Nationalized Industries

 

In Chapter 16 we distinguished between government production of public goods such as defence and government production of private goods such as steel. The nationalized industries are basically the part of government production that covers the provision of private goods for sale through the market place. Thus the nationalized industries include British Rail and British Coal, but not the provision of defence or the provision of social services such as education or housing, which are not sold commercially.

Nationalized industries tend to be much more capital-intensive than the rest of the economy, and it is precisely the presence of these large capital costs that generates the economies of scale that make many of these industries natural monopolies.

Nationalized industries or other forms of public ownership are not confined to the UK. Other Western countries face the same problem of natural monopoly in these industries. The precise extent and nature of public involvement differs from country to country (for example, France had a very large degree of state involvement in industry), but the basic pattern is essentially the same. Whereas European countries tended to acquire public ownership of the assets of natural monopolies, the United States preferred to handle the same problems through public regulation of industries whose assets were left in private ownership. Regulatory agencies set prices and specify quality and quantity of output.

Hence, when countries concluded that the public sector was too involved in the economy, the initial policy priorities differed in Europe and the United States. Having few nationalized industries, the US emphasis was immediately on deregulation, which began with airlines in 1978. In Europe, privatization came first, but deregulation is now also under way.

 

Reasons for Nationalization

 

We distinguish three reasons why governments may wish to nationalize industries. The first is the natural monopoly problem, which we examined in the previous chapter. Large economies of scale mean that marginal cost lies below average cost. Social efficiency requires that prices he close to marginal cost but this will imply losses for the natural monopolist. Public subsidy may therefore be desirable, but the public commitment to pick up the bills requires public monitoring to ensure that the monopolist continues to minimize costs and produce efficiently. Public management may be the simplest solution. Since private shareholders cannot be expected to subsidize the wider goals of society as a whole, public ownership may then be inevitable.

Second, externalities may be important. The social gains from an efficient road or rail network may exceed the private benefit for which direct users are prepared to pay. In Chapter 16 we argued that taxes and subsidies could sometimes be used to offset externalities and guide market equilibrium to the efficient allocation. But taxing road use may be administratively difficult and expensive, and direct regulation may be preferable.

Third, important judgements of equity or distribution may be involved. A private profit-maximizing railway would close most rural railway lines. Society might judge that this severely reduced the welfare of citizens in remote areas or that it promoted regional dissent which reduced the sense of national unity. Again, society faces two options. It can order a private supplier to provide these services, perhaps with the carrot of an explicit bribe or subsidy, or it can directly take over production to run the industry in the interests of the nation as a whole.

We now consider the principles by which nationalized industries should be run. We distinguish investment policy and pricing policy, though the two are closely connected. Decisions on pricing will affect the rate of return on investment and the incentive to carry out new investment, but past investment, by affecting the current capital stock, will affect current marginal costs to which prices will be related.

 

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Taxes and Public Spending:

The Government and Resource Allocation

 

By the 1980s many people felt that the government had too big a role in the economy. They believed that high levels of government spending were pre-empting resources that could have been used more productively in the private sector, that high taxes were stifling private enterprise, and that the abolition of the complex system of government regulations, interventions, and subsidies would unleash a new wave of private initiative and energy.

These were not quack ideas that never made it in practice. On the contrary, electorates in many countries turned to the political leaders who promised to implement these new policies - Mrs. Thatcher in the UK, President Reagan in the United States, and Chancellor Kohl in West Germany.

This chapter is about the extent of government involvement in the economy. How much should the government raise in taxation? Are there good taxes and bad taxes? If taxes are needed to pay for government spending, why do we need government spending in the first place?

We begin with three tables that provide some historical perspective. Table 16-1 shows the scale of government spending in the UK over three decades. It is important to distinguish government spending on goods and services - schools, defence, the police, and so on - from government spending on transfer payments, such as social security and state pensions. Whereas spending on goods and services directly uses up factors of production that could otherwise have been employed in the private sector, transfer payments do not directly pre-empt society's scarce resources. Rather they transfer purchasing power from one group of consumers, those paying taxes, to another group of consumers, those in receipt of transfer payments or subsidies.

Table 16-1 shows that between 1956 and 1976 there was a moderate increase in the share of national income and national resources directly pre-empted by the government through government spending on goods and services. It also shows that the Thatcher government found it difficult to implement its objective of quickly reducing this percentage. Nevertheless, the share of national income going to government spending on goods and services is now falling.

The second row of Table 16-1 shows that government spending on transfer payments has also risen faster than national income. In part this reflects increasing expenditure on state pensions as more and more people live to a ripe old age. However, the most important source of the large rise in transfer payments was the steady rise in unemployment until the mid-1980s. The subsequent decline in unemployment has also been responsible for the fall in the share of transfer payments since 1984. The last row of Table 16-1 shows the turnaround in total spending since 1984.

One reason for trying to reduce government spending is to make room for tax cuts. Table 16-2 picks out the most controversial aspect of the tax system, the marginal rate of income tax.

The marginal rate of income tax is the percentage taken by the government of the last pound that an individual earns. In contrast, the average tax rate is the percentage of total income that the government takes in income tax.

A progressive tax structure is one in which the average tax rate rises with an individual's income level. The government takes proportionately more from the rich than from the poor. A regressive tax structure is one in which the average tax rate falls as income level rises. The government takes proportionately less from the rich.

Table 16-2 shows that, as in most countries, the UK has a progressive income tax structure. Figure 16-1 explains why. We plot pre-tax income on the horizontal axis and post-tax income on the vertical axis. The line OG with a slope of 45 degrees would correspond to no taxes. A pre-tax income OA on the horizontal axis corresponds to the same post-tax income OA on the vertical axis. Now suppose there is an income tax with a tax allowance OA. The first OA pounds of income are untaxed. If the marginal tax rate on taxable income is constant, individuals face a schedule such a OBC. The individual gets to keep only a constant fraction of each pound of pre-tax income above OA. The higher the marginal tax rate the flatter the portion BC of the schedule.

How do we calculate the average tax rate at a point such as D? We join up OD. The flatter the slope of this line the higher the average tax rate. Hence, even with a constant marginal tax rate and a constant slope of the portion BC of the tax schedule, the presence of an initial tax allowance makes the tax structure progressive.

Table 16-1. Government spending as a percentage of UK national income*
SPENDING ON
Goods and services	20.7	21.6	25.9	23.8	22.0
Transfer payments	13.2	16.5	21.0	22.7	20.0
Total spending	33.9	38.1	46.9	46.5	42.0
Spending of central and local government as a percentage of gross domestic product at market prices. Source: CSO, UK National Accounts.

 

Table 16-2. Marginal income tax rates in the UK (tax rates on an extra pound of income)
TAXABLE Income* (1990 £)	MARGINAL TAX RATE (%)
1978-79	1986-97	1990-91
*Taxable income after deduction of allowances, In 1990-91 the single person's allowance was £3005. Source: HMSO, Financial Statement and Budget Report 1990-91.

            

 

 

Pre-tax income

 

Fig. A progressive income tax. The line OG with a slope of 45 degrees shows what would happen in the absence of any income tax. A pre-tax income measured on the horizontal axis would convert into the same amount of post-tax income measured on the vertical axis. An income tax plus an allowance 0-A implies that the first OA pounds of pre-tax income are still retained after-tax. If income above OA is taxed at a constant marginal rate, the individual is then on the schedule BC with a constant slope. The slope is less than 45 degrees because for each extra pound earned the individual is only allowed to keep a constant fraction of it. Higher pre-tax incomes move the individual up BC and imply that the government is taking a larger and larger fraction of total pre-tax income. The individual is falling further and further below the no-tax schedule OG. With a rising marginal tax rate, the schedule falls even further below OG.

 

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International Trade and Commercial Policy

 

International trade is a part of daily life. Britons drink French wine, Americans drive Japanese cars, and Russians eat American wheat. If this is -unremarkable, why is there a separate branch of economics devoted to international trade? Why is trade between the UK and France different from trade between London and Birmingham?

There are two reasons. First, because international trade crosses national frontiers, governments can monitor this trade and treat it differently. It is hard to tax or regulate goods moving from London to Birmingham but much easier to impose taxes or quota restrictions on goods imported from Taiwan or Japan. Governments have to decide whether or not such policies are desirable.

Second, international trade involves the use of different national currencies. A British buyer of American wine pays in sterling but the American vineyard worker is paid in dollars. International trade involves international payments. We began the study of exchange rates and the balance of payments and we examine the system of international payments more fully in the next chapter.

In this chapter we concentrate on trade flows and trade policy. We begin by taking a look at the facts. Who trades with whom and in what commodities? We then examine why international trade takes place. Countries trade with one another because they can buy foreign goods at a lower price than it costs to make the same goods at home.

How can this be possible for all countries? The basis of international trade is exchange and specialization. International differences in the availability of raw materials, oilier factors of production such as labour, and technology, lead to international differences in production costs and goods prices. Through international exchange, countries supply the world economy with the commodities that they produce relatively cheaply and demand from the world economy the goods that are made relatively cheaply elsewhere.

These benefits from trade are reinforced if there are economics of scale in production. Instead of each country having a lot of small-scale producers, different countries can concentrate on different things and everyone can benefit from the cost reductions that ensue.

We discuss in detail the benefits from international trade and examine whether our analysis can explain the trade flows that actually take place. Although there are many circumstances in which international trade can make countries better off, international trade can also carry costs, especially in the short run. Cheap Japanese cars are great for British consumers but not so good for unemployed car workers in the Midlands.

Because foreign competition may make life difficult for some voters, governments are frequently under pressure to restrict imports. We conclude the chapter by discussing government trade or commercial policy and whether it might be a good idea to restrict imports under some circumstances.