Public finance

Last updated

Public finance is the study of the role of the government in the economy. [1] It is the branch of economics that assesses the government revenue and government expenditure of the public authorities and the adjustment of one or the other to achieve desirable effects and avoid undesirable ones. [2] The purview of public finance is considered to be threefold, consisting of governmental effects on: [3]

Contents

  1. The efficient allocation of available resources;
  2. The distribution of income among citizens; and
  3. The stability of the economy.

Economist Jonathan Gruber has put forth a framework to assess the broad field of public finance. [4] Gruber suggests public finance should be thought of in terms of four central questions:

  1. When should the government intervene in the economy? To which there are two central motivations for government intervention, Market failure and redistribution of income and wealth. [5]
  2. How might the government intervene? Once the decision is made to intervene the government must choose the specific tool or policy choice to carry out the intervention (for example public provision, taxation, or subsidization). [6]
  3. What is the effect of those interventions on economic outcomes? A question to assess the empirical direct and indirect effects of specific government intervention. [7]
  4. And finally, why do governments choose to intervene in the way that they do? This question is centrally concerned with the study of political economy, theorizing how governments make public policy. [8]

Overview

The proper role of government provides a starting point for the analysis of public finance. In theory, under certain circumstances, private markets will allocate goods and services among individuals efficiently (in the sense that no waste occurs and that individual tastes are matching with the economy's productive abilities). If private markets were able to provide efficient outcomes and if the distribution of income were socially acceptable, then there would be little or no scope for government. In many cases, however, conditions for private market efficiency are violated. For example, if many people can enjoy the same good (the moment that good was produced and sold, it starts to give its utility to every one for free) at the same time (non-rival, non-excludable consumption), then private markets may supply too little of that good. National defense is one example of non-rival consumption, or of a public good. [9]

"Market failure" occurs when private markets do not allocate goods or services efficiently. The existence of market failure provides an efficiency-based rationale for collective or governmental provision of goods and services. [10] Externalities, public goods, informational advantages, strong economies of scale, and network effects can cause market failures. Public provision via a government or a voluntary association, however, is subject to other inefficiencies, termed "government failure."

Under broad assumptions, government decisions about the efficient scope and level of activities can be efficiently separated from decisions about the design of taxation systems (Diamond-Mirrlees separation). In this view, public sector programs should be designed to maximize social benefits minus costs (cost-benefit analysis), and then revenues needed to pay for those expenditures should be raised through a taxation system that creates the fewest efficiency losses caused by distortion of economic activity as possible. In practice, government budgeting or public budgeting is substantially more complicated and often results in inefficient practices.

Government can pay for spending by borrowing (for example, with government bonds), although borrowing is a method of distributing tax burdens through time rather than a replacement for taxes. A deficit is the difference between government spending and revenues. The accumulation of deficits over time is the total public debt. Deficit finance allows governments to smooth tax burdens over time and gives governments an important fiscal policy tool. Deficits can also narrow the options of successor governments. There is also a difference between public and private finance, in public finance the source of income is indirect for ex:various taxes(specific taxes,value added taxes), but in private finance sources of income is direct. [11]

Public finance management

Collection of sufficient resources from the economy in an appropriate manner along with allocating and use of these resources efficiently and effectively constitute good financial management. Resource generation, resource allocation, and expenditure management (resource utilization) are the essential components of a public financial management system.

The following subdivisions form the subject matter of public finance.

  1. Public expenditure
  2. Public revenue
  3. Public debt
  4. Financial administration
  5. Federal finance

Government expenditures

Economists classify government expenditures into three main types. Government purchases of goods and services for current use are classed as government consumption. Government purchases of goods and services intended to create future benefits – such as infrastructure investment or research spending – are classed as government investment. Government expenditures that are not purchases of goods and services, and instead just represent transfers of money – such as social security payments – are called transfer payments. [12]

Government operations

Government operations are those activities involved in the running of a state or a functional equivalent of a state (for example, tribes, secessionist movements or revolutionary movements) for the purpose of producing value for the citizens. Government operations have the power to make, and the authority to enforce rules and laws within a civil, corporate, religious, academic, or other organization or group. [13]

Income distribution

Financing of government expenditures

Budgeted revenues of governments in 2006. 2006budget income.PNG
Budgeted revenues of governments in 2006.

Government expenditures are financed primarily in three ways:

How a government chooses to finance its activities can have important effects on the distribution of income and wealth (income redistribution) and on the efficiency of markets (effect of taxes on market prices and efficiency). The issue of how taxes affect income distribution is closely related to tax incidence, which examines the distribution of tax burdens after market adjustments are taken into account. Public finance research also analyzes effects of the various types of taxes and types of borrowing as well as administrative concerns, such as tax enforcement.

Taxes

Taxation is the central part of modern public finance. Its significance arises not only from the fact that it is by far the most important of all revenues but also because of the gravity of the problems created by the present day tax burden. [14] The main objective of taxation is raising revenue. A high level of taxation is necessary in a welfare State to fulfill its obligations. Taxation is used as an instrument of attaining certain social objectives, i.e., as a means of redistribution of wealth and thereby reducing inequalities. Taxation in a modern government is thus needed not merely to raise the revenue required to meet its expenditure on administration and social services, but also to reduce the inequalities of income and wealth. Taxation might also be needed to draw away money that would otherwise go into consumption and cause inflation to rise. [15]

A tax is a financial charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state (for example, tribes, secessionist movements or revolutionary movements). Taxes could also be imposed by a subnational entity. Taxes consist of direct tax or indirect tax, and may be paid in money or as corvée labor. A tax may be defined as a "pecuniary burden laid upon individuals or property to support the government [ . . .] a payment exacted by legislative authority." [16] A tax "is not a voluntary payment or donation, but an enforced contribution, exacted pursuant to legislative authority" and is "any contribution imposed by government [ . . .] whether under the name of toll, tribute, tallage, gabel, impost, duty, custom, excise, subsidy, aid, supply, or other name." [17]

Debt

Governments, like any other legal entity, can take out loans, issue bonds, and make financial investments. Government debt (also known as public debt or national debt) is money (or credit) owed by any level of government; either central or federal government, municipal government, or local government. Some local governments issue bonds based on their taxing authority, such as tax increment bonds or revenue bonds.

As the government represents the people, government debt can be seen as an indirect debt of the taxpayers. Government debt can be categorized as internal debt, owed to lenders within the country, and external debt, owed to foreign lenders. Governments usually borrow by issuing securities such as government bonds and bills. Less creditworthy countries sometimes borrow directly from commercial banks or international institutions such as the International Monetary Fund or the World Bank.

Most government budgets are calculated on a cash basis, meaning that revenues are recognized when collected and outlays are recognized when paid. Some consider all government liabilities, including future pension payments and payments for goods and services the government has contracted for but not yet paid, as government debt. This approach is called accrual accounting, meaning that obligations are recognized when they are acquired, or accrued, rather than when they are paid. This constitutes public debt.

Seigniorage

Seigniorage is the net revenue derived from the issuing of currency. It arises from the difference between the face value of a coin or banknote and the cost of producing, distributing and eventually retiring it from circulation. Seigniorage is an important source of revenue for some national banks, although it provides a very small proportion of revenue for advanced industrial countries.[ citation needed ]

Public finance through state enterprise

Public finance in centrally planned economies has differed in fundamental ways from that in market economies. Some state-owned enterprises generated profits that helped finance government activities. The government entities that operate for profit are usually manufacturing and financial institutions, services such as nationalized healthcare do not operate for a profit to keep costs low for consumers. The Soviet Union relied heavily on turnover taxes on retail sales. Sale of natural resources, and especially petroleum products, were an important source of revenue for the Soviet Union.

In market-oriented economies with substantial state enterprise, such as in Venezuela, the state-run oil company PSDVA provides revenue for the government to fund its operations and programs that would otherwise be profit for private owners. In various mixed economies, the revenue generated by state-run or state-owned enterprises are used for various state endeavors; typically the revenue generated by state and government agencies goes into a sovereign wealth fund. Examples of this are the Alaska Permanent Fund and Singapore's Temasek Holdings.

Various market socialist systems or proposals utilize revenue generated by state-run enterprises to fund social dividends, eliminating the need for taxation altogether.

Government finance statistics and methodology

Macroeconomic data to support public finance economics are generally referred to as fiscal or government finance statistics (GFS). The Government Finance Statistics Manual 2001 (GFSM 2001) is the internationally accepted methodology for compiling fiscal data. It is consistent with regionally accepted methodologies such as the European System of Accounts 1995 and consistent with the methodology of the System of National Accounts (SNA1993) and broadly in line with its most recent update, the SNA2008.

Measuring the public sector

The size of governments, their institutional composition and complexity, their ability to carry out large and sophisticated operations, and their impact on the other sectors of the economy warrant a well-articulated system to measure government economic operations.

The GFSM 2001 addresses the institutional complexity of government by defining various levels of government. The main focus of the GFSM 2001 is the general government sector defined as the group of entities capable of implementing public policy through the provision of primarily non market goods and services and the redistribution of income and wealth, with both activities supported mainly by compulsory levies on other sectors. The GFSM 2001 disaggregates the general government into subsectors: central government, state government, and local government (See Figure 1). The concept of general government does not include public corporations. The general government plus the public corporations comprise the public sector (See Figure 2).

Figure 1: General Government (IMF Government Finance Statistics Manual 2001(Washington, 2001) pp.13 General Government.jpg
Figure 1: General Government (IMF Government Finance Statistics Manual 2001(Washington, 2001) pp.13
Figure 2: Public Sector(IMF Government Finance Statistics Manual 2001(Washington, 2001) pp.15 Public Sector.png
Figure 2: Public Sector(IMF Government Finance Statistics Manual 2001(Washington, 2001) pp.15

The general government sector of a nation includes all non-private sector institutions, organisations and activities. The general government sector, by convention, includes all the public corporations that are not able to cover at least 50% of their costs by sales, and, therefore, are considered non-market producers. [18]

In the European System of Accounts, [19] the sector “general government” has been defined as containing:

Therefore, the main functions of general government units are :

The general government sector, in the European System of Accounts, has four sub-sectors:

  1. central government
  2. state government
  3. local government
  4. social security funds

"Central government" [20] consists of all administrative departments of the state and other central agencies whose responsibilities cover the whole economic territory of a country, except for the administration of social security funds.

"State government" [21] is defined as the separate institutional units that exercise some government functions below those units at central government level and above those units at local government level, excluding the administration of social security funds.

"Local government" [22] consists of all types of public administration whose responsibility covers only a local part of the economic territory, apart from local agencies of social security funds.

"Social security fund" [23] is a central, state or local institutional unit whose main activity is to provide social benefits. It fulfils the two following criteria:

The GFSM 2001 framework is similar to the financial accounting of businesses. For example, it recommends that governments produce a full set of financial statements including the statement of government operations (akin to the income statement), the balance sheet, and a cash flow statement. Two other similarities between the GFSM 2001 and business financial accounting are the recommended use of accrual accounting as the basis of recording and the presentations of stocks of assets and liabilities at market value. It is an improvement on the prior methodology Government Finance Statistics Manual 1986 – based on cash flows and without a balance sheet statement.

Users of GFS

The GFSM 2001 recommends standard tables including standard fiscal indicators that meet a broad group of users including policy makers, researchers, and investors in sovereign debt. Government finance statistics should offer data for topics such as the fiscal architecture, the measurement of the efficiency and effectiveness of government expenditures, the economics of taxation, and the structure of public financing. The GFSM 2001 provides a blueprint for the compilation, recording, and presentation of revenues, expenditures, stocks of assets, and stocks of liabilities. The GFSM 2001 also defines some indicators of effectiveness in government's expenditures, for example the compensation of employees as a percentage of expense. The GFSM 2001 includes a functional classification of expense as defined by the Classification of Functions of Government (COFOG) .

This functional classification allows policy makers to analyze expenditures on categories such as health, education, social protection, and environmental protection. The financial statements can provide investors with the necessary information to assess the capacity of a government to service and repay its debt, a key element determining sovereign risk, and risk premia. Like the risk of default of a private corporation, sovereign risk is a function of the level of debt, its ratio to liquid assets, revenues and expenditures, the expected growth and volatility of these revenues and expenditures, and the cost of servicing the debt. The government's financial statements contain the relevant information for this analysis.

The government's balance sheet presents the level of the debt; that is the government's liabilities. The memorandum items of the balance sheet provide additional information on the debt including its maturity and whether it is owed to domestic or external residents. The balance sheet also presents a disaggregated classification of financial and non-financial assets.

These data help estimate the resources a government can potentially access to repay its debt. The statement of operations (“income statement”) contains the revenue and expense accounts of the government. The revenue accounts are divided into subaccounts, including the different types of taxes, social contributions, dividends from the public sector, and royalties from natural resources. Finally, the interest expense account is one of the necessary inputs to estimate the cost of servicing the debt.

Fiscal data using the GFSM 2001 methodology

GFS can be accessible through several sources. The International Monetary Fund publishes GFS in two publications: International Financial Statistics and the Government Finance Statistics Yearbook. The World Bank gathers information on external debt. On a regional level, the Organization for Economic Co-operation and Development (Dibidami ) compiles general government account data for its members, and Eurostat, following a methodology compatible with the GFSM 2001, compiles GFS for the members of the European Union.

See also

Notes

  1. Gruber, Jonathan (2005). Public Finance and Public Policy. New York: Worth Publications. p. 2. ISBN   0-7167-8655-9.
  2. Jain, P C (1974). The Economics of Public Finance.
  3. Oates, Wallace E. “The Theory of Public Finance in a Federal System.” The Canadian Journal of Economics / Revue Canadienne D'Economique, vol. 1, no. 1, 1968, pp. 37–54
  4. Gruber, J. (2010) Public Finance and Public Policy (Third Edition), Worth Publishers, Pg. 3, Part 1
  5. Gruber, J. (2010) Public Finance and Public Policy (Third Edition), Worth Publishers, Pg. 3, Part 1
  6. Gruber, J. (2010) Public Finance and Public Policy (Third Edition), Worth Publishers, Pg. 6, Part 1
  7. Gruber, J. (2010) Public Finance and Public Policy (Third Edition), Worth Publishers, Pg. 7, Part 1
  8. Gruber, J. (2010) Public Finance and Public Policy (Third Edition), Worth Publishers, Pg. 9, Part 1
  9. Tresch, Richard W. (2008). Public Sector Economics. 175 Fifth Avenue, New York, NY 10010: PALGRAVE MACMILLAN. pp. 143pp. ISBN   978-0-230-52223-7.CS1 maint: location (link)
  10. Hewett, Roger (1987). "Public Finance, Public Economics, and Public Choice: A Survey of Undergraduate Textbooks". The Journal of Economic Education. 18 (4): 426. doi:10.2307/1182123. JSTOR   1182123.
  11. businessfinancearticles.org
  12. Robert Barro and Vittorio Grilli (1994), European Macroeconomics, Ch. 15–16. Macmillan, ISBN   0-333-57764-7.
  13. Columbia Encyclopedia, Government'
  14. C. E. Bohanon, J. B. Horowitz and J. E. McClure (September 2014). "Saying Too Little, Too Late: Public Finance Textbooks and the Excess Burdens of Taxation". Econ Journal Watch. 11 (3): 277–296. Retrieved November 2014.Check date values in: |accessdate= (help)
  15. "Archived copy". Archived from the original on 2009-06-09. Retrieved 2010-04-13.CS1 maint: archived copy as title (link)
  16. Black's Law Dictionary, p. 1307 (5th ed. 1979).
  17. Id.
  18. 1 2 3 General Government sector, Eurostat glossary
  19. ESA95, paragraph 2.68
  20. Central government, Eurostat glossary
  21. State government, Eurostat glossary
  22. Local government, Eurostat glossary
  23. Social security fund, Eurostat glossary

Related Research Articles

Economy of Denmark economy of the country

The economy of Denmark is a modern mixed economy with comfortable living standards, a high level of government services and transfers, and a high dependence on foreign trade. The economy is dominated by the service sector with 80% of all jobs, whereas about 11% of all employees work in manufacturing and 2% in agriculture. Nominal gross national income per capita was the tenth-highest in the world at $55,220 in 2017. Correcting for purchasing power, per capita income was Int$52,390 or 16th-highest globally. Income distribution is relatively equal, but inequality has increased somewhat during the last decades, however, due to both a larger spread in gross incomes and various economic policy measures. In 2017, Denmark had the seventh-lowest Gini coefficient of the 28 European Union countries. With 5,822,763 inhabitants, Denmark has the 39th largest national economy in the world measured by nominal gross domestic product (GDP) and 60th largest in the world measured by purchasing power parity (PPP).

Tax Method to impose financial charge or other levy upon a taxpayer by a government or functional equivalent

A tax is a compulsory financial charge or some other type of levy imposed upon a taxpayer by a governmental organization in order to fund government spending and various public expenditures. A failure to pay, along with evasion of or resistance to taxation, is punishable by law. Taxes consist of direct or indirect taxes and may be paid in money or as its labour equivalent. The first known taxation took place in Ancient Egypt around 3000–2800 BC.

This aims to be a complete article list of economics topics:

Fiscal policy use of government revenue collection and spending to influence the economy

In economics and political science, fiscal policy is the use of government revenue collection and expenditure (spending) to influence a country's economy. The use of government revenues and expenditures to influence macroeconomic variables developed as a result of the Great Depression, when the previous laissez-faire approach to economic management became unpopular. Fiscal policy is based on the theories of the British economist John Maynard Keynes, whose Keynesian economics theorized that government changes in the levels of taxation and government spending influences aggregate demand and the level of economic activity. Fiscal and monetary policy are the key strategies used by a country's government and central bank to advance its economic objectives. The combination of these policies enables these authorities to target inflation and to increase employment. Additionally, it is designed to try to keep GDP growth at 2%–3% and the unemployment rate near the natural unemployment rate of 4%–5%. This implies that fiscal policy is used to stabilize the economy over the course of the business cycle.

In economics, the fiscal multiplier is the ratio of change in national income arising from a change in government spending. More generally, the exogenous spending multiplier is the ratio of change in national income arising from any autonomous change in spending. When this multiplier exceeds one, the enhanced effect on national income may be called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased income and hence increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output that is a multiple of the initial change.

Deficit spending Spending in excess of revenue

Deficit spending is the amount by which spending exceeds revenue over a particular period of time, also called simply deficit, or budget deficit; the opposite of budget surplus. The term may be applied to the budget of a government, private company, or individual. Government deficit spending is a central point of controversy in economics, as discussed below.

Government budget balance Difference between revenues and spending

A government budget is a financial statement presenting the government's proposed revenues and spending for a financial year. The government budget balance, also alternatively referred to as general government balance, public budget balance, or public fiscal balance, is the overall difference between government revenues and spending. A positive balance is called a government budget surplus, and a negative balance is a government budget deficit. A budget is prepared for each level of government and takes into account public social security obligations.

In macroeconomics and finance, a transfer payment is a redistribution of income and wealth by means of the government making a payment, without goods or services being received in return. These payments are considered to be non-exhaustive because they do not directly absorb resources or create output. Examples of transfer payments include welfare, financial aid, social security, and government subsidies for certain businesses.

As a subfield of public economics, fiscal federalism is concerned with "understanding which functions and instruments are best centralized and which are best placed in the sphere of decentralized levels of government". In other words, it is the study of how competencies and fiscal instruments are allocated across different (vertical) layers of the administration. An important part of its subject matter is the system of transfer payments or grants by which a central government shares its revenues with lower levels of government.

Government spending Government consumptions, investments, and transfer payments

Government spending or expenditure includes all government consumption, investment, and transfer payments. In national income accounting, the acquisition by governments of goods and services for current use, to directly satisfy the individual or collective needs of the community, is classed as government final consumption expenditure. Government acquisition of goods and services intended to create future benefits, such as infrastructure investment or research spending, is classed as government investment. These two types of government spending, on final consumption and on gross capital formation, together constitute one of the major components of gross domestic product.

Circular flow of income kelle_morgan_hilton_son_Daughter

The circular flow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents. The flows of money and goods exchanged in a closed circuit correspond in value, but run in the opposite direction. The circular flow analysis is the basis of national accounts and hence of macroeconomics.

Articles in economics journals are usually given classification codes according to a system originated by the Journal of Economic Literature. The JEL is published quarterly by the American Economic Association (AEA) and contains survey articles and information on recently published books and dissertations. The AEA maintains EconLit, a searchable data base of citations for articles, books, reviews, dissertations, and working papers classified by JEL codes for the years from 1969. A recent addition to EconLit is indexing of economics-journal articles from 1886 to 1968 parallel to the print series Index of Economic Articles.

Michael Boskin American businessman

Michael Jay Boskin is the T. M. Friedman Professor of Economics and senior Fellow at Stanford University's Hoover Institution. He also is Chief Executive Officer and President of Boskin & Co., an economic consulting company.

Government budget government document presenting the governments proposed revenues and spending for a fiscal year

A government budget is a document prepared by the government or other political entity presenting its anticipated revenues and proposed spending for the coming financial year. In most parliamentary systems, the budget is presented to the lower house of the legislature and often requires approval of the legislature. Through this budget, the government implements economic policy and realizes its program priorities. Once the budget is approved, the use of funds from individual chapters is in the hands of government, ministries and other institutions. Revenues of the state budget consist mainly of taxes, customs duties, fees and other revenues. State budget expenditures cover the activities of the state, which are either given by law or the constitution. The budget in itself does not appropriate funds for government programs, which requires additional legislative measures.

Ministry of Finance (India) finance ministry of India

The Ministry of Finance is an important ministry within the Government of India concerned with the economy of India, serving as the Indian Treasury Department. In particular, it concerns itself with taxation, financial legislation, financial institutions, capital markets, centre and state finances, and the Union Budget.

Ministry of Finance (Chile) ministry in the government of Chile

The Ministry of Finance of Chile is the cabinet-level administrative office in charge of managing the financial affairs, fiscal policy, and capital markets of Chile; planning, directing, coordinating, executing, controlling and informing all financial policies formulated by the President of Chile.

Public economics is the study of government policy through the lens of economic efficiency and equity. Public economics builds on the theory of welfare economics and is ultimately used as a tool to improve social welfare.

Several theories of taxation exist in public economics. Governments at all levels need to raise revenue from a variety of sources to finance public-sector expenditures.

Fiscal sustainability, or public finance sustainability, is the ability of a government to sustain its current spending, tax and other policies in the long run without threatening government solvency or defaulting on some of its liabilities or promised expenditures. There is no consensus among economists on a precise operational definition for fiscal sustainability, rather different studies use their own, often similar, definitions. However, the European Commission defines public finance sustainability as: the ability of a government to sustain its current spending, tax and other policies in the long run without threatening the government's solvency or without defaulting on some of the government's liabilities or promised expenditures. Many countries and research institutes have published reports which assess the sustainability of fiscal policies based on long-run projections of country's public finances. These assessments attempt to determine whether an adjustment to current fiscal policies that is required to reconcile projected revenues with projected expenditures. The size of the required adjustment is given with measures such as the Fiscal gap. In empirical works, weak and strong fiscal sustainability are distinguished. Differences are related to both econometric techniques used for examination and variables involved.

China's Tax-Sharing Reform in 1994 was a fiscal and taxation system reform initiated by the Chinese government in 1992, prepared and promulgated in 1993, and finally implemented in 1994. The reform was a large-scale adjustment of the tax distribution system and tax structure between the central and local governments, which was regarded as a milestone in the transition of China's fiscal system from planned economy to market economy. The main purpose of the tax-sharing reform is to alleviate the budget deficit since the end of the 1980s. As the reform achieved indeed remarkable results, it yet evoked problems like heavier financial burden of local governments. In order to make ends meet, governments started to let lands which eventually pushed up the land and housing price. Therefore, the tax-sharing reform is considered to be the reason of China's severe land finance.

References