Public Economics Principles and Practice

Peter Abelson Applied Economics and University of Sydney

Public Economics: Subject Outline: 10 Parts

1. 2. 3. 4. 5. 6. Nature of Government Markets and Government Economic Evaluation and Policy Public Choice Building Economic Foundations Public Supply of Goods and Services

Public Economics: Outline (Cont.)

7. Public Finance and Taxation 8. Taxation in Practice 9. Social Welfare and Income Redistribution 10. Multi-Government Systems

Public Economics Principles and Practice

Part 1: Nature of Government
Peter Abelson Applied Economics and Sydney University

Chapter 1 Foundations of Public Economics

Introduction to Issues

Government and the State

General Functions of Government Economic Functions of Government Historical Perspective Public Policy and Principles of Economic Analysis

Introduction to Issues
The defining attribute of government is power The mixed economy

When and how should government intervene in the

economy? Examples of topical public policy questions

Fundamental questions: what are objectives and

roles of government?

Government and the State

State and government defined
Figure 1.1: Typical Institutions of Government
Role of Constitution and Bill of Rights Government consists of three main branches

Budget and non-budget sectors

Statutory authorities are also part of the public sector Government and the public sector

Constraints on power of government

Typical government institutions

The Constitution Rules of the State Bill of Rights

International Laws

Head of State

Legislature Houses of Parliament

Executive Prime Minister / Cabinet

Judiciary Higher Courts

Military

Police

Public Administration

Statutory Authorities

Public Trading Enterprises

Lower Courts

General Functions of Government

Organic and mechanistic views of the state. Libertarians, Conservatives, Social Democrats, Socialists.

Various views of role of government

Economic Functions of Government

Economics is the study of the use of scarce resources to maximise the welfare of the community
For model of economy: see Figure 1.2 What is the role of government: - in production and exchange? - in distribution?

The economic process

Resources Inputs Political institutions Labor, Capital Natural resources Technology

Processes Means Product markets Public supply of goods

Outputs Goods and Services Market goods Publicly provided goods Environmental goods Household goods

Outcomes Welfare Market income Non-market income Distribution of income Individual liberties

Factor markets

International trade

International trade

Efficiency of markets
The efficiency of willing trades and markets The power of the invisible hand: prices and incentives create efficient outcomes. Households get the goods they want at least cost. The First Theorem of Welfare Economics. But efficient markets require laws of contracts, property and security.

Economic roles of government

Despite the invisible hand, three sets of issues:

1. Inefficient allocation of resources - market failures 2. Unequal distribution of income 3. Macroeconomics - instability These establish potential roles for government.

Economists views of economic functions over 200 years

Adam Smith and J.S.Mill: more than laisser- faire

Changes in views:
early twentieth century: increasing government after 2nd World War: 1945-80 more government since 1980: public choice theory, less government

Recent changes: Globalisation

And growth And GFC Global Financial Crisis

New Views of Role of Government

Globalisation and growth
More cautious views on role of government. What matters is not only what government does, but also how well it does these things

GFC
Causes Effects Policies

GFC Causes
National macro-economic imbalances Low interest rates led to excessive and unsustainable borrowing (debt / leverage) Securitisation of poorly understood assets Failures of credit agencies Failures of government regulators

GFC Effects
Asset bubble prices burst Credit squeeze Whole process thrown into reverse
Public de-leveraging through asset sales Spending of firms squeezed, employment falls, lower sales of firms, further asset sales, selfreinforcing process The deleveraging cycle much faster than the original leveraging cycle Sand castle collapses in less time than it takes to build!

GFC Policies
Clean up credit mess and get credit channels open again Fiscal stimulus Avoid excessive national imbalances Monetary policy should target credit and asset prices in future Increase regulation of financial markets

Public Policy and Principles of Economic Analysis

Four public policy questions 1. What are the objectives? 2. What are the options? 3. What are the implications of each option? 4. Which is the preferred option?

Positive and normative economics

Positive economics: explains how an economy works. Explanations are true or false Normative economics deals with how an economy should work. Involves subjective opinions. Questions 1 and 4 are normative. Questions 2 and 3 are positive. What can economic analysis provide?

Seven economic principles and the public sector

1. Scarcity, choice and opportunity costs apply to private and public sector 2. Trade is the basic means of extracting gains from markets 3. Incentives matter (explain behaviour) in the public sector as in the private 4. Price theory and the core concepts of demand and supply apply even when there are no prices.

Seven economic principles (cont.)

5. Principles of efficient production opportunity cost, division of labour apply to public production as to private 6. Markets are powerful forces of demand and supply: Governments should generally work with markets 7. Aim to maximise social welfare subject to constraints. This implies that social marginal benefit should equal social marginal cost

The principles of economics apply equally to actions of government as to the private sector

Summary
Key attribute of government is power Government includes all services financed through the budget. Public sector includes PTEs. Dominant (Western) view of state is mechanistic and individualistic Fundamental economic role of government is to establish institutions and rules so markets work Other key functions:
Allocating resources when there are markets failures An acceptable income distribution, Macroeconomic management

Summary
Economic analysis includes normative and positive economics Governments may act distributively to change the outcomes of market and so raise social welfare. However, basic principles of economics apply to actions of government as to actions of the private sector. Principles of demand and supply and role of markets are essential to understanding and assessing consequences of public policies.

Chapter 2 Government in Practice

Legal Basis of Government Measures of Government Size Government Regulation Government Expenditure and Revenue Government Budgets: Deficits, Debt and Assets International Comparisons Determinants of Government Expenditure

Legal Basis of Government

Commonwealth of Australia Constitution Act 1900 Monetary policy Commonwealth exclusive power Taxation Commonwealth and states may levy income tax External trade and excise taxes Commonwealth has exclusive control Trade between states to be free

Legal basis of government (cont.)

Uniform law for commerce across Australia Labour markets Commonwealth can intervene if across states Redistribution of public monies to the states discretionary after transition arrangements Redistribution of public monies to individuals 1946 referendum increased Commonwealth powers
Note: almost all changes have increased powers of central government.

Size of Government
Size is most often measured by general government expenditure (GGE) as % of GDP GGE = expenditure on goods and services and transfer payments financed through annual budget. It excludes expenditures by PTEs except for subsidised components. In Australia, GGE/GDP in 2007-08 = about 31% (see Table below). Note distinction between expenditure on goods and transfer payments.

General Government Expenditure in Australia in 2007-08

2007-08 Expenditure on goods and services Current expenditure Capital expenditure Total Transfer payments Subsidies Personal benefits Interest payments Other transfers Total Total general government expenditure GDP Source: ABS Cat. 5204.0, Table 30 $ billion 200.1 19.3 219.4 16.2 87.2 15.1 30.0 133.5 352.9 1132.2 % of GDP 17.7 1.7 19.4 1.4 7.7 1.3 2.7 11.8 31.2

Alternative measures of size of government

Government expenditure on goods and services / GDP GGE + PTE capital outlays / GDP Total government employment / total employment Total tax revenue / GDP

Government as regulator
Regulations can have more impact on resource allocation than public expenditure. Regulations include price and quantity controls, import controls, product standards, labour market regulations, environmental standards. Expenditure substitutes: coerced private expenditures, eg. Super, workers compensation

Tax concessions: have similar effect to expenditures, eg, family tax credits or allowances

Government Expenditure and Revenue: Trends

More expenditure trends

24
20

Final consumption expenditure 16

% GDP

12 Social benefits in cash to residents

Interest payments 4 Capital expenditure 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Source: ABS Cat. 5204.0

General Government Consumption Expenditure by Function

2007-08, $billion General public services Defence Public order and safety Education Health Social security and welfare Economic services Other Total final consumption expenditure Source: ABS Cat. 5204.0, Table 35 Commonwealth 7.1 18.6 1.7 8.0 24.1 12.0 5.9 2.8 80.1 State and local 9.5 0 14.8 29.6 33.0 5.4 16.5 11.3 120.0 Total Government % of total expenditure 16.7 8.3 18.6 9.3 16.4 8.2 37.5 18.8 57.0 28.5 17.4 8.7 22.4 11.2 14.1 7.0 200.1 100.0

Sources of General Government Revenue

2007-08, $billion Taxation revenue Sales of goods and services Grants and subsidies received Interest received from public non-financial corporations Interest received from public financial corporations Interest received from other Other receipts Total Source: ABS Cat. 5504.0, Table 30 Total government % of total revenue 340.5 82.7 34.8 8.4 1.5 0.4 0.1 0.0 2.6 0.6 3.8 0.9 28.5 6.9 411.8 100.0

General Government Taxation Revenue

2007-08, $billion Commonwealth Taxes on income Individuals 128.0 Enterprises 78.6 Non-residents 2.0 Total 208.6 Employers payroll and labour taxes 0.4 Taxes on the provision of goods and services General taxes (sales taxes) 1.1 Goods and services tax (GST) 44.4 Excises and levies 24.3 Taxes on international trade 6.1 Taxes on gambling Taxes on insurance Total 75.9 Taxes on the use of goods and performance of activities Motor vehicle taxes Other Total Taxes on property Land taxes Municipal rates Taxes on financial and capital transactions Other Total Other 0.8 Total taxation revenue 285.7 Percentage of total (%) 81.9 Source: ABS Cat. 5506.0, Tables 1,19 State and local Total government % of total revenue 128.0 78.6 2.0 208.6 16.4 1.1 44.4 24.3 6.1 4.9 4.3 85.0 6.4 0.6 6.9 4.3 10.2 15.5 1.0 31.0 0.8 348.8 36.7 22.5 0.6 59.8 4.7 0.3 12.7 7.0 1.7 1.4 1.2 24.4 1.8 0.2 2.0 1.2 2.9 4.4 0.3 8.9 0.2 100.0

16.0

4.9 4.3 9.2 6.4 0.6 6.9 4.3 10.2 15.5 1.0 31.0 63.1 18.1

Government Budgets: Deficits, Debt and Assets

Key budget concepts Accrual and cash accounting
Expenses Revenue

Net operating budget (NOB): operating revenue minus operating expenses including depreciation

Net capital investment (NCI): capital expenditure on new assets less depreciation
Overall budget balance = operating revenue minus operating and capital expenses = NOB NCI

Australian Budget: 2009-2010

Budget figure Total revenue Total expenses Net operating balance (NOB) Net capital investment (NCI)b Fiscal (budget) balance Underlying cash balance Headline cash balance
c a

Basis Accrual Accrual Accrual Accrual Accrual Cash Cash

$ billion 290.6 338.2 -47.6 5.5 -53.1 -57.6 -59.8

Comments Includes all current revenues Effective (real) operating espences The real operating balance Capital expenditure - depreciation The net lending balance = NOB - NCI (Underlying) fiscal balance on a cash basis Includes financial purchases and sales

(a) Excludes GST revenues and equivalent payments to the states (b) Net capital investment is the net acquisition of non-financial assets (c) Underlying cash balance excludes expected Future Fund earnings Source: Treasurer, Budget Strategy and Outlook, Table 3, Statement 3, Budget Paper No. 1, p. 3-9.

Key balance sheet concepts

Assets/liabilities Assets Financial assets Definition/components Are controlled and provide future economic benefits Cash, advances paid, investments, loans, other financial assets

Non-financial assets
Total assets Liabilities Financial liabilities Other liabilities Total liabilities Net measures Net public debt Net financial liability Net public worth

Land and fixed assets, equity in PTEs, other non-financial assets

Financial plus non-financial assets Amounts owed to other parties Deposits held, advances received, borrowing Unfunded employee entitlements, other provisions Financial plus other liabilities Financial liabilities less financial assets Total liabilities less financial assets excluding PTE equity Total assets less total liabilities

Balance sheet trends

100
90

Net worth 80 70 60

% GDP

50 Net debt 40 30 20 10
0

Source: ABS Cat. 5204.0

GGE / GDP by country

International Comparisons
Australia at low end of GGE/GDP ratios. This reflects mainly low transfer payments rather than low expenditures on goods and services Reasons include income targeting, demographic structures, mandated private expenditures, and tax concessions. Australia traditionally a relatively regulated economy. Possibly less so today.

Explaining Government Expenditure

The basic equation: goods (g), welfare payments (w) and other transfer payments (OTP). Drivers are quantities and unit costs. Economic and political determinants

Economic determinants of government expenditure

Four main economic variables: 1. Quantity of consumption goods demanded 2. Unit costs of government consumption goods 3. Quantity of transfer payments 4. Unit costs of transfer payments Capital formation and interest payments are not generally significant in Australia.

Determinants of government expenditure: economics and politics

Demand and supply framework Increased demand for goods (1) does not appear to be a major factor Increased unit costs (Baumol hypothesis) more political than economic Increased quantity of welfare payments partly socioeconomic Increased dollar value of welfare payments political.

Summary: political factors appear more important than economic ones.