GOVERNMENT SECTOR

Charles Masili Banda

Department of Economics
 PUBLIC FINANCE
• Public finance is about the taxing and spending
activities of the government.
• Also known as “public sector economics” or
“public economics.”
• 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.
 PUBLIC FINANCE Cont’d
• Public finance studies how governments at all
levels—national, state, and local—provide the
public with desired services and how they secure
the financial resources to pay for these services.
 Why Public Finance Is Needed?
• Governments provide public goods—government-
financed items and services such as roads,
military forces, lighthouses, and street lights.
• Private citizens would not voluntarily pay for
these services, and therefore businesses have no
incentive to produce them.
 Why Public Finance Is Needed?
• Public finance also enables governments to
correct or offset undesirable side effects of a
market economy.
• These side effects are called spillovers or
externalities.
• Example: households and industries may
generate pollution and release it into the
environment without considering the adverse
effect pollution has on others.
 Why Public Finance Is Needed?
• Pollution is a spillover because it affects people
who are not responsible for it.
• To correct a spillover, governments can
encourage or restrict certain activities.
• For example, governments can sponsor
recycling programs to encourage less pollution,
pass laws that restrict pollution, or impose
charges or taxes on activities that cause
pollution.
 Why Public Finance Is Needed?
• Public finance provides government programs
that moderate the incomes of the wealthy and
the poor.
• These programs include social security, welfare,
and other social programs.
• For example, some elderly people or people with
disabilities require financial assistance because
they cannot work.
 Why Public Finance Is Needed?
• Governments redistribute income by collecting
taxes from their wealthier citizens to provide
resources for their needy ones.
• The taxes fund programs that help support
people with low incomes.
 The Budget
• Each year national, Provincial, and local
governments create a budget to determine how
much money they will spend during the
upcoming year.
• The budget determines which public goods to
produce, which spillovers to correct, and how
much assistance to provide to financially
disadvantaged people.
 The Budget
• The chief administrator of the government—
such as the prime minister, governor, or
mayor—proposes the budget.
• The legislature—such as the parliament,
Provincial council, or Municipality council—
ultimately must pass the budget.
• The legislature often changes the size and
composition of the budget, but it must not
make changes that the chief administrator will
reject and veto.
 Government Spending
• Government spending takes two forms:
• Exhaustive spending
• Transfer spending.
 Government Spending
• Exhaustive spending: refers to purchases
made by a government for the production of
public goods.
• For example, to construct a new harbor the
government buys and uses resources from the
economy, such as labor and raw materials.
 Government Spending
• Transfer spending when government transfers
income to people to help them support themselves.
• Transfers can be one of two kinds:
– cash or in-kind.
1. Cash transfers are cash payments, such as social
security checks and welfare payments.
2. In-kind transfers involve no cash payments but
instead transfer goods or services to recipients.
Examples of in-kind transfers include food stamp
coupons and Medicare.
 Taxes
• In legal terms, a tax is defined as an involuntary
charge on individuals and business by the state. This
means taxes are monies that are paid to the
government.
• Note from the definition that there is no
attachment of a good or service in exchange. This
differentiates taxes from other monies that may be
paid to government in direct exchanges for a good.
• A tax is paid without a direct benefit to the payer.
Because of this, the payer would under normal
circumstance not be willing to pay. He/she pays
because it is mandatory.
 Taxes Cont’d
• Taxes are broadly divided into two. The direct
and indirect taxes.
• A direct tax is a tax collected directly when
income is earned. Examples include the Personal
Income Tax. This tax is charged whenever an
income is earned. It is charged on wages, rent,
interest or any other incomes earned. In
Zambia, it is famously known as the Pay As You
Earn (PAYE). Another example of direct tax is a
corporate tax. This is charged on profits made
by business entities.
 Taxes Cont’d
• Indirect taxes on the other hand tend to be
indirectly charged.
• It is normally charged when we spend. The
notable example is the Value Added Tax (VAT).
You will not see VAT on you pay slip. But every
time you walk into a shop, you pay it indirectly.
• It is paid through goods and services that we
buy in everyday life.
 Retrogressive, Proportional and Progressive Taxes
• In the past, there was what was referred to as
Poll tax. This was levied on an individual
irrespective of their income status. This was
viewed as the most unfair tax because it treated
the unequal equally.
• Taxes that are based on income level, for
individual or businesses can be classified into
three; retrogressive, proportion and progressive
taxes.
 Retrogressive Tax
• A tax is retrogressive if the percentage of tax to
income reduces with an increase in income. In
percentage terms, the poor pay more than the rich.
• Under this definition, a poll tax qualifies as a
retrospective tax. If the amounts under the poll tax
are converted into percentages of income, the
proportion would decline as income goes up.
• What the poor pay would be a big proportion of
their income while for the rich; it might actually be
a negligible portion.
 Proportional Tax
• A proportional tax is one where everyone pays a
fixed portion of their income.
• If it is 30% corporate tax, every business will
have to pay only 30% of their income. This is
the most common type of corporate tax.
• They all pay a fixed proportion of their income
irrespective of the level.
 Progressive Tax
• A progressive tax system is one in which the
percentage increases with income. The rich do
not only pay high amounts; they also pay a high
proportion of their incomes in tax.
• This is the system currently used in Zambia’s
income tax.
 Public Revenue

• Governments must have funds, or revenue, to

pay for their activities.
• Governments generate some revenue by
charging fees for the services they provide, such
as entrance fees at national parks or tolls for
using a highway.
• However, most government revenue comes
from taxes, such as income taxes, and sales and
excise taxes.
 Public Revenue

• An important source of tax revenue in most countries

is the income or payroll tax, also known as the personal
income tax.
• Income taxes are imposed on labor or activities that
generate income, such as wages or salaries.
 Public Revenue
• Another important source of government revenue is the
capital tax.
• Capital includes items or facilities that generate profits,
such as factories, business machinery, and real estate.
• Some types of capital taxes are known as “profits” taxes.
• One kind of capital tax used by governments is the
corporate income tax.
• A property tax is a capital tax used by state and local
governments. Property taxes are levied on items such as
houses
 Public Revenue
• Sales and excise taxes are also a major source of
government tax revenue.
• Many state and local governments levy a sales tax on
the purchase of certain items.
• Consumers usually pay a percentage of the sales price
as the tax.
• Excise taxes are used by all levels of government.
• An excise tax is levied on a specific product, such as
alcohol, cigarettes, or gasoline.
 Public Revenue
• The value-added tax (VAT) provides significant
revenue for most governments.
• The VAT is levied on the value added to a
product during production as its components
are assembled into final goods.
 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 to shrink.
 Government Deficits
• 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.
 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
 Fiscal Policy
• Fiscal Policy is;
– Government Expenditure and
– Taxation
• Fiscal Policy can either be;
– Expansionary or
– Contractionary
• Expansionary is;
– Either increasing govt expenditure or reduction in taxes
• Contractionary Fiscal Policy is either;
– Reduction in govt expenditure
– Increasing Taxes
 Fiscal Policy
• The government can influence the circular flow
of income through taxes (T), a withdrawal from
the circular flow of income, or through
government expenditure (G), an injection into
the circular flow.
– A budget deficit (T < G) would have an
expansionary effect on the economy;
– A budget surplus (T > G) would have a deflationary
effect on the economy.
 Fiscal Policy
• Government has the ability – and the
responsibility- to manage aggregate demand to
ensure continuous prosperity. This is achieved
through a fiscal policy.
• This is a policy on government expenditure and
taxation.
 Fiscal Policy Cont’d
• This proposed operation of fiscal policy is
known as functional finance, meaning that there is
no single automatic rule that should be followed
regarding the relationship between government
expenditure and government taxation.
• Instead, fiscal policy should be discretionary.
The relationship between G and T should
deliberately be varied to reflect the underlying
conditions in the economy.
 Fiscal Policy Cont’d
• Government taxation and government
expenditure are analogous, in their effects on the
circular flow of national income, to household
saving and business investment.
• Taxation is a withdrawal from the circular flow
of income, as the act of taxation is not a claim
on output that creates factor income and
employment.
 Fiscal Policy Cont’d
• On the other hand, government expenditure is
an injection into the circular flow of income,
constituting a claim for output and creating
factor income and employment. If the
government purchases goods and services in
order to provide medical services, build roads
and airports, and provide law, order and defence,
then the expenditure creates both income and
employment.
• Government expenditure is therefore a
component of aggregate demand or expenditure
 Fiscal Policy Cont’d
• Government expenditure on goods and services adds to
the aggregate demand. The more government spends, the
higher the aggregate demand.
• The tax does not directly appear in the model. It
nonetheless affect aggregate demand through
consumption and Investment.
• When tax is high, net income is low and so will
consumption.
• For firms, taxation will eat into net profit (Profit after
Tax) which results in less money available for
reinvestment or dividend payment.
• Thus both G and T are important components of
aggregate demand.
 Fiscal Policy Cont’d
• This provides government with an ability to
manage aggregate demand.
A. During periods of high inflation caused by too
much aggregate demand, government can
restrain aggregate demand through high
taxation or reduced government expenditure.
B. In periods of high unemployment caused by
insufficient aggregate demand, government can
increase its expenditure or cut taxes in order to
boost aggregate demand.
 Expansionary Fiscal Policy
• To obtain a given increase in aggregate demand
will require a smaller budget deficit if the deficit
is created by raising G, and a larger budget
deficit if the deficit is created by lowering T.
• Alternatively, the same increase in aggregate
demand could be obtained by raising both G
and T, but where a substantial stimulus to the
economy is required, it would necessitate a very
large increase in the size of the government
sector to produce the same effect as a budget
deficit created by (a) or (b) above.
Listing fiscal policies in descending orders of
expansionary effects, we obtain:
1) a budget deficit created by raising G relative to
T;
2) a budget deficit created by reducing T relative
to G;
3) increasing both G and T by the same amount
 Contractionary Fiscal Policy
• This can be done by lowering government
expenditure and/or raising taxes and thus
creating a budget surplus.
The Laffer Curve
 The Laffer Curve Explanation
• If the tax rate were y per cent, a decrease in the tax
rate would increase tax revenues.
• On the other hand, if the tax rate were z per cent,
an increase in the tax rate would increase tax
revenues.
• Thus if a policy goal of the government were to
balance the budget and suppose this necessitated
increasing tax revenues, the government would have
to decide where on the Laffer Curve the economy
actually was before it decided whether the correct
policy was to increase or decrease the tax rate.
 Budget including Debt Management
• Basically a budget is a plan on revenue and
expenditure for an entity. At household level, the
key question is often what to buy. This is the
expenditure side of the budget.
• The revenue side is rarely an issue for one simple
reason. As individuals, we lack control of our
revenue (salaries).
• We do not decide how much to have in a particular
month or year. For this reason, we take them as
given.
• Once the revenue part is known, a family or
individual goes on to formulate the expenditure side
 Budget including Debt Management Cont’d

• For a government however, they have control of

both the expenditure as well as the revenue.
• They can decide how much to collect
(procedurally of course) by employing various
taxations mentioned earlier.
• A government budget will therefore outline
how much government plans to collect and how
that is going to be collected.
• On the expenditure side, it will give the various
goods and services that government will spend
on.
 Balanced Budget and Debt Management
• For every budgeting entity, the possibility of saving
or borrowing is not ruled out. For a household, it is
possible to spend more than is earned by resorting
to borrowing.
• But borrowing simply means consuming now and
paying later. The borrowed money will ultimately
have to be paid back.
• The same applies for savings. They are not meant to
last for eternity. They must be consumed at some
point.
• So revenue and expenditure may be unequal in
some periods but must be equal over lifetime.
 Balanced Budget and Debt Management Cont’d
• In a similar manner, government revenues and
expenditures need to be equal at all times. We
define a budget deficit as the gap between
expenditure and revenue.
• (G) Stands for government purchases of goods and
services and (T) is tax revenues.
• When there is neither deficit nor surplus, that is ,
the budget is said to be balanced. It is often called a
balanced budget.
• It is balanced because the revenue and expenditure
sides are balanced. They are equal and government
spends exactly what it collects
 Balanced Budget and Debt Management Cont’d
• Since there is room for debt (or saving which is rare),
government can decide to spend more that it receives by
borrowing.
• Government borrows buy issuing Treasury Bills and
Bonds which are short and long terms loans to
government respectively.
• When Government expenditure is more than Tax
revenue, we say there is a budget deficit.
• This must not be confused with an overrun which is
unintentional.
• A deficit is part of the plan and will include plans on how
it is to be covered.
• The opposite is called a budget surplus. Some money is
saved and available for loaning to deficit states.
 But what is the limit to borrowing?
• Government can borrow as much as it desires
provided the source is there. As long as there are
entities willing to lend to government, it will
borrow.
• The moral limit however is that the borrowed
money will ultimately have to be paid back.
• Thus borrowing must be limited by the ability to
pay back.
• So how much should government collect in tax and
how much must be borrowed? Well, such question
can be ably answered by turning to fiscal policy.
 Conclusion!!!
• Using fiscal policy, government can reduce
fluctuations in aggregate demand so as to ensure
the economy grows smoothly.
• When fiscal policy is used to expand aggregate
demand, it is known as expansionary fiscal policy. it
is intended to increase aggregate demand usually in
times of depressions.
• When aggregate demand is too high, this will
manifest in high inflation.
• In such a case, the ideal steps are to restrain or
contract aggregate demand. This is referred to as
contractionary fiscal policy