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There is a vigorous debate on whether we should have 'more' or 'less' government, 'more' or 'less' regulation of the economy. In countries emerging from central planning, such as Vietnam or the former Soviet Union, the future role of government is, perhaps, the most crucial political and economic issue facing those societies. In other countries the issues seem more administrative in nature; should our buses be owned and operated by private enterprise or by the government, should used car dealers be required to issue warranties?
There are many normative(1) theories about the role of government in the economy - ranging from laissez faire philosophies, as espoused by extreme libertarians, through to highly interventionist philosophies, practised (or attempted) by centrally planned economies. There is, however, a set of basic functions common to all modern economies.
Most texts list the economic roles of government in a capitalist or mixed economy under three headings:
(1) Stabilization
(2) Distribution
(3) Allocation
The first belongs in the realm of macroeconomics; the second and third to microeconomics. The annual budget is an instrument in all three functions, and this chapter concentrates on the budgetary aspects of government's economic activities.
Stabilization has come to mean not only the removal of economic fluctuations, but also the achievement of high employment, low inflation and sustained growth.
This begs the question as to what is an acceptable level of unemployment. There will always be some level of unemployment, even in a well functioning economy, as people seek better work, or as regional or structural mismatches develop (these elements being called frictional and structural unemployment respectively). Leaving aside the issue of what is an acceptable level of unemployment, just to stabilize the unemployment rate at a certain level, be that the 2 percent of the sixties or the 10 percent of the early nineties, the economy must experience a certain level of growth.
This growth is necessary to take up increases in the labor force and growth in productivity. If, for example, the population of working age is growing at 1.2 percent a year, and labor productivity is growing at 1.4 percent a year, then production would have to increase at 2.6 percent just for the unemployment rate to stand still. These figures were typical of the '80s and early '90s, when unemployment doggedly remained at around 10 percent. In the mid to late '90s, when economic growth was around 4.0 percent, unemployment fell.
This analysis contains some simplification. It assumes, for example, that the labor force grows at the same rate as the population of working age; in fact it may grow slightly faster or slower, depending on what happens to the labor force participation rate, which tends to rise in times of economic growth, and tends to fall when people become discouraged from seeking work. Labor force participation has risen a little over the last ten years - men's participation has fallen, while women's has risen strongly. The simple analysis also assumes that as productivity rises working hours do not decrease; in fact there is sometimes a higher growth in hourly labor productivity than in annual labor productivity, as standard hours of work decrease and as part time work takes the place of full time work. This represents a some sharing of available work. At other times, particularly the late 1990s, however, annual labor productivity tended to rise faster than hourly productivity, as working hours lengthened. (It is questionable whether such an increase output per worker should be called "productivity".)
In spite of these simplifications, it is reasonable to say that Australia needs at least 3 percent growth just to stand still in terms of unemployment, and, of course, to maintain living standards economic growth must at least match population growth.
What constitutes "economic growth", and whether conventional measures account adequately for all costs and benefits, are contentious issues. For example, conventional national accounting measures do not account for unpaid housework, or voluntary housework. A 1997 study by the Australian Bureau of Statistics found that if housework and unpaid voluntary work were added to conventional measures, Australia's gross domestic product (GDP) would be up to 60 percent higher.(2) Also, conventional measures do not take into account depletion of natural resources, such as soils. In general, if such changes in natural resources were to be taken into account, there would generally be a downward adjustment in GDP. Measures such as GDP are crude aggregates, and they say nothing about how income or wealth are distributed. These qualifications are all major issues in their own right; their mention here is to point out that there are limits to conventional measures.
Historical Performance
This has been patchy as is shown in the graph below, which shows Australia's growth and unemployment over a long time period, and suggests there is a clear relationship between growth and unemployment. Australia did have a period of high growth and low unemployment in the postwar years, which came to an abrupt end in the early seventies. That period was one of high commodity prices, domestic markets hungry for new housing and consumer goods, high immigration, plenty of productive capital (capital in Europe and Japan was repairing war torn economies), and the early and beneficial effects of tariff protection.
There were recessions in the early 1980s and early 1990s. The 1990s were a period of strong growth as measured by GDP and declining unemployment, but with rising problems of public infrastructure, skills and environmental degradation.
While we have enjoyed growth in the past, we have never really enjoyed a period of economic stability; Australia's economy has had spurts of high growth and short, sharp contractions. In part this has been due to Australia's heavy reliance on agricultural production and export, subject to the vicissitudes of world price fluctuations and an unpredictable climate. In later years instability has resulted from other factors, mainly world wide. Australia's economy is becoming more open to world pressures and as a consequence the capacity of the Federal Government to stabilize the economy through budgetary or other influences is being lessened.
Although the main determinants of economic growth are international factors and national endowments of physical and human capital, there is still a place for governments to have a stabilization policy. The main instruments they use are monetary policy and fiscal policy.
Monetary Policy
Monetary policy is basically concerned with control of the aggregate money supply. Economic activity and money supply are positively correlated; more money means more economic growth, until, at some point, there is more demand than the capacity of the economy to supply goods and services. The result is either inflation, or, in the case of a small open economy like Australia, a surge in imports, resulting in a deterioration in external balance (which is a current incipient problem). Interest rate manipulation is the prime lever in money supply, and we will see later how spending, particularly business investment, is heavily influenced by interest rates. When interest rates are low, people are inclined to go out and borrow; when they are high, people are enticed to save, putting their funds into financial investments, many of which ultimately finish up as government bonds and therefore out of circulation.
In most economic analysis the key interest rate is the real interest rate. This should not be confused with the nominal interest rate. The two are related as under:
Real Interest Rate = Nominal Interest rate - Inflation(3)
In the late eighties, for example, when inflation was running at around 7 to 10 percent, nominal interest rates (conventionally measured as the interest on 90 day bank bills) were between 13 and 18 percent. Real interest rates probably peaked in 1988-89 at around 11 percent, when bank bills were around 18 percent, and inflation was around 7 percent. In 1994, with annual inflation around 1 percent, the interest rate on bank bills was around 6 percent. Measures of real and nominal interest rates are shown in Chapter 9.
Discussion issues:
1. In the Canberra Times on Thursday July 30 1992, just after the Government's announcement of 1.3 percent inflation, George Harris, a pensioner, expressed fear that interest rates may fall further. "If interest rates drop much further it will be pointless having money invested". Is this correct?
2. In the1992 recession the Government tried to stimulate the economy by reducing interest rates, which fell faster than inflation. Yet business investment remained sluggish, while there were sharp upturns in housing. What are the possible explanations?
Fiscal Policy
Fiscal policy is concerned with nett government spending in the economy. A macroeconomics text defines fiscal policy as "the policy of the government with regard to the level of government purchases, the level of transfers, and the tax structure".(4) Basically the more the government spends the more it stimulates the economy; conversely if the government collects more in taxes than it spends then it suppresses economic activity. Government spending has a multiplier effect; the $130 million to build the Lake George section of the Federal Highway is spent in turn by contractors and their workers on local services, and so on, creating much more than $130 million in new economic activity.
Only the Commonwealth Government has the capacity to accumulate a deficit - that is, to spend more than they collect in the form of taxes and other revenue. State and local governments have little fiscal leeway - they are limited in their capacity to fund deficits. In the postwar years the Commonwealth generally ran a surplus budget; from the mid 1970s to the mid 1990s the budget was generally in deficit. Surpluses have been achieved since then by means of sharp cuts in public expenditure.
Governments are constrained in use of fiscal policy, in that many expenditures are non-discretionary in the short term. For example, payments to states and pensions are subject to explicit or implicit long term commitments. Also, the dictates of fiscal policy may mean taking decisions which are not necessarily wise. For example, under constraints of tight fiscal policy, governments have tended to cut back on capital expenditure (from 8 percent to 4 percent of GDP over the last 20 years in Australia).
Fiscal and monetary policy are not independent. If a government wants to run a loose fiscal policy and a tight monetary policy it will have to set very high interest rates to stop the money supply expanding too fast. The present Federal Government policy seems to be to run an expansionary monetary policy, but still a moderately tight fiscal policy.
Other Stabilization Instruments
Some governments try to stabilize their exchange rates; Australia ran a managed exchange rate until the early eighties. Some try to limit the pace of structural change across regions and industries. For example Australia's tariff reductions and labor market reforms.
While governments use fiscal and monetary policy to influence broad aggregates, they may also, at times, try to influence employment and productivity through labor market programs. These are not really instruments of long run demand management; rather they are microeconomic interventions to achieve specific purposes.
A major arm of stabilization policy, used by some countries including Australia, is wages policy. This is lessening in importance as the labor market is slowly deregulated and decentralized. Apart from public sector wages (and linked payments like health care), wages policies have little direct budgetary impact.
This is the second major function of government. Most texts talk about distribution with respect to taxation and social welfare policy. In a federation like Australia there is another level of distribution, and that is intergovernmental transfers, with the Commonwealth having most taxing authority and power to distribute funds to other governments.
Distribution to Individuals
The major instrument of distribution in Australia is direct and progressive personal income taxation, and Australia has been more dependent on this type of mechanism than many other countries, which have tended to use less personal income tax and more specific social welfare payments. (A major switch in this policy was in the tax changes in 1999.) Most societies have some distribution from the well-off to the less well-off. Generally this is from higher to lower income groups, but it may also be on the basis of wealth, or on other means of assessing means and needs.
Tax and welfare systems are said to be progressive if effective tax rates are higher among groups with high ability-to-pay groups than in groups with lower ability-to-pay, proportional if they are neutral, and regressive if they are higher on groups with low ability-to-pay. Taxes on household or corporate income are said to be direct taxes; other taxes including sales taxes are indirect. More detail on tax theory is in Chapter 2.
Australia's income distribution, before and after taxes and welfare payments, is shown on the graph, by household quintile. The flattening of income after taxes, transfers (being pensions and social security payments), and benefits (in this case housing, health and education) is evident. (As a government accounting convention transfers are distinguished from benefits, in that transfers are cash or near cash payments to individuals, while benefits are usually purchased by or supplied by the government, and counted in national accounts as part of government consumption.) For example a pension payment of $100 is counted as a transfer, a Medicare payment of $100 is counted as a benefit.
Distributions Between Tiers of Government
In Australia the Commonwealth is the main collector of taxes, having, under agreement with the states, sole power to levy corporate and individual income taxes. The Commonwealth pays $44 billion (2000-01) to the states and other levels of government. In 2000-01 this comprises $24 billion of GST collected, $18 billion of specific purpose payments, and $2 billion of other payments. The major categories of specific purpose grants are universities, hospitals, roads and schools. These general purpose and tied grants comprise almost one half of all state government revenue.
The amount and relativities of these grants are an ongoing issue between the states and the Commonwealth. In distributing general purpose revenues the Commonwealth is advised by the Grants Commission, which, through a process known as fiscal equalization (basically ensuring all states have the capacity to provide government services at the same standard) sets population weights, which see the smaller states coming off considerably better than the larger ones. In 2000-01 per capita payments range from $2 025 for Victoria (NSW $2 106) up to $3 207 for Tasmania and $8 004 for the Northern Territory.(5)
Other Distributions
Besides distributions between individuals and to regions, governments also make major transfers to industries.
For example, in 1998-99, through the effects of tariff restrictions on imports, $4.8 billion was transferred from consumers to assist manufacturers, mainly of clothing, footwear and motor vehicles(6). Some was collected as import duty, but the major part of these transfers was through prices. For example, if a pair of imported shoes could be sold for $50, but, because of protection, costs $90, that $90 extra is a consumer tax equivalent. Although such transfers are reported on by the Productivity Commission, they do not pass through the Budget. Similarly, priviliged positions associated with privatizations, granting monopoly rights to businesses, do not pass through the Budget, although they may come under scrutiny from the Australian Competition and Consumer Commission (ACCC).
Other transfers are harder to quantify, but they include the benefits of governments allowing markets to operate less than competitively in a number of areas. For example, state governments restrict medical practitioners and pharmacists from price advertising. All governments maintain practising and licensing restrictions, most notably on the legal profession. Industrial awards often contain restrictions and demarkations, some of which are being phased out with award restructuring and enterprise bargaining. These restrictions result in large consumer transfers and in deadweight loss, points we'll re-visit in Chapter 15, when we look at the costs of monopoly.
Apart from some direct grants to industry, these transfers generally do not pass through any government budget, and therefore escape the scrutiny of the budget process; in fact they are of little concern to the Federal Department of Finance and Administration. The major agency of surveillance is the ACCC and the Productivity Commission. Naturally the beneficiaries of such transfers do not want them to be subject to the scrutiny of the budget process.
Market Failure
The other function of government is to intervene in the economy to ensure resources are allocated to their most efficient use. When we look at markets in Chapter 14 we'll see how markets are supposed to allocate, and we will go on to examine the areas of market failure, where unregulated markets either do not allocate resources at all, or do so inefficiently. Most texts on market failure mention the provision of public goods. We'll cover public goods in more detail in Chapter 16. Basically there are two main reasons why governments have to provide public goods:
(1) Because it is not possible (physically or perhaps morally) to exclude people from use of the good or service. (Markets can operate only when non-payers can be excluded. Defense is a classic non-excludable public good. Other examples include emergency wards and street lighting.
(2) Because goods or services are not rival; provided the road is not congested my use of the road does not detract from your use of the road, my use of ABS statistics does not detract from your use.
Public goods must still be paid for, and designing charging systems (such as user pay) which balance equity and efficiency is a major challenge in public pricing.
Most economists agree that markets do not always handle externalities well. Externalities are the costs (or sometimes benefits) associated with private activities which are not always reflected in prices. Classic examples center on pollution; some governments are imposing hydrocarbon taxes to take into account the environmental costs of fossil fuel burning.
Another market failure relates to the difficulty in establishing property rights. Computer software and pharmaceuticals have many elements of public goods. In unregulated markets, which would not allocate property rights through patents or copyright, there would be no incentive for producers to make such goods.
Markets also need a legal system to operate. A régime of contract law, a framework of corporation law, and a well regulated banking system, are all necessary for investors to place trust in markets.
In many cases markets need standards and conventions. Weights and measures, wiring codes, and standardized contracts are the road rules of markets. Sometimes, when parties can get together, such conventions can emerge without regulation; computer operating systems are a case in point. In other cases, where there are many parties, governments have to intervene. For example Australia would never have converted to metric measures without a major government initiative.
Sometimes markets are very unstable, and intervention is justified on the basis of this instability. In the name of stabilization governments frequently intervene in commodity prices, such as oil, grains, etc. (These are some of the most botched and expensive of all interventions, and often aggravate the underlying instability.)
Other failures occur in information; markets require rapid and free exchange of information on comparative prices, quality etc if they are to work well. For 'short term experience goods', such as shampoo and T shirts, markets work well; the consumer can judge the quality, can see the price, and even a bad purchase doesn't mean a long term commitment. For some other goods, such as used cars, it is much harder for consumers to judge quality; governments may intervene with requirements for guarantees. For some goods, such as superannuation, there are not repeat purchases, and the risks of poor performance are high, so governments intervene with prudential regulation.
Sometimes markets do not provide adequately for the future. There can be an imbalance between the social rate of time preference (that is the value people put on future benefits, such as education or a clean environment for the next generation) and the opportunity cost of capital (that is, the value financial markets put on future benefits). Colloquially the problem is called 'short sightedness', and is most likely to be manifest when governments are maintaining high interest rates to achieve monetary targets. Left to unregulated markets, it is unlikely commercial foresters would re-invest in tree regeneration, for example.
In many cases governments intervene because unregulated markets are prone to monopolization. This is particularly so when there are declining cost industries or natural monopolies (industries with ever improving economies of scale), such as power distribution. Sometimes, unless prohibited from doing so, producers collude to set prices. Policy responses include public provision (e.g. electricity), maintaining competition through trade practices legislation, (real estate agents' fees, concrete and gasoline prices have come to the notice of the ACCC), price capping (e.g. price controls on milk), and benchmark competition, where there is public ownership of a key competitor. This last approach was a very Australian approach, and explains (historically in most cases) the operation of enterprises like the Commonwealth Bank, Medibank Private and Australian Airlines, which have operated alongside private sector competitors.
Other interventions, particularly common in developing countries, center on protection of scarce resources. Many countries maintain restrictions on foreign exchange transactions. Many countries restrict foreign investments in key sectors of the economy, or in land, in order to maintain national sovereignty. Australia, for example, maintains media ownership regulations ostensibly for cultural reasons.
Countries in the transition from centrally planned economies to market economies often keep certain large industries in public sector ownership, even though the same industries in other countries are privately owned. Sometimes this is because financial markets are not sufficiently developed to mobilize the private capital for privatization. Sometimes it is because the industry is important to the whole economy (e.g. iron and steel in times past).
Regulatory Failure
Not only do markets fail, but also regulation sometimes fails - known as regulatory failure. This is not to say that whenever regulatory failure occurs, governments should withdraw, but they should review their regulations.
Sometimes there is regulatory capture. The agencies which are supposed to regulate a market for the public good become 'captive' to the industry they are supposed to be regulating. Such accusations are often levelled against banking regulators. Government monopolies, originally charged with avoiding the evils of private monopolies, may forget their obligations to the community and act in the interests of other stakeholders. For example, many railroads and electricity utilities in Australia have extremely high labor costs and executive salaries and extensive featherbedding.
Another problem is the tyranny of small jurisdictions. Small governments are weak. For example, all states levy charges on heavy vehicles to pay for damage to roads. But if one state levies lower charges than the others, it gets the benefits of more registrations and therefore higher revenues. This is an example of the prisoners' dilemma situation, which we cover (in another context) in Part 5. Higher levels of government may have to establish and enforce contracts to ensure all parties act in their agreed self-interest (a point often overlooked by avid federalists).
It can happen that the costs of regulation outweigh the benefits of regulation. This may happen when technologies change, for example, removing the original need for regulation. With the advent of wireless telephone technologies it is doubtful that telecommunications is any more a natural monopoly.
General References
William C Apgar and H J Brown Microeconomics and Public Policy (Scott, Foreman and Co 1987)
Peter Coaldrake and John Nethercote (Eds) What Should Government Do? (Hale & Iremonger 1993)
Australian Government Budget Paper # 1 - Budget Statements.
Peter Groenewegen Public Finance in Australia: Theory and Practice (Prentice Hall NSW 1990)
Richard A Musgrave and Peggy B Musgrave Public Finance in Theory and Practice (McGraw Hill NY 1989)
Public Sector Management Institute, Monash University, and labour Research Center The Role of the Public Sector in Australia's Economy and Society (Monash University 1990)
Edith Stokey and Richard Zeckhauser A Primer for Policy Analysis (WW Norton NY 1978)
Specific References
1. Normative theories are concerned with what ought to be, in contrast to positive theories which is concerned with what is observed.
2. ABS Unpaid Work and the Australian Economy Occasional Paper ABS Cat 5240.0, 2000.
3. This is slightly simplified. If the real interest rate is r, the nominal rate n, and inflation p, then 1 + n = (1 + r) * (1 + p) = 1 + r + p + rp. This last term, rp, is usually small enough to be ignored for practical purposes.
4. Rudiger Dornbusch and Stanley Fischer Macroeconomics (McGraw Hill 1984).
5. Derived from Tables 2 and 4 of Federal Financial Relations Budget Paper #3 2000-01.
6. Productivity Commission Trade and Assistance Review 1999-2000 (Productivity Commission 2000)
