Government failure occurs when the result of government intervention in the economy results in a net loss of economic welfare, in example the social cost of the intervention is greater than the social benefit.
It can happen for any of the following reasons:
Distortion of Price Signals
Indirect taxes and subsidies may lead to a misallocation of resources, particularly when the reason for the tax or subsidy is NOT to correct for a market failure. In many countries agriculture and other industries considered strategically important may be protected from foreign competition by taxing imports. This will lead to higher levels of domestic production at the expense of producers overseas. This can create a welfare loss to consumers, as food prices rise. It also results in inefficiency, as high cost domestic producers displace low cost foreign producers.
A subsidy to domestic producers will also lead to increased domestic output at the expense of foreign producers, and therefore causes a loss of efficiency, but it won’t cause food prices to rise. It also results in a redistribution of income from taxpayers, who bear the cost of the subsidy, to domestic producers. This may not necessarily be considered desirable if the producers are already well off.
In Europe, most governments have imposed minimum wages in particular industries or across the economy as a whole. In Britain it is unlawful to pay an adult over 21 less than the National Living Wage, which will rise to £9.00 an hour by 2020. This may benefit workers who keep their jobs, at the expense of an increase in unemployment as firms lay off some workers or invest in machines to do the work instead.
Generous benefits for people who are not working may reduce incentives for them to find work. This may also lead to higher levels of unemployment and a loss of efficiency as the economy is not operating on its production possibility frontier.
Excessive Administrative Costs
Some forms of intervention by government may be costly to implement and produce little benefit. Some regulations of businesses, such as health and safety may cost firms a lot of money to put in place and taxpayers have to pay for the cost of inspection and enforcement. If the regulation does not make much difference to employees’ health and safety, it may not be worthwhile. The same point may apply to excessive environmental regulations that are costly to enforce but do little to improve the environment.
Sometimes government intervention can have undesirable consequences that were not foreseen. A recent example is the Renewable Heat Incentive in Northern Ireland, that paid a subsidy to businesses who used wood burners rather than fossil fuel boilers. The subsidy turned out to be more than the cost of the wood, so businesses had a perverse incentive to burn as much wood as possible, just to collect more in subsidy. Similarly, the Common Agricultural Policy of the EU used to give farmers guaranteed prices for their produce, with the EU buying up any output farmers could not sell. This gave farmers an incentive to overproduce and lead to beef and butter ‘mountains’ and milk ‘lakes’ across Europe, at vast cost to taxpayers.
Governments spend a lot of money on expensive projects that the private sector might regard as too risky. This is a legitimate thing for governments to do, but they may underestimate the costs and/or overestimate the benefits. In the 1960s the government constructed a huge reservoir in the North East of England called Kielder Water, believing it was necessary to ensure an adequate supply of water for industrial users in the region. But over the next 20 years there was a big decline in industries such as heavy engineering, shipbuilding and steel, which were all big users of water. The reservoir cost many £millions and was not needed.