Public Finance in Theory and Practice Second edition

Holley H. Ulbrich

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781136726187
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

The events of the last decade have challenged the contemporary neo-classical synthesis in all branches of economics, but particularly public finance. The most notable feature of the 2 nd edition of Public Finance in Theory and Practice is the infusion of behavioral economics throughout the text, with an end of chapter question inviting the student to apply a behavioral lens to some question or issue. There continues to be an emphasis on the importance of the institutional context, drawing on examples from many countries and emphasizing the role of lower level governments in a federal system. The first five chapters establish this context by reviewing the role of government in a market system, the description of government structure from an economic perspective, the basic data about revenue and expenditures, the elements of public choice, and the distributional role of government.

The book has been substantially reorganized to put more emphasis on public expenditure. Expanded treatment of public goods includes common property resources and congestible or club goods. Expanded discussion of budgeting and cost-benefit analysis provides some practical application of the theory. Updated discussions of social security, public education and health care address these three major contemporary public finance issues. The traditional emphasis on revenue (taxes, fees and grants) has been retained but follows rather than precedes the discussion of expenditures.

Part 1

Government and the Market

Like other branches of economics, public finance or public sector economics combines a body of theory with a set of institutions to describe, analyze, and interpret the workings of government in a predominantly private economy. The theory is more or less universal, but it works out differently in different institutional contexts. Policies that work well for a small, homogeneous, highly centralized nation or in highly competitive markets may have very different effects in a nation that is larger, heterogeneous, and decentralized, or in an economy with a substantial concentration of private economic power. While much of this book is written from an American perspective, that viewpoint is heavily qualified by frequent comparisons with experience in other countries, particularly but not exclusively other English-speaking industrial and post-industrial countries.

From before recorded history, human societies have felt the need to have governments. Very small societies may get by with relatively little government, but once societies become large, complex, and technologically sophisticated, they need a referee, a rule setter, an authority for resolving disputes. Many of those rules and disputes are economic in nature.

Some governments, like the American government in the words of the Declaration of Independence, “derive their just powers from the consent of the governed.” Others exist by force of arms, or tradition, or external imposition, or other sources of power. Governments come into being to balance the desire of the individual for autonomy and freedom with the need for citizens to find ways to work together to address common concerns, manage shared resources, protect themselves from each other and external enemies, and resolve the boundary problems that separate one household from another.

In many countries, the powers and limitations of government are laid out in formal documents. Among the major English-speaking countries, those documents are a more or less continuous series, beginning with Magna Carta in 1215; the US Articles of Confederation in 1781, superseded by the US Constitution of 1787; the British North America Act of 1867 that is the core of the Canadian Constitution; the 1900 Constitution of the Commonwealth of Australia; and the 1949 Constitution of India, just to list a few.

However limited the original mandate—and in the United States, the original mandate, the Articles of Confederation, was very limited indeed—sooner or later, the role of government begins to expand. Much thought and discussion goes into determining what government should be permitted to do when the central vision is a private society that is largely governed by individual choice, with government intervening only when necessary. However, the opportunity to use the government to get others to pay for your pet project or to restrict your pet annoyance tends to expand both the budgetary and regulatory reach of government.

The paragraph above describes a distinctly American (and to a lesser degree, British) view of government. Most Americans assume that this individualistic interpretation of the role of government—as an intruder into primarily market and private decisions—to be “the way it is,” rather than one interpretation among many possible ones. Many nations have no such hierarchy of activity, with the market as primary and the government as secondary. Instead, there may be a fluctuating blend of public and private activity, with the assignment of tasks to one or the other determined on an ad hoc basis. Western and Latin American countries have shifted back and forth between a larger public role and a larger private role in an effort to balance competing demands of equity and efficiency, individual security and work incentives, public infrastructure, and private capital.

Still other countries have undergone a public/private sorting-out process in reverse. In the former Soviet Union and Eastern Europe, the challenge has been to transition from a system in which the community took precedence over the individual to one that provides a much larger sphere for private, individual decisions. It has been a slow and confusing road, from a system in which the government managed almost all economic activity to an alternative model in which individuals, markets, and private voluntary associations play important roles in organizing economic activity. One of the biggest needs was the creation of the social infrastructure that supports the market, such as financial institutions, regulatory agencies, property rights, and contract law.

Reflecting on the transition experience of Eastern and Central European countries in the past two decades suggests that there is no single “right” balance between individual and community, public and private, government and the market. Different societies can and do settle at different points along the continuum from minimum government, maximum market/ private sector to the opposite extreme. The point of settlement is always a moving target.

Mindful of diversity, we nevertheless attempt to distill the common ground of public sector economics across many different cultural and institutional contexts. The five chapters in Part 1 address some fundamental issues about government that provide the background for a closer examination of the revenue and expenditure dimensions of public sector activity. Chapter 1 reviews basic understandings about the division of responsibility between governments and markets. Chapter 2 provides a quantitative measure of the size and scope of government—how much revenue flows into public coffers and from what sources, and which services those revenues are used to provide.

Chapter 3 addresses the structure of governments, which is particularly important in federal systems with three levels of government, such as the United States, Canada, and Australia. In a federal system, authority and responsibility are sometimes shared and sometimes divided across levels of government. While most countries have local governments with varying degrees of autonomy, there is a more limited number of countries with three levels of government with their own defined spheres of activity. In such countries, the structure must address such questions as: Do the benefits from government programs stay local (or within the state or province), or do they spill over to other areas? Which taxes are suited to local use? What responsibilities are national in scope? Understanding the interplay between theory and context, including the formal and informal division of responsibility between state, local and federal, between government, market and the nonprofit sector is an essential part of one’s education as a policy economist.

The decision-making process in the public sector is of necessity different from that of the private sector. While decisions in the private sector are made by voting with dollars, public sector decision-making is more complex, involving both economic and political considerations such as agenda-setting, monitoring and incentives, and incomplete information. The branch of political economy that addresses that decision-making process from an economic perspective is known as public choice, the subject of Chapter 4.

Everything the government does (or fails to do) affects the distribution of income and wealth. Some of it is intentional—the progressive income tax, welfare, Social Security. Some redistribution is a byproduct of government decisions made for other reasons. More often, decisions about public goods and services and the distribution of their costs and benefits are made simultaneously. Chapter 5 examines the impact of public sector activities on the distribution of income, resources, wealth and opportunities among citizens.

1

Government in a Market System

Introduction

Once students get past their introductory course in economics, they probably find that their university or college offers a fairly standard package of upper division courses in economics. This package almost always includes intermediate macroeconomics, intermediate microeconomics, statistics and/or econometrics, money and banking, and labor economics.

Note that even in this short list there are several courses in which the government plays a central role. One is macroeconomics, and another is money and banking, two courses taken by most economics majors. Monetary and fiscal policy, debts and deficits, stimulus packages and bank regulation are very much the stuff of both daily headlines and courses in macroeconomics and money and banking. Students may also have an opportunity to take courses in government and business, environmental economics, economic development, urban economics, public choice and, of course, public finance or public sector economics. All of these courses cover some substantial role of government in directing economic activity.

Breaking the subject matter of economics down into individual courses is a challenging task. There is substantial overlap between one field and another. Which parts of the role of government in a market system are included in a course in public sector economics, and which are reserved for other courses? The answer to that question has evolved considerably in the past 30 years.

One of the best-known twentieth-century economists in the field of public finance, Richard Musgrave, divided the economic role of government into allocation, distribution, and stabilization. Allocation refers to anything the government does that affects the mixture (quantity and quality) of goods and services that the economy produces, from direct government production to regulation to tax incentives to penalties for illegal activities. Distribution refers to anything the government does that affects the distribution of income and wealth. Just about everything the government does, from locating roads to tax cuts to school vouchers and college scholarships to mortgage insurance guarantees, affects the distribution of income and wealth, intentionally or otherwise. Finally, stabilization covers those government actions that influence the overall level of employment, output, and prices. To do justice to all of those aspects of government involvement in the economy would require several volumes and span several courses. So courses and textbooks in public sector economics or public finance have developed some boundaries that have narrowed the subject matter.

Although public sector economics has been displacing public finance as the preferred title of the field, the older title of public finance does have an advantage in defining its scope. The finance in public finance refers to the budgeting, taxing, and spending activities of government. Most activities of the government that are not primarily budget-related (such as regulatory activities) are left to other courses.

A second way in which public finance/public sector economics has narrowed its scope in the past two decades was to assign the stabilization function to courses in macroeconomics and money and banking, along with government policies that encourage or retard economic growth. So technically speaking, a course in public sector economics or public finance is focused on the microeconomics of government revenue and spending. Except for some limited discussion of the size and management of the public debt and budget deficits and surpluses, stabilization policy is largely absent from public finance courses and textbooks. This narrower definition, tying public finance to microeconomics and to budget-centered issues of taxing and spending, provided the central focus for the economic sub-discipline of public finance for several decades.

More recently, as public finance has evolved into public sector economics, the scope of the field has broadened beyond the components of the budget.¹ The use of taxes, fees, and charges as instruments to achieve social or regulatory objectives has led to much more analysis of issues in public sector pricing, such as the design of congestion fees and effluent charges, demand measurement for public goods, and setting prices for publicly provided goods and services.

The relatively new field of public choice that has developed over the past 30 years has also exerted considerable influence on economists’ understanding of how decisions are made in the public sector. Public choice is a partially separate field of economics that analyzes the behavior of elected officials and bureaucrats in the public sector and explores the policy implications of government failure. Sometimes public choice is taught as part of a course in public sector economics or public finance. In other cases, public choice commands a separate course of its own.

Governments, Markets and Efficiency

In a market system, private individuals and organizations (including corporations) in pursuit of their own self-interest make most of the economic decisions. The widespread preference for markets as the decision-making tool is grounded in microeconomic theory. Microeconomics demonstrates that under ideal conditions, the market will be more efficient than any alternative system at providing the maximum social welfare out of available resources.

Economic efficiency is measured by the quantity and variety of goods and services that its members produce, consume, and distribute out of their limited available resources. The market is more efficient at determining which combination of goods and services people want and delivering that combination. The market is more efficient in ensuring that goods are produced at the lowest possible resource cost and sold at the lowest possible price. The market is more efficient at rewarding those who heed market signals and punishing those who pay no attention. If efficiency in the use of scarce resources is the sole or primary objective, the market is the ideal tool to achieve that goal.

In its strongest form, this ideal efficient outcome of markets is referred to as Pareto optimality. An economic situation of production or distribution or both is Pareto optimal when it is not possible to make at least one person better off without making one or more persons worse off. In a Pareto optimal world, all prices are equal to marginal cost, all products are being produced with the most efficient resource mix, all inputs are paid the value of their marginal product, and all consumers have allocated their budgets so that the satisfaction that they receive from the last unit of each good purchased is just equal to the price, which is in turn equal to the marginal cost of producing it. Costs and prices reflect social as well as private costs. In such a Pareto optimal world, there would be little need for government.

What should Government Do?

Because a perfectly functioning market system would lead to a Pareto optimal allocation of resources, such a system would limit government’s role to those functions that the market cannot perform at all. The list is surprisingly short. Almost all of the activities that people have come to associate with government—providing for defense, controlling the money supply, ensuring law enforcement, building highways, and educating the next generation—can be and have been produced privately by either non-profit or for-profit firms at some time. Private security guards can protect life and property. Hired mercenaries can defend citizens from foreign enemies. Private toll roads were the norm in colonial New England and continue to exist along public highways in some places. Scrip in company towns in the nineteenth and early twentieth centuries served as private mone...