WHAT IS PUBLIC FINANCE?
In simple layman terms, public finance is the study of finance related to government entities. It revolves around the role of government income and expenditure in the economy.
Prof. Dalton in his book Principles of Public Finance states that “Public Finance is concerned with income and expenditure of public authorities and with the adjustment of one to the other”
By this definition, we can understand that public finance deals with income and expenditure of government entity at any level be it central, state or local. However in the modern day context, public finance has a wider scope – it studies the impact of government policies on the economy.
Let’s understand the scope of public finance to understand how public finance impacts the economy.
The main components of public finance include activities related to collecting revenue, making expenditures to support society, and implementing a financing strategy (such as issuing government debt). The main components include:
Tax collection is the main revenue source for governments. Examples of taxes collected by governments include sales tax, income tax (a type of progressive taxes, estate tax, and property tax. Other types of revenue in this category include duties and tariffs on imports and revenue from any type of public services that are not free.
The budget is a plan of what the government intends to have as expenditures in a fiscal year. In the U.S., for example, the president submits to Congress a budget request, the House and Senate create bills for specific aspects of the budget, and then the President signs them into law
Expenditures are everything that a government actually spends money on, such as social programs, education, and infrastructure. Much of the government’s spending is a form of income or wealth redistribution, which is aimed at benefiting society as a whole. The actual expenditures may be greater than or less than the budget.
If the government spends more then it collects in revenue there is a deficit in that year. If the government has less expenditures than it collects in taxes, there is a surplus.
If the government has a deficit (spending is greater than revenue), it will fund the difference by borrowing money and issuing national debt. The U.S. Treasury is responsible for issuing debt, and when there is a deficit, the Office of Debt Management (ODM) will make the decision to sell government securities to investors.
There are three main functions of public finance as follows –
THE ALLOCATION FUNCTION
There are two types of goods in an economy – private goods and public goods. Private goods have a kind of exclusivity to themselves. Only those who pay for these goods can get the benefit of such goods, for example – a car. In contrast, public goods are non-exclusive. Everyone, regardless of paying or not, can benefit from public goods, for example – a road.
The allocation function deals with the allocation of such public goods. The government has to perform various functions such as maintaining law and order, defense against foreign attacks, providing healthcare and education, building infrastructure, etc. The list is endless. The performance of these functions requires large scale expenditure, and it is important to allocate the expenditure efficiently. The allocation function studies how to allocate public expenditure most efficiently to reap maximum benefits with the available public wealth.
THE DISTRIBUTION FUNCTION
There are large disparities of income and wealth in every country in the world. These income inequalities plague society and increase the crime rate of the country. The distribution function of public finance is to lessen these inequalities as much as possible through redistribution of income and wealth.
In public finance, primarily three measures are outlined to achieve this target –
THE STABILIZATION FUNCTION
Every economy goes through periods of booms and depression. It’s the most normal and common business cycles that lead to this scenario. However, these periods cause instability in the economy. The objective of the stabilization function is to eliminate or at least reduce these business fluctuations and its impact on the economy. Policies such as deficit budgeting during the time of depression and surplus budgeting during the time of boom helps achieve the required economic stability.
Now that we understand the study of public finance, we must look into its practical applications. So let us understand the career opportunities in public finance –
INVESTMENT BANKING
An investment banking career in public finance domain entails raising funds for the development of public projects. Investment bankers help government entities in the following three areas –
RESEARCH
This is a fairly large area of public finance careers, and a lot of public finance professionals eventually become researchers. Many large banks, government entities, and world organizations require public finance professionals to consolidate necessary data points for decision making. Thus there is a regular requirement of public finance professionals in the field of research.
ACADEMIA
A lot of public finance professionals eventually go on to become professors and teach public finance in universities and colleges. Not only limited to teaching, but they also participate in university researches to improve understanding of the field and create new tools for efficient practical applications.
Study shows that developing economies are catching up with developed economies in ease of doing business.
Still, the gap remains wide. An entrepreneur in a low-income economy typically spends around 50 percent of the country’s per-capita income to launch a business, compared with just 4.2 percent for an entrepreneur in a high- income economy.
There’s ample room for developing economies to catch up with developed countries on most of the Doing Business indicators. Performance in the area of legal rights, for example, remains weakest among low- and middle-income economies.
The important work countries have done to improve their regulatory environments. Among the 10 economies that advanced the most, efforts were focused on the areas of starting a business, dealing with construction permits, and trading across borders. In general, economies that score the highest share several features on easy doing business including the widespread use of electronic systems and online platforms to comply with regulatory requirements.
At the same time, the least reformed area was resolving insolvency. Putting in place reorganization procedures reduces the failure rates of small and medium-size enterprises and prevents the liquidation of insolvent but viable businesses.
TICGL FIRM is a valuable tool that governments can use to design sound regulatory policies. By giving policymakers a way to benchmark progress, it stimulates policy debate, both by exposing potential challenges and by identifying good practices and lessons learned.
It’s important to note that Doing Business isn’t meant to be an investment guide, but rather a measurement of ease of doing business. Potential investors consider many other factors, such as the overall quality of an economy’s business environment and its national competitiveness, macroeconomic stability, development of the financial system, market size, rule of law, and the quality of the labor force.
In economies with flexible employment regulation, more young women join the labor force.
Low- and lower-middle-income economies tend to regulate employment more than do high- and upper-middle-income economies.
Although labor laws provide essential protections to workers, firms should not have to confront overly burdensome regulation. By changing restrictive labor regulation, economies could better adjust to fast-changing market conditions and dynamic work environments, generating positive outcomes that include smaller informal sectors, increased employment, and higher growth. Reinstating the option of fixed-term contracts would boost youth employment. Similarly, miscalculated changes to the minimum wage could lead to a decline in employment. Easing redundancy procedures facilitates businesses in allocating resources more efficiently, while revising legal restrictions on nonstandard working hours allows both employers and employees to maintain competitiveness.
By the end of this section, you will be able to:
The underpinnings of economic growth are investments in physical capital, human capital, and technology, all set in an economic environment where firms and individuals can react to the incentives provided by well-functioning markets and flexible prices. Government borrowing can reduce the financial capital available for private firms to invest in physical capital. But government spending can also encourage certain elements of long-term growth, such as spending on roads or water systems, on education, or on research and development that creates new technology.
A larger budget deficit will increase demand for financial capital. If private saving and the trade balance remain the same, then less financial capital will be available for private investment in physical capital. When government borrowing soaks up available financial capital and leaves less for private investment in physical capital, the result is known as crowding out.
A larger budget deficit will increase demand for financial capital. If private saving and the trade balance remain the same, then less financial capital will be available for private investment in physical capital. When government borrowing soaks up available financial capital and leaves less for private investment in physical capital, the result is known as crowding out.
Assume that government borrowing of substantial amounts will have an effect on the quantity of private investment. How will this affect interest rates in financial markets? the original equilibrium (E0) where the demand curve (D0) for financial capital intersects with the supply curve (S0) occurs at an interest rate of 5% and an equilibrium quantity equal to 20% of GDP. However, as the government budget deficit increases, the demand curve for financial capital shifts from D0 to D1. The new equilibrium (E1) occurs at an interest rate of 6% and an equilibrium quantity of 21% of GDP.
Figure 2. Budget Deficits and Interest Rates. In the financial market, an increase in government borrowing can shift the demand curve for financial capital to the right from D0 to D1. As the equilibrium interest rate shifts from E0 to E1, the interest rate rises from 5% to 6% in this example. The higher interest rate is one economic mechanism by which government borrowing can crowd out private investment.
After all, use expansionary monetary policy to reduce interest rates, or in this case, to prevent interest rates from rising? This useful question emphasizes the importance of considering how fiscal and monetary policies work in relation to each other. Imagine a central bank faced with a government that is running large budget deficits, causing a rise in interest rates and crowding out private investment. If the budget deficits are increasing aggregate demand when the economy is already producing near potential GDP, threatening an inflationary increase in price levels, the central bank may react with a contractionary monetary policy. In this situation, the higher interest rates from the government borrowing would be made even higher by contractionary monetary policy, and the government borrowing might crowd out a great deal of private investment.
On the other hand, if the budget deficits are increasing aggregate demand when the economy is producing substantially less than potential GDP, an inflationary increase in the price level is not much of a danger and the central bank might react with expansionary monetary policy. In this situation, higher interest rates from government borrowing would be largely offset by lower interest rates from expansionary monetary policy, and there would be little crowding out of private investment.
However, even a central bank cannot erase the overall message of the national savings and investment identity. If government borrowing rises, then private investment must fall, or private saving must rise, or the trade deficit must fall. By reacting with contractionary or expansionary monetary policy, the central bank can only help to determine which of these outcomes is likely.
Public physical capital investment of this sort can increase the output and productivity of the economy. An economy with reliable roads and electricity will be able to produce more. But it is hard to quantify how much government investment in physical capital will benefit the economy, because government responds to political as well as economic incentives. When a firm makes an investment in physical capital, it is subject to the discipline of the market: If it does not receive a positive return on investment, the firm may lose money or even go out of business.
In some cases, lawmakers make investments in physical capital as a way of spending money in the districts of key politicians. The result may be unnecessary roads or office buildings. Even if a project is useful and necessary, it might be done in a way that is excessively costly, because local contractors who make campaign contributions to politicians appreciate the extra business. On the other hand, governments sometimes do not make the investments they should because a decision to spend on infrastructure does not need to just make economic sense; it must be politically popular as well. Managing public investment so that it is done in a cost-effective way can be difficult.
If a government decides to finance an investment in public physical capital with higher taxes or lower government spending in other areas, it need not worry that it is directly crowding out private investment. Indirectly however, higher household taxes could cut down on the level of private savings available and have a similar effect. If a government decides to finance an investment in public physical capital by borrowing, it may end up increasing the quantity of public physical capital at the cost of crowding out investment in private physical capital, which is more beneficial to the economy would be dependent on the project being considered.
In most countries, the government plays a large role in society’s investment in human capital through the education system. A highly educated and skilled workforce contributes to a higher rate of economic growth. For the low-income nations of the world, additional investment in human capital seems likely to increase productivity and growth. For the United States, tough questions have been raised about how much increases in government spending on education will improve the actual level of education.
Not all spending on educational human capital needs to happen through the government: many college students in the United States pay a substantial share of the cost of their education. If low-income countries of the world are going to experience a widespread increase in their education levels for grade-school children, government spending seems likely to play a substantial role. For the U.S. economy, and for other high-income countries, the primary focus at this time is more on how to get a bigger return from existing spending on education and how to improve the performance of the average high school graduate, rather than dramatic increases in education spending.
Research and development (R&D) efforts are the lifeblood of new technology. According to the National Science Foundation, federal outlays for research, development, and physical plant improvements to various governmental agencies have remained at an average of 8.8% of GDP. About one-fifth should be R&D spending goes to defense and space-oriented research. Although defense-oriented R&D spending may sometimes produce consumer-oriented spinoffs, R&D that is aimed at producing new weapons is less likely to benefit the civilian economy than direct civilian R&D spending.
Fiscal policy can encourage R&D using either direct spending or tax policy. Government could spend more on the R&D that is carried out in government laboratories, as well as expanding federal R&D grants to universities and colleges, nonprofit organizations, and the private sector.
Economic growth comes from a combination of investment in physical capital, human capital, and technology. Government borrowing can crowd out private sector investment in physical capital, but fiscal policy can also increase investment in publicly owned physical capital, human capital (education), and research and development. Possible methods for improving education and society’s investment in human capital include spending more money on teachers and other educational resources, and reorganizing the education system to provide greater incentives for success. Methods for increasing research and development spending to generate new technology include direct government spending on R&D and tax incentives for businesses to conduct additional R&D.
A market economy is a system where the laws of Supply and Demand directly the production of goods and services. Supply includes natural resources capital, and labor. Demand includes purchases by consumers, businesses, and the government.
Businesses sell their wares at the highest price consumers will pay. At the same time, shoppers look for the lowest prices for the goods and services they want. Workers bid their services at the highest possible wages that their skills allow. Employers seek to get the best employees at the lowest possible price.
Capitalism requires a market economy to set prices and distribute goods and services. Socialism and communism need a command economy to create a central plan that guides economic decisions. Market economies evolve from traditional economies. Most societies in the modern world have elements of all three types of economies. That makes them mixed economic.
Key Takeaways
The following six characteristics define a market economy.
Private Property
Most goods and services are privately-owned. The owners can make legally-binding contracts to buy, sell, or lease their property. Their assets give them the right to profit of ownership. There are some assets U.S. law excludes. Since 1865, for example, you cannot legally buy and sell human beings.3
Freedom of Choice
Owners are free to produce, sell, and purchase goods and services in a competitive market. They only have two constraints. First is the price at which they are willing to buy or sell. Second is the amount of Capital they have.
Motive of Self-Interest
Everyone sells their wares to the highest bidder while negotiating the lowest price for their purchases. Although the reason is selfish, it benefits the economy over the long run. This auction system sets prices for goods and services that reflect their market value. It gives an accurate picture of supply and demand at any given moment.
Competition
The force of competitive pressure keeps prices low. It also ensures that society provides goods and services most efficiently. As soon as demand increases for a particular item, prices rise thanks to the law of Demand. Competitors see they can enhance their profit by producing it, adding to supply. That lowers prices to a level where only the best competitors remain. This competitive pressure also applies to workers and consumers. Employees vie with each other for the highest-paying jobs. Buyers compete for the best product at the lowest price.
System of Markets and Prices
A market economy relies on an efficiency in market which to sell goods and services. That's where all buyers and sellers have equal access to the same information. Price changes are pure reflections of the laws of supply and demand. There are five determinant of Demand : product price, buyer's income, prices of related goods, consumer taste, buyer's expectations.
Limited Government
The role of government is to ensure that the markets are open and working. For example, it is in charge of national defense to protect the markets. It also makes sure that everyone has equal access to the markets. The government penalize monopolies that restrict competition. It makes sure no one is manipulating the markets and that everyone has equal access to information.5
Advantages of a Market Economy
Since a market economy allows the free interplay of supply and demand, it ensures that the most desired goods and services are produced. Consumers are willing to pay the highest price for the things they want the most. Businesses will only create those things that return a profit.
Second, goods and services are produced in the most efficient way possible. The most productive Companies will earn more than less productive ones.
Third, it rewards innovation. Creative new products will meet the needs of consumers in better ways that existing goods and services. These cutting-edge technologies will spread to other competitors so they, too, can be more profitable. This illustrates why Silicon Valley is America's innovative advantage.
Fourth, the most successful businesses invest in other top-notch companies. That gives them a leg up and leads to increased quality of production.1
Disadvantages of a Market Economy
The key mechanism of a market economy is competition. As a result, it has no system to care for those who are at an inherent competitive disadvantage. That includes the elderly, children, and people with mental or physical disabilities.
Second, the caretakers of those people are at a disadvantage. Their energies and skills go toward caretaking, not competing. Many of these people might become contributors to the economy's overall comparative advantage if they weren't caretakers.
That leads to the third disadvantage. The human resources of society may not be optimized. For example, a child who might otherwise discover the cure for cancer might instead work at McDonald's to support her low-income family.
Fourth, society reflects the values of the winners in the market economy. A market economy may produce private jets for some while others starve and are homeless. A society based on a pure market economy must decide whether it's in its larger self-interest to care for the vulnerable.1
If it decides it is, society will grant the government a significant role in redistributing resources. That is why many market economies are also mixed economies. Most so-called market economies are mixed economies.