CHAPTER ONE

1 BEC 310: Public

Finance

Introduction to Public Finance

In this chapter……

 Public Finance
 Normative and Positive Analysis
 Modelling
 Methodology
 The Minimal State
 Market Failure
 Redistribution
 The Goals of Government Policy

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 Public Finance

 Public finance is about the interaction of the

government and the economy.
 It considers the effects of taxes and government
expenditures, with particular emphasis upon
how the choices of the government can improve or
hinder economic efficiency.
 Public finance also investigates the extent to
which it is possible, or desirable, for the
government to influence the distribution of income
and wealth.
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 Public Finance

 The study of public finance has a long tradition

as a sub discipline of economics and many
eminent economists have contributed to the
subject.
 Notable among these are:
 Ricardo’s discussion of the effects of public debt,
 Edgeworth’s analysis of the effects of taxation on
multi-product firms and
 Pareto’s contribution to the theory of social
decision making.
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 Public Finance

 More recently, the contributions of Arrow

(1951) to social choice and Mirrlees (1971) to
the study of income taxation have been
awarded Nobel prizes.
 The explanation for this interest in public
economics is found in its close connection to
policy analysis and the interest of most
economists in contributing to raising economic
wellbeing.

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 Public Finance

 Public finance attempts to understand

 when the government makes decisions,
 how the government makes decisions and
 what decisions it should make and
 why the government makes decisions the way
they do.
 The subject encompasses topics as diverse as
responses to market failure due to the existence
of externalities and the philosophy behind the
measurement of economic welfare.
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 Public Finance

 This reflects two things:

 the development of public finance from its
initial emphasis upon the collection and
spending of government revenues
 to its present concern with all aspects of
government economic intervention.

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 Public Finance

 The intention of this course is to provide an

accessible introduction to both these aspects of
public finance.
 It draws upon the tools of economic analysis to
present an analytical approach to policy
analysis.

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 Positive and Normative Analysis

 When thinking about economic policy, it is

helpful to focus upon the distinction between
positive and normative analysis.
 A clear distinction is required because we do
not wish to confuse what governments ideally
ought to do with what governments actually do.

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 Positive Analysis

 Positive analysis is about explaining why there

is a public sector, how government policies are
chosen and how these policies affect the
economy.
 Examples of Positive Analysis
 Analysing the voting of the monetary policy committee of a
central bank over the level of the interest rate and
 Analysing the effect of the corporate tax on inward investment.
 People with higher incomes vote for higher levels of local public
services, all else equal.
 Communities with higher property tax rates have lower house
values, all else equal.

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 Positive Analysis

 The primary positive question that we shall

ask is:
 What do we predict will be the outcome when voters
and taxpayers delegate responsibilities to
governments through public finance and public
policy?
 In principle, positive statements can be tested
against evidence.

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 Normative Analysis

 Normative analysis investigates what the best

policies are, and aims to provide a guide to
good government.
 It examines the best choices for public officials
to make.
 Simply combines positive analysis with
values—yours!

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 Normative Analysis

 The primary normative question, upon which

all others turn, is the question of legitimacy.
 In what areas of economic activity can the
government legitimately become involved?
 The legitimacy question points to the
expenditure side of government budgets,
asking what items we should expect to find
there and why.

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 Normative Analysis

 Examples of Normative Analysis

 A property tax is a better way to finance local public
services than a local income tax.
 Prison provision should be contracted out to private
companies.
 Cities should not use property tax exemptions to promote
economic development.
 States should give more education aid to school districts
with a high concentration of at-risk students.

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 Normative and Positive Analysis

 Separating positive and normative arguments

may be the most difficult task in a public
policy debate.
 This is because positive analysis and
normative analysis are not entirely distinct.

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 Normative and Positive Analysis

 To proceed with a normative analysis, it is

first necessary to conduct the positive
analysis.
 This so as it is not possible to determine the best
policy without knowing the effects of alternative
policies upon the economy.

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 Modelling

 Public finance uses economic models to

provide simplified descriptions of the parts of
the economy relevant for the analysis.
 Models usually incorporate independent
decision making by firms and consumers.

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 Modelling

 They are used because the possibilities for

experimentation are limited in public finance
and policy.
 Besides, past experience cannot always be
relied upon to provide a guide to the
consequences of new policies.

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 Modelling

 The two basic forms of models are:

 Partial equilibrium models that focus only on
one or two markets, taking behaviour elsewhere
in the economy as given.
 General equilibrium models that provide a
complete economic system with prices
equilibrating supply and demand on all markets
simultaneously.

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 Modelling

 The choice of which form to use depends

upon how widely the repercussions of the
policy being analysed affect the economy.
 The institutional setting for the study of public
finance is the mixed economy where individual
decisions are respected but the government
intervenes to affect choices.

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 Modelling

 Even within this setting, two alternative

objectives can be assigned to the government:
 It can be assumed to be benevolent and to
act selflessly to serve society.
 Alternatively, the government can be
viewed as being composed of a set of
individuals, each of whom is pursuing their
own selfish agenda.

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 Modelling

 This model of self-serving provides a very

different interpretation of the actions of the
government.
 It also implies a general suspicion of
government intervention.

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 Modelling

 The analysis is applicable to most developed

and developing economies.
 This is because its setting concurs with the
present ascendancy of the mixed economy as
the form of economic organisation.
 It also permits a study of how the government
behaves and how it should behave.

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 Methodology

 The method of analysis is to build models of

the economy that consist of a government,
consumers and firms.
 It is assumed that firms seek to maximise their
profits and that consumers seek to maximise
their private welfare.
 The reaction to a policy change can be
predicted through the solutions to these
optimisation decisions.

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 Methodology

 Normative analysis is conducted under the

assumption that the government has a
specified set of objectives and chooses the
economic policy that best achieves these.
 Positive analysis investigates alternative
explanations for the choice of government
actions, for the emergence of objectives and the
consequences of actions.

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 Methodology

 When considering policy choice, the focus of

the analysis is upon the equilibrium achieved
by the economy.
 The subject matter of public finance is both the
comparison of alternative policies, including
the policy of laissez faire and the choice of the
optimal policy.

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 Methodology

 A change in policy can be viewed as resulting

in a different equilibrium for the economy.
 To treat the question of comparison of policies,
the equilibria for different policies are
contrasted with respect to how well they
satisfy the government’s objectives.

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 Methodology

 The same approach is taken to the selection of

the optimal policy, which is defined as the
policy yielding the highest level for the
government’s objective.
 When the government’s objective is taken to be
the aggregate level of welfare in the economy,
further questions are raised as to how this is
actually measured.

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 Methodology

 This issue is discussed in some detail in later,

but it can be noted here that the answer
involves invoking some degree of comparison
between individual welfare levels.
 It has been the willingness to accept such
comparisons that has allowed the development
of the theory of public finance.

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 Methodology

 Whilst differences of opinion exist upon the

extent to which these comparisons are valid, it
is still scientifically justifiable to investigate
what they would imply if they could be made.

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 The Minimal State

 The question we may ask is, ‚Why do we have

government?‛
 The most basic motivation for the existence of a
public sector follows from this observation:
 Entirely unregulated economic activity could not
take place in a very sophisticated way.

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 The Minimal State

 An economy could not function effectively if

there were no property rights, the rules
defining the ownership of property.
 Without property rights, it would not be
possible to enforce a prohibition against theft.
 Theft discourages enterprise since the gains
accrued may be appropriated by others.
 It also results in the use of resources in the
unproductive business of theft prevention.
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 The Minimal State

 An economy also needs contract laws, the

rules governing the conduct of trade.
 Examples include:
 the formalisation of weights and measures and
 the obligation to offer product warranties.

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 The Minimal State

 Contract laws exist to ensure that the

participants to a trade receive what they expect
from that trade or, if they do not, have open an
avenue to seek compensation.
 Without contract laws, the satisfactory
exchange of commodities could not take place
given the lack of trust that would exist between
contracting parties.

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 The Minimal State

 Property rights and contract laws are of limited

consequence unless they can be policed and
upheld in law.
 Law enforcement cannot be provided free of
cost as enforcement officers must be employed
and courts provided to hear litigation.
 An advanced society would also face a need for
the enforcement of more general criminal laws.

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 The Minimal State

 Once a country develops its economic activity,

it will need to defend its gains from being
stolen by outsiders.
 This implies the provision of a means of
defence for the nation which is also costly.

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 The Minimal State

 The minimal state provides contract law,

polices, and defends the economy against
outsiders.
 The minimal state does nothing more than this,
but without it, organised economic activity
could not take place.
 These arguments provide a justification for at
least a minimal state and hence for having a
public sector and public expenditure.

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 The Minimal State: Market Failure

 The minimal state intervenes only to ensure the

smooth functioning of the economy.
 Whether this intervention is able to achieve
efficiency depends upon the structure of the
economy.
 Efficiency will be achieved in the idealised
competitive economy – an economy with no
market power in which equally-informed
agents interact only with the ‘market’.

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 The Minimal State: Market Failure

 Outside of this setting, there are many

circumstances in which efficiency will not be
achieved.
 Market failure is said to arise when efficiency is
not achieved.
 The sources of market failure are:
 monopoly
 public goods
 externalities
 asymmetric information.
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 The Minimal State: Market Failure

 When market failure is present, the argument

for considering whether government
intervention would be beneficial is compelling.
 But this does not imply that intervention will
always be beneficial.
 In every case, it must be demonstrated that the
public sector has the ability to improve upon
what the unregulated economy can achieve.

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 The Minimal State: Market Failure

 This may not be possible if the choice of policy

tools is limited or government information is
restricted.
 It must be recognised that the actions of the
state, and the policies that it can choose, are
often restricted by the same features of the
economy that make the market outcome
inefficient.

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 The Minimal State: Redistribution

 An argument for government intervention can

also be made if the economy has widespread
inequality of income, opportunity or wealth.
 Such inequalities can occur even if the
economy is efficient in a narrow economic
sense.
 In such circumstances, the level of economic
welfare may be raised by the redistribution of
resources to alleviate these inequalities.

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 The Minimal State: Redistribution

 This reasoning underlies the provision of state

education, social security programmes and
compulsory pension schemes.
 It should be stressed that the gains from these
policies are with respect to normative
assessments of welfare, unlike the positive
criteria lying behind the concept of economic
efficiency.

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 The Minimal State: Redistribution

 In conducting an economic policy the state will

have two conflicting aims.
 On the one hand, it will aim to raise revenue to
finance the policy with the minimum loss to
society.
 The raising of revenue leads to losses due to
the resources used in the collection process and
from the economic distortions that it causes.

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 The Minimal State: Redistribution

 Minimising these losses is the efficiency aspect

of policy design.
 Conversely, the state may also feel that it is
desirable to intervene in the economy in order to
attain a more equitable distribution of the
economy’s resources.
 This is often accompanied by a corresponding
reduction in the degree of concern for the
aggregate level of economic activity.
 This motivation represents the equity side of
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 The Minimal State: Redistribution

 Due to their distinct natures, it is inevitable

that the aims of equity and efficiency regularly
conflict.
 The efficient policy is often highly inequitable,
whilst the equitable policy may introduce into
the economy significant distortions and
disincentives.
 Given this, the design of optimal policy is
concerned with reaching the correct trade-off
between equity and efficiency objectives.
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 The Minimal State: Redistribution

 The optimum trade-off will depend upon the

concern for equity that is expressed in the
objectives of the policy maker.
 The resolution of the trade-off between equity
and efficiency is the major determinant of the
resulting policy program, with aspects of the
policy being attributable to one or the other.
 This distinction is often a helpful way in which
to think about optimality problems and their
solutions.
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 The Goals of Government Policy

 The goal of any economic system is often

loosely stated as promoting the economic well-
being of a nation’s citizens, in keeping with the
humanist philosophy.
 The same goal applies to government policy as
well.
 This goal is difficult to define more precisely,
however.

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 The Goals of Government Policy

 It cannot be to maximise each individual’s

economic well-being or even to allow
individuals to reach their full economic
potential.
 These goals may sound attractive, but they are
meaningless because they violate the law of
scarcity.
 This law says that only a limited amount of
resources are available to promote each individual’s
economic well-being or economic potential.
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 The Goals of Government Policy

 Therefore, economists have chosen two

proximate goals that are directly related to
individual well-being as the principal
economic objectives: efficiency and equity
(fairness).
 When economists speak of promoting the
‚public interest,‛ they mean the public’s
interest in efficiency and equity.

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 The Goals of Government Policy

 Efficiency
 The efficiency criterion is the standard one of
pareto optimality stated in terms of people:
 An allocation is efficient if it is impossible to
reallocate resources such that one person can be
made better off without making at least one other
person worse off.
 Moreover, the people themselves must be the
judges of whether they are better or worse off,
by the principle of consumer sovereignty.
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 The Goals of Government Policy

 Efficiency
 An immediate corollary is that the government
should pursue all pareto superior allocations,
those that make at least one person better off
without making anyone else worse off.

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 The Goals of Government Policy

 Equity
 The equity criterion is more difficult to define
because neither economists nor anyone else has
reached a consensus on what is equitable or
fair in the realm of economic affairs.
 About all one can point to are some notions of
equity that commonly appear in the economic
literature.

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 The Goals of Government Policy

 Equity
 They fall into two categories: process equity
and end-results equity.
 Process equity is a judgment about the rules of
the economic game: Are the rules fair,
independently of the outcomes that result?
 End-results equity is a judgment about the
outcomes of the economic game: Are the
outcomes fair, independently of how they were
achieved?
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 The Government as an Agent

 The humanistic value judgment of consumer

sovereignty has one final and rather
remarkable implication for normative public
sector theory.
 This is concerned with the way the government
should proceed in designing its policies.
 The government is not supposed to have a will
of its own, in the sense that government
officials are not permitted to interject their
 own preferences into the design of policy.
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 The Government as an Agent

 Instead, the proper role of the government is

that of an agent acting on behalf of the citizens.
 Below is the idea behind this argument.
 Suppose that the market system fails in some
way that legitimises government intervention.
 The government is expected to design policies
to set the economy back on the path toward
efficiency or equity, but in doing so it should
follow only the preferences of its citizens.
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 The Government as an Agent

 The preferences of the president or the

members of the legislature carry no special
weight; these people are just one of the many
citizens with one voice and one vote.
 Their only job is to accurately represent the
desires of their constituents.
 This is when politicians use words such as,
“The government is of the people, by the people, and
for the people.”

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 The Government as an Agent

 This is simply reminding us that the purpose of

democratic or representative forms of
government is to follow the will of the people.
 Nonetheless, accepting this view of
government severely limits the scope of public
sector theory.
 It implies that the theory is not meant to be a
theory of government behaviour in the sense of
recognising the state as an organic being with a
(political) life of its own.
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 The Government as an Agent

 It also consciously removes the theory from the

reality that government officials often interject
their own preferences into the decision making
process.
 They do not simply follow the preferences of
their constituents.

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 The Government as an Agent

 Ignoring the preferences of public officials is

clearly a severe limitation for a political theory
of the government, but it happens to be a
source of richness and subtlety for an economic
theory.
 A normative economic analysis based solely on
the preferences of some group of government
administrators would be little more than an
exercise in the theory of consumer behaviour.

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 The Government as an Agent

 What are the administrators’ objectives?

 What choices are available to them?
 What constraints are they operating under?
 These may be interesting practical questions,
but they do not carry much normative weight.

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 The Government as an Agent

 By forcing the government to consider only the

preferences of its citizens, however, all sorts of
interesting and difficult problems arise.
 For example, what should the government do
if individual preferences clash, as they
inevitably will?
 Suppose one group of citizens wants more
spending on national defense, while another
group wants less spending.

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 The Government as an Agent

 How should the government resolve this

conflict?
 Normative theory must provide answers to
questions such as these.
 Other puzzling questions arise as well about
the appropriateness of government
intervention.

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 The Government as an Agent

 If the market system cannot solve a particular

problem, acting as it does on individual
preferences:
 Why should the government be able to do any
better, if all it has to work with are the same
individual preferences?

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 The Government as an Agent

 A strict libertarian economist might insist that

government intervention can only be justified
if markets fail.
 Also if it can be demonstrated conclusively
that some viable government policy will
actually improve upon the market results.
 Most economists have been content to assign to
normative theory the lesser task of describing a
potential improvement through government
action.
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 The Government as an Agent

 But this does leave open the question of

whether some normative policy prescription
really is viable, and, if not, whether a different,
viable, policy can actually improve social
welfare.

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 The Government as an Agent

 This question lies at the heart of social decision

theory, a rapidly expanding subspecialty
within public sector economics.
 Social decision theory analyses the problem of
designing practical decision rules and
procedures that can achieve optimal normative
policies.
 One of its main concerns is whether democratic
voting procedures are consistent with
economic efficiency and equity.
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 The Government as an Agent

 Another concern is whether government

policies can be decentralised.
 Suppose a market goes astray for some reason
and generates non optimal outcomes.
 The preferred solution is to let the market
continue to operate but nudge it with policies
toward the optimal outcome.
 This solution is decentralised in the sense that
the individuals and firms remain the decision
makers in the market.
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 The Government as an Agent

 The alternative to decentralisation is

government provision or some form of coercion.
 This may be inevitable to solve some problems,
but it is never the preferred choice.
 As one might expect, sometimes there are clear
answers to practical questions such as these,
and sometimes not.
 In any event, it is the principle of consumer
sovereignty and the government-as-agent
perspective that makes them all so compelling.
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END

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