Public finance

There are four elements of public finance to be considered:

  1. Public expenditure
  2. Taxation
  3. Public sector net borrowing
  4. Public sector net debt

Public expenditure

Expenditure by central and local government can be categorised into three distinct types:

  • Current expenditure: This is the day-to-day expenditure on goods and services, e.g. salaries of teachers, nurses and drugs used by the NHS
  • Capital expenditure: This relates to expenditure on long term investment projects, such as new hospitals and roads
  • Transfer payments. These are payments that are made by the state to individuals in the form of benefits where there is no production in return.

The objectives of public expenditure include the provision of public goods, defence and internal security; the provision of goods and services which yield external benefits and/or where there may be information gaps and asymmetric information, for example health and education; the redistribution of income; and expenditure to deal with external costs such as pollution, and waste.

Analysis of pubic expenditure

The following synoptic issues arise when considering public expenditure:

  • Given the amount of pubic expenditure is likely to be restricted in any one year, then an increase in one area will involve an opportunity cost
  • Increasing expectations relating to healthcare and education are associated with real incomes, so it could be inferred that demand for these services is income elastic
  • An increase in public expenditure represents an injection into the circular flow of income and so will have a multiplier effect on GDP. Not only will aggregate demand increase but expenditure on areas such as eduction, infrastructure and health may cause an increase in LRAS.
  • Part of public expenditure might be used for dealing with external costs.
  • Public expenditure could result in government failure, where government involvement causes a net welfare loss

In addition, there is the issue of crowing out, which might result from increased public expenditure. This might take two forms: resource and financial. Resource crowding out occurs when the economy is operating at full employment and an increase in public expenditure results in insufficient resources being available to the private sector. Financial crowding out is when increased borrowing or tax cuts are funded by increased private sector borrowing, so increasing the demand for loanable funds and driving up interest rates.

The size and pattern of public expenditure

Factors influencing the size and pattern of government expenditure include:

  • The level of GDP: incomes increase, the demand for many government provided services such as health and education rises more than proportionately because demand for them is income elastic.
  • The size and age distribution of the population: an increase in the size of the population (e.g through immigration) is likely to place extra pressure on public services, while an ageing population will increase demand for medical services and social security for the elderly.
  • Political priorities: the Labour government placed a particular emphasis on improving the quality of health and education services
  • Redistribution of income: expenditure on those in relative poverty and those will disabilities has increased significantly in recent years. For example, there has been an increase in means-tested benefits such as family tax credits and pensioner’s credits.
  • Discretionary fiscal policy: the credit crunch has led to the ressurection of fiscal policy as a means of managing the economy
  • Debt interest: the massive increase in fiscal deficits from 2008 is leading to sharp rises in public sector debt. In turn this will result in higher interest payments on the national debt.


Taxes may be divided into two types: direct and indirect. Direct taxes are those levied on income and wealth and the tax burden cannot be passed onto anyone else. Indirect taxes are those levied on expenditure.

The main direct taxes are income tax, corporation tax, and capital gains tax, while indirect taxes include VAT, excise duties and tariffs.

There are three broad categories of taxes: progressive, proportional and regressive.

  • Progressive: proportion rises as expenditure increases.
  • Proportional: proportion constant as income increases.
  • Regressive: proportion declines as expenditure increases.

Analysing the effects of taxation

While analysing the effects of taxation, the following synoptic issues should be considered:

  • An increase in taxes may represent a leakage from the circular flow and so would have a downward multiplier effect in GDP
  • An increase in direct tax on a product would cause a leftward shift in the supply curve, The incidence of tax on producers and consumers depends on the PED.
  • Indirect taxes might be applied to products that cause external costs.
  • An increase in indirect taxes could cause inflation via a wage-price spiral. For example, if VAT is increased, prices rise. This could be inflationary if it results in workers demanding higher wages to compensate for the increase in prices.

A more detailed consideration of tax changes is given below:

The net effect of a change in income tax rates

If income tax rates are changed there will be a variety of effects on an economy. Given the increase in fiscal deficits and national debts of many countries, its seems likely that taxes will be raised. For example, in the UK, there will be a 50p income tax rate from April 2010, and a rise of VAT to 20% was implemented in 2011. Higher income tax rates could have the following effects:

  • Income distribution: the tax system is more progressive, making income distribution less equitable
  • Incentives to work: May create significant disincentives.
  • Tax revenues: Depends on placement on Laffer curve.
  • Level of economic activty: cause fall in disposable income. Reduction in propensity to consume, so less consumption.  Fall in AD. Disincentives of tax may cause shift in AS to left.

An increase in VAT could have the following effects:

  • On income distribution: regressive tax. Income distribution less even
  • Incentives to work. May cause people  to work harder so that they can maintain their standard of living
  • Tax revenues: Raising indirect taxes would increase tax revenues to the government so ling as the demand for products and services affected is price inelastic.
  • Rate of inflation: an increase in VAT will raise the price of most goods and services. If workers and trade unions respond by demanding wage increases to compensate for price rises, then an inflationary wage-price spiral could result.
  • Level of economic activity: a rise in VAT would act as a leakage from the circular flow, increased by the multiplier. The real incomes would fall, so causing a fall in AD. Costs would rise leading to a fall in AS.

Public sector borrowing and debt
Public sector net borrowing or fiscal deficit

Public sector net borrowing is the difference between public expenditure and tax revenue.

The PSNB is significant for the following reasons:

  • Excessive borrowing could be inflationary because AD would be increasing
  • Public sector net debt must not exceed 3% to meet the criteria of entry to the Euro
  • Taxen as a percentage of GDP given an indication of the size of the state sector relative to the whole economy. This might have some significance for foreign direct investment (FDI), since high taxes may act as a deterrent.
  • Until 2009, borrowing could only be for capital expenditure over the course of the by business cycle to meet the requirements of the Golden Rule.

Public sector net debt

PSNB, formerly known as the national debt, is the culmative total of past government borrowing.

  • To meet the sustainable investment rule, this should not exceed 40% of GDP and to meet the conditions of entry to the Euro it should not exceed 60% of GDP.
  • As with the PSNB, the absolute size of the PSND is less significant than its size relative to GDP, because this provides an indication of how readily it can be serviced.
  • Until 2007, the PSND was below 40% of GDP, but the global financial crisis had a massive effect. In 2008, it rose to 47% of GDP and is currently at 60%.

Do large national debts matter?

Some argue that, if the money is being used to finance improvements of infrastructure and other capital projects, then a large PNSD might be justified because it would keep increasing a country’s future productive potential, so making it easier to repay in the future. However, certain problems may arise:

  • There is an opportunity cost for future generations: interest payments on the national debt mean that less money will be available for public services.
  • Crowding out: if the increasing size of PSND is an indication of the increasing size of the public sector, resource or financial crowding out may occur
  • Danger of inflation: if the rising PSND has been caused by successive PSNB deficits, then there is a danger that inflationary pressures will develop, since injections will be rising relative to leakages.
In the long run, future governments might be forced to raise taxes and cut public expenditure so that the national debt can be reduced.

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