Government revenues come mainly from direct taxes on personal incomes and company
profits, indirect taxes on purchases of goods and services, and contributions to state-run
social security schemes. Government spending comprises government purchases of goods
and services and transfer payments.
Governments intervene in a market economy in pursuit of distributional equity and allocative
efficiency. A progressive tax-and-transfer system takes most from the rich and gives most to
the poor. The UK system is mildly progressive. The less well-off get transfer payments and
the rich pay the highest tax rates. Although some necessities, notably food, are exempt
from VAT, other goods intensively consumed by the poor, notably cigarettes and alcohol, are
heavily taxed.
Externalities are cases of market failure where intervention may improve efficiency. By taxing
or subsidizing goods that involve externalities, the government can induce the private sector
to behave as if it takes account of the externality, eliminating the deadweight burden arising
from the misallocation induced by the externality distortion.
A public good is a good for which one person’s consumption does not reduce the quantity
available for consumption by others. Together with the impossibility of effectively excluding
people from consuming it, this implies all individuals consume the same quantity, but they
may get different utility if their tastes differ.
A free market will undersupply a public good because of the free-rider problem. Individuals
need not offer to pay for a good that they can consume if others pay for it. The socially
efficient quantity of a public good equates the marginal social cost of production to the sum
of the marginal private benefits over all people at this output level. Individual demand curves
are vertically added to get the social demand or marginal benefit curve.
Except for taxes to offset externalities, taxes are distortionary. A wedge between the sale
price and purchase price prevents the price system equating marginal costs and marginal
benefits. The size of the deadweight burden is higher the higher the marginal tax rate and
the size of the wedge, but also depends on supply and demand elasticities for the taxed
commodity or activity. The more inelastic supply and demand are the less the tax changes
equilibrium quantity and the smaller the deadweight burden.
Tax incidence describes who ultimately pays the tax. The more inelastic demand is relative
to supply, the more incidence falls on buyers not sellers.
Rising tax rates initially increase tax revenue but eventually lead to such large falls in the
equilibrium quantity of the taxed commodity or activity that revenue falls. Cutting tax rates
will usually reduce the deadweight tax burden but might increase revenue if taxes were
initially very high. Few economies are in this position. Lower tax rates usually reduce tax
revenue.
The economic sovereignty of nation states is reduced by cross-border mobility of goods,
capital, workers and shoppers. Policy co-ordination may increase efficiency by making
decisions reflect previously neglected policy spillovers.
Political economy examines political equilibrium and incentives to adopt particular policies.
When all those voting have single-peaked preferences, majority voting achieves what the
median voter wants.
