• Theoretical Tools of Public Finance

• Empirical Tools of Public Finance

• Analysis
• Tools of Budget Analysis

Feb 25, 2024 DR HASAN RACHMANY, MA 1

 The BASICS OF FISCAL POLICY

Discretionary fiscal policy: (beside: to produce good &

services, to help achieve an equitable income
distribution ........, to promote full employment, price
stability, and economic growth).
-change of government expenditures, and
-tax collections
Government uses expansionary fiscal policy: to shift
the aggregate demand curve rightward in order to
expand real output. (this means to increase in
government spending, reduce taxes, or combination).

Feb 25, 2024 DR HASAN RACHMANY, MA 2

 The BASICS OF FISCAL POLICY
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Government uses contractionary fiscal policy: to

shift the aggregate demand curve leftward in an
effort to halt demand-pull inflation. (This means a
reduction in government spending, tax increases,
or some combination of the two).

The expansionary effect of fiscal policy is greater

when the budget deficit is financed through money
creation rather than through borrowing; the
contractionary effect of the creation of a budget
surplus is greater when the budget surplus is
retained rather than used for debt reduction.

Feb 25, 2024 DR HASAN RACHMANY, MA 3

 The New Classical View
of Fiscal Policy
The New Classical view stresses that:
debt financing merely substitutes higher future taxes
for lower current taxes, and thus,
budget deficits affect the timing of taxes, but not their
magnitude.

New Classical economists argue that when debt

is substituted for taxes:
people save the increased income so they will be able to
pay the higher future taxes, thus,
the budget deficit does not stimulate aggregate
demand.

Feb 25, 2024 DR HASAN RACHMANY, MA 4

 The New Classical View
of Fiscal Policy

Similarly, New Classical economists

believe that the real interest rate is
unaffected by deficits as people save more
in order to pay the higher future taxes.

Further, they believe fiscal policy is

completely impotent – that it does not
affect output, employment, or real interest
rates.
Feb 25, 2024 DR HASAN RACHMANY, MA 5
What is fiscal policy?
The budgetary stance of govt
Using govt expenditure, taxation and govt borrowing to
affect AD, prices and the BoP
A broader view includes
social and developmental responsibilities
Govt’s fiscal policies are outlined in the annual
budget
Responsibility of the Minister of Finance
To reveal govt’s priorities

Feb 25, 2024 DR HASAN RACHMANY, MA 6

How Fiscal Policy Influences Aggregate
Demand
Fiscal policy refers to the government’s choices
regarding the overall level of government
purchases or taxes.
Fiscal policy influences saving, investment, and
growth in the long-run. In the short-run, fiscal
policy affects the aggregate demand.

Feb 25, 2024 DR HASAN RACHMANY, MA 7

Schematic: Fiscal Policy-Public Expenditure-Growth Linkages

Fiscal Policy

Level of Expenditure

Resource (Pol.choices)
Mobilization

Composition of Expenditure

(Institutional cap)

Growth
Welfare
MDGs Efficiency

Public sector
Outputs
Feb 25, 2024 DR HASAN RACHMANY, MA 8
Principles of government fiscal framework
Transparency in the setting of fiscal policy
objectives
 Stability in the fiscal policy process and in the
way fiscal policy impacts on the economy;
 Responsibility in the management of the
public finances;
 Efficiency in the design and implementation of
fiscal policy and in managing both sides of the
public sector balance sheet; and
 Fairness, including between generations.
Feb 25, 2024 DR HASAN RACHMANY, MA 9
Fiscal rules (Best Practice)
Golden rule:
over the economic cycle, the
Government will borrow only to invest
and not to fund current spending

Sustainable investment rule:

public sector net debt as a % of GDP will
be held over the economic cycle at a
stable and prudent level (<60%GDP)

Feb 25, 2024 DR HASAN RACHMANY, MA 10

Functions of Fiscal policy
3 broad functions:
Provide public goods and services
 Allocative function
Help achieve an equitable income
distribution
Distribution function
Promote economic growth and employment
Stabilisation function

Feb 25, 2024 DR HASAN RACHMANY, MA 11

Instruments of Fiscal policy
The basic instruments therefore are:
Govt expenditure
Current vs capital expenditure
Direct and indirect taxes
E.g. personal income tax, corporate tax vs. VAT
Govt borrowing (and public debt management)
Domestic vs foreign

Feb 25, 2024 DR HASAN RACHMANY, MA 12

 Budget Deficits
Conventional Deficit
• Total govt exp > total govt revenue for a given year
Primary Deficit
• Conventional deficit – interest payments
Public Debt
• Sum of all govt liabilities. Sum of all conventional
deficits plus other liabilities
Debt-to-GDP ratio
• Total govt debt/GDP
• An estimate of ‘solvency’

Feb 25, 2024 DR HASAN RACHMANY, MA 13

Are deficits good or bad for
economic growth?
ed govt spending AD
However, deficits still need to be repaid!
Different economic paradigms consider different
impact
Neoclassical paradigm
G AD thus increasing the deficit
As national saving is lower, Md r
rI (“crowding out” of private investment)

Feb 25, 2024 DR HASAN RACHMANY, MA 14

 What is the Appropriate Size of the Public
Sector?
• Rapid growth in size over the past 50 years
• Two reasons:
a. Desire to increase rate of growth and industrialization
- growth in state owned enterprises.
- this trend is reversing
b. Growth in social program
- social security
- health expenditure
- unemployment insurance
- welfare programs
• Need to think how these objectives and programs can be more
effectively delivered. E.g. public-private partnerships.
Feb 25, 2024 DR HASAN RACHMANY, MA 15
 Keynesian Paradigm
Supports budget deficit to stabilise and stimulate
economy
ADboosts output and employment
Crowding out is insufficient to reduce output
Public investment is complementary to private
investment

Feb 25, 2024 DR HASAN RACHMANY, MA 16

 Ricardian Equivalence Paradigm
David Ricardo’s theory of tax
Has a neutral approach to fiscal deficits
If government cuts tax (fiscal deficit)
=>financed by bonds
Rational individual realize that tax will
 in future
Therefore put additional wealth into
savings
Feb 25, 2024 DR HASAN RACHMANY, MA 17
 ed saving relieves pressure on r thus
reducing crowding out
ed saving can also be used to pay govt
debt in future
The ‘Fourth’ Paradigm
Evidence is not consistent with other 3
approaches
The effect of deficits depends on
How it’s financed, its size and current
GDP rate

Feb 25, 2024 DR HASAN RACHMANY, MA 18

Changes in Government Purchases
The central government can influence the economy
because
 of the size of the central government in relation to the
economy and other economic entities.
 of the deliberate use of spending and taxes to
manipulate the economy toward achieving a
predetermined outcome.

Feb 25, 2024 DR HASAN RACHMANY, MA 19

 Changes in Government Purchases
The central government’s control of the
economy is both direct and indirect.
Its expenditures have a direct effect on
aggregate spending and therefore
equilibrium GDP.
Taxes and tax policy indirectly affect the
aggregate spending of consumers.

Feb 25, 2024 DR HASAN RACHMANY, MA 20

Changes in Government Purchases
There are two macroeconomic effects
from government purchases:
The Multiplier Effect
The Crowding-Out Effect

Feb 25, 2024 DR HASAN RACHMANY, MA 21

 The Multiplier Effect of
Government Purchases
The formula for the multiplier is:

Multiplier = 1 ÷ (1 - MPC)
 the MPC is the Marginal Propensity to Consume.

Feb 25, 2024 DR HASAN RACHMANY, MA 22

The Crowding-Out Effect
An increase in government purchases causes the
interest rate to rise, and a higher interest rate tends to
choke off the demand for goods and services.
The reduction in demand that results when a fiscal
expansion raises the interest rate is called the
crowding-out effect.

Feb 25, 2024 DR HASAN RACHMANY, MA 23

 Changes in Taxes
When the government cuts taxes, it:
 Increases households’ take-home pay, which ...
… results in households saving some of the additional
income, but
… households will spend some on consumer goods, thus
… shifting the aggregate-demand curve to the right.

Feb 25, 2024 DR HASAN RACHMANY, MA 24

Changes in Taxes
The size of the shift in aggregate demand resulting
from a tax change is also affected by the multiplier
and crowding-out effects.
The duration of the shift in the aggregate demand is
also determined by the B of C’s policy for the
exchange rate (fixed or varied).

Feb 25, 2024 DR HASAN RACHMANY, MA 25

 Lags in Fiscal Policy
The time required approving and
implementing fiscal legislation may hamper
its effectiveness and weaken discretionary
fiscal policy and may in fact do more harm
than good

Since a recession is not usually identified as

such until at least six months after it begins,
and since the eight recessions since 1949
lasted an average of 11 months, this leaves a
narrow window in which to execute
discretionary fiscal policy

Feb 25, 2024 DR HASAN RACHMANY, MA 26

 Principles of Central Bank monetary policy
framework
Clear and precise objectives (proper target of
annual rise in CPI inflation)
 Full operational independence for the Bank of
Indonesia Monetary Policy.
 Openness, transparency and accountability
Credibility and flexibility

Feb 25, 2024 DR HASAN RACHMANY, MA 27

 Keynesian Policy
to Combat Recession
When an economy is operating below its
potential output, the Keynesian model suggests
that the government should institute
expansionary fiscal policy, by:
increasing the government’s purchases
of goods & services, and/or,
cutting taxes.

Feb 25, 2024 DR HASAN RACHMANY, MA 28

 Keynesian Policy
To Combat Inflation
When inflation is a potential problem,
Keynesian analysis suggests a shift toward a
more restrictive fiscal policy by:
reducing government spending, and/or,
raising taxes.

Feb 25, 2024 DR HASAN RACHMANY, MA 29

Tax Assignment Principles
Efficiency of internal common market
National equity
Efficiency in tax administration
Fiscal Need

Feb 25, 2024 DR HASAN RACHMANY, MA 30

What is decentralization?
Transfer of authority from central to local
Encompasses a variety of concepts which must be
carefully analyzed in any particular country before
application.
Each country has its own “rhythm” of change
This analysis should include the various types of
decentralization

DR HASAN RACHMANY, MA 31 Feb 25, 202

4
Or
In what ways does
decentralization occur?

?
DR HASAN RACHMANY, MA 32 Feb 25, 202
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Types of Decentralization
Political:
Aims to give citizens or their elected representatives
more power in public decision-making. Advocates
assume that decisions made with greater participation
will be better informed and more relevant to diverse
interests in society than those made only by national
political authorities.

DR HASAN RACHMANY, MA 33 Feb 25, 202

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Types continued..
 Administrative Decentralization –
Seeks to redistribute authority and financial
resources among different levels of government.
The 3 forms are: Deconcentration, Delegation, and
Devolution

DR HASAN RACHMANY, MA 34 Feb 25, 202

4
Types continued..
 Fiscal Decentralization –
Giving local governments and private organizations
revenues to carry out service effectively. Forms
include: a) self-financing; b) expansion of local
revenues; c) intergovernmental transfers; d)
authorization of municipal borrowing

DR HASAN RACHMANY, MA 35 Feb 25, 202

4
Types continued..
 Privatization –
Government and private sector cooperate to
provide services or infrastructure
 Deregulation –
Reduces legal constraints on private participation
or allows competition among private suppliers for
services that in the past were provided by the
government or regulated monopolies

DR HASAN RACHMANY, MA 36 Feb 25, 202

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What are some drawbacks or
potential dangers of
decentralization?

?
DR HASAN RACHMANY, MA 37 Feb 25, 202
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Argument against decentralization
Makes stabilization policies more difficult to
implement, or even destabilization of public
expenditures and debt
Offloading of fiscal imbalances by central
governments to local governments. Strong association
between decentralization and fiscal imbalances at
lower levels
Possibility that decentralization retards economic
growth

DR HASAN RACHMANY, MA 38 Feb 25, 202

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Argument for decentralization
 Efficiency:
Decisions about public expenditure on a closer
level of government are more responsive and reflect
local demand more so than remote gov’t. Also,
improvement of competitiveness of gov’t and
enhances innovation – more likely to act to satisfy
the wishes of citizens.

DR HASAN RACHMANY, MA 39 Feb 25, 202

4
Argument for decentralization
 Political –
Decentralization an essential part of
democratization as autocratic central regimes are
replaced by elected governments

DR HASAN RACHMANY, MA 40 Feb 25, 202

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 INDONESIA
after 2040

?
A Stronger Unitary State Federal State
Democracy Democracy
Decentralization Decentralization
Governance Governance

Feb 25, 2024 DR HASAN RACHMANY, MA 41

 Unitary State Federal State

Central
Federal

Provincial

Local
State
Local

 Federal (USA Type)

State
Federal
Local

Feb 25, 2024 DR HASAN RACHMANY, MA 42