BA DEGREE STAGE 4: ECONOMICS EXAM APRIL 2007 SECTION C QUESTION 1

How much government does a modern economy need?

Background /Introduction
Government plays a very prominent role in the economies of developed countries as a: Spender Taxer Employer Government has a very important economic role to play in: Regulating behaviour of businesses & individuals Delivering goods & services Contribute to economic growth Redistributing income At the end of the Cold War, there was a change in emphasis away from the State provision and a move towards market domination, heavily influenced by the work of classical economists It is in this context that I will endeavour to bring my perspective on how much government a modern economy needs.

Regulatory Role
It is the responsibility of government to put in place the legal and regulatory framework to enable business to take place It is fundamentally important to an efficient economy that property rights are protected and contracts enforced Both the 2008-2012 Business Environment Ranking of the Economist Intelligence Unit and the World Banks Ease of Doing Business index, compiled on an annual basis, rank the worlds economies on the basis of ease of doing business. The criteria used by both are directly related to the regulatory environment in a country.

Both of these indices illustrate the vital role played by government in putting in place a stable political environment and an effective regulatory system to ensure economic success This is particularly vital to small open economy in an era of globalisation. In an Irish context, this has been one of the primary factors in the attraction of such a high level of Foreign Direct Investment into this country, a sector that directly employs almost 140,000 people. In the most recent results for the period up to May 2009, Ireland is ranked 11th globally out of 82 countries and seventh from 183 countries respectively. The regulatory role of government has come under close scrutiny in recent times in relation to the current financial crisis Until relatively recently, nudge intervention was the favoured approach used by the vast majority of governments in regulating the financial markets. However, the current crisis has led to a questioning of the appropriateness of this approach. The current financial and economic crisis makes a strong argument for a greater regulatory role for the state and its agencies in overseeing the effective operation of the financial system. The challenge for government now is to adapt the regulatory system to meet todays needs rather than the needs of a market which has changed utterly in recent times.

Delivering goods & services

As stated at the outset, there has been a move away from direct public provision However, in all economies there is still a role for such provision as markets will not function absolutely perfectly and market failures will occur One such failure relates to public goods. Public goods are goods which will either not be supplied at all by the market or will not be supplied in sufficient quantity to meet demand. By its nature, a public good is both non-excludable and non-rival. If the good is available to one individual in the economy, it is available to all and the consumption by one person will not affect the amount available to anybody else.

Thus, the state must provide street lighting as, if this were left to the market, it is likely that many areas of towns and cities would be left in the dark as citizens would not pay for the provision of same. Another source of market failure is externalities. These occur when the action of one firm or individual impacts on another are and hence are a reason for government involvement in the economy. Musgrave defines the foregoing as The Allocation Function of Government.

Redistributing Income
Markets, if left to their own devices, will ensure that some people will get very rich and others will remain very poor. From a societal perspective, this is not the ideal outcome and thus the role of government is to try and ensure a more equal distribution of wealth amongst citizens. Governments endeavour to redistribute wealth in various ways including such measures as transfer payments, e.g. Job Seekers Allowance, a progressive income tax system with higher rates imposed on the higher earners and VAT with zero rating on food and higher rates on luxury goods The recent Commission on Taxation Report made a number of recommendations around ensuring equity in the system but these have been shelved for the time being at least

Assessment of the level of government involvement in the economy

There are a number of factors to be considered in determining the level of government an economy needs. The stage of development of the economy is the first consideration. The level of government intervention, for example, needed to protect infant industry in a SOE like Ireland is negligible when compared to what may be needed in one of the new Baltic republics The level of public indebtedness must also be considered. In Ireland, the level of national debt has risen from 12% of GDP in 2007 to 41% of GDP in 2009. The government has taken a much more direct role in the economy. The importance of this intervention can be measured by the reaction of the money markets which has a direct impact on the cost of borrowings

The extent of market failure in an economy will also determine the level of government involvement. Carbon taxes are a direct state response to the negative externality that is pollution. Water charges are likely to be introduced in this country in the next budget. The development of a knowledge is seen as critical to Irish economic recovery which will see a strong state emphasis on the delivery of the public good, education Demographics must also be considered. As the age profile increase in western countries, provision must be made for the increase cost of pensions and a greater level of healthcare provision. One percent of GDP has been put into the National Pensions Reserve Fund on an annual basis. The recently announced National Pensions Framework is proposing some very fundamental reforms Political ideology and voter preference are important. A SOE may tend to vote for a higher social safety net than bigger closed economies. Election cycle may have an impact with more voterfriendly economic policies introduce close to election in an effort to retain control and power The trend has been to privatisation in a drive towards maximising efficiency of public service delivery. OECD recommends a greater sharing of services in order to deliver a more integrated public service

Conclusion
Role of government never more important than in the current financial & economic crisis Despite the policy trend away from direct government provision, the OECD average is government represents 40% of the economy and provides on average 14% of employment Citizens are increasingly looking to governments to solve problems at a time when they are facing major deficits with strong pressure to reduce public spending Must be a rethink on long-term growth strategy to improve productivity and competitiveness Government needs to be agile and respond quickly We do not want to revert to the situation in Ireland in the 1980s where government represented 60% of the economy in Ireland

The level of government that an economy needs can only be established on the basis of empirical evidence to ensure the most appropriate response and to quantify the exact level of intervention

(Very important reference for this question OECD Report Governance at a Glance)