FIN702: Public Finance

Lecturer Notes

Introduction

Economics: The study of economics is the study of how individuals or decision making

units (DMUs) make decisions in a world where resources are scarce and limited.

The scarcity of resources leads DMUs to exercise choice—choice, that is, with

regard to how, in order to maximise returns, the resources are to be allocated

amongst alternative uses.

These returns are linked to human wants. In the public sector, the DMUs are

confronted with the same problem, that of deciding how to allocate the limited

resources amongst alternative and competing uses in a way that will ensure that

its social and economic objectives are maximised.

The process of decision making in the public sector differs slightly from that in

the private sector, as depicted in Figure 1.1.

In general, the public sector focuses primarily on public consumption: the supply

of public goods and services by spending government tax income, as opposed to

the consumption of individual goods by the citizens.

The social aspect of the public sector, which is inherent in its very nature, makes

it fundamentally different from a private sector organisation.

First, the public sector leaders in charge of running public institutions are elected

or chosen by those who have themselves been elected by the democratic process

to represent the people who are governed and served.

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In contrast, those responsible for the running of the private institutions are self

appointed and represent their own interest. Secondly, governments are endowed

with certain rights of compulsion that private sector organisations do not have,

such as the right to collect taxes.

Figure 1.1: Public and Private Sector Resource Path

Scarce and Limited Resources

Public Sector Private Sector

Public sector allocation of resources => Budget

Private sector allocation of resources => Market

Pricing => Political process Pricing => Demand and supply

Provision => Public good Provision => Private good

Public wants Private wants

The Economy/Society

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The social aspect of the public sector makes it fundamentally different from private

sector;

Public sector leaders are elected via democratic process – represent public

interest;

Private sector are self appointed and therefore represent own interest.

Mixed economies: Private and Public sector provide a combination of goods.

Private sector=> private good

Public sector => public good

Figure 1.3: Production Possibility Frontier

This interface between public sector and private sector brings to light many issues

that need to be examined to ensure a smooth interplay between the two.

One area of crucial importance is Public Finance.

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. A

Public Good

Private Good

Sharp and Sliger state that it is an

. . . inquiry into the facts, techniques, principles, theories, rules and policies

shaping, directing, influencing, and governing the use of scarce resources of

government. It examines government spending, taxing, borrowing, and managing

the public debt (Sharp and Sliger, 1964:33).

Gunning (2001): states that Public Finance began as the study of how government could

raise revenue for three purposes:

(1) to supply the basic services needed to maintain a market economy, including

the policing of property rights and defence against foreign invaders;

Three arms of government:

a) Legislature

b) Judiciary

c) Executive

(2) to supply particular services; and,

(3) to enrich the sovereign.

Given the political dimensions of decision making and resource allocation, public sector

economics also lies within the realm of political economy. Adam Smith (1776) wrote:

Political economy, considered as a branch of the science of a statesman or

legislator, proposes two distinct objects: first to provide a plentiful revenue or

subsistence for the people, or more properly to enable them to provide such revenue

or subsistence for themselves; and secondly to supply the state … with revenue

sufficient for the public services.

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Roles/Functions of Government

The question of whether a government should intervene does not arise. Rather, the

question is to what extent and in what areas and when should that intervention

occur.

In 1776, Adam Smith wrote his path breaking book Wealth of Nations, in which

he argued for a limited role for government. Smith attempted to show how

competition and the profit motive would lead individuals, while pursuing their

own private interests, to serve the public interest. The profit motive would lead

individuals in competition to supply at competitive prices the goods and services

that other individuals wanted. The economy, he argued, would operate as if led by

an invisible hand:

… he intends only his own gain, and he is in this, as in many other cases, led by an

invisible hand to promote an end which was no part of his intention. Nor is it

always the worse for the society that it was no part of it. By pursuing his own

interest he frequently promotes that of the society more effectually than when he

really intends to promote it. (Smith, 1776:345)

In fact, all governments have involved themselves in activities to preserve justice

and good order; provide for defence; and engage in activities leading to the

improvement of the standard of living of the general population.

Because the resources utilised by government are generated by the general public,

the state has to engage in activities that are in the best interests of the public.

Provision of infrastructure to foster economic growth is also of utmost importance

to any government.

The general approach to these objectives depends to a large extent on the ideology

on which the government operates. Ideologies include those held by people of

Classical, Neoclassical/Monetarist, Keynesian and Post-Keynesian persuasion.

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A summary of the difference in the key assumptions among these schools of

thought is provided in appendix 1.

Appendix 1: Summary of Assumptions in Classical, Neoclassical/ Monetarist, Keynesian and Post-

Keynesian Economic Theory.

Assumption

s

Classical Neoclassical/

Monetarist

Keynes Post-Keynesians

(Cambridge)

Explanation

of

unemploym

ent

Wage equals

subsistence wage;

K<Kf

Natural rate of

unemployment

(frictional)

Insufficient

effective

demand

Mismatch between sectors

producing different types of

goods

Allocation

of resources

governed

by

Equalisation of

profit rates; not

by marginal

equivalence

Perfectness of

markets

Uncertainty;

external effects

Imperfect competition;

uncertainty; increasing

returns to scale;

complementarities

Savings s out of P=1

s out of W = 1

s out of R = ?

One function:

optimisation over

time

0 < mpc < 1 Classical assumption

Savings–

Investment

Causation

Savings

determine

investment

Savings determine

investment

Investment

determines

savings

Investment determines

savings

Real

financial

linkages

Exogenous

money supply:

‘Classical

dichotomy’

Exogenous money

supply determines

absolute price

level; inflation is a

monetary

phenomenon

Money market

determines the

rate of interest

Md=L(r)=Ms

Money supply adapts to

demand (Kaldor); Inflation

is a real phenomenon (cost-

push, sectoral mismatches,

distributive struggles)

Role of the

State

State has no

prominent

function

State has a limited

social role (creation

of laws and

institutions

State has an

obligation to

secure full

employment

State has a role in

generating fuller

employment and securing

balanced growth

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conducive to the

operation of market

forces)

Note: K stands for capital stock, M for money stock, mpc for the marginal propensity to

consume, P for profits, R for rent, r for interest rate, s for the savings rate and W for wage

income.

Source: Naastepad (1999:327).

Classification of Roles of Government

The roles and functions of government can be classified in a number of ways. Bailey

(2000) provides a classification under the following headings: a) the allocative role; (b)

the distributive role; (c) the regulatory role; and (d) the stabilisation role.

a) The allocative role concerns government’s ability to allocate the scarce and limited

resources in a manner that maximises economic welfare.

b) The distributive role comes into play when in any country inequality in terms of

income and resource endowment is prevalent and the government engages in other

measures, such as provision of social security, health and education and housing

assistance, and the creation of employment opportunities, to ensure improvement of the

standard of living of those with low income and those who are marginalised. Government

engages in taxation, which garners the resources used for distributive purposes.

c) The regulatory role is seen when the government, with apparent economies of scale,

legislates and enforces laws of contract and property rights, and provides an efficient

judicial system and defence. This is to ensure that citizens feel secure in living and

investing, thus allowing the economy to function well and grow.

d) The stabilisation role comes into play when government makes efforts to ensure that

inflation and unemployment are low and the macroeconomic climate is stable. To

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enhance this, the government uses its fiscal and monetary policies. Government could,

for instance, change money supply targets and adjust tariffs and exchange rates.

Furthermore, it could embark on discretionary or built-in changes in fiscal policy.

Discretionary changes are deliberate changes in expenditure programs and the tax

structure, while built-in changes are primarily tax and transfer changes.

Rationale for Government Intervention

=> based on the assumption that markets do fail.

=> When resources are fully employed, economic welfare can be maximised in a

purely competitive market.

In such markets, firms are competitive, such that they buy inputs at the lowest

cost and sell their product for a competitive price, thus making only normal

profits (price equals marginal cost).

Competition in factor markets allows least-cost combination of input and

competition in the product market allows quality products sold at competitive

prices.

That is to say, we achieve economic efficiency.

Fundamental Theorems of Welfare Economics

Two fundamental theorems in welfare economics explain how economic

efficiency could be achieved.

1st Theorem: states that in a competitive market where there is a large number of

buyers and sellers with no individual having the power to affect the market price,

we have a Pareto efficient allocation of resources.

2nd theorem states that every point on the utility possibilities schedule can be

attained by a competitive economy, provided we begin with the correct

distribution of resources.

However:

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=> in developing countries, all markets do not operate on a purely competitive basis.

=> Markets are small and institutions are either absent or not functioning well or badly

governed.

Causes of market Failure

a) when price does not equal marginal cost in all sectors of the economy.

=> perfect competition may fail to exist because producers have monopoly power and

can therefore control prices.

=> This results from potential monopoly arising out of a small, underdeveloped

economy.

Competition could be potentially restricted in other ways too, for instance if

markets are not contestable or as a result of imperfect information.

b) The second reason is the failure of prices to incorporate all costs and benefits.

Perfect competitive market equilibrium will be distorted when individual

consumers make poor judgement of their own welfare, thus not consuming the

optimal level of the commodities.

Table 3.1: Forms of Distortion and Market Failure.

No. Distortion Effects

Domestic Product Market

1. Consumption

externality

Private consumption levels that

exceed or fall short of socially

optimal levels.

2. Monopoly

sellers

Price in excess of marginal cost,

leading to private production and

consumption at levels that are

socially sub-optimal

3. Production

externality

Private production levels that

exceed or fall short of socially

optimal levels.

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Domestic Factor Markets

1. Monopoly

suppliers of

labour

Wages in excess of marginal

revenue, leading to employment

below the socially optimal level.

2. Interest rates in

excess of social

discount rates

Investment levels below the

socially optimal level.

3. Surplus labour Wages in some sectors above their

social opportunity cost, leading to

underemployment in those sectors

International Product Markets

1. Market power Unexploited gains from trade

available to the large country.

Source: Greenaway and Milner (1987:44).

Externalities

Market failure also arises from externalities, existence of public goods and natural

monopolies.

The Principles of Public Finance

There are, in general, six principles of public finance. In postulating them, Von Justi

(1760) stated that these six form the normative core of public finance. These principles

are:

1) The ability of the citizen to pay a tax. Citizens must be able to take the burden

without being compromised in their ability to enhance the welfare of the state.

Given that this is an objective criterion, von Justi (1760) states that only so much

should be taken by taxation that the economic process is not impeded at all.

Therefore, tax should not incite any tax resistance.

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2) Equity and fair proportions. Equal treatment before law has been turned into one

of equity, as fairness serves as the moral underpinning and argument for

redistribution.

3) Welfare and civil liberty. Von Justi (1760) states that each and every measure of

the state must be shown to enhance the welfare of the citizenry and it must not

infringe on civil liberties.

4) This principle requires each measure of the state, notably those that entail

burdens, to be established in tune with or according to the nature of the state in

question and the form of its government.

5) This principle requires certainty and a broad legal and constitutional basis of

every state measure, particularly with respect to taxation.

6) The last principle refers to the implementation of all state measures, particularly

those of taxation. The tax must be levied in the easiest and the most convenient

way available from the point of view of the citizens.

Theory of Public Finance and Public Expenditure Growth

Public finance can be studied by examining five theories:

1) The Theory of Revenue Extraction

2) The Theory of Externalities

3) The Theory of Public Goods and Natural Monopolies

4) The Theory of Macroeconomic Stabilisation

5) The Theory of Public Choice.

The Theory of Revenue Extraction

To carry out functions of government, government needs finance and thus extracts

revenue. Therefore, the theory of revenue extraction is the study of the means through

which a government obtains money. Government’s major sources of finance are

borrowings and taxation.

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The Theory of Externalities

The theory of externality refers mainly to negative externalities as defined earlier and

government’s role in internalising this externality.

Market failures have been attributed to externalities.

An externality arises when the production or consumption process of one person

or activity affects the production or consumption process of another individual or

activity.

The production or consumption process may lead to both positive and negative

externality.

Positive externality is one where the second person may benefit from an effect on

the production or consumption process into which this second person has had no

input. For example, a bee farmer raising bees for honey production provides a

benefit from this process to the neighbouring orchid farm, whose flowers the bees

pollinate.

A negative externality is one where the production or consumption process affects

negatively another person’s production or consumption process and in the process

results in a loss to the society, as illustrated in Figure 3.2.

Figure 3.2: Effect of Negative Externality on Quantity Produced and Price.

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S2 S1

Price

In this market, under initial supply and demand conditions, output Q1 and price P1

exist. If all costs are fully identified and measured, then the new supply curve S2

results in output Q2 < Q1 and price P2 > P1.

With external costs (negative externality) too many units are produced at a price

below the one that would prevail if all costs were identified and factored into the

market process.

Case Study of Internalising Negative Externality

Both these cases could be resolved if government were to intervene. Bailey (2000) lists

five options if we assume that a private industry dumps untreated industrial waste in

rivers that another company uses for drinking water.

a) Internalise the negative externality. The second company would incur substantial

costs in purifying the water to make it potable. If these two companies merge,

then the negative externality is internalised.

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D1

Q2 Q1

P1

P2

Quantity

b) Prohibit the negative externality: This tends to be the most common governmental

response. Anti-dumping legislation is passed and violators are prosecuted and

fined.

c) Regulate the negative externality: This is the case where a maximum limit is set

for discharge by the first company, to the point where the social marginal cost

(SMC) is equal to marginal revenue (MR).

d) Tax the negative externality: This is an alternative to c) above, which could

achieve the same objective but with some revenue for government. Under this

case, the tax is equivalent to an amount that will reduce production to a level

where SMC is equal to MR. This is at q1.

e) Introduce a trading scheme in negative externality licences. To limit the output,

licences are issued on the pollution levels each company could emit. Companies

investing in technologies can sell their licences to other companies and recover

their investment costs. However, as Bailey (2000) suggests, companies should

only be allowed to sell a portion of their licences.

Expenditure research over the last four decades expanded on Pigou’s work by identifying

different types of externalities and the necessary government interventions to correct

externality problems.

(i) In general, government can ignore distribution issues when addressing

externalities, even when externalities can affect one group of consumers or

producers more than others.

(ii) To correct externalities, government needs only to concentrate on the markets

with the externalities.

(iii) The best policy option for government to deal with externalities is through a

direct tax, of the sort proposed by Pigou on the good or factor causing the

externality. The form of tax will vary but for an externality caused by

production of a particular product, the optimal tax is a commodity tax on that

good that equals “the sum of its external effect on the margin”.

(iv) Subsidies or indirect taxes on other commodities will either not solve the

problem or will lead to unrealistically complex taxation on all other

commodities.

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The Theory of Public Goods and Natural Monopolies

Theory of Public Goods

=> pure public good as those goods that a number of people could use simultaneously

without diminishing their value (non-rivalry), and once these goods were provided, it was

infeasible to exclude people from their use (non-exclusion).

That is, the benefits of the good or service were said to be enjoyed by all

consumers.

The provision of public goods arises when markets fail to exist for public goods

because they are both non-excludable and non-rival in consumption.

If they are non-excludable, use of them by those who are not paying for them is

not prevented; and they are non-rival in consumption if one person’s consumption

does not affect the level of consumption for another person.

o Common examples of such goods are national defence and lighthouses.

o Other examples where there is a degree of non-rivalry in the consumption

include police protection, public parks, etc. Common property resources

are not a pure public good because while property rights cannot be

assigned to any one individual, the collective consumption of such

resources can deplete the resource or exhaust the good (note the tragedy of

the commons example) thus violating the non-rival aspect of the good.

National defence, street lights, etc. are examples where an individual

cannot be excluded from consumption of the good. Stiglitz (1986)

explains public goods using different terms but with the same meaning.

=> Pure public goods have two critical properties: first, it is not feasible to ration

their use; and secondly, it is not desirable to ration their use.

=>By the first he means that it is impossible to exclude individuals from the

consumption of such a good simply because it is indivisible. Using the second

property, he states that because the marginal cost of supply for the good or service

to an additional individual is zero, it is not desirable to ration the use.

Table 3.2: Key Efficiency Conclusions from Normative Expenditure Theory

Marke Conclusions Policy Implications

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t

Failur

e

Exter

nalitie

s

Private market provides

goods with externalities

inefficiently

Governments need to

take the lead role in

correcting externality

Policy solution needs to be

concentrated only on market

with externality

Can establish separate

government regulatory

agencies (pollution,

health)

The best policy option is tax

(in direct proportion to

marginal impacts) or

vouchers

Government should

use pollution tax (or

vouchers) instead of

absolute standards

Subsidies or indirect taxes

are not efficient tools

Public

Goods

Private market will under-

provide public goods

Government needs to

produce or regulate

provision of public

goods

Efficient provision requires

knowledge of consumer

demand for public good

Preference revelation

mechanisms are not

generally useful

Consumers have no

incentive to reveal their

preferences accurately

Except in the case of

complex government

auctions

Accurate preference

revelation will require a

carefully designed two-part

tax (or voting) scheme

Survey methods (e.g.

CVM) that ask

citizens to reveal

demand for public

goods are used in

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cost-benefit analysis

Natur

al

Mono

polies

Private market (monopoly)

will under-provide and

over-charge for this good

Government needs to

provide or regulate

natural monopolies

such as utilities

Optimal pricing is based on

marginal costs; deficits

should be made up with a

lump-sum tax

Most present utility

regulation is not

consistent with

economic

recommendations

If utility must break even,

then a “Ramsey pricing”

rule or multi-part pricing

should be used to determine

prices

Economic analysis has

raised concern about

“rate of return”

regulation.

“Rate of return” regulation

leads to over-utilisation of

capital.

Source: Duncombe (1996:30)

The Theory of Macroeconomic Stabilisation

The main objective of stabilisation policy is to ensure that output levels are close to the

potential while inflation and the current account deficit are kept at acceptable levels. A

set of co-ordinated financial management of government resources is required. Baptiste

(1980) identifies three schools of thought with respect to governments’ financial

management of an economy: the Keynesian, Monetarist and New Cambridge schools.

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Keynesian School

Demand Side Effects of Fiscal Policy: Keynes, in his book The General Theory, states

that an expansionary fiscal policy (increased government spending) in times of

depression or recession could be a means to raise aggregate levels of income and

employment without a corresponding increase in the general level of prices. The simplest

Keynesian model assumes price rigidity and excess capacity, so that output is determined

by aggregate demand. Keynes argues that demand can be managed by changes in public

expenditure and revenue and by stimulating investment. He argues that a fiscal expansion

has a multiplier effect on aggregate demand and output. Using the extended Keynesian

model, one can show the crowding out effect through induced changes in interest rates

and the exchange rate, along with the direct crowding out that occurs when government

goods and services substitute those provided by the private sector.

The standard model used for the analysis of stabilisation policy in an open economy is

the Mundell-Flemming model.

This model describes the short-run fluctuations in an open economy.

a) Fiscal expansion with a fixed level of money supply will shift the IS

curve thus pushing up the interest rates.

b) The resulting capital inflow will result in an increase in the exchange

rate, which in turn will reduce the demand for domestically produced

goods, thus reducing the initial fiscal expansion.

c) However, there is a net positive effect from expansionary fiscal policy

under a fixed exchange rate.

d) With a push to increase the exchange rate resulting from expansionary

fiscal policy, money supply should be increased to neutralise the push,

thus realising the fiscal expansion (readers should refer to any standard

macroeconomics text to obtain a detailed treatment of the Mundell-

Flemming Model).

Supply-Side Effects of Fiscal Policy: The analysis of Keynesian theory mostly examines

the demand side effects of fiscal policy, which are mostly the short-term effects.

=> However, the longer-term supply-side issues also need to be considered.

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Institutional Aspects of Fiscal Policy: Institutional factors can affect the fiscal policy

impact in a number of ways.

Ricardian equivalence: One of the fundamental assumptions of the Keynesian approach

is that consumption is related to current income.

However, let us include some microeconomic fundamentals that are generally

ignored by the Keynesian approach. Let us assume that consumers are forward

looking and are fully aware of the government’s intertemporal budget constraints.

That is, they are Ricardian in a sense.

In such a case, consumers will anticipate that a tax cut today, financed by

borrowing, will result in higher taxes being imposed on their families in future.

Therefore, if we take permanent income into account, it remains unaffected and

therefore, there will be no change in consumption.

=> This equivalence between taxes and debt (borrowing) is known as Ricardian

equivalence.

=> It implies that a reduction in government saving resulting from a tax cut is fully

offset by higher private saving with no effect on aggregate demand

Monetarist School of Thought

The Keynesian position denies the classical view according to which persistent

high unemployment will lead to ongoing deflation of wages and prices; the

resulting decline in the transaction demand for money (causing an excess supply

of money) will lead to a reduction in the rate of interest, which in turn will

stimulate investment, causing aggregate output and employment to rise, thus

returning the economy to full employment (Naastepad, 1999).

As an extension of this, the monetarists argue that it is monetary policy rather

then a fiscal measure that will stabilise the economy during a recession and thus

monetary policy rather then fiscal policy should be the main tool for stabilisation

of an economy (Baptiste, 1980).

They argue that the use of monetary policy will keep the resources fully employed

without any effect on prices, citing the quantity theory of money, which states that

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the volume of money in the hands of the public largely determines total spending

in nominal terms and by its extension, the level of output and prices.

Therefore, controlling money supply can in many ways be the key stabilisation

instrument.

Monetarists argue that the manner in which the deficit budget is financed is

critical. If it involves borrowing from bank credit or public, then private

borrowers will get less credit, thus increasing the cost of borrowing (interest

rates). This will have a negative effect on investment. However, an alternative

would be for the Reserve Bank to expand bank reserve assets to allow financing

of the deficit.

In such a case, there would be an overall increase in bank credit and the volume

of money in the system. The public and the banks would now be in a better

position to lend more to private borrowers. Interest rates would remain

unaffected, with an expansionary effect on the economy.

The New Cambridge School of Thought

The New Cambridge school of thought suggests that there is a direct relationship

between the public sector deficit and the current account of the balance of

payments in an open economy: the larger the public sector financial deficit the

larger the deficit on the current account of the balance of payments (BOP)

(Baptiste, 1980).

This relationship can be further explained if one examines the New Cambridge

School proposition that the net acquisition of financial assets by the public,

private and overseas sector (i.e. BOP on CA) plus net transfers must total zero.

Along with this, the assertion that the private sector’s net acquisition (personal

and company sectors) is stable, suggests that any change in the budget or public

sector borrowing requirements must be reflected in the BOP on the current

account.

A major implication coming out of this is that any government that carelessly

follows a principle of deficit financing to boost the economy of a small open

economy can end up destroying the balance of payments in the long run.

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However, Jansen (2004) argues that fluctuations in economic activity in

developing countries are often due to exogenous supply shocks such as natural

disasters or international commodity prices.

She argues that if the supply shock is expected to be temporary, then fiscal

intervention is justified and it will stabilise the fluctuations in output and the

exchange rate over time.

Under these circumstances, fiscal policy is more effective than monetary policy

(Bird, 1998).

However, if the supply shock is expected to be permanent, then fiscal intervention

is undesirable as it would hinder the adjustment to the new situation (Jansen,

2004).

External shocks from the international financial market, such as sudden change in

capital flows, in global interest rates or in the alignment of major currencies, can

lead to substantial fluctuations in economic activity in developing countries

(Jansen, 2004).

Heller (1997) argues that cautious fiscal policy should accompany such capital

inflow. There are other studies as well that suggests prudent macroeconomic

management in the face of large capital flows.

The inflow will stimulate economic activity, leading to a rise in tax collection,

and with unchanged expenditure, will lead to improvement in the fiscal balance.

Jansen (2004) argues that fiscal contraction beyond this automatic adjustment will

be required,

o (i) to limit the expansionary pressures in the economy,

o (ii) to reduce the liquidity in the financial market and

o (iii) to limit the appreciation of exchange rate caused by inflow of capital.

=> However, during periods of capital outflow, contractionary fiscal policy is

required.

=> A contractionary policy would help in reducing domestic absorption

and creating current account surplus necessary to finance the capital outflows and

to maintain confidence of the investors, thus minimising capital outflow.

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Public Finance in New Growth Theory

The Theory of Public Choice

Worldwide, a trend towards democratic government is being established, with gradual

reduction in the numbers and power of autocracies. Democratic governments receive

advice from many people in a bid to make collective decisions. Given that this advice

comes from many and varied sources, decisions are costly to make and may result in

inefficient resource allocation.

However, the current literature is still grappling with the problem of aggregation of

individual preferences and how the political process transmits the preferences of the

citizens to the government through the voting process.

Several voting models, such as the Optimal Constitution Model, the Bowen-Black

Majority Voting Model, the Buchanan-Tullock Model and the Downs Model,1 have been

developed to provide some insight into this area.

They fall into two categories, direct democracy and representative democracy. Direct

democracy refers to citizens voting directly upon decisions, say by a referendum; and

representative democracy refers to voting for representatives who then vote on behalf of

the voters on decisions. Dickenson states

that in a democratic society, people have the opportunity to decide how much they

wish to provide for themselves and how much they want the state to provide for

them. Their individual preferences can be expressed by putting a vote in the ballot

box at the next election for a political party whose manifesto most closely reflects

their views. It is the majority vote, which is the aggregate of individual preferences,

that gives the government the mandate to carry out its policies. (Dickenson, 1996:

77)

=> At a general election, people give a block vote to a party and a manifesto ‘package’

containing various proposals.

=> They do not have a choice with regard to individual issues in the manifesto and thus

not all proposals in the manifesto may be acceptable to them.

=> Sometimes, though rare and costly, a referendum is carried out; if it is done during an

election, costs are minimal.

1 For further information on these models refer to Robin W. Boadway’s Public Sector Economics, Winthrop Publishers, Cambridge, 1979, p. 467.

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Model of Public Expenditure

In a static analysis of government expenditure, the ability of a government to spend in a

democratic society depends in the long run on

(i) national resources (national income),

(ii) the level of taxation required to finance spending; and

(iii) the acceptability of the public expenditure programmes to the electorate.

The Ballot Box Theory states that in a democratic society, people have the opportunity to

indicate how much and what they wish the state to do for them via their individual

preferences, that is by putting a vote in the box at the next election for a party whose

manifesto reflects their views as closely as possible.

The dynamics of public expenditure growth could be explained by examining two

categories of model, the micro- and macroeconomic models of public expenditure.

Brown (1990) examines in great depth these two types of models. Produced below is a

summary of his presentation, along with other writers.

Macro-Models of Public Expenditure

Under this category, three models are commonly cited. These are the “development

models of public expenditure”, “Wagner’s law of expanding state activity”, and “Peacock

and Wiseman’s” hypothesis.

Development Models of Public Expenditure

The Rostow’s stages of growth model is quite useful in explaining the pattern of public

sector expenditure change.

=> Early stages of growth, the state plays a very important role in investment,

employment, law and order, health, education and infrastructure development. Therefore,

public sector investment as a proportion of the total investment is quite high.

=> As the economy grows and expands, the private sector increases its role in the

economy, as both an employer and an investor. At the same time, the public sector plays

a complementary role, declining gradually, particularly in investment and employment.

Wagner’s Law of Expanding State

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Adolf Wagner, a German economist, was the first scholar to propose a theory explaining

the share of GNP that is taken up by the public sector. Over the years, researchers have

termed his proposition “Wagner’s Law”.

Wagner (1893) stated that “as per capita income in an economy grows, the

relative size of the public sector will grow also”.

Wagner’s proposition was based on empirical work using data from a number of

European countries, Japan and United States.

Wagner suggested the relationship after seeing three main reasons for the

increased government involvement.

o First, said Wagner, industrialisation and modernisation would lead to a

substitution of public for private activity.

o Furthermore, the relationship between the expanding markets and the key

actors in these markets would become more complex. With this

complexity, the role of the state would increase.

o Wagner also expected that the emergence of legal services, police services

and other public services (public goods) would increase.

o Secondly, Wagner argued that as income grows, income-elastic “cultural

and welfare” expenditures such as on education and health will also

expand, requiring increased public sector expenditures. As real incomes in

a country increase, public expenditures on these services would rise more

than in proportion, which would account for the rising ratio of government

expenditure to GNP.

o The third reason forwarded by Wagner was that economic development

and changes in technology required government to take over the

management of natural monopolies in order to enhance economic

efficiency (Henrekson, 1990).

Peacock and Wiseman’s Analysis

=> Using the political economic literature, Peacock and Wiseman provided an analysis of

the “time pattern” of public expenditure.

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=> They state that “governments like to spend more money, that citizens do not like to

pay more taxes and that governments need to pay some attention to wishes of their

citizens”.

=> Peacock and Wiseman explain that as an economy grows, government income will

increase (with constant tax rates).

=> With increasing revenue, the government can make more expenditure on public

goods.

=> Peacock and Wiseman also explain the “displacement effect” that takes place in

unforeseen circumstances. During these circumstances, such as natural disasters or war,

public expenditure is displaced upwards and for the period of the crisis, displaces private

expenditures. Peacock and Wiseman also explain the “inspection effect”, which arises

from social problems that may be raised by the voters.

=>To attend to this, the government needs to expand its expenditure .

Micro-Models of Public Expenditure

The micro-models are used to identify the variables that directly influence the

demand for and supply of public sector outputs, thus explaining changes in public

expenditure.

The main categories of actors in a society are voters, politicians, bureaucrats and

pressure groups. The behaviour of each of these actors, which affects the supply

and demand for public sector outputs, has an impact on public sector expenditure.

Public sector outputs require public sector inputs. Therefore, public expenditure

levels are based on the derived demand of the public sector inputs.

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