Government plays a major role in the economy. Among industrial countries, the
share of
government spending in GDP ranges from 32 per cent in the US
cent in
Sweden._1 In addition to this, the authorities affect the business environment
through a
myriad of taxes, rules and regulations. The purpose of this chapter is to
analyse the contribution of government to economic welfare and
the business
environment.
The objectives of government and business
are to some extent in opposition.
The social
objectives of government policy can impose restraints on a firm’s
behaviour in
relation to employees and investment. Competition policy limits
the scope of
business to acquire and exploit monopoly power, environmental
legislation
can impose heavy financial burdens on industry, and progressive
income taxes
impact severely on executive salaries. However, governments and
business
also share much common ground. Both have an interest in fostering
growth,
securing high levels of employment and promoting social harmony.
Hence,
business should not allow itself to be cast in the role of opposing all
public
intervention. Much of this intervention is desirable, necessary and
directly
beneficial to business. This much has always been recognised in
economics.
Adam Smith himself devoted a long chapter to discussing the
various
functions of government. In addition to the provision of defence and
justice, he
asserted that ‘the sovereign or commonwealth’ had a duty to erect
and maintain
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.
The debate has come a long way since then,
as we shall see.
For four decades after the Second World
War, the influence of government in
the economy
grew at an unprecedented rate. Some of this growth was fuelled by
Keynesian
ideas of macroeconomic management. We defer discussion of this
aspect of
government intervention until Part II. This chapter focuses on the
microeconomic
considerations that prompted governments to play a more active
role in the
economy.
The economics of government intervention
have undergone extensive review
in recent
decades and the tide of government expansion has turned. Whereas
50 years ago
governments regarded nationalisation as a solution to market imperfections,nowadays
the debate is about privatisation. Many no longer see the
welfare
state as the solution to the problem of poverty, but rather as a possible
source of
its exacerbation. Instead of providing people with pensions, governments
are
encouraging people to make provision for the future for themselves.
Changing
ideas have spilled over into changing budgets. Government spending
as a
percentage of GDP has stopped increasing and in some countries has declined
Income distribution and the equity–efficiency trade-off
Economics seeks to improve society’s
material welfare. This seems a reasonable
definition
of the aim of economic activity, although at various times in the past
other
objectives have taken precedence. To some, economic activity was useful
primarily as
a means of securing and maintaining political power. Colbert, the
influential
finance minister of Louis XIV, saw as the main purpose of his subjects’
labour not
the increase in their own happiness, but the enhancement of the glory
and power of
their sovereign, who personified the nation. Despots, through the
centuries,
have viewed economic activity primarily as a means of securing and
extending
their power rather than of improving the welfare of the masses. Even
those who
agree with the objective of maximising individual utilities may disagree
over the
interpretation of what truly gives utility to us as human beings and
who is best
equipped to judge.
The value judgements underlying modern
economics are derived from a philosophy of individualism and liberalism.
Individualism means that what ultimately
counts is
the utility every individual attains and that the utility of each individual
should be given an equal weight. Liberalism signifies that individuals
should be
free to decide what provides the greatest utility. Individual preferences
are taken as
given. The task of the economist, in this view, is to advocate structures
which ensure
that they are satisfied to the maximum extent, not to pass
judgement on
them.
It is important to distinguish between
utility and income. The standard
assumption
underlying economic reasoning is that the marginal utility of income
is positive,
but decreases as income rises._2 ‘Economic man’ always prefers a higher income
to a lower one, but the intensity of this preference diminishes as income rises.
Ascetics, who are happiest with a minimal income, and Scrooges, for whom income
becomes more important the more they have of it, are both excluded by this
definition. A systematic relationship thus links utility to income. On the face
of it, the
individualist principle of treating the utility of every person equally,
coupled with
the assumption of declining marginal utility for all individuals,
would seem
to imply that the total utility in society is maximised when income
is
distributed perfectly evenly. However, few would advocate total income
equalisation.
There are two reasons for this. First,
different people derive different amounts
of
satisfaction from the same income levels. Material wealth does not matter
equally to
all. Second, policies to achieve greater equality have an adverse effect
on
incentives to work and enterprise and may, after a point, lead to a fall in
total
income. The
size of the cake to be distributed may be affected by how the cake is
sliced. In
this metaphor, the slicing pattern represents the egalitarian or equity
factor and
the size of the cake stands for the second major criterion of economic
judgement:
efficiency._3 If the unweighted utility sum in a society can only be
maximised by
allowing a degree of inequality, then the inequality outcome
might be
preferred to perfect income equalisation.
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