Kurdistan Regional Government-Iraq

Ministry of Higher Education and Scientific Research

Lebanese French University

College of Administration and Economics

Department of accounting

(Second Stage)(A)

How Public Finance Affects the Economy

The student’s name: Lana Tahr Azez

The name of the teacher: Khurram Sultan

Academic year: 2019-2020

Name of the lecturer: Public Finance

: Signature: Date:

Mark (number) Mark (written) Signature

Contents

Introduction......................................................................................................................................2

Public Finance.................................................................................................................................4

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Economic Efficiency.......................................................................................................................4

The Role of Public Finance in Development...................................................................................5

Public finances and macroeconomic stability..................................................................................6

References........................................................................................................................................9

Introduction
he quality of public finance is one of the crucial economic matters as it comprises all
important tasks and goals of public sector and public finance and its improvement
should lead to supporting long-term economic growth. Therefore, analysis of its
conception as well as used channels and tools (structure of revenue system, size of the
government, composition and efficiency of expenditure, level and sustainability of fiscal
position, fiscal governance) is of critical importance for both the economic theory
and economic policy. The quality of public finance (QPF) is a multidimensional concept. QPF
may be defined as signifying all the arrangements and operations regarding the financial
politics that sustain the macroeconomic objectives, particularly the long-term economic
growth. In contrast to past discussions on the short-term impact of fiscal policy on
aggregate demand, QPF focuses on fiscal policy’s role for raising the long-run
growth potential. Improving the quality of public finance is a major challenge for
governments and European policy makers as establishment of Working Group on Quality
Public Finances confirms. At the same time, the European Commission conducted
its own analytical work in a number of QPF areas, in part to support the QPF
Working Group. Both focused predominantly on the link between the composition of
public expenditure and growth, the role of fiscal governance and expenditure efficiency. In the
literature, one can also find a large set of theoretical and empirical analysis in all of the
above and additional areas (e.g. Taxation and growth). Unfortunately, the global
downturn and financial crisis have moved the focus of governments on other issues
and concentrated the effort especially on budget consolidation and the activity of QPF
Working Group nearly disappeared [1]. The linkages between the qualities of public finances,
that is the level and composition of public expenditure and it’s financing via revenue and

2
deficits, and economic growth. The importance of high-quality fiscal policies for economic
growth has been brought to the forefront by a number of developments over the past decades.
Member States of the European Union are bound to fiscal discipline through the Stability and
Growth Pact which limits their scope to conduct unfinanced spending. Globalization makes
capital and even tax payers more mobile and exerts pressure on governments’ revenue base. At
the same time, expenditure pressures do not abate, and countries will soon have to face up to the
fiscal consequences of ageing population.

Since the market is inefficient with respect to the provision of public goods, the government
should provide public goods as appropriate. This is the standard function of the public sector.
Public finance investigates how and when the government should intervene in resource
allocation in the market. In this regard, some argue that the government should only provide
microeconomic measures such as the provision of public goods and improvements in the event of
market failure. These measures are considered the main role of small government. Such an
approach is also called cheap government or small nation, names that emphasize the efficiency
criterion. In order to provide public goods, the government needs to collect tax revenues.
Imposing taxes in the private sector produces a burden on private agents, thereby harming
economic activities. This is called the distortionary effect of taxation. With regard to the revenue
side, public finance investigates how the government should collect taxes in order to minimize
the distortionary effect of such taxes. This is an important topic of optimal taxation and tax
reform.

An important function of the public sector in addition to resource allocation is income

redistribution. As explained in any standard textbook of microeconomics, even if the market is
perfect and resources are efficiently allocated among economic agents, the outcome is not
necessarily ideal. We could observe a large degree of income inequality ex post. The economic
situation of agents depends on the initial state of asset holdings and/or good or bad luck, in
addition to their efforts regarding economic activities. The initial state of assets and human
capital holdings among agents is predetermined before economic activities. Good or bad luck
affects the economic performances of agents differently. Even if the market is perfect, ex post
inequality of income and assets among agents is unavoidable to some extent.

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Different arguments consider how we should intervene with regard to ex post inequality. One
side may argue that strong intervention is desirable so as to realize equitable outcomes ex post.
Another may argue that minimum intervention is desirable so as to enhance economic activities.
However, if ex ante opportunity is unequal, many feel a degree of unfairness. Moreover, ex ante
equality of opportunity does not necessarily mean ex post equality of outcome.[2]

Public Finance
Public finance can be defined as the study of government activities, which may include spending,
deficits and taxation. The goals of public finance are to recognize when, how and why the
government should intervene in the current economy, and also understand the possible outcomes
of making changes in the market. In addition, public finance can involve issues outside of the
economy, including accounting, law and public finance management.
Public Finance is the branch of economics that studies the taxing and spending activities of
government. The term is something of a misnomer, because the fundamental issues are not
financial (that is, relating to money). Rather, the key problems relate to the use of real
resources. For this reason, some practitioners prefer the label public sector economics or
simply public economics. Public finance encompasses both positive and normative analysis.
Positive analysis deals with issues of cause and effect.

Understanding the role of the government and how changes may affect the economy are a few
important aspects of public finance professionals. When the government intervenes and takes
action within the economy, the outcomes are classified into one of three categories: economic
efficiency, distribution of income or macroeconomic stabilization.

Economic Efficiency

Economic efficiency is the standard that economists use to evaluate a variety of resources.
Typically, efficiency can be determined by a general formula of ratios and their generated
outcomes. The difference between technical efficiency and economic efficiency is the
relationship of values people place on things. Values in technical efficiency may be subjective
from one person to another.  Economic efficiency focuses on eliminating waste to provide as

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much value as possible. Technical efficiency looks to maximize value, while sacrificing as much
as is needed to create the best initiative.[3]

The Role of Public Finance in Development

Most developing countries have faced a fiscal crisis of one sort or another during the past
decade. Until 1982 public sector deficits rose to unsustainable levels almost without regard to
economic structure and income level: oil exporters, oil importers, middle-income countries, low-
income countries, commercial debtors, aid recipients, and planned and market economies all
followed the same course. When the external economic shocks of the early 1980s made it
impossible to finance these deficits, a period of severe fiscal retrenchment became inescapable.
The reduction in deficits since then has been remarkable, but many countries still deprived of
external financial resources need to do more. For them the dilemma is how to cut deficits further
without sliding even deeper into recession. The urgency of this problem has distracted attention
from the broader role of public finance in development. The short-term imperative has been to
contain fiscal deficits through some mixture of reduced expenditure and higher revenues. The
concern for the longer term is that such changes be carried out in ways that promote, rather than
hamper, growth. Indeed prudent control of fiscal deficits is just one aspect of sound public
finance in the widest sense. Among other things this means confining (or extending) public
expenditure to those areas in which the public sector can act efficiently; it also means raising the
necessary revenues in ways that distort prices as little as possible. This chapter introduces the
broad perspective within which deficit reduction should be viewed. Governments everywhere
play an essential role in allocating resources in influencing what gets produced, how it is
produced, who receives the benefits, and who pays. They do so both directly and indirectly. For
instance, all directly provide defense and social infrastructure; most supply power and telephone
services; a few produce industrial and agricultural goods. Often governments create state-owned
enterprises (SOEs) to carry out these functions. But governments also indirectly influence the
production and allocation of privately produced goods through subsidies, taxes, and a wide range
of regulatory tools such as price controls and quantitative restrictions. In centrally planned
economies governments rely mainly on direct intervention; in market economies they tend to
favor the indirect approach. Both modes of intervention involve public spending and revenue and
are thus equally subject to the strictures of sound public finance. Public finance affects
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economies in many different ways. Revenue, expenditure, and the public sector deficit they
imply are essential tools for macroeconomic stabilization: they help to determine the inflation
rate, the current account deficit, the growth of the national debt, and the level of economic
activity. They also affect adjustment and growth by influencing the rates of consumption,
savings, and investment in both physical and human capital. At the microeconomic level, taxes,
subsidies, and government purchases of commodities encourage the production and consumption
of some goods and discourage the production and consumption of others. Public finance policies
can, in principle, affect all sectors of the economy, and they typically do so in developing
countries as in industrial countries. We all know that the existence of a large and growing public
sector is a reason enough to study public finance. Adam Smith in his monumental work. The
Wealth of Nations laid out the basic jobs of the government. The government is to play an
important role in providing for the defense of the nation, the administration of justice, and in the
provision of those goods and services not wholly to be the result of ordinary private activity.

Adam Smith also had an acute awareness of the problems that would be associated with raising
the funds needed to finance these obligations. His four maxims of taxation remain today a guide
in designing a nation’s revenue structure. The four maxims focus attention on matters of
economic efficiency as well as equity.[4]

Public finances and macroeconomic stability

Fiscal policies are one factor that can contribute to macroeconomic stability and a sound policy
mix and, thereby, also support monetary policy in maintaining stable prices at low interest rates.
Low deficits and debt ratios create expectations that public finances are sustainable so that
expenditure policies and tax systems and rates will be predictable. This is conducive to economic
growth because it creates an environment conducive to long-term-oriented savings and
investment decisions. By contrast, if, over a sustained period of time, government revenue is
much lower than total public spending, (thus, creating unsustainable macroeconomic imbalances
and public debt accumulation) growth may be reduced because the private sector might come to
see the fiscal situation as unsustainable and reduces investment in anticipation of future higher
taxes. Moreover, uncertainty about the future tax changes and, thereby, the tax structure may
exacerbate the negative effects and, in particular, reduce immobile capital investment that is

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vulnerable to tax increases.10 Moreover, low deficits prevent the absorption of a large share of
savings to finance the public sector (crowding out) which, in turn, benefits investors via lower
interest rates and raises the capital stock .This argument is based on the presumption that
Ricardian equivalence (i.e., lower public saving as reflected in higher deficits is fully offset by
higher private savings) does not hold. However, here a number of arguments and empirical
evidence that suggests that at least some crowding out of private investment due to public
imbalances should be expected.[5]

The third function of the public sector is to stabilize the macroeconomic. Because of exogenous
negative shocks such as financial crises, private economic activity may remain in a recession for
a long while. Even if the market mechanism is perfect in the long run, unemployment and idle
capital equipment are situations that can occur in the short run. Moreover, in reality, price
rigidity and pessimism cause the market mechanism to work badly, thereby encouraging a
serious recession in the long run. It is then desirable for the government to intervene in the
private economy and alleviate the unwanted outcomes of negative shocks. In particular,
according to Keynesian economics, the government should stimulate aggregate demand by
raising government spending and reducing taxes when the macroeconomic experiences
underemployment and lacks aggregate demand. Further, a lack of effective demand cannot easily
be cleared by the price mechanism. Thus, public finance should incorporate a stabilization policy
for macroeconomic activities. For example, expansionary fiscal policy is useful to stimulate
aggregate demand in a recession. In addition, employment insurance is effective for alleviating
the detrimental outcomes of unemployment. On the other hand, monetary restriction and public
spending cuts are effective for reducing inflation and over-utilization of labor and capital in a
boom. Public finance investigates how the government can avoid macroeconomic instability.[2]

HOW PUBLIC FINANCE AFFECTS THE ECONOMY

Government spending and taxation directly affect the overall performance of the economy. For
example, if the government increases spending to build a new highway, construction of the
highway will create jobs. Jobs create income that people spend on purchases, and the economy
tends to grow. The opposite happens when the government increases taxes. Households and
businesses have less of their income to spend, they purchase fewer goods, and the economy tends

7
to shrink. A government's fiscal policy is the way the government spends and taxes to influence
the performance of the economy.

When the government spends more than it receives, it runs a deficit. Governments finance
deficits by borrowing money. Deficit spending that is, spending funds obtained by borrowing
instead of taxation can be helpful for the economy. For example, when unemployment is high,
the government can undertake projects that use workers who would otherwise be idle. The
economy will then expand because more money is being pumped into it. However, deficit
spending also can harm the economy. When unemployment is low, a deficit may result in rising
prices, or inflation. The additional government spending creates more competition for scarce
workers and resources and this inflates wages and prices.

The total of all federal government deficits forms the national debt. The size of the U.S. national
debt has grown during the 20th century. The debt equaled about $25 billion in 1919 after World
War I and about $260 billion in 1945 after World War II. In 1970 the debt stood at about $380
billion. Ten years later, the national debt had soared to nearly $1 trillion. In 2000 the national
debt totaled $5.7 trillion.

Many people are concerned about the size of the U.S. national debt. They fear that a large
amount of debt harms the economy and feel that the money used to pay interest on the debt could
be better spent on other uses. Some people are also concerned about the ability of future
generations to pay back the debt. However, many economists argue that the size of the debt is
misleading. They point out that an important measure of the severity of a nation's debt is its size
as a percentage of the nation's gross domestic product. Based on this measurement, the national
debt of the United States during the mid-1990s was about half the size of the U.S. debt at the end
of World War II in 1945. Other economists contend that when the balance of the debt is
compared between years it does not account for the effects of inflation, which makes balances
from later years appear larger.[6]

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References

1. Szarowská, I., Quality of public finance and economic growth in the Czech Republic.
Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, 2016. 64(4): p.
1373-1381.
2. Dalton, H., Principles of public finance. Vol. 1. 2013: Routledge.
3. Zimbalist, A. and H.J. Sherman, Comparing economic systems: a political-economic
approach. 2014: Academic Press.
4. Shoup, C., Public finance. 2017: Routledge.
5. Ocampo, J.A., A broad view of macroeconomic stability. The Washington consensus
reconsidered, 2008: p. 63-94.
6. Johansson, Å., Public Finance, Economic Growth and Inequality. 2016.