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Public Finance

Public Finance (or public economics) = Study of the Role ofthe Government in the Economy. It is about the taxing and spending activities of the government.Government is instrumental in most aspects of economic life:Government in charge of huge regulatory structure• Taxes: governments in advanced economies collect 30-45% of GDP in taxes• Expenditures: tax revenue funds traditional public goods(infrastructure, public order and safety, defense) and welfarestate (Education, Retirement benefits, Health care, IncomeSupport)• Macro-economic stabilization through central bank (interest rate,

inflation control), fiscal stimulus, etc.

The Four Questions of Public Finance

Four questions of public finance:

1. When should the government intervene in the economy?

2. How might the government intervene?

3. What is the effect of those interventions on economic outcomes?

4. Why do governments choose to intervene in the way that they do?

When Should the Government Intervene in the Economy?Economics generally presumes that markets deliver efficient outcomes, so why should government do anything? Government intervention may improve the situation.• Primary motive for government intervention is therefore market failure.

• Market Failure: Problem that causes the market economy to deliver an outcome that does not maximize efficiency.• Imperfect competition (Example, Monopoly)• Nonexistence of markets

Information failures (asymmetric information)ExternalitiesPublic goods

• Redistribution: Market economy generates substantial inequality in economic resources across individuals. Government intervention may help reduce inequality by redistributing resources through taxes and transfers.

Why market Fail (Harvey Rosen ch.3 page 51 )

• If individual or firms are price maker , then the allocation of the resources will be inefficient. Why P>MC

If a market for a commodity does not exist , then we can hardly expect the market to allocate efficiently the resources.

Information Failure

Asymmetric information: one party in the transaction has information that is unavailable to the another.

Two Outcome:Adverse selection—the insured individual knows more about their own risk level

than does the insurer.Moral hazard--- The possibility that a person will change their behavior as the result

of a an agreement. when you insure against adverse events, you can encourage adverse behavior. For example, the market of insurance particularly poverty insurance . If you purchased such insurance, you might decide not to work hard.

Problem: Difficult to monitor your determine , whether your low income was due to bad luck or not working hard. Monitoring is costly. Rationalization of Govt. for income support programs is that they provide poverty insurance not available privately.

Why market Fail (Harvey Rosen ch.3 page 51 )

• Another inefficiency may arise due to non-existance of market is Externality. A situation in which one person behaviour effect the welfare of another in way that is outside existing market.

• Suppose a person begin smoking, polluting the air and making you worse off. Why inefficiency problem?

• The individual use up a scare resource, clear air when smoke. However there is no market that force him pay , with zero price the individual over use it. P=MC but P<SMC.

• On Production side, For example, factories generate air pollution that affects people's health. Carbon emission (Pigouvian taxes/subsidies)

• Public Good, a commodity that is non-rival in consumption (everyone can consume it) -the fact that one person consumes it does not prevent anyone else from doing so as well.

• Example: Street lights, when turn all the people living in that street can benefit.

• The people may have incentive to hide there true preferences. It would be worthwhile to have a street light, but I know I can benefit whether to pay or not. Therefore, I may claim that the light street nothing mean to me.

• The market mechanism may fail to force people to reveal there true preferences for public goods and possibly result inefficient resources being devoted to them.

• Measles vaccine introduced in 1963, and measles cases had become relatively rare in the United States by the 1980s.

• 1989−1991: Huge resurgence in measles.

• This outbreak resulted from very low immunization rates among disadvantaged inner-city youths.

• Unimmunized children imposed a negative externality on other children.

• The federal government responded to this health crisis in the early 1990s:

o Encouraged parents to immunize their children.

o Paid for the vaccines for low-income families.

• Impressive results:

• Immunization rates never higher than 70% prior to outbreak.

• Rose to 90% by 1995.

• Government intervention clearly reduced this negative externality.

APPLICATION (Negative Externality): The Measles Epidemic of 1989−1991

National Emergency Action Plan for Polio Eradication (Negative externality)

• Polio eradication in Pakistan is vital not only for the health of the nation, but for the whole global community.

• The plane should ensure that all children will be reached with vaccine, no matter what geographical area of the country or what community they come from.

• The stimulus for this plan is from the highest levels for the nation's Government, and is recognition of the national responsibility to finish polio eradication so that the children of Pakistan, and of the world, can be free of the threat of polio forever.

National TB control

•Tuberculosis (TB) is a major public health problem in Pakistan. Pakistan ranks fifth amongst high burden countries for TB in the world.

•Based on this prevalence, the incidence was estimated at 275 TB cases per 100,000 populations.

•NTP will strive for TB free Pakistan by reducing 50% prevalence of TB in general population by 2025 in comparison to 2012 through universal access to quality TB care and achieving Zero TB death".

When Should the Government Intervene in the Economy?

• Even if the market is well-functioning, an efficient outcome is not necessarily socially desirable. As market equilibrium might generate very high economic disparity across individuals.

• Redistribution is a second reason for government intervention. Governments use taxes and transfers to redistribute from from rich to poor and reduce inequality.

• In Pakistan, Conditional Cash Transfer (CCT) program i.e Benazir Income Support (BISP) provision of cash transfers of Rs. 1,500/month to eligible families particularly poor women., Child Support Program (CSP), a cash subsidy to eligible beneficiaries for sending their children aged between 5-16 year to school to get primary education.

• The shifting of resources from some groups in society to others.• Problem: Taxing a rich person to distribute money to the poor, then this

may cause to work less…….inefficiency problem!

• Equity-efficiency tradeoff

Tax or Subsidize Private Sale or Purchase

• Use the price mechanism, changing the price of a good to encourage or discourage use.

Two waysTaxes raise the price for private sales or purchases of

goods that are overproduced. (Example is carbontax)…. a tax on fossil fuels, intended to reduce the

emission of carbon dioxide.Subsidies lower the price for private sales or

purchases of goods that are under-produced. (example is subsidized flu vaccine ).

How Might Governments Intervene?

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Restrict or Mandate Private Sale or Purchase

• Quotas restrict private sale of goods that are overproduced

• Mandates require private purchase of goods that are under-produced (and force individuals to buy that good (example is auto insurance)

Public Provision

• The government can provide the good directly, that maximize social welfare. (Example , Defense)

Public Financing of Private Provision • Governments pays, private companies produce. example is

privately provided health insurance paid for by government in Medicare-Medicaid) , Public-Private Partnerships for Metro Transportation Projects in Pakistan

How Might Governments Intervene?

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 12 of 32

Interventions have direct and indirect effects.

• Direct effects: The effects that would be predicted if individuals did not change their behavior in response to the interventions.

With 49 million uninsured, providing universal health insurance covers 49 million people. The cost for treating each uninsured $2,000 per year.

• Indirect Effects: The effects of government interventions that arise only because individuals change their behavior in response to the interventions (sometimes called unintended effects).

• In providing free health insurance, the Govt. provide strong incentive to those paying for their own, drop and take part in Govt. free health program.

Empirical public finance analysis tries to estimate indirect effects • Example: increasing top income tax rates mechanically raises tax revenue but

top earners might work less and earn less, reducing tax revenue relative to mechanical calculation

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What Are the Effects of Alternative Interventions?


Normative vs. Positive Public Economics

• Normative Public Economics: Analysis of How Things Shouldbe (e.g., should the government intervene in health insurancemarket? how high should taxes be?, etc.) The govt should raise the tax on tobacco to

reduce the quanity.

• Positive Public Economics: Analysis of How Things ReallyAre (e.g., Does govt provided health care crowd out privatehealth care insurance? Do higher taxes reduce labor supply?)An increase in the minimum wage will increase the rate of teenage unemployment.

An increase in i-rate will cause a decline in investment.

• Positive analysis is primarily empirical and Normative analysis• is primarily theoretical.


Political economy: The theory of how the political process produces decisions that affect individuals and the economy.

Example: Understanding how the level of taxes and spending is set through voting and voters' preferences

Why Do Governments Do What They Do?


The government is a huge part of the economy:

• Government spending represents a large sector of the economy, in the United States and around the world.

• This spending is financed with taxes or with debt, and these affect every aspect of the economy.

• Many sectors of the economy are also directly affected by regulation.

Why Study Public Finance?


Federal Spending as a Percent of GDP, 1930−2011


Decentralization

• A key feature of governments is the degree of centralization across local and national government units.

• Centralization: The extent to which spending is concentrated at higher (federal) levels or lower (state and local) levels.

• In the United States, state and local spending is about one-fourth of total government spending.


Federal Revenues and Expenditures, 1930−2011


Tax Rates as % of GDP (2008)

Sweden: 54.2 % Denmark: 48.8 % Finland: 46.9 % Belgium: 45.6 % France: 45.3 % Austria: 43.7 % Italy: 42 % Netherlands: 41.4 % Norway: 40.3 % Germany: 37.9 % United Kingdom:

37.4 %

Russia: 36.9 % Canada: 35.8 % Switzerland: 35.7 % New Zealand: 35.1 % Australia: 31.5 % Ireland: 31.1 % United States: 29.6

% Japan: 27.1 % China: 17% Mexico: 9.7% Iran: 7.3% Nigeria: 6.1%


Distribution of Spending

• Public goods: Goods for which the investment of any one individual benefits everyone in a larger group.o Example: Defense spending

• Social insurance programs: Government provision of insurance against adverse events to address failures in the private insurance market.o Example: Health insurance

• Over time, spending has shifted dramatically toward social insurance, especially health insurance.


Distribution of Federal Spending, 1960 and 2012

Category: 1960 2012National defense 49.4% 19.1%Social Security 13.4 15.9Net interest 9.7 7.6Unemployment, disability 8.6 9.1Education, welfare, housing 4.0 11.0Health (including Medicare) 2.9 25.2Other 12.0 12.1


Distribution of State/Local Spending, 1960 and 2012

Category: 1960 2012Education 38.8% 33.4%Transportation 11.7 5.9Public order and safety 10.2 12.9Welfare, social services 10 6.6Health 8.2 22.3Other 21.1 18.6


Distribution of Federal Revenue Sources, 1960 and 2011

Category: 1960 2012Income taxes 44% 42%Corporate taxes 23 35Social insurance contributions 17 13Excise taxes 13 7Other 3 3


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Distribution of State/Local Revenue Sources, 1960 and 2011

Category: 1960 2012Property taxes 36% 21%Sales taxes 27 22Federal grants-in-aid 9 24Income taxes 6 14Other 22 19


Regulatory Role of the Government

The government regulates a wide range of economic and social activities:

• Securities Exchange Commission of Pakistan (SECP):responsible for regulating the securities and any businesses in stock exchange or in other security market.

• PTA: It has been formed to ensure and facilitate the availability of high quality, efficient, cost-effective, and competitive telecommunication services throughout Pakistan and to protect the interests of consumers and licensees.

• Pakistan Electronic Media Regulatory Authority (PEMRA),

• National Electric Power Regulatory Authority (NEPRA),

• Oil and Gas Regulatory Authority (OGRA) etc.

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