What is the role of the government in economics?

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pohnpei397 eNotes educator| Certified Educator

Perhaps a better question is what the role of government in the economy *should* be.  After all, there are governments around the world and across time that have taken almost every conceivable role in the economy.  Therefore, there is no way to say what the role of the government is for every country and every time.

As for what the role should be, there is a great deal of dispute on this issue.  Most economists think that the government should not be heavily involved in the economy.  They think that the free market should be left to itself.  However, there is a rising trend toward "state capitalism" in which the state does things like owning companies and setting economic priorities.  With the recent financial crisis in the West, this sort of attitude is taking hold to a greater degree than it once did.

penemra | Student
  1. Remember that while recorded money transactions enable us to quantify the extent of government intervention for economic policy purposes in a relatively simple fashion, this biases discussion of the relations between government and industry towards forms of intervention involving financial transactions between governments and firms. The Ministry of Finance may have an important role to play in influencing the finance of industry in conjunction with the Central Bank, but that cannot be shown, except in an indirect way, by the size of the financial surplus or deficit (in this case) of the government (item 12 in Table 2.1). A deficit has to be financed in some way, and the mode and extent of finance may affect the terms on which companies may be able to borrow. On the other hand, government repayment of debt from a surplus will also affect borrowing terms. By far the most important omission is that of government regulation by the use of legislation governing the activities of companies. Governments may attempt to control the prices of industrial goods and interfere in wage settlements with workers. Regulation has become particularly important (seeModule 9), influencing the activities of public enterprises which have been privatized and as a form of consumer protection for those investing in the stock market or in pensions and life insurance. Such regulations will represent a significant influence on industrial and commercial decision-making, going far beyond the influence of government expenditure and taxation alone.

    It is one thing to list the forms of intervention, but another to quantify them. One way might be to ascertain the financial cost of employing those who run the central banking system or who administer government industrial regulation. However, to translate these expenses into some measure of ‘influence’ on the economy would be difficult if not impossible. The central bank normally employs relatively few persons, but the influence of central bank operations on the economy can be enormous. At the same time, it must be remembered that companies also incur costs in having to comply with government regulations, and these can be far from negligible.

  2. Do not be taken in by the idea that because some group is responsible for paying taxes or is in receipt of benefits, that this gives a complete picture of the distribution of benefits and burdens. This is the vexed question of who ‘bears’ the taxes and who ‘gains’ from government expenditure. It is not necessary to explore in detail theeconomic analysis which might throw light on this problem, but we shall consider particular cases as they affect firms at various stages in later sections of the Course. Indeed, the student will already have noticed that it was raised in our very first example illustrating our approach when various groups attempt to shift the burden of a tax in such a way as to minimize its effect on their economic position. It follows that the imbalances in receipts and payments by sector in budget-derived figures can only be the starting point for much further analysis of their effects.

  3. While the totals in Table 2.1 seem to be very large, note that they give no information on the size of the government relative to the rest of the economy. So the search is on for some suitable ‘numerator’, which measures the size of government and a ‘denominator’, representing the size of the economy.


penemra | Student

The Place of Government in the Economy

  1. First, always check which definition of government is being used, for it can make a considerable difference to the perspective gained about government's role in the economy. In the example given in Table 2.1, both central and local government are included and lumped together, but the transactions of public corporations are excluded. Which concept of government is used will depend on the purpose in view. A firm interested in defence contracting acquiring background on government activities might confine its attention to the central government budget. A firm looking for contracts in the supply of educational equipment might want to concentrate on lower layers of government and the pattern of educational expenditure within those lower layers. A firm supplying capital equipment to nationalized fuel and power undertakings would wish to have data on public corporations' role in government and in the economy. A firm which considered it possible to bargain with government about tax treatment of its capital expenditure or its liability to pay some national tax, such as a value added tax (VAT), might again wish to concentrate on the tax ‘burden’ imposed by central government. The problem of definition will reappear time and time again.

    Table 2.1 UK central and local government transactions by economic category 2000–01 (£ billion) Paid by Households and non- Government receipts Firms profitmaking institutions 1. Income tax – 95.2 2. Corporation tax 34.1 – 3. Social security contributions – 56.4 4. Taxes on expenditure 126.4 – 5. Other receipts 14.0 7.9 TOTAL 334.0 Received by Households and non- Government payments Firms profitmaking institutions 6. Current expenditure on goods and services 164.9 – 7. Expenditure on gross domestic capital formation 10.4 – 8. Interest on public debt – 25.9 9. Transfer payments – 112.3 10. Subsidies 5.2 – 11. Other 18.9 – TOTAL 337.6 12. Financial deficit 3.6


penemra | Student

The Budget

Every year democratic countries present, for the approval of their parliaments, a budget alongside which there will be published extensive information on the central government's finances, including accounts of past years. In this respect governments have to achieve certain standards of accountability and audit. It is taken for granted here that these standards are being met and this enables us to concentrate on the method of presentation of accounting data by the government which gives us the best idea of its structure andsize in relation to the rest of the economy. While accounting and audit standards will require the government to produce full information on the responsibility of each main administrative unit for its use of authorized funds, what is needed here is an economic classification which enables us to identify government transactions which have their counterpart in receipts and payments of other major sectors of the economy. Table 2.1 presents such a classification.

Table 2.1 is a typical extract from data supplied by governments when they are putting forward the annual budget. When considering the government's place in the economy and its impact on business, the following check-list of questions should be applied.


penemra | Student

The third function is to intervene in the distribution of income generated by private market transactions in order to conform with some acceptable criterion of equity, for example a minimum income guarantee. This will be reflected in the national accounts principally in the choice of taxes and in the provision of transfer payments to households against which there is no counterflow of current services. For example, state pension payments are transfer payments, and though pensioners do not render current services in order to receive them, they may have contributed to their finance through compulsory levies on their past incomes. Transfer payments do not form a direct link between government and industry but major efforts by government to alter income distribution have considerable influence on the structure of household purchases and therefore on the pattern of demand for industrial products.

The fourth function is the stabilization of the economy by attempting to reduce fluctuations in income and employment and to control movements in the general price level. The effects of this action can be seen in both the volume and the mix of transactions between the government and the rest of the economy. Policy models of the economy which place particular emphasis on the control of the money supply and interest rates will pay close attention to the size of the government budget deficit/surplus. Therefore, no particular transaction with the private sector is solely identified with this function except perhaps for the interest paid by government to firms and households as a payment for holding government debt accumulated in the course of financing past government deficits.


penemra | Student

The economic role of government can best be defined by a classification of its economic policy aims. Broadly speaking the political choices made by electorates in Western-type democracies influence governments to perform four functions.

The first is production of services which private firms are either unwilling to produce or for some reason are not allowed to produce (or at least not exclusively). This public provision may be to provide immediate benefits (e.g. defence, law and order) or deferred benefits (e.g. investment in roads).

These ‘production’ activities may be divided into two types.

  1. Services which are not sold in the market but are financed out of compulsory levies. It is considered preferable in economic analysis to treat the government here as acollective consumer in a position to influence the allocation of resources, rather than as a producer because the ‘output’ is intangible and is not priced. For our purposes, what is important is that the government has to purchase in the market the current output of private firms and the labour services of households in order to fulfil its task. It can, of course, ‘rig’ the market. For example, the UK government is not only an important purchaser of vehicles for use in government departments; it also buys almost exclusively only vehicles produced in the UK.

  2. Goods produced and sold in the market by public corporations. Many countries have state-owned fuel and power industries whose operation is very similar to private industry though the policy instructions laid down by governments for their operation will usually include objectives other than the making of profits (see Module 8.)

The second function is the alteration of the structure of private production in order to conform with some conception of the allocation of resources which is considered ‘better’ than that resulting from private market transactions. This aim has already been illustrated in the example given in Section 1.3. In the national accounts, this aim will be reflected in the choice of taxes levied on goods and services (e.g. taxes on expenditure), in corporation taxes and in current subsidies.