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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 arescarce and limited.

The scarcity of resources leads DMUs toexercise choice—choice, that is, with regardto how, in order to maximise returns, theresources are to be allocated amongstalternative uses.

These returns are linked to human wants. In

the public sector, the DMUs are confrontedwith the same problem, that of deciding howto allocate the limited resources amongstalternative and competing uses in a way thatwill ensure that its social and economicobjectives are maximised.

The process of decision making in the publicsector differs slightly from that in the privatesector, as depicted in Figure 1.1.

In general, the public sector focuses primarilyon public consumption: the supply of publicgoods and services by spending governmenttax income, as opposed to the consumption of individual goods by the citizens.



The social aspect of the public sector, which isinherent in its very nature, makes itfundamentally different from a private sector

organisation.

First, the public sector leaders in charge of running public institutions are elected orchosen by those who have themselves beenelected by the democratic process torepresent the people who are governed and

served.

In contrast, those responsible for the runningof the private institutions are self appointedand represent their own interest. Secondly,governments are endowed with certain rightsof compulsion that private sectororganisations do not have, such as the right tocollect taxes.

Figure 1.1: Public and Private Sector ResourcePath



Scarce and Limited Resources

Public Sector Private Sector

Public sector allocation of

resources => Budget

Private sector allocation of

resources => Market

Pricing => Political processPricing => Demand and

supply

Provision => Public good Provision => Private good

Public wants Private wants

The Economy/Society



The social aspect of the public sector makes itfundamentally different from private sector;

Public sector leaders are elected via

democratic process – represent publicinterest;

Private sector are self appointed andtherefore represent own interest.

Mixed economies: Private and Public sector providea combination of goods.

Private sector=> private goodPublic sector => public good

Figure 1.3: Production Possibility Frontier

. .. A

Public Good

Private Good



This interface between public sector andprivate sector brings to light many issues thatneed to be examined to ensure a smoothinterplay between the two.

One area of crucial importance is PublicFinance.

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 examinesgovernment spending, taxing, borrowing, andmanaging the public debt (Sharp and Sliger,1964:33).

Gunning (2001): states that Public Finance began asthe study of how government could raise revenuefor three purposes:

(1) to supply the basic services needed tomaintain a market economy, including the policingof property rights and defence against foreign

invaders;

Three arms of government:a) Legislatureb) Judiciaryc) Executive

(2) to supply particular services; and,(3) to enrich the sovereign.



Given the political dimensions of decision makingand resource allocation, public sector economicsalso 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 aplentiful 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 … withrevenue sufficient for the public services.



Roles/Functions of Government

The question of whether a government shouldintervene does not arise. Rather, the question

is to what extent and in what areas and whenshould that intervention occur.

In 1776, Adam Smith wrote his path breakingbook Wealth of Nations, in which he arguedfor a limited role for government. Smithattempted to show how competition and theprofit motive would lead individuals, while

pursuing their own private interests, to servethe public interest. The profit motive wouldlead individuals in competition to supply atcompetitive prices the goods and servicesthat other individuals wanted. The economy,he argued, would operate as if led by aninvisible hand:

… he intends only his own gain, and he is inthis, as in many other cases, led by an invisiblehand to promote an end which was no part of his intention. Nor is it always the worse for thesociety that it was no part of it. By pursuing hisown interest he frequently promotes that of thesociety more effectually than when he really

intends to promote it. (Smith, 1776:345)

In fact, all governments have involvedthemselves in activities to preserve justiceand good order; provide for defence; andengage in activities leading to theimprovement of the standard of living of the

general population.



Because the resources utilised by governmentare generated by the general public, the statehas to engage in activities that are in the bestinterests of the public.

Provision of infrastructure to foster economicgrowth is also of utmost importance to anygovernment.

The general approach to these objectivesdepends to a large extent on the ideology onwhich the government operates. Ideologiesinclude those held by people of Classical,

Neoclassical/Monetarist, Keynesian and Post-Keynesian persuasion.

A summary of the difference in the keyassumptions among these schools of thoughtis provided in appendix 1.



Appendix 1: Summary of Assumptions in Classical, Neoclassical/ Monetarist,Keynesian and Post-Keynesian Economic Theory.

Assumptions

Classical Neoclassical/Monetarist

Keynes Post-Keynesians(Cambridge)

Explanation of unemployment

Wage equalssubsistencewage; K<K f

Natural rate of unemployment(frictional)

Insufficienteffectivedemand

Mismatch betweensectors producingdifferent types of goods

Allocationof resourcesgovernedby

Equalisation of profit rates;not bymarginalequivalence

Perfectness of markets

Uncertainty;externaleffects

Imperfect competition;uncertainty; increasingreturns to scale;complementarities

Savings s out of P=1s out of W = 1

s out of R = ?

One function:optimisation

over time

0 < mpc < 1 Classical assumption

Savings–InvestmentCausatio

Savingsdetermineinvestment

Savingsdetermineinvestment

Investmentdeterminessavings

Investment determinessavings



nRealfinanciallinkages

Exogenousmoney supply:‘Classicaldichotomy’

Exogenousmoney supplydeterminesabsolute price

level; inflationis a monetaryphenomenon

Moneymarketdeterminesthe rate of

interestMd=L(r)=Ms

Money supply adaptsto demand (Kaldor);Inflation is a realphenomenon (cost-

push, sectoralmismatches,distributive struggles)

Role of the State

State has noprominentfunction

State has alimited socialrole (creation of laws andinstitutionsconducive tothe operation of market forces)

State has anobligation tosecure fullemployment

State has a role ingenerating fulleremployment andsecuring balancedgrowth

Note: K stands for capital stock, M for money stock, mpc for the marginal propensityto 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).

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Classification of Roles of Government

The roles and functions of government can beclassified in a number of ways. Bailey (2000)provides a classification under the followingheadings: a) the allocative role; (b) the distributiverole; (c) the regulatory role; and (d) the stabilisationrole.

a) The allocative role concerns government’s abilityto allocate the scarce and limited resources in amanner that maximises economic welfare.

b) The distributive role comes into play when in anycountry inequality in terms of income and resourceendowment is prevalent and the governmentengages in other measures, such as provision of

social security, health and education and housingassistance, and the creation of employmentopportunities, to ensure improvement of thestandard of living of those with low income andthose who are marginalised. Government engagesin taxation, which garners the resources used fordistributive purposes.

c) The regulatory role is seen when the government,with apparent economies of scale, legislates andenforces laws of contract and property rights, andprovides an efficient judicial system and defence. This is to ensure that citizens feel secure in livingand investing, thus allowing the economy tofunction well and grow.



d) The stabilisation role comes into play whengovernment makes efforts to ensure that inflationand unemployment are low and the macroeconomicclimate is stable. To enhance this, the government

uses its fiscal and monetary policies. Governmentcould, for instance, change money supply targetsand adjust tariffs and exchange rates. Furthermore,it could embark on discretionary or built-in changesin fiscal policy. Discretionary changes are deliberatechanges in expenditure programs and the taxstructure, 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 andsell their product for a competitive price, thusmaking only normal profits (price equalsmarginal cost).

Competition in factor markets allows least-

cost combination of input and competition inthe product market allows quality productssold at competitive prices.

That is to say, we achieve economicefficiency.

Fundamental Theorems of Welfare Economics



Two fundamental theorems in welfareeconomics explain how economic efficiencycould be achieved.

1st Theorem: states that in a competitive

market where there is a large number of buyers and sellers with no individual havingthe power to affect the market price, we havea Pareto efficient allocation of resources.

2nd theorem states that every point on theutility possibilities schedule can be attainedby a competitive economy, provided we begin

with the correct distribution of resources.

However:=> in developing countries, all markets do notoperate on a purely competitive basis.=> Markets are small and institutions are eitherabsent or not functioning well or badly governed.

Causes of market Failure

a) when price does not equal marginal cost in allsectors of the economy.

=> perfect competition may fail to exist becauseproducers have monopoly power and can thereforecontrol prices.

=> This results from potential monopoly arisingout of a small, underdeveloped economy.

Competition could be potentially restricted inother ways too, for instance if markets are notcontestable or as a result of imperfectinformation.

b) The second reason is the failure of prices toincorporate all costs and benefits. Perfectcompetitive market equilibrium will be



distorted when individual consumers makepoor judgement of their own welfare, thus notconsuming the optimal level of thecommodities.



Table 3.1: Forms of Distortion and Market Failure.No. Distortion EffectsDomestic Product Market

1. Consumption externality

Private consumption levelsthat exceed or fall short of socially optimal levels.

2. Monopolysellers

Price in excess of marginalcost, leading to privateproduction and consumptionat levels that are socially

sub-optimal3. Productionexternality

Private production levelsthat exceed or fall short of socially optimal levels.

Domestic Factor Markets1. Monopoly

suppliers of

labour

Wages in excess of marginalrevenue, leading to

employment below thesocially optimal level.

2. Interestrates inexcess of socialdiscount

rates

Investment levels below thesocially optimal level.

3. Surpluslabour

Wages in some sectorsabove their socialopportunity cost, leading tounderemployment in thosesectors

International Product Markets

1. Market Unexploited gains from



power trade available to the largecountry.

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 publicfinance. In postulating them, Von Justi (1760) statedthat these six form the normative core of public

finance. These principles are:

1) The ability of the citizen to pay a tax. Citizensmust be able to take the burden without beingcompromised in their ability to enhance thewelfare of the state. Given that this is anobjective criterion, von Justi (1760) states that

only so much should be taken by taxation thatthe economic process is not impeded at all. Therefore, tax should not incite any taxresistance.

2) Equity and fair proportions. Equal treatmentbefore law has been turned into one of equity,as fairness serves as the moral underpinningand argument for redistribution.

3) Welfare and civil liberty. Von Justi (1760)states that each and every measure of thestate must be shown to enhance the welfareof the citizenry and it must not infringe oncivil liberties.

4) This principle requires each measure of thestate, notably those that entail burdens, to be

established in tune with or according to thenature of the state in question and the form of its government.

5) This principle requires certainty and a broadlegal and constitutional basis of every statemeasure, particularly with respect to taxation.

6) The last principle refers to the implementationof all state measures, particularly those of

taxation. The tax must be levied in the easiest



and the most convenient way available fromthe point of view of the citizens.

Theory of Public Finance and PublicExpenditure Growth

Public finance can be studied by examining fivetheories:

1) The Theory of Revenue Extraction

2) The Theory of Externalities3) The Theory of Public Goods and NaturalMonopolies

4) The Theory of Macroeconomic Stabilisation5) 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 themeans through which a government obtains money.Government’s major sources of finance areborrowings and taxation.

The Theory of Externalities

The theory of externality refers mainly to negativeexternalities as defined earlier and government’srole in internalising this externality.

Market failures have been attributed toexternalities.

An externality arises when the production orconsumption process of one person or activity

affects the production or consumption processof another individual or activity



of another individual or activity.

The production or consumption process maylead to both positive and negative externality.

Positive externality is one where the secondperson may benefit from an effect on the

production or consumption process into whichthis second person has had no input. Forexample, a bee farmer raising bees for honeyproduction provides a benefit from thisprocess to the neighbouring orchid farm,whose flowers the bees pollinate.

A negative externality is one where the

production or consumption process affectsnegatively another person’s production orconsumption process and in the processresults in a loss to the society, as illustrated inFigure 3.2.



Figure 3.2: Effect of Negative Externality onQuantity Produced and Price.

In this market, under initial supply anddemand 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.

D1

S2 S1

Q2 Q1

P1

P2

Quantity

Price



results in output Q2 < Q1 and price P2 > P1.

With external costs (negative externality) toomany units are produced at a price below theone that would prevail if all costs wereidentified and factored into the market

process.



Case Study of Internalising Negative ExternalityBoth these cases could be resolved if governmentwere to intervene. Bailey (2000) lists five options if we assume that a private industry dumps untreated

industrial waste in rivers that another company usesfor drinking water.

a) Internalise the negative externality. Thesecond company would incur substantial costsin purifying the water to make it potable. If these two companies merge, then the

negative externality is internalised.b) Prohibit the negative externality: This tends tobe the most common governmental response.Anti-dumping legislation is passed andviolators are prosecuted and fined.

c) Regulate the negative externality: This is thecase where a maximum limit is set fordischarge by the first company, to the point

where the social marginal cost (SMC) is equalto marginal revenue (MR).

d) Tax the negative externality: This is analternative to c) above, which could achievethe same objective but with some revenue forgovernment. Under this case, the tax isequivalent to an amount that will reduce

production to a level where SMC is equal toMR. This is at q1.e) Introduce a trading scheme in negative

externality licences. To limit the output,licences are issued on the pollution levelseach company could emit. Companiesinvesting in technologies can sell theirlicences to other companies and recover their

investment costs. However, as Bailey (2000)



suggests, companies should only be allowedto sell a portion of their licences.



Expenditure research over the last four decadesexpanded on Pigou’s work by identifying differenttypes of externalities and the necessary

government interventions to correct externalityproblems.

(i) In general, government can ignoredistribution issues when addressingexternalities, even when externalities canaffect one group of consumers orproducers more than others.

(ii) To correct externalities, government needsonly to concentrate on the markets withthe externalities.

(iii) The best policy option for government todeal with externalities is through a directtax, of the sort proposed by Pigou on thegood or factor causing the externality. Theform of tax will vary but for an externality

caused by production of a particularproduct, the optimal tax is a commoditytax on that good that equals “the sum of its external effect on the margin”.

(iv) Subsidies or indirect taxes on othercommodities will either not solve theproblem or will lead to unrealistically

complex taxation on all other commodities.

The Theory of Public Goods and Natural Monopolies

Theory of Public Goods=> pure public good as those goods that a numberof people could use simultaneously without

diminishing their value (non-rivalry), and once these



goods were provided, it was infeasible to excludepeople from their use (non-exclusion).

That is, the benefits of the good or servicewere said to be enjoyed by all consumers.

The provision of public goods arises whenmarkets fail to exist for public goods becausethey are both non-excludable and non-rival inconsumption.

If they are non-excludable, use of them bythose who are not paying for them is notprevented; and they are non-rival in

consumption if one person’s consumptiondoes not affect the level of consumption foranother 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 consumptioninclude police protection, public parks,etc. Common property resources arenot a pure public good because whileproperty rights cannot be assigned toany one individual, the collectiveconsumption of such resources candeplete the resource or exhaust thegood (note the tragedy of the commons

example) thus violating the non-rivalaspect of the good. National defence,street lights, etc. are examples wherean individual cannot be excluded fromconsumption of the good. Stiglitz (1986)explains public goods using differentterms but with the same meaning.



=> Pure public goods have two criticalproperties: 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 consumptionof such a good simply because it is indivisible.Using the second property, he states thatbecause the marginal cost of supply for thegood or service to an additional individual iszero, it is not desirable to ration the use.



Table 3.2: Key Efficiency Conclusions from Normative Expenditure TheoryMarketFailu

re

Conclusions Policy Implications

Externalities

Private marketprovides goods withexternalitiesinefficiently

Governmentsneed to take thelead role incorrectingexternality

Policy solution needsto be concentratedonly on market withexternality

Can establishseparategovernmentregulatoryagencies

(pollution, health) The best policy optionis tax (in directproportion to marginalimpacts) or vouchers

Governmentshould usepollution tax (orvouchers) instead



of absolutestandards

Subsidies or indirecttaxes are not efficienttools

PublicGoods

Private market willunder-provide publicgoods

Governmentneeds to produceor regulateprovision of publicgoods

Efficient provisionrequires knowledge of consumer demand forpublic good

Preferencerevelationmechanisms arenot generallyuseful

Consumers have noincentive to revealtheir preferencesaccurately

Except in the caseof complexgovernmentauctions

Accurate preferencerevelation will require

Survey methods(e.g. CVM) that

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a carefully designedtwo-part tax (or voting)scheme

ask citizens toreveal demand forpublic goods areused in cost-benefit analysis

NaturalMonopolies

Private market(monopoly) will under-provide and over-charge for this good

Governmentneeds to provideor regulatenaturalmonopolies suchas utilities

Optimal pricing isbased on marginalcosts; deficits shouldbe made up with alump-sum tax

Most presentutility regulationis not consistentwith economicrecommendations

If utility must breakeven, then a “Ramseypricing” rule or multi-part pricing should beused to determine

Economic analysishas raisedconcern about“rate of return”regulation.

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prices“Rate of return”regulation leads toover-utilisation of capital.

Source: Duncombe (1996:30)

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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 deficitare kept at acceptable levels. A set of co-ordinated financialmanagement of government resources is required. Baptiste (1980)identifies three schools of thought with respect to governments’financial management of an economy: the Keynesian, Monetarist andNew Cambridge schools.

Keynesian SchoolDemand Side Effects of Fiscal Policy: Keynes, in his book The GeneralTheory , states that an expansionary fiscal policy (increased governmentspending) in times of depression or recession could be a means to raise

aggregate levels of income and employment without a correspondingincrease in the general level of prices. The simplest Keynesian modelassumes price rigidity and excess capacity, so that output is determinedby aggregate demand. Keynes argues that demand can be managed bychanges in public expenditure and revenue and by stimulatinginvestment. He argues that a fiscal expansion has a multiplier effect onaggregate demand and output. Using the extended Keynesian model,one can show the crowding out effect through induced changes ininterest rates and the exchange rate, along with the direct crowding outthat occurs when government goods and services substitute thoseprovided by the private sector.

The standard model used for the analysis of stabilisation policy in anopen 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 willshift the IS curve thus pushing up the interest rates.

b) The resulting capital inflow will result in an increase in theexchange rate, which in turn will reduce the demand fordomestically produced goods, thus reducing the initialfiscal 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 beincreased to neutralise the push, thus realising the fiscalexpansion (readers should refer to any standardmacroeconomics text to obtain a detailed treatment of theMundell-Flemming Model).

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Supply-Side Effects of Fiscal Policy: The analysis of Keynesian theorymostly examines the demand side effects of fiscal policy, which aremostly the short-term effects.=> However, the longer-term supply-side issues also need to beconsidered.

Institutional Aspects of Fiscal Policy: Institutional factors can affect thefiscal policy impact in a number of ways.

Ricardian equivalence: One of the fundamental assumptions of theKeynesian approach is that consumption is related to current income.

However, let us include some microeconomic fundamentals thatare generally ignored by the Keynesian approach. Let us assumethat consumers are forward looking and are fully aware of thegovernment’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 imposedon their families in future.

Therefore, if we take permanent income into account, it remainsunaffected and therefore, there will be no change in consumption.

=> This equivalence between taxes and debt (borrowing) is knownas Ricardian equivalence.

=> It implies that a reduction in government saving resulting from atax cut is fully offset by higher private saving with no effect onaggregate demand

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Monetarist School of Thought

The Keynesian position denies the classical view according towhich persistent high unemployment will lead to ongoing deflationof wages and prices; the resulting decline in the transactiondemand for money (causing an excess supply of money) will lead

to a reduction in the rate of interest, which in turn will stimulateinvestment, 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 monetarypolicy rather then a fiscal measure that will stabilise the economyduring a recession and thus monetary policy rather then fiscalpolicy should be the main tool for stabilisation of an economy(Baptiste, 1980).

They argue that the use of monetary policy will keep theresources fully employed without any effect on prices, citing the

quantity theory of money, which states that the volume of moneyin the hands of the public largely determines total spending innominal terms and by its extension, the level of output and prices.

Therefore, controlling money supply can in many ways be the keystabilisation instrument.

Monetarists argue that the manner in which the deficit budget isfinanced is critical. If it involves borrowing from bank credit orpublic, then private borrowers will get less credit, thus increasingthe cost of borrowing (interest rates). This will have a negativeeffect on investment. However, an alternative would be for theReserve 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 bankswould now be in a better position to lend more to privateborrowers. Interest rates would remain unaffected, with anexpansionary effect on the economy.

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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 thecurrent 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 NewCambridge School proposition that the net acquisition of financialassets 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 netacquisition (personal and company sectors) is stable, suggeststhat any change in the budget or public sector borrowingrequirements 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 theeconomy of a small open economy can end up destroying thebalance of payments in the long run.

However, Jansen (2004) argues that fluctuations in economicactivity in developing countries are often due to exogenous supplyshocks such as natural disasters or international commodityprices.

She argues that if the supply shock is expected to be temporary,then fiscal intervention is justified and it will stabilise thefluctuations in output and the exchange rate over time.

Under these circumstances, fiscal policy is more effective thanmonetary policy (Bird, 1998).

However, if the supply shock is expected to be permanent, thenfiscal intervention is undesirable as it would hinder the adjustmentto the new situation (Jansen, 2004).

External shocks from the international financial market, such assudden change in capital flows, in global interest rates or in thealignment of major currencies, can lead to substantial fluctuationsin economic activity in developing countries (Jansen, 2004).

Heller (1997) argues that cautious fiscal policy should accompanysuch capital inflow. There are other studies as well that suggests

prudent macroeconomic management in the face of large capitalflows.

The inflow will stimulate economic activity, leading to a rise in taxcollection, and with unchanged expenditure, will lead toimprovement in the fiscal balance.

Jansen (2004) argues that fiscal contraction beyond this automaticadjustment will be required,

o (i) to limit the expansionary pressures in the economy,

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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 domesticabsorption and creating current account surplus necessary tofinance the capital outflows and to maintain confidence of theinvestors, thus minimising capital outflow.

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Public Finance in New Growth Theory

The Theory of Public ChoiceWorldwide, a trend towards democratic government is being

established, with gradual reduction in the numbers and power of

autocracies. Democratic governments receive advice from manypeople in a bid to make collective decisions. Given that this advicecomes from many and varied sources, decisions are costly to makeand 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 processtransmits the preferences of the citizens to the governmentthrough the voting process.

Several voting models, such as the Optimal Constitution Model, the

Bowen-Black Majority Voting Model, the Buchanan-Tullock Modeland the Downs Model,1 have been developed to provide someinsight into this area.

They fall into two categories, direct democracy and representativedemocracy. Direct democracy refers to citizens voting directly upondecisions, say by a referendum; and representative democracyrefers to voting for representatives who then vote on behalf of thevoters 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 theywant the state to provide for them. Their individual preferences canbe expressed by putting a vote in the ballot box at the next electionfor a political party whose manifesto most closely reflects theirviews. It is the majority vote, which is the aggregate of individualpreferences, that gives the government the mandate to carry outits policies. (Dickenson, 1996: 77)

=> At a general election, people give a block vote to a party and amanifesto ‘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 acceptableto them.=> Sometimes, though rare and costly, a referendum is carried out; if itis 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 ExpenditureIn a static analysis of government expenditure, the ability of agovernment 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 tothe electorate.

The Ballot Box Theory states that in a democratic society, people havethe opportunity to indicate how much and what they wish the state to dofor them via their individual preferences, that is by putting a vote in thebox at the next election for a party whose manifesto reflects their viewsas closely as possible.

The dynamics of public expenditure growth could be explained byexamining 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 otherwriters.

Macro-Models of Public ExpenditureUnder 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 thepattern of public sector expenditure change.

=> Early stages of growth, the state plays a very important role ininvestment, employment, law and order, health, education andinfrastructure development. Therefore, public sector investment as aproportion of the total investment is quite high.=> As the economy grows and expands, the private sector increases itsrole in the economy, as both an employer and an investor. At the sametime, the public sector plays a complementary role, declining gradually,

particularly in investment and employment.

Wagner’s Law of Expanding StateAdolf Wagner, a German economist, was the first scholar to propose atheory explaining the share of GNP that is taken up by the public sector.Over the years, researchers have termed his proposition “Wagner’sLaw”.

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Wagner (1893) stated that “as per capita income in an economygrows, the relative size of the public sector will grow also”.

Wagner’s proposition was based on empirical work using datafrom 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 becomemore complex. With this complexity, the role of the statewould 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 oneducation and health will also expand, requiring increasedpublic sector expenditures. As real incomes in a countryincrease, public expenditures on these services would risemore than in proportion, which would account for the risingratio of government expenditure to GNP.

o The third reason forwarded by Wagner was that economic

development and changes in technology requiredgovernment to take over the management of naturalmonopolies in order to enhance economic efficiency

(Henrekson, 1990).

Peacock and Wiseman’s Analysis=> Using the political economic literature, Peacock and Wisemanprovided an analysis of the “time pattern” of public expenditure.=> They state that “governments like to spend more money, thatcitizens do not like to pay more taxes and that governments need to paysome 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” thattakes place in unforeseen circumstances. During these circumstances,such as natural disasters or war, public expenditure is displacedupwards and for the period of the crisis, displaces private expenditures.Peacock and Wiseman also explain the “inspection effect”, which arisesfrom social problems that may be raised by the voters.=>To attend to this, the government needs to expand its expenditure .

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Micro-Models of Public Expenditure

The micro-models are used to identify the variables that directlyinfluence the demand for and supply of public sector outputs, thusexplaining changes in public expenditure.

The main categories of actors in a society are voters, politicians,bureaucrats and pressure groups. The behaviour of each of theseactors, which affects the supply and demand for public sectoroutputs, 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 thepublic sector inputs.

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public finance lecture notes

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