and policies of past governments, inadequate knowledge and expertise of policymakers etc., exert considerable influence on government activities.

Thus, the task is to minimize the divergence between the actual behaviour of the government and the desired one so as to achieve maximum social-economic welfare.

The field of public economics attempts to analyze why government behaves as it does during the decision-making process, how that government behaviour provides economic incentives for private firms and individuals to change their behaviour, and what the impact is of those changes on the economic welfare of the firms and individuals. The issues of public revenue and expenditure are a subset of the larger objectives of the governments.

Keynes (1963) pointed out, “The political problem of mankind is to combine three things: economic efficiency, social justice, and individual liberty.”

Governments across nations try to achieve the goals of economic efficiency and equity through an appropriate design of public sector programs and financing. Apart from ensuring internal and external security, the provision of infrastructure and public utilities are the main functions of the government.

In countries such as the former Soviet Union, paternalistic government policies were adopted where resources were under government control. In some countries, the government also influences resource allocation through a system of incentives and directives.

In market-oriented economies such as the US, market failure also necessitates government intervention in resource allocation, as achievement of an efficient resource allocation and market correction require well-defined property rights and enforcement of contracts. And still, another government role can be rationalized because of the existence of public goods and externalities.

There is a strong case for government intervention in resource allocation in low-income countries. These countries are characterized by low levels of savings and investment, scarcity of skilled labour, underdeveloped factor and product markets, and a virtual absence of an entrepreneurial class.

These countries also have highly skewed income distribution and therefore, the allocation of resources catering to the prevailing demand pattern of the society would only result in the allocation of scarce resources in favour of high-income communities.

Let us understand the essential and necessary roles of the government through a historical perspective and how different perspectives have evolved over time.

Changing Perspective About the Role of the Government

Government Role in Eighteenth and Nineteenth Century

If one looks into history, one can find that government came into existence for the purpose of protecting the communities. Thus, its scope was limited and narrow.

The eighteenth-century Mercantilists were advocates of the government’s role in the promotion of trade and industry. Their aim was to maintain a reasonable balance of trade through an adequate stock of gold and silver by playing a protectionist role in the economy and encouraging exports, and discouraging imports, especially through the use of tariffs.

In response to them, Adam Smith, in his Wealth of Nations (1776), argued for the limited role of government. Accordingly, there exists an invisible hand in the economy that would ensure full employment through the operation of market forces. Thus, there is no need for government intervention in economic activities.

It was pointed out that the profit motive would lead individuals to interact with each other, and only those firms that would supply the products demanded at the lowest price would be able to survive. The persuasion of private interest would serve the public interest.

He pointed out that government has three fundamental duties to perform:

National defence– “protecting the society from the violence and invasion of other independent societies.”
Maintenance of law and order/Administration of justice– “protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice.”
Provision of Public goods– “erecting and maintaining those public institutions and those public works, which, though they may be in the highest degree advantageous to a great society, are, however, of such a nature, that the profit could never repay the expense to any individual or small number of individuals, and which, it therefore, cannot be expected that any individual or small number of individuals should erect or maintain.”

Adam Smith’s view influenced the classical economists who advocated the doctrine of Laissez-Faire – a market-oriented economic system with no government intervention.

John Stuart Mill argued that government should not control private enterprises. In his words, “The best of all plans of finance is to spend little, and best of all taxes is that which is the least in amount.”

“Laissez-faire should be the general practice: every departure from it unless required by some great good, is a certain evil.”

Since the individuals try to maximize their income, total national income would also be maximized in the process. The governments should aim to protect the economic and political liberties of the individuals and guarantee property rights and ensure the enforcement of contracts. As a consequence, the economic role of the government during this period was limited and public expenditure constituted hardly 10% of the GDP.

To meet the expenditure associated with the above three duties of the government, Adam Smith laid out four canons of taxation:

the canon of Equality,
the canon of Convenience,
the canon of Economy and
the canon of Certainty.

The Classists argued that taxes hinder private initiatives and restrict resources available to the private sector.

Government Role in the Twentieth Century

However, there was a gradual change in the concept of the state, and its scope steadily increased. With a rise in income inequalities and unemployment, there was a gradual change in the thinking of nineteen-century economists and policymakers. These evils were attributed to private ownership of capital.

The great depression saw the rise of the Keynesian school of thought, which advocated an active role of the government in the economic sphere. It became a driving force of economic decision-making in the twentieth century.

In 1929, unemployment reached a peak of 25%, and it was widely argued that markets had failed and there was increasing pressure for government intervention to curb the economic downfall.

Keynes forcefully argued in favour of the economic role of the government in saving the economy by affecting a rise in effective demand. He demonstrated that fiscal activities of the government could raise employment and maintain it at a high level.

He introduced the concept of ‘compensatory finance’ whereby government expenditure is augmented to compensate for the decline of private expenditure.

The Depression brought many other problems to the forefront. Stock markets had crashed, banks failed, and poverty and unemployment rose along with deflation. The US government took active steps to stabilize the economy and introduced many programs under the ‘New Deal program’ to alleviate problems of unemployment, social security, insurance and a host of other social-economic problems.

Post World War II period witnessed high periods of economic growth. However, it was accompanied by high levels of poverty and inequality. This provided an impetus for further government intervention, and more programs were announced targeted at the education, health, employment and social security sectors.

By the 1950s, governments across countries had assumed a greater role, from protecting the country from aggression and war to a wider role of a welfare state with the objective of achieving maximum social welfare. There was a large expansion in the role of the government, public spending as a percentage of GDP increased from 12% in 1913 to 45% in 1995.

Since then, the government has assumed greater importance in affecting economic activities. They play an even more critical role in the development of less developed and developing countries. Both political and ideological factors have contributed to the rise of government activities.

So far, the Classical economists had focused their attention on the allocative function of the government, but gradually Marxist and socialist thinking took over, and governments started playing significant distributive functions in market economies.

The rise of centrally planned economies of the Soviet Union and Eastern European economies saw a gradual movement of many economies towards a ‘Mixed economy system.’ Mixed economies involve a larger role of governments with income redistribution and equity, poverty reduction, and economic stabilization as main policy objectives.

Countries with larger public sectors were seen as less prone to fluctuations in the business cycle. Public spending on education and health, progressive taxation, subsidies, welfare schemes etc., were the common government programs, and public enterprises were used for generating productive employment.

Overall, Keynesian thinking and technical development were used as a justification for the expanded government sector.

As discussed earlier, public goods and externalities became an important justification for the expanded government role. Public provision of some goods was justified on the grounds that the market would undersupply such goods, and in the case of externalities, it was expected that government would increase the private cost of production and consumption of goods with negative externalities and decrease the cost of goods with positive externalities.

Another argument put forward for a greater public sector role was that the private sector lacked the managerial skills that were available to the public sector. In some cases, large capital requirements, information essentials, and long gestation periods justified public investment.

Thus the period after the 1950s witnessed an expanded role of the government in economic decision-making, especially in developing countries. The ideology that the governments are the best judge and have more knowledge than the private sector on how an economy operates and what the public desires was the key factor guiding the government policy formulation and execution.

Functions of the Government in Economy

Musgrave, in his Theory of Public Finance (1959), has summarized the three essential economic functions of the government- allocation, distribution and stabilization functions. The resources are allocated through the market mechanism.

However, in the case of market failure – when markets fail to achieve a microeconomic efficient allocation of resources, the government is required to intervene to guide, correct and supplement the markets to achieve the desired outcome.

There are six cases where markets fail to achieve an efficient outcome– incomplete information, incomplete markets, public goods, externalities, macroeconomic imbalances and failure of competition.

Allocation Function:

Public goods are a classic case of market failure. Markets fail to supply public goods. Such gods are collectively desired, whereas the need for private goods is felt individually. The markets can efficiently and optimally provide private goods where producers are guided by consumer demands.

However, in the case, of public goods, the properties of non-exclusion and non-rivalry make market exchange operation inefficient. And it would be inefficient to exclude anyone from partaking in the benefits of the consumption of a public good. From here arises the problem of free riders.

Non-exclusion implies that people can refrain from making payments for the use of public goods assuming others are paying for it, and thus, they can escape nonpayment.

The government, through the imposition of taxes, can easily solve the problem of the refusal of voluntary payment in the case of public goods. The government must judiciously determine the amount of supply of these goods. Individuals may refrain from revealing their true preference, and the government may resort to the voting process.

Decision-making through voting becomes a substitute for preference revelation, and taxes become a method of collecting cost shares. Thus, an approximate efficient solution can be achieved through the government provision of public goods.

Distribution Function:

The study of economics deals with efficient utilization of scarce economic resources given the distribution of income and pattern of consumer preferences. Income distribution depends on the distribution of factor endowments that, in turn, is determined by the process of factor pricing.

Under perfect competition, the factors receive a payment equal to the value of the marginal product. However, under imperfect competition, factors receive less than the value of the marginal product.

Moreover, even if factor prices are determined under a competitive setup, it does not guarantee a fair distribution of income. It is difficult to compare individual utilities derived from their income, and, moreover, redistribution policies involve considerable efficiency costs (in the form of welfare losses associated with taxes and changes in consumer and producer surpluses). Thus, the question– what constitutes a fair distribution is a difficult one.

It is here where the government plays a critical role. Redistribution is implemented through:

Tax redistribution– Progressive taxation of high-income groups and provision of subsidies for the low-income group.
Use of progressive taxation to finance programs targeted to benefit low-income groups.
Combination of taxes on goods consumed largely by high-income groups and subsidy on goods consumed largely by low-income groups.

Stabilization Function:

The allocation and distribution function of the government exert significant influence on the macroeconomic variables of the country. The market functioning cannot ensure the achievement of economic objectives such as high employment, price stability, sound balance of payment, along with maximum social welfare. The government assumes a greater role in augmenting the market for the achievement of desired macroeconomic goals.

Without proper policies, the economy of any country is subject to wide economic fluctuations such as unemployment and inflation. The great depression is one important example in this regard. It exposed the loopholes of the market system and exhibited the important role played by the governments in the revival of the global economy.

In recent years, with the growth of globalization, countries are even more vulnerable to market fluctuations. The recent US subprime crisis and the global economic downturn is a prime example in this regard. It has exposed the loopholes and vulnerabilities of growing economic and financial international integration.

The government plays an instrumental role in affecting aggregate demand– the key parameter affecting employment level and price levels. Aggregate demand depends upon the income of the consumers, which in turn depends on factors such as present and past income, and wealth of the consumer.

In any adverse event, government action through expansionary/restrictive monetary and fiscal measures can restore equilibrium conditions.

Role of Government in Economy

Introduction

Role of Government in Organized Society

Changing Perspective About the Role of the Government

Government Role in Eighteenth and Nineteenth Century

Government Role in the Twentieth Century

Functions of the Government in Economy

Allocation Function:

Distribution Function:

Stabilization Function:

Read More in: Theory of Public Finance

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Introduction

Role of Government in Organized Society

Changing Perspective About the Role of the Government

Government Role in Eighteenth and Nineteenth Century

Government Role in the Twentieth Century

Functions of the Government in Economy

Allocation Function:

Distribution Function:

Stabilization Function:

Read More in: Theory of Public Finance

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