Download - 84669403 Public Finance Lecture Notes
FIN702: Public Finance
Lecturer Notes
Introduction
Economics: The study of economics is the study of how individuals or decision making
units (DMUs) make decisions in a world where resources are scarce and limited.
The scarcity of resources leads DMUs to exercise choice—choice, that is, with
regard to how, in order to maximise returns, the resources are to be allocated
amongst alternative uses.
These returns are linked to human wants. In the public sector, the DMUs are
confronted with the same problem, that of deciding how to allocate the limited
resources amongst alternative and competing uses in a way that will ensure that
its social and economic objectives are maximised.
The process of decision making in the public sector differs slightly from that in
the private sector, as depicted in Figure 1.1.
In general, the public sector focuses primarily on public consumption: the supply
of public goods and services by spending government tax income, as opposed to
the consumption of individual goods by the citizens.
The social aspect of the public sector, which is inherent in its very nature, makes
it fundamentally different from a private sector organisation.
First, the public sector leaders in charge of running public institutions are elected
or chosen by those who have themselves been elected by the democratic process
to represent the people who are governed and served.
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In contrast, those responsible for the running of the private institutions are self
appointed and represent their own interest. Secondly, governments are endowed
with certain rights of compulsion that private sector organisations do not have,
such as the right to collect taxes.
Figure 1.1: Public and Private Sector Resource Path
Scarce and Limited Resources
Public Sector Private Sector
Public sector allocation of resources => Budget
Private sector allocation of resources => Market
Pricing => Political process Pricing => Demand and supply
Provision => Public good Provision => Private good
Public wants Private wants
The Economy/Society
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The social aspect of the public sector makes it fundamentally different from private
sector;
Public sector leaders are elected via democratic process – represent public
interest;
Private sector are self appointed and therefore represent own interest.
Mixed economies: Private and Public sector provide a combination of goods.
Private sector=> private good
Public sector => public good
Figure 1.3: Production Possibility Frontier
This interface between public sector and private sector brings to light many issues
that need to be examined to ensure a smooth interplay between the two.
One area of crucial importance is Public Finance.
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. A
Public Good
Private Good
Sharp and Sliger state that it is an
. . . inquiry into the facts, techniques, principles, theories, rules and policies
shaping, directing, influencing, and governing the use of scarce resources of
government. It examines government spending, taxing, borrowing, and managing
the public debt (Sharp and Sliger, 1964:33).
Gunning (2001): states that Public Finance began as the study of how government could
raise revenue for three purposes:
(1) to supply the basic services needed to maintain a market economy, including
the policing of property rights and defence against foreign invaders;
Three arms of government:
a) Legislature
b) Judiciary
c) Executive
(2) to supply particular services; and,
(3) to enrich the sovereign.
Given the political dimensions of decision making and resource allocation, public sector
economics also lies within the realm of political economy. Adam Smith (1776) wrote:
Political economy, considered as a branch of the science of a statesman or
legislator, proposes two distinct objects: first to provide a plentiful revenue or
subsistence for the people, or more properly to enable them to provide such revenue
or subsistence for themselves; and secondly to supply the state … with revenue
sufficient for the public services.
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Roles/Functions of Government
The question of whether a government should intervene does not arise. Rather, the
question is to what extent and in what areas and when should that intervention
occur.
In 1776, Adam Smith wrote his path breaking book Wealth of Nations, in which
he argued for a limited role for government. Smith attempted to show how
competition and the profit motive would lead individuals, while pursuing their
own private interests, to serve the public interest. The profit motive would lead
individuals in competition to supply at competitive prices the goods and services
that other individuals wanted. The economy, he argued, would operate as if led by
an invisible hand:
… he intends only his own gain, and he is in this, as in many other cases, led by an
invisible hand to promote an end which was no part of his intention. Nor is it
always the worse for the society that it was no part of it. By pursuing his own
interest he frequently promotes that of the society more effectually than when he
really intends to promote it. (Smith, 1776:345)
In fact, all governments have involved themselves in activities to preserve justice
and good order; provide for defence; and engage in activities leading to the
improvement of the standard of living of the general population.
Because the resources utilised by government are generated by the general public,
the state has to engage in activities that are in the best interests of the public.
Provision of infrastructure to foster economic growth is also of utmost importance
to any government.
The general approach to these objectives depends to a large extent on the ideology
on which the government operates. Ideologies include those held by people of
Classical, Neoclassical/Monetarist, Keynesian and Post-Keynesian persuasion.
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A summary of the difference in the key assumptions among these schools of
thought is provided in appendix 1.
Appendix 1: Summary of Assumptions in Classical, Neoclassical/ Monetarist, Keynesian and Post-
Keynesian Economic Theory.
Assumption
s
Classical Neoclassical/
Monetarist
Keynes Post-Keynesians
(Cambridge)
Explanation
of
unemploym
ent
Wage equals
subsistence wage;
K<Kf
Natural rate of
unemployment
(frictional)
Insufficient
effective
demand
Mismatch between sectors
producing different types of
goods
Allocation
of resources
governed
by
Equalisation of
profit rates; not
by marginal
equivalence
Perfectness of
markets
Uncertainty;
external effects
Imperfect competition;
uncertainty; increasing
returns to scale;
complementarities
Savings s out of P=1
s out of W = 1
s out of R = ?
One function:
optimisation over
time
0 < mpc < 1 Classical assumption
Savings–
Investment
Causation
Savings
determine
investment
Savings determine
investment
Investment
determines
savings
Investment determines
savings
Real
financial
linkages
Exogenous
money supply:
‘Classical
dichotomy’
Exogenous money
supply determines
absolute price
level; inflation is a
monetary
phenomenon
Money market
determines the
rate of interest
Md=L(r)=Ms
Money supply adapts to
demand (Kaldor); Inflation
is a real phenomenon (cost-
push, sectoral mismatches,
distributive struggles)
Role of the
State
State has no
prominent
function
State has a limited
social role (creation
of laws and
institutions
State has an
obligation to
secure full
employment
State has a role in
generating fuller
employment and securing
balanced growth
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conducive to the
operation of market
forces)
Note: K stands for capital stock, M for money stock, mpc for the marginal propensity to
consume, P for profits, R for rent, r for interest rate, s for the savings rate and W for wage
income.
Source: Naastepad (1999:327).
Classification of Roles of Government
The roles and functions of government can be classified in a number of ways. Bailey
(2000) provides a classification under the following headings: a) the allocative role; (b)
the distributive role; (c) the regulatory role; and (d) the stabilisation role.
a) The allocative role concerns government’s ability to allocate the scarce and limited
resources in a manner that maximises economic welfare.
b) The distributive role comes into play when in any country inequality in terms of
income and resource endowment is prevalent and the government engages in other
measures, such as provision of social security, health and education and housing
assistance, and the creation of employment opportunities, to ensure improvement of the
standard of living of those with low income and those who are marginalised. Government
engages in taxation, which garners the resources used for distributive purposes.
c) The regulatory role is seen when the government, with apparent economies of scale,
legislates and enforces laws of contract and property rights, and provides an efficient
judicial system and defence. This is to ensure that citizens feel secure in living and
investing, thus allowing the economy to function well and grow.
d) The stabilisation role comes into play when government makes efforts to ensure that
inflation and unemployment are low and the macroeconomic climate is stable. To
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enhance this, the government uses its fiscal and monetary policies. Government could,
for instance, change money supply targets and adjust tariffs and exchange rates.
Furthermore, it could embark on discretionary or built-in changes in fiscal policy.
Discretionary changes are deliberate changes in expenditure programs and the tax
structure, while built-in changes are primarily tax and transfer changes.
Rationale for Government Intervention
=> based on the assumption that markets do fail.
=> When resources are fully employed, economic welfare can be maximised in a
purely competitive market.
In such markets, firms are competitive, such that they buy inputs at the lowest
cost and sell their product for a competitive price, thus making only normal
profits (price equals marginal cost).
Competition in factor markets allows least-cost combination of input and
competition in the product market allows quality products sold at competitive
prices.
That is to say, we achieve economic efficiency.
Fundamental Theorems of Welfare Economics
Two fundamental theorems in welfare economics explain how economic
efficiency could be achieved.
1st Theorem: states that in a competitive market where there is a large number of
buyers and sellers with no individual having the power to affect the market price,
we have a Pareto efficient allocation of resources.
2nd theorem states that every point on the utility possibilities schedule can be
attained by a competitive economy, provided we begin with the correct
distribution of resources.
However:
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=> in developing countries, all markets do not operate on a purely competitive basis.
=> Markets are small and institutions are either absent or not functioning well or badly
governed.
Causes of market Failure
a) when price does not equal marginal cost in all sectors of the economy.
=> perfect competition may fail to exist because producers have monopoly power and
can therefore control prices.
=> This results from potential monopoly arising out of a small, underdeveloped
economy.
Competition could be potentially restricted in other ways too, for instance if
markets are not contestable or as a result of imperfect information.
b) The second reason is the failure of prices to incorporate all costs and benefits.
Perfect competitive market equilibrium will be distorted when individual
consumers make poor judgement of their own welfare, thus not consuming the
optimal level of the commodities.
Table 3.1: Forms of Distortion and Market Failure.
No. Distortion Effects
Domestic Product Market
1. Consumption
externality
Private consumption levels that
exceed or fall short of socially
optimal levels.
2. Monopoly
sellers
Price in excess of marginal cost,
leading to private production and
consumption at levels that are
socially sub-optimal
3. Production
externality
Private production levels that
exceed or fall short of socially
optimal levels.
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Domestic Factor Markets
1. Monopoly
suppliers of
labour
Wages in excess of marginal
revenue, leading to employment
below the socially optimal level.
2. Interest rates in
excess of social
discount rates
Investment levels below the
socially optimal level.
3. Surplus labour Wages in some sectors above their
social opportunity cost, leading to
underemployment in those sectors
International Product Markets
1. Market power Unexploited gains from trade
available to the large country.
Source: Greenaway and Milner (1987:44).
Externalities
Market failure also arises from externalities, existence of public goods and natural
monopolies.
The Principles of Public Finance
There are, in general, six principles of public finance. In postulating them, Von Justi
(1760) stated that these six form the normative core of public finance. These principles
are:
1) The ability of the citizen to pay a tax. Citizens must be able to take the burden
without being compromised in their ability to enhance the welfare of the state.
Given that this is an objective criterion, von Justi (1760) states that only so much
should be taken by taxation that the economic process is not impeded at all.
Therefore, tax should not incite any tax resistance.
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2) Equity and fair proportions. Equal treatment before law has been turned into one
of equity, as fairness serves as the moral underpinning and argument for
redistribution.
3) Welfare and civil liberty. Von Justi (1760) states that each and every measure of
the state must be shown to enhance the welfare of the citizenry and it must not
infringe on civil liberties.
4) This principle requires each measure of the state, notably those that entail
burdens, to be established in tune with or according to the nature of the state in
question and the form of its government.
5) This principle requires certainty and a broad legal and constitutional basis of
every state measure, particularly with respect to taxation.
6) The last principle refers to the implementation of all state measures, particularly
those of taxation. The tax must be levied in the easiest and the most convenient
way available from the point of view of the citizens.
Theory of Public Finance and Public Expenditure Growth
Public finance can be studied by examining five theories:
1) The Theory of Revenue Extraction
2) The Theory of Externalities
3) The Theory of Public Goods and Natural Monopolies
4) The Theory of Macroeconomic Stabilisation
5) The Theory of Public Choice.
The Theory of Revenue Extraction
To carry out functions of government, government needs finance and thus extracts
revenue. Therefore, the theory of revenue extraction is the study of the means through
which a government obtains money. Government’s major sources of finance are
borrowings and taxation.
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The Theory of Externalities
The theory of externality refers mainly to negative externalities as defined earlier and
government’s role in internalising this externality.
Market failures have been attributed to externalities.
An externality arises when the production or consumption process of one person
or activity affects the production or consumption process of another individual or
activity.
The production or consumption process may lead to both positive and negative
externality.
Positive externality is one where the second person may benefit from an effect on
the production or consumption process into which this second person has had no
input. For example, a bee farmer raising bees for honey production provides a
benefit from this process to the neighbouring orchid farm, whose flowers the bees
pollinate.
A negative externality is one where the production or consumption process affects
negatively another person’s production or consumption process and in the process
results in a loss to the society, as illustrated in Figure 3.2.
Figure 3.2: Effect of Negative Externality on Quantity Produced and Price.
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S2 S1
Price
In this market, under initial supply and demand conditions, output Q1 and price P1
exist. If all costs are fully identified and measured, then the new supply curve S2
results in output Q2 < Q1 and price P2 > P1.
With external costs (negative externality) too many units are produced at a price
below the one that would prevail if all costs were identified and factored into the
market process.
Case Study of Internalising Negative Externality
Both these cases could be resolved if government were to intervene. Bailey (2000) lists
five options if we assume that a private industry dumps untreated industrial waste in
rivers that another company uses for drinking water.
a) Internalise the negative externality. The second company would incur substantial
costs in purifying the water to make it potable. If these two companies merge,
then the negative externality is internalised.
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D1
Q2 Q1
P1
P2
Quantity
b) Prohibit the negative externality: This tends to be the most common governmental
response. Anti-dumping legislation is passed and violators are prosecuted and
fined.
c) Regulate the negative externality: This is the case where a maximum limit is set
for discharge by the first company, to the point where the social marginal cost
(SMC) is equal to marginal revenue (MR).
d) Tax the negative externality: This is an alternative to c) above, which could
achieve the same objective but with some revenue for government. Under this
case, the tax is equivalent to an amount that will reduce production to a level
where SMC is equal to MR. This is at q1.
e) Introduce a trading scheme in negative externality licences. To limit the output,
licences are issued on the pollution levels each company could emit. Companies
investing in technologies can sell their licences to other companies and recover
their investment costs. However, as Bailey (2000) suggests, companies should
only be allowed to sell a portion of their licences.
Expenditure research over the last four decades expanded on Pigou’s work by identifying
different types of externalities and the necessary government interventions to correct
externality problems.
(i) In general, government can ignore distribution issues when addressing
externalities, even when externalities can affect one group of consumers or
producers more than others.
(ii) To correct externalities, government needs only to concentrate on the markets
with the externalities.
(iii) The best policy option for government to deal with externalities is through a
direct tax, of the sort proposed by Pigou on the good or factor causing the
externality. The form of tax will vary but for an externality caused by
production of a particular product, the optimal tax is a commodity tax on that
good that equals “the sum of its external effect on the margin”.
(iv) Subsidies or indirect taxes on other commodities will either not solve the
problem or will lead to unrealistically complex taxation on all other
commodities.
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The Theory of Public Goods and Natural Monopolies
Theory of Public Goods
=> pure public good as those goods that a number of people could use simultaneously
without diminishing their value (non-rivalry), and once these goods were provided, it was
infeasible to exclude people from their use (non-exclusion).
That is, the benefits of the good or service were said to be enjoyed by all
consumers.
The provision of public goods arises when markets fail to exist for public goods
because they are both non-excludable and non-rival in consumption.
If they are non-excludable, use of them by those who are not paying for them is
not prevented; and they are non-rival in consumption if one person’s consumption
does not affect the level of consumption for another person.
o Common examples of such goods are national defence and lighthouses.
o Other examples where there is a degree of non-rivalry in the consumption
include police protection, public parks, etc. Common property resources
are not a pure public good because while property rights cannot be
assigned to any one individual, the collective consumption of such
resources can deplete the resource or exhaust the good (note the tragedy of
the commons example) thus violating the non-rival aspect of the good.
National defence, street lights, etc. are examples where an individual
cannot be excluded from consumption of the good. Stiglitz (1986)
explains public goods using different terms but with the same meaning.
=> Pure public goods have two critical properties: first, it is not feasible to ration
their use; and secondly, it is not desirable to ration their use.
=>By the first he means that it is impossible to exclude individuals from the
consumption of such a good simply because it is indivisible. Using the second
property, he states that because the marginal cost of supply for the good or service
to an additional individual is zero, it is not desirable to ration the use.
Table 3.2: Key Efficiency Conclusions from Normative Expenditure Theory
Marke Conclusions Policy Implications
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t
Failur
e
Exter
nalitie
s
Private market provides
goods with externalities
inefficiently
Governments need to
take the lead role in
correcting externality
Policy solution needs to be
concentrated only on market
with externality
Can establish separate
government regulatory
agencies (pollution,
health)
The best policy option is tax
(in direct proportion to
marginal impacts) or
vouchers
Government should
use pollution tax (or
vouchers) instead of
absolute standards
Subsidies or indirect taxes
are not efficient tools
Public
Goods
Private market will under-
provide public goods
Government needs to
produce or regulate
provision of public
goods
Efficient provision requires
knowledge of consumer
demand for public good
Preference revelation
mechanisms are not
generally useful
Consumers have no
incentive to reveal their
preferences accurately
Except in the case of
complex government
auctions
Accurate preference
revelation will require a
carefully designed two-part
tax (or voting) scheme
Survey methods (e.g.
CVM) that ask
citizens to reveal
demand for public
goods are used in
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cost-benefit analysis
Natur
al
Mono
polies
Private market (monopoly)
will under-provide and
over-charge for this good
Government needs to
provide or regulate
natural monopolies
such as utilities
Optimal pricing is based on
marginal costs; deficits
should be made up with a
lump-sum tax
Most present utility
regulation is not
consistent with
economic
recommendations
If utility must break even,
then a “Ramsey pricing”
rule or multi-part pricing
should be used to determine
prices
Economic analysis has
raised concern about
“rate of return”
regulation.
“Rate of return” regulation
leads to over-utilisation of
capital.
Source: Duncombe (1996:30)
The Theory of Macroeconomic Stabilisation
The main objective of stabilisation policy is to ensure that output levels are close to the
potential while inflation and the current account deficit are kept at acceptable levels. A
set of co-ordinated financial management of government resources is required. Baptiste
(1980) identifies three schools of thought with respect to governments’ financial
management of an economy: the Keynesian, Monetarist and New Cambridge schools.
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Keynesian School
Demand Side Effects of Fiscal Policy: Keynes, in his book The General Theory, states
that an expansionary fiscal policy (increased government spending) in times of
depression or recession could be a means to raise aggregate levels of income and
employment without a corresponding increase in the general level of prices. The simplest
Keynesian model assumes price rigidity and excess capacity, so that output is determined
by aggregate demand. Keynes argues that demand can be managed by changes in public
expenditure and revenue and by stimulating investment. He argues that a fiscal expansion
has a multiplier effect on aggregate demand and output. Using the extended Keynesian
model, one can show the crowding out effect through induced changes in interest rates
and the exchange rate, along with the direct crowding out that occurs when government
goods and services substitute those provided by the private sector.
The standard model used for the analysis of stabilisation policy in an open economy is
the Mundell-Flemming model.
This model describes the short-run fluctuations in an open economy.
a) Fiscal expansion with a fixed level of money supply will shift the IS
curve thus pushing up the interest rates.
b) The resulting capital inflow will result in an increase in the exchange
rate, which in turn will reduce the demand for domestically produced
goods, thus reducing the initial fiscal expansion.
c) However, there is a net positive effect from expansionary fiscal policy
under a fixed exchange rate.
d) With a push to increase the exchange rate resulting from expansionary
fiscal policy, money supply should be increased to neutralise the push,
thus realising the fiscal expansion (readers should refer to any standard
macroeconomics text to obtain a detailed treatment of the Mundell-
Flemming Model).
Supply-Side Effects of Fiscal Policy: The analysis of Keynesian theory mostly examines
the demand side effects of fiscal policy, which are mostly the short-term effects.
=> However, the longer-term supply-side issues also need to be considered.
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Institutional Aspects of Fiscal Policy: Institutional factors can affect the fiscal policy
impact in a number of ways.
Ricardian equivalence: One of the fundamental assumptions of the Keynesian approach
is that consumption is related to current income.
However, let us include some microeconomic fundamentals that are generally
ignored by the Keynesian approach. Let us assume that consumers are forward
looking and are fully aware of the government’s intertemporal budget constraints.
That is, they are Ricardian in a sense.
In such a case, consumers will anticipate that a tax cut today, financed by
borrowing, will result in higher taxes being imposed on their families in future.
Therefore, if we take permanent income into account, it remains unaffected and
therefore, there will be no change in consumption.
=> This equivalence between taxes and debt (borrowing) is known as Ricardian
equivalence.
=> It implies that a reduction in government saving resulting from a tax cut is fully
offset by higher private saving with no effect on aggregate demand
Monetarist School of Thought
The Keynesian position denies the classical view according to which persistent
high unemployment will lead to ongoing deflation of wages and prices; the
resulting decline in the transaction demand for money (causing an excess supply
of money) will lead to a reduction in the rate of interest, which in turn will
stimulate investment, causing aggregate output and employment to rise, thus
returning the economy to full employment (Naastepad, 1999).
As an extension of this, the monetarists argue that it is monetary policy rather
then a fiscal measure that will stabilise the economy during a recession and thus
monetary policy rather then fiscal policy should be the main tool for stabilisation
of an economy (Baptiste, 1980).
They argue that the use of monetary policy will keep the resources fully employed
without any effect on prices, citing the quantity theory of money, which states that
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the volume of money in the hands of the public largely determines total spending
in nominal terms and by its extension, the level of output and prices.
Therefore, controlling money supply can in many ways be the key stabilisation
instrument.
Monetarists argue that the manner in which the deficit budget is financed is
critical. If it involves borrowing from bank credit or public, then private
borrowers will get less credit, thus increasing the cost of borrowing (interest
rates). This will have a negative effect on investment. However, an alternative
would be for the Reserve Bank to expand bank reserve assets to allow financing
of the deficit.
In such a case, there would be an overall increase in bank credit and the volume
of money in the system. The public and the banks would now be in a better
position to lend more to private borrowers. Interest rates would remain
unaffected, with an expansionary effect on the economy.
The New Cambridge School of Thought
The New Cambridge school of thought suggests that there is a direct relationship
between the public sector deficit and the current account of the balance of
payments in an open economy: the larger the public sector financial deficit the
larger the deficit on the current account of the balance of payments (BOP)
(Baptiste, 1980).
This relationship can be further explained if one examines the New Cambridge
School proposition that the net acquisition of financial assets by the public,
private and overseas sector (i.e. BOP on CA) plus net transfers must total zero.
Along with this, the assertion that the private sector’s net acquisition (personal
and company sectors) is stable, suggests that any change in the budget or public
sector borrowing requirements must be reflected in the BOP on the current
account.
A major implication coming out of this is that any government that carelessly
follows a principle of deficit financing to boost the economy of a small open
economy can end up destroying the balance of payments in the long run.
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However, Jansen (2004) argues that fluctuations in economic activity in
developing countries are often due to exogenous supply shocks such as natural
disasters or international commodity prices.
She argues that if the supply shock is expected to be temporary, then fiscal
intervention is justified and it will stabilise the fluctuations in output and the
exchange rate over time.
Under these circumstances, fiscal policy is more effective than monetary policy
(Bird, 1998).
However, if the supply shock is expected to be permanent, then fiscal intervention
is undesirable as it would hinder the adjustment to the new situation (Jansen,
2004).
External shocks from the international financial market, such as sudden change in
capital flows, in global interest rates or in the alignment of major currencies, can
lead to substantial fluctuations in economic activity in developing countries
(Jansen, 2004).
Heller (1997) argues that cautious fiscal policy should accompany such capital
inflow. There are other studies as well that suggests prudent macroeconomic
management in the face of large capital flows.
The inflow will stimulate economic activity, leading to a rise in tax collection,
and with unchanged expenditure, will lead to improvement in the fiscal balance.
Jansen (2004) argues that fiscal contraction beyond this automatic adjustment will
be required,
o (i) to limit the expansionary pressures in the economy,
o (ii) to reduce the liquidity in the financial market and
o (iii) to limit the appreciation of exchange rate caused by inflow of capital.
=> However, during periods of capital outflow, contractionary fiscal policy is
required.
=> A contractionary policy would help in reducing domestic absorption
and creating current account surplus necessary to finance the capital outflows and
to maintain confidence of the investors, thus minimising capital outflow.
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Public Finance in New Growth Theory
The Theory of Public Choice
Worldwide, a trend towards democratic government is being established, with gradual
reduction in the numbers and power of autocracies. Democratic governments receive
advice from many people in a bid to make collective decisions. Given that this advice
comes from many and varied sources, decisions are costly to make and may result in
inefficient resource allocation.
However, the current literature is still grappling with the problem of aggregation of
individual preferences and how the political process transmits the preferences of the
citizens to the government through the voting process.
Several voting models, such as the Optimal Constitution Model, the Bowen-Black
Majority Voting Model, the Buchanan-Tullock Model and the Downs Model,1 have been
developed to provide some insight into this area.
They fall into two categories, direct democracy and representative democracy. Direct
democracy refers to citizens voting directly upon decisions, say by a referendum; and
representative democracy refers to voting for representatives who then vote on behalf of
the voters on decisions. Dickenson states
that in a democratic society, people have the opportunity to decide how much they
wish to provide for themselves and how much they want the state to provide for
them. Their individual preferences can be expressed by putting a vote in the ballot
box at the next election for a political party whose manifesto most closely reflects
their views. It is the majority vote, which is the aggregate of individual preferences,
that gives the government the mandate to carry out its policies. (Dickenson, 1996:
77)
=> At a general election, people give a block vote to a party and a manifesto ‘package’
containing various proposals.
=> They do not have a choice with regard to individual issues in the manifesto and thus
not all proposals in the manifesto may be acceptable to them.
=> Sometimes, though rare and costly, a referendum is carried out; if it is done during an
election, costs are minimal.
1 For further information on these models refer to Robin W. Boadway’s Public Sector Economics, Winthrop Publishers, Cambridge, 1979, p. 467.
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Model of Public Expenditure
In a static analysis of government expenditure, the ability of a government to spend in a
democratic society depends in the long run on
(i) national resources (national income),
(ii) the level of taxation required to finance spending; and
(iii) the acceptability of the public expenditure programmes to the electorate.
The Ballot Box Theory states that in a democratic society, people have the opportunity to
indicate how much and what they wish the state to do for them via their individual
preferences, that is by putting a vote in the box at the next election for a party whose
manifesto reflects their views as closely as possible.
The dynamics of public expenditure growth could be explained by examining two
categories of model, the micro- and macroeconomic models of public expenditure.
Brown (1990) examines in great depth these two types of models. Produced below is a
summary of his presentation, along with other writers.
Macro-Models of Public Expenditure
Under this category, three models are commonly cited. These are the “development
models of public expenditure”, “Wagner’s law of expanding state activity”, and “Peacock
and Wiseman’s” hypothesis.
Development Models of Public Expenditure
The Rostow’s stages of growth model is quite useful in explaining the pattern of public
sector expenditure change.
=> Early stages of growth, the state plays a very important role in investment,
employment, law and order, health, education and infrastructure development. Therefore,
public sector investment as a proportion of the total investment is quite high.
=> As the economy grows and expands, the private sector increases its role in the
economy, as both an employer and an investor. At the same time, the public sector plays
a complementary role, declining gradually, particularly in investment and employment.
Wagner’s Law of Expanding State
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Adolf Wagner, a German economist, was the first scholar to propose a theory explaining
the share of GNP that is taken up by the public sector. Over the years, researchers have
termed his proposition “Wagner’s Law”.
Wagner (1893) stated that “as per capita income in an economy grows, the
relative size of the public sector will grow also”.
Wagner’s proposition was based on empirical work using data from a number of
European countries, Japan and United States.
Wagner suggested the relationship after seeing three main reasons for the
increased government involvement.
o First, said Wagner, industrialisation and modernisation would lead to a
substitution of public for private activity.
o Furthermore, the relationship between the expanding markets and the key
actors in these markets would become more complex. With this
complexity, the role of the state would increase.
o Wagner also expected that the emergence of legal services, police services
and other public services (public goods) would increase.
o Secondly, Wagner argued that as income grows, income-elastic “cultural
and welfare” expenditures such as on education and health will also
expand, requiring increased public sector expenditures. As real incomes in
a country increase, public expenditures on these services would rise more
than in proportion, which would account for the rising ratio of government
expenditure to GNP.
o The third reason forwarded by Wagner was that economic development
and changes in technology required government to take over the
management of natural monopolies in order to enhance economic
efficiency (Henrekson, 1990).
Peacock and Wiseman’s Analysis
=> Using the political economic literature, Peacock and Wiseman provided an analysis of
the “time pattern” of public expenditure.
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=> They state that “governments like to spend more money, that citizens do not like to
pay more taxes and that governments need to pay some attention to wishes of their
citizens”.
=> Peacock and Wiseman explain that as an economy grows, government income will
increase (with constant tax rates).
=> With increasing revenue, the government can make more expenditure on public
goods.
=> Peacock and Wiseman also explain the “displacement effect” that takes place in
unforeseen circumstances. During these circumstances, such as natural disasters or war,
public expenditure is displaced upwards and for the period of the crisis, displaces private
expenditures. Peacock and Wiseman also explain the “inspection effect”, which arises
from social problems that may be raised by the voters.
=>To attend to this, the government needs to expand its expenditure .
Micro-Models of Public Expenditure
The micro-models are used to identify the variables that directly influence the
demand for and supply of public sector outputs, thus explaining changes in public
expenditure.
The main categories of actors in a society are voters, politicians, bureaucrats and
pressure groups. The behaviour of each of these actors, which affects the supply
and demand for public sector outputs, has an impact on public sector expenditure.
Public sector outputs require public sector inputs. Therefore, public expenditure
levels are based on the derived demand of the public sector inputs.
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