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Al 13 - chapter 8

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  2. 08 : Investigates the Type of Intervention of the Government to Achieve Macroeconomic Objectives. • 8.1 Logically represents the reasons for market failure. • 8.2 Examines the effects of externalities on market failure. • 8.3 Investigates the role of the government in a market economy. • 8.4 Investigates the use of Fiscal policy to achieve macro economic objectives. • 8.5 Investigates the tax system as a major source of government revenue. 2
  3. • 8.6 Reveals recent changes in the composition of government expenditure. • 8.7 Analytically investigates economic effects of government budgetary policies. • 8.8 Investigates the government budget and its economic effects. • 8.9 Investigates the composition and trends of public debt in Sri Lanka. • 8.10 Analyses economic effects of supply promotion policies of government. 3
  4. The Failure of the Market System • The term market failure describes any market performance that is judged to be less good than the best possible performance. • In other words. Market failure means that the best attainable outcome has not been achieved; it ones not mean that nothing good has happened. • The phrase market failure applies to 2 quite different sets of circumstances. One is the failure of the market system to achieve efficiency in the allocation of societies resources. The other is the failure of the market system to serve social goals other than efficiency, such as achieving desired distribution of income or preserving our value systems. 4
  5. Failure to Achieve Efficiency • There are five broad types of phenomenon that led to inefficient market outcomes, I. Imperfect Competition. II. Externalities. III. Absence of Property Rights. IV. Public Goods. V. Imperfect Information. • Now we will examine each respectively. 5
  6. Imperfect Competition. • Economic efficiency is likely o be present in a market where there are many buyers and sellers. But in many markets , there are either only a few buyers or a fewer sellers. In the railway industry, for instance most travelers have no choice about which company to use on a particular journey. In the water industry, households are forced to buy their water from one company. In Sri Lanka soap and detergent powder market, may be 1 firm dominate the sales. • On the other hand , the defense industry, the Sri Lankan government is the only buyer of those goods and services. • Trade unions would like to be in a position where only union members work in a place of work. Where there is imperfect competition, there is likely to be market failure. 6
  7. • Firms which dominate their markets, for instance, will attempt to charge high prices in order to make greater profit. But they can only do this by restricting supply to the market, denying customers the ability to buy as much competitive. • This leads to allocative inefficiency. Trade can push up costs to firms if they are successful in getting higher wages for their members than the market rate. This leads to productive inefficiency. 7
  8. Allocative Inefficiency of Monopoly 8 0 Qm Q0 MR D MC (Monopoly) = S (Competition) P0 Pm Em Price Quantity Competitive Price 5 6 1 2 7
  9. • Monopoly is allocatively inefficient because it produces less than the competitive output and thus does not maximize the sum of consumers and producers surplus. • If this market were perfectly competitive, price would be Po, output would be Qo, and consumers surplus would be 1, 5 and 6. when the industry is monopolized, price rise to Pm and consumers surplus falls to 5. consumers lose area would be 1, because that output is not produced. They lose area 6, because the price rise has transferred it to monopolist. 9
  10. • Producers surplus in a competitive equilibrium would be the sum of 7 and 2. when the market is monopolized and price rises to Pm, the surplus area 2 is lost, because the output is not produced. • However the monopolists gains area 6 from consumers.(6 is greater than 2, because Pm maximizes the profit). While 6 is transferred from consumers to producers surplus by the price rise, areas 1 and 2 are lost. They called as deadweight loss resulting from monopoly. • For all output between Qm and Qo, the value of the output to consumers, given by D, exceeds the cost of production, given by MC. Thus, failure to produce this output reduces consumers plus producers surplus. 10
  11. Externalities • If the market system to work well, it is important that the people who make economic decisions are those who are affected by those decisions. A transaction between a supplier and a consumer for a product needs only to affect the supplier and consumer involved. As long as this is the case, then both sides will act only so long as both feel that they will benefit from any action-all is well in the market. • However, a problem could clearly arise if someone else, not party to the economic decisions, is affected by that decisions, this is the economic concept of externality. 11
  12. • An externality is said to arise if a 3rd party (someone not directly involved) is affected by the decisions and actions of others. Example – if you decide to shout loudly to your friend in pubic, then others (3rd parties) not involved in making that decisions are affected by the assault on other ear drums. 12
  13. An “externality occurs if privet production or consumption of a product imposes involuntary economic costs or benefits on others.” 13
  14. Privet & Social Costs • There are 2 costs involved in producing goods and services. Eg. Electricity. One is internal costs, such as for purchasing land, labour, capital and fuel. The other is an external cost, such as the cost of pollution damages to the community. The social costs of producing electric power are sum of the 2 costs mentioned above. • Internal costs are the opportunity costs a firm or consumer incurs by producing or consuming a good. External costs are the costs borne by others (external to the firm or consumer) because a good produced or consumed. • The social costs of production are the privet costs plus the external costs. 14
  15. Privet & Social Benefits • Similarly, the social benefits of consuming my stereo (speakers) are sum of the internal, or privet, benefits plus the external benefits (or minus the external costs) to my neighbor. • The social benefits of consumption are the privet benefits plus the external benefits. The privet benefits are those that mount up solely to the decision maker. 15
  16. Externalities of Consumption • Benefits or losses born to an external party due to a consumption activity is identified as externalities of consumption Examples of positive externalities of consumption are; • educational T. V. programmes Examples of negative externalities of consumption are; • collection of garbage • emission of smoke (fumes) from vehicles. 16
  17. Externalities of Production • Benefits or losses borne by an external party due to a production activity is identified as externalities of production. Examples of positive externalities of production • Research focused on new technology • Beautiful gardens Examples of negative externalities of production are; • Industrial activities that burn fossil fuels. • Industrial activities that deplete the ozone layer.17
  18. Socially Optimum Level of Output and Market Failures. • If MSB > MSC, then it is said to be socially efficient to produce more (or to consume) more. On the other hand, if MSC > MSB, then it is socially efficient to produce (or consume) less. It follows, therefore, that if MSB = MSC, then the current level is optimum (socially equilibrium). • Hence, the socially optimum level of output occurs where MSB = MSC. • However, in the real world, the market rarely leads to social efficiency. The Marginal Social Benefit of most goods and services do not equal the Marginal Social Cost. This is due to externalities, whether adverse or beneficial, which cause market failure because they lead to allocation of resources that are non-optimal from the society's point of view. As noted, the price system considers only private costs and private benefits, and ignores any external costs and benefit. Hence, private producers produce too much of commodities that generate harmful externalities because they bear none of the costs suffered by others. In other words, external costs result in a level of output greater than the social optimum. This can be illustrated as follows: 18
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  20. • The MPC curve represents the supply curve of the industry, and assumes no external benefit, MSB is also the MPB and the demand curve for the industry. As the private producers reaches equilibrium where Demand = Supply (consider only their private costs and private benefits), the equilibrium output of the industry id thus 0QE. MSC lies above MPC as MSC includes both MPC and MEC. • The socially optimum output would be 0Qs, where MSB = MSC. Thus, in terms of socially efficiency, there is an overproduction of goods which generate negative externalities. By summing the excess of MSB and MSC for the units between Qs and Qe, a monetary measure of the welfare loss to society is occurred (shaded area). 20
  21. • In the same sense, activities which generate positive externalities can also bring welfare loss. Private producers will tend to produce too little of commodities that generate beneficial externalities because they bear all the costs, while others reap part of the benefits. This is illustrated as follows: 21
  22. • The MSB is greater than the MPB since there are external benefits. The socially optimum level of output is OQs which is above the equilibrium output that would occur in an "uncorrected' free market, 0QE. • In other words, when there are positive externalities, there is a tendency for underproduction of the product in question. The shaded area shows the welfare loss brought by underproduction. • From the above expose, it can be deduced that whenever there are external benefits, there will be too little produced or consumed. On the other hand, whenever, there are external costs, there will be too much produced or consumed. The market will not equate marginal social benefit and marginal social cost. 22
  23. Government Intervention to Deal with Externalities • When there are imperfections in the market, social efficiency will not be achieved. Marginal social benefit will not equal marginal social cost. A different level of output would be more desirable. Hence, the government has a number of instruments it can use to change the way markets operate. These include taxes, subsidies, laws and regulatory bodies. The more efficient method to correct these imperfections is taxes and subsidies. • Essentially the approach is to tax those goods or activities where the market produces too much, and subsidize those where the market produces too little. The government should impose a tax on each unit of output, where the amount of tax is equal to the amount of pollution (MEC). Hence, the externality will be internalized by the imposition of the tax. This means the government will make the externality to enter into the firm's own calculations of its private costs and benefits. As a result, output would be reduced to the desired level. Assume, for example, that a chemical plant emits smoke and thus pollutes the atmosphere. This creates external costs for the people who breathe in the smoke. This can be illustrated as follows: 23
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  25. • The firm produces output 0QE where MPC = MPB (demand = supply), and in doing so, it takes no account of the external pollution costs it imposes on society. If the government imposes a tax on production equal to the Marginal pollution cost (MEC), it will effectively internalize the externality. • The firm will have to pay an amount equal to the external costs it creates. It will, therefore, now maximize profit at OQs, which is the socially optimum output where MSB = MSC. Similarly, in the case of positive externality, the government has to grant subsidies equal to the MEB. This can be illustrated as follows: 25
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  27. • Consider the demand and supply conditions for education. The market reaches equilibrium at output OQE. The government examines that there involves a positive externality. Hence, the government has to encourage the consumption of such good so that the whole society will benefit and grant subsidies on education. The subsequent effect is that the quantity consumed rises to OQs, the socially optimum level of output where MSB - MSC. 27
  28. Effectiveness of Implementing Taxes and Subsidies 1. Many economies favor the tax / subsidy solution to the problem of externalities because it still allows the market to operate. It forces firms to take on board the full social costs and benefits of their actions. It also has the flexibility of being adjustable according to the magnitude of the problem. For example, the bigger the external cost of a firm's actions, the bigger the tax can be. 2. Firms are encouraged to find socially better ways of producing. The tax, thus, acts as an incentive over the longer term to reduce pollution. The more a firm can reduce its pollution, the more taxes it can save. Likewise, when granting subsidies, firms are given the incentive to adopt more good practices. 3. Taxes will raise revenue for the government. 28
  29. Drawbacks of Implementing Taxes & Subsidies 1. However, it would be administratively very difficult and expensive to charge every offending firm its own particular tax rate or grant every relevant firm its own rate of subsidy. Given that costs and revenues differ substantially from one firm to another, separate tax and subsidy rates would be needed for each firm. Hence, an army of tax inspectors would be necessary to administer the system. 2. Even if government decides to charge a tax equal to each firm's MEC or grant subsidy equal to MEB, it would still have the problem of measuring these costs and benefits. It is very difficult to estimate the value of the MEC and MEB in monetary terms. 3. Imposition of polluting tax to cure negative externalities may also lead to inflationary pressure in the country. Hence, a government should be very cautious when imposing tax on its country's industries since it is likely to make its products more expensive than those of foreign competitors. 29
  30. Other Measures 1. Laws - The firms could be prohibited by law from producing more than socially optimum, output. Various polluting activities could be banned or restricted. 2. Regulatory bodies - Having identified possible cases where action might be required, the regulatory body would probably conduct an investigation and then prepare a report containing its finding and recommendations. 3. Persuasion - Government runs public campaign to try to limit the problem. 4. Nationalization - Firms with associated externalities could be taken into public ownership and their output controlled to take account of social costs and benefits. 30
  31. Public Goods / Pure Public Goods • A pure public good can be defined as one which is consumed collectively by all members of a society. Although it is produced by an individual no one can be excluded from its consumption even if one does not pay for the good. No price can be charged or no profit can be made from these products. • Production of public goods generates benefits which go to all the members of a society whether intended or not. These goods are supplied by the government using tax revenue. No marginal cost occurs to provide them to an extra consumer. Example, light houses, clock towers, street lights, public well, national security, weather forecast, coastal conservation, environmental conservation. 31
  32. Two Characteristics of Public Goods • Non Rivalry – consumption of the good by one person does not reduce the amount available for consumption by another person. The marginal cost of a PG to additional consumption is zero. • Non Excludability – once provided, no person can be excluded from its benefits or effects ( or indeed suffering in the case of public good like pollution). These are only provided by the government. Example, defense, judiciary, prison, police, street light, education, health. 32
  33. Semi Public Goods / Quasi Public Goods • The goods and services that are collective in consumption, excludable and non rival are called as semi public goods. Though there is price for such goods, consumption by one person does not prevent consumption by others. • They seem similar to pure public goods. But the ability to charge a price and ability to exclude those who are not willing to pay this price, differentiates pure public goods from semi public goods. Example, Electricity, Water and Transport Services. 33
  34. Merit Goods • Goods or services provided free for the benefit of the entire society by a government, because thy would be underprovided if left to the market forces or privet enterprise. • Example, Education, Health Care. 34
  35. Demerit Goods • A good which is considered unhealthy or damaging in some way. A demerit good can be physically harmful (cigarettes), mentally harmful (gambling), or morally harmful (prostitution). In many cases, demerit goods are subject to additional taxes in an effort to reduce consumption. • Example, excise taxes, legal control by laws and fines. 35
  36. ROLE OF THE GOVERNMENT IN THE MARKET ECONOMY. • All economic concepts such as tax system, sources of government revenue, government expenditure, nature of the budget, its practical results, methods of financing the budget deficit, sources of internal and external debts of the government in a particular year are referred to as public sector economy. • The relative importance of the public sector in the economy is different from country to country. Government contribution is relatively high in planned economies whereas the same is low in market economies. In Sri Lanka the government contribution was relatively high up to 1990s and then it had gradually declined afterwards. 36
  37. Government Role in a Market Economy can be as follows • Allocation/distribution of resources efficiently. • Distribution of income and wealth fairly/equally. • Formulation of rules and regulations and good governance. • Stabilization of macro - economic policies. • Achieving economic development and sustainable development. • Provision of infrastructural facilities. 37
  38. The Government has taken the following action to minimize inefficiency in the market economy. • Production of public & welfare goods. • Prevention of imperfect competition. • Greater focus on the prevention of externalities like environmental pollution. • Ensuring the ownership of public resources. 38
  39. The Government Takes Following Actions To Ensure Equity. • Redistribution of income and wealth. • Limitations on assimilation of wealth. • Land reforms. 39
  40. • The government makes use of fiscal policy to minimize inflation and unemployment in order to achieve macroeconomic stability. The government endeavors to increase the level of economic development and the level of development of the country. • The government provides the following in order to develop infrastructure facilities. • Provision of physical Infrastructure facilities. Example; Main roads, highways, bridges, airports, buildings. • provision of institutional infrastructure facilities. Example; Legal structure, courts, regulatory institutions. 40
  41. Government Intervention • All governments in the world intervene the market to a greater or lesser extent and the reasons for the intervention vary enormously between them. However, the justification for intervention is usually given under 2 broad headings; “Market failure and the desire to achieve a fair or equitable distribution of resources in economy.” 41
  42. • The 1st intervention occurs when markets do not allocate resources efficiently and the 2nd is concerned with ensuring that all members of the society have fair access to goods and services. • The role of the government is to intervene in markets that are not seen to be allocating resources in the most efficient or equitable manner. When government attempt to achieve this aim it must be recognize that there is also the possibility that they will fail and create rather than remove distortions. 42
  43. Methods of Government Intervention • Government policy and the methods of intervention can be summarized under 4 broad headings; Regulations, Financial Interventions, Production and Transfer Payments. • The method chosen will depend to a large extent on whether the reason for intervention is concerned with market failure or with the desire to achieve equity. 43
  44. Regulations • The government uses a large number of methods of regulation as a means of controlling a market. Legal and other methods are used to control the quality and quantity of goods and services that are produced and consumed. For example, the government may regulate the sale of certain drugs by making them only available on prescription from a qualified doctor. • Hygiene law's set standards for the production of foods. there ay be controls on shop opening hours or the setting of a minimum age at which a person can buy certain products such as alcohol, cigarettes. 44
  45. • Other forms of regulation may include the requirement for an individual to purchase an insurance policy before being legally permitted to drive a car, the age at which people are required to attend school and the payment of social incurrence contributions. • Regulation may not apply to the quantity and quality of gods and services sold but may also refer to prices. Examples of price controls include minimum wage legislation, maximum price and rent controls. 45
  46. Financial Intervention • Financial tools, such as taxes and subsidies, are also frequently used by governments to influence production, prices of commodities, incomes or the distribution of wealth in an economy. • Price subsidy may vary. They might be in the form of a partial subsidy, as in the case of public transport, or total, as in the case of free health care and free education. 46
  47. • Tax instruments may also vary. For example, excise tax, which contributes 15% of the total tax revenue during 2010, is levied mainly on liquor, tobacco, petroleum, and motor vehicles. • Governments also provide the finance that is needed to produce a good or service. It is very important to note at this early stage that just because the government provides finance for a product, it does not necessarily mean it has to produce the product too. For example, the government could finance education but some schools, universities are privately owned and run. Health care may be provided free but the drugs used in prevention and cure of illness could be privately produced. 47
  48. State Production • In addition to providing the finance it is also possible for a government to take over the production of a good or service, either in whole or in part. State owned industries are often referred to as nationalized industries. Industries such as the electricity, coal, mining and railway industries are entirely owned by the state in many countries. • It is very important and common to find some goods and services being produced by both the state and privet sectors. Education and health care are particularly good examples of these types of service industries. National hospitals and government schools function alongside and privet hospitals and schools also function separately. 48
  49. Income and other Transfers • Income transfers are used by the governments as a means of redistributing income or transferring income from one group to another group, for example, from people in work to those who are retired or from relatively rich people to those who in poverty. • The justification for these transfers is to achieve fairness or equity in an economy. These transfers of income may be in the form of cash benefit paid by the government to someone with a low income. This may be used to cover the unexpected loss of income when a person is not working due to illness or unemployment. These cash transfers include social security benefits, such as income support, a job seekers allowance or a state pension. in Sri Lanka such as, PinPadi, state pension, EPF & ETF. 49
  50. The Impact of Government Intervention in the Market. • A rational assessment of government intervention requires an assessment of costs as well as the potential benefits. They are; • Internal Costs refers to the governments costs of administering its policies. Example, government inspections on health standards, industrial safety and environmental protection. • Direct External Costs refer to the costs imposed on the non government sector by these policies in such terms as extra production costs, costs of compliance and losses in productivity. 50
  51. • Indirect External Costs refers to the efficiency losses resulting from the alternations in price signals caused by government tax and expenditure policies. Example, regulating new drugs to enter market which are not safe, control of price of goods and services. 51
  52. Government Failure • Government Failure – not achieving some possible gains – can arise because of rigidities causing a lack of adequate response of rules and regulations to changing conditions, poorer insight on the part of the government regulators compared with private participants in the market, and government objectives – such as winning the next election – that conflict with such objectives as improving economic efficiency. 52
  53. The Causes for Government Failure • Imperfect knowledge or foresight – regulators may not know enough to set correct standards. Example, natural gas prices. • Rigidities – regulatory rules and allocations are hard to change. Example, technological changes. • Inefficient means – government may fail to choose the least costly means of solving a problem. • Myopic regulations – regulation may become too restricted and too narrowly defined because the regulators are forced to specialize. Example, railroad industry. • Political constraints – political reality may prevent the right policy from being adopted, even when it has been clearly identified. • Decision makers objectives – governments own goals and objectives with respect to their political thoughts. 53
  54. The Fiscal Policy to Achieve Macroeconomic Objectives • Fiscal policy is the management of the government budget to attain price stability, near full employment, and a satisfactory rate of economic growth. • To attain these goals, the government must manage its spending and taxes. 54
  55. • Fiscal policy is usually relating to taxation, government spending and public debt, with the instruments of full employment, price stability, and economic growth. • The instruments of fiscal policy are; Public expenditure Taxes Public debts 55
  56. Fiscal Policy EXPANSIONARY FISCAL POLICY – increase in government expenditure & or a decrease in taxes that causes the government budget deficit to increase or its budget surplus to decrease. CONTRACTIONARY FISCAL POLICY – decrease in government expenditure & or an increase in taxes that causes the budget deficit to decrease or its budget surplus to increase. 56
  57. The use of Fiscal Policy to Achieve Macroeconomic Goals.  Full Employment.  Price Stability.  Economic Growth.  Balance of Payments stability.  Equity in Income and Wealth Distribution.  Sustainable Development. 57
  58. Full Employment • Achieving the objective of full employment means holding national product at its potential, or full employment level. It does not mean achieving zero unemployment. Indeed, zero unemployment is an impossibility in any real economy because of the normal turnover of labour. • Turnover occurs because people leave one job to take, or look for, another, and because there are always some people leaving the labor force due to retirement, or death, and others entering it. • As a result, there is always a pool of people who are unemployed because they are currently between jobs or looking for their 1st job. Such unemployment, which is due to the normal turnover of labour, is called frictional unemployment. It is the amount of unemployment that exists when output is at its potential level. 58
  59. • Accordingly, a more realistic interpretation of full employment suggests itself; full employment is achieved when the number of registered unemployed people is equal to number of job vacancies. • The labour market consists of 2 groups, namely households who supply labour and firms who demand labour. • When the supply of labour is equal to the demand for labour, the economy is in fully employment. When labour supply exceeds the demand, there is surplus labour. This results in unemployment in the economy. This is a major economic problem in Sri Lanka since independence. 59
  60. LABOUR FORCE ECONOMICALLY ACTIVE POPULATION – persons who are employed and who are willing to work, but unemployed. ECONOMICALLY INACTIVE POPULATION – who are unable to engage in productive employment, they include children, elderly and disabled. 60
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  62. • In Sri Lanka the overall employment levels remained stagnant until the late 1970s. Slow economic growth during that period did not permit to absorb the growing labour force in that period. • With the economic liberalization of the economy in 1977, the GDP growth accelerated and more jobs were created in the newly growing sectors like manufacturing , banking and financial services, construction and trade. As a result , the total employment rose from 3.8 million in 1973 to 4.7 million by 1981/82. it reached 6.4 million by 2002. • Today, Sri Lanka’s total labour force reached to 8.864 million by 2013 compared to 8.254 million in 2012. 62
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  64. Price Stability • Economic and price stability is a situation where there are no wide fluctuations in the general price level in an economy which helps to achieve sustainable economic growth. When the prices fluctuate at a low rate, they would not have any significant influence on economic decisions of participants of an economy, viz. households and firms. • Therefore, stable prices would not distort the economic decisions regarding what to produce and how to produce, thus enabling efficient allocation of resources in the economy leading to economic stability. 64
  65. • Price Stability is the economic term used to refer to a situation where the general price level covering Consumer goods remains unchanged or if it does change, it happens at a low rate so that it is not strong enough to make any significant influence on economic decisions of participants in an economy, viz. households and firms. • We encounter prices in different forms in our daily activities as buyers or sellers when we get engaged in consumption, investment, production or trade. • In a market economy, price changes are a common phenomenon depending on the demand for and supply of goods and services. Since prices change in both directions and in different magnitudes, it is difficult to figure out the general movement in prices by examining each individual price change in isolation 65
  66. • The price level is usually examined through a “basket of goods” approach, in which a collection of consumer based goods and services are examined in aggregate; changes in the aggregate price over time will push the index measuring the basket of goods higher. • Price levels provide a snapshot of prices at a given time, making it possible to review changes in broad price level over time. • As price rises (inflation), or fall (deflation), consumer demand for goods is also affected, which leads broad production measures like gross domestic product higher or lower. 66
  67. Economic Growth • Economic growth is a major concern of Macroeconomics. Economic growth means a rise in real income or real output. • Very often, economists use the rate of change of national income to measure economic growth. • Most of the countries measure the GDP growth in real terms. Economic growth in a particular year is measured as the rate of change in real GDP over the previous year.67
  68. • Sources of economic growth ; the total output or GDP of an economy depends on the quantity and quality of various resources that are used as inputs in production. These include land , labour, capital and raw materials. Producers can raise their output by the following 2 methods: By increasing factors of production: land, labor, capital and raw material. By increasing the productivity of factors of production: this means an increase in output with the same quantities of inputs. This can be achieved by several ways: A. By improving human capital through skills development. B. By technological progress. C. By adopting new management techniques. 68
  69. Balance of Payments Stability • Maintenance of equilibrium in the external payments positions, known as the balance of payments equilibrium and also is one of the macroeconomic goals. • Continuous external deficits reduce the country's capacity to import and leads to an accumulation of foreign debt. Hence it is important to reduce the external deficits. The main policy instruments that are used to attain macroeconomic stability is the fiscal policy. 69
  70. • The use of government spending, taxation and borrowings for the achievement of macroeconomic stability. The monetary policy also known as the management of the money supply, cost of money and credit conditions by the central bank so as to achieve macroeconomic goals. • These two sets of policies are closely interrelated, and they may be contradictory at times. For example, when the government runs a high budget deficit, monetary authorities would find it difficult to mange the money growth. 70
  71. Income & Wealth Distribution • Justice or fairness in the manner in which the economy’s output is distributed between individuals. distributional equity is some times expressed in terms of the distribution of income, of wealth. • This is also a policy concerned with altering the pattern of the personal distribution of income in an economy, mainly with social rather than economic objectives in mind. • The general aim of such a policy is to achieve a more equitable distribution of income as between the various sections of the community so as to ensure that everybody is provided with some minimum standard if living. The transfer of income from one section to another is achieved primarily by the use of a progressive taxation system and a verity of welfare provisions. Example. Housing schemes, old age pensions, etc. 71
  72. Sustainable Development • Sustainable development is the development which meets the needs of the present generation without compromising the needs of future generations. • The term 'sustainable development' was used by the Brundtland Commission, which coined what has become the most often-quoted definition of sustainable development: "development that meets the needs of the present without compromising the ability of future generations to meet their own needs. 72
  73. • In 1987, the United Nations released the Brundtland Report, which included what is now one of the most widely recognized definition said above. • The concept of sustainable development divided in to three constituent parts: environmental sustainability, economic sustainability and socio-political sustainability. • In real terms all the macroeconomic variables should be directed towards economic development so as to mange the domestic economy successfully. 73
  74. • According to the Brundtland report, the above definition contains main two key concepts: • the concept of 'needs', in particular the essential needs of the world's poor, to which overriding priority should be given; and • the idea of limitations imposed by the state of technology and social organization on the environment's ability to meet present and future needs. 74
  75. Issues in Achieving Macroeconomic Goals. • A central issue in macroeconomics is whether or not markets, left alone, automatically bring about long run economic equilibrium. If the free operation of market forces eventually resulted in a full employment level of national income with stable prices and economic growth, there would be no need for government intervention in the macro economy - no need for fiscal, monetary ,exchange rate and supply side policies. • The reality is that all governments intervene through their macroeconomic policies in a bid to achieve certain policy objectives and improve the overall performance of the economy. 75
  76. Demand Management • Demand management occurs when the government attempts to influence the level and growth of AD hence the levels of national income, employment, rate of inflation, growth and the balance of payments position. • Reflationary policies seek to increase AD and raise the level of planned expenditure at or near the level of potential GDP. • Deflationary policies decrease AD in the event of aggregate demand running ahead of AS and posing inflationary risks or leading to an unsustainable deficit on the balance of payments. 76
  77. The Main Problems of Managing the Macroeconomy • The government’s task of managing the economy is made difficult by several factors some of which are discussed below: • Inaccurate Economic Data: All of the main macroeconomic indicators are subject to a margin of error. They rely on statistical data collected from tax returns and surveys and data is often revised many months after its first release. 77
  78. • Conflicting Policy Objectives: A policy of stimulating aggregate demand may reduce unemployment in the short term but initiate a period of higher inflation and make worse the current account of the balance of payments. Choices have to be made between objectives i.e. there exist trade- offs between them. • Selecting the Right Policy Instrument: Each macroeconomic objective requires a separate policy instrument: The usual ‘rule of thumb’ is that one main policy instrument should be assigned to one policy objective. • So, for example, interest rates might be assigned as the main instrument for keeping control of inflation, whilst fiscal policy instruments such as changes to the tax system might be allocated to achieving some supply-side objectives such as increasing the labour supply, boosting incentives, raising investment and increasing productivity. There are quite deep- rooted disagreements between some economists (who belong to different ‘schools of thought’) as to which policies are most effective to meet a certain objective. 78
  79. • Uncertain time lags when running a policy: Changes in economic policies are subject to uncertain time lags e.g. a change in interest rates is estimated to take some 18- 24 months to work its way fully through the whole economy to filter through to a change in prices. The length of the time lags can change over the years as the reactions of consumers and businesses to policy measures alters. • External shocks: Unexpected external shocks to economy such as the events surrounding Sept 11th 2001 or unexpected volatility in exchange rates and commodity prices can upset economic forecasts and take the economy some distance from the expected path. The Government might under-estimate or exaggerate the potential impact of an economic shock to either the demand or supply-side of the economy and therefore apply too little or too much of a policy response. 79
  80. The Tax System as a Main Source of Government Revenue. • What is tax? Tax is a legal obligation which impose a financial charge or other levy upon an individual or legal entity by a state or the functional equivalent of a state. • Tax is not a voluntary payment or donation, but an enforced contribution, exacted pursuant to legislative authority. In modern time taxation systems, taxes are levied in money. raising the tax rates were being a severe issue in Sri Lanka. • There are 2 major revenue sources of the government which are; tax revenue and non tax revenue. 80
  81. The Principle of Taxation • Since the general public believes government has the authority to impose tax on them and the government should also have a responsibility not to over burden the general public using the tax. Thus the government should obey the following principles of taxation when a tax is imposed. 81
  82. Principle of Equity • This tax principle enforces the just or the fairness of the tax system. In this it prescribes to tax on general public considering “ ability to pay or ability to bear the burden of the tax.” under this concept there are 2 main suggestions are presented. • Horizontal equity – this is achieved when people in the same financial circumstances pay the same amount of tax. • E. g. 2 persons who get the same income should be taxed similarly. 82
  83. • Vertical Equity – people in the different income levels should be taxed differently. E. g. – higher tax from higher income earners and low tax from less income earners. • Principle of economy – the cost of tax collection and administration should be small in relation to the total revenue for both the government and tax payer. • Principle of convenience – taxes should be convenient for tax payers to pay and for the government to collect. Otherwise tax payers will be demotivated to pay the tax. • Principle of certainty – this suggests the tax system the way in which the tax is imposed should not be changed frequently. If the ax system changes frequently investors and other parties cannot predict the tax payments that they should pay in the future. This will demotivated the tax payer. • Principle of efficiency – tax should not be reduce the economic efficiency and ideally increase it. E. g. taxes on environmental pollution, taxes on demerit goods. 83
  84. • Principle of flexibility – a tax should be capable of being changed to meet changing economic conditions and changing government objectives. • Principle of neutrality – neutrality refers to the absence of distortions of the market mechanism and adverse effect in the economy. That is a tax should not adversely effect on economic agents. When a tax is imposed it should cause minimum affects on consumption, production, investments, savings. 84
  85. Taxes Direct tax – is the tax where the burden of the tax is owned by the tax payer himself and there is no possibility to transform the burden to another. E. g.- income tax Indirect tax – these are taxes on expenditure, which can be transferred to other. When the government imposes an indirect tax on producers, they can transfer the tax burden to consumers by raising the prices of the products. 85
  86. Progressive Tax • This is a tax method where there is a positive relationship between the income and the tax rate. If the income of individuals goes up the tax rate also responds in a positive way. • Income Tax • 10,000 10% • 20,000 20% 86
  87. Proportionate Tax • If the tax rate or the ratio does not vary with tax base (income), such tax method is called proportionate tax. • Income Tax • 10,000 10% • 20,000 10% 87
  88. Regressive Tax • This is the tax method where there is negative relationship between tax base and tax rate. That is the tax rates decreases when tax base (income) increases. • Income Tax • 10,000 10% • 20,000 8% 88
  89. • According to the budget for 2013, total government revenue in 2013 is estimated to increase by 19.6 % to Rs. 1247.5 billion. • Total government revenue as a percentage of estimated GDP, declined to 5.5% during the 1st half of 2013 from 6.9% in the same period of 2012. • The share of the tax revenue in the total revenue increased to 90.4% in the 1st half of 2013 from 88.0 % in the corresponding period of the previous year. • Non tax revenue declined to 9.6% in the 1st half of 2013 from 12.0% in the corresponding same period in 2012. 89
  90. Recent Changes in the Government Expenditure. • The government expenditure is classified in to following 2 categories. • Current expenditure – this is the spending on the day to day running of the public services. E.g. government servants salaries, the purchase of medicines, the pay of those in armed services and the purchase of uniforms, interest payments on public debts etc. • According to the functional classification divided in to 3 main categories. 90
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  93. The Economic Classification of Government Expenditure Current Goods & Services Social Services Economic Services Others Capital Goods & Services Social Services Economic Services Others 93
  94. Current Expenditure. Current Expenditure on Goods & Services. Interest Payments. Current Transfers & Subsidy. 94
  95. Current Expenditure on Goods & Services. • Current expenditure on goods and services is recurring spending or, in other words, spending on items which are consumed and only last a limited period of time. They are items which used in the process of providing a good or service. In the case o government, current expenditure would include wages and salaries and expenditure on consumables – stationary, drugs for health services, and so on. This can be divided in to 2 groups. • Salaries and wages • Other goods and services. 95
  96. Interest Payments This contains 2 main divisions, 1.Interest payments on foreign debts 2.Interest payments on local debts. 96
  97. Transfer Payments and Subsidies. • A transfer payment is a payment which no good or service is exchanged. In other words money has simply been transferred from one person to another without anything being done for it. • This has main 2 components. • Transfer payments to government services and institutions. E.g. railway department. • Transfer payments to households and other sectors. E.g. Samurdhi scheme, pensions, fertilizer subsidy, school text books, uniforms, donations for displaced people. 97
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  100. Capital Expenditure • This is spending on the social infrastructure and includes, e.g. spending on new hospitals, schools and roads. Capital expenditure adds to the country's capital assets. • According to the economic classification, capital expenditure has the following sub divisions. • Achieving of real assets – (capital assets), rehabilitation and maintenance cost. • Capital transfers. 100
  101. • Purchase of properties and buildings are included in capital expenditure on acquisition of real assets. The capital transfers to government co-operations, government office and boards are all included in capital transfers. • Government makes investments directly mainly due to the following reasons. 1) There is a need for the production of some capital goods which are not produced by the private sector in order to ensure economic growth. 2) Provide facilities and services which are needed to create a conducive environment for investments by the private sector. 101
  102. Government capital expenditure and net lending were limited till recent times due to: 1) increase in expenditure in defense. 2) increase in loan payment (payment of interest on loans) 3) increase in current transfers. 102
  103. The following factors have affected gradual increase in government capital expenditure in recent years. • Examples of large scale Infrastructural development projects. 1) Gama Neguma 2) Southern Province rural development projects. 3) Small scale irrigation projects. 4) Rehabilitation and provincial government projects 103
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  106. Functional Classification of Government Expenditure. • Under the functional classification of government expenditure, Both current and capital expenditure are divided in to 4 subsections. They are; • General and public expenditure • Social service expenditure • Economic service expenditure • Other expenditure 106
  107. The Economic Effects of Government Budget Policies • The budget is an account of planed expenditures and expected receipts of the government for the forthcoming year. It is contained in the budget speech presented annually by the minister of finance to the parliament of Sri Lanka. The budget is not only a presentation of government finance, but also a statement of government economic policies. • The fiscal policy of the government is implemented mainly through the budget proposals. The budget id formulated by the general treasury which I under the preview of the minister of finance. The general treasury deals very closely with the line ministers in preparing the budget. 107
  108. Types of Budgets Budget Balanced Surplus Deficit 108
  109. Balanced Budget • A government budget is said to be a balanced budget in which government receipts (revenue and capital) are shown equal to the government expenditure. Balanced Budget = Estimated Gov. Receipts = Estimated Gov. Expenditure. 109
  110. Surplus Budget • When government budget receipts are more than government expenditure in the budget, the budget is called as a surplus budget. In other words a surplus budget implies a situation wherein government revenue is in excess of government expenditure. 110
  111. • A surplus budget shows that government is taking away more money than what it is pumping in the economic system as a result, aggregate demand tends to fall which helps in reducing price level. Therefore in times of severe inflation a surplus budget is the correct one. But in the case of deflation and recession surplus budget should be avoided. Surplus Budget = Estimated Gov. Receipts > estimated Gov. Expenditure. 111
  112. Deficit Budget • When government expenditure exceeds than the government receipts in the budget, the budget is said to be a deficit budget. Deficit Budget = Estimated Gov. Expenditure > Estimated Gov. Revenue. 112
  113. Revenue Deficit • The excess of revenue expenditure over revenue receipts called as revenue deficit. It implies that resources have to be borrowed from other sectors of economy to cover this deficit. It ay lead either to borrowing or sale of government asset thus high revenue deficit give a warning signal to the government either or curtail its expenditure or increase its revenue. Revenue Deficit = Revenue Expenditure – Revenue Receipts. 113
  114. Fiscal Deficit • Fiscal deficit is the excess of total expenditure over revenue receipts (revenue and capital receipt) excluding borrowing. Fiscal deficit therefore, is a compressive measure of the implications for economy. The government has to borrow to meet this deficit, a major part of fiscal deficit is financed by the deficit financing (printing extra currency notes). It leads to rise in the prices. Fiscal Deficit = Total Expenditure – Revenue Receipts – Capital Receipts (excluding borrowing). 114
  115. Primary Deficit • The excess of fiscal deficit over payments of interest is called primary deficit. This shows how much of the government borrowing is going to meet expenses other than interest payment. A lower primary deficit indicates that the interest payment has forced the government to borrow. Thus it indicates the real position of government. This can be calculated as Follows; Primary Deficit = Revenue Deficit – Interest Payments or Primary Deficit = Total Revenue – Total Expenditure except interests 115
  116. How to Correct The Budget Deficit? • Expansionary and contractible budget policies are used to settle the budget deficit. If the loans that are obtained to settle budget deficit increases the money supply in the country, such loans are known as “expansionary loans”. If the loans taken do not affect the supply of money in the economy, they are known as “contractible loans” • Examples of expansionary loans are as follows. Government obtaining loans from the Central Bank. Obtaining loans from the Commercial Banks.  Obtaining foreign loans. • Examples of contractible loans are giving below. Obtaining loans from non-banking institutions. Taking loans from the general public. • Contractible budget policies are more favorable for an economy than expansionary budget policies. 116
  117. The Deficit Budget in Sri Lanka. • An excess of government expenditure over its revenue results in a budget deficit. Budget deficits lead to many economic problems including high money growth, high inflation, government borrowings and high interest rates. When spending its greater than revenue, the excess spending must be covered by borrowing, and this borrowing can effect on investment and consumptions well as economic relationships with other countries. 117
  118. • In 2012, the overall budget deficit of Rs. 489 billion was largely financed through foreign sources. Accordingly, foreign financing contributed to around 59 per cent of the total compared to Rs. 207.6 billion expected in the budget. • However, the share of non bank sector borrowings in total domestic borrowings increased to 35 per cent in 2012, compared to 19 per cent in 2011. As in previous years, the Employees’ Provident Fund (EPF) and the National Savings Bank (NSB) continued to be the key institutional investors in the non bank sector. 118
  119. • In line with the medium term debt management strategy of improving the government securities market while reducing the risks associated with government debt portfolio, the government relied heavily on marketable debt instruments with longer maturities to finance the budget deficit in 2012. Accordingly, net borrowings by way of instruments financed through non commercial sources. The Asian Development Bank (ADB), China and Japan were the major sources of non commercial loans. 119
  120. The Reasons for the Budget Deficit in Sri Lanka. • We can identify the following weaknesses of the Sri Lankan government budget. The government spend more than it earns. This leads to a budget deficit. The government has to borrow to finance the deficit. The government disserves, thereby absorbing the part of private sector savings. 120
  121. • Examples of factors that affected budget deficit in Sri Lanka in recent years. Reduction in tax revenue due to tax relief. Increase in expenditure when paying Bank debts. Increase in transfer costs of the government. Increase in expenditure on public sections. 121
  122. Various steps have been taken to settle the budget deficit in Sri Lanka. • E.g. Use of foreign financial resources Foreign loans. Foreign grants. Use of local financial resources. Borrowing from the market. 122
  123. . • The constant budget deficit will have many effects on the economy of a country. • Examples Increase in state loans. Increase in inflation. Decrease in investment by private sectors. Rise in interest rates. Declining international credibility. Reduction in foreign exchange rates/ values. Decrease in local savings. 123
  124. • An economy can gain many things as it reduces budget deficit. A deficit in the current account of an economy will results in disadvantages, effects and a surplus in a country’s current account will results in advantages. • The advantages of having a surplus in current account are as follows. Reduction in burden of state loans. Decrease in inflationary effects. Increase in government investments. Ability to maintain interest rates at a low level. Reduction of tax burden on people. Leading to macroeconomic stability. 124
  125. Budget Deficit & Its Financial Implications. • As we observed above, the government spending has exceeded its revenue, resulting in continuous budget deficits. These deficits are a major macroeconomic problem in Sri Lanka. • The government has to borrow from the following 2 sources to finance the deficit. 125
  126. Foreign Sources • These include concessional and non concessional loans. Continuous borrowings from abroad have led to the accumulation of a large foreign debt. Annually, the country has to allocate a large amount of foreign exchange to meet the capital repayments and interest payments on these loans. 126
  127. Domestic Sources • The government can borrow from the banking sector or non banking sector for deficit financing purposes. As resources available in the non banking sector were rather limited, the government relied heavily on the baking sector. • This led to a rapid increase in the money supply causing macroeconomic instability. Since 2002, however, the government not only managed to avoid borrowing from the banking sector, but government has actually succeeded in repaying a part of past bank borrowings. This reduced the high inflationary deficit financing. Also it eased pressure on interest rates. 127
  128. Criticism • A major criticism raised against deficit financing policies is that excessive government spending leads to reduce private investment which is much more productive. • This is known as the crowding out hypothesis: large budget deficits are financed by treasury borrowing, while then crowds private borrowers out of financial markets and drives up interest rates. • The crowding out effect arises because government expenditure increases the interest rate. The rise in the interest rate causes a fall in the private investment speeding. This kind of all investment is called as crowding-out effect. 128
  129. Fiscal Management (Responsibility) Act. • The fiscal management act, which came into effect in 2003, is an important landmark in the country's fiscal management. It reflects the governments commitment to improve transparency and accountability in fiscal management. • The act requires reducing the budget deficit to 5% of GDP by 2006, and maintained it below that level thereafter. It also requires reducing the government debt as a ratio of GDP to 85% by 2006 and to 60% by 2013. it is the responsibility of the government to maintain these fiscal targets. 129
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  133. The Composition of State Loans • The loans that the government takes on the condition that its pays it back with interest is known as state borrowings. The government borrows from local sources as well as foreign sources. • The borrowings of the state from the monetary market and capital market are known as “market borrowing” (loans). 133
  134. Examples.  A large part of government revenue has to be paid as loans and interest on the loan.  Only a small part of the government revenue remains behind in order to spend to achieve development objectives and for other needs.  Increase in interest rates in the local market.  Decrease in external value of the local currency. • Reduction in resource allocation to the public sector reduce private investments and it has a negative effect on economic development. Difficulty in state monetary system management and state debt management causes inflation. Creation of inflation due to borrowings from banking sector. Balance of payment problems arise as a result of increase in total expenditure. This leads to face a crisis in international debt.  Decline in local savings rate.  Damaging international competition by the decrease in monetary value of foreign exchange rates due to inflation in the economy. 134
  135. • Payment of loan installments with interest on the total state borrowings is known as debt service payment". • The loan installments on the total borrowings of the government and the interest to be paid on them can be shown as a percentage of domestic production. It is known as debt service ratio. • Different types of debt service ratios can be calculated by using debt installments and interests, export revenue, government revenue and government expenditure. The debt service ratios are calculated in different ways an shown as debt service index. 135
  136. • Examples of recent trends of borrowings of Sri Lanka are; Continuous decrease in the debts that have not been settled as a percentage of the gross domestic product. A large amount of the total borrowings is domestic (local) loans. Middle term and long term loans are greater than the short term loans according maturity period. Loans taken from non-banks are greater than the loan taken from banking sector. The main component (instrument) of unsettled local loans is treasury bonds. The loans on concessional interest rates are more important in foreign loans. 136
  137. The Composition of State Loans & Trends, Public Debt Crisis. • Sri Lanka has maintained an annual average investment of about 27 per cent of GDP over the last decade compared with its annual average national savings ratio of about 22 per cent of GDP. Such investments, partly funded through foreign borrowings, directly helped the country to achieve a higher economic growth thereby tripling the per capita income to USD 2,923 in 2012 from USD 981 in 2003. • If however, the Government had restricted the public investments to the country's national savings only, the people of the country would not have been able to secure the higher growth momentum as achieved. In a similar manner, in the near future too, Sri Lanka would need to attract foreign resources, including borrowings, to bridge the investments savings gap, until such time that the domestic savings are sufficient to finance the required level of national investments. 137
  138. • During the recent past, the global debt market continued to provide greater diversification, wealth preservation and attractive returns. As a result, the demand for debt instruments, particularly in emerging markets has increased sharply. Approximately 75 per cent of the global financial instruments today constitutes debt, whereas the relative share of equity is only about 25 per cent. Since strong investor sentiment has reduced the effective cost of debt to substantially low levels, Sri Lanka has also benefitted from such positive development, as reflected in Sri Lanka’s progressively lowered cost of borrowing from international markets. 138
  139. • The prudential debt management strategies implemented by the Central Bank over the past few years has served to ensure that both the level and rate of growth in the country’s public debt is sustainable, and the cost and risk objectives stipulated in the medium term debt management strategy are met. At the same time, the continuous commitment of the Government towards fiscal consolidation has helped the country’s debt to GDP ratio to record about 79 per cent, down sharply from about 106 percent in 2002. 139
  140. • The responsibility of the management of public debt in Sri Lanka has been entrusted to the Central Bank of Sri Lanka under the Monetary Law Act No.58 of 1949. • This function needs a high level of professionalism, analytical ability, awareness and confidence of all stakeholders including lenders to the government and investors in government securities. 140
  141. • The public debt stock as at end 2012 stood at Rs. 6.0 trillion consisting of domestic debt of Rs. 3.2 trillion and foreign debt of Rs. 2.8 trillion. Foreign debt constitutes loans received from a number of multi- lateral institutions, bi-lateral loans and other commercial debt in a number of currencies. The size and the diversity of the public debt portfolio demand a high level of analysis and sharing of information with the stakeholders. To fulfill this need, the Central Bank of Sri Lanka started in 2006, disseminating information in the form of an annual publication with regard to the public debt portfolio and the debt management function, aiming to enhance the transparency of the debt management function. 141
  142. • The objective of public debt management is to ensure that the government's financing needs are met at the lowest possible cost consistent with a prudent degree of risk, and to develop enhancing its efficiency and maintaining its stability. • Although the strategic objective to be pursued in public debt management has not been made explicit by any law in Sri Lanka, it is implicitly understood that public debt management should be carried out in such a way as to:  Minimize the direct and indirect cost of public debt on a long-term perspective;  Prevent an excessive concentration on redemptions and thereby minimize any type of rollover risk/refinancing risk;  Promote an efficiently functioning government securities market. 142
  143. The Structure of State Loans. State Loans Local Borrowings Market Banks Central Bank Com. Banks Non Banks Insurance Firms EPF Savings Institutions Non Market Foreign Borrowing s Projects Non Projects 143
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  155. The Effects of the Government Supply Development Policies. • Supply side policies are designed to increase the average rate of growth of the country. They may also help reduce inflation and unemployment and improve the current account position. • Some economists, called supply side economists, believe that governments should not intervene in the workings of the free market. The governments role, they argue, is to remove restrictions to the operations of individual markets. Keynesian economists believe that governments need to intervene on the supply side to correct market failure. 155
  156. • Aggregate supply in the economy can be increased if government intervene to ensure that labour markets operate more efficiently and if there is an increase in human capital over time. • There are different approaches to implement the supply side policies by the state. • They include: Tax reforms Privatization Deregulation Reforms of Labour market Reforms of capital market 156
  157. Tax Reforms • Taxes on labour, firms will not take on workers if their total wage cost is too high. Part of the total cost is the wages of workers. However, many county's tax firms for employing labour, often by imposing employer contributions to state social security funds. In Sri Lanka, for instance, employers have to pay EPF and ETF contributions. The higher the tax, fewer workers will be employed and hence the lower will be the level of aggregate supply. 157
  158. • Making changes in the tax system in order to increase production is known as tax reforms. Imposing taxes can affect the competitiveness of the market. The Optimum level of production, consumption, investments and savings will be lost as a result of taxation. Therefore it is important to be concerned when imposing taxes in order to minimize influence of taxes on competitiveness of the market. • Example - tax relief, tax exemption, reduction of taxes • When these concessions are given, cost of production will be reduced and production will increased. 158
  159. • Taxes may affect the economy positively and negatively. Negative effects of tax reforms are; Reduction of government revenue due to decrease in taxes. Increase in unequal distribution of income. Tendency to increase the consumption of unwanted goods. • Positive effects of tax reforms are; Increase in production. Covering the losses of tax concession by the optimum levels of consumption investments and savings. • It is important to make use of tax reforms as supply development policy in a way to minimize its negative effects on an economy. 159
  160. Privatization • Privatizing firms, and in the process creating competition between newly created firms, eliminates the distortions created by the operation of public sector monopolies. Along this the government also implement deregulation, which is the process of removing government controls from the market. • This leads to encourage the market to function more efficiently. Making use of the private sector to manage the business activities under the ownership of the government (business activities managed by the public sector) is known as privatization. 160
  161. • Different methods of privatization are given below. Sale or transfer full or a part of ownership of public sector firms to the private sector. Providing the authority of management of public establishments to the private sector. Taking over of certain private firms which belong to the public sector. 161
  162.  Privatization can cause both positive and negative effects on the economy. Positive effects are as follows.  Efficient production due to greater productive employment of resources in the process of production.  End of government monopoly and creation of competitive markets.  Relieving the burden on government budget.  Removing political influence on business activities.  Harnessing solutions to problems of lack of capital.  Rise in quality of goods and services produced.  Decrease in cost of production  Prevention of waste, corruption and fraud.  Receiving quick response to the customer wants. 162
  163. Deregulation • Removal of government regulations and the regulation created by society which (Social factors) affect to reduction of the competitiveness in the market is known as “deregulation”. • E.g. relaxing the rigid regulations concerning setting up of a business. (regarding location of a business, getting approval for accruing the capital to start it.) • In other word deregulation states, reducing strict government supervision that can disturb free trade and also prevent the increase in costs of transaction of goods as a result of the influence of social factors (when selling fish, certain individuals demand at a higher price than the price fixed by the supplier/ producer. This differs the price which is not given to the producer). 163
  164. • The government remove the obstacles that affects competitiveness in the market by deregulation and strengthening the producers. It reduces the cost of production, increases productivity and helps increase production. Total deregulation may have a negative influence on the economy though it affects positively to reduce cost of production increase investments and increase production. E.g. Providing harmful goods and services for consumption to the market. Possible production of low quality goods. Import of unwanted or harmful goods to the economy. Deregulation should be carried out within some limits in order to minimize their ill effects on the economy. 164
  165. Labour Market Reforms • The level of aggregate supply is determined in part by the quantity of labour supplied to the market and the productivity of that labour. Classical economists argue that there is a number of ways in which the quality and quantity of labour are restricted because markets are not allowed to work freely. • The state is making relevant changes in order to retain the rigid nature of demand and supply of labour in the labour market. 165
  166. • Example. Removing rigid / strict labour laws. Taking actions not to recruit people who are not competent in certain professions. Making the workers aware of training programmes relevant to different jobs. • Competitive labour market is created by the reforms done with regard to demand and supply. It helps to increase the level of production in the economy. 166
  167. • Control of trade unions by the government is also important under the labour market reforms. Because by this the state control the power of ability of striking by labors. Because they raise the wage rates and impose their higher demand, due to this government take actions to control the trade unions. • The high marginal tax rates (the tax rate on the last 1 Rs. earned or spent), discourage economic activity. A tax on cigarettes leads to fewer cigarettes being bought. A tax on work (income tax) leads to people working less. A tax on profits (cooperation tax) is a disincentive to firms to make profits. Lowering certain taxes therefore raise the economic activity and increase aggregate supply. 167
  168. • But it is important to know that attention is not paid to implement the reforms within certain limits, it may have negative effects on the economy. E.g. The private firms are given freedom to recruit people for their firms it may cause injustice to these worker. When they are removed from service during the time there is no adequate work to be done. • Labour market reforms should be used as supply development policy to minimize the negative effects of such reforms. 168
  169. Capital Market Reforms • Increasing the capital stock of the country, such as its factories, offices and roads, will push the aggregate supply curve to the right. According to classical economists, the government has a key role to play this. • Allocating scarce capital sources – the government is in a poor position to decide how to allocate resources. It should leave this to private sector. Hence, state owned companies should be privatized wherever possible. They should offer only limited taxpayers money to subsidize industry. 169
  170. • Increasing the range of sources of capital available to firms – firms can be constrained in their growth if they are unable to gain access to financial capital like bank loans or share capital. due to this the state should encourage private sector to provide loans, partially to small businesses. • Along this they must liberalize trade, which means removing tariffs and other barriers to imports. 170
  171. • Taking action to solve the problems of lack of capital that hinders increase in production is known as “Capital market reforms”. E. g. Increase in productivity of capital Encouraging direct foreign investments. Obtaining foreign loans on favorable terms. Taking steps to increase savings 171
  172. • Rise of production with increased investments as a result of these reforms creates a healthy situation. It may cause an unhealthy situation too. E. g. Sending profits and dividends earned from increased foreign investments to foreign countries. Spending a large amount of money on loan installments and interests on foreign loans. It might affect social welfare negatively if the government reduced current expenditure. When capital market reforms are used as supply development policy, it should be done in a way to ensure that negative influences are removed. 172
  173. Summary • When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. • Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. • Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity. 173
  174. • A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction in consumer and producer surplus usually exceeds the revenues raised by the government. • The fall in total surplus—the sum of consumer surplus, producer surplus, and tax revenue — is called the deadweight loss of the tax. • As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. • Tax revenue first rises with the size of a tax. • Eventually, however, a larger tax reduces tax revenue because it reduces the size of the market. 174
  175. • Taxes have a deadweight loss because they cause buyers to consume less and sellers to produce less. • This change in behavior shrinks the size of the market below the level that maximizes total surplus. 175
  176. Review Questions 1. Explain briefly what is market failure and their reasons. 2. What is merit goods, demerit goods and quasi public goods? Briefly explain. 3. What do you mean by externalities and explain the externalities of production and consumption with examples. 4. What is the role of the government in a market economy? Briefly explain. 5. What is government failure? 176
  177. 6. What is a fiscal policy? 7. What are macroeconomic objectives? Briefly explain. 8. What are the issues in achieving macroeconomic objectives? 9. Explain the composition of government revenue. 10. What is known as he principle of taxation ? 11. Briefly explain different types of taxes with example. 12. What is economic classification of government expenditure? 13. What is functional classification of expenditure? 14. What is budget and explain briefly the types of budgets. 177
  178. 15. Define the types of budgetary policies. 16. What is budget deficit and the causes for budget deficit in Sri Lanka? 17. How the government of Sri Lanka financing the budget deficit? 18. Explain with reference to the central bank report, what is the current situation of public debt in Sri Lanka. 19. How the government correct the public debt? 20. What are the supply side policies of the government? Briefly explain. 178
  179. References • Colombage. Prof. S. S. ” Principles of Macroeconomics” 2006. The Open University Press, Nugegoda, Sri Lanka. • Lipsy. Richard G. ,” An Introduction to Positive Economics” 7th Low Price Edition ,1989, Butler & Tanner Ltd, London. • Gordon. Robert J," Macroeconomics” 3rd Edition,1984, Little Brown & Company Canada Ltd, USA. • Frank. Robert H, Ben S. Bernake, ”Principles of Macroeconomics”, 2001. McGraw-Hill Companies Inc, New York. 179
  180. • Pearce. David. W," The Dictionary of Modern Economics” 2nd Low Price Edition, 1985, Anchor Brendon Ltd. UK. • Dharmawardena. Prasadini, GCE A/ L Economics – New Complete Text Books for grade 12 & 13, ESL Publishers. • Central Bank Reports 2009, 2010, 2011, 2012. • Recent Economic Development Reports from 2008, 2009, 2010, 2011, and 2012. • Economics and Social Statistics form 2010, 2011, 2012.The Central Bank of Sri Lanka. • Teacher Guides & Instructional Manuals, Grade 12 & 13. revised 2012. The National Institute of Education of Sri Lanka. Mahargama. 180