Week 1:

Introduction to Public Finance

Fahmida Sultana
Associate Professor
Department of Development Studies
University of Dhaka
 Lecture Outline
•Some Basic Questions
•Examples of Some Government Activities
•Definition of Public Finance
•Emergence of Public Finance as a Separate
Branch
•Subject Matter of Public Finance
•Scope and Limitations of Public Finance
 Some Basic Questions

According to Economist Jonathan Gruber, Public Finance

should be thought of in terms of four central questions:
• When should the government intervene in the economy?
• How might the government intervene?
• What is the effect of those interventions on economic
outcomes?
• And finally, why do governments choose to intervene in the
way that they do?
 When should the government intervene
in the economy
• The general assumption of Economics is that the markets
deliver efficient outcomes.
• And if so, why should the government do anything?
• Therefore, the primary motive of the government intervention
is market failure.
• Market failure occurs when the market economy produces an
outcome which does not maximize efficiency.
Examples of market failure: Externalities and Public Goods
 When should the government intervene
in the economy
• Even if the market is well functioning, the efficient outcome
sometimes may not be socially desirable.
• So government intervention is needed then for the sake of
redistribution to ensure or achieve the equity in the society.
• Redistribution refers to shifting resources from one group to
another.
• Redistribution causes equity efficiency trade off as it entails
efficiency loss because it sometimes push some group of
people to change their behaviour
 How might the government intervene
• Price Mechanism(Tax or Subsidize private sale or Purchase)
Use the price mechanism: changing the price of a commodity to encourage
or discourage the purchase/use of that
– By tax (bads) which raises the price of goods that are overproduced(e.g. Tobacco), or
– By subsidy (goods) which lowers the price of goods that are underproduced (e.g.
Children’s education)
• Regulation
• Quotas restrict private sale of goods that are overproduced
• Mandates require private purchase of goods that are underproduced. (Example:
Requiring car insurance for all cars)
• Provision
• Public Provision -The government can provide the good directly
• Public Financing of Private Provision -Government pays, private companies
produce
• Create/facilitate market (e.g.loan guarantees)
 What is the effect of those interventions
on economic outcomes
• Direct Effects: Individual does not change their behaviour in response to
the intervention
– With X million uninsured, providing universal health insurance covers X
million people
– Increase in G > rise in AD > rise in GDP

• Indirect Effects: Individuals change their behaviour in response to the

intervention
– If people drop private coverage, many more people may end up covered by the
public plan
– Increase in G > (rise in AD > rise in GDP) rise in Labour demand > rise in
wage > rise in employment ( reduce unemployment)
Why do governments choose to intervene
in the way that they do
• We don’t live in a perfect world where the government applies
the things we learn from books 100%
• Government do not choose the efficient and socially desirable
outcome always
• It face big challenges to find what the people wants and how to
choose policies that meets those wants
• So government might end up with the actions that satisfies the
citizens but that may not be the most efficient and optimal
option
 Examples of some government activities

• We are born in the hospitals

• We attend schools
• We receive money from the government through various
programs like student subsidies, unemployment payments and
so on
• We pay taxes to the government
• We work in the government sector
• Profits and employment opportunities in many areas of
production are greatly affected by whether the government
allows foreign competitors to sell goods in domestic market
without a tariff or quota
 Examples of some government activities

• What we eat and drink, where we can live and what kinds of
houses we can live in are all regulated by government agencies
• We travel on public roads, we use public transports, our
garbage collection and sewage disposal by government sector
• Legal structures to sign contracts and so on
• Environmental regulations to control pollution
• Safety regulations
Definition of Public Finance
•Related with financing of state activities

•Can be narrowly defined as a subject that discusses the

financial operations of the fisc (or public treasury)

•Public finance is basically the study of the role of the

government in the economy. It is the branch of economics
which 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.
 Definition of Public Finance
• The purview of public finance is considered mainly to
be threefold, consisting of governmental effects on:
• The efficient allocation of available resources;
• The distribution of income among citizens; and
• The stability of the economy.
 Emergence of Public Finance as a
Separate Branch
• To protect the society against internal disruption and ensure that effective
law and order situation prevailed

• To protect the society against any foreign aggression that might take place

• Without public sector , essential social overheads would not come into
existence
 Subject Matter of Public Finance
We have four major divisions (traditionally set) in the
study of Public Finance:
• 1. Public Revenue, which deals with the method of raising funds and the
principles of taxation. Thus, within the purview of public revenue, we take
up the classification of public revenue, canons and justification of taxation,
the problem of incidence and shifting of taxes, effects of taxation, etc.

– tax(direct and indirect)

– nontax
• 2. Public Expenditure, which deals with the principles and problems
relating to the allocation of public spendings. Here we study the
fundamental principles governing the flow of public funds into different
channels; classification and justification of public expenditure; expenditure
policies of the government and the measures adopted for general welfare.
– Productive/unproductive
– Planned/unplanned
 Subject Matter of Public Finance
• 3. Public Debt, which deals with the study of the causes and
methods of public loans as well as public debt management.
– Internal
– External
• 4. Financial Administration, this deals with the problem of
how the financial machinery is organised and administered.
 Scope and Limitations of Public
Finance
Scopes
• Market mechanism supplies only priced goods

• Some of the external effects of public goods cannot be priced. So private

and social marginal cost of the products will not be the same. Thus supply
of goods will not be at the optimum level.

• Since market mechanism fails in case of public goods because of the failure
of forcing the users to reveal their demand preferences, free riders problems
are very much likely to be faced by the suppliers.
 Scope and Limitations of Public
Finance
Limitations
• Lack of enough resources

• Administrative mechanism may not be efficient enough

• Efficiency of the public undertakings are notoriously low

• The boundaries of the government activities depend upon the political and
social acceptability of its policies
 Basic References
• Stiglitz
• Rosen
• Bhatia