Public Finance Session1 - Definition

Defined Public finance is about the taxing and spending activities of the government. Also known as “public sector economics” or “public economics.” The fundamental issues are not financial but relate to the use of real resources. “micro” functions : allocation of resources, distribution of income. “macro” functions : use of taxing, spending and monetary policies to affect overall level or GDP or unemployment. Focus is on microeconomic functions of government – polices that affect overall unemployment or price levels are left for macroeconomics. Scope of public finance unclear – government has role in many activities, but focus will be on taxes and spending.

What is public finance ? By tradition (Musgrave), three roles devoted to the public sector : Allocation: Public good provision Redistribution : social transfers, progressivity in the tax system Stabilization : “automatic stabilizers” Do these 3 objectives conflict ? The answer is yes. Trade-off efficiency/equity Room for macroeconomic stabilization

Three roles Allocation Justifications for the State intervention in the provision of public goods are well known: the very nature of public goods, externalities, … justice, defense, security, education, health…but also direct interventions to corporations and individuals.

Three roles Distribution Social insurance, horizontal and vertical distribution. Difficult to disentangle from the third function (stabilization): insurance aims at avoiding hysteresis effects in bad times (unemployment insurance, on-the-job training, minimum benefits)

Three roles Stabilization Size and effectiveness of automatic stabilizers Justifications for discretionary action along the business cycle

Public Finance and Ideology How should a government function in economic sphere? Ideology influences the way economists think on how the government functions. Political thinkers distinguish between two major approaches. Organic view – community stressed above individual. Goals of society set by the state. Mechanistic view – government is a contrivance created by individuals to better achieve their individual goals. Individual, not group, is at center stage.

Organic view of govt Society is seen as an organism, with each individual being part of the organism. The govt is viewed as the heart. The individual is important only as part of the society or the whole. The objectives of the society are set by the state. Proponents of the organic view usually argue that certain goals are natural for the societal organism to purse. E.g. pursuing sovereignty.

Mechanistic view of govt Government is not an organic part of society but is a tool made by individuals to better achieve their individual goals. The individual rather than the group is at the centre stage. Govt exists for the good of the people. To protect individuals from violence and invasion. According to Adam Smith should create and maintain public works and institutions

Government at a Glance Legal framework Federal government No real constraints on spending in Constitution Taxes must originate in the House of Representatives. Equal tax rates across states. Income tax came from 16th amendment to Constitution. Can run budget deficits State and local government Can impose spending / taxing restrictions on itself. Many states cannot run budget deficits.

Government at a Glance Size of government – how to measure? Number of government employees Annual expenditures Purchases of goods and services, transfers, and interest payments Unified budget – the document which itemizes all the federal government’s expenditures and revenues at state and local levels. If expenditures go up people conclude that government has grown.

Government at a Glance These numbers ignore activities that do not have explicit outlays, but substantial effects on resource allocation. Regulations, for example. Conceivably, could construct a “regulatory budget” to account for these costs, but difficult to compute.

Government Expenditure Some SA numbers Annual expenditures have grown strong from 28.3% in 2006/7 to 34.1% in2009/2010 as a percentage of GDP. This was attributed to countercyclical measures to downswings in the economy Eskom loan In the medium-term govt expenditure is expected to moderate

Table 1.1

Government Expenditure United States versus other developed countries. U.S. public sector is quite small compared to Sweden or France, and smaller than all the countries listed. Although large, the U.S. government is small in relative terms. More reliance on private sector.

Table 1.2

Figure 1.1

Government Expenditure Much of the government budget consists of entitlement programs – programs with costs determined by number of people who qualify. Social Security, Medicare, welfare Three-quarters of the federal budget is relatively uncontrollable, because of these entitlements.

Government Expenditure Federal government responsible for about 45% of direct expenditure. State governments responsible for 25%. Local governments responsible for 30%. State & local governments primarily responsible for police & fire protection, education, transportation, and some welfare programs.

Government Revenues Federal taxes mainly consist of individual income taxes, payroll taxes, and corporate taxes. Personal income tax 43% of collections. State & local taxes mainly consist of property taxes, sales taxes, individual income taxes, and grants from federal government. Less reliance now on property tax, more on income tax.