Chapter 15

The government
Sector
Learning Outcomes
By the end of this chapter you should be able to:
oExplain why government participates in economic affairs
oDescribe how government intervenes in the economy
oExplain why governments, like markets, can fail
oDistinguish between nationalisation and privatisation
oExplain what fiscal policy means
oDiscuss government spending and the financing of such spending
oDiscuss the criteria of a good tax
What comes to
mind when you
think of the
government?
Introduction
• The government plays an integral part in a country/economy
• All citizens of a country are affected by actions of the
government (e.g. funding Eskom & SAA affects us).
• Roads we use, water, health & education services are some of the
basic goods and services provided by the government.
• To effectively provide these services, the government needs to
source finance and one way of getting the finance is through
taxation that we have to pay.
• In this chapter, the government sector is being put under a
microscope.
15.1 The Government or Public
Sector
Concerned with
national issues Concerned
including with regional
issues like
foreign affairs
housing,
health
services

Includes other
Deals with local government
issues like businesses such
provision of as SAA,
Transnet, Eskom
sewerage, street
lighting
 Figure 15-2
The interaction between government and households
and firms (Textbook pg. 277[311])
15.2 The Role of Government in
the economy
• Remember mixed economy? Government, market forces and private sector
play a role
• The right combination of government and market intervention remains a
controversial issue
• Recall from chapter 2: Market system (free enterprise/price system) is
the most efficient market system. Why?
• However, when markets do not function properly (due to phenomenon
like imperfect competition/monopoly), the market outcome might not
be efficient or fair. Why is that so?
• In a market system, only money votes counts therefore those without
income or wealth cannot register their wants in the market place
Cont…
• What then is the right mix between the government and the market?
Few things to note:
▫ First: Private initiative and market forces are the most important factors
in achieving efficiency in as far as the 3 central economic questions are
concerned, thus governments should not intervene in the production
process
▫ Second: Government always has a role to play → Markets cannot
properly function without government
▫ Third: Government may be required to correct market failure
 Market failure: Occurs when the market is unable to achieve an
efficient allocation of resources.
▫ Fourth: Government intervention is justified by the fact that markets do
not always produce equitable outcomes, though they may be considered
as efficient.
15.3 Market Failure (as
justification for government
intervention)
• Remember that markets fail when the market system is unable to attain an
efficient allocation of resources
• Externalities
o “Externalities refers to situations when the effect of production or consumption
of goods and services imposes costs or benefits on others which are not reflected
in the prices charged for the goods and services being provided” ~ Khemani &
Shapiro (1993)
o Externalities can either be positive or negative.
– A positive externality is the benefit or positive effect an activity imposes on an
unrelated third party
– A negative externality is the cost or negative effect an activity imposes on a third
party
o We focus on externalities in production
Negative externalities
• A firm that produces chemical discharge that contaminates / pollutes rivers
• The firms imposes costs on others that they themselves do not experience
• Contaminated water is harmful to human beings, depending on the nature of the
pollutants and the type of exposure.
• Water purification costs, including treatment and inspection, are a burden on
municipal budgets.
• Another dimension includes damage to recreational facilities, particularly around
fresh water lakes and major beaches.
• Local fishermen will not be able to catch fish. This loss of income will be the
negative externality.
• The spill-over effects are many…..
• The social cost of producing the firm’s products is greater than the private cost to a
firm.
• Market failure in this case happens when prices do not reflect social costs
Negative externalities
• The demand for the product is represented by
DD.
Negative externalities in
production
• The supply of the product, which is also the
marginal private cost (MPC) of the industry, is
represented by SS
• As a result of the pollution, the marginal social
cost (MSC) > MPC.
• In a free market, producers ignore the external
costs to others. Therefore output will be at Q1
(where Demand = Supply) at price P1.
• The problem with negative externalities is
that too much of the product concerned is
being produced
• This is a socially inefficient solution. Social
efficiency requires that MSC be equal to the
price of the product. Welfar
• This occurs at price P2 and quantity Q2. e loss
to
society
Positive externalities
• A farmer grows apple trees.
• An external benefit is that he provides nectar for a nearby beekeeper who gains
increased honey as a result of the farmers’ orchard.
• In this case, the social cost is less than the private cost.
• The beekeeper saves the cost of having to provide a source of nectar.
• In this example, it works both ways. The beekeeper provides an external benefit to
the apple grower because his bees help to fertilise the apple tree.
• Another one, Tim Berners Lee who developed the World Wide Web, made it freely
available, creating a very large positive externality.
• Building a mall in an excluded area might lead to employment creation and the
provision of essential services that might not have been present otherwise
• There are many spill-over benefits……
Positive externalities
• With positive externalities, the benefit to society is greater than your personal
benefit.
• Because there are positive externalities in production, the social marginal cost of
production is less than the private marginal cost of production.
• In a free market, a firm will ignore benefits to third parties and will produce less
quantity (free market outcome)
• However, the socially efficient level will be at more quantity (where social marginal
cost = social marginal benefit)
• If external benefits are experienced, the marginal social cost (MSC) will be lower
than the marginal private cost (MPC), again resulting in a socially inefficient
allocation of resources.
• In this case, however, the problem with positive externalities is that too little
is produced.
• Further reading on textbook page 281
Overcoming externalities
• Theoretically, Coase Theorem argued that if the two parties to an externality – the
one causing it and the one suffering from it – can bargain with one another, they will
reach an efficient allocation of resources.
• Failure of the theorem’s assumption to hold in practise
• To overcome externalities, we require some form of government intervention:
o Tax – To reduce consumption of negative externalities, we can place a tax on
goods with negative externalities (e.g. Pigovian Tax)
o Subsidy – To increase consumption of positive externalities, we can place a
subsidy on these goods.
o Regulation – The government may place regulations which limit the amount of
pollution such as direct control, force anti-pollution equipment etc.
o Nudges and behavioural economics – The government could place incentives
and make it easier to choose less costly environmental choices.
• Further reading in textbook
15.5 How does government
intervene?
• Public provision of goods and services
▫ Such as infrastructure through public ownership or by public financing of production
undertaken by the private sector
• Market participant
▫ For e.g. as the largest employer of labour, through its own wage/employment,
government can bring about certain influences on the achievement of broader
macroeconomic objectives such as employment stimulation
• Government spending
▫ Besides deciding on quantities of goods and services to buy, spending components
such as transfer payments (e.g. Child grants) can also assist in the achievement of
broader objectives like poverty alleviation
• Taxation
▫ Can be a useful tool for income redistribution, the promotion of certain durable
activities and the penalisation of other socially undesirable activities
• Regulation
▫ Through the various laws, rules and regulation that will affect private behaviour
• Further reading on textbook
15.6 Government failure
• Markets fail and the government intervenes – but there is always the risk of
government failure
• This is true because government is not just an institution that naturally serve
the interest of the public
• It consists of public officials who while may be trying to serve society’s
interests, are human beings who have their own motives, goals and faults
• This therefore proves that to understand the reasons why governments fail,
there is a need to examine the behaviour of people that make up the government
• Public officials
▫ Politicians
▫ Bureaucrats
• Rent seeking, as a cause of government failure
15.6 Government failure

Politicians Bureaucrats / Civil servants

• Vote maximising agents • Not necessarily the lazy, incompetent
• Want to retain political office people they are thought to be
• Rational beings trying to maximise their
• Looking for popularity
status, salary, power etc..
• People pleaser, most of the time
• All about increasing the size of their
• Buy votes without consideration of benefits, departmental budget allocations and staff
costs or the consistency of their policies complements.
• Policy myopia – in favour of quick fixes • This brings greater the opportunities for
promotion and more power or status
• Slow to admit mistakes - it is politically
easier to proceed with failed • Do not face market tests, and therefore
programmes/policies than to abandon their inefficient behaviour can persist
them • Tend to be less cost conscious than private
• So on …. Further reading on textbook sector workers
• Further reading on textbook
15.6 Government failure
• Rent seeking, behaviour of interest groups
▫ The pursuit of self-interest amongst politicians and civil servants can often
lead to a misallocation of resources.
▫ For instance, decisions about where to build new roads, schools and hospitals
may be decided with at least one eye to the political consequences.
▫ For instance, the pressures of a looming election or the influence exerted by
special interest groups can foster an environment in which inappropriate
spending and tax decisions are made.
▫ For instance, boosting welfare spending in the run up to an election, or bringing
forward major items of capital spending on infrastructural projects without the
projects being subjected to a full and proper cost-benefit analysis to determine
the likely social costs and benefits.
• Rent-seeking gives rise to an unwarranted redistribution of resources in favour of
the relevant special interests
• Further reading on textbook
15.7 Nationalisation and
Privatisation
• Nationalisation
o The transfer of ownership from private enterprise to the government.
o The transfer could be with or without compensation
▫ Nationalisation policy was the ANC's key focus of its economic policy until it was
abandoned in the 90s because of its failure in the Eastern European countries
▫ Most observers agree that nationalisation is an economic failure – Any advantages
it may have in principle are usually not realised in practice
▫ Often results in large bureaucracies, inefficiency and political interference

▫ Burden on taxpayers

▫ Poor financial control?

 15.7 Nationalisation and
Privatisation
• Privatisation
o Opposite of nationalisation

o Arguments for privatisation:

▫ SOEs are bureaucratic, inefficient and unresponsive to consumer wishes and often a
burden on the taxpayer – Privatisation can will limit the shortcomings of
nationalization
▫ Privatization will attract FDI – increasing the country’s foreign exchange reserves.

▫ It will also broaden the tax base – public enterprises do not necessarily pay tax.

▫ It can serve as an instrument for BEE due to share ownership

▫ Proceeds from privatization will make funds available for spending on housing,
education and healthcare
▫ Further reading
• Arguments against privatisation:
▫ Privatization might just mean replacing a state monopoly with a private
one.
▫ Private companies don’t necessarily consider their external costs or
benefits.
▫ They will not take a broader view of the public interest e.g. postal
services for rural town – may entail losses – hence if such services were
privatised, they may be expensive for the poor
▫ Further reading
15.8 Fiscal Policy and the Budget
• Every government:
o Buys goods and services
o Regulates (raises) taxes
o Borrows funds to finance expenditure
• Therefore, every government must regulate:
o How much to spend?
o What to spend it on?
o How to finance its expenditure?
• The government must therefore have a policy in respect to the level and composition
of government spending, taxation and borrowing
• Fiscal Policy
o Main instruments – the budget which is a reflection of political decisions
o Main variables – government spending and taxation
• Fiscal policy is seen as an effective means of influencing total spending in the
economy
o Classified as an instrument of demand management that can be used to manage
total demand for goods and services in the economy.
o Conducted by the government (finance/treasure ministry)
• Expansionary Fiscal Policy
o Applied when the economy is in recession to stimulate economic activity
o ↑ (G) and/or ↓ taxes
o Tends to increase budget deficit
• Contractionary / Restrictive Fiscal Policy
o Applied when the economy is expanding rapidly and there are inflation and BOP
problems
o ↓ (G) and/or ↑ taxes
• Budget deficit - the difference between spending and taxation
• Broadly, there’s difficulties in stabilising the economy = Existence of delays or lags
• Another instrument of demand management: Monetary policy (Chapter 14).
• Monetary policy
o Conducted by the Central Bank (Reserve Bank)
o Entails the manipulation of the interest rates, through the repo rate
o Refer to chapter 14
o Contractionary
– ↑ repo rate
– Implemented to combat inflation
o Expansionary
– ↓ repo rate
– Implemented to boost economic activity
• Both the monetary and fiscal policies have to be applied in harmony
• Further reading
15.9 Government Spending
• Government involvement in economic activity is measured by the share of
government spending in the economy
• Can be classified economically (Categorises spending into C and I) or functionally
(Categorizes government activities based on their broad objectives)
• See table 15.2 on page 290
• Reasons for increased government spending in South Africa over the years:
• Changing consumer preferences
• Political and other shocks
• Redistribution of income
• Misconceptions and entitlement
• Population growth and urbanisation
• Further reading
15.10 Financing of Government
Spending

INCOME FROM TAXES BORROWING

PROPERTY

From domestic and

Such as rent in a form international capital
Such as direct (e.g. markets, central bank.
of property rights,
PAYE) and indirect
licence fees and user
taxes (e.g. VAT) NB - government
charges
borrowing increasing
public debt
 15.11 Taxation
• Taxation is mandatory payment to the government and is a major source of
government revenue.
• Criteria For A Good Tax:
• Neutrality - Have the minimum possible effect on relative prices
• Equity - Tax burden should be spread as fairly as possible. Also, pay
according to their ability:
o Horizontal Equity (same position, taxed equally)
o Vertical Equity (different positions, taxed different)
o Benefit principle (pay for goods and services provided by the
government – user charges)
15.11 Taxation

• Administrative simplicity - Compliance and administration costs should

be low and simple.
o Tax evasion (the illegal non-payment or underpayment of tax)
o Tax avoidance (the arrangement of one's financial affairs to minimize
tax liability within the law)
• Different Types Of Tax:
• Direct and Indirect taxes – Direct tax is levied on income and wealth
(persons). Indirect tax on goods and services (transactions).
• General and Selective taxes – General tax is levied on most goods and
services (e.g. VAT). Selective on specific goods only (e.g. sin taxes)
 15.11 Taxation
• Nature Of Taxation:
• All 3 are based on the relationship between tax and total taxable income
• Progressive tax - Ratio of tax paid to taxable income increases as taxable income
increases (e.g. Personal Income Tax)
• Proportional tax - Ratio of tax paid to taxable income is the same at all levels of
income, but the actual amount of tax paid ↑ as income ↑ (e.g. Company Tax)
• Regressive tax - Ratio between tax paid and taxable income decreases as taxable
income increases (or rises as taxable income falls) (e.g. VAT).
• Three Important taxes in South Africa:
• Personal income tax
• Company tax
• Value added tax
 15.11 Taxation in South Africa
• Personal income tax
• The most important form of direct tax in South Africa
• Levied on individuals’ taxable income.
• Progressive in nature
• Company tax
• Companies in SA pays company tax of 28%
• Proportional in nature
• Tax contribution depends significantly on general economic conditions, i.e.
better economy – more company profit – more taxation paid
• Value added tax
• Main source of indirect tax in SA
• Currently 15% and regressive in nature – Remember
• Goods are taxed at the same standard rate – the tax burden increases as income
decreases (or falls as income rises) – Hence it affects the relatively poor people
15.11 Taxation
• Take note of the following when it comes to personal income tax:

• Tax tables are used to determine how much you should pay.

• For each table there is the minimum amount of tax to be paid per taxable
income and a rate to be paid for each rand by which taxable income
exceeds the starting point of the bracket.

• Marginal rate is the rate at which each additional rand of income is taxed.

• The average tax rate (effective tax rate):

• It is the ratio between the amount of tax paid and taxable income – also called
the effective rate .

• It measures the tax burden

• How do you calculate it?

Average tax rate = amount of tax paid / taxable income x 100

15.11 Taxation

• A tax rebate may be a partial sum of money refunded to people from paid
taxes, or it may be an amount by which you reduce your taxes before you
pay them.
• primary rebate is for everybody below the age of 65
• secondary rebate only applies to persons who are 65 years and
older.
• tertiary rebate only applies to persons who are 75 years and older

Nb! Study guide page 37-44

15.12 Tax Incidence: who really
pays the taxes?
• Governments determines the statutory or legal incidence of the different taxes
(i.e. who has to hand over the money to them)
BUT
• It cannot determine who will ultimately bear the tax burden
• This is because of the interdependency of the economic system which affects tax
decisions
• Nobody wants to pay taxes, so everyone tries to turn the tax to someone
else.
• Companies will always try to transfer the tax burden of shareholders and
employees to their consumers.
• Ultimately all individuals (owners of the companies, workers employed by
the company or the consumer) will in fact bear the tax burden.
• NB! Further reading
 Class exercise
See the tax table below and answer the questions that follow.

2016
Taxable income Tax rates
284 000 – 393 000 69 000 + 35% above 284 000
393 001 – 550 000 103 000 + 40% above 393 000
550 001 – 750 000 120 000 + 47% above 550 000
Tax rebate: R15 000

1)Calculate the total tax for an individual with an income of R475 000 in
2016. (2)
2)Show the effective tax rate for 2016. (1)
Solution
1. Calculate the 2016 total tax for an individual with an income
of R475 000. (2)
Total tax = basic tax + marginal tax – rebate (0.5 marks)
= 103 000 + (0.40) (475 000 – 393 000) – 15 000 (0.5 marks)
= 103 000 + 32 800 – 15 000 (0.5 marks)
= R120 800 (05 marks)

2. Show the effective tax rate for 2016.

(1)
Effective tax rate = Total tax / Total taxable income
= (120 800/ 475 000) * 100 (0.5 marks)
= 25.43% (0.5 marks)
 Exercise 1
1. Suppose Judy’s annual income is R 18 900. Given
the following tax bracket, how much tax will she
pay?
Income groups Scale
R15 000-20 000 R 2 550 + 21% of the amount above R15 000

2. What is Judy's marginal tax rate?

3. What is Judy's average tax rate?
Solution
1. Total tax = basic + marginal
= 2 550 + (21% of (18 900– 15 000))
= 2 550 + (0.21 x 3 900)
= 2 550 + 819
= R 3 369

• What is Judy's marginal tax rate? 21%

• What is Judy's average tax rate?
Average tax rate = amount of tax paid ÷ taxable
income.
= R 3 369 ÷ R 18 900 X 100
= 17,83%
Exercise 1,2
Suppose Judy’s annual income has increased to R83
450 use the table below to answer the following
questions:

1.How much tax is payable?

2.What is the marginal tax rate?
3.How would you classify this type of tax? Motivate
your answer?
Solution
1. Total tax = basic + marginal
= 25 000 + (43% of (83 450 – 80 000))
= 25 000 + (0.43 x 3 450)
= 25 000 + 1 483,50
= 26 483,50

2. Marginal Tax Rate is 43%

3. This is an example of a progressive type of tax.

Initially (on 18 900) average tax was: 17.83%

After the salary increase, the average tax rate is now

26 483,50 ÷ 83 450 x 100 =31.74%
Abigail is thus paying much more income tax
Exercise 2
1. Suppose the government levels a VAT rate of 14%.
Donald earns an income of R5000 a month, while
Alex earns an income of R2000 a month. Donald
spends 75% of his income on consumption on
expenditure and saves the residual. Alex spends all
his money on consumption expenditure. Calculate
the average VAT tax rate of Donald and Alex.
2. Who had the highest average tax rate? Donald (the
richer one) or Alex (the relatively poorer one).
3. What type of tax is this?
 Solution
1. Donald spends 75% of his income on consumption expenditure,
which is R 3 750.
He has to pay 14% on that R3 750 that he spends:
(0.14 x R 3 750) = R 525.

Average VAT rate for Donald: R 525 ÷ R 5 000 X 100 = 10.5%

Alex spends all his income, which is R 2 000.

He has to pay 14% on that R 2 000 that he spends:
(0.14 X R 2 000) = R 280.

Average VAT rate is then: R 280 ÷ R 2 000 X 100 = 14%

2. We can see that the average VAT rate is higher for Alex with
the lower income than for Donald.
3. This is regressive tax.
Exercise 3: Tax
including rebate
Nicole has just graduated from university and starts her first
job.
Her monthly salary is R12 000. Calculate her annual total tax
payable, her effective tax rate and the marginal tax rate.
Taxable Income Individual Rates of Tax 2008/2009
R R R R

0 to 122 000 0 + 18% of the amount over 0

122 001 to 195 000 21 960 + 25% of the amount over 122 000
195 001 to 270 000 40 210 + 30% of the amount over 195 000
270 001 to 380 000 62 710 + 35% of the amount over 270 000
380 001 to 490 000 101 210 + 38% of the amount over 380 000
490 001 and more 143 010 + 40% of the amount over 490 000

Tax rebate: Primary rebate R8 280

Secondary rebate R5 040
Solution
1. Annual Salary = 12 x 12 000 = 144 000
2. Total tax = basic + marginal – rebate
= 21 960 + (0.25x (144000-122000)) – 8280
= 21960 + 5500 -8280
= 19180

3. Effective Tax Rate (ETR) = Payable Tax/Income

= 19180/144000
= 13.3%

4.Marginal Tax Rate = 25%

NB! REVISE STUDY GUIDE PAGE 25-46

Learning Outcomes
By the end of this chapter you should be able to:
odefine the public sector or government 
oexplain why government participates in economic affairs 
• Externalities
oDescribe how government intervenes in the economy 
oExplain why governments, like markets, can fail 
odistinguish between nationalisation and privatisation 
odefine fiscal policy and its instruments 
odiscuss government spending and the financing thereof 
odescribe the criteria of a good tax 
oexplain government revenue by referring to the functions, types of taxation and tax
concepts 
oTax incidence 
ocalculate the average tax rate, marginal rate and tax of an individual's taxation 
References
• Examples on negative and positive externalities sourced from Economics Help (
https://www.economicshelp.org/blog/glossary/externalities/
• Externalities of Water Pollution (https://transportgeography.org/?page_id=5814
• Government failure https://www.tutor2u.net/economics/reference/government-
failure

Real-life case studies

• https://www.news24.com/SouthAfrica/News/sasol-intentionally-polluted-the-
vaal-river-sahrc-inquiry-hears-20190221
• https://www.enca.com/news/polluted-vaal-river-remains-health-risk
• https://www.enca.com/news/vaal-river-clean-resumes
Important concepts
• General government • Adverse selection
• Public sector • Common property resources
• Market failure • Tragedy of the commons
• Public goods • Business cycle
• Rivalry • Macroeconomic policy
• Excludability • Fiscal policy
• Mixed goods • Merit goods
• User charge • Government spending
• Externalities • Transfer payments
• External costs • Taxation
• External benefits • Regulation
• Asymmetric information • Government failure
• Principal–agent problem • Rent-seeking
• Moral hazard • Nationalisation
• Privatisation • Direct taxes
• Budget • Indirect taxes
• Demand management • General tax
• Expansionary policy • Selective tax
• Contractionary policy • Progressive tax
• Lags • Proportional tax
• Budget deficit • Regressive tax
• Inflationary financing • Taxable income
• Public debt • Marginal tax rate
• Interest on public debt • Average tax rate
• Tax neutrality • Bracket creep
• Horizontal equity • Capital gains tax
• Vertical equity • Value-added tax
• Benefit principle • Tax incidence
• Tax avoidance • Statutory incidence

• Tax evasion • Effective incidence

Thank you