From an economic perspective, a number of key governmental functions are commonly identified. If the market mechanism always worked perfectly, cir- cumstances where governments could beneficially intervene in the economy would, in theory, be non-existent. However, even the strongest champions of free markets accept that the market will not always function in this way: three clear circumstances where government intervention may be warranted are commonly proposed:
(a) The provision of ‘public goods’ and prevention of ‘public bads’
From the earliest days of economic thinking, a key role of the state has been seen as the production of ‘public goods’. A public good is one that, even if consumed by one person, can still be consumed by others. Furthermore, it is not possible to prevent other people consuming it, or at least not in any
practicable sense. Consequently, such a good will not be provided by the private sector, since they cannot control its consumption and thereby profit from its use.
For example, if the state did not provide street lighting, you might decide to invest in a system of lighting for your street. However, there would be no way to prevent other residents from benefiting from this – from ‘free riding’ on the back of your investment, despite the fact that they had not contributed to it.
As well as public goods of this form, there are also ‘public bads’ – pollu- tion, for example. Just as the private sector has no incentive to provide public goods, they have little or no incentive to prevent public bads.
This captures the idea of ‘externalities’, where the cost or benefit to society differs from the private cost or benefit in ways that cannot be captured by the price mechanism. The idea of externalities was formalised in the work of the economist Arthur Pigou in the first half of the twentieth century. Pigou was concerned with how economics could be used to enhance public welfare, and argued that the presence of externalities prevented the market producing many welfare-enhancing goods. For example, Pigou argued that the planting of trees by a private individual brought benefits to his neighbours for which the planter was not compensated – they were able to free-ride on his efforts.
As a result, there would be fewer trees planted than was desirable from soci- ety’s perspective. Similarly, a company that pollutes a river may be able to escape the economic consequences of its action, but the cost to society may be large. Again, there will be an ‘overproduction’ of such social bads as those responsible do not bear the economic consequences of their actions.
To address these issues, governments therefore have an accepted role in the provision of public goods, and, increasingly, in the prevention of public bads.
No other party can perform this function.
(b) Correcting (or compensating for) market failures
If the market mechanism were always perfect the result would be a Pareto efficient competitive equilibrium, where it would be impossible to allocate resources more efficiently – for one person to be made better off without another being made worse off. However, where markets do not operate in this manner, government may be able to improve outcomes through intervention.
Formally, this is a situation of ‘market failure’ where the first fundamental theorem of welfare economic17 does not hold.
Market failures may occur in many situations. For example, a lack of competition, the presence of externalities as discussed above, or – as has been increasingly stressed – the impact of asymmetric information, may all lead to market failures. This latter point came to the fore in the 1970s and 1980s,18 where it was demonstrated that the pervasive nature of asymmetric informa- tion inevitably implied that market failure was not a rare anomaly, but rather was commonplace in many market situations. Having said that, the degree to which the existence of market failure is accepted, and the extent to which it is
seen as possible for governments to improve on the situation is very much a matter of perspective.
Stiglitz (1989a) famously argues that the extent of market failure was such that government intervention could be welfare-enhancing in many situations and was therefore often justified. Others have argued that, while this may be correct in principle, in practice government policy rarely achieves its stated outcomes: ‘government failure’ is therefore the other side of the coin to market failure.
Those who look for market failure tend to find it. Those who look for mar- ket efficiency (or at least potential efficiency) also tend to find it. Similarly, examples of government failure are not difficult to find, but supporters of government intervention can also point to significant successes.
On balance, therefore, it is certainly the case that markets can and do fail, and that this occurs more frequently than is often supposed. Furthermore, in many of these situations, government intervention has the potential to produce superior outcomes. However, to err is certainly human, and this fact is compounded by strong pressures on government which often have the effect of distorting policy, even if correctly conceived in the first place.
The acceptance of the fact that markets do not automatically lead to opti- mal outcomes is demonstrated by the pervasive use of regulation by govern- ments of all hues, even those with the strongest free-market traditions. As we have seen, in the financial sphere, if liberalisation proceeds before a robust and effective system of prudential regulation and supervision is in place the result is very often a serious financial crisis. That is, if left to their own devices, the activities of financial actors do not necessarily produce positive outcomes from the perspective of society: they need to be firmly steered in this direction through regulation and supervision.
In the more general economic sphere, competition is often viewed as the guarantor of efficient and positive outcomes. However, many of the privatisa- tions described above have turned public monopolies into private monop- olies. Economic theory teaches that monopolists will tend to exploit their position to the detriment of society at large. Again, therefore, the government has a vital role to play in effectively regulating these newly privatised industries.
(c) Redistribution
Although, as we have seen, competitive market equilibriums result in Pareto efficient outcomes, this says nothing about the equity of these outcomes. In this regard, the role of redistributing income and wealth has also long been a key function of government. Consequently, despite its erosion in many coun- tries, most developed nations retain a progressive taxation system to at least some extent. Under these systems the rich pay proportionally more of their income in tax, allowing resources to be redistributed to poorer sections of society.
As we shall see below, progressive taxation systems of this form are far less common in developing countries, although the greater levels of inequality in these countries – particularly in Latin America – suggest that redistribution is, if anything, a more urgent task in these societies.
These three categories describe the broad areas within which governments operate, but what does this mean in practice?
4.4.1 Implement fiscal policy
In order to do almost anything a government needs resources. By far the most important source of government revenue is the tax system, and two distinct different forms of taxation can be identified.
(a) Direct taxes
Direct taxes are, as the name suggests, levied directly on income or wealth and are applied to both individuals and corporations.
The two major forms of direct taxation are, first, personal income tax, which is levied on personal income regardless of its source. Income tax may be levied in a uniform (or ‘global’) system where everyone’s income – regard- less of source – is subject to a single tax rate or, alternatively, taxes may be set at different rates depending on the individual’s level of income. The first of these finds its modern expression in the increasingly popular ‘flat tax’, whereas the latter is associated with ‘progressive taxation’ where the rate levied on income rises as you move up the income scale. With progressive taxation, higher earners pay a proportionally larger slice of their income in taxes. Income tax may also be applied as a differentiated (or ‘schedular’) system, where each source of income is subject to a specific rate of tax.
The second main form of direct taxation is corporation tax. As with per- sonal income tax, corporation tax could, in principle, be levied in a ‘global’
or ‘schedular’ manner, though in practice a flat rate is usually applied to all profits, regardless of source.
Having said that, governments can and do use the corporate tax system to encourage growth in particular industries, and may also apply a lower rate of tax to smaller companies so as to spur the development of the small-and- medium-enterprises (SME) sector.
In addition to personal and corporate income taxes, many countries implement a levy to fund national services such as social security and health- care. In theory, such schemes are not officially taxes at all, as individuals contribute to national schemes from which they can later draw down benefits – such as pensions, for example. In the UK, this is termed National Insur- ance, and the corresponding scheme in the USA is known as the Payroll Tax.
Despite the fact that such schemes are not officially taxes, they have gradually increased so that, in some cases, their impact on the individual is greater than that of direct personal taxation.
(b) Indirect taxes
Indirect taxes are most commonly applied to the sales of goods and services – such as VAT in the UK, for example. Indirect taxes derive their name from the fact that, although they are collected from the seller of a good or service, they are passed on to the ultimate consumer in the form of higher prices.
As well as sales taxes such as VAT, other forms of indirect taxation are, first, excise duties, where the intention is not to raise revenue per se, but rather to influence the pattern of consumption, by discouraging the consumption of certain goods – tobacco, for example.
A third form of indirect taxation is trade taxes, which may be levied on either imports or exports – overwhelmingly they have been applied to imports in practice. As we shall see, in many developing countries, import taxes have been and remain an important source of government revenue. As with direct taxation, import taxes may be uniformly applied to all imports or may be differentiated if the desire is to protect a particular sector from international competition.
Having considered the various forms of taxation that could, in principle, be levied, Table 4.9 below details the sources of government tax revenue in practice for different categories of country and region.
Perhaps the most striking feature of Table 4.9 is the disparity between the total tax take as a proportion of GDP between developed and developing countries. For the former the average figure for 1990 to 2002 is 27.6% of GDP, while the corresponding figure for developing countries is just 12.6%.
Clearly, therefore, the scope for public expenditure in developing countries – relative to the size of the economy – is far less. Indeed, it is less than half of what is possible in the developed world.
When we consider the different sources of tax revenue, we see that developed countries obtain roughly a third of their total tax take from each
Table 4.9 Sources of government tax revenues as percentage of GDP, 1990–2002 averages
Category Direct
taxes
Payroll taxes
Sales taxes Trade taxes
Total
Developed countries 9.9 8.9 8.7 0.1 27.6
Developing countries
4.3 0.1 5.2 3.0 12.6
Region Direct
taxes
Payroll taxes
Sales taxes Trade taxes
Africa 4.6 0.0 5.2 5.0 14.8
Asia & Oceania 4.8 0.0 4.0 2.6 11.4
Latin America &
Caribbean
3.4 1.1 5.6 2.1 12.2
Source: United Nations Online Network in Public Administration and Finance (UNPAN).
of direct, payroll and sales taxes and a negligible quantity from trade taxes. In contrast, almost a quarter of developing countries’ tax take was derived from trade taxes with 34% and 41% being obtained from direct taxes and sales taxes respectively.
The regional snapshot highlights the fact that trade taxes are a particularly important source of revenue in Africa – amounting to 5% of GDP – and that the direct tax take is particularly low in Latin America and the Caribbean.
The second aspect of fiscal policy is obviously government expenditure.
What are the key issues and trends in this respect? Although, as we have seen, government tax revenues in developing countries are, on average, less than half that of developed countries, this pattern is not mirrored when we con- sider expenditure.
Table 4.10 highlights the fact that, although developed country govern- ments receive only 12.6% of GDP as tax revenues, their expenditure is almost double this at more than 24% of GDP. Governments clearly have other sources of revenue beyond taxation – as demonstrated by the fact that developed countries’ expenditure is also considerably higher than their total tax revenue. However, in relative terms the additional expenditure in develop- ing countries is far greater than that seen in the developed economies, which reflects the impact of external borrowing on the one hand, and ‘official devel- opment assistance’ (i.e. aid) on the other. These issues will be explored in depth in Chapter 6 when we consider the external sector, but it is worth highlighting the importance of these external sources of finance to many developing countries at this stage.
Table 4.11 reveals some interesting facts about the pattern of public expenditure – as well as its scale relative to GDP – in developed and develop- ing countries. For the developed economies, the largest expenditure item by far is ‘other social services’, which refers to social safety nets such as unemployment benefits, as well as pensions and other direct transfers by the state. For developed countries, expenditure of this form amounts to 42% of
Table 4.10 Government expenditure as percentage of GDP, 1996–2002
Category Median level
Developed countries 36.8 Developing countries 24.1
Region Median level
Africa 28.6
Latin America &
Caribbean
21.0 Asia & Oceania 23.6
Source: United Nations Online Network in Public Administration and Finance (UNPAN).
total government expenditure, and almost 15% of GDP – the corresponding figure for developing countries is just 14.2% of total spending, and 3.9%
of GDP.
More generally, another important difference is that spending is quite evenly spread in developing countries, with no single category accounting for more than a fifth of total expenditure. The largest single category is ‘eco- nomic services’, which relates to government spending on agriculture, energy, all forms of industry (including research and development), transport and communication. On average developing countries devote 18.6% of total spending to these areas, compared to 9.9% for developed countries.
This higher relative spending reflects the fact that, on average, governments in developing countries have been and remain more directly involved in their economies than is generally the case in developed countries. However, the data presented here are averages for 1990–2002, a period that, as we have seen, witnessed more than eight thousand privatisations in developing countries.
Clearly, therefore, the difference between developed and developing countries in this respect has narrowed, though it is certainly the case that a significant distinction remains.
Figure 4.2 highlights spending patterns on the key areas of defence, educa- tion and health, comparing developed countries as a group with Africa, Asia and Latin America. Again some interesting and rather surprising features emerge. First, spending on education as a proportion of total expenditure is considerably higher in each of the developing regions than is the average case in developed countries – indeed, as Table 4.11 makes clear, this is true even if one looks at education spending as a proportion of GDP. Secondly, relative spending on defence is also higher in each of the developing regions than is Table 4.11 Government expenditure as percentage of total expenditure and GDP,*
1990–2002 average
Category Region
Developed Developing Africa Asia Latin America Administration and
public order
11.2 (2.1) 13.7 (3.4) 15.4 (3.9) 12.8 (3.5) 13.3 (2.8) Defence 5.3 (1.8) 10.6 (2.7) 10.3 (2.4) 14.7 (4.3) 5.9 (1.1) Education 7.8 (2.9) 15.9 (4.1) 16.1 (4.6) 15.1 (4.1) 16.7 (3.6) Health 10.9 (3.8) 7.6 (2.0) 6.1 (1.8) 6.3 (1.8) 10.6 (2.3) Other social services 42.0 (14.9) 14.5 (3.9) 10.1 (3.2) 12.3 (3.8) 21.3 (4.7) Economic services 9.9 (3.5) 18.6 (4.5) 18.1 (4.8) 21.3 (5.3) 15.7 (3.3) Interest payments 9.8 (3.4) 11.6 (3.0) 13.4 (3.7) 9.4 (2.4) 12.8 (3.0) Other expenditure 7.9 (2.6) 7.4 (1.7) 10.4 (2.5) 8.1 (1.9) 3.7 (0.7) Source: United Nations Online Network in Public Administration and Finance (UNPAN).
* Figures in parentheses equal expenditure as proportion of GDP.
the average case in developed countries – the difference in Latin America is slight, but that for Africa and, particularly Asia is far more pronounced, with both committing a substantially higher proportion of their GDP to defence spending.
Thirdly, relative health expenditure in developed countries is above that seen in all the developing regions – again, the difference with Latin America is slight in terms of total expenditure, but not so with respect to GDP. On average developed countries commit almost double the proportion of GDP to health expenditure compared with developing countries as a group, and more than double the amount committed in Africa and Asia.
A final, quite surprising, aspect of the comparative patterns of public spending to emerge from this analysis is that expenditure on debt interest payments is quite similar across all the categories. For developed countries as a whole the figures are 9.8% of expenditure, or 3.4% of GDP, while the corresponding figures for developing countries are 11.6% and 3%. Regionally, Africa devotes the highest proportion of total expenditure to interest pay- ments at 13.4%, but even here this amounts to 3.7% of GDP, a similar level to that seen in developed countries.
4.4.2 Macroeconomic policy and macroeconomic stability
In every aspect of development finance that we have considered thus far, the importance of macroeconomic stability has been stressed. Indeed, if the government is to achieve its principal long-term objective of raising growth rates, it is widely accepted that achieving macroeconomic stability is an Figure 4.2 Pattern of government expenditure on selected categories, 1990–2002
(% of total expenditure).
Source: United Nations Online Network in Public Administration and Finance (UNPAN).
essential prerequisite. What are the issues and what is the record in this regard, however?
The three principal instruments used to conduct macroeconomic policy are fiscal policy, monetary policy and exchange rate policy. In the previous sec- tion we examined government revenue raising and expenditure but, from a stability perspective, the crucial issue is the overall fiscal balance. That is to say, a government that consistently spends more revenue than it obtains runs an overall fiscal deficit, which must ultimately undermine macroeconomic stability – not least through the temptation to print money to finance the deficit.
Table 4.3 illustrates the recent record in this respect, comparing central government fiscal balances between developed and developing countries on the one hand, and between the developing regions on the other. As we can see, the aggregate picture for developing countries – while still in deficit in 2006 – has shown a steady improvement from the late 1990s. In contrast, the trend for aggregate balances in developed countries has gone in the other direction, with the situation in 2006 being considerably worse than was the case in 1998 – though an improvement on the low point of 2003.
From a regional perspective, all have seen an improvement over the period, with Eastern and Central Europe showing the least progress and Africa showing the most. Indeed, of all the categories and regions considered, it is only Africa that ends the period with a central government fiscal surplus.
Turning to monetary policy, the key to stability is control of the rate of inflation. Various approaches to this have been adopted over recent decades, which have been more or less successful. From the late 1970s and early 1980s, the monetarist prescription of controlling the money supply as a means of
Figure 4.3 Central government fiscal balances, 1998–2006.
Source: IMF WEO.