Public Finance

Public Finance (or public economics) = Study of the

Role of
the 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
3045% of GDP in taxes
Expenditures: tax revenue funds traditional public
goods
(infrastructure, public order and safety, defense) and
welfare
state (Education, Retirement benefits, Health care,
Income
Support)
Macro-economic stabilization through central bank

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)
Externalities
Public 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 selectionthe 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

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.

APPLICATION (Negative Externality): The Measles

Epidemic of 19891991

Measles vaccine introduced in 1963, and measles cases had

become relatively rare in the United States by the 1980s.

19891991: 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:

Encouraged parents to immunize their children.

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.

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.

How Might Governments Intervene?

Tax or Subsidize Private Sale or
Purchase
Use the price mechanism, changing the
price of a good to encourage or discourage
use.
Two ways
Taxes raise the price for private sales or
purchases of goods that are
overproduced. (Example is carbon
tax). 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-

1.1

How Might Governments Intervene?

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

1.1

What Are the Effects of Alternative Interventions?

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
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

12 of 32

Normative vs. Positive Public Economics

Normative Public Economics: Analysis of How Things Should
be (e.g., should the government intervene in health insurance
market? 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 Really

Are (e.g., Does govt provided health care crowd out private
health 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.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

13 of 32

Why Do Governments Do What They Do?

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

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

14 of 32

Why Study Public Finance?

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.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

15 of 32

Federal Spending as a Percent of GDP, 19302011

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

16 of 32

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.

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

17 of 32

Federal Revenues and Expenditures, 19302011

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

18 of 32

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%

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

19 of 32

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.
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

20 of 32

Distribution of Federal Spending, 1960 and 2012

Category:
National defense
Social Security
Net interest
Unemployment,
disability
Education, welfare,
housing
Health (including
Medicare)
Other

1960
49.4%
13.4
9.7
8.6

2012
19.1%
15.9
7.6
9.1

4.0

11.0

2.9

25.2

12.0

12.1

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

21 of 32

Distribution of State/Local Spending, 1960 and 2012

Category:
Education
Transportation
Public order and safety
Welfare, social
services
Health
Other

1960
38.8%
11.7
10.2
10

2012
33.4%
5.9
12.9
6.6

8.2
21.1

22.3
18.6

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

22 of 32

Distribution of Federal Revenue Sources, 1960 and

2011
Category:
Income taxes
Corporate taxes
Social insurance
contributions
Excise taxes
Other

1960
44%
23
17

2012
42%
35
13

13
3

7
3

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

23 of 32

1.2

Distribution of State/Local Revenue Sources, 1960

and 2011
Category:
Property taxes

1960
36%

2012
21%

Sales taxes
Federal grants-in-aid
Income taxes

27
9
6

22
24
14

Other

22

19

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers

24 of 32

1.2

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),
Public Finance
Public
Policy Regulatory
Jonathan Gruber Fourth
Edition Copyright
2012 Worth
Oil and
and
Gas
Authority
(OGRA)
etc.Publishers

25 of 32