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Subject ECONOMICS

Paper No and Title 7- Theory of Public Finance

Module No and Title 1, Nature and Scope of Public Finance

Module Tag ECO_P7_M1

ECONOMICS PAPER No. 7:Theory of Public Finance

MODULE No.1 :Nature and Scope of Public Finance
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Nature of Public Finance
3.1 Overview of Public Finance
3.2 Analyzing the Public sector: Role of the government
4. Scope of Public Finance
4.1 Why study Public Finance? Facts on the functions of the government
around the world
4.2 Relevance of Public sector today: Changing role of the government
5. Summary

ECONOMICS PAPER No. 7:Theory of Public Finance

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1. Learning Outcomes
After studying this module, you shall be able to

 Know what the study of public finance is all about, different roles played by the
government in an economy.
 Learn about the interaction between the public and the private sector regarding several
economic functions in an economy
 Analyze the rationale behind different public sector activities by the government as
suggested from the study of public finance.

2. Introduction

Study of Public Finance

In simple terms, the branch of public finance studies the role of the government in an economy.
Often, economists share contrasting views and therefore raise fundamental questions regarding
the actions of the government. Therefore, the goal of public finance is to understand the proper
role of the government in the economy. By observing various economies in the current time, we
may come up with questions like: why is the government the primary provider of the essential
goods and services like highways, education, unemployment insurance, while the provision of
other goods and services such as clothing, entertainment is generally left to the private
companies? On the expenditure side of public finance, we can ask: what kind of goods and
services should government provide, if any? Similarly, on the revenue side of the public finance,
we ask: how would the government raise the funds necessary for such expenditure, what kind of
taxes should be levied and on whom and finally what could be the resulting effect of such action
on the economy as a whole. The subject of pubic finance tries to answer these fundamental
questions by studying the role of government in an economy.

3. Nature of Public Finance

3.1 Overview of Public Finance

The subject of public finance broadly studies the role of the government in an economy and
analyzes various functions of the government or the public sector based on this well structured
role. The term “finance” loosely suggests monetary flows represented by the revenue and the
expenditure activities of the governmental fiscal process. Nevertheless, the basic economic
functions of the public sector are those that influence allocation of resources, distribution of real
output and effective demands among population and finally, the aggregate economic
performance. These three basic functions from the government’s part: allocation, distribution, and
stabilization are viewed as the targets or the objectives of the public sector economic activities. It
has been observed for most all economies in the world that government plays a central role in the
lives of the citizens through different activities. Therefore, the subject matter of public finance
mainly deals with the theoretical models as well as empirical tools to explain and analyze the role
of the public sector. The theory of public finance also considers the ongoing debate regarding the

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changing role of the government in an economy. For example:

in recent past, the governmental share of economic activity is
over 20 percent of the GNP whereas in western Europe, the share of government expenditure as a
percentage of GNP is over 50 percent (Musgrave & Musgrave, 1989). This observation also
reveals the steady disagreement among the policy-makers about whether the role of the
government should expand, contract, or stay the same. The subject of public finance also
discusses these issues to understand the changing role of the government in an economy.

3.2 Analyzing the Public Sector: Role of the government

According to some economists, the first function of any government is to establish and enforce
the “rules of economic games” which includes laws defining property rights and liabilities, legal
enforceability of contracts, provisions for bankruptcy. These are considered as the ground rules
set by the government for the proper functioning of both the private and the public sector. But,
since we are concentrating on the basic economic activities of the government such as allocation
of resources, distribution of output, and stabilization of the economic activities for modern, mixed
economies, we will try answering the following questions that consider the appropriate role of the
government in that context:

 When should the government intervene in the economy?

 How might the government intervene?
 What is the effect of those interventions on the economic outcomes?
 Why do the governments choose to intervene in the way that they do?

These four questions of public finance essentially capture all fundamental aspects of public
sector activities. The first question discusses the motivation for government intervention in an
economy. In a modern economy, all kinds of allocation decisions are made through either of
the two institutions: the market and the government. The market institution is designated as
the private sector and the government institution as the public sector. Allocation function in
private sector is carried out by the market forces such as supply –demand laws, and price
mechanisms supported by consumer sovereignty and profit motives of the producers. Public
sector allocation on the other hand is accomplished through the expenditure and revenue
related activities under government budgeting. Therefore, government intervention implies
the intervention of public sector in the operation of one or more of the private markets in an
economy when those markets fail to generate efficient outcomes. As we have learned from
basic microeconomic theory, competitive market equilibrium is considered to be the most
efficient outcome for a society. In the absence of government intervention, competitive
market equilibrium guarantees efficient trade outcome between consumers and producers
through the free adjustment of price resulting demand equal to supply. A trade is efficient if it
makes at least one party better off without making the other party worse off. Competitive
market outcome maximizes the number of efficient trades and hence maximizes efficiency.

Therefore, the reasons for government intervention in some market economies are: market
failures and redistribution.

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The first motivation for government intervention in private

market is due to the presence of market failure. In
economics, market failure is defined as a problem that causes the market economy to deliver
an outcome which does not maximize efficiency. One example of such a situation is the
presence of negative externality in a private market. Negative externality occurs in a market
when a consumer’s decision imposes on others a cost that the consumer does not bear. For
example, we can think about the market for private health insurance where there are hundreds
of consumers to buy health insurance and hundreds of private insurers to provide. But, still
we find that there exist a huge number of people without any health insurance plan. The
decision of these consumers poses a health risk cost on other people in the society as they
have the greater chance of falling ill. In this case, government intervention through regulation
or through price mechanism corrects the negative externality problem.

The second reason for government intervention is redistribution which means shifting of
resources from some groups in the society to others. The government can intervene with the
motive for redistribution even in the absence of market failure when the competitive market
maximizes efficiency. The government intervention in such cases can be justified on the
equity ground where the government thinks the resource allocation by the market economy is
unfair towards some groups in the society. Such action on the government’s part is often
criticized as it involves an equity-efficiency trade-off which means that in order to get a fairer
distribution of resources, there is social efficiency loss. Therefore, the first fundamental
question in public finance justifies the need for government intervention in a mixed economy.

The next question is how should government intervene? This deals with the different
approaches that the government can take to intervene. The frequently used methods are the
following:

 Tax or subsidize private sale or purchase

 Restrict or mandate private sale or purchase
 Public provision
 Public financing of private provision

The first approach corrects any form of market failure through price mechanism. Imposing a
tax raises the price of a commodity that is overproduced (in case of negative externality) and
imposing a subsidy lowers the price of a commodity that is under produced (case of positive
externality).

The second approach proposes a direct method of government regulation where public sector
can directly restrict or mandate the quantity and the price of a commodity in private market.
For example, regulation of wearing a seat belt while driving is a government mandate.

Under the third approach of government intervention, the public sector itself provides certain
goods and services directly to the society when those are not available in the market or under
produced by the private producers. Public schools and public hospitals are the examples of
such government activity.
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Finally, the fourth approach indicates the situation when government wants to influence the
consumption level of its citizens and does not want to get directly involved in the provision of
goods and services. In such cases, government can finance the private entities to provide the
desired amount of a particular good in the society.

Under the second fundamental question of “how”, government also has another role to play
by deciding between several alternative options to intervene. This question deals with the
cost-benefit analysis of the public sector to evaluate alternative policy options.

Answering the third fundamental question of public finance that what would be the effect of
government intervention on the society requires the government to critically analyze the
consequences of each public policy in order to evaluate it’s immediate as well as long-term
effect on the society. This is the branch of public finance that employs the empirical tools to
analyze the impact of public policies. Another important issue discussed in theory of public
finance is that any government policy involves two effects on the society. First is a direct
effect which occurs when individuals do not change their behavior in response to a policy
change and the second is an indirect effect which must be considered when individuals
change their behavior in response to the intervention in the society. The final effect of a
policy must include these both effects.

Finally, to answer the fourth fundamental question of public finance, why the governments
act the way that they do, we focus on the theory of political economy in public finance which
describes the government not as a benevolent actor who maximizes the welfare of the citizens
but as an agent with political motives. The theory also discusses the social, political and
historical forces that shape a current fiscal institution and the problems like preference
revelation, and preference aggregation that government faces before taking a policy decision.
Government faces a huge problem to figure out what millions of people want and how to
aggregate their want into a unique public policy. Theory of political economy also claims that
government and the politicians face a political pressure while taking a decision. They also
have a political motivation of being selected and to remain in their office apart from the
motivation for social welfare. Therefore, answer to this last question provides us with a
theory of how the political process produces decisions that affect all individuals in the
society.

4. Scope of Public Finance

4.1 Why study Public Finance? Facts on the Functions of the Governments around
the world

As we have seen in the previous section, study of public finance is important to understand the
proper role of the government. Why do we need the public sector in a modern, mixed economy is
a normative question in economics which explains how things should be done when private
markets can not deliver an efficient outcome to the society. Therefore, the motivation to study
public finance comes from the dominant role played by the governments in every economy

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around the world. In this section we will briefly highlight some

key facts regarding the government’s role in various developed
nations.

4.1.1 Changing Trends in Government Activities

The amount of government expenditure as a percentage of GDP indicates the level of

government intervention and plays a crucial role for the public provision in a country. If
we look at the size and the growth of government expenditure over a period for some
developed countries, we find some interesting trends.

Years

Figure 1.1

(source: Musgrave and Musgrave, 1976)

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Figure 1.1 shows government expenditure as a share of GDP across developed nations
from 1960 to 2000. The graph shows a steady growth in government spending for
countries: USA, Sweden, Greece and the average of industrialized nations as a part of
Organization for Economic Cooperation and Development (OECD). The striking fact
found from the figure is that although government spending as a share of GDP has grown
across all developed nations but the pace at which that growth occurred varies across
countries. While USA experienced a modest growth over time, almost all European
nations experienced a much larger growth in government spending during this period. So,
the natural question that comes to our mind is why the growth of government expenditure
varies across countries or what explains the striking growth in government spending in
countries after 1960s.

Another key feature of government spending that varies across countries is the degree of
centralization across central and local government levels within a country. This tells us
the extent to which government spending is concentrated at the central and at the local
level. The theory of fiscal federalism discusses this concept in detail under public
finance.

Another interesting feature of government’s activities is the changing pattern of

government finances as reflected in the government’s budget. As we know, the spending
on the government budget represents the outflows whereas the tax revenues represent the
inflows. If revenue exceeds the spending, government has a budget surplus and if
spending exceeds the revenue, government faces a budget deficit. Each rupee of
government deficit adds to the government’s existing stock of debt. The following three
panels of figure 1.2 show the government revenue and spending, the deficit or surplus,
and the level of government debt for US federal government from 1930 to 2000.

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Years

(source: Musgrave and Musgrave, 1976)

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Years

(source: Musgrave and Musgrave, 1976)

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Years
Figure 1.2

(source: Musgrave and Musgrave, 1976)

As seen from the three panels, except between 1941 and 1945, during the period of
World War II, US federal government’s budget was more or less balanced showing
amount of spending matched by the amount of tax revenue. This trend continued till late
1960s after which the deficit grew relatively larger to be 5 percent of GDP. The deficit
shrank significantly during 1990s but went up again in the early twenty-first century. This
same trend is mirrored in the second and the third panels of the figure. So, study of
government budget in public finance can motivate us to ask the following policy
questions:

Why do some governments face budget deficit relatively more than the other country’s
governments?

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What are the costs of having larger deficits and larger government debt on a nation?

Another interesting feature of the government spending discussed in public finance is the
distribution of government spending across different sectors for central as well as local
government levels. The following figure 1.3 shows the distribution of spending for the
US federal and local & state government across several broad categories in 1960 and
2001.

Figure 1.3

(source: Musgrave and Musgrave, 1976)

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The above figure shows us the sectors that have larger

propensity to receive public provision or government
spending. It also captures the changing composition of central and state government’s
spending over time as a share of total spending. As shown in the figure, federal
government spending in US is mostly in national defense and social insurance programs
such as Medicare, Social Security. On the other hand, state and local government spends
mostly on education, public order and safety, transportation and other social services. So,
we can ask the following question:

What are the appropriate types of sectors to receive spending from federal government
versus the areas to receive spending from state and local government? This leads us to the
question of fiscal federalism in public finance.

4.1.2 Regulatory role of the Government

Besides all of the above mentioned roles of a government in an economy, we also have
some examples where government perform as a regulatory body controlling our social
and economic activities. This is called the regulatory role of the government. For
example, the food and medications we buy from a store are all subject to the approval of
the Food and Drug administration body of the government.

4.2 Relevance of Public Sector today: Changing role of the Government

The important role played by the government in our lives makes the subject of public finance an
interesting and relevant course at any point in time. By looking at the trends and features of the
public sector activities we have motivated some questions based on that. Those questions remain
at the focus of any current policy debates and news in an economy. The importance of the role of
the government is acknowledged in public finance. But the changing pattern in that role is across
nations is what motivates the policy debates among the economists. For example, in the US the
three areas which receive the maximum attention regarding government’s role in the recent past
are the Social security, health care and education. In all cases, the debate was on whether the role
of the government is too conservative or too liberal and what could be the possible impact of such
policies on the overall economy. This same argument is valid for any country in the world
regarding any government policy.

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5. Summary
 This introductory module on public finance explains the concept and nature of public
finance as a subject.
 The goal of public finance is to understand the role of government in a country.
 The four fundamental questions asked in public finance that captures the various roles
played by the government including when a government should intervene (need for
government intervention), how the government can intervene (tools for government
intervention), what could be the result of such intervention (cost-benefit analysis,
empirical analysis), why do the government choose to act the way they do (theory of
political economy).
 The scope of public finance as a subject is motivated through various stylized facts from
the government activities around the world. This shows the trends in government
spending, government budget deficit, debt, distribution of spending and finally the
regulatory role of the government.
 The changing role of the government in public finance keeps the subject interesting and
relevant for ever. This also makes public finance a great subject for policy debates.

ECONOMICS PAPER No. 7:Theory of Public Finance

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