Public Finance Chapter 1: Basics of Public Finance

Basics of Public Finance

• Public finance is the study of the provision, custody, and disbursement of resources needed for the conduct of public or governmental functions.
• It deals with the budgeting of revenues and expenditures of a public sector entity, usually government, and its effects on economic and social systems.

Meaning of Public Finance

• Financing of government is a universal concern, requiring adequate revenue to provide social amenities like education, health, and sanitation facilities, and public utilities.
• Public finance is sometimes crudely defined as the study of states, but this definition is vague and unhelpful.
• Public finance is also referred to as public sector economics or simply public economics.

Scope of Public Finance

• The scope of public finance includes:
  • Public expenditure
  • Public revenue
  • Public debt
  • Financial administration
  • Federal finance

Public Expenditure

• Public expenditure refers to spending by the public sector during a given period of time.
• It includes fiscal spending, plus all spending by fiscal and semifiscal firms with autonomous administration from the central government.
• Public spending is used for goods for public consumption or capital goods, public investment.
• Governments undertake expenditures to pursue a variety of economic, social, and political goals, such as poverty alleviation and creating an enabling environment for the private sector.

Public Revenue

• Public revenue refers to the various sources of government income, including taxation, fees, sale of goods and services, fines, gifts, and grants, and government properties.
• Taxation is the most important source of revenue for the government.
• A tax is a compulsory contribution from the person to the government to defray the expenses incurred in the common interests of all, without reference to special benefits conferred.

Public Debt

• Public debt is the money or credit owed by any level of government, including central, state, and local governments.
• Budget deficit is the excess of government expenditure over government revenue, and can be reduced by cutting spending or increasing revenue.
• Governments usually borrow by issuing securities such as government bonds and treasury bills.

Financing Budget Deficit

• Budget deficit can be financed in four basic ways:
  • Printing money
  • Running down foreign exchange reserves
  • Borrowing abroad
  • Borrowing domestically

Effects of Public Debt

• Each of the above mechanisms could lead to at least one potential problem:
  • Printing money acts like a tax, but the associated inflation exacts a heavy toll on social cohesion
  • Drawing foreign exchange reserves could lead to a balance-of-payment crisis
  • Borrowing abroad could precipitate a foreign debt crisis
  • Domestic borrowing might crowd-out private investment by raising interest rates

Economic Functions of Modern Government

• The economic functions of modern government include:
  • Allocation function: providing public goods and services to maximize social welfare
  • Distribution function: redistributing income and wealth to reduce inequality and promote social welfare### Fiscal Operations
• Fiscal operations aim to reduce income and wealth inequality by:
  • Implementing progressive taxation to reduce the income and wealth of the rich
  • Using the collected revenue to increase the income and standard of living of the lower-income group through public expenditure
• This approach has been commonly used in many countries to address income and wealth inequality

Stabilization Function

• Fiscal operations help to moderate fluctuations in the economy, such as:
  • Business booms and inflations
  • Business recessions and depressions
• To achieve this, fiscal operations may:
  • Increase taxation to control business booms and inflations
  • Increase public expenditure to stimulate economic growth during recessions

Private vs. Public Goods

Private Goods

• Are goods and services that are consumed by individuals to satisfy their personal wants or needs
• Examples: food, clothing, shelter, recreation, transportation, communication
• Characteristics:
  • Are priced in the market based on cost of production and demand
  • Can be divided among individuals based on their willingness to pay
  • Are subject to the principle of exclusion (those who don't pay can't consume)
  • May be affected by externalities (favorable or unfavorable effects on third parties)

Public Goods

• Are goods and services that are produced and supplied to meet collective wants
• Examples: defense, education, public health, infrastructure facilities
• Characteristics:
  • Cannot be divided among individuals
  • Are collectively consumed by all members of society
  • Are not priced in the market
  • Are not subject to the principle of exclusion (everyone benefits, regardless of payment)

Public Finance vs. Private Finance

Similarities

• Both aim to satisfy human wants
• Both involve balancing income and expenditure
• Both aim for maximum satisfaction
• Both involve borrowing to finance expenditure
• Both face the problem of economic choice (limited resources, unlimited wants)

Dissimilarities

• Income and expenditure adjustment:
  • Private finance: adjusts income to expenditure
  • Public finance: adjusts expenditure to income
• Nature of benefits:
  • Private finance: individual benefits
  • Public finance: collective benefits
• Other differences:
  • Postponement of expenditure
  • Allocation of resources
  • Motive of expenditure
  • Influence on expenditure
  • Nature of perspective
  • Nature of budget
  • Nature of resources
  • Coercion
  • Publicity
  • Audit

Role of the State in a Market Economy

• Ongoing debate about the role of the state in a market economy
• Different perspectives:
  • Laissez-faire: minimal government intervention
  • Industrial policy advocates: active government role in a market economy
• Arguments for government intervention:
  • Market irrationalities
  • Need for efficient markets
  • Challenges that cannot be settled through voluntary transactions
• Most economies today are mixed economies, with both government and private sector involvement

Market Failure and the Need for Government Intervention

• Market failure: a situation where markets are not able to provide enough of a particular socially desirable good
• Sources of market failure:
  • Public goods
  • Externalities
  • Market power (monopoly)
  • Equity considerations
  • Inadequate information
• Classification of goods and resources:
  • Excludable vs. non-excludable
  • Rival vs. non-rival
  • Private goods
  • Public goods
  • Common resources
  • Natural monopolies
• Public goods and the free-rider problem: since no one can be excluded from consuming a public good, public goods create a free-rider problem, and private firms will not provide them.### Public Goods and Externalities
• Private firms cannot provide public goods because they are non-rivalrous and non-excludable, leading to free riders who consume the good without paying for it.
• Government intervention is necessary to provide public goods.

Externalities

• An externality is a valued impact (cost or benefit) resulting from an action that affects someone who did not fully consent to it.
• Externalities can be positive (benefit) or negative (cost).
• Social costs are the full resource costs of an economic activity, including externalities.
• Private costs are the costs of an economic activity directly borne by the immediate producer or consumer (excluding externalities).
• External costs are the difference between social and private costs.

Market vs. Social Demand

• Market demand expresses only the anticipated private benefits of consumption.
• Social demand includes private benefits and accounts for externalities.
• If there is a negative externality, market demand exceeds social demand, leading to overproduction.
• If there is a positive externality, social demand exceeds market demand, leading to underproduction.

Correcting Externalities

• Approaches to correct externalities include:
  • Bargaining (Coase Theorem)
  • Legal System
  • Tax
  • Regulation
  • Subsidy
  • Market for Externality Rights

Market Power (Monopoly)

• Market power is the ability of a firm to alter the market price of a good or service.
• Government intervention is necessary to prevent or dismantle concentrations of market power.

Equity

• Equity concerns the distribution of goods and services generated by the free market.
• Government intervention may be needed to redistribute income if the market fails to reflect our notions of fairness.

Inadequate Information

• Inadequate information can lead to market failure.
• Government intervention is necessary to prevent information failures, such as:
  • Moral hazard
  • Adverse selection

Government Revenue Raising Mechanisms

• Government revenue raising mechanisms include:
  • Sale of goods or services
  • Borrowing
  • Printing paper money
  • Taxation

Taxation

• A tax is a compulsory charge imposed by the government without any expectation of direct return in benefit.
• Characteristics of taxation:
  • Compulsory contribution
  • Benefit is not the basic condition
  • Personal obligation
  • Common interest
  • Legal collection
  • Element of sacrifice
  • Regular and periodical payment
  • No discrimination
  • Wide scope

Structure of Taxation

• Taxation structures can be centralized or decentralized.

Objectives of Taxation

• Tax objectives are goals that are expected to be achieved through the taxation system.