Learning objective 1.1.3 Explain the role of government including economic and industrial policy, regulation, taxation and social welfare
3.1 Overview
There are various ways in which Government actions impinge on people’s lives and on the activities of businesses.
Legislation (laws) introduced by Parliament often gives authority for Government departments to introduce secondary legislation in the form of additional regulations.
Government agencies and local authorities affect our lives in many aspects, whether for example, through taxation or in the services they provide to us – including roads, and services and benefits to enhance people’s welfare such as medical services, education, State pensions and elderly services. An argument for public (Government) provision of services such as healthcare and education postulates that these are merit goods which, if left to private free market transactions, would be consumed in quantities that would be insufficient for the optimisation of social welfare. For example, if the Government did not provide free or subsidised education, it could be argued, many parents would go without educating their children rather than pay fees for education.
The extent to which the Government influences what we do reflects the type of economic system we have.
The economic system of the UK and of the wider European Union to which the UK belongs can be described as that of the mixed economy.
A mixed economy involves some degree of State intervention in economic activity, while mostly markets are allowed to operate as freely as possible so long as intervention is not needed in the public interest. Some goods and services – for example, postal services – may be provided by the State. The government may be seen as playing a role in reducing inequalities in the distribution of income and wealth through the tax system.
This type of economy stands between the two extremes of a laissez-faire free market economy in which market forces are allowed to reign, with minimal State intervention, and of a centrally planned command economy, such as that of the former Soviet Union and other Communist-ruled States, in which the government controls most industries and regulates many prices and wages, possibly with a rationing system to distribute scarce goods and services.
3.2 The UK and the EU
3.2.1 Overview
The European Union (EU), formerly called the EEC or the European Community (EC), is one of several international economic associations. Its immediate aim is the integration of the economies of the member states. A more long-term aim is political integration. The association dates back to 1957 (the Treaty of Rome) and the EU now has 27 members including the UK.
The European Union has a common market combining different aspects, including a free trade area and a customs union.
A free trade area exists when there is no restriction on the movement of goods and services between countries. This may be extended into a customs union when there is a free trade area between all member countries of the union, and in addition, there are common external tariffs applying to imports from non-member countries into any part of the union. In other words, the union promotes free trade among its members but acts as a protectionist bloc against the rest of the world.
A common market encompasses the idea of a customs union but has a number of additional features. In addition to free trade among member countries there are also free markets in each of the factors of production. A British citizen has the freedom to work in any other country of the European Union, for example. A common market will also aim to achieve stronger links between member countries, for example by harmonising government economic policies and by establishing a closer political confederation.
3.2.2 UK sovereignty and EU membership
UK Statute law is made by Parliament (or in exercise of law-making powers delegated by Parliament). Until the United Kingdom entered the European Community in 1973, the UK Parliament was completely
sovereign.
In recent years however, UK membership of the EU has restricted the previously unfettered power of Parliament. There is an obligation, imposed by the Treaty of Rome on which the EU is founded, to bring UK law into line with the Treaty itself and with EU Directives. Regulations, having the force of law in every member state, may be made under provisions of the Treaty of Rome.
3.2.3 Status of EU legislation
EU legislation takes the following three forms.
Regulations have the force of law in every EU state without need of national legislation. Their objective is to obtain uniformity of law throughout the EU. They are formulated by the Commission but must be authorised by the Council of Ministers. Regulations are passed by the European Commission, or jointly by the EU Council and European Parliament.
Directives are issued to the governments of the EU member states requiring them within a specified period (usually two years) to alter the national laws of the state so that they conform to the directive. Until a Directive is given effect by a national (UK) statute, it does not usually affect legal rights and obligations of individuals.
Decisions of an administrative nature are made by the European Commission in Brussels. A decision may be addressed to a state, person or a company and is immediately binding, but only on the recipient.
The Council and the Commission may also make recommendations and deliver opinions, although these are only persuasive in authority.
3.3 Monetary policy
3.3.1 Overview
Monetary policy is the area of government economic policy making that is concerned with changes in the amount of money in circulation – the money supply – and with changes in the price of money – interest rates. These variables are linked with inflation in prices generally, and also with exchange rates – the price of the domestic currency in terms of other currencies.
3.3.2 Setting interest rates
Since 1997, the most important aspect of monetary policy in the UK has been the influence over interest rates exerted by the Bank of England, the central bank of the UK. The Monetary Policy Committee (MPC) of the Bank of England was charged with the responsibility of setting interest rates with the aim of meeting the government’s current inflation target which currently stands at 2%, plus or minus 1% as measured by the Consumer Prices Index (CPI), also known as the Harmonised Index of Consumer Prices (HCIP).
Inflation below the target of 2% is judged by the Bank of England to be unsatisfactory, as is inflation above the target.
The UK inflation objective was originally formalised in the 1998 Bank of England Act. That Act states that the Bank of England is expected 'to maintain price stability, and, subject to that, to support the economic policy of HM Government including its objectives for growth and employment'.
The MPC decides the short-term benchmark ‘repo’ rate at which the Bank of England deals in the money markets. This will tend to be followed by financial institutions generally in setting interest rates for different financial instruments. However, a government does not have an unlimited ability to have interest rates set how it wishes. It must take into account what rates the overall market will bear, so that the benchmark rate it chooses can be maintained. The Bank must be careful about the signals it gives to the markets, since the effect of expectations can be significant.
The monthly minutes of the MPC are published. This arrangement is intended to remove the possibility of direct political influence over the interest rate decision.
The Bank of England reducing interest rates is an easing of monetary policy.
Loans will be cheaper, and so consumers may increase levels of debt and spend more. Demand will tend to rise and companies may have improved levels of sales. Companies will find it cheaper to borrow: their lower interest costs will boost bottom-line profits.
Mortgage loans will be cheaper and so there will be upward pressure on property prices.
Values of other assets will also tend to rise. Investors will be willing to pay higher prices for gilts (government stock) because they do not require such a high yield from them as before the interest rate reduction.
Interest rates on cash deposits will fall. Those who are dependant on income from cash deposits will be worse off than before.
The Bank of England increasing interest rates is a tightening of monetary policy.
Loans will cost more, and demand from consumers, especially for less essential ‘cyclical’ goods and services, may fall. Companies will find it more expensive to borrow money and this could eat into profits, on top of any effect from reducing demand.
Mortgage loans will cost more and so there will be a dampening effect on property prices.
Asset prices generally will tend to fall. Investors will require a higher return than before and so they will pay less for fixed interest stocks such as gilts.
Interest rates on cash deposits will rise, and those reliant on cash deposits for income will be better off.
3.4 Exchange rate policy
The exchange rate of the national currency (pounds sterling) against other major currencies (such as the US dollar, the euro and the Japanese yen) is another possible focus of economic policy.
The Government could try to influence exchange rates by buying or selling currencies through its central bank reserves. However, Government currency reserves are now relatively small and so such a policy might have to be limited in scope.
Another way the Government might wish to influence exchange rates is through changes in interest rates:
if UK interest rates are raised, this makes sterling a relatively more attractive currency to hold and so the change should exert upward pressure on the value of sterling. As we have seen, interest rate policy is now determined by the MPC. Interest rate policy is decided in the light of various matters apart from exchange rates, including the inflation rate and the level of house prices.
If the UK joined the single European currency, the euro, interest rates would effectively be determined at the European level, by the European Central Bank, instead of at the national level as now. It would not be possible for interest rates in different eurozone countries to be much out of line at any one time, since differences would encourage money flows to seek the higher rates available in a particular country, and borrowers would seek the best rates available. The forces of supply and demand would lead to an approximate equalisation of rates.
3.5 Fiscal policy
A government's fiscal policy concerns its plans for spending, taxation and borrowing.
These aspects of fiscal policy reflect the three elements in public finance.
Expenditure. The government, at a national and local level, spends money to provide goods and services, such as a health service, public education, a police force, roads, public buildings and so on, and to pay its administrative work force. It may also, perhaps, provide finance to encourage investment by private industry, for example by means of grants.
Income. Expenditure must be financed, and the government must have income. Most government income comes from taxation, but some income is obtained from direct charges to users of government services such as National Health Service charges.
Borrowing. To the extent that a government's expenditure exceeds its income, it must borrow to make up the difference. The amount that the government must borrow each year is known as the Public Sector Net Cash Requirement (PSNCR) in the UK.
Government spending is an injection into the economy, adding to the level of overall demand for goods and services, whereas taxes are a withdrawal.
A government's 'fiscal stance' may be neutral, expansionary or contractionary, according to its overall effect on national income.
Spending more money and financing this expenditure by borrowing would indicate an
expansionary fiscal stance. Expenditure in the economy will increase and so national income will rise, either in real terms, or partly in terms of price levels only: the increase in national income might be real, or simply inflationary.
Collecting more in taxes without increasing spending would indicate a contractionary fiscal stance. A government might deliberately raise taxation to take inflationary pressures out of the economy
The impact of changes in fiscal policy is not always certain, and fiscal policy to pursue one aim (eg lower inflation) might for a while create barriers to the pursuit of other aims (eg employment).
Government planners need to consider how fiscal policy can affect savers, investors and companies.
(a) The tax regime as it affects different savings instruments will affect investors’ decisions.
(b) Companies will be affected by tax rules on dividends and profits, and they may take these rules into account when deciding on dividend policy or on whether to raise finance through debt (loans) or equities (by issuing shares).
The formal planning of fiscal policy usually follows an annual cycle. In the UK, the most important statement is the Budget, which takes place in the Spring of each year. The Chancellor of the Exchequer also delivers a Pre-Budget Report each Autumn. The Pre-Budget Report formally makes available for scrutiny the Government's overall spending plans.
3.6 Industrial policy
3.6.1 Overview
While macroeconomic policy-making is concerned with the economy as a while, industrial policy is focused on particular sectors of the economy. The UK government current’s approach to industrial policy aims to create an institutional framework that allows businesses to prosper, and individuals and
households to improve steadily their living standards.
The institutional framework has the following aims.
Promoting effective competition
Flexibility in labour and capital markets
Maintaining a legal system which gives confidence and trust to market participants
Providing a stable macroeconomic framework
Other aspects of UK policy concentrate on the advance and commercial application of scientific
knowledge, and investment in physical infrastructure, education and health. Innovation policies seek to balance the benefits of intellectual property protection with facilitating the widespread exploitation of new knowledge through, among other things, easing barriers to the widespread dissemination and adoption of ideas.
Underpinning this approach is a presumption that, as a whole, the effective operations of markets are a better way of bringing about improvements to business efficiency and the most economically beneficial allocation of capital, knowledge and employment. Government is however seen to have a role where market failures arise, for example, in the provision of ‘merit goods’ in the public interest such as
education and healthcare services, in overcoming ‘externalities’ such as pollution, and through policies on science, skills, innovation and regulation.
Responsibility for the various themes of industrial policy is spread across difference central Government departments, although the Department for Business, Innovation and Skills plays a key role.
3.6.2 Industry policy and the European Union
The UK works with the European Commission and other EU Member States to address from the European perspective issues that are confronting all industrialised countries – the challenges laid down by
globalisation, including for example the intense competition from growing economies like China and India,
the greater fragmentation and wider dispersion of supply chains and increased pressures on industrial and local adjustment in relation to our international competitiveness, and energy and climate change.
Actions under the EU Policy agenda
A commitment to focus on economic growth and employment
Shaping policies to allow businesses to create more and better jobs implemented in a way that balances and mutually reinforce economic, environmental and social objectives
An integrated approach aimed at improving the coherence between different policy dimensions and increasing their relevance to business
Bringing business directly into the process through the establishment of ‘High Level Groups’
These High Level groups bring together members of the various European Commission Directorates General, Member State Governments and relevant stakeholders from industry, consumers/civil society, trade unions, Non-Governmental Organisations and regulators and are mandated to provide advice to policy makers at Community and national levels, industry and civil society organisations on issues effecting European industrial competitiveness.
3.7 Free movement of capital
Free international trade is generally associated with the free movement of goods (and services) between countries. Another important aspect of international trade is the free movement of capital.
If a UK company (or investor) wishes to set up a business in a different country, or to take over a company in another country, how easily can it transfer capital from the UK to the country in question, to pay for the investment?
Similarly, if a Japanese company wishes to invest in the UK, how easily can it transfer funds out of Japan and into the UK to pay for the investment?
Some countries (including the UK, since the abolition of exchange controls in 1979) have allowed a fairly free flow of capital into and out of the country. Other countries have been more cautious, mainly for one of the following two reasons.
The free inflow of foreign capital will make it easier for foreign companies to take over domestic companies. There is often a belief that certain key industries should be owned by residents of the country. Even in the UK, for example, there have been restrictions placed on the total foreign ownership of shares in companies such as British Aerospace and Rolls Royce.
Less developed countries especially, but other more advanced economies too, are reluctant to allow the free flow of capital out of the country. After all, they need capital to come into the country to develop the domestic economy.
3.8 Regulation
3.8.1 Overview
While it is widely accepted that the market mechanism enables prosperity, there are aspects of unbridled free markets that can lead to exploitation, abuse of information and dishonest dealing to the detriment of the overall welfare. There is a need, given that such market failures have the potential to occur, to have certain protections in place to ensure that markets are conducted in accordance with principles of fairness and consumers in general are dealt with fairly.
Consumer protection in the financial services industry and other consumer markets became an
increasingly important aspect of UK Governments’ policy from the 1970s onwards. The Financial Services
Act 1986 (FSA 1986) was brought in to replace the system of self-regulation which had previously prevailed in the UK financial sector. The FSA 1986 brought a new system of 'self-regulation within a statutory framework', with financial services firms authorised by Self-Regulatory Organisations (SROs).
A series of financial scandals, including those involving the Maxwell Group, Barings Bank, BCCI and pensions mis-selling, had added weight to the political impetus for change, leading to the establishment of the Financial Services Authority (FSA) as the single statutory regulator of the financial services industry, under the Financial Services and Markets Act 2000 (FSMA 2000).
The financial crisis of the late 2000s brought into focus the problems of financial instability affecting some banks and other financial sector institutions. In 2013, the UK’s single-regulator system was abolished. The Prudential Regulation Authority (PRA) was established to oversee the stability of
‘prudentially significant’ firms. The regulation of conduct across the sector, including issues surrounding advice given to retail consumers, became the responsibility of the Financial Conduct Authority (FCA),
‘prudentially significant’ firms. The regulation of conduct across the sector, including issues surrounding advice given to retail consumers, became the responsibility of the Financial Conduct Authority (FCA),