6.Government and Economic Growth: Government Flashcards
What is the simplest way in which government can affect the economic growth?
The simplest way in which the government affects economic growth is through the CHANNELS OF FACTOR ACCUMULATION.
Government affects the ACCUMULATION OF PHYSICAL CAPITAL:
- directly THROUGH INVESTMENTS in GOVERNMENT CAPITAL (e.g., infrastructure such as roads)
- indirectly THROUGH ITS BUDGET (because budget deficits absorb savings that would otherwise be invested in physical capital).
We have also seen the hand of government in the ACCUMULATION OF HUMAN CAPITAL because in most countries, government PAYS FOR A LARGE FRACTION OF EDUCATION.
And the government also influences population growth, through pro- or anti-natalist policies.
How can government affect economic growth beyond factor accumulation?
BEYOND FACTOR ACCUMULATION, government policy can significantly affect the SPEED OF TECHNOLOGICAL PROGRESS:
- both through direct government funding of research
- and through government administration of the patent system, which allows researchers to reap (пользоваться) rewards for their inventions and thus provides an incentive for inventive activity.
However, the area in which GOVERNMENT PLAYS ITS MOST IMPORTANT ROLE IS EFFICIENCY through:
-TAXATION
- REGULATION
- ADMINISTRATION OF LAWS
governments create the environment in which firms and workers go about (занимаются) their activities. By setting the “rules of the game” for the economy, government can profoundly affect economic development.
Relationship between government and institutions?
Government creates institutions and is itself an outcome of them.
Government Intervention in the Economy: What is the most common case for government intervention in the economy?
The starting point for most analyses of GOVERNMENT INTERVENTION in the economy is MARKET FAILURE, the idea that in some circumstances unfettered markets will not produce an efficient outcome. Although MARKET FAILURE can take many forms, we focus here on four types:
1) PUBLIC GOODS: The simplest form of market failure occurs when there are particular goods, called PUBLIC GOODS THAT PRIVATE MARKET CANNONT SUPPLY — most commonly because there is no practical way to charge those who benefit from the use of such goods. The classic example of a public good is national defence.
Other PUBLIC GOODS THAT ARE RELEVANT FOR ECONOMIC GROWTH:
1) THE RULE OF LAW
2) INFRASTRUCTURE ( airports and highways
3) STABLE CURRENCY
2) EXTERNALITIES: the incidental results of some economic activity that affect people who do not control this activity and are not intentionally affected by it.
One example of a government policy motivated by externalities: The CREATION OF A NEW TECHNOLOGY often involves large externality benefits to people other than the inventor. Because the inventor does not take these positive externalities into account—and instead compares only his or her private benefit from making an invention to his or her cost in creating it—the amount of invention is naturally lower than the socially optimal amount.
Such positive externalities are the reason that governments play a role in supporting research and development (R&D) through both direct spending and patent protections that raise the fraction of an invention’s social benefits received by the inventor.
A second example of a POLICY MOTIVATED BY EXTERNALITIES is EDUCATION. When a person chooses how much education to pursue, he or she weighs the private costs of an education against the benefits that he or she will receive. But it is often argued that education provides benefits to society beyond those that the individual receives: An educated person helps improve the quality of life of those around him or her. Because people ignore these external benefits, the quantity of education that individuals will decide on for themselves will be lower than the socially optimal amount, so the government has a role to play in encouraging education. Similarly, in the case of negative externalities, such as pollution, a private firm will tend to produce more than the socially optimal quantities.
Government regulation is required to limit this externality:
there are always less positive externalities that negative ones- intervention of government is then needed.
3) MONOPOLY: A third form of market failure that can motivate government economic policy is the existence of monopolies, single firms that are the sole suppliers of a particular commodity.
An industry such as electricity transmission is often viewed as a natural monopoly because it would be impractical for several companies to string electric wire to every house. In such a case, there is a role for GOVERNMENT REGULATION TO PREVENT THE MONOPOLIST FROM CHARGING AN INEFFICIENTLY HIGH PRICE.
4) COORDINATION FAILURE: The private MARKET can also potentially FAILS IN CASES REQUIRING THE COORDINATION OF ACTIVITIES by many firms or many people.
Some potential coordination failures—and the need for a government to correct them—are obvious. It is useful for everyone to drive on the same side of the road, and even the most diehard free marketer would have little objection to letting the government announce which side it should be.
But COORDINATION FAILURE may also be more SUBTLE. Consider a case in which FIRMS are RELUCTANT TO INVEST IN ONE INDUSTRY—say, a bicycle factory— because they fear there will be no raw materials for them to purchase, whereas firms are reluctant to invest in a second industry—say, steel production—because they fear there will be no market for their output. It is often argued that in such cases, GOVERNMENT PLANNING CAN BREAK THE LOGJAMM (метрвая точка) AND FURTHER THE PROCESS OF ECONOMIC DEVELOPMENT.
Another MOTIVATION FOR GOVERNMENT TO INTERVENE: not the concerns about the total quantity of output but rather the way that output is distributed among the citizens of a country.
Governments may view INCOME REDISTRIBUTIONS—the transfer of income from rich to poor, from working-age adults to the elderly, or from the general population to members of some favored group—as one of their proper roles.
Arguments against government’s intervention in the economy.
Few economists would argue that there should be no government intervention in the economy.
Rather, it is a QUESTION OF DEGREE. For many economists, the reasons for government intervention are not sufficient to justify the degree of intervention that we observe. As a result, they argue, government intervention, at the margin, reduces economic welfare.
1) GOVERNMNET FAILURE: The case against government intervention starts with the observation that, ALTHOUGH POORER GOVERNMENT POLICY CAN THEORETICALLY FIX ANY MARKET FAILURE, IN PRACTICE IT OFTEN FAILS TO ACHIEVE ITS GOAL.
REASONS WHY: When GOVERNMENT tries to take the PLACE OF PRIVATE FIRMS, the resulting enterprises tend to OPERATE INEFFICIENTLY because they LACK THE INCENTIVES (specifically, profit) that motivate private firms.
Similarly, in cases in which industries are regulated as natural monopolies, often such regulation effectively preserves the absence of competition.
In general, the SUCESS OF ANY GOVERNEMENT INTERVENTION DEPENDS CRUCIALLY ON THE ABILITY AND THE HONESTY OF THE OFFICIALS ENTRUSTED TO CARRY IT OUT. When these qualities are lacking, the resulting government failure can be worse than any market failure that government policy was designed to correct.
Recognizing the difficulty that governments have when they try to intervene in the economy suggests that, whenever possible, the role of government should be defined as narrowly as possible.
2) PRIVATIZATION AND DEREGULATION: Critics also argue that MANY FEWER MARKET FAILURES EXIST THAN THE PROPONENTS OF GOVERNMENT INTERVENTION ARGUED.
In the case of , the PUBLIC GOODS the debate centers on the question of whether some of the goods that governments supply could have been supplied privately if the government had not taken over their provision. In much of the world, functions previously performed by the government are being privatized, that is, handed over to the private sector. In various countries, privatized activities have included the building of roads and telephone networks and the operation of jails. A parallel trend has been the deregulation of industries (removing them from government supervision).
3) EQUITY-EFFICIENCY TRADE-OFF:
The issue of INCOME DISTRIBUTION PRESENTS SOME OF THE MOST DIFFICULT QUESTIONS REGARDIN THE PROPER ROLE OF GOVERNMENT.
For other issues, the costs and benefits of intervention can be measured in the same terms—for example, the inefficiency of monopoly versus the inefficiency of government regulation. (COSTS-BENEFITS COMPARISON)
In the case of INCOME REDISTRIBUTION, however, the BENEFITS of such a policy (A GREATER DEGREE OF EQUALITY) are of a DIFFERENT NATURE THAN THE COSTS (A LOWER DEGREE OF EFFICIENCY).
However, CRITICS of big government ARGUE that much of the income that GOVERNMENTS REDISTRIBUTE DOESN’T FLOW FROM RICH TO POOR.
Rather, it is REDISTRIBUTED AMONG PEOPLE IN THE SAME INCOME GROUPS, WHO ARE AT DIFFERENT STAGES OF THEIR LIFE CYCLES:
-e.g TAXES ARE TAKEN FROM WORKING-AGE ADULTS AND ARE PAID TO ELDERLY.
Critics argue that these redistributions have a LARGE EFFECT ON THE EFFICIENCY with which the economy operates, but DO LITTLE OR NOTHING TO IMPROVE EQUITY.
Government’s intervention in the economy: Swings of the pendulum
Although there has never been a consensus about government’s proper role in the economy, either among economists or among those who govern, the 20th century saw TWO BROAD SWINGS OF THE PENDULUM IN THE ANALYSIS AND THE PRACTICE OF GOVERNMENT INTERVENTION.
1) Beginning around World War I, the idea that the government could play a decisive, active role in furthering economic development gained ground throughout the world. The most extreme EXAMPLE IS THE SOVIENT UNINON, where a series of five-year plans, including government ownership of factories and forced collectivization of agriculture, sparked impressive economic growth during the 1920s and 1930s.
The economic collapse of the Great Depression, which seemed to be evidence of coordination failure on a massive scale, inspired forceful government intervention in the workings of the economy.
The fascist states of Germany and Italy imposed strong controls over the market, with the apparent result that these countries were able to shake off the effects of the Depression more rapidly than their neighbors.
In the United States, where politicians had long been hostile to government interference in the economy, President Franklin Roosevelt’s New Deal program to promote economic recovery represented an unprecedented degree of government meddling in the economy, including price controls, purchases of surplus agricultural output, and direct job creation through public works. The Great Depression also inspired the theories of John Maynard Keynes, which provided an intellectual foundation for activist monetary and fiscal policies designed to maintain full employment.
2) The last two decades of the 20th century witnessed a SHIFT AWAY FROM GOVERNMENT CONTROL OF THE ECONOMY. This was most pronounced among the communist and for-mer communist countries, most of which moved decisively toward a market system. In the industrialized world, there was a wave of DEREGULATION and PRIVATIZATION of some functions of government, along with reduction in the generosity of welfare-state benefits. In the developing world, in response to the problems of economic planning that are discussed below, there was a turning away from state-led industrialization, toward a more market-based approach with an emphasis on free trade.
Following the financial crisis of 2007–2008, and the subsequent global recession, there may be yet another change of direction.
It is hard not to notice that THE COUNTIRS THAT SIFFERED THE LARGEST ECONOMIC SHOCK WERE THOSE WITH THE FREEST MARKETS.
By contrast, CHINA, with its HEAVY-HANDED GOVERNMENT CONTROL, (as well as lack of democracy) SUFFERED HARDLY AT ALL. Whether the “Chinese model” of economic growth is something that can be exported to other countries remains to be seen.
How government affects growth in practice: what two aspects are we considering in this lecture?
To examine how governments have affected growth in practice, we focus on the following aspects of government action :
1) The maintenance of the RULE OF LAW : enabling the enforcement of contracts, it is among the most important public goods.
2) TAXATION, EFFICIENCY AND THE SIZE OF GOVERNMENT: big governments – governments that spend a lot of money – require big government revenue.
How government affects growth in practice: THE RULE OF LAW
One of the most IMPORTANT PUBLIC GOODS that governments provide is the RULE OF LAW.
The rule of law cannot be taken for granted in most of the world. In many countries, judicial systems are weak, and legal cases are as likely to be settled on the basis of who has better political connections as on legitimate legal claims. Douglass North, who won the Nobel Prize in economics in 1993, concluded, “The inability of societies to develop effective, low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the Third World.”
AN EXAMPLE OF THE LACK OF THE RULE OF LAW AND ITS EFFECT ON THE EOCNOMIC GROWTH: The former Soviet Union provides one of the best examples of the importance of the rule of law. With the fall of communism, the legal structure surrounding basic economic activity became highly uncertain. The line between legitimate business and organized crime blurred because assets formerly owned by the government in trust for the citizenry as a whole rapidly found their way into the hands of a well-connected few. (The Russian slang term biznesman carries the connotation of someone who en-gages in semilegal, slimy transactions.) In this legally unstable environment, income per capita in the Russian Federation fell by 12% in the decade following the 1991 breakup of the Soviet Union.
Relationship between the Rule of Law and factor accumulation (Slide 10 + 11)
In an environment in which the RULE OF LAW IS WEAK, we would expect that FACTORS OF PRODUCTION WOULD NOT BE ACCUMULATEDd and that economic activIty would be plagued by INEFFICIENCY. For both these reasons, output would decline.
The available data are consistent with these predictions. The data we use measure rule of law as a composite of the enforceability of contracts, the effectiveness and predictability of the judiciary, and the incidence of crime. Sources for this information include surveys of businesspeople and citizens, as well as compilations of opinions of experts at nongovernmental organizations (NGOs).
Figures on the slides 11 and 12 show the relationship between the rule of law and the productivity measure. In both cases, there is a strong positive correlation, and the figures show that the channels of factor accumulation and productivity are of roughly equal importance in explaining the effect of the rule of law on income per capita. The exceptions to the general trend in these data are also interesting. For example, India has both low factor accumulation and low productivity, considering its level of the rule of law, whereas Italy has higher factor accumulation and higher productivity than would be expected, given its level of the rule of law.
How government affects growth in practice: TAXATION, EFFICIENCY, AND THE SIZE OF GOVERNMENT
One of the most important ways in which government affects the state of the econ-omy is by its sheer size. Big government—that is, government that spends a lot of money—requires big government revenue. Governments RAISE FUNDS BY TAXING citizens and businesses. These TAXES in turn AFFECT the EFFICIENCY of economic activity.
WAGNER’S LAW:
THE SIZE OF GOVERNMENT WOULD INEVITABLY INCREASE AS COUNTRIES BECAME WEALTHIER because a more developed economy requires MORE COMPLEX REGULATION and because many PUBLIC GOODS provided by the government are of the type WHERE THE SPENDING RISES MORE THAN PROPORTIONALLY WITH INCOME.
Slide 13 graphically shows the growth of government spending: Among the industrialized countries of the Organisation for Economic Co-operation and Development (OECD), the average share of govern-ment spending in GDP was 47% in 2009. Examining the size of government in poorer countries reveals a second striking fact: Although these countries tend to have smaller governments than do he richest countries, their governments are much larger than were rich-country governments at a comparable stage of economic development.
Government spending, taxation and efficiency: relationship
The INCREASE IN GOVERNMENT SPENDING has been funded by an equally large INCREASE IN THE TAXES.
TAXES are relevant for economic growth because they DIRECTLY AFFECT THE EFFICIENCY with which output is produced.
Slide 14: The RELATIONSHIP BETWEEN EFFICIENCY AND TAXATION can be illustrated using a simple diagram of supply and demand. Consider the market for some good, in which there is an upward-sloping supply curve and a downward-sloping demand curve. The good in question could be anything that is taxed: For example, it could be labor if we are thinking of an income tax, or it could be gasoline or some other commonly taxed commodity.
In the absence of taxes, the equilibrium price and quantity of the good would be determined by the intersection of the supply and demand curves. The effect of a tax is to place a wedge (клин) between the price that a supplier receives and the price that a demander pays.
As the figure shows, the IMPOSITION OF THE TAX WILL LOWER THE PURCHASED QUANTITY OF THE GOODS; this quantity is called the TAX BASE.
The total revenue collected by the TAX=TAX BASE MULTIPLIED BY THE PER-UNIT TAX. This total revenue is represented by the shaded rectangle on the SLIDE 14.
The LARGER GAP between the price received by suppliers and the price paid by demanders—that is, the LARGER IS THE TAX IMPOSED in a given market—the SMALLER NUMBER IF TRANSACTIONS–> EFFICIENCY REDUCTION!
In other words, RAISING THE TAX WILL LOWER THE TAX BASE.
This is the SOURCE OF THE INEFFICIENCY associated with taxes:
When TAXES are HIGH, SOME of the potential TRANSACTIONS between buyers and sellers WON’T TAKE PLACE, and these transactions would have made both groups better off.
No tax will be collected on these forgone transactions, but by DISCOURAGING TRANSACTIONS, THE TAX MADE BOTH BUYERS AND SELLERS WORSE OFF.
The SIZE of this INEFFICIENCY GROWS grows WITH THE SIZE OF THE TAX, beecause HIGHER TAXES SHRINK THE TAX BASE. i
INCREASES IN REVENUE COLLECTED when TAX RATES RISE ARE NOT PROPORTIONAL TO INCREASES IN TAX RATES.
Indeed, ONCE TAX RATES ARE HIGH ENOUGH, FURTHER INCREASES IN THE TAX RATE WON’T RAISE ANY REVENUE AT ALL, because they will be more than OFFSET BY REDUCTIONS IN THE TAX BASE.
Since taxes cause a lot of inefficieny in the economic activity, should there be no taxes?
The fact that taxes cause inefficiency in the economy does not mean that there should be no taxes.
As we have seen, GOVERNMENT PROVIDES PUBLIC GOODS WITHOUT WHICH THE ECONOMY COULDN’T FUNCTION AT ALL.
These PUBLIC GOODS public goods are PAID for BY TAXATION.
Thus, even if the government were solely concerned with maximizing GDP per capita, the OPTIMAL CHOICE OF PUBLIC GOODS AND TAXATION INVOLVES A TRADE-OFF BETWEEN COSTS AND BENEFITS.
However, NOT ALL OF THE MONEY that governments collect as tax revenue GOES TOWARD SUPPLYING PUBLIC GOODS.
Increasingly one of the major functions of government is to make TRANSFERS OF INCOME TO PEOPLE.
The largest transfers are old-age PENSIONS; other transfers include UNEMPLOYMENT BENEFITS and WELFARE PATMENTS TO THE POOR.
In the United States, such transfers now amount to 16% of GDP in 2010, and their share has more than doubled since the 1960s.
Why governments do things that are bad for growth?
Three main reasons why governments do things that are bad for growth:
1) SOME OTHER GOAL: government may spend taxpayer money on things that might reduce economic efficiency:
- ANTI-POLLUTION REGULATIONS: anti-pollution regulations raise the amount of input used without raising the quantity of output produced, hence they reduce economic efficiency. However, governments view this reduction in efficiency as a price worth paying for a cleaner environment.
- INCOME REDISTRIBUTION: the most important example of a policy goal that may impede eco-nomic growth is one that we already have touched on, is INCOME INEQUALITY. Governments that redistribute income from rich to poor face an EQUITY-EFFICIENCY TRADE-OFF: RAISING EQUITY LOWERS ECONOMIC EFFICIENCY AND THUS REDUCES ECONOMIC GROWTH. This is a price that many governments are willing to pay.
2) CORRUPTION AND KLEOPTACRACY: Government corruption takes many forms, from a tax inspector who accepts a bribe to overlook income on which he is supposed to collect taxes, to a mayor who trades city contracts for cash payments. When corruption reaches to the highest levels of government, it is labeled kleptocracy,meaning “rule by thieves.”
In the last decade, economists studying economic development have increas-ingly come to view corruption as one of the most important impediments to de-velopment. In a report in 2002, the World Bank identified CORRUPTION as “THE SINGLE GREATEST OBSTACLE TO ECONOMIC AND SOCIAL DEVELOPMENT because it WEAKENS THE INSTITUIONAL FOUNDATION on which economic growth depends.
Some of the links between corruption and economic growth are straightfor-ward. First, corruption directly wastes taxpayers’ money. he waste of government revenue is only the beginning of the inefficiency brought about by corruption. A second effect of corruption is that governments undertake policies solely to generate more opportunities for bribery.
3) SELF-PRESERVATION: A final reason that governments do things that are bad for growth is that this tactic is often the best way to keep themselves in power (PUTIN). Many of the changes in social struc-ture that inevitably accompany economic growth pose a threat to those in power. New technologies can redistribute economic power away from the groups that support the current ruler; rising education may introduce destabilizing new ideas; the movement of population from farms to cities creates a potential revolutionary class; and trade with the outside world can carry with it dangerous foreign ideas.
A government with a weak grip on power will be inclined to preserve the status quo, at the cost of forgo-ing growth; a government that is secure in power will be willing to tolerate the social dislocations that accompany rapid growth.
Example: First, the Russian rulers feared that industrial workers concentrated in cities would be susceptible to the contagion of revolutions such as those that swept Europe in 1848. Second, industrialization would undermine the land-based wealth of the elites who supported czarist rule.
The trade-off between economic growth and political security that concerned the czars in the 19th century was the same dilemma faced by Mikhail Gorbachev, the leader of the Soviet Union, at the end of the 20th century. The policies of perestroika (restructuring) and glasnost (political openness) that Gorbachev insti-tuted in 1986 aimed to shake up the moribund Soviet economy, which was falling increasingly behind its competitors in the West. Once again, however, the price of economic modernization proved high: Within five years, Gorbachev was out of power, and the Soviet Union had dissolved.
Why poor countries have bad governments?
Examination of data suggests that although no government is perfect, poor countries tend to have particularly bad governments. When we examined the rule of law and corruption, for example, we found that poorer countries tended to score much worse on these measures.
The fact that poor countries have bad governments raises an obvious question: Are these countries poor because of their bad governments, or is bad government a symptom, rather than a cause, of poverty?
- CAUSATION RUNNING FROM INCOME TO GOVERNMENT QUALITY:
The first is that bad government is not always an impediment to economic growth (China); second is that the quality of government often improves in response to growing income. - CAUSATION RUNNING FROM GOVERNMENT TO INCOME: a good example is the analysis of the effect of early institutions in ex-colonies on their economic growth today.
