FIN 321:PUBLIC

FINANCE AND
TAXATION
Topic 1:Introduction to public finance
Facilitator: Dr Joseph Kiria
Expected Learning Outcomes (ELOs)

At the end of this session, you should be able to:

 Explain the meaning, nature and components of
public finance (recall Macroeconomic studied in first
year)
 Understand the reasons Government Intervention in
the economy is important/economic role of
government
Expected Learning Outcomes (ELOs) ctd…

 Understand the main causes of market failure

 Define and identify typical public goods and
merit goods
• Describe economic functions of
governments/define economic role of the
government
Expected Learning Outcomes (ELOs) ctd…

•Identify some of the issues that must be

addressed or considered when
government is planning for intervention
•Analyze the methods of intervention
•Understand risks associated with
government intervention
The concept of public finance: definition,
nature, and its role
• Public finance = public + finance
• The 'public' represents Government (Central, Local,
other segments), while
• ‘Finance' means income and expenditure.
• Therefore Public finance is concerned with income
and expenditure of the Government
The concept of public finance: definition,
nature, and its role ctd…
• The essence of public finance stems originally from the basic nature
of any economy
• Any economy is concerned with dealing with scarcity of its
productive resources in relation to its wants
• Therefore, in order to perform its role, government needs to:
a) collect resources from the economy, in sufficient and
appropriate manner i.e., PUBLIC REVENUE; and
b) allocate and use those resources responsibly, efficiently and
effectively i.e., PUBLIC EXPENDITURE.
• Hence, Public finance = Public revenue + public expenditure
The concept of public finance: definition,
nature, and its role ctd…
• Therefore, public finance is defined as the
science which deals with the manner in which
public authorities acquire and allocate
resources to various sectors of economy.
• Public finance is concerned with the study of how the
government collects revenue, how the expenditure is
financed and how this procedure is monitored.
The concept of public finance: definition,
nature, and its role ctd…
• Public revenue deals with resources mobilization or acquisition from alternative or
various sources of government revenue
•The theory of public revenue recognises the following as types and sources of
government revenues (taxation and non-tax revenues):
 Taxes/taxation
 Borrowing (both foreign and local)
 Retained profit: Profit from public enterprises
 Administrative revenue; this include fines by courts, and police traffic penalties
 Foreign funds in form of grants, aid, (Project grants, and/or Programme grants)
 Other sources: Dividends, Royalties, Fees, Charges, Voluntary contributions, and
State lottery.
Class activity: any implications for choosing any of the above against the other?
The concept of public finance: definition,
nature, and its role ctd…
• Public expenditure on the other hand, deals with how the government
allocate the various revenues into various expenditures.
• Public expenditure represents the expenditure incurred by public
sector entities to satisfy the collective social wants of the people.
• Why should government spend?
to provide public goods and social services
to cause, guide and direct the rate of growth, employment and productivity
and to improve income distribution;
prevention of cyclical fluctuations (e.g. inflation) and counter acting any
secular tendency towards stagnation
Role and/or objectives/importance of
Public Finance in the Economy
• The role of public finance is examined from the
perspective of role of government
• Can you imagine of a nation without government?
• Does an economy require a public sector at all ?
WHY?; why is it not possible for the private sector i.e.
the market to take care of all that the people in the
country need for their living and wellbeing?
Importance of public finance ctd…
a country there would be no ‘any’ system,
• In such
e.g. system of defense, education, health, social
security etc
• Then, how would services such as public primary
and secondary education, health care, roads,
police and fire protection etc be provided?
• Regulation?
Role and/or objectives/importance of Public
Finance in the Economy ctd…
• Obviously, institutions involved (e.g. ranging from medical
schools to public clinics and hospitals) would have their
operations impaired without government support.
• This highlights that reliance on government services each day
is inevitable
• We all benefit from government activities and expenditures
(RECALL: Why should government spend discussed
previously).
• Government activities and spending need a strong base of
financing
Role and/or objectives/importance of Public
Finance in the Economy ctd…
Therefore, the focus (role) of public finance in the economy is to
achieve the following(recall: why government should spend):
• To facilitate resource pooling and capital formation
• Resource allocation
• Redistribution of income (income and wealth redistribution)
• To facilitate efficient use of resources, e.g. to discourage wasteful
competition
Role and/or objectives/importance of Public Finance
in the Economy ctd…
• To regulate the market where competition is
inefficient.
• Provision of public and social goods
• Provide solutions to market failure [to bring about
employment, price level stability, socially required rate
of economic growth).
Tools of public finance
How does public finance achieve its role or objectives?
• It is through policy instruments designed carefully to conform the with
principle of maximum social advantage.
• The principle deals with the question of the size of public budget, the level
at which the state should operate, and the boundaries of state activities.
• The purpose should be to design the policy and operations of the state so
as to achieve maximum possible advantage for the society as a whole
• The common policy instrument is fiscal policy. The other one is
monetary policy
Tools of public finance ctd…
How does public finance achieve its role or objectivists…
What is fiscal policy?
• It is about changes in taxes and government expenditures.
• It is a direct way through which the government can influence
tendency of the economy by changing the level and direction of
government spending, tax instruments and rates.
• Fiscal policy instruments are categorised by purpose as
(1)“reflationary fiscal policy tools or instruments” and
(2)“deflationary fiscal policy tools or instruments”.
Tools of public finance ctd…
Fiscal policy tools ctd…
(1)Reflationary policy tools
•Government uses reflationary policy in times of general down turn in
economic activities (recession).
•Reflationary fiscal policy is used to boost the level of economic activities
in the economy.
•This can be achieved by lowering taxes in some ways or increasing
government expenditures[how? …through the following approaches]
•Approaches used should be (i) non-distortionary taxation and (ii)productive
expenditure.
Tools of public finance ctd…
Fiscal policy tools ctd… “reflationary policy tools”
(i) Non-distortionary taxation
• Taxes which encourage savings are therefore good for
economic growth.
• Tax policy on domestic goods and services (VAT, excise
duties and others) should be designed and amended from
time to time to ensure no distortion on the consumption
and saving patterns of economic units and households.
Tools of public finance ctd…
Fiscal policy tools ctd… “reflationary policy tools” ctd…
(ii)Productive expenditure
•Productive expenditure = Expenditure which results in the creation of further
wealth e.g. on construction of roads, machinery and equipment's etc
•Productive expenditure ends up in the production function. They increase returns
to investment, thereby fostering economic growth.
•Public expenditure (e.g. on infrastructure, education, health etc) has an
immediate impact on GDP (e.g. has positive effect on economic growth)
•By contrast, un-productive expenditure e.g. payment of wage bills end up into
utility function rather than production function
Fiscal policy tools ctd…

(2) Deflationary Fiscal Policy

• Deflationary fiscal policy is used to manage an economy which is growing at
above its capacity, and which is likely to cause inflation and/or balance of
payment problems.
• Deflationary fiscal policy measures may involve increasing taxes to reduce
disposable income (income after tax) and/or decreasing government spending.
• Instruments used are such as increasing tax on income and profits, PAYE,
property tax and social security contributions.
Economic Functions of the Government
• The economic role and/or function of the government can be
examined under the three areas or functions namely allocation
function, distribution function, and stabilisation function.
• Through budget as a policy tool, government allocate limited
resources in order to meet various needs of its people
• The allocation function of the government involves a systematic
distribution of limited quantity of resources over various operations
for consumption and investments over the period of time.
• The government has a duty to allocate resources to the public through
provision of public goods and services.
Economic Functions of the Government
ctd…
• The essence of distribution function in the economy is to reduce income
inequality among individual in the society.
• This is done through “progressive income tax system” where by a high income
earners pay a higher tax rate and lower income earners pays lower tax rate.
• The government also distributes income through supporting poor individuals
and provision of subsides to selected sectors of the economy.
• Public provision of goods or services (such as health care, education and food) to
certain individuals alters the consumption of goods and services to such
individuals and therefore removes inequalities in the country.
Economic Functions of the Government
ctd…
• Stabilisation function deals with the use of budgetary policy
as a means of maintaining high employment rate, a
reasonable degree of price stability, exchange rate stability,
correcting negative externalities, protecting infant industries,
stability in economic growth, with allowances for effects on
trade and balance of payments.
• The major instruments of stabilisation policy are monetary
policy and fiscal policy
Government intervention in the economy
• Recall, the questions we asked previously
Can you imagine of a nation without government?
Does an economy require a public sector at all ? WHY?;
Why is it not possible for the private sector i.e. the market
to take care of all that the people in the country need for
their living and wellbeing?
Government intervention in the economy
Issue: Why should the government intervene in the economy?
• The role of government in society has been and will always be controversial.
• Some believe government does too much while others believe it needs to do more.
• Minimum role (minimum intervention) versus ‘adequate’ role/intervention
• Many look to government to solve problems they believe to be important to them but would rather not have
it engage in activities that benefit others. No matter what your view of government it is clear that its programs
and scope have grown significantly

• The share of public spending on the GDP is on an upward trend in all

countries across the globe
Why should the government intervene in the economy? Ctd…

• Rationale for government intervention (or objectives for government

intervention) in the economy has its basis from the nature of public
goods and services
• There are 3 general arguments for government intervention
I. Efficiency arguments (market failure argument)
II. Equity arguments
III. Ethical arguments
I:Efficiency or market failure argument
• Some goods and services have specific characteristics which suggest
that a competitive market will not deliver an efficient amount of them
• That is, government intervene in order to correct market failure
• Market failures occurs in the situation where a market does not
deliver an efficient allocation of resources due to specific problems
with the market mechanisms
• E.g. market operate under ‘exclusion’ and ‘revealed preference’
principles
I:Efficiency or market failure argument ctd…
Causes of market failure
• There are 4 common causes of market failure:
i. Public goods
ii. Externalities or spill-overs
iii. Imperfect information
iv. Imperfect competition
I:Efficiency or market failure argument ctd…
(i) Public goods argument
• Public goods are goods that are ‘non-rival’ and ‘non-excludable’
• Non-rival means that one person’s consumption of a good does not
prevent anyone else from consuming it (jointness in consumption),
e.g. Clean air and national defence
• Non-excludable means that if one person can consume a good, it is
not possible to prevent others from consuming that good
• Examples o public goods that are both ‘non-rival’ and ‘non-
excludable’ are national defence and street lighting
I:Efficiency or market failure argument ctd…
Public goods argument ctd…
• Merit goods are goods the consumption of which should be encouraged, either
through direct provision, or through financial transfers, e.g. Education, health, housing
Quiz:
• Identify goods which will display one of the characteristics of non-rivarly and non-
excludability but not both
• For non-excludable goods, the market will frequently not be able to function correctly
(WHY??)
• It is because once provided, the goods can be consumed beyond those who were prepared to
pay for its provision. This leads to the ‘free rider problem’ where people avoid paying for the
provision of the goods because they know they will be able to benefit from them anyway. This
reduces returns to potential suppliers and therefore the good will be under-supplied by the
market
(ii)Externalities argument
• There are cases where producers and consumers do
not bear full costs and benefits of their activity
• This is because there are costs or benefits obtained by
people not directly involved in the transaction
• An externality describes a cost or benefit resulting
from an economic transaction that is borne or
received by parties not directly involved in the
transaction
(iii)Imperfect information/information failure argument

• Markets are efficient when all parties to a transaction have equal

information about the good or service on offer
• If individuals and firms do not have access to reliable information,
they may be unable to make decisions that are beneficial to
themselves or to society, e.g. People who live in a deprived area may
be unaware of job opportunities that exist in other areas
• I the seller of a good or service has more information than the buyer
on the quality of the good or service for sale then such a situation is
known as asymmetric information and may result in less trade
occurring than in a case where the consumer has better information
(iv)Imperfect competition argument
• Usually occurs when there are not a sufficiently large number of
suppliers in a market
• In such a case there will be a lack of the competitive pressure
necessary to ensure prices are kept at economically efficient levels
• That is, when there are few suppliers in a market then these
suppliers have some market power and may in some cases be able to
raise prices
II: Equity arguments
• Equity arguments for intervention take a number of forms:
• Redistribution of income from richer individuals to poor individuals
(horizontal equity)
• Horizontal equity i.e .individuals with similar needs should be
treated similarly e.g. In terms of access of services such as health
care and education
• Social inclusion-implies that everyone should have access to
income, opportunities and services, which allow them to fully
participate in the life of the society in which they live
• Intergenerational equity i.e. Balancing the needs of current and
future generations
III:Ethical arguments for government
intervention
• Ethical arguments for government intervention arise where there are
perceived to be boundaries to the role that markets should play
• As a matter of ideology there are some goods and services that the
society may not wish to see bought or sold
• Some societies believe that it is wrong as a matter of principle that
key public services like health care should be bought and sold or
profit-making providers should be involved in their provision
• It is unethical, say, to have a market for health care such as human
blood, human organs etc
When should the government intervene?

• The government should only intervene when there is a market failure

and when intervention will lead to an improvement
• This is most likely to occur where:
The market failure is big i.e. There is evidence of significant problem (refer
current pandemic/COVID-19); and
Public sector intervention is effective
• Government intervention is more likely to be effective when it
addresses the cause of the market failure, and where it seeks to
improve the functioning of the market rather than replacing it.
What are the potential risks of government
intervention?
Relevant considerations when deciding whether to undertake
any intervention programme:
• The existence of market failure is not a sufficient case for
intervention
• Public intervention comes at cost
• Therefore it needs to demonstrate that the intervention will
make an improvement and that the benefits of intervention
will exceed the costs
What are the potential risks of government
intervention? Ctd…
a. Government failure
b. Crowd out effect
c. Political failings
d. Administrative failings
What are the potential risks of government
intervention? Ctd…
Government failure
• Government has poor mechanism available to it in deciding how to allocate resources
• Government failure frequently occurs because the public sector faces the same, or
worse, information problems than the market itself
Crowd effect
• Government intervention may also fail to deliver the anticipated benefits if private
agents do not respond to the intervention in the way the public sector thought they
would
• That is, there is a risk that public sector intervention may crowd out or displace future
activity by the private sector, such that there is no overall improvement
• Consideration also needs to be given to the displacement, substitution and income
effects of an intervention
What are the potential risks of government
intervention? Ctd…
Political failing
• Arise when individual interests override the public interest, e.g.
When special interest groups are successful in lobbying for an
intervention for their own interest rather than the public’s benefit
Administrative failings
• Arise primarily because public servants work for others rather than
themselves and face different incentive structures to those of the
private sector
Government intervention in the economy:
Common methods
• Regulation
• Financing
• Provision