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The Economic Role of Government

The economic role of government can best be defined by a classification of its economic policy aims. Broadly speaking the political choices made by electorates in Western-type democracies influence governments to perform four functions.

The first is production of services which private firms are either unwilling to produce or for some reason are not allowed to produce (or at least not exclusively). This public provision may be to provide immediatebenefits (e.g. defence, law and order) or deferred benefits (e.g. investment in roads).

These ‘production’ activities may be divided into two types.

  1. Services which are not sold in the market but are financed out of compulsory levies. It is considered preferable in economic analysis to treat the government here as a collective consumer in a position to influence the allocation of resources, rather than as a producer because the ‘output’ is intangible and is not priced. For our purposes, what is important is that the government has to purchase in the market the current output of private firms and the labour services of households in order to fulfil its task. It can, of course, ‘rig’ the market. For example, the UK government is not only an important purchaser of vehicles for use in government departments; it also buys almost exclusively only vehicles produced in the UK.

  2.  Goods produced and sold in the market by public corporations. Many countries have state-owned fuel and power industries whose operation is very similar to private industry though the policy instructions laid down by governments for their operation will usually include objectives other than the making of profits

The second function is the alteration of the structure of private production in order to conform with some conception of the allocation of resources which is considered ‘better’

The third function is to intervene in the distribution of income generated by private market transactions in order to conform with some acceptable criterion of equity, for example a minimum income guarantee. This will be reflected in the national accounts principally in the choice of taxes and in the provision of transfer payments to households against which there is no counterflow of current services. For example, state pension payments are transfer payments, and though pensioners do not render current services in order to receive them, they may have contributed to their finance through compulsory levies on their past incomes. Transfer payments do not form a direct link between government and industry but major efforts by government to alter income distribution have considerable influence on the structure of household purchases and therefore on the pattern of demand for industrial products.

The fourth function is the stabilization of the economy by attempting to reduce fluctuations in income and employment and to control movements in the general price level. The effects of this action can be seen in both the volume and the mix of transactions between the government and the rest of the economy. Policy models of the economy which place particular emphasis on the control of the money supply and interest rates will pay close attention to the size of the government budget deficit/surplus. Therefore, no particular transaction with the private sector is solely identified with this function except perhaps for the interest paid by government to firms and households as a payment for holding government debt accumulated in the course of financing past government deficits.

The Budget

Every year democratic countries present, for the approval of their parliaments, a budget alongside which there will be published extensive information on the central government's finances, including accounts of past years. In this respect governments have to achieve certain standards of accountability and audit. It is taken for granted here that these standards are being met and this enables us to concentrate on the method of presentation of accounting data by the government which gives us the best idea of its structure and size in relation to the rest of the economy. While accounting and audit standards will require the government to produce full information on the responsibility of each main administrative unit for its use of authorized funds, what is needed here is an economic classification which enables us to identify government transactions which have their counterpart in receipts and payments of other major sectors of the economy. 

The Place of Government in the Economy

  1. First, always check which definition of government is being used, for it can make a considerable difference to the perspective gained about government's role in the economy. Which concept of government is used will depend on the purpose in view. A firm interested in defence contracting acquiring background on government activities might confine its attention to the central government budget. A firm looking for contracts in the supply ofeducational equipment might want to concentrate on lower layers of government and the pattern of educational expenditure within those lower layers. A firm supplying capital equipment to nationalized fuel and power undertakings would wish to have data on public corporations' role in government and in the economy. A firm which considered it possible to bargain with government about tax treatment of its capital expenditure or its liability to pay some national tax, such as a value added tax (VAT), might again wish to concentrate on the tax ‘burden’ imposed by central government. The problem of definition will reappear time and time again.


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