An introduction to economics - Lesson 6: Public Goods and Services

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Public Goods and services - their value and source

Consider now the public goods and services that we referred to earlier, what are they, how are they enjoyed, and how they are paid for? We are referring here to those goods and services that, by their nature fall under some measure of public control or regulation.

The value of these services does not relate to the cost of providing them but rather to the value that would be lost if they were not provided. Thus the value of a community’s defence from and avoidance of an external attack or breakdown of internal law and order cannot be measured by the cost of providing adequate armed forces or civil law enforcement arrangements. Similarly, the value of flood and fire defences cannot be measured by their operating or building costs. Likewise with roads, bridges, sewers, public water supplies, electricity, transport and communications infrastructure etc.

All these are subject to public control and regulation since, by their nature, they are, or are liable to become, monopolies. In addition to natural monopolies we also need to consider those goods and services that the community has chosen to supply from public funds and for which the beneficiaries do not pay directly for all or part of the costs. These would include such things as educational establishments (schools, colleges and universities), health services (hospitals, clinics and surgeries), gardens, parks, recreation grounds and sports facilities, libraries and the like.

All these are paid for completely, or in part, out of the tax revenue of national and local government. This public revenue can only come from the aggregate value of the goods and services that are produced by all of the nation’s firms. The main economic impact of all these public goods and services is on land values. The land, or site values in locations that enjoy more benefits from publicly provided goods and services will be higher than those where the benefits are less. These benefits will be enjoyed both directly by the firms themselves and indirectly through the benefits that the people who constitute the firms enjoy. The firms and people in locations, such as that of firm ‘A’ discussed earlier, will derive much greater benefit than those who work and reside in less well served locations, such as where firm ‘B’ operates.

The Effect of Taxes on Firms

The UK government’s tax revenue amounts to around 40% of the nation’s Gross Domestic Product (GDP). Ultimately it can only come from what firms in the UK produce, thus firms, in aggregate, are required to pay around 40% of the value that they produce to the community in tax. Little of this is paid directly by the firms themselves, most is paid indirectly through taxes on employment (National Insurance contributions and Income Tax) and taxes on the goods that their workers purchase. When the price of these ‘wage goods’ is increased by the imposition of VAT, customs and excise duties etc. the effect is to reduce the real earnings of the firm’s workers. This has the effect of increasing the wage costs to the firm for a given purchasing power of their employees. Under current tax arrangements, it can be shown that firms in marginal locations pay much the same tax, as a proportion of their production, as those firms who operate from better locations. We have already noted above that marginal firms have no spare capacity to absorb any increase in their costs of production (or reduction in revenue). The tax imposed on marginal firms operating from rented sites must then be drawn from the revenue that would otherwise have gone to the land-owner as a rent payment. Where the marginal firm is operated by an owner-occupier, the buffer effect of ‘unpaid rent’ will be lost, and if any additional tax burden cannot be absorbed by a reduction in earnings the firm must close down. The individuals who constituted the firm must then find another way to earn a living or become dependant upon the value created by others.

The Marginal Firm

As we have already noted with our firms A and B it is the position of the firm in the most marginal location that is most economically significant. It is the viability of this firm that sets the benchmark, that determines the general level of earnings, that will obtain for all firms and their people throughout the economy. We noted also that the earnings of this firm are, by definition, the minimum it needs to just stay in business. It does not relate directly to the value of what it produces for the economy but rather what is left after the tax-man and the land-owner (as mere landowner) have taken from that value. Clearly the earnings of the marginal firm and then of all firms would be enhanced if these deductions could be removed.

It is equally clear that it is uneconomic to require the marginal firm to bear the same tax burden as its more fortunate (but no more able) competitors. The solution must be simple – relieve taxes at the margin and collect more revenue from the better sites! But how? We have seen that if taxes were reduced at the margin the land-owner would simply increase his land-rent charge accordingly – since that’s where they came from. If however we were to link the tax to the land-rent charge itself this would limit the ability of the marginal site land-owner to exploit our marginal firms enterprise.

We could also make the tax charge higher on the better sites where there is a much larger taxable capacity. The land-rent would then be effectively split between that which goes to the land-owner and that which goes for public revenue. The question is now how much is the land-rent at the margin. We might assume as now, that it would be determined by the bargain that would be struck in the market and would amount to something between what a potential firm would be prepared to pay to occupy the site and the amount that the land-owner would be prepared to accept. The big difference however now is that if the landowner gets no takers at his asking price and the site stands unoccupied and unproductive it will cost him. If the land-rent charge was set at say 90% of the land-rent there would be a big incentive for the land-owner to ensure that the site was put to its most economic use.

With the supply of more suitable land (already approved for the given land use) becoming available the land-rent charges might be expected to fall somewhat. It should be noted however that capital land values are likely to fall dramatically, since what they actually represent is the capitalisation of an indefinite stream of future income benefits that the land-owner is able to enjoy. These will now be severely reduced and, if the land-rent value was to be collected in its entirety by the community for public revenue purposes, they would be eliminated entirely.


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