Chapter 1 : Introduction

A story recorded on clay tablets excavated at Lagash, a region that

is now known as modern Iraq:
The people of Lagash instituted heavy taxation during a terrible war, but when the
war ended, the tax men refused to give up their taxing powers. Everything was
taxed. Even the dead could not be buried unless a tax was paid. The story ends
when a good king “established the freedom” of the people, and once again,
“there were no tax collectors”…

Shortly thereafter the city was destroyed by foreign invaders. (Adams, 1993)
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Defining the Field of Study

• Public Finance – Field of economics that analyzes

government taxation and spending activities.
• Public Sector Economics or Public Economics
• Terms that better capture the fundamental issues of
this field of economics - government’s role in the
allocation of resources - that includes, but is not
limited to, government’s financial behavior.
• Focus on microeconomic functions of government.

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Public Finance and Ideology

• Views of how government should function are influenced by

general attitudes toward the individual/state relationship.
• Organic view of government
• Society is a natural organism
• Government is the heart.
• Individuals are parts of the organism that have significance only as
part of the community, which is stressed above the individual.
• Mechanistic view of government
• Government is not an organic part of society, but created by
individuals for individuals.

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• Before the modern period, the interests of the group
took priority over the wishes of the individual and
the achievement of his/her particular ends.
• “Life, liberty and the pursuit of happiness” were personal
ideals which the average, educated 16th-century man
would have rejected as the prime goals of a good society.

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• Anglo-American Political thought: the government is a
contrivance created by individuals to better achieve their
individual goals.
• Less so in Canada than in U.S.
• In Canada, the government provides health care, federal equalization
payments, etc.

• Ideology itself is insufficient

• Need economic analysis and economic institutions

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Government Canada has three levels
at a Glance: of government:
The Legal
Framework
• federal
• provincial or territorial
• municipal (city)

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 Constitutional Provisions: The 1867
Constitution Act
• Section 91 gives the federal
government the power “to make
laws for the peace, order, and good
government of Canada”, including
the power to raise money by any
system or mode of taxation.
• Section 125 prevents the federal
Federal government from levying taxes on
provincial lands and property.
Government • Most of the taxing power residing
at the federal level.
• Main sources of tax revenues:
taxes on imports and excise taxes
‒1916: Excess profits tax and taxes on
corporate
‒1917: personal income tax
‒1920: general sales tax
 ‒Conditional grants (first in 1912 in
agricultural education): extending Fed’s
spending powers into areas of provincial
responsibility

‒1940 Amendment (Section 91(2A))

gave the Fed responsibility for
unemployment insurance

Federal ‒1951 Amendment (Section 94A):

Shared jurisdiction with provinces for
Government old age pensions
(cont’d) ‒Conditional grants were protested by
some provinces, most strongly by
Quebec

• Provinces are free to choose

whether to participate in a
conditional grant program
 ‒Government bills (tax and spending) must
originate in the House of Commons and
must be introduced to the House by a
government minister. Cannot originate in
the Senate.
‒Expenditure must be approved annually
for new and old programs.
‒Yearly approvement not required for tax
Federal measures.
‒The federal government is not required to
Government finance all its expenditures by taxation. It
(cont’d) is empowered to “the borrowing of
money on the public credit”(Section
91(4)).
‒Responsibilities include: national defence,
navigation and shipping, regulation of
trade and commerce, the criminal justice
system, and money and banking
 Provincial Governments

The 1867 Constitution Act

• Limited to use of direct taxes

(e.g. personal income tax)
• Forbids use of indirect taxes
• No customs duties or taxes
that inhibit trade
• Entrenched equalization
payments
• Levy indirect taxes on
natural resources

The 1982 Constitution Act

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• Provincial governments’ revenue
Per capita subsidies, federal grants, licenses and fees, goods and
services sales, revenues from lands and natural resources, provincial
Property taxes, income taxes and succession duties
• The provincial role in public finance in Canada has grown
significantly relative to that of the federal since 1867.
• Key areas of responsibility: health, education, and
welfare

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 • The Constitution Act does not
have provisions for local
governments' taxing and
spending powers.
• Have only taxing and spending
Local powers that provincial
governments choose to delegate
Governments to them.
• Substantial variation across
provinces in local taxing and
spending decisions.
• The dominant revenue source is
property tax; relies on provincial
government transfer.

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 Question 1
Key areas of provincial responsibility include
A. welfare.
B. education.
C. health.
D. all of these answers are correct.

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 Question 2
The Constitution Act has provisions for local
governments' taxing and spending powers.
A. True
B. False
C. Uncertain

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The Size of How big is government? How to measure
the extent to which society’s resources are
Government subject to control by government?

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A common approach: annual expenditures

• Three types of government expenditure

- Purchases of goods and services
- Transfers of income
- Interest payments
• Budget documents
• Anticipated changes in tax and spending programs;
• the anticipated revenues and expenditure for the coming fiscal
year

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• Can be misleading
❑Accounting issues: off-budget items
The size of the government budget depends on some arbitrary
accounting decisions regarding whether and how certain items
are included.
e.g. loan guarantees, pension plans, contingent environmental
liabilities
Alternative: accrual accounting, which takes into account the
future liabilities created by present decision
❑Hidden costs of government
Activities with substantial effects on resource allocation but
minimal explicit monetary outlays

e.g. costs of issuing regulations, tax expenditures, the flow of

current services from capital investments
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Local, Provincial, and Federal Government
Expenditures (selected years)
Adjusting for Adjusting for Relative to
Inflation Population Economy
1 2 3 4
Total 2007 Dollars In 2007 Percentage
Expenditures ($ millions) Dollars of GDP
($ millions)
$ per capita
1991 352,796 493,421 17,559 50.9%
1995 390,496 511,790 17,466 47.5%
1999 418,762 524,764 17,261 41.8%
2003 493,117 557,194 17,610 39.6%
2007 589,927 589,927 17,937 37.7%
2011 720,678 667,913 19,448 40.9%
2014 774,877 685,732 19,294 39.6%
Source: Statistics Canada. CANSIM data from the following series v52531007, v62471023, v466668, v62471340.

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 Government Expenditures as a % of GDP (2011)

United
States

US

Source: Organization for Economic Cooperation and Development [2011b].

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The Size of Government
Government Expenditures as a Percentage of GDP, Selected
Countries

Sources: OECD (2014), “OECD Economic Outlook, annual data”, OECD Economic Outlook: Statistics and Projections
(database).
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 Composition of Total Government Expenditures,
1965 and 2009 (percent of total)

• Total government spending on health and social welfare increased by 20% 1965-2009.
• Spending on education has not changed much.
• Spending on transportation, communication, and the protection of persons and
property in 2009 (13.1%) is less than half of that in 1965 (26.9%) 22
 Composition of Government Expenditures by
Level of Government, 2009 (percent of total)

• Health and education accounted for 50% of the combined expenditures of provincial
and local governments.
• The share of federal spending on the protection of persons and property doubled the
share at the provincial/local level. 23
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 Composition of Total Government Tax Revenue,
1965 and 2009 (percent of total)

• The personal income tax is the most important revenue source (36.7%) in 2009.
• The relative importance of the corporate income tax fell since the 1960s. 24
 Composition of Government Tax Revenue by
Level of Government, 2009 (percent of total)

• The federal government relies heavily on the personal income tax (52.1%)
• Property tax is exclusively in the domain of provincial and local governments (21.8%).
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 Government Revenues and Expenditures by Level
of Government, 2009 (percent of total)

• The federal government collected 53.3% of all revenues but accounted for 1/3 of
government spending at all levels in 2009.
• The provincial and local governments accounted for 2/3 of all government spending
whereas their share of total revenue was 46.7%. 26
Transfers

• Federal transfers to provinces (and provincial transfers to

local governments) address gaps in revenue and
expenditure
• About 25 percent of federal spending takes the form
of transfers to provincial, territorial, and local
governments.

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Revenues

❑At the Federal level, the personal income tax is the

single most important source of revenue.
❑At the Provincial and Local levels:
• Transfer from the federal government
• Personal income tax, Consumption taxes and
Property taxes are important source of revenue
❑Changes in the Real Value of Debt is also an important
source of government revenue.
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Summary

• Public Finance/Public Sector Economics focuses on the

taxing and government spending and government’s role in
the allocation of resources and the distribution of income.
• Individual decision-making is the focus. The government is
a contrivance created by individuals to better achieve their
individual goals.
• The Constitution Act outlines the roles of and constraints
placed on provincial, and federal government economic
activity.

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• All common measures of the size of government involve
some deficiency, and miss the impact of off-budget
activities.
• The level of government expenditures has increased in both
nominal and real absolute terms, and in per capita terms,
while government spending as a percentage of gross
domestic product has fallen since the early 1990s.
• The share of spending on public welfare and health has
increased in importance.
• Personal income taxes, payroll taxes, and consumption taxes
are currently the largest sources of government revenue.

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 Question 3
___________ are exclusively the domain of
provincial and local governments, and the
federal government does not receive any
revenue from this source.
A. Personal income taxes
B. Property taxes
C. Sales taxes
D. Payroll taxes
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 Question 4
In evaluating changes in the growth of
government, economists take into account
A. population growth.
B. size of the economy.
C. inflation.
D. all of these answers are correct.

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 Question 5
If the size of government triples but at the same
time the economy doubles, then the relative size
of government has
A. shrunk.
B. grown.
C. remained constant.
D. no relevance.

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