PUBLIC • FINANCE IN-THEORY AND-PRACTICE

FIRST 'CANADIAN'EDITION

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Richard A. Musgrave H.H. Burbank Prof~ssor of Political Economy. Emtritus

Harvard Univt'rsity

Adjunct Prof~ssor of Economics University of California at Santa Cru:

Peggy B. Musgrave Professor of Economics

University ofCalifornia 01 Santa Cruz

Richard M. Bird Prof~ssor of Economics

Uniwrsity of Toronto

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Cbap4er I Fuca! FURCtions: All Ovaview J

most European countries. The modem "capitalist" economy is thus a thoroughly mixed system in which public- and private-sector forces interact in an integral fashion. The economic system can be viewed as neither public nor private. but involves a mix of both sectors.

Subject of. Study

This volume deals with the economics of the public sector. including not onJy its financing but its entire bearing on !he level and allocation of resource use•• well as on the distribution of income IIDOOg consumers. Althougb our subject-maner is traditionally referred to as public finance, it thus deals with the real as weU as the financial aspects of the problem. Moreover, it cannot be a matter of "public" economics only. Since the public sector operates in interaction with the private, both sectors enter the analysis. Not only do the effects of expenditure and tax policies depend upon the reaction of the private sector. but the need for fiscal measures is determined by how the private sector would perform in their absence.

Notwithstanding this broad view. we shall not deal with the entire range of economic policy but limit ourselves to that pan which operates through the rtl'~nue

and apnu/iture measures of the public budget. Other aspects. such as the regulation of competition through the courts. the operation of public enterprise. and the conduct of monetary policy, are only minor budget items. but of great importance as in­struments of economic policy. Yet. we shall deaJ with them only where they are associated with the economics of budget policy. The term "public sector" as used here thus refers to the budgetary sector of public policy only.

Modes of Analysis

In an analysis of the public sector. various types of questions may be asked. They include the following:

1. Wbal criteria should be applied when one is judging the merit of various budget policies? 1. What are the responses of the private sector to various fiscal measures. such IS tall

and expenditure changes? 3. What arc the social. political. and historical forces which have fonned the shape oC

present fiscal institutions and which detennine the Connulation of contemporary fiscal policy?

Question I asks how the quality of fiscal institutions and policies can be evaluated and how their performance can be improved. The answer requires setting standards of "good" performance. Corresponding to the analysis of efficient behaviour of households and firms in the private sector. this calls for a type of economics which. in professional jargon, is referred to as .•welfare economics." Its application to the public sector is more difficult. however, because the objectives of fiscal policy are not given but must be determined through the political process. Moreover. objectives oC efficiency in resource use must be supplemented by coosiderations of equity and distributional justice. thus enlarging the sphere of "nonnative" analysis.

Question 2 must be asked if the outcome of alternative policies is to be traced. If the merits of a cOl]X>C3tion profits tax or of a sales tax are to be judged. one must know who will bear the final burden, the answer to which in tum depends on bow

tIw: private sector responds to the imposition of such taxes. Or if aggregate demand is to be i:Dcreased, one must know what the effects of the reductioo in taxes or

iocrease in public expenditures wiU be, effects which once more depend upon the magnitude and speed of responses by consumers ..firms in the private sector, Analysing the effects of fiscal measures thus involves what bas been referred to as "positive" economics-i.e .• the type of economic'analysis which deals with pre­dicting, 00 the basis of empirical analysis, bow finmlDd consumers will respond to economic changes and with resting such prediai<m-empiricalJy.

Question 3 likewise involves a "positive" ~.mg4n this case why the fial behaviour of governments is what it is. This notooly is a matter of economics but also includes a wide range of historical, politieal. and social factors. How do inIierest groups try to affect the fiscal process, aad how do legislators respond to such pressures? How are the fiscal preferences of voters detenn.ined by their income and their social and demographic characteristics, and bow does the political process. in fact, serve to reflect their preferences?

Need ror Publk Sector

From the normative view, why is it that a public sector is required? If one stans witb the premises, generally accepted in our society, that (I) the composition of OOIpUt should be in line with the preferences of individual consumers and that (2) there is a preference for decentralized decision-making. why may not the entire ecooomy be left to the private sector? Or, putting it differently. why is it that in a supposedly private enterprise economy, a substantial part of the economy is subject to some form of government direction, rather than left to the "invisible hand" of mnet forces?

In part, the prevalence of government may reflect the presence of political and social ideologies which depart from the premises of consumer choice and decen­tralized decision-making. But this is only a minor part of the story. More important, there is the fact that the market mechanism alone cannot perform all economic fuDctioos. Public policy is needed to guide, correct, and supplement it in cenain

respects. It is important to realize this fact since it implies that the proper size of the public sector is. to a significant degree, a technical rather than an ideological issue. A variety of reasons explain why this is the case, including the following:

1. The claim that the market mechanism leads to efficient resource usc (i.e,. produces what consumers want most and does so in the cheapest way) is based on the condition of competitive factor and product markets. This means that there must be no obstacles to free entry and that consumers and producers must have full marltet knowledge. Government regulation or other measures are needed to secure these conditions.

2. They are needed also where. due to decreasing cost. competition is inefficient, 3. More geoenlly. the contractual arrangements and exchanges needed for market op­

eratioo cannot exist without the protection IIld enforcement of a governmentally pro­vided legal sttueture.

4. Even if the legal structure were provided. aod all barriers to competition were removed. the production or consumption characteristics of certain goods are sucb that these goods cannot be provided for through the market. Problems of "externalities" arise which lead to "market failure" and require solution through the public sector,

~ 1 Fiscal Functions: An Overview S

S. Social values may require -eljustments in !he dilittibution of income and wealth which results from the market s)'5lem and from the trmsmi&Sion of propeny rights through inheritance.

6. The market ~, especiaIJy in a highly develcped financial economy, doei DOl

necessarily bring bigh employment, price level stability, and the socially desired rate of economic gowth. Public policy isoeeded to secure Ibese objectives.

7. Public and private pOints of view 011 the rate of discount used in the valuation of future (relative to present) consumption may differ.

As we shall see later 00, items 3 through 7 are of particular importance in evaluating budget policy.

To argue that these limitations of the market mechanism call for corrective or compensating measures of public policy does DOl prove. of course. that any policy measure which is undertaken will in fact improve the performance of the economic system. Public policy, no less than private policy, can err and be inefficient. and the basic purpose of OUT study of public finance is precisely that of exploring how the effectiveness of policy fonnulation and application can be improved.

Major FUDdions

Although particular tax or expenditure measures affect the economy in many ways and may be designed to serve a variety of purposes. several more or less distinct policy objectives may be set forth. T'bcy include:

1. The provision for social goods. or the process by which total resource use is divided between private and social goods and by wbicll the mix of social goods is chosen. This provision may be termed the allocation function of budget policy. Regulatory policies. which may also be considered a pan of the allocation function. are not included here because they are not primarily a problem of budget policy.

2. Adjustment of the distributioo of income and wealth to assure conformance with what society considers a "fair" or "just" state of distribution. here referred to as the distribution full€tion.

3. The use of budget policy as a means of maintaining high employment. a reasonable degree of price level stability. and IJ) appropriate rate of economic growth, with allowances for effects on trade and 00 the balance of payments. We refer to all these objectives as the stabilization function.

B. The AUocation Function

We begin with the allocation function and the proposition that certain goods­referred to here as social as distinct from private good~annot be provided for through the market system. i.e., by transactions between individual consumers and producers. In some cases the market fails entirely. while in others it can function only in an inefficient way. Why is this the case?

Social Goocb and Market Failure

The basic reason for market failure in the provision of social goods is not that the need for such goods is "felt" collectively, whereas that for private goods is felt

6 PIrt I IRtrododion

individually. While people's preferences are influenced by their social eoviroomcnt. in the last resort wants and preferences are expmeoced by indiv1dua.ls and not by society as a whole. Moreover. both social and private goods are included in their preference maps. Just as I can rant my prefe1eOCeS aiDODgbousing and blckyard facilities. so I may also rank my preferences amoftg my private yard and my use of public paries. Rather. the difference arises because the benefits to which social goods give rise are DOC limited to one particular consumerwbo purchases the goods. as is the case for private goods. but become avaiiabJe.o others IS wen.

H I consume a.bamburger or wear .. pair of shoes..... particular products will not be available to other individuals. My and their consumption stancl in • rival relationship. This is the situation with private- goods. But DOW consider measures to ~uce air poIllItion. If a given air quality improvement ii obtained, the resulting gain will be available to all who tnathe. In other words. conswnption of such products by various individuals is "ooo-rival" in the sense that one person's pac­taking of benefits does not reduce the benefits available to others. To put it differ­ently. the benefits derived by anyooc's consuming a social good are "externalized" in that they become available to all others. This is the situation with sociaJ goods. In the case of private goods, the benefits of consumption are "internalized" with a particular consumer whose consumption excludes consumption by others.

The market mechanism is well suited for the provision of private goods. It is based on exchange. and exchange can occur only where there is an exclusive- title to the property which is to be exchanged. In fact, the market system may be viewed as a giant auction where consumers bid for products and producers sell to the highest bidders. Thus the market furnishes a signalling system whereby producers are guided by consumer demands. For goods such as hamburgers or pairs of shoes this is an efficient mechanism. Nothing is lost and much is gained when consumers are excluded unless they pay. Application of the exclusion principle tends to be an efficient solution.

But not so in the case of social goods. For one thing. it would be inefficient to exclude anyone consumer from partaking in the benefits. when such paniciparion would not reduce consumption by anyone else. The application of exclusiou would thus be undesirable. even if it were readily feasible. Furthennore. the application of exclusion is frequently impossible or prohibitively expensive. Gains from air­cleaning measures cannot readily be withheld from particular consumers. street­lights shine upon all woo pass by. and so forth. Given these conditions, the benefits from social goods are not vested in the prt>perty rights of certain individuals. and the market cannot function. In other instances, such as provision of sewer lines. fees can be charged and the government can function on a market basis.

But where the benefits are available to all. consumers will not voluntarily offer payments to the suppliers of social goods. I will benefit as much from the con­sumption of others as from my own, and with thousands or millions of other consumers present. my payment is only an insignificant pan of the total. Hence. no voluntary payment is made. especially where many consumers are involved. The linkage between producer and consumer is broken and the government must step in to provide for such goods.

7 Cbapler I Fiscal Funttians: An Overview

Public Provision for SodaI Gaods

The problem, then. is how the government should detennine how much of such goods is to be provided. Refusal of volunWy payment is not the basic difficulty. The problem could be solved readily, at least from the theoretical point of view. if the task were merely one of sending the tax collector to those coosumers to whom the benefits of social goods accrue. But matters are not this simple. The difficulty lies in deciding the type and quality of a social good that should be supplied to begin with and how much a particular consumer should be asked to pay. It may be reasonable to rule that the individual shooJd pay for the benefits received, as in the case of private goods, but this does not SOIve·the problem; die difficulty lies in finding out how these benefits are valued by the recipient.

Just as indivldual consumers have no reason to offer voluntary payments to the private producer, so they have no reason to reveal to the govellUllCnt how highly they value the public service. if I am only one member in a large group of consumers, the total supply available to me is not affected significantly by my own contribution. Consumers have no reason to step forward and declare what the service is truly worth to them indivlduaIJy unless they are assured that others will do the same. Placing tax contributions on a voluntary basis would, therefore. be to no avail. People will prefer to enjoy as "free riders" what is provided by ochers. A different technique is needed by which the supply of social goods and the cost allocation thereof can be detennined.

This is where the political process enters the picture as a substitute for the market mechanism. Voting by ballot must be resorted to in place of dollar voting. Since voters know that they will be subject to the voting decision (be it simple majority or some other voting rule), they will find it in their interest to VOle so as to let the outcome fall closer to their own preferences. Thus decision-making by voting becomes a substitute for preference revelation through the market. The results will not please everyone, but they wiJ) approximate an efficient solution. They will do so more or less perfectly, depending on the efficiency of the voting process and the homogeneity of the community's preferences in the matter. I

National and Local Sodal Goods

Although social goods are available equally to those concerned, their benefits may be spatially limited. Thus, the benefits from national defence accrue nationwide while those from street-lights are of concern only to local residents. This suggests that the nature of social goods has some interesting bearing on the issue of fiscal

'This summary of the a1~ function oversimplifies mancrs in various respccu. Two major qualifications. to be noted ill !be later discussion. are:

(a) It is unrealistic to think of all goods as being divided into those which are privatc and those whicb are social. The ~ of externalities and tbe social-goods problems to which they give rise are I maner of degree. and many goods carry both characteristics. Your eduatioo. for insllDCC. will benefit not only yOll (we !lope) but also others.

(b) In some instances. government decides to interfcre with consumer prcfcrcllCC$. Cenain goods may be considered meritorious (milk). whereas others arc considered hannful (liquor). so that one is subsidized while the ocher is taxed. This practice does not fit into the above framework and requires further cxplanation. See p. 70.

centralization. As we sballsce in Chapter 23. a good case CIIl be made for letting national public services be provided by national government and local pubUcSClVices by local sovemmeot.

PubIk Prcmsioa ftI'SUS PublIc Produdloa Before coosidc:ring bow such public provision is to be arranged, a clear distinction must be drawn between public provision for social goods, as tbeterm is used here, and public p1'tJdfletion. These are two distinct and indeed umdatcd cooccpCS which should DOt be confused with each other.

Private goods may be produced and sold to private buyers either by private firms. as is nonnaUy done, or by public entetprises. such as public power and transportation authorities or the nationalized British coal industry. Social goods, such as spaceships or military hardware, similarly may be produced by private firms and sold to government; or they may be produced directly under public management, as are services rendered by civil servants or municipal enterprises. H we say dlat social goods are provided publicly, we mean that they are financed through the budget and made available free of direct charge. How they are produced does DOt matter.

This distinction is brought out in the estimates of Table I-I, where the total product of the Canadian economy is broken down according to (I) wbetbcr the goods and services are purchased privately or provided through the budget (cor­responding roughly to our distinction between private and social goods), and (2) whether they have been produced publicly or by private firms. We find that only 18.6 percent of total production is in the public sector (line 4, column ill), while 23.1 percent of output is provided through the budget (line 9, column 11). We also note that 60.7 percent of social goods are produced publicly (line 4, column U). while only 5.9 percent of private goods are produced publicly (line 4. column n. Finally. 75.6 percent of public production consists of social goods (line 7, column 11) as against 11.2 percent of private production (line 8. column m. In short, production in Canada is undertaken almost entirely in the private sector, although social goods constitute a substantial part of total output. and the existing public production is very largely for the provision of social goods. Public production for sale (public enterprise) plays only a minor role.

A similar analysis for other countriesl shows that Canada ranks low in me public production share, as does the United States. The share rises as we move to the United Kingdom and Sweden, where public enterprise is more important. It becomes much larger in the case of socialist economies such as the U.S.S.R.• where the bulk of production is by public enterprise. But one also finds that the share of total output going into social goods differs much less. This is true even with regard to the U.S.S.R.• provided that investment in public enterprise is excluded and that the comparison is limited to final goods. It is thus evident that the decision whether to allocate resources to social goods or to private goods is quite different from the decision wbdber to produce any good (private or social) in a public or a private enterprise. A socialist economy. in which most production is public. may produce largely private goods, while a capitalist economy. where all production is private.

1See Richard A. Musgrave, Fiscal Systnru, New Haven. Conn.: Yale. 1969, chap. 2.

TABLE J.J Forms of Productioa and Types Of Goods. Canada, 1981

priYtzte/y Goods hvvided PwdttDetl Goods dtroIIglt Bwlgrtr (PriwJk Goods) (SocitJI Goods) TOlQ/

(/} (//) (II/)

I. Public producttoft. bilI.iocs of dollars 15.41 47.72 63.1

2. Private productioo. biIIioos ofdoUan 245.8 30.91 1:76.7

3. T()(a). billioas of doIJars 261.2 78.6 339.114 ... Pelcenra8e pablidy produr;:ed 5.9 fIJ.7 18.6 S. Pelceofage privuely

produced 94.1 39.3 81.4 6. Percentage. bod! forms 100.0 100.0 100.0 7. Percentage of public

production 24.4 75.6 100.0 8. Percentage of private

production 88.8 11.2 100.0 9. Percentage of local

production 76.9 23.1 100.0

IEstimated value added by federal aDd provincial gOvernmeDl enterprises from Statistics Canada. FiNJncioJ Suuislics of FeJkraJ Go~nI Enluprisa. CaWogue 61-203. Table I. IIId StatiIUcI Canada, Provir.cial Gormurttnl ElIl~rpris~ F~. Catalogue 61-204, Table I.

ZWages. salaries, aDd supplcmcuwy labour income at aU levels of gOVClllID:Ill. Statistics CanIda, NazUHlaJ1_ tJNl ~1IdiJ/luAtXOfUUS, CaWogue 13-201. Table 49. 'Govcrumeul expendilUJeS OIl goods and servi<:e$ adler Iban wages. SWistics Canada. National 11K~ and ~rrdi1llnAcc:OU7IIs. Catalogue 13-201, Table 49.

<Equals GNP.

may produce a larger share of social goods. In fact. provision for social goods poses much the same problem in the capitalist (private finn) as in the sociaJist (public enterprise) setting. In both cases, it is difficult to detennine how such goods are valued by consumers. At the same time, provision for social goods requires taxation. which may interfere with incentives. As explained later. this may be more damaging in the capitalist than in the socialist setting. 3

c. The Distribution Function

The allocation function of securing an efficient provision of social goods poses the type of problem with which economic analysis has traditionally been concerned. but the problem of distribution is more difficult to handle. Yet. distribution issues are a major (frequeotJy the major) point of controversy in the detennination of public policy. In particuJar. they play a key role in determining tax and transfer policies.

lSee p. 87.

.e _odDctioaPIll I

DetenDIBaIdI.,:IHIa......

In the abIJeace of policy measmes to adjust the prevmling state of'distribution, the distribution' of income and wealth depeDds' first of aU on the distributioo of factor eudowIneDti. Earnings abilitia differ,,:. does the owoersbip of inheriled wealth. The diitributioo of income, based 00 Ibis disttibution of factor endowments, is then deterntiDed-by the process-of factor pricing;- which, in a competitive market, sets factor returDs equal to the value of the marginal product.' The distribution ofincome IIDIODt iDdividuals thus depends on 1hCir' factor supplies and the prices which- they fetch. tb& market.

ThiI:di.uibution of income may or may not be in line witbwbatsociety ~ f.air « just. A distinction must be drawn between (I) the priDcipJe tbIt cfficierit factor use requires factor inputs to be valued in line with competitive factor pricing, and (2) the proposition that the distribution of income among families should be fixed by the marlcet process. Principle 1 is an economic role that must be observed if ~ is to be efficient use of resources, be it in a market economy or in a planned economy. Proposition 2 is a different matter. For one thing, factor prices as de­termined in the market may not correspond with the competitive norm. But even if all factor prices. including wages and other returns to personal services, were determined competitively, the resulting pattern of distribution might DOt be ac­ceptable. It involves a substantial degree of inequality, especially in the distribution of capital income; and though views on distributive justice differ, most would agree that some adjustments are required, if only to provide an adequate floor at the bottom of the scale.

OptImal DistributIon

This being the case, one must consider what constitutes a fair or just state of distribution. Modem economic analysis has steered shy of this problem. The essence of modem welfare economics has been to define economic efficiency in terms which exclude distributional considerations. A change in economic conditions is said to be efficient (i.e., to improve welfare) if, and only if, the position of some person, say A, is improved without that of anyone else, including B and C, being worsened. This criterion. which may be qualified and amended in various ways, cannot be applied to a redistributional measure wl1ich by definition improves A's position at the expense of 8's and C's. While the "someone gains, no one loses" role has served well in assessing the efficiency of markets and of certain aspects of public policy, it contributes little to solving the basic social issues of distribution and redistribution.

The answer to the question of fair distribution involves considerations of social philosophy and value judgement. Philosophers have come up with a variety of answers, including the view that persons have the right to the fruits derived from their particular endowments. that distribution should be arranged so as to maximize total happiness or satisfaction. and that distribution should meet certain standards of equity,which, in a limiting case, may be egalitarian. The choice among these criteria is not simple. nor is it easy to translate anyone criterion into the corre­sponding "correct" pattern of distribution. We shall encounter these difficulties wben dealing with redistribution policy and again in interpreting the widely accepted

proposition that pecple should be taxed in line with their "'ability to pay." There are two major problems involved in the translation of a justice role into

an actual state of income distribution. FIlSt, it is difficult or impossible to compare the levels of utility which various individuals .derive from their income. There is DO simple way of adding up utilities; 'so thai Cdb;a based on such c:omparisons are not operational. This limitation bas led people .to think in terms of social evaluation rather than subjective utility measurement. The other difficulty arises from the fact that the size of the pie which· is availabJe ·for distribution is DOt unrelated to bow it is to be distributed. We ~.fiod chat redistributioo policies may involve an efficiency cost which must be .Iaken into account wbed one is . deciding on the extent to which equity objectives should be pursued.

Notwithstanding these difficulties, however. distributional considerations have remained an important issue of public policy. Auention appears to be shifting from the traditional concern with relative income positions, with the overall state of equality, and with excessive income at the top of the scale, to adequacy of income at the lower end. Thus the current discussion emphasizes prevention of poverty, setting what is considered a tolerable cut-off line or floor at the lower end rather than putting a ceiling at the top, as was once the popular view.

FlSC8llnstruments or Distribution Policy

Among various fiscal devices. redistributioo is implemented most direcdy by (I) a tax-transfer scheme, combining progresme taxation of high-income with a subsidy to low-income households.· Alternatively, redistribution may be implemented by (2) progressive income taxes used to finance public services, especially those such as public housing. which particularly beoefit low-income households. Finally, re­distribution may be achieved by (3) a combination of taxes on goods purchased largely by high-income consumers with subsidies to other goods which are used chiefly by low-income consumers.

In choosing among alternative policy instruments. allowance must be made for resulting "deadweight losses" or efficiency costs, Le.• costs which arise as con­sumer or producer choices are interfered with. Redistribution via an income tax­transfer mechanism has the advantage that it does DO( interfere with particular consumption or production choices. However. even this mechanism is not without its "efficiency cost." since the choice between income and leisure will be distorted. As we shall see later, an optima) solution might call for a complex mix of taxes and subsidies. However. we shall disregard this for the time being and think of the function of the distribution branch as being met by a set of direct income taxes and transfers. S

While redistribution inevitably involves an efficiency cost. this consequence by itself establishes no conclusive case against such policies. It merely tells us that (1) any given distributional change should be accomplished at the least efficiency cost, and that (2) a need exists for baJaocing conflicting equity and efficiency

"A p'ogr~ssiv~ flU is defined IS one in which the ratio of tall to income rises with income. 'See p. 284.

objectives. Efficiency in the broad sense, i.e., an ~ly conducted policy, must allow for both concerns.

D. The StaNfinfioo FuDdion Having dealt with the bearing Of budget policy on matters of a:Docation and distri­bution. we must now examine its role as III instrument·of macro-ec:ooomic poliCy. Fiscal policy must be desigDecJto maintain or achieve tbe goals of high empJoyment, a reasonable degree of price level stability, soundness of foreign accounts, and an acceptable rate of economic growth.

Need fer·SCabIIJzMIo8 Policy

Fiscal policy is needed for stabi.lizatioIt, sincefuD employment and price level stability do not come about aatomatically in a market economy but require public policy guidance. Without it, the economy tends to be subject to substantial fluc­tuations, and it may suffer &om sustained periods of unemployment or inflation. To make matters worse, unemployment and inflation--as we have painfully learned in recent years--may exist at the same time. To hold that public policy is needed to deal with these contingencies does not preclude the possibility that public policy, if poorly conducted. may itself be a destabilizer. TIle purpose of our study, as noted before, is to see how policy can be shaped more effectively.

The overall level of employment and prices in the economy depends upon the level of aggregate demand, mative to potential Of capacity output valued at pre­vailing prices. The level of demand is a function of the spending decisions of millions of consumers, corporate managers, financial investors, and unincorporated operators. These decisions in turn depend upon many factors, such as past and present income, wealth position. credit availability. and expectations. In any one period. the level of expenditures may be insufficient to secure full employment of labour and other resources. For various reasons, including the fact that wages and prices tend to be downwardly rigid. there is DO ready medwrism by whicb such employment will restore itself automatically. Expansionary measures to raise ag­gregate demand are needed. At ocher times, expenditures may exceed the available outpUt under conditions of high employment and thus may cause inflation. In such situations, restrictive conditions are needed to reduce demand. Furthermore. just as deficient demand may generate further deficiency. so may an increase in prices generate a further price rise. leading to renewed inflation. In neither case is there an adjustment process which assures that the economy is automatically returned to high employment and stability.

Whereas in the decades following the Great Depression of the 1930s fisca1-policy thinking was directed primarily to maintaining a high level of employment. the problems of inflation and capacity growth have become of increasi ng concern since then. As just noted. fiscal policy may be used to resbiet aggregate demand and thereby to combat inflation, but Ibis remedy will work only jf the underlying cause of inflation is excess demand. If inflation is generated from the cost side, demand restriction may cause unemployment rather than check inflation. Moreover. the problem becomes one of halting an inflation spiral that is based on wage responses

'~L' !.~

(

.. ,

to existing and anticipated JD::e iDftation. The ~ of "stagflation" bas Ibus raised doubts about the effectiveness of traditiooal iscal and monetary policy ap­proaches to stabilization.

Moreover, tbe problem ia DOt only ODe.of maintaiDing high employment or of curtailing intlation within a given level of capacity output. The- effects of fiscal policy upon the rate of growth of potential output must also be allowed for. Fiscal policies may affect the rate of saving IDd thcwilliJlgDl::as to iBvest and may thereby influence the rate ofcapitaJ foonation. Capital formation in tum affects productivity growth, so that fiscal policies are a ~gnificant factor in economic growth. This aspect has been given recent emphasis in abe supply-side ecooomics of the early 1980s.

Finally, the task of stabilization policy is. <:omplicated by the fact that economies do not operate in isolation but are linked to one another by trade and capital flows. Policies which affect the level ofdomesticfncome and prices also affect a countIy's exports, imports, and balance ofpayments. This in tum affects the economicposition of other countries. Stabilization policy thus must take into account the complex problems of international policy co-ordination, particularly with the United States, since economic conditions in the United States have far-reaching effects on Canada.

Fiscal IJIstrumenb of Stabilization Policy

The very existence of the fiscal system has an immediate and inevitable influence on the level and structure of demand. Even if fiscal policy was intended to be ,.neutral, ,. it would be necessary to consider" effects on aggregate demand to secure such neutrality. Moreover, changes in budget policy may be used as a positive means of obtaining or offsetting changes in demand.

uverage Effects or a Given Budget Government expenditures add to total (pri­vate plus public) demand, while taxes reduce it. This suggests that budgetary effects on demand increase as the level of expenditures increases and as the level of laX

revenue decreases. Deficits m expansionary and surpluses are restrictive. but even a balanced budget has an expansionary effect.

Changes In Budget PoUcy Discretionary policy measures may thus be taken to affect the level of aggregate demand. The government may raise its expenditures or reduce tax rates if demand is to be expanded and vice versa if it is to be contracted. Depending on the type of expenditure or tax adjustments made. consumption or investment in the private sector may be affected, and the promptness of the ex­penditure response may differ. The policy problem. therefore. is one not only of direction of change but also of selecting the proper type and magnitude of change.

Built-in Responses Not only may changes in the level of public expenditures or laX rates be used to affect the overall level of demand, but changes in the level of economic activity will also affect public expenditures and tax revenue. Thus. the level of expendirure under any given program may vary with economic activity. most obviously in the cases of unemployment benefits and welfare. More important, the revenue obtained from given tax rates will rise or fall with changes in the level

« income or sales subject to taX. Thus, die' fiscal system poslleSlIeS • ·'built-in ftWbiIity" which responds to changes iIJ Ibe economie sceoe. even Iboup no dlanges in policy (changes in tax rates or expenditure Iegislatia&)are made. As we sbaU see later. these built-its responses are helpful under some cireumscaDcet and bnIfuf under odJers. ..

Sell elite PeUdes In addition to chaogea itt the level offtpenditures and receiIMs. ~« fiscal policy may cboosc to",alY their stn.Jcture;·On the expenditufe tide, sdectiYe employment programs may.de8I with UDCIiIpIoyment. public capital for­IIIIIion -may. 00Iltribtfe to growth. aod~sqbsidies may tffect private investment behaviour. On the tax side. incentive provisions may be built into the tax structure. dIc:Ieby affecting private sector behaviour. 'CspecialIy ·investmelll.

~IwUameats

While the market mechanism, if it ~ well, may be relied upon to detenniDe die allocation of resources among privale goods. economists .,ree that it cannot by itself regulate the proper money supply. As Walter Bagebot pointed out • century ago. "Money does DQC control itself." The banking system. if left to its own devices, will not generate just that money supply which is compatible witbecooomic stability, but will-in response to the credit demands of the maIket accentuate prevailing tendencies to fluctuation. Therefore. the money supply must be conuolled by the ccnttal banking system and be adjusted to the needi of the ClCOIlOIDy in terms of bach sbOrt-run stability and longer-run- growth. MoDdaq.poIicy-includiDg the devices of reserve requirements. discount rarest open martet policy, and selective credit controls-is rhus an indispensable compooent of stabilization policy.

Monetary and fiscal policies thus suppJement each other. Anexpansiooary policy may take the fonn of(I) easing credit orof(2) reducing taxes or raising expenditures. just as a restrictive policy may involve the opposite moves. At the same time, the fiscal and mooetary approaches differ in their impact. Changes in cedit conditioos bear most directJy OD the level of private investment. wbile tilt changes tend to bear on consumption. Thus a mix of easy money (permitting high expeod.itwes, particularly investment) and a tight budget (reducing the level of aggregate expen­ditures. particularly consumption) is favourable to ecooomic: powth. Given fixed exchange rates. we sbal.I DO(e that mooetary policy bas a special advantage (due to its effects on international capital movements) in securing balance-of-payments adjustments. while fiscal policy is more effective in dealing with domestic needs. Monetary and fiscal policies. therefore. are Iinkcd by the need fcrobtaining a policy mix which will pennil the pursuit of multiple policy objectives.

Moreover, there is a mechanical link between fiscal and monetary measures. While budgetary imbalance (surplus or deficit, depending OIl the needs of the situation) is an important tool of fiscal policy. this means that the structure of claims. including mooey and public debt. is changed in the process. These "claim effects," with their impact on credit markets and interest rates. are an inevitable by-product of budgetary imbalance. providing an important link between fiscal and monetary policies.

Fiscal and monetary policies thus interact and complement each other in important

ways. But they also suffer from the same weakness. So long u die problems of unemployment and inftation are merely due to • deficie.ocy or excess of agregate dem8IJd, measures aimed at conbOl1ing aggregate demand are likely to be-effective. but they become lcsi so in dea1iug widt stagflation.

E. ~tioDor (;onftid of Functions

It remains to be considered bow the three fui1ctioos of fiscal policy-aJJocation. distribution. and stabilization----an be co-ordiJiated into an overall pattern of budget policy..Here in particuJllr. OUt earlier distinctiOn between anonnative and a de­scriptive (or predictive) viewrL the fiscal process must be kept in mind. While fuUy co-ordinated policy determination would pennit amultaneous achievement of the various objectives. actual pactice falls short of this ideal. Conflicts arise and policy decisions are distorted. .

Co-orcUnatitMt

Consider first the co-ordinated approach as it would proceed under a normative or optimally conducted fiscal ~. In dealing with the analysis of public policy. economists have shown that the number of available policy tools must match the number of policy targets. If the tools are insufficient. a conRict among targets must be accepted. Given our three targets-( 1) provision for social goods. (2) adjustments in distribution, and (3) stabilizalioo.--thr policy instruments are needed to meet them. Let us think of them as tkee separate sub-budgets or fiscal "branches" of an imaginary budget system. eada designed for the implementation of its particular objective.

The manager of the allocation branch will provide for social goods and finance them with taxes imposed in line with consumer evaluation of those goods. The budget will thus be in balance. 'In preparing the budget. the manager wiD assume that the distribution branch has secured the "proper" state of income distribution and that the stabilization branch bas secured full employment.

The manager of the distribution branch will design a tax-transfer plan to secure

the desired adjustment in distribution. For this purpose a full-employmenllevel of income will be assumed. The manager will also assume that the aUocation branch provides for public services financed by taxes imposed in line with consumer evaluation thereof. The sub-budget of the distribution branch will by its very nature be balanced.

The manager of the stabilization branch. finally, will provide for the necessary adjustment in aggregate demand. as required by considerations of stabilization policy. He or she will again proceed on the assumption that the other two branches have met their tasks. By its nature. the budget will consist of either taxes or transfers and thus will most likely be in imbalance. Taxes and transfers used to accomplish

"As we shall note later. there is an imporllnc e_cepcion 10 Ihis rule wbereby ,oosideralions at inlergeneration equity call for loan finlllte of public capital fonnalioo. See p. 642. AllOlher excepcion may arise 10 the CXlCnl eXlenulitics arc lAJlCd Of subsidiz.ed: see. for enmple. the discussion of pricing pollution in Chapccr 33.

Ihe stabilizatioo task may be desiped so as not to interfere with the "proper" distribotion as provided by the distribution branch, i.e., they will be proportional to the "proper" pattern of income distribution.

The reader may wonder bow all this .can be done. since .the respective plans of the three branches are closely interdependent. The answer is that the system may be solved by simultaneous detenni:nation. 7 When the three budgets have beeD de­termined in this fashion. it would be-cumbcnomc 101' administrative purposes to carry out eacb budget separately. Radler. it is convenient to clear the taxes imposed by the allocation branch, the taxes and transfers of the distribution brancb.l and the ~ and transfen of the stabilizatioo brqdr. against ooeanotber and to implanent ooly the resulting net transfen and taxes with regard to eacb person. ·10 addition to these net taxes and transfers, govmunent.must UPdeftake the purchases of prod­ucts or resources needed to provide for the services of the allocation branch.

The combined or net budget may thus be viewed as a composite of the three sub-budgets. It will have a deficit or surplus. depeading on the position of the stabilization branch. Whether the net payment system.will be progressive. propor­tional, or regressive is not obvious. The distribution branch component would tend to make it progressive, but it remains to be seen bow the allocation component will

look.• This system has been spelled out not as a description of the actual budget process,

but to show how the various objectives could be co-ordinated and pursued without interference with one anotber.9 We now turn to the real world of fiscal politics, where the situation is quite different.

ConftJct

The distinction among the allocation, distribution, and stabilization aspects of fiscal policy is helpful not only in separating more or less distinct policy objectives but also as a guide to fiscal politics. In the real-world setting, budget planning frequently does not pennit evaluation of the various policy objectives on their own merits. Individual and group interests clash in their implementation so that achievement of one objective is frequently accomplished at the cc;>st of another. The history of fiscal politics abounds with illustrations of this sort.

AIIocatioo and Distribution Consider first the relationship between allocation and redistribution measures. Although redistribution is accomplished most directly through tax-transfer schemes. it is achieved also by progressive tax finance of the provision for social goods. This is based on an "ability-to-pay approach," by which the distribution of the tax burden is detennined by the ability of a taxpayer to sustain

7JU funher disl:u.ssion. sec Richard A. Musgrave, TM Theory of Pllblic Finonce. New York: Mc:Graw-Hill. 1959. chap. 2.

'Seep.21t. 'While our model bas divided budgel functions inlo duee branches. a more ~ompIell: system mighl suagesl further divisions. In particular. it mighl be useful co separale die maiolcnan<:e 01 high empIOymcrJl IIIId inflation control from die Iongcr-run problem of C<XlnOmic growth. thus dividiJIg the stabilization branch ineo cwo paru. Since groWlh involves die division of cesourccs between caasumplion IIld capicaJ formation. growth policy might also be coosidered an allocation issue.

the _ '. e of iDcome reduction. iadepeDdeut of the mix of social goods supplied and .. benefits- derived therefrom. Because of this, the degree of redistribution tends, MI·cSepend 00 the levels ofpogram.s which are &0 be financed. thus associating ell~ provisioo for social goods -wiJb extensive rcdiSlribution.

n.. JIPPl1*b furtbered the case oftedistributioo when budgets were small and the I 51tional burden could be imposed Gt bigb-income reciplcots. But over time, liS tl I.e inaeased relative fO.DIIional income. additional6nance bad to be drawn more..-.ely from the middle- aod low-mcome groups. thus reversing this effect. In e:iIIiIa"ase, die linbge betweaI ~ .levels and redistribution does DO(

make t« efficiency from a ~'Ye point of ·view. People's attitudes toward rediaaiilW«ioo need not coincide wiIb ·Ibeir preferences for social goods. A person who.-. public services should WJl ba1eto oppose them because be or she dislikes redisujhnrioo. or vice versa. A bebr cboicewill be made, tberef<n. if each issue is taka up on itll merits.

AJlOddoa and Stabilization Now take the relationship between considerations of alloc:ation and stabilization. In times of unemployment. when an expansion of aggregae demand is needed, an increase in government expenditures is often pro­posed at a remedy. Similarly, at times of inflation. when demand is to be restricted, a case i~ made for a reduction in such expenditure.

Once more. this distorts policy-making. While it is proper for social goods to share in a general expansion or reslrktioo of expe~itures, mere is no reason why they should account for the entire or major part of the change. As we have seen, the stabilizing adjustment can also be made through increase or reduction in taxes. or reduction or increase in transfers. while leaving the provision for social goods (appropriate at fulleemployment income levels) unaffected.

Mixing the issues leads to an oversupply of social goods or to wasteful public expenditures when expansion is needed. and to a no-less-wasteful undersupply when restriction is called for. MoreovCT. mixing the issues leads to opposition to expan­sionary fiscal measures by those who oppose high provision for such goods and to opposition to restrictive measures by those who favour high provision of social goods. If the issues are separated, reasonable people may agree on the need for stabilizing action while differing. iD line with their preferences. on the appropriate scale at which social goods are to be provided. The budget debates of the early 19805 show bow these issues are iaratwioed with fiscal politics.

Diltrfbutloa and StabUlzation FiDally, consider the relationship between distri­,,­ bution and stabilization objectives. ID the past it bas been argued during periods of

severe unemployment that lower-income groups should be given greater tax relief, since lhey are likely to spend more oflbeirtax savings than higher-income recipients. The opposite case bas been made in times of inflation. namely that taxes on low­income groups should be raised. since they are more potent in reducing demand than taxes on the higher incomes.

Again. proper stabilization action may be interfered with, or redistributional action !NY be biased, because the two objectives are linked. This is unnecessary since the stabilization adjustment can be made with distributionally neutral taxes­

or, for that matter, any pattern of tax distribuIion-pr only tbal'lhc overall level of laXation is raised or reduced by a sufficicat amount.

DiJIriIHIdaII and Growth Similar problema .. if the growm objective is in­lmOccd. It higher rate of gowtb may call fora bigbcr rate of capital formation. which calls for increased saving and investme8l. Since me marginal propensity to save is -Per among high-income recipients.1bIJl among Iow-iDcome groups. this woaJd seem to call for a regressive tax syslem.. As wesbaIlsce later, d1is conclusion may be miIipecd by taxing COOIUIDptioo rather.. iDcomc, «by ~gODpublic aaviap. A further and more serious cooftict may.me once elfects.of eaxatioD on investmeot inceotives are coosidcn:d. Unless J.-ger re1iance Clft public inve:stmeot is iDtIoduced, a higbee rate of growlh may be in caftict with n:disIributiooot;:lCtives.

As we view these potential cooftiets, il becomes evident that the oormative view of neatly attuned sub-budgets is not a realistic description of lhc fiscal-process. Ralber, it must be understood as a standard againsl which actual performance may be measured and lbe quality of existing fiscal institutions may be assessed.

F, Interaction of Private and Public Sectors

It wiJI be evident from the preceding review that the functions of the public sector differ sharply from those pursued by private households or finns. At the same time. both seeton interact and are linked in the ol'el'llll economic process. This inter­dependence is illustrated in Figure I-I. which presents a Ilighly simplified picture of the circular flow of income and expenditure in the economy. We disregard business saving and the foreign sector and assume that aU tax revenue derives from the income tax. A more detailed view of tax flows is given later 00. 10

Income and Expenditure Flows The solid lines of Figure I-I show income and expenditure flows in the private sector; the broken lines show public sector 80ws. Suppose first that there is no public sector. Moving clockwise along the solid lines, we note how households obtain income through the sale of factors in the factor market (line I), income which is then spent (line 4) or saved Oine 5). Saving in turn finances investment expenditure (line 6). II Lines 4 and 6, combining the purchases of products in the product market. give rise to the ~ipts of finns, which in turn are used for the purchase of factor services.

When abe government is introduced, we note that factors are bought by the public sector (line 2) as well as by the private sector. and that output of private finns is purchased by government Oine 7) as well as by private buyers. In addition to factor and product purchases. the government also makes transfer payments Oine 8). Government revenue in tum is derived from taxes (line 9) and from borrowing (line 10).

10See p. 203.� "For a discussion of whal happens when people wish 1o invest more or less than ochers intend 1o�

save. see p. S29.

,,' . ~

••••••••••••••••••••• •••

i

FIGURE 1·1 The Public Sector in the Economy.

t

I:

,-9 40--­II"':8 -�....-- Houxbolds

3 5

I I r-­II I 21I , I� ..

A� Capital market

I ,I I , I� . FtlCtOr market

ProductI I i 8 mutcet i : 6 II I 1 I� i

FinnsII:I1� ~7'',I t� -- I ~ : I t� 12 I: 1lit 1°1 II: I I 8 L._~ ~":"_J I:GovernmeDl

L L_-_-_-� --~-~ : budget ••••••••••• ~ ••••••••••• :9� --',

As this diagram shows, the private and public sector ftows are closely intertwined. Note especially that the public sector participates as a buyer in both the factor and the product markets. Its operations are thus an integral part of the pricing system. This is why it is necessary, in designing fiscal policies. to allow for how the private sector will respond. Imposition of a tax at ODe point in the system-for instance, at point A or point B-rnay lead to responses which wiU shift the burden to a quite different point. Moreover, the governmenl not only diverts private income to public use, but through factor and product purchases also contributes to the income 80w to households. It is thus misleading to think of the public sector as being "super. imposed" on the private sector. Rather, they are both integral and interacting parts of what in fact is a mixed economic system.

It is hardly necessary to note that Figure I-I gives a highly simplified view of public and private sector interaction. By showing flows at a given level of income we have disregarded the effects of fiscal policies on the level of employment. as well as on productivity growth. All this will be taken up in more detail in Part 6 of this text.

Factor and Product flows Instead of viewing Figure I-I in tenns of income and expenditure flows, one may interpret it as showing the ruJ flows of factor inputs and product outputs. Reversing the arrows and moving DOW in a counter­clockwise direction, lines I and 2 show the flow of factor inputs into the private

111� PIn I lnoodlK1ioa

and public sed(n. respe<:tively. while lines 4, 6, UJd 7 show the ftow of finn outputs to private and government buy~. reapective1y. 12 We must now add dotted line II to show the flow of public: goods and services wtUch are provided free of direct charge to the consumer. 1'bis flow, which bypasses the product marlc:et, is

financed not through sales proceeds but through taxation or through borrowing. Note also that the goods and services which government thus provides (liRe II) are only in part produced by government (based on the factor inputS of line 2); the remainder is privarely produced and sold to govemmeot. as shown in line 7.

G. Summary This chapter, being itself in the form of a summary, can hardly be summarized further. However, the main ideas presented are these:

1.� Modern ~ed capitalist eronomies are in fact "mixed" economies. with one-third or more of economic activity ocCUlTing in the public sector.

2.� For purposes of this book. the term "public sector" is used to refer 10 those pans of governmental cconom.ic policy which fiod their expression in budgetary (expenditure and revenue) measures.

3.� Three major types of budgetary activity are distinguished: namely. (I) the public provision of certain goods and services. refmed to as "social goods"; (2) adjustment

in the state of distribution of iacome and wealth; and (3) measum to deal with unemployment. inflation. and inadequate economic growth.

4.� In discussing the provision of sociaJ goods (the allocaI.ion function). reference is made 10 payment for eenain goods and services through budgetary finance. Whether the production of these goods is under public management. or whether the goods and services are purchased from private firms. is a different matter.

5.� Provision for so-called social goods poses problems which differ from those which arise in COIIDCCtion with private !QOds. The main point of differenu is that social goods teod 10 be ooo-rivaJ in COftSumptioo and that coasumer preferences with regard 10 sucb goods are DOl revealed by COI1SI1IDCr bidding in the market. Therefore. I political process is required.

6.� The pattern of distribution whicb raults from the existing pauem of factOf' endowments

and from the saJe of factor services in the market is DOl necessarily one which 50Ciety considers as fair. Distributional adjustments may be called for. and tax and IranSfer policies offer an effective means of implementing them, thus calling for a distribution function in budget policy.

7.� Tax and expenditure policies affect aggregate demand and the level of economic activity. They are also an important instrument in maintaining economic stability. including high employment and control of inflation. Hence. the stabilization function enters as the third budgetary function.

8.� Fiscal policies may be conducted in centralized or decentralized fashion. with different budgetary functions being more or less appropriate at various levels of governmental activity.

12Since public sector sa1es (the role of public enlerprise) are smaU in the Canadian economy. this item has been omitted in Figure 1·1. We may think of govei'llrncnt enterprises as included IIJldcr private finns.

Cblprer 1 FISCal fimctiorts: All Overview 21

9.� Theoretically. budget policies can be designed so thaI alkx:ation. distribution. and stabilization objectives are accomplished withoul conflict. But in praclice. coofIiclS are frequent and distortions arise.

10.� Although the functions of the public and private sectors differ in imponant respects. the operations of bod! interact in the product and factor markets as we1J as in the income and expenditure ftows of the economy.

Further Readings

Buchanan. J. M.• and M. Rowers: Th~ Public Fi1llJ1Ius. Homewood. III.: Irwin, 1975, parts I and O.

Colm, G.: Essays in Public FiM1lu and Fiscal Polic)'. New York: Oxford University Press. 1955, chap. I.

Musgrave, R. A.: The Theory of Public FiM1lCe. New York: McGraw-Hili, 1959, chaps. 1, 2.

Phelps. E. (ed.): Private Wallls and Public Nuds. rev. ed.. New Yortc W. W. Nonon. 1965.

Pigou, A. c.: A Study in Public FiM1lCe. London: Macmillan. 1928. part I. Stigler. G. F.: The Citizen 01Id the Stau. Chicago: University of Chicago Press. 1975. chaps.

I, 2.5.

Appendix: Public Sector in the National Income Accounts

Since the national income accounts offer the most comprehensive frame of reference in which to view the economy, it is helpful to understand the role of governmenl items in these accounts. This is shown in Table I-AI for 1984. For this purpose. federal. provincial. and local governments are combined inlO one public sector.

Public Sector in GNP

j The gross natiooaJ product may be looked upon as the aggregate of expenditures on currently produced outpUt. Government contributes to these expenditures through its purchases of goods and services.

t� Total Share

As shown in items 4 and 1 of Table I-AI, such purchases are a major component of the GNP, with 25 percent of total output purchased by government. Looked at from the other end. 25 percent of goods and services are not paid for directly when received by users but are provided free of direct charge and are paid for indirectly through the government budget. While not all these goods can be strictly classified as "social goods" (as we shall use the term in Chapter 3), we may nevertheless record the fact that one-quarter of total output is based on budgetary provision.

In examining how this provision fits into the economic structure. we now inquire how government purchases are divided between (1) purchases of factors and pur­

1.6

TABU I-AI Compositioo IIId Uses 0( Cmadi. Gross National Product, 19&4 (ill BilJiau of Do/JIIn)

I. Pmoaal expenditure Oft COlISlIIDCl' JOOds and setYica 247.1 2. Orosa capital bmIIioD· by basiRess 68.3 3. Ndexpons 4. OOVERNMEN'T CURRENT EXPENDITURE 90.8

5. WI3C pllymeMS 61.3 6. Purcbases of JOOds IIId ieI'Vices 29.6 7. GOVERNMENf CAPITAL FORMATION 14.3 8. GroG NaIQW ProdIIet 422.1 9. - Capital ~ a1IoInDces 51.7

10. - INDlRECTTAXES LESS SUBSIDIES 44.2 II. Net DIIliooaI iDcome at factor C05I 362.2 12. - DIRECT TAXES ON ENrERPRISES 15.~

13. + GOVE:RNMBNf TRANSFERS TO PERSONS 55.1 14. + INTEREST ON ll{E PUBUC DEBT 33.2 15. - GOVERNMENT INVESTMENT INCOME 27.8 16. - Other eamiIlas DOt pUd om to persons --2:.! 17. PmonaI iucome 362.1 18. - PERSONAL TAXES 72.0 19. Disposable persouI iDcome 290.1 20. - PenooaI expeoctitures and ttansfers 251.8 21. PmooaI saving 38.3

NotQ: ~ iICIII5 lie 5boq ia tapilallett.en. Uocs 2 to 7 iDchIde n1ue of physical dlanae ill iD¥ClIfOrics. LiDe 13 includcs capital assistance mel current transfers from lIOll-residents. LiDe 16 is DC( of a portioo of iDterest 011 COIlSlllDel' delle. LiDe 18 iDcludes odIef direQ nnsfen 10 govmuDelIl.

Sotu«: StaIiUi<:5 Canada. NGtioItoJ llICVfIIe IJItd Ex,HNlitItn AccDIDIU 1970-1984. c.laJopc 13-201. reproduced wiIb permis5ico of !be Minister of Supply mel Services.

chases of products. (2) provision for consumption and provision for investment, and (3) provision to consumers and provision to finns.

Pun:base of Factors venus Purchase of Prodadl

The first distinction does not appear directly in the national income accounts. but is approximated in Table I-AI by equating governmental factor purchases with public sector wage payments. Such compensation amounted to over two-thirds of current government purchases. the remainder being the purchases of products from private finns. Thus. govemmeot assumes the role of producer for about two-thirds of the current goods and services which it provides through the budget.

ProvisioD lor ConsumptioD venus Investment

TIle second distinction is between consumption and capital fonnation. Government capital formation (item 7 ofTable I-AI) in J984 was 14 percent of total government purchases of goods and services and 3 percent of GNP. Private sector capital formation constituted 22 perceut of total private activity. 16 percent of GNP, and 83 percent of all capital formalion.

Chapter I FISCal FWlCtioM; AD 0Yerview 13

~ to Coosumen nnua Provision to FirmI

The division of publicly provided goods and services between final goods supplied to consumers and uiDeermediate goods" supplied to firms does not lend itself readily to statistial detcrminIdon. A substantial part of highway expenditures, ofmunicipal services, aod of developmental outlays are in the intennediate good category, Le., they are grants which reduce (he cOS( of production for private firms rather than going d.im:t.ly to the private consumer. 13 At least part of education outlays also belong in this category. Some intermediate goods are of the current service type (police proeection for firms), whereas others are of the investment type (roads). A rough estimate for the 19708 is that, excluding defence.. close to half of !Ovemment purchases are of the intermediate type.'"

Public Sector in National Income

In moving from GNP to net nalional income at factor cost, depreciation or capital consumption allowances, including depreciation on government assets, are de­ducted, as are indirect taxes less subsidies. Indirect taxes, such as sales taxes, are deducted because they reduce the amount available for disbursement to factors. with national income defined as the swn of factor incomes. IS For similar reasons, subsidies to business firms are added, !be impact being the same as that of negative taxes.

Since national income reflects the total of private factor earnings, it may be broken down into income derived from. or "originating in," the government and the private sector. 16 The bulk of income originating in government is in the form of wages and salaries pili<! by government; i.e .• it is equal to the share of government purchases used for factor rather than product purchases. In 1984. such payments ~ualled 17 percent of national income.

PubUc Sector in Personal Income

Moving from national to personal income. we again encounter a number of gov­ernment items. of wbich some divert from. and others add to, income available at the personal level.

"See p. 155. ''Calculaled from R. M. Bini, FilttDtciltg CanadUm Gov~mm~nt: A Qllmtlilari,'~ Ov~rvir.<', Toronlo:

Canadian To. Foundation. 1979, pp. lOS. 115. ''One difficulty willi this treatmePl is !bat in the Canadian Ralional income and expendilW'e KCOWIts.

indirecl !&Xes iDcIude property lUes. about balf of which are derived from l'C$idences and should 1101 be included in !his put of !be ICCOUIlIS. Ralher. Ibese !axes should be deducted aJong with income laX when moving from penoaaJ 10 disposable income.

'6Other ilems included in the transitioll from gross national product 10 nalional income do DOt involve government. They are business lJlIn5fer paymeolS and the statistical discrepancy. which recoociles the estimatioll of the ICCOWIU from the product and lhe income sides.

First, direct taxes on enterprises (item 12 of Table I-A I) are deducttrl. 17 Gov­ernment transfer payments are !ben added. They largely involve family IDowances, unemployment insurance benefits, old age pensions, and similar social insurance and welfae payments. Government investment income, which includes profits remitted from government business enterprises, is then deducted. Next. interest 00

the public debt is added. Such interest is treated as a transfer payrnenlllDll excluded from national income because for the most part it was incurred to fiaance past government expenditure and beoce does DOC constitute a paymenl for the production of cwmJl goods and services. The aervicc which is rendered by the boodholders. and for which they must be paid, it significant for stabilization policy, 11 but it does Dot enter into current output. Debt issued by private business. on the oIbcr hand, goes to finance capital used in lhe process of production, and interest ~ such debt reflects the factor earnings which accrue to the capital which this debt finances. It is thus included in the value of total output (GNP) as in the factor payments which comprise national income. 19 Finally, earnings not paid out to persoos (such as undistributed corporation profits) are deducted and some other minor adjustments made to obtain personal income.

Personal income. finally, nay again be broken down into the part received from payments by government and the part received from private disbursemeots. For 1984, the government share (equal to government wages plus interest aad transfers to persons) was 41 percent. Reflecting the important role of transfer payments, this is a substantially larger share than that of nationaJ income originating ill the public sector.

PubUc Sector in Disposable Income In moving to disposable income, personal tax payments (item 18 of Table I-A I) must be deducted. These amount to 20 percent of personal income. Personal taxes include both employee and employer contributions to social insurance and pension funds. In effect, employer contributions are treated as a form of supplementary labour income received by employees and then transferred 10 government as a tax.

Proceeding to the uses of disposable income (item 19), no further budget items appear, since all taxes have been deducted in advance and since public enterprise sales to consumers are included in consumption. along wilh private sales.. Disposauie income as defined in the accounts, however, falls shon of a person's real income. in addition to the cash earnings that are reflected in an individual's disposable income, real income also includes the free provision of public services by govern­ment, and if such real income were included on the income side. p~ic services would become an important item of income use.

17"fheTe is some question as 10 why business wes should be dedIKled when moVing fIom gross naliooal prodlKt 10 national income. while the corporation profits laX is deducled wllm moving from the latter to personal income. See Richard A. Musgrave. Th" Th"ory of Public FiJrona. New York: McGraw-Hili. 1959. p. 198.

'"Sec p. 648. 19'fbe exclusion of governmenl inleteSl from GNP is analogous. however. to the lreal1llC1ll of inlerest

on consumer debl in the privale sector. which is ellcluded for similar reasons.