Budgeting is probably the single most important function in government, considering the amount of money a government spends each year on various expenditure programs and activities, as well as the time it spends in preparing the budget, appropriating funds for these activities and, finally, executing them. This book integrates the complex theory and practice of public budgeting into a single text. Written in a simple, concise and easy to understand manner, The Fundamentals of Public Budgeting and Finance captures the multidimensional perspective of public budgeting that students, as well as practitioners will find useful.
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The level of budgetary activities in a government is directly related to the economic system of which it is a part. In a command economy, where there is no private sector, budgeting is central to all economic and noneconomic decisions of the government. In a free market economy, such as the United States, while the presence of a strong private sector limits the role of government, it is still substantial considering the size of the federal budget that runs into several trillion dollars each year. Although not as high as the federal budget in percentage terms, state and local budgets also constitute a significant percentage of their respective gross products. Therefore, to understand the nature of budgetary activities in a government it is important to understand how the market system operates—its strengths and limitations and, more importantly, the role government plays in a market system. As the conventional wisdom goes, the more efficient the market system, the less the role of government.1 In budgetary parlance, it means less government expenditures, less taxes, and less regulations. Ideally, if the market system could address all our needs and fully regulate its own behavior, there will not be any need for government intervention, but, in reality, that is seldom the case. A market system, by itself, cannot perform all the functions necessary to meet the needs of society nor can it fully regulate itself, hence the need for government intervention. This chapter briefly discusses how the market system operates, the problems an unchecked market system creates for society, and why government intervention is necessary, including an overview of some of the measures commonly used to address the problems.
1.1 A Simple Illustration of How the Market System Operates
Let us begin with a brief discussion of how the free market system operates to understand why collective action vis-à-vis government intervention is necessary. A market system, in particular a free market system, is a system of interactions between the buyers (consumers) and sellers (producers) in a market without any, or as little as possible, intervention by the government. It is based on the notion of a “perfectly competitive market,” characterized by a number of conditions such as a large number of buyers and sellers, full information for both buyers and sellers, no barriers to entry into or exit from the market, perfect mobility of resources (factors of production), and absence of public goods and externalities. If these ideal conditions were to exist, the free market system should be able to meet all the needs of society, guaranteeing maximum welfare for the public and maximum profit for firms and businesses. However, in reality, such a system does not exist; nevertheless, it provides a conceptual framework for understanding market behavior in all its forms and variations.
To illustrate how the system operates, let us begin with a simple market economy consisting of households (HHs) and firms and businesses (FBs), with no government intervention.2 In this simple and uncomplicated economy, households demand goods and firms and businesses supply the goods that the households demand. The interaction between supply and demand takes place in the economic marketplace, following the rules of free market competition. The interaction determines a price at which the goods brought to the market will be cleared off, setting an equilibrium condition in the market. The price is called the equilibrium price , P0, and the quantity sold—the equilibrium quantity , Q0. However, in order for firms and businesses to be able to produce goods, they need factors of production (land, labor, capital, etc.) which the households must supply. As before, the interaction between supply and demand will determine the price, P0, at which all the factors of production brought to the market will be cleared off, establishing equilibrium in the respective factor market—labor in the labor market, capital in the capital market, and land in the land market (Fig. 1.1).
Fig. 1.1
A two-sector free market economy
In the event that the market conditions change, say, supply increases from S to S′, as shown in Fig. 1.2a, the price will come down from P0 to P′ and at the reduced price the surplus goods will be cleared off the market, creating a new equilibrium condition. The converse will be true if demand increases from D to D′, but supply remains constant. It will increase price, from P0 to P′, and with increased price more suppliers will join the market, which will increase supply but will also lower the price to P″. The process will continue until all the goods brought to the market are cleared off, creating a new equilibrium, Q″ (Fig. 1.2b). An identical situation will also take place in the factor markets where the interaction between demand and supply of land, labor, and capital will determine the price (rent for land, wage for labor, and interest for capital) at which all the factors brought to the market will be cleared off, creating a new equilibrium in each factor market. When all the markets are in equilibrium, the result will be a “general equilibrium ” in the market.
Fig. 1.2
Changes in Supply (a), demand (b), and equilibrium conditions
A general equilibrium in the market does not mean that the markets are independent of each other; in reality, they are interdependent in that what happens in one market can easily affect the equilibrium in another market. Thus, if the demand for a commodity, say coffee, increases, it will not only increase the price of coffee, but will also increase the demand for tea (a close substitute), assuming more consumers will move to tea. Similarly, if the demand for input factors, say capital, in one market increases, there will be less capital available for investment in another market, and so forth. In other words, a change in demand and supply will change the equilibrium condition in a given market, as well as in all other markets with which it has a direct or indirect relationship until a new equilibrium is established.
1.2 Market Failure and the Need for Government Intervention
As simple and uncomplicated as the system appears, it also has a tendency to create certain conditions in the marketplace that economists call “anomalies,” which, if left unchecked, will lead to “market failure ” (Bator 1958). The failure occurs because of market’s inability (1) to operate efficiently, (2) to deal with aggregate (macro) economic problems, (3) to provide goods that are necessary for collective consumption called public goods, and (4) to regulate itself. Richard Musgrave , in his classic text “The Theory of Public Finance,” recognized three essential functions a government performs in response to these failures—allocation, distribution, and stabilization (Musgrave 1959). The allocation function , according to Musgrave , deals with the process by which the resources of society are divided between private and public goods. The distribution function adjusts the inequities in income and wealth to ensure that they conform to what society considers “fair” or “equitable,” while the stabilization function deals with measures necessary to maintain high employment, a reasonable degree of price stability, economic growth , and balance of payment equilibrium. The fourth function—regulation—is a process that regulates the behavior of firms and businesses to ensure competition in the marketplace.3
1.2.1 Failure to Operate Efficiently
Although in principle the market system is supposed to operate efficiently, it often fails to do so. The failure occurs when the market deviates from the rules of free market operation, creating inefficiency in the marketplace. This does not mean that the market disappears literally—only that it creates certain conditions that are detrimental to free market operation and, consequently, to society at large. Important among these conditions are monopoly, externality, imperfect information , incomplete markets , and income inequality .
1.2.1.1 Monopoly
At the opposite end of free market competition is monopoly, where a single firm dominates the market. Monopolies occur because of economies of scale (lower average cost of production), where it may be advantageous for a firm to have control over a vast amount of resources, including capital to achieve economies for large-scale production, such as steel, heavy industries, and public utilities.4 What this means is that it may be cheaper for a large firm to produce the entire output rather than allowing a number of small firms to produce parts of it because it will be less costly. High start-up or fixed costs for products, such as public utilities, may also discourage small firms to compete. These types of monopolies are called natural monopolies. Monopolies may also occur when a government gives exclusive rights to a firm to conduct business such as the British East India Company during the mercantile period, or more recently the rights given to firms such as AT&T to have full control of local and long-distance calls until 1984 by protecting it from competition. These types of monopolies are called legal monopolies. A somewhat different form of legal monopoly that is not so direct would be patent rights given to a firm for invention for a certain number of years. Although patent rights can serve as an incentive for innovation, it can also stifle competition depending on the condition and the time length of protection.5
Theoretically, there is nothing wrong with monopoly as a market condition; in particular, a natural monopoly since it allows some competition in the market, but the problem with monopoly, in particular a pure monopoly is that it can control price by controlling output. Additionally, monopolies can exercise undue influence through political and non-political means to control raw materials and prevent others from entering the market. Since none of these conditions are in the best interest of the consumers, some interventions are necessary to prevent monopoly formation and encourage competition. Government intervention through regulations, such as antitrust laws, is an effective way to deal with this, especially where there is no natural monopoly. The earliest antitrust law passed in the country was the Sherman Antitrust Act in 1890. A number of other acts have been passed since then such as the Clayton Act in 1914, the Public Utility Holding Company Act in 1935, the Cellar-Kefauver Act of 1950, and so forth. The primary objective of these and other similar acts is to ensure competition by allowing unrestricted entry into the market by other firms and prevent unfair competition by firms of all sizes.
In reality, the market is neither perfectly competitive nor dominated by a single firm, but rather lies somewhere in between. A good example is oligopoly , where a few large firms dominate the market. Interestingly, to have control over the market oligopolies often collude with each other and behave like a monopoly firm, as in a cartel such as the Organization of the Petroleum Exporting Countries (OPEC) and, occasionally, they would compete with each other to maximize individual profit. As the number of oligopolies increases, an oligopolistic market would resemble a competitive market and the oligopolies may assume some of the same characteristics of a competitive firm. In fact, the competition will produce equilibrium in the marketplace, called Nash equilibrium —a non-cooperative equilibrium, where each firm tries to maximize its profit by taking into consideration other firms’ output, as given. Since the market is in equilibrium, no single firm has an incentive to unilaterally adjust output, thereby producing a profit margin that will be less than the profit for a monopoly firm but more than a competitive firm. From the point of view of consumers, however, the effect will be essentially the same as a monopoly.
A Note on Natural Monopoly
It is worth expanding a little on a term we introduced earlier called natural monopoly. Unlike pure monopolies, natural monopolies are not necessarily undesirable from society’s point of view, as long as the benefits to society of lower price from economies of scale outweigh the higher price generally associated with pure monopolies. Under these circumstances, society may be better off allowing some monopolies to exist or it can assume the responsibility by producing the goods itself or use regulation to control the price a monopoly firm may charge for the provision of the goods. Goods such as electricity, water, sewer, gas pipelines, and other capital intensive goods are classic examples of activities that have built-in economies of scale that can be produced at a lower cost without the complications of higher prices. Also, as noted earlier, the initial setup costs of these activities are quite high making them prohibitive for small firms to enter the market to provide the goods. This may explain why a government often allows large private firms to undertake these activities and, in some cases, assumes the ownership of these activities itself such as electricity or gas, thereby serving the role of a natural monopolist.
1.2.1.2 Externality
Externality simply means spillover or third-party effect; it is the unpriced cost or benefit the action of an individual or a firm produces for a third party. ...
