To speak of the government's role in the economic system, let us first define government. Why do we commonly term certain institutions as "government"? What distinguishes government from other segments of an economic system? Does it have a distinct role to play in economic decision-making? If so, why?
A government is quite similar in many respects to other institutions of our society. Its activities are managed by a bureaucracy that is not unlike those that manage modern corporations. A government buys resources in the marketplace just like businesses and individuals. It provides goods and services free of charge or at a subsidised price, as do private philanthropic institutions.
Government decisions are collective in the sense that there is a group agreement about the action to be taken. Markets are mechanisms, in contrast for individual choices; that is, the outcomes are usually the results of the choices based on decisions of individual buyers and sellers. No collective or group decision is made in the markets about what is to be done that is, how resources are to be allocated and incomes distributed. Nevertheless, government's decisions are collective and the fact distinguishes a government from markets.
A government may have characteristics in common with other social institutions, yet it differs from them. For example, it exercises the police power in a society that is the power to deprive persons of life, liberty, and property. It may be observed that a government is the ultimate focus of power.1
The exercise of police power is significant in economic decision-making because the government can confront people, businesses, and other organisations with choices that other institutions cannot. For example, the government can confront economic decision-makers with the choice of either paying their taxes, honouring their contracts, and recognising the property rights of others or going to jail. Markets, on the other hand, can confront a person with the choice of either paying the price or doing without the good or service. That is, markets confront decision makers with choices among goods and services, alternatives that do not include incarceration or loss of life or property. The choices private clubs and co-operatives present similarly differ from government's. Private organisations confront their members with the choice of paying dues or being dismissed, ostracised, or otherwise denied the benefits of membership. Thus, we can say that the hallmark or defining characteristic of government is its exercise of police power in a society.
When government buys, sells, or borrows in the market it does not employ police power. And if the government were only involved in these activities, it would not be distinct from other institutions, such as large corporations. But the government must employ police power in a majority of its activities in order to raise taxes to finance its expenditure, define and enforce property rights and rules of exchange, and regulate industry.
Market exchanges are sometimes said to be voluntary, while transactions with the government are involuntary. That is, in the marketplace, individuals are "free" to buy or not to buy, sell or not to sell, while with regard to the government they "must" pay their taxes and abide by its rules, regulations, and laws. Thus, the government possesses the power to coerce, to force choices, compared with other institutions.
There is an alternative to paying taxes and complying with the government rules, that is, the fines and imprisonment that are imposed for not paying taxes or not to follow the rules. Therefore, if people pay taxes, we can infer that they choose to do so and are not coerced into doing so.
On the other hand, we may point out that there appears to be a choice involved in tax payment, in fact there is no choice: The alternative to payment is so undesirable, obviously it is not chosen. But this reasoning conflicts with the reality: People do in fact elect non-payment and opt for suffering the associated risk of fines and imprisonment, as is shown by the trial and conviction of people for tax evasion. In addition, people who are unhappy about their tax payments can sometimes move to a more suitable political jurisdiction (a different city, country, state). Or, they can work through the political process or engage in revolutionary activity to change the basic tax structure.
All these alternatives are, of course, costly and otherwise undesirable. But they are not necessarily more costly and unattractive than the alternatives presented in the market. For example, the market confronts the coal-miners with two fairly unattractive alternatives: Either mine coal and bear the high risks of mining accidents and black lung disease or accept a much lower standard of living.
Individuals may be bound by collective governmental decisions even when the decisions adversely affect their welfare, while market decisions in which an individual is directly involved usually do not make that individual worse off. This difference between governments and markets is more apparent than real. Persons are bound by adverse governmental decisions only in the sense that compliance is the lesser of two evils: Compliance is relatively attractive in comparison to the alternative of risking fine and/or imprisonment for non-compliance. But individuals are also bound by their market decisions, some of which make them worse off, even though they may have expected otherwise at the time of the decision. In addition, the resource allocation and income distribution decisions that are made through the market process may adversely affect particular individuals.2 Such adverse impacts are likely to derive from the market decisions of others, while the market decisions in which an individual is a direct participant are likely to enhance the welfare of that individual.
Use of resources by the government Regardless of whether the government coerces or whether it is more coercive than markets, there is the question of whether police power can be used constructively. The answer is yes: There is at least the potential for this power to be used to enhance individual welfare. Through the exercise of police power, a government can bring about distributive and allocative outcomes in a desired way that would otherwise be not attainable. In some cases, the exercise of police power and the resulting alteration of economic decisions may promote a society's economic objectives.
Resources are reallocated when taxes are collected and the revenues are used to finance the provision of services to a community. The taxes paid by members of the community cause them to reduce their demands for such goods and services as housing, entertainment, transportation, etc. The resources released by this reduction in private demand are then absorbed by the government's expenditure of the tax revenue. This process of resource reallocation, which may make the community better off, requires the use of scarce resources. The resources consumed in the process of making and implementing economic decisions may be less if police power is used to tax and spend, than if resources for the provision of community services are obtained by voluntary contributions or by an agreement among community members that is not enforced by police power.
This potential for saving scarce resources provides an economic rationale for the government. That is, we might hypothesise that the institutions capable of exercising police power stand created as a means of using scarce resources more efficiently. There is thus an economic rationale for the government, as there are other reasons for the creation of the government.
Without scarcity, there would be no need for economic choice and, correspondingly, no economic rationale for the government. Even with scarcity, an economic rationale is lacking if the scarcity does not lead to interpersonal conflicts of interest about the use and distribution of scarce resources. And even then the government (the police power) may not be called for if the conflicts of interest can be resolved by means other than the exercise of police power. Thus, while the economic rationale for the government is based on scarcity, scarcity does not imply the existence or the need for government.
Furthermore, the potential for economising on resource use by using police power depends on the ethical and moral codes of a society and the motivations of individuals in their dealings with others. Conflicts of interest that grow out of economic scarcity can, of course, be resolved through the use of police power in economic decision-making.
Government and its effects In general terms, the economic effects of government activities. Virtually all government activities affect resource allocation and income distribution in several distinct ways. First, such activities may directly alter the allocation of resources or the distribution of income. Second, they may affect the so-called constraints on the economy - rules of contract and exchange, tastes, and technology. Third, they may produce indirect effects as individuals and firms adjust their resource allocation and income distribution decisions in response to government activities. These various effects may or may not be intended.
Government activities may be usefully classified as (1) law making and regulatory and (2) budgetary. Of course, law-making and regulatory activities have a budgetary impact, but they also have distinct economic effects of their own. For example, a law that requires a license to be issued before a person can enter a particular occupation may influence the flow of resources into that occupation and the incomes of those entering the occupation.3 A law or regulation that places a ceiling on rental payments affects the real incomes of landlords and tenants and the incentives to construct rental housing. Antimonopoly laws may affect prices, output, and the real incomes of consumers and factory owners.
Economic analysis of the law-making and regulatory functions of the government is obviously important, but other applied areas of economics tell the economic effects of these activities. Government's budgetary activities, with law-making and regulatory activities either require budgetary decisions or constitute alternatives to government spending.
Budgetary activities of the government involve raising and spending money (1) to secure resources that are then used to provide goods and services and (2) to redistribute incomes. These are called resource-using and income-transfer activities, respectively. Fire protection is an example of the resource-using function, and unemployment compensation, if any, is an example of the income-transfer function.
Government budgetary decisions can affect resource allocation and income distribution both directly and indirectly. The distribution of incomes is influenced by the way the benefits from fire protection are distributed among households and firms and how the service is financed. If a property tax finances the fire protection, a person who owns vacant land suffers a reduction in real income. That is, she or he pays taxes on the land but derives little benefit from fire protection. On the other hand, others may experience an increase in real income because they receive benefits from government services that exceed the taxes they pay. The resulting redistribution of incomes may or may not be consistent with our notions of fairness.
Similarly, the construction and maintenance of dams that provide irrigation facilities increase agricultural output and may thereby raise the incomes of farmers in the irrigated regions. If taxes are levied on the general population to finance the construction of dams, there is a redistribution of income from the general population to those farmers.
To carry out its activities, the government secures resources and obtains funds to purchase resources by money creation, borrowing, taxation, or the sale of goods and services. Each method of securing resources affects the allocation of resources differently. Alternative means of financing defence spending also have different effects. If, for example, the financing required to support a army were obtained by increasing income taxes, such factors as work incentive, choice of occupation, saving, and investment would be affected. If higher tax rates discourage effort, people may choose lower paying but less onerous occupations, to be a butcher, for example, rather than a surgeon. If such reallocations do in fact occur, the net effect of conscription and lower income taxes would be a lower private-sector supply of resources.
Budgetary policy and constitutional basis The government has the power to tax and spend. In Pakistan the government's power to tax and to spend is defined and limited by the Constitution.
The federal government derives its basic power to tax and spend from the Constitution, which gives the power "to levy and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defence and general welfare of the country." The Constitution also requires that taxes be uniformly applied throughout Pakistan. That is, the federal government must tax whatever it taxes (income, product sales, etc) in the same way in each province. Thus production of particular products generally cannot be taxed at lower rates in some province, but as a means of encouraging economic development the government has the authority to provide for a tax holiday or application of lower rates of taxes.
The Constitution also requires that all direct taxes levied by the federal government be on the income of individuals, businesses, association of persons and corporations. Income tax, for example, would be collected more from business centers with relatively high-income residents than from agrarian areas with relatively low-income residents.
The Constitution imposes few constraints on the taxing power of the province. The primary restriction relates to trade: Neither exports nor imports may be taxed, and provincial taxation may not interfere with inter-provincial or foreign commerce. Also, provinces may tax only those activities that are specified in the constitution.
Income taxation or government borrowing is prohibited for the provinces. Similarly, local governments differ in their power to tax, with such power being derived from the provinces. Provincial governments determine the rules under which local governments may tax. Thus constitutional considerations are more likely to be important in tax policy decisions at the provincial and local levels than at the federal level.
1. Anthony Downs, An Economic Theory of Democracy (New York: Harper & Bros., 1957), pp. 22-23.
2. For example, a shift to smaller cars caused by higher gasoline prices and a concern about air pollution would reduce the demand for steel and adversely affect the incomes of steelworkers and the owners (stockholders) of steel companies.
3. Examples of such laws are those requiring licenses for retailers, barbers, and stockbrokers. Apprenticeship requirements for persons entering the building and construction trades may have similar effects.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates)