Readers question: What are the functions of government in a capitalist economy?
In summary, the economic functions of a government include:
- Protection of private property and maintaining law and order / national defence.
- Raising taxes.
- Providing public services not provided in a free market (e.g. health care, education, street lighting)
- Limit market failure through the regulation of markets, e.g. regulations on environment/labour markets/monopoly.
- Macroeconomic management, e.g. use of fiscal and monetary policy to control business cycle – recession and inflation.
- Reducing inequality/poverty.
What do we mean by a capitalist economy?
A capitalist / free market economy means that most business and consumption decisions are left to private firms and individuals. The government does not get involved in owning the means of production or deciding what and how to produce. However, there is no ‘pure capitalist’ system without any kind of government intervention. In practice, there are degrees of government intervention – a mixed economy. These are the reasons governments intervene in the economy.
Main functions of government
1. Protection of private property / national security. If a country has a problem with crime, then it will discourage investment and the quality of life. The role of the government is to ensure basic law and order, through ensuring the rule of law. This involves protecting the rights to private property. In a free market, there is an incentive to free ride on the provision of law and order, therefore it tends to be under-provided. A government can pay for policing through general taxation. A similar function of the government is to provide for national defence – paying for an army. It is military spending which often was the primary cause of the first taxes. Kings raising taxes to pay for his army.
Policing and courts are an example of a public good – which usually require government provision.
2. Raising taxes. To provide public goods and public services, the government needs to raise tax. They can do this in a variety of ways – taxes on goods (customs duties), taxes on income, taxes on people (poll tax) and tax on property and land. The government has to consider the best way of raising taxes. A good tax is efficient (doesn’t distort economic activity); easy to collect (hard to avoid); fair (may involve taking a higher proportion of high earners). If the government run a budget deficit, they will need to raise the shortfall through borrowing and selling government bonds.
3. Providing public services. Public goods tend to be not provided in a free market because of the free rider problem. Therefore, these goods and services need to be provided by the government. Examples of public goods include street lighting, roads and law and order. There are also public services which are provided piecemeal in a free market, like education and healthcare. However, the government may feel that these merit goods are important for equality and improving labour productivity. Therefore, most governments provide some form of state provided education and health care.
4. Regulation of markets. Adam Smith in ‘Wealth of Nations‘ noted that in a free market, firms were often able to create monopoly power. This enables them to charge excessive prices to consumers. The government may need to regulate monopoly power, e.g. prohibiting mergers or setting price limits in natural monopolies (industries like tap water and railways).
Also, firms may develop monopsony power, where they are able to pay low wages and provide poor working conditions for workers. In this case, the government may need certain regulations on labour markets, such as minimum wages, minimum age of working and provide basic levels of health and safety.
5. Macroeconomic management. Capitalist economies can be subject to economic cycles – economic booms and recession. Recessions can lead to lost output and higher unemployment. In this case, the government may use fiscal policy to influence aggregate demand. The government may also use monetary policy, though, in recent years, many governments have delegated monetary policy to an independent Central Bank. In addition to trying to solve recessions, the government will also try to avoid inflation. This can involve higher taxes and higher interest rates.
6. Reducing inequality/poverty. In a capitalist economy, we may see a growth in inequality and poverty. This can be due to inherited wealth and opportunity. It can also be due to monopoly power. The government may feel the need to ensure everyone has an equal opportunity, for example providing education so even those from poor family have the opportunity to get qualifications. It may also involve redistributing income from high earners to low-income earners, e.g. progressive taxes such as higher rate of income tax and providing means-tested benefits such as income support/housing benefit and state pensions.
Where does the government spend its money?
This shows the relative destination of government spending. The largest budget is for social protection pensions and welfare benefits.