State Intervention in the Economy and Fiscal Policy

State Intervention in the Economy

State intervention in the economy is justified in two ways:

1. The market mechanism generates a combination unwanted by society.
2. The existence of so-called market failures.

Market failure occurs when the intervention generates the same market imperfections, preventing optimal results. Main market failures:

• Existence of public goods: These goods are characterized because the consumption of one individual does not cause exclusion from the consumption of other individuals.
• Existence of imperfectly competitive markets (monopolies, oligopolies, and monopolistic competition): The fundamental characteristic of this market is the ability of companies to influence the market price. The state tries to make such markets disappear or create new competition in the market.
• Inequitable distribution of income: This way, charging taxes on those who have a higher income level and providing public goods are often used by people with incomes below the income distribution.
• Existence of externalities: An externality occurs when the consumption or production of one operator influences another operator that is not involved in the production or consumption. There are two types:
  • Positive: The operator that does not cause consumption or production activity is favored.
  • Negative: The consumption or production activity done by one economic operator harms another that does not participate in the production or consumption activity.

Fiscal Policy

One of the instruments with regard to the state's involvement in economic activity is fiscal policy. There are two instruments through which it can perform its functions: spending and taxes.

Objectives of the State

• Output
• Employment
• Inflation

Macroeconomic policies are always going to be countercyclical. Being able to be in different stages within a business cycle over time, the state must implement the fiscal policy that is necessary in each case.

Types of Fiscal Policy

• Expansionary (recession): The effect of increasing aggregate demand (increased government spending and lower taxes) is as follows: increased price level, increased employment (lower unemployment), and also an increase in inflation (price level).
• Contractionary (expansion): The instruments used in contractionary fiscal policy are increasing public spending, lower taxes, and finally, reducing personal disposable income. The effects of this policy are to reduce the level of consumption and production, decrease employment (increase unemployment), decrease the level of production, and decrease inflation (price level).

Taxes

Taxes are payments made by private agents (domestic economies and private enterprises) to the public sector of the economy. Types according to the tax rate:

• Progressive: These take a larger portion of income from those individuals with a higher income (e.g., income tax).
• Regressive: These represent a higher load on those with low-income levels (e.g., VAT).
• Proportional: These take a fixed proportion of each income level (e.g., corporate tax).

Taxes as Automatic Stabilizers of the Economy

Taxes are considered automatic stabilizers because they move without any individual acting to stabilize the negative effects of economic cycles. For example, in a recession phase:

• Effects: Low production level, GDP declines, aggregate demand decreases, businesses close, tax revenue decreases, the number of unemployed increases, and the amount of unemployment benefits increases.