PUBLIC FINANCE

Dr. Venkataramanaiah.M
Assistant Professor
Department of Business Studies
University of Kurdistan Hewler
 Part-I
Introduction and Background
 What is Public Finance?
The study of how governments
collect and spend money and real
resources
How do governments collect/spend
money? Positive analysis
How should governments
collect/spend money? Normative
analysis
We are studying public finance in a
market economy
Four Functions of Public Finance
Allocation
Distribution
Stabilization
Growth

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Allocation
An organized society requires the
consumption of public goods and services that
would be unprofitable to produce privately
Public goods include:
Defense,
Law and order, justice
Infrastructure
Taxation is used to raise funds to pay for
production of these goods and services

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Redistribution
Very difficult to do in a short period of time
Redistributing wealth does not change individual
incomes much.
Redistribution is impossible to do via the tax
system alone.
Redistribution through expenditure system is
much more promising.
Redistribution should be related to the role of
governments in promoting growth.

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Redistribution (contd)
Only through growth can people in developing
countries be lifted out of economic backwardness
Public education, health services
Rural roads, rural telephone, electricity and public
water supplies all ways that people can change
their position in life overtime
Important to consider changing income
distribution between generations

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 Stabilization
A short run objective
Outgrowth of the Keynesian revolution in
economics.
The main objective to keep actual level
of income close to its potential.
The target is full employment and price
stability.
Inflation extremely damaging to poor
and reduces the efficiency of market
system.
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 Growth
Probably the most important objective when per
capita incomes are low
Sources of Per Capita growth
Capital accumulation, Human capital (education, health),
and Productivity change
Tools of taxation and public expenditure need to be
focused on how to promote growth
Need policies that encourage investors to reinvest
their business surpluses not take them out of country
Government budget surplus important for providing
savings for private sector to borrow
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What are the most frequent causes
of Government Budget Crisis ?
1. Current expenditures on personnel explode ?
2. Investment expenditures have huge cost over
runs ?
3. Crop failures ?
4. Exchange rate fluctuations ?
5. Rapid increase in military expenditures ?
6. A contingent liability comes due
- e.g. Guarantee of bank deposits
- Guarantee of exchange rate
- Guarantee of state enterprise loans
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 What is the Role of
Government?
To maintain and improve the welfare
of the people
To protect the people from harm
To provide the institutions that allow market
to function (e.g. protection of property
rights)
To provide the essential goods and services
that markets fail to adequately provide
The Role of Government:
Ideology
 Current Trends
Reagan tax cuts
Shrink government down to the size
where we can drown it in a bathtub
Grover Norquist
The era of big government is over
Bill Clinton
Bush tax cuts
Free market ideology
 Organic view of
government
Society is a natural organism
Goals of society set by state
Actions of individual are judged by
the contribution they make to the
state
Ask not what your country can do
for you; ask what you can do for your
country.
 Mechanistic view of government
Individuals are paramount,
government created to meet the
needs of individuals
Big debate over importance of
individual freedom
Two types of freedom:
Freedom to do as you like
Freedom not to suffer from activities of
others
As society grows more crowded, second
type of freedom becomes more important
 The Role of Government: Objective
Analysis
Complexity theory and systems thinking
Government in a market economy
 Complexity theory and
Systems thinking
Bringing together many, many simple
components leads to emergence of
spontaneous order, complex system:
2 H and 1 0 atoms form water molecule,
molecules form cell, cells form organs, organs
make up humans, humans make up society
Complex systems greater than the sum of
their parts
Characterized by non-linearities, feedback
loops, emergent properties, unpredictable
surprises, etc.
Government is a complex system
 Government in a market economy
Economics is the allocation of scarce resources
among alternative desirable ends
What are the desirable ends?
To maintain and improve the welfare of the people
Government and economics have the same desirable
ends
What are the scarce resources?
What are the characteristics of the scarce
resources?
Whether resources should be allocated by
government or the market depends on the
physical nature of the scarce resources
Once we agree on the desirable ends, deciding
on the role of government moves towards
Legal Framework
 Federal Government:
Expenditure
Constitution empowers government
to pay the debts and provide for the
common defense and general welfare
of any country.
Bills to appropriate expenditures can
be initiated in either house, must be
approved by both houses and Prime
minister/President.
 Federal Government: Revenue
Duties, imposts/customs and excises
must be uniform throughout a
country
Constitutional amendment may be
required for federal income tax in
time to time
Empowered to borrow money
 State and regional/local
governments
States have power not explicitly
relegated to federal government
Cant impose duties on imports or
exports
Power of local governments granted
by states
The Size of Government
 What was the
Historical context
highest marginal
tax rate

ghest tax bracket currently applies to single people earning $54,000/yr

What has happened to the
deficit?
What has happened to the size of
government as a share of GDP?
 How does size of US government
compare with other countries (2001)?
USA 29.3% of GDP
Australia 31%
Canada 37.4%
Japan 38.3%
UK 38.8%
France 49.4%
Sweden 53.1%
How does the federal government
spend its money?
 How do state governments spend
money?
Miscellaneous (~43%, +)
Education (~35%, -)
Public welfare (~17%, +)
Highways (~5%, -)
 Where does the government get its
money?
Federal State and local
Individual income Other (+)
tax (+) Sales tax
Social insurance (+ Grants from federal
+) government (+)
Corporate tax (--) Property tax (-)
Other (-) Individual income
tax (+)
Corporation tax
Theories of Public Finance
 Neoclassical Economic Theory
Assumes humans are rational, self
interested utility maximizers
Empirical studies reject this
Assumes perfect market competition
Empirical studies reject this
Assumes in perfect markets invisible hand leads to
efficient allocation: greatest good for greatest number
Cant be tested in practice, because governments
always intervene with perfect functioning of market
 Ecological Economic
Theory
Assume economy is subset of
ecosystem
Ecologically sustainable scale is first
priority
Socially just distribution
Efficient allocation
 Georgist Economic Theory
Ownership of land leads to poverty
Value of land is created by nature
and society, not hard work of
individual
Land tax could finance all
government expenditure, prevent
land speculation and concentration of
ownership, end poverty
Land tax could be extended to
include all value created by nature
 The Economic and social objectives
of the modern government include

Provision of public goods and

services
Full employment of resources
A stable value of money
Steady economic growth
Satisfactory balance of payments
Reasonably equitable distribution of
income and wealth
Minimum standard of individual
welfare
The Government objectives in the field
of public finance

Provision of public goods

Redistribution of income and wealth
Stabilization of level of activity at full
employment without inflation
Balanced and steady growth of
national product
 The Necessity of Public Sector
- Classical theory laissez- faire
Two economic groups:
1- Producers
2- Consumers ( suppliers of inputs
Two Markets:
1- Outputs market
2- Inputs or factors market
In outputs markets:
The consumer the ratio of marginal utility per price for particular
commodity is equal to the ratio of marginal utility per price of other
commodities
MU1 MUm
MU2 - - - - - --=
P1 = P2 = Pm
 In inputs markets:

The producer marginal product of all inputs relative to its prices

are equal
MP1 MP2 MPm
P1 = P2 =- - - - - - - - - = Pm

This equilibrium reflects the most efficient use of resources

- But this requires perfect competition in all markets (inputs & outputs)

- What about the social welfare?

 THE CIRCULAR FLOW MODEL

$
Consumers and
Suppliers of inputs
Demand Supply

Intput Markets
Output Markets
Firms
Input owners

Consumers Firms
0
0 Q Output Q intput

Supply Demand
Firms

$ $
 Based on some assumptions:
1- The market price and quantity are determined by
equilibrium of demand and supply
2- The price and quantity of specific resources are
determined by equilibrium of firms demand for resources
and owners supply
3- Capability of reducing and increasing quantities of
supply according to the changes of prices
4- Prices in the inputs markets continually adjust to the
equilibrium of market demand (firms) and market supply
(resources)
5- Organization of production is determined by consumers
sovereignty
6- The price system allows to declare consumers tastes
so producers can adjust their productions and achieve
maximum profits
 The Necessary Conditions for perfect
Competition

Basic Assumptions:
- The motive is self interest
- Freedom of choice
- Private Property
- Reliance upon private price mechanism
- Limited role of government

Pareto Optimum
Perfect competition maximizes economic welfare
- The consumer preferences outputs are
automatically allocated to maximize utility
- Any reallocation of inputs or outputs will reduce allocative
efficiency
- Allocative efficiency optimal welfare situation =
Pareto Optimum
 The pareto optimum accepts whatever distribution of income
arises out of free market system first best
isolated from social and political justice

The value of equity is disregarded

THE NEED FOR GOVERNMENT INTERVENTION

The Deficiencies of the Price
System:
1- Divergence between private and social costs and benefits
2- Diffusion of benefits
3- Loss of consumers sovereignty
4- Inequality of distribution of income and wealth
5- Unemployment
6- Insufficient scale of provision of capital
 The Economic Intervention of
Government
- The theory of market failure

- J. M. Keynes: The general theory of employment,

interest and money (1936)

- The periodic booms and slumps of private

enterprises (trade cycle)

- The need of various actions of government to

stabilize the national economy