Introduction
The question that had engulfed the economists during the 1930s-50s was – If a price system is efficient, what role is there for government policy? It is important to remember that efficiency is not the only criterion by which an economic system may be judged.
Since the 1930s, there has been a profound change in the way government economic activities are perceived. Government participation in economic activities is hardly a matter of disagreement. There had been numerous instances- one being the latest economic crisis of 2008-09, where markets failed, and governments across economies had to play a major role in controlling the markets and ensuring economic stability.
Unlike the pre World War-I period, governments these days are expected to look into economic matters and ensure economic stability apart from performing political and social activities.
In addition, a price system itself requires certain governmental action. A case can clearly be made for the government to redistribute incomes in the interest of equity. For this purpose, the government uses many policy instruments to allocate resources and redistribute income. The chapter highlights the role of government in economic planning and development.
Role of Government
Over the period of time, the government’s role in an economy has been redefined. There has been the dilution of laissez-faire principles, and governments are called for intervention, even in sectors that were exclusively reserved for the private sector. The markets have failed to ensure full employment and economic stability.
Governments across the country and around the world play a dominant role, despite many countries being market economies, because markets do not allocate all, or even nearly all, of the output the economy produces. The governments are involved in affecting the way income is produced and allocated.
Changing Role of Government in Economic Development and Planning
Since the 1930s, there has been a gradual change in the concept of the state, and its scope steadily increased. With the rise in income inequalities and unemployment, there was a gradual change in the thinking of nineteenth-century economists and policymakers. These social-economic evils were attributed to private ownership of capital.
The great depression saw the rise of the Keynesian school of thought, which advocated an active role of the government in the economic sphere. It became a driving force of economic decision-making in the twentieth century. In 1929, unemployment reached a peak of 25%, and it was widely argued that markets had failed and there was increasing pressure for government intervention to curb the economic downfall.
Keynes forcefully argued in favour of the economic role of the governments in saving the economy by effecting a rise of effective demand. He demonstrated that fiscal activities of the government could raise employment and maintain it at a high level. He introduced the concept of ‘compensatory finance’ whereby government expenditure is augmented to compensate for the decline of private expenditure.
The Depression brought many other problems to the forefront. The stock markets had crashed, banks failed, and poverty and unemployment rose along with deflation.
The government took active steps to stabilize the economy and introduced many programs under the ‘New Deal program’ to alleviate problems of unemployment, social security, insurance, etc. and a host of other social-economic problems.
The World War II period saw high periods of economic growth. However, it was accompanied by high levels of poverty and inequality. This provided an impetus for further government intervention, and more programs were announced targeted at education, health, employment and social security sectors.
By the 1950s, governments across countries had assumed a greater role, from protecting the country from aggression and war to a wider role of a welfare state, with the objective of achieving maximum social welfare. There was a large expansion in the role of the government; public spending as a percentage of GDP increased from 12% in 1913 to 45% in 1995.
Since then, the government has assumed greater importance in affecting economic activities. They play an even more critical role in the development of less developed and developing countries. Both political and ideological factors have contributed to the rise of government activities.
So far, the Classical economists had focused their attention on the allocative function of the government, but gradually, Marxist and socialist thinking took over, and governments started playing significant distribution functions in market economies. The rise of centrally planned economies of the Soviet Union and Eastern European economies was another move in this direction.
Gradually, the pure market economies, such as the US, moved towards a mixed economy system. Mixed economies involve a larger role of governments with income redistribution, poverty reduction and equity and economic stabilization as main policy objectives.
Countries with larger public sectors were seen as less prone to fluctuations in the business cycle. Public spending on education and health, progressive taxation, subsidies, welfare schemes etc., were the common government programs, and public enterprises were used for generating productive employment.
Keynes (1963) pointed out, “The political problem of mankind is to combine three things: economic efficiency, social justice, and individual liberty.” Governments across nations try to achieve the goals of economic efficiency and equity through the appropriate design of public sector programs and financing.
Apart from ensuring internal and external security, the provision of infrastructure and public utilities are the main functions of the government. In countries such as the former Soviet Union, paternalistic government policies were adopted where resources were under government control.
In some countries, the government also influences resource allocation through a system of incentives and directives. In market-oriented economies such as the US, market failure also necessitates government intervention in resource allocation, as the achievement of an efficient allocation of resources and market correction requires well-defined property rights, enforcement of contracts and the establishment of anti-trust measures.
And still, another role can be rationalized because of the existence of public goods and externalities. There is a strong case for government intervention in resource allocation in low-income countries. Very low levels of savings and investment, scarce skilled labour, underdeveloped factor and product markets, and a virtual absence of an entrepreneurial class characterize these countries.
Functions of the Government
Musgrave, in his Theory of Public Finance (1959), has summarized the three essential economic functions of the government- allocation, distribution and stabilization functions. The resources are allocated through the market mechanism.
However, in the case of market failure- when markets fail to achieve the macroeconomic efficient allocation of resources, the government is required to intervene to guide, correct and supplement the markets to achieve the desired outcome.
● Allocation Function:
Public goods are a classic case of market failure. Markets fail to supply public goods. Such gods are collectively desired, whereas the need for private goods is felt individually. The markets can efficiently and optimally provide private goods where producers are guided by consumer demands.
However, in the case of public goods, the properties of non-exclusion and non-rivalry make market exchange operations inefficient. And it would be inefficient to exclude anyone from partaking in the benefits of the good.
From here arises the problem of free ridership. Non-exclusion implies that people can refrain from making payments for the use of public goods, assuming others are paying for it, and thus they can escape non-payment.
The government, through the imposition of taxes, can easily solve the problem of the refusal of voluntary payment in the case of public goods. Moreover, individuals may refrain from revealing their true preferences, and the government may resort to a voting process.
Decision-making through voting becomes a substitute for preference revelation, and taxes become a method of collecting cost shares. Thus, an approximate efficient solution can be achieved through government provision of public goods.
● Distribution Function
The study of economics deals with the efficient utilization of scarce economic resources given the distribution of income and pattern of consumer preferences. Income distribution depends on the distribution of factor endowments that, in turn, is determined by the process of factor pricing. Under perfect competition, the factors receive a payment equal to the value of the marginal product.
However, under imperfect competition, factors receive less than the value of the marginal product. Moreover, even if factor prices are determined under a competitive setup, it does not guarantee a fair distribution of income. It is difficult to compare individual utilities derived from their income, and moreover, redistribution policies involve considerable efficiency costs. Thus, the question- what constitutes a fair distribution is a difficult one.
It is here where the government plays a critical role. The government carries out redistribution through a combination of tax and subsidy policies targeted at the high-income and the low-income groups.
● Stabilization Function:
The allocation and distribution function of the government exert significant influence on the macroeconomic variables of the country. The market functioning cannot ensure the achievement of objectives such as high employment, price stability, sound balance of payment along with socioeconomic welfare. The government assumes a greater role in augmenting the market for the achievement of desired macroeconomic goals.
Without, proper policies, the economy of any country is subject to wide economic fluctuations such as unemployment and inflation. The great depression is one important example in this regard. It exposed the loopholes of the market system and exhibited the important role played by the governments in the revival of the global economy. In recent years, with the growth of globalization, countries are even more vulnerable to market fluctuations.
The government plays an instrumental role in affecting aggregate demand – the key parameter affecting employment level and price levels. In any adverse event, government action through expansionary/ restrictive monetary and fiscal measures can restore equilibrium conditions.
Roadblocks in the Process of Economic Development
The above discussion highlights the importance of government in social-economic activities. It assumes even more importance in the case of developing and under-developed countries facing a resource crunch, high poverty, and unemployment. They face a vicious circle of underdevelopment through the forces of low productive investment, the absence of skilled labour and high poverty.
The market forces in such economies suffer from structural imbalances and economic rigidities and thus fail to achieve a high rate of investment and employment. The jinx can only be broken through comprehensive government planning.
The underdeveloped and developing economies suffer from a lack of basic social and economic overheads such as highways, telecom, health facilities, ports, etc., required for the initiation of the development process as they result in significant external economies for the expansion of the private sector. These overheads involve large-scale investment, long gestation periods, and low and uncertain returns that spread over a period of time.
Moreover, the returns from them in the form of specialized labour, higher standards of education and health services, etc., that are spread over a long period of time accrue to the whole society rather than to an individual investor. The private investment in such overheads, as a result, is not forthcoming.
Thus, there emerges the need for public investment in social overheads to speed up the pace of economic development. Further, the government can easily raise the resources required for incurring such investments through modes of taxation, public debt, and deficit financing.
Another area where undeveloped countries suffer is the lack of resources and adequate skills. The markets, as we know, cannot allocate all resources efficiently all the time. They suffer from both incentive and information constraints. Thus, the government, through planning and scheme of priorities, can lead to efficient allocation of scarce resources and investment in sectors involving large external benefits.
Besides, the private sector in these countries lacks attention to the long-run problems and objectives of the economy and rather concentrates on short-term profit objectives, is unprepared and reluctant to invest in social projects, and suffers from uncoordinated activities among various sectors of the economy.
Role of Government in Economic Development and Planning
Given the problems faced by underdeveloped economies, there is an important need for development efforts to push up the pace of economic development. The reluctance and problems with the private sector give rise to the need for a comprehensive set of measures by the government to break the vicious circle of underdevelopment.
The following are the principal measures undertaken by the government to push up the speed of economic growth:
● Provision of Economic and Social Overheads
As discussed, underdeveloped economies face a lack of private investment in economic and social overheads such as education, health, railways, roads, telephone, power, etc. Such overheads create large external economies for other industries, improve the efficiency of capital, and thus make it possible to accelerate the pace of economic growth. Given the importance of social and economic infrastructure, it is the responsibility of the government to make such investments.
● Mobilization of Economic Surpluses
The under-developed countries face the gigantic task of mobilization of savings into productive investment. Three kinds of economic surpluses have been identified for the purpose: Existing economic surplus, Potential economic surplus, and additional economic surplus.
These are the excess of income over consumption that is not invested. When such surpluses are not productively invested, the government must resort to some measures to mobilize them. It can do so through modes of taxation and borrowings.
Mobilization of economic surpluses into productive investment will lead to higher employment, output and income generation. It is also necessary to mobilize surpluses in order to reduce income inequalities through progressive taxation and expenditure policies.
● Provision of Financial Facilities
The success of an economy is also dependent upon its financial sector. A well-developed and sound financial system ensures the availability of capital and efficient mobilization of savings to meet the growing needs of trade and industry.
The government needs to ensure that appropriate financial institutions are available to meet such financial needs. For example, The Indian government nationalized 14 major commercial banks in 1969 in the wake of banking system reforms.
● Institutional Changes
Outmoded institutions stand in ways of economic development. For example, traditional tenancy laws, landlords, feudal systems, ceilings on land holdings, etc., were a roadblock to the growth of agriculture and industry.
Reforms and reorganization in such areas were required to accelerate the pace of economic growth. The Indian government initiated land reforms to protect the interests of small and marginal landowners/ tenants.
Similar measures are adopted to encourage small-scale industries, improve labour efficiency, regulate relations between labour and capital, etc. Such measures go a long way in improving production efficiency and building up intangible capital.
Rationale for Public Sector in Economic Development
As we know, the government directly participates in economic activities through public sector enterprises. The public sector is composed of enterprises which are owned and controlled by the government. Such an entity includes institutions such as hospitals, government-run schools, defence, local and state government management and their departments, etc.
They engage in the production, delivery and allocation of goods and services by and for the government or its citizens, whether national, regional or local/municipal with the aim of maximizing social welfare.
The public sector has three important roles to play-
1. Compensatory or Substitutive Role:
The need for the public sector arises when there is a need to compensate for the deficiency of the market system. It can substitute for the private sector and perform corrective productive and distributive activities and, at the same time, ensure efficient utilization of scarce resources. The public sector also makes up for the deficiencies of the market system in the achievement of socially desirable objectives such as those concerning health and education. The private provision of such services has often been inadequate and inequitably distributed.
2. Adjunctive Role:
The public sector plays an adjunctive role in the provision of public and merit goods. The market fails in the assessment of the true preferences of individuals for goods satisfying social wants and thus does not provide such goods.
3. Competitive Role:
The public sector plays a competitive role in the provision of merit goods in order to keep the private sector’s monopolistic tendencies in check. The government either directly provides these goods or subsidizes the private sector provision of these goods.
Overall, the public sector, especially in an underdeveloped and developing economy, can help in realizing the goals of economic development through
- Generating more employment
- More foreign exchange earnings
- Diversified economic structure
- Supporting private sector
- Building industrial base
- Capital formation
- Optimum allocation of resources
- Balanced Regional development
- Achieving social objectives
Economic Planning
The process of economic development requires planning, especially in developing and underdeveloped economies. It is the process by which key economic decisions are undertaken by the government to achieve targets of economic development within a specified period of time.
The idea of planning gained momentum after World War II when advanced countries suffered serious disruptions and required rehabilitation. On the other hand, the underdeveloped countries were embarking on a growth process. The socialist economies of the Soviet Union and the Eastern European countries also popularized the concept of planning.
By the late 1960s, with the gradual extension of government economic activities, planning gained considerable importance across countries. Even in capitalist economies, planning is an essential element to take care of defects associated with the market system and to ensure economic stability.
In the case of developing economies, planning takes the form of development planning to secure a rapid rate of growth and to take care of economic rigidities and structural bottlenecks.
As described, “The change in ideology of people, their growing social and economic evils of mal-distribution of income and wealth have drawn attention to the need of directing economic growth in a manner that but would bring about not only increased production, but would ensure more equitable distribution of the larger output; egalitarian measures have, therefore, been called for, and regulation of economic mechanism has become necessary to ensure social justice and equality.”
There are two main constituents of economic planning:
- A system of ends to be pursued.
- Knowledge as to available resources and their optimum allocations.
Thus, economic planning involves organization and utilization of resources to maximum advantage in terms of defined social ends. Planning involves:
- Formulation of goals
- Fixing targets to be achieved and priorities for each sector
- Mobilization of financial and other resources required for the execution of the plan
- Creation of organization for the execution of the plan
- Assessment or evaluation of the progress of the plan
The government is vested with the responsibility of successful implementation of the plan through regulations and control measures. It is entrusted with the tasks such as what to produce, for whom to produce and how to produce.
Objectives of Planning
The planning process is adopted to achieve various objectives, varying from the removal of poverty to raising living standards for achieving rapid industrial growth and correcting macroeconomic imbalances. It is regarded as a panacea of all economic ills. The objectives vary from country to country depending upon the social, political and economic structure of an economy, stage of economic development and so on.
The following are the key objectives of the planning process-
● To Achieve Full Employment:
The primary concern of an economy is to ensure maximum employment. The market forces fail to ensure the optimum allocation of resources. The planning process is directed to those areas where employment is low, and steps are taken to improve skills and for the creation of employment opportunities.
● To Improve Living Standards:
The planning process aims to increase national income and to achieve higher living standards through rapid growth in primary, secondary and tertiary sectors.
● Rapid Industrialization:
Industrialization is regarded as key to economic growth and a solution to the problems of unemployment. Governments across countries try to achieve industrial progress through the planning process by specifying plans targeted to the industrial sectors.
● Reduction in Inequalities:
The markets are criticized for raising income inequalities. Therefore, governments are entrusted with the task of ensuring a just distribution of income and equal opportunities for all. At the same time, steps are taken for the development of backward and under-developed regions of the country.
● Economic Growth:
Another main objective of planning in underdeveloped and developing economies is to remove obstacles to economic growth. Steps are targeted to achieve balanced regional growth and break the vicious circle of underdevelopment. It also ensures that the economy is less prone to fluctuations so as to achieve economic stability.
● Self-sufficiency:
Every economy aims to achieve self-sufficiency in food and raw materials in order to reduce dependence on imports and meet the needs of all allied sectors. Self-sufficiency is essential for ensuring a stable food supply and prices and, in turn, for national security. Thus, the national plans give considerable importance to the objective of promoting farm output and a stable food supply.
● Price Stability:
Another objective arising from ensuring self-sufficiency is keeping inflationary and deflationary tendencies in check. Unstable prices are detrimental to the achievement of growth objectives.
● Social Security:
The poor and the weaker sections of an economy are more prone to exploitation in terms of unemployment, poverty, disease, accidents, etc. One of the main social objectives of planning is to provide social and economic security to the weaker class of society and at the same time, to provide equal opportunities to every citizen.
● National Security:
Internal peace and national security are signs of strength in a country. National plans give due importance to matters of defence and domestic and international peace.
Thus, through planning, governments across countries attempt to achieve social-economic goals. It enables optimum utilization of scarce resources as a clear distinction can be made between essential and non-essential uses, directs them towards the production of goods for mass consumption and reduces wastage of resources.
Governments, through their various tools and rights, can operationalize these plans. The success of planning thus depends on how effectively governments can implement these plans and reach the planned targets. As discussed, successful planning can go a long way in promoting economic growth in underdeveloped and developing economies.
Read More in: Theory of Public Finance
- Public Finance: Meaning, Nature & Scope
- Role of Government in Economy
- Role of Government in Mixed Economy: Public & Private Sector
- Role of Government under Cooperation and Competition
- Role of Government in Economic Development and Planning
- Concept of Public Goods, Private Goods, and Merit Goods
- Concept of Market Failure and Functions of Government
- Market Failure and Functions of Government: Decreasing Costs
- Market Failure and Functions of Government: Externalities
- Market Failure and Functions of Government: Public Goods
- Future Market: Meaning, Role & Uncertainty
- Concept of Information Asymmetry
- Theory of Second Best: Concept & Explanation
- Problem of Allocation of Resources: Public & Private Mechanisms
- Preferences: Meaning, Types & Problems of Preference Revelation
- Preference Aggregation & Its Mechanism
- Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
- Economic Theory of Democracy: Concept & Explanation
- Politico Eco Bureaucracy: Concept & Explanation
- Rent-Seeking and Directly Unproductive Profit-Seeking Activities
- Rationale for Public Goods: Concept & Explanation
- Benefit Theory or Voluntary Exchange Theory
- Lindahl Model: Concept, Equilibrium & Limitations
- Bowen Model: Concept, Advantages & Limitations
- Samuelson’s Model of Public Expenditure
- Musgrave’s Model of Public Expenditures
- Demand Revealing Schemes for Public Goods
- Vickery-Clarke-Groves Mechanism
- Groves-Ledyard Mechanism
- Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
- Theory of Club Goods
- Keynesian Principles of Stabilization Policy
- Difference Between Keynesian Economic Thought and Others
- Role of Expectations and Uncertainty in Formulating Stabilization Policy
- Intertemporal Markets Efficiency & Failure
- Liquidity Preference Theory
- Diamond-Dybvig Banking Model
- Preference Shocks, Adverse Selection & Central Bank
- Equilibrium Deposit Contract
- Social Goods and Its Effect on Stabilization Policy
- Effect of Infrastructural Facilities on Stabilization Policy
- Effect of Distributional Inequality on Stabilization Policy
- Effect of Regional Imbalances on Stabilization Policy
- Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
- Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
- Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
- Pure Theory of Public Expenditure
- Structure & Growth of Public Expenditure in India
- Trends, Lessons & Priorities in Public Expenditure in India
- Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
- Performance Based Budgeting and Zero Based Budgeting
- Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
- Tax System and Its Principles
- Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
- Ability to Pay and Benefits Received Principle of Taxation
- Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
- Deadweight Loss of Taxation: Causes, Measurement & Example
- Concept of Equity & Efficiency in Economics
- Trade-Off Between Equity and Efficiency: Meaning & Example
- Theory of Measurement of Dead Weight Loss
- Double Taxation: Meaning, Desirability, Forms & Solution
- Solution to Problem of Double Taxation: Intra-Country & International
- Double Taxation Avoidance Agreement (DTAA) and Indian Policy
- Classical View on Public Debt
- Compensatory Aspect of Public Debt Policy
- Public Debt or Borrowings: Concept, Need, Sources & Types
- Concept of Public Debt or Public Borrowings
- Need for Public Debt or Public Borrowing
- Sources of Public Debt
- Classification of Public Debt
- Burden of Public Debt: Meaning, Types & Explanation
- Debt Through Created Money or Deficit Financing
- Public Debt (Public Borrowings) and Inflation (Price Level)
- Crowding Out of Private Investment and Activity
- Principle of Public Debt Management and Debt Repayment