Why governments intervene
In a purely market economy, decisions about what, how and for whom to produce are left to the price mechanism. However, markets may not always allocate resources efficiently or equitably. Governments intervene to correct market failure, provide public goods, redistribute income, stabilise the economy and establish a legal framework for economic activity.
Main functions of government
| Function | Description | Examples |
|---|---|---|
| Provide public goods | Certain goods (e.g. street lighting, national defence) are non‑excludable and non‑rivalrous, so private firms would not supply them efficiently. | Lighting, police, flood defences |
| Correct externalities | Taxes, subsidies and regulation address negative externalities (e.g. pollution) and encourage positive externalities (e.g. education). | Carbon tax, vaccination programmes |
| Redistribute income | Governments can reduce inequality through progressive taxation and welfare payments. | Income tax, unemployment benefits, pensions |
| Macro‑economic management | Use fiscal, monetary and supply‑side policies to achieve economic stability (growth, low inflation, low unemployment). | Stimulus spending, interest rate changes |
| Legal and regulatory framework | Establish and enforce property rights, competition policy, consumer protection and labour laws. | Competition commissions, safety standards, minimum wage |
| Provide merit goods | Merit goods such as education and healthcare are often under‑consumed in a free market, so governments subsidise or provide them directly. | Public schools, hospitals |
Public expenditure and taxation
To finance public services, governments raise revenue through taxation. Direct taxes (e.g. income tax, corporation tax) are levied on income and profits, while indirect taxes (e.g. value added tax, excise duties) are charged on spending. Progressive tax systems collect a higher proportion of income from high earners. Governments also borrow funds to finance investment in infrastructure and to smooth fluctuations in the business cycle.
Examples and applications
Governments provide public goods that markets would undersupply. For instance, street lighting is available to all residents and cannot be restricted to those who pay, so it is funded through taxation. Likewise, national defence protects every citizen regardless of their contribution.
To correct externalities, authorities may impose taxes on goods that cause harm (e.g. a carbon tax on fossil fuels) or subsidise activities that create benefits (e.g. free vaccination programmes to prevent the spread of disease). In 2019, more than 50 countries introduced or strengthened carbon pricing to discourage greenhouse gas emissions.
Income redistribution policies include progressive income tax systems and welfare benefits. For example, Scandinavian countries finance generous social security programmes through high taxes. This reduces inequality and ensures that everyone has access to healthcare and education.
