PUBLIC FINANCE I

1. PUBLIC FINANCE I LECTURES 1&2 Introduction: Issues in Public Finance E. Nketiah-Amponsah

2. Learning Outcomes • Understand and explain the size of government and how it affects resource allocation • Explain why we need the public sector in every economy • Organic view • Mechanistic view • Explain the market failure argument and why the need for the public sector • Explain the budgetary process: • Allocative function • Distribution function • Stabilization function • Regulatory Function • Distinguish between positive and normative analysis with respect to public policy E. Nketiah-Amponsah

3. Public Finance-definitional Issues Sampled Definitions • Public Finance is the study of how government policies especially tax and expenditure policies affect the economy and thereby the welfare of its citizens. • Public Finance is a field of economics concerned with how governments raise money, how that money is spent and the effects of these activities on the economy and society • Public Finance is about the taxing and spending activities of the government. “The field of economics that analyzes government taxation and spending policies” • From these definition, the study of public Finance will help you to do two main things: how government spending and taxation affect the overall performance of the economy • To analyze the effects of government taxes on the welfare of its citizens. • To analyze the effects of government expenditure on the welfare of its citizens E. Nketiah-Amponsah

4. Size of Government E. Nketiah-Amponsah • Size of government-how to measure it? • Number of government employees • Ghana’s public sector employs over 500,000 workers • Public sector wage bill • Between 2011 and 2012, Ghana’s wage bill grew by 47%. • In 2012, the wage bill accounted for 12% of GDP • The recent astronomical growth in the wage bill is largely attributable to the Single Spine Salary Structure (SPSS) • Annual government expenditures as a proportion of GDP • In 2011, government payments accounted for about 28% of GDP • Government Consumption as a proportion of GDP • Budget Deficit • In 2012, a budget deficit of about 12% was recorded by the government of Ghana.

5. Where are we coming from? Wage bill????Ghana’s Wage Bill to GDP Ratio 1989-2008 (%) FWSC

6. Trends in Government Payments (% GDP)-2001-2011 E. Nketiah-Amponsah Source: SGR 2011, ISSER, Legon

7. The Role of the Government-Ideological Perspective E. Nketiah-Amponsah • We should think of the government as an entity that levies taxes on individuals and firms, spends the proceeds from taxation to provide mainly public goods and regulates several aspects of economic activity. • An economy can be divided into two main sectors (i.e. public and the private sectors). There are two main views on the need for the public sector/government • Organic view • Mechanistic view • Organic view - Governments treat an entire society as a natural organism and that each individual is part of the organism. - The government is at the heart of the organism - Although individual goals differ, some goals are naturally needed for the societal organism (functioning) - Hence, governments exist to lead a community of citizens to a common and “natural” goal and that actions of individuals are judged by the contribution they make to the state.

8. The Role of the Government-Ideological Perspective E. Nketiah-Amponsah • Mechanistic view • Individuals are paramount • Government is created by individuals to help them achieve their individual goals. Thus, government is a contrivance created by individuals to better achieve their individual goals. • The individual not group is at the centre • Government exists both to maintain property rights and to serve the good of the underprivileged, i.e. providing social security, health insurance for the poor, etc. • There is a big debate regarding the importance of individual freedom • Freedom to do as you like • freedom not to suffer from activities of others

9. Why The Need For The Government/Public Sector E. Nketiah-Amponsah • The extent of government’s involvement is debatable • Libertarian : Small government is desirable • Social Democrats: Large government is desirable

10. Organic and Mechanistic Views • Which way one looks at it(i.e. whether organic or mechanistic) the public sector is needed for the following reasons: • Market failure argument. It is argued that, if the private sector alone is allowed to determine the allocation of resources, it will lead to market failure. Market failure may arise because of the following reasons • Existence of Public Goods • Existence of Externalities • Risk and Uncertainty • Monopoly Power • Information Asymmetry E. Nketiah-Amponsah

11. Interaction Between The Public and Private Sector • The public sector do not always lead to the efficient allocation of resources. • Just as we have market failure, we also have government failure. • Government failure refers to a situation where government’s action (in terms tax collection, spending and regulation) ended up deepening market failure • What are the possible causes of government failure? • pursuit of self-interest • electoral pressures • tendency to look for short-term (ad hoc) solutions • Regulatory Capture • Imperfect Information E. Nketiah-Amponsah

12. Interaction Between the Public and Private Sector-Cont. • The pursuit of self-interest amongst both politicians and civil servants rather than operating on behalf of citizens which leads to a misallocation of resources. • Electoral pressures leading to inappropriate government spending and tax decisions • Can you mention some examples? • A tendency to look for short term solutions to economic problems rather than making considered analysis of long term considerations. The risk is that myopic decision-making will only provide short term relief to particular problems but does little to address structural problems. E. Nketiah-Amponsah

13. Interaction Between The Public And Private Sector • Regulatory capture. This is when the industries under the control of a regulatory body begin to move policy options so that their outcome is in their favour or interest. Some economists argue that regulators can prevent the ability of the market to operate freely. • Imperfect information - How does the government establish what citizens want it to do? Allocation of resources by the government in performing its allocative, distributive, stabilization and regulatory roles thrives on information and accurate statistics. Governments need population and demographic statistics inter alia to undertake long-term planning. However, most developing countries especially those in SSA are unable to provide correct statistics/information on several economic and social indicators. • Given that both the market and government could fail, there is the need for the public and private sector to work together to ensure efficient allocation of resources E. Nketiah-Amponsah

14. Some Benefits/Advantages associated with PPP • Improve service delivery • Improve cost-effectiveness • Inject much needed funds/increase in investment in public infrastructure (How?) • Reduce Public Sector Risk • Improve Budget Certainty etc • What about the potential challenges of PPP? E. Nketiah-Amponsah

15. Implementation Of Gov’t Public Expenditure Policies • The government implements its expenditure policies through its annual budget • Budget is a financial statement or plan that shows government expenditure and receipts. • Budgetary Cycle • Formulation and Submission by the executive • The Authorization and Approval stage • Budgetary execution and implementation • Evaluation stage (Auditing Process) • The Budgetary Process has three main functions • Allocation Function • Distribution Function • Stabilization Function E. Nketiah-Amponsah

16. Allocation Function • It’s a process by which total resource used is divided between private and social goods and by which the mix of social goods is chosen. • Social goods/public goods cannot be provided for efficiently through the market mechanism • The government therefore uses the budgetary process to allocate some resources for the provision of public goods E. Nketiah-Amponsah

17. Distribution Function • Is the process by which distribution of income and wealth are adjusted to conform to what society considers a “fair” distribution. • The market mechanism may not lead fair distribution of income and wealth. • Hence the government uses the budgetary process to redistribute incomes and wealth E. Nketiah-Amponsah

18. Stabilisation Function • Through this function, the government is to maintain high employment, a reasonable degree of price level stability, and an appropriate rate of economic growth. • Full employment and price stabilization do not come about automatically in a market economy • Hence the government uses the budgetary process to stabilize the economy. E. Nketiah-Amponsah

19. Conflicts Of Functions • There are instances where the government in an attempt to achieve one function end up worsening another function. • For example, the allocation of more resources to social goods may lead to destabilization of prices etc (i.e. conflict between allocation and stabilization functions) E. Nketiah-Amponsah

20. Positive And Normative Analysis • Public finance deals with public policies, therefore it is important to understand what economics analysis can contribute to determining what is a ‘’Good Policy’’ • To better analyze the effects of government/public policies on citizens, one need to distinguish between Positive Analysis and Normative/Value Judgment Analysis. E. Nketiah-Amponsah

21. Positive Analysis • Positive analysis involves determining what the consequences of a policy will be (i.e. it effects on resources allocation and income distribution) • Positive analysis deals with measurable or observable outcomes of a policy. for example, if one wants to know how minimum wage law affect unemployment. He/she will be doing positive analysis • Positive analysis of policies consists of proposition about the effects of policies. It deals with proposition that can be tested with respect to both their underlying logic and empirical evidence E. Nketiah-Amponsah

22. Normative Analysis • Knowing the consequence of a policy is not sufficient to determine that it is desirable • There is the need for value judgment/normative analysis to determine whether the consequence of a policy is desirable • Normative analysis is nonscientific (i.e. it cannot be proven to be right or wrong by facts or evidence • Normative analysis investigates what the best policies are, and aims to provide a guide to good governance. They are based on value judgments. • To determine whether the consequences of a policy is desirable or not, it is necessary for each person to make subjective judgment (value judgment) • Value judgments are non-scientific and cannot be proven right or wrong by facts or evidence. • Examples of normative analysis are whether the level of pensions should be indexed to average wages or whether a minimum income guarantee should be provided. E. Nketiah-Amponsah

23. Positive Analysis Some tools of positive analysis. How do we objectively measure government performance? Role of Economic theory: Observe, form hypothesis, test hypothesis (through continued observation, measurement and experiments), confirm hypothesis repeatedly and you have theory In establishing relationships among economic variables, such as the effect of personal income tax on labour supply or unemployment, the relationship may be overstated or understated since there may be other variables that have effect on say labour supply. Economic theory helps to isolate a small set of variables that are important in influencing behavior (ceteris paribus assumption) Theory helps us to organize our thoughts about how people react to changes in their economic environment

24. Positive Analysis Methods of empirical analysis. empirical work is important Helps in determining magnitudes of key economic indicators. Normally, three types of empirical strategies are considered Personal interviews Asking individuals how government policy influences their behavior subjective, hard to interpret Experiments: Social and laboratory experiments Ethical issues, self selection, etc Sample size Econometrics (Statistics) Statistical analysis of economic data to help infer the effects of various policies. ‘Torture the data and it will confess’ Theories could be very hard to test.

25. Tools of Normative Analysis The most prominent framework/tool used by Public Sector economists is welfare economics (recall our first lecture in this class) To evaluate the alternative economic situations we need some criterion of measuring social welfare which requires some ethical standard and interpersonal comparisons, both of which involve subjective value judgments Various criteria have been suggested over time: Growth of GNP/GDP, Bentham’s criterion, Cardinalist Approach and Pareto Optimality inter alia This course emphasizes the Pareto Efficiency criterion, which is widely used in welfare economics Pareto Improvement: Any change in allocation that makes at least one person better off without making anyone worse off. Pareto Optimum: An Allocation where no further pareto improvements are possible Society always wants to be at a pareto optimum.

26. Summary • There are two main views on the existence of government • Organic and mechanistic views • Market failure exist under the following conditions: • Public goods, externalities, information asymmetry, risk and uncertainty etc. • Possible causes of government failure includes: • Pursuit of self interest, electoral pressures, imperfect information etc • The budgetary process has three basic functions • Allocation function • Distribution function • Stabilization function • Positive and Normative analysis are need to determine the effect of a public policy E. Nketiah-Amponsah

27. Summary • There are two main views on the existence of government • Organic and mechanistic views • Market failure exist under the following conditions: • Public goods, externalities, information asymmetry, risk and uncertainty etc. • Possible causes of government failure includes: • Pursuit of self interest, electoral pressures, imperfect information etc • The budgetary process has three basic functions • Allocation function • Distribution function • Stabilization function • Positive and Normative analysis are need to determine the effect of a public policy E. Nketiah-Amponsah

28. Exercise • Pick the 2012 Budget Statement of Ghana and identify two(2) actions of Government that are intended to perform the allocation function of the budgetary process. E. Nketiah-Amponsah