Public Finance: Meaning, Nature & Scope

Study of Public Finance

In simple terms, the branch of public finance studies the role of the government in an economy. Often, economists share contrasting views and, therefore, raise fundamental questions regarding the actions of the government. Therefore, the goal of public finance is to understand the proper role of the government in the economy.

By observing various economies in the current time, we may come up with questions like:

Why is the government the primary provider of essential goods and services like highways, education, and unemployment insurance, while the provision of other goods and services, such as clothing and entertainment, is generally left to private companies?

On the expenditure side of public finance, we can ask:

What kind of goods and services should the government provide, if any?

Similarly, on the revenue side of public finance, we ask:

How would the government raise the funds necessary for such expenditure, what kind of taxes should be levied and on whom and finally, what could be the resulting effect of such action on the economy as a whole?

The subject of pubic finance tries to answer these fundamental questions by studying the role of government in an economy.

Nature of Public Finance

Overview of Public Finance:

The subject of public finance broadly studies the role of the government in an economy and analyzes various functions of the government or the public sector based on this well-structured role. The term “finance” loosely suggests monetary flows represented by the revenue and expenditure activities of the governmental fiscal process.

Nevertheless, the basic economic functions of the public sector are those that influence the allocation of resources, distribution of real output and effective demands among the population and, finally, the aggregate economic performance.

These three basic functions from the government’s part: allocation, distribution, and stabilization are viewed as the targets or the objectives of the public sector economic activities. It has been observed for almost all economies in the world that government plays a central role in the lives of citizens through different activities.

Therefore, the subject matter of public finance mainly deals with theoretical models as well as empirical tools to explain and analyze the role of the public sector.

The theory of public finance also considers the ongoing debate regarding the changing role of the government in an economy. For example, in the recent past, the governmental share of economic activity is over 20 percent of the GNP, whereas, in Western Europe, the share of government expenditure as a percentage of GNP is over 50 percent (Musgrave & Musgrave, 1989).

This observation also reveals the steady disagreement among the policy-makers about whether the role of the government should expand, contract, or stay the same. The subject of public finance also discusses these issues to understand the changing role of the government in an economy.

Analyzing the Public Sector: Role of the Government

According to some economists, the first function of any government is to establish and enforce the “rules of economic games”, which include laws defining property rights and liabilities, legal enforceability of contracts, and provisions for bankruptcy. These are considered as the ground rules set by the government for the proper functioning of both the private and the public sectors.

But, since we are concentrating on the basic economic activities of the government, such as allocation of resources, distribution of output, and stabilization of the economic activities for modern, mixed economies, we will try answering the following questions that consider the appropriate role of the government in that context:

When should the government intervene in the economy?
How might the government intervene?
What is the effect of those interventions on the economic outcomes?
Why do the governments choose to intervene in the way that they do?

These four questions of public finance essentially capture all fundamental aspects of public sector activities.

The First Question discusses the motivation for government intervention in an economy. In a modern economy, all kinds of allocation decisions are made through either of the two institutions: the market and the government. The market institution is designated as the private sector, and the government institution as the public sector.

Allocation function in the private sector is carried out by market forces such as supply-demand laws and price mechanisms supported by consumer sovereignty and the profit motives of the producers. Public sector allocation, on the other hand, is accomplished through the expenditure and revenue-related activities under government budgeting.

Therefore, government intervention implies the intervention of the public sector in the operation of one or more of the private markets in an economy when those markets fail to generate efficient outcomes.

As we have learned from basic microeconomic theory, competitive market equilibrium is considered to be the most efficient outcome for a society. In the absence of government intervention, competitive market equilibrium guarantees efficient trade outcomes between consumers and producers through the free adjustment of price, resulting in demand equal to supply.

A trade is efficient if it makes at least one party better off without making the other party worse off. Competitive market outcome maximizes the number of efficient trades and hence maximizes efficiency.

Therefore, the reasons for government intervention in some market economies are market failures and redistribution.

The first motivation for government intervention in the private market is due to the presence of market failure. In economics, market failure is defined as a problem that causes the market economy to deliver an outcome which does not maximize efficiency. One example of such a situation is the presence of a negative externality in a private market.

A negative externality occurs in a market when a consumer’s decision imposes on others a cost that the consumer does not bear. For example, we can think about the market for private health insurance where there are hundreds of consumers to buy health insurance and hundreds of private insurers to provide.

But, still, we find that there exists a huge number of people without any health insurance plan. The decision of these consumers poses a health risk cost on other people in society as they have a greater chance of falling ill. In this case, government intervention through regulation or through price mechanism corrects the negative externality problem.

The second reason for government intervention is redistribution, which means shifting of resources from some groups in the society to others. The government can intervene with the motive for redistribution even in the absence of market failure when the competitive market maximizes efficiency.

Government intervention in such cases can be justified on the equity ground where the government thinks the resource allocation by the market economy is unfair towards some groups in the society.

Such action on the government’s part is often criticized as it involves an equity-efficiency trade-off, which means that in order to get a fairer distribution of resources, there is a social efficiency loss. Therefore, the first fundamental question in public finance justifies the need for government intervention in a mixed economy.

The Second Question is how the government should intervene? This deals with the different approaches that the government can take to intervene. The frequently used methods are the following:

Tax or subsidize private sales or purchase
Restrict or mandate private sales or purchases.
Public provision
Public financing of private provision

The first approach corrects any form of market failure through a price mechanism. Imposing a tax raises the price of a commodity that is overproduced (in case of negative externality), and imposing a subsidy lowers the price of a commodity that is under-produced (in case of positive externality).

The second approach proposes a direct method of government regulation where the public sector can directly restrict or mandate the quantity and the price of a commodity in the private market. For example, the regulation of wearing a seat belt while driving is a government mandate.

Under the third approach of government intervention, the public sector itself provides certain goods and services directly to society when those are not available in the market or are under-produced by private producers. Public schools and public hospitals are examples of such government activity.

Finally, the fourth approach indicates the situation when the government wants to influence the consumption level of its citizens and does not want to get directly involved in the provision of goods and services. In such cases, the government can finance private entities to provide the desired amount of a particular good in society.

Under the second fundamental question of “how”, the government also has another role to play by deciding between several alternative options to intervene. This question deals with the cost-benefit analysis of the public sector to evaluate alternative policy options.

Answering the Third fundamental question of public finance that what would be the effect of government intervention on society, requires the government to critically analyze the consequences of each public policy in order to evaluate its immediate as well as long-term effect on society. This is the branch of public finance that employs empirical tools to analyze the impact of public policies.

Another important issue discussed in the theory of public finance is that any government policy involves two effects on society. First is a direct effect, which occurs when individuals do not change their behaviour in response to a policy change and the second is an indirect effect, which must be considered when individuals change their behaviour in response to the intervention in society. The final effect of a policy must include both of these effects.

Finally, to answer the Fourth fundamental question of public finance, why the governments act the way that they do, we focus on the theory of political economy in public finance, which describes the government not as a benevolent actor who maximizes the welfare of the citizens but as an agent with political motives.

The theory also discusses the social, political and historical forces that shape a current fiscal institution and the problems like preference revelation and preference aggregation that the government faces before making a policy decision. The government faces a huge problem in figuring out what millions of people want and how to aggregate their wants into a unique public policy.

The theory of political economy also claims that the government and the politicians face political pressure while making a decision. They also have a political motivation to be selected and to remain in their office, apart from the motivation for social welfare.

Therefore, the answer to this last question provides us with a theory of how the political process produces decisions that affect all individuals in society.

Scope of Public Finance

Why study Public Finance? Facts on the Functions of Governments around the World

As we have seen in the previous section, the study of public finance is important to understand the proper role of the government. Why do we need the public sector in a modern, mixed economy is a normative question in economics which explains how things should be done when private markets can not deliver an efficient outcome to society.

Therefore, the motivation to study public finance comes from the dominant role played by the governments in every economy around the world. In this section, we will briefly highlight some key facts regarding the government’s role in various developed nations.

Changing Trends in Government Activities

The amount of government expenditure as a percentage of GDP indicates the level of government intervention and plays a crucial role in the public provision in a country. If we look at the size and the growth of government expenditure over a period for some developed countries, we find some interesting trends.

Figure 1 shows government expenditure as a share of GDP across developed nations from 1960 to 2000. The graph shows steady growth in government spending for countries: USA, Sweden, Greece and the average of industrialized nations as a part of the Organization for Economic Cooperation and Development (OECD).

The striking fact found from the figure is that although government spending as a share of GDP has grown across all developed nations but the pace at which that growth occurred varies across countries. While the USA experienced modest growth over time, almost all European nations experienced a much larger growth in government spending during this period.

So, the natural question that comes to our mind is why the growth of government expenditure varies across countries or what explains the striking growth in government spending in countries after the 1960s.

Another key feature of government spending that varies across countries is the degree of centralization across central and local government levels within a country. This tells us the extent to which government spending is concentrated at the central and at local levels. The theory of fiscal federalism discusses this concept in detail under public finance.

Another interesting feature of the government’s activities is the changing pattern of government finances as reflected in the government’s budget. As we know, the spending on the government budget represents the outflows, whereas the tax revenues represent the inflows.

If revenue exceeds the spending, the government has a budget surplus, and if spending exceeds the revenue, the government faces a budget deficit. Each rupee of government deficit adds to the government’s existing stock of debt.

The following three panels of Figure 1.2 show the government revenue and spending, the deficit or surplus, and the level of government debt for the US federal government from 1930 to 2000.

Changing Trends in Government Activities Fig2 (source: Musgrave and Musgrave, 1976)

Changing Trends in Government Activities Fig3 (source: Musgrave and Musgrave, 1976)

Changing Trends in Government Activities Fig4 (source: Musgrave and Musgrave, 1976)

As seen from the three panels, except between 1941 and 1945, during the period of World War II, the US federal government’s budget was more or less balanced, showing the amount of spending matched by the amount of tax revenue. This trend continued till the late 1960s, after which the deficit grew relatively larger to be 5 percent of GDP.

The deficit shrank significantly during the 1990s but went up again in the early twenty-first century. This same trend is mirrored in the second and the third panels of the figure. So, the study of government budgets in public finance can motivate us to ask the following policy questions:

Why do some governments face budget deficits relatively more than the other country’s governments?

What are the costs of having larger deficits and larger government debt on a nation?

Another interesting feature of the government spending discussed in public finance is the distribution of government spending across different sectors at central as well as local government levels. The following figure 1.3 shows the distribution of spending for the US federal and, local & state governments across several broad categories in 1960 and 2001.

Changing Trends in Government Activities Fig5 (source: Musgrave and Musgrave, 1976)

The above figure shows us the sectors that have a larger propensity to receive public provision or government spending. It also captures the changing composition of central and state government spending over time as a share of total spending.

As shown in the figure, federal government spending in the US is mostly in national defence and social insurance programs such as Medicare and Social Security.

On the other hand, state and local government spends mostly on education, public order and safety, transportation and other social services. So, we can ask the following question:

What are the appropriate types of sectors to receive spending from the federal government versus the areas to receive spending from state and local government? This leads us to the question of fiscal federalism in public finance.

Regulatory Role of the Government

Besides all of the above-mentioned roles of a government in an economy, we also have some examples where the government perform as a regulatory body controlling our social and economic activities. This is called the regulatory role of the government.

For example, the food and medications we buy from a store are all subject to the approval of the Food and Drug Administration body of the government.

Relevance of Public Sector Today: Changing Role of the Government

The important role played by the government in our lives makes the subject of public finance an interesting and relevant course at any point in time. By looking at the trends and features of the public sector activities, we have motivated some questions based on that. Those questions remain at the focus of any current policy debates and news in an economy.

The importance of the role of the government is acknowledged in public finance. However, the changing pattern in that role is across nations is what motivates the policy debates among the economists.

For example, in the US, the three areas which received the maximum attention regarding the government’s role in the recent past are Social security, health care and education.

In all cases, the debate was on whether the role of the government is too conservative or too liberal and what could be the possible impact of such policies on the overall economy. This same argument is valid for any country in the world regarding any government policy.

Public Finance: Meaning, Nature & Scope

Study of Public Finance