government economic policy

government economic policy, measures by which a government attempts to influence the economy. The national budget generally reflects the economic policy of a government, and it is partly through the budget that the government exercises its three principal methods of establishing control: the allocative function, the stabilization function, and the distributive function.

(Read Milton Friedman’s Britannica entry on money.)

Over time, there have been considerable changes in emphasis on these different economic functions of the budget. In the 19th century, government finance was primarily concerned with the allocative function. The job of government was to raise revenue as cheaply and efficiently as possible to perform the limited tasks that it could do better than the private sector. As the 20th century began, the distribution function acquired increased significance. Social welfare benefits became important, and many countries introduced graduated tax systems. In the later interwar period, and more especially in the 1950s and ’60s, stabilization was central, although equity was also a major concern in the design of tax systems. In the 1970s and ’80s, however, the pendulum swung back. Once more, allocative issues came to the fore, and stabilization and distribution became less significant in government finance.

The allocative function in budgeting determines on what government revenue will be spent. Because a high proportion of national income is now devoted to public expenditure, allocation decisions become more significant in political and economic terms. At all times and in all countries the calls for expenditure on specific services or activities, or for more generous transfer payments, will always exceed the amount that can reasonably be raised in taxation or by borrowing. The debate about how these scarce resources should be allocated has continued for hundreds of years, and, although numerous methods of deciding on priorities have emerged, it has never been satisfactorily resolved. In practice, most democracies contain a number of different factions that disagree on the proper allocation of resources and indeed the proper level of public sector involvement in the economy; the frequent change of national governments is related to the constant search for the right answers.

Economists have sought to provide objective criteria for public expenditures through the so-called theory of public goods. It is generally recognized that some goods needed by the public cannot be provided through the private market. Lighthouses are a classic example. The costs of a lighthouse are such that no one shipowner will want to finance it; on the other hand, if a lighthouse is provided for one shipowner, it can be made available to all for no additional cost. Indeed it must be available to all, since there is no practical means of excluding ships from using the facility provided by the lighthouse, even if their owners have refused to pay for it. The only practical method of providing such services is by collective action.

If goods are to be provided in this way, rather than through the private market, it is immediately necessary to confront the twin problems of deciding how much to provide and who should pay for that provision. Even if all individuals wanted the service equally—as, perhaps, with lighthouses—their views on the extent of the service would be influenced by the allocation of the costs. Where different households may have different preferences and some may not want the service at all—as, for example, with defense by nuclear weapons—these difficulties are compounded. Economists have tried to devise abstract voting schemes that would reconcile these difficulties, but these appear to have little practical application.

Moreover, others would challenge this whole approach to the problem. It would be absurd to say that the consumer has a taste for national defense and that it is the job of the government to satisfy it. The task of national leaders is to evolve a defense policy and persuade the public to accept it. Similarly, conservationists must attempt to awaken the public to the importance of parks and wildlife. In the context of public policy, the efficient allocation of resources consists not merely of distributing funds in the pursuit of given objectives but also involves determining the objectives themselves.

Genuine public goods pose severe problems for the national budget; it is very difficult to decide how far particular goods—the arts, national parks, even defense—should be supplied, and therefore no formal procedure of determination is likely to evolve. What should be given to each will continue to be the subject of intense political debate, with allocation changing as the government changes.

The concept of merit goods assists governments in deciding which public or other goods should be supplied. Merit goods are commodities that the public sector provides free or cheaply because the government wishes to encourage their consumption. Goods such as subsidized housing or social services, which predominantly help the poor, or health care services, which help the poor and elderly, are generally regarded as having considerable merit and therefore have a strong claim on government resources. Other examples include the provision of retraining schemes or urban regeneration programs.