CHAPTER 1 INTRODUCTION Mc GrawHillIrwin Copyright 2008 by

Defining the Field of Study o “Public Finance is nothing else than a sophisticated discussion of the relationship between the individual and the estate. There is no better school of training than public finance. ” Former Czech Prime Minister, Vaclac Klaus. o This book is about the taxing and spending activities of a government, subject usually called public finance. o Public Finance – the field of economics that analyzes government taxation and spending policies. Therefore, some authors prefer the label: Public Sector Economies or Public Economies. o The resources for all government expenditures ultimately must come from the private sector. 1 -2

Defining Public Finance o Public finance may be defined in a general term "as being concerned with the manner in which public services are provided. o However, this definition is not clear in determining the activities of public finance. o This is because there are various criteria that may be used to confine the framework of public finance which lead to different definitions such as: 1 -3

Defining Public Finance 1. 2. 3. 4. The source criterion, which means goods and services provided through government budget are public services. The goods criterion, which means that all nonmarketable goods and services are considered as public services such as defense and justice. The consumption criterion, which means that all collective consumption goods and services are considered as public services. The price criterion, which means that free or subsidized goods and services are considered public services. 1 -4

Public Finance and Ideology o Views of how government should function in the economic sphere are influenced by ideological views concerning the relationship between the individual and the state. o Political philosophers have distinguished two major approaches: Organic view of government Mechanistic view of government 1. 2. 1 -5

Organic view of government o Society is a natural organism, each individual is part of the organism, and the government is the heart of the organism. o In an organic view of sociology, individuals are valued only by their contribution to the realization social goals. These goals are determined by the government. o Individuals are important only as part of the society, and the good of the individual is subordinate to the good of society. o Society or community is above the individual. The objectives of a society are set by government. 1 -6

Organic view of government o The problem is who is to represent government. • Platon: realization of perfect rationality. • Hitler: realization of racial purity. • Lenin: realization of socialism 1. Social objectives can be distinguished, and the most important thing is how to choose the objectives of the society. 2. Still, in spite of the many philosophers, it is not clear what is natural. 1 -7

Mechanistic view of government o Government is not an organic part of society. Rather, it is a contrivance created by individuals to better achieve their individual goals. o Government is a contrivance erected to further individual goals. It is not clear how the government can reconcile sometimes conflicting individual goals. o At the centre of attention is the individual, not the group, not the society. o Government exists for the good of the nation, but the problem is what is good and how government should achieve it. 1 -8

Mechanistic view of government o Government is trust and state servants are trustees, and trustees have been created for the wellbeing welfare of the nation. o General consensus: it is good for individuals when government protects them from violence, for which reason it must have the power of coercion, otherwise there will be anarchy. 1 -9

Continue … o Adam Smith (Wealth of Nations, 1776) “government should protect a society against violence and the assaults of other independent societies… and every member of the society against injustice and oppression from any other member of the society. ” o However, J. S. Mill held that “the only reason for which a government should use its power to coerce any member of society against his will is to prevent him injuring others. ” o But what is injury to others, and how great must this injury be to justify the use of state coercion? o The minimum that government should provide is protection and the infrastructure necessary for the life of society (lighthouses, roads, bridges, sewers etc. ) 1 -10

Within mechanical view we distinguish o Within mechanical view we distinguish: o Liberals, libertarians – for a very limited government and against any economic role for government. o Social democrats – for the good of the individual, considerable government intervention is required (benefits to the unemployed, subsidies for shipbuilding. . . ). o There is no hard and fast division, rather a sliding scale of view about the necessary scope of government intervention. 1 -11

liberal – what is that o o o Classic liberals - government is legitimate, but alas it oversteps its boundaries and hence we must be watchful over what government is doing. Libertarians – government is not a servant of society that sometimes errs, rather it is its enemy. Classic liberals argue for a limited government, for laissez faire in combination with a limited but still active government. American liberals are on the whole into race and gender orientation and abortion, while British liberals are really social democrats. USA liberals/libertarians – Republicans (Bush and Reagan) versus the democrats (Clinton, Obama) – taxes, redistribution, privatization. 1 -12

The View Point of the Book o The mechanistic view of government has come to dominate Anglo-American political thought. However, its dominance is not total. o The tension between society and the individual is inevitable. o The mechanistic view does not by itself provide us with an ideology that tells us whether any particular economic intervention should be undertaken. 1 -13

Government at glance o The Legal Framework: Constitution, laws, sub-laws and regulations. o Constitution of Republic of Croatia – entrepreneurial and market freedoms are the basis of the economic organization of the Republic of Croatia. o The government makes sure that all enterprises have equal legal status on the market. The abuse of the monopolistic positions defined by law is forbidden. o Government encourages economic development and the welfare of the local governments and takes care of the economic development of all of its regions. o Rights acquired by the investment of capital cannot be diminished by law or any other legal instrument. 1 -14

…continue o Constitutional and statutory restrictions to government spending, deficits and public debt. o Division responsibilities for levy taxes and collect revenue o Statutory defined responsibilities for borrowing (E. g. public debt shouldn't exceed 60% of GDP). o Balanced budget, borrowing only for capital expenditure funding. o Unitary and complex/federal states. 1 -15

The role of government o We can be against state intervention as much as we like, but we have to understand the circumstances in which we live. o For several centuries, there has been an ever increasing degree of complexity in legislation, regulations, taxation, public services. . . o It is in vain to expect any considerable reduction in the role of government, indeed, I am afraid that government intervention and regulation might become much worse (Victoria Curzon-Price on the EU). o In spite of the tempting and logical thesis that government is actually unnecessary and that we might live in either anarchy or spontaneous order, it is hardly worthwhile urging the abolition of government or the state – or indeed of constantly testing out its legitimacy (Friedrich Hayek – The Road to Serfdom). 1 -16

The Size of Government o How to measure the size of government? n n Number of workers Annual expenditures o Types of government expenditure n n n o Purchases of goods and services Transfers of income Interest payments Budget documents n n Unified budget: Government itemizes its expenditure in a document referred to unified budget. Regulatory budget: The cost imposed on the economy by government regulations be published in an annual regulatory budget. 1 -17

The size of government o How to measure the size of government? 1. Measurement via annual expenditure Purchase of goods and services Size of transfers (social and subsidy) Payment of interest Expenditure of general government Inflation-adjusted expenditure Government spending per capita Government spending as proportion (%) of GDP 2. 3. 4. 5. 6. 7. 8. 1 -18

The size of government o All common measures of the size of government- employees, expenditures, revenues, etc. - involve some deficiency. In particular, these items miss the impact of regulatory costs. o Nevertheless, there is strong evidence that the impact of the government on the allocation of national resources has increased over time. 1 -19

The expenditures of government o The expenditures of government can go for: 1. The national defense. Social security. Medicare. Public welfare activities. Payment of interests on debt. 2. 3. 4. 5. o Entitlement Programs: Governmental programs with cost determined not by fixed dollar amounts but by the number of people who qualify. 1 -20

The revenues of government o The revenues of government: 1. Tax 2. Loans 3. Changes in real value of debt. 1 -21

Changes in the Real Value of Debt o Inflation Tax: When the government is a debtor and the price level increases, changes in the real value of the debt may be an important source of revenue. E. g. increased inflation reduces the real value of your debt. (Read example on P. #14). 1 -22

State, Local, and Federal Government to Adjusting. Relative for Adjusting for Expenditures (selected years) Economy Inflation Population 1 2 3 4 2005 Dollars (billions)* 2005 Dollars per capita Percent of GDP 1960 Total Expenditures (billions) 123 655 3, 627 24. 3% 1970 295 1, 201 5, 858 28. 4% 1980 843 1, 749 7, 679 30. 2% 1990 1, 873 2, 574 10, 289 32. 2% 2000 2, 887 3, 237 11, 461 29. 4% 2005 3, 876 13, 066 31. 1% *Conversion to 2005 dollars done using the GDP deflator Source: Calculations based on Economic Report of the President, 2006 (Washington, DC: US Government Printing Office, 2006), pp. 280, 284, 323, 379 1 -23

United States Source: Organization for Economic Cooperation and Development [2006]. Figures are for 2005.

Note increase in Social Security, Medicare and Income Security Note decline in Defense Source: Economic Report of the President [2006, p. 377].

Increase in public welfare Decline in highways Source: Economic Report of the President [2006, p. 383].

Social insurance and individual income tax have become more important Corporate and other taxes have become less important Source: Economic Report of the President [2006, p. 377].

Individual tax more important Property tax less important Source: Economic Report of the President [2006, p. 383].

Doing Research in Public Finance o Public Finance journals n n n o International Tax and Public Finance Journal of Public Economics National Tax Journal Public Finance Quarterly General-interest journals n n n American Economic Review Journal of Economic Perspectives Journal of Political Economy Quarterly Journal of Economics Review of Economics and Statistics 1 -29

Doing Research in Public Finance o Other sources n n n o Journal of Economic Literature Brookings Institution’s Studies of Government Finance Congressional Budget Office reports National Bureau of Economic Research working papers Tax Foundation’s Facts and Figures on Government Finance U. S. Government Printing Office publications n n n Statistical Abstract of the United States Economic Report of the President Budget of the United States U. S. Census of Governments Historical Statistics of the United States from Colonial Times to 1970 1 -30

Doing Research in Public Finance o Public Finance data available on internet n Resources for Economists on the Internet n U. S. Census Bureau n University of Michigan’s Office of Tax Policy Research n Urban-Brookings Tax Policy Center 1 -31