Public EconomicsPrinciples and Practice

Peter AbelsonApplied Economics

and University of Sydney

Public Economics: Subject Outline: 10 Parts

• 1. Nature of Government

• 2. Markets and Government

• 3. Economic Evaluation and Policy

• 4. Public Choice

• 5. Building Economic Foundations

• 6. Public Supply of Goods and Services

Public Economics: Outline (Cont.)

• 7. Public Finance and Taxation

• 8. Taxation in Practice

• 9. Social Welfare and Income Redistribution

• 10. Multi-Government Systems

Public EconomicsPrinciples and Practice

Part 1:Nature of Government

Peter AbelsonApplied Economics

and Sydney University

Chapter 1 Foundations of Public Economics

• Introduction to Issues

• Government and the State

• General Functions of Government

• Economic Functions of Government

• Historical Perspective

• Public Policy and Principles of Economic Analysis

Introduction to Issues

• The defining attribute of government is power

• The mixed economy

• When and how should government intervene in the

economy?

• Examples of topical public policy questions

• Fundamental questions: what are objectives and

roles of government?

Government and the State

• State and government defined • Figure 1.1: Typical Institutions of Government

• Role of Constitution and Bill of Rights

• Government consists of three main branches

• Budget and non-budget sectors

• Statutory authorities are also part of the public sector

• Government and the public sector

• Constraints on power of government

Typical government institutions

The ConstitutionRules of the State

Bill of Rights

Head of StateInternational Laws

Legislature Executive J udiciary

Houses of Parliament Prime Minister / Cabinet Higher Courts

Military PolicePublic

AdministrationStatutory

AuthoritiesPublic Trading

EnterprisesLowerCourts

General Functions of Government

• Organic and mechanistic views of the state.

• Libertarians, Conservatives, Social

Democrats, Socialists.

Various views of role of government

Economic Functions of Government

• Economics is the study of the use of scarce resources to maximise the welfare of the community

• For model of economy: see Figure 1.2

• What is the role of government:- in production and exchange?- in distribution?

The economic process

ResourcesInputs

ProcessesMeans

OutputsGoods and Services

OutcomesWelfare

Internationaltrade

Political institutionsLabor, Capital

Natural resourcesTechnology

Factormarkets

Product marketsPublic supply of

goods

Market goodsPublicly provided goods

Environmental goodsHousehold goods

Market incomeNon-market income

Distribution of incomeIndividual liberties

Internationaltrade

Efficiency of markets

• The efficiency of willing trades and markets

• The power of the ‘invisible hand’: prices and incentives create efficient outcomes.

• Households get the goods they want at least cost. The First Theorem of Welfare Economics.

• But efficient markets require laws of contracts, property and security.

Economic roles of government

• Despite the invisible hand, three sets of issues:

1. Inefficient allocation of resources - market failures

2. Unequal distribution of income

3. Macroeconomics - instability

These establish potential roles for government.

Economists’ views of economic functions over 200 years

• Adam Smith and J.S.Mill: more than laisser- faire • Changes in views:

– early twentieth century: increasing government – after 2nd World War: 1945-80 more government– since 1980: public choice theory, less government

• Recent changes: Globalisation– And growth– And GFC – Global Financial Crisis

New Views of Role of Government

• Globalisation and growth– More cautious views on role of government.

What matters is not only what government does, but also how well it does these things

• GFC– Causes– Effects– Policies

• National macro-economic imbalances

• Low interest rates led to excessive and unsustainable borrowing (debt / leverage)

• Securitisation of poorly understood assets

• Failures of credit agencies

• Failures of government regulators

GFC Causes

GFC Effects• Asset bubble prices burst

• Credit squeeze

• Whole process thrown into reverse– Public de-leveraging through asset sales– Spending of firms squeezed, employment falls, lower

sales of firms, further asset sales, self-reinforcing process

– The deleveraging cycle much faster than the original leveraging cycle

– Sand castle collapses in less time than it takes to build!

• Clean up credit mess and get credit channels open again

• Fiscal stimulus

• Avoid excessive national imbalances

• Monetary policy should target credit and asset prices in future

• Increase regulation of financial markets

GFC Policies

Public Policy and Principles of Economic Analysis

Four public policy questions

1. What are the objectives?

2. What are the options?

3. What are the implications of each option?

4. Which is the preferred option?

Positive and normative economics

• Positive economics: explains how an economy works. Explanations are true or false

• Normative economics deals with how an economy should work. Involves subjective opinions.

• Questions 1 and 4 are normative.

• Questions 2 and 3 are positive.

• What can economic analysis provide?

Seven economic principles and the public sector

1. Scarcity, choice and opportunity costs apply to private and public sector

2. Trade is the basic means of extracting gains from markets

3. Incentives matter (explain behaviour) in the public sector as in the private

4. Price theory and the core concepts of demand and supply apply even when there are no prices.

Seven economic principles (cont.)

5. Principles of efficient production opportunity cost, division of labour apply to public production as to private

6. Markets are powerful forces of demand and supply: Governments should generally work with markets

7. Aim to maximise social welfare subject to constraints. This implies that social marginal benefit should equal social marginal cost

• The principles of economics apply equally to actions of government as to the private sector

Summary • Key attribute of government is power

• Government includes all services financed through the budget. Public sector includes PTEs.

• Dominant (Western) view of state is mechanistic and individualistic • Fundamental economic role of government is to establish

institutions and rules so markets work

• Other key functions: – Allocating resources when there are markets failures – An acceptable income distribution, – Macroeconomic management

Summary

• Economic analysis includes normative and positive economics

• Governments may act distributively to change the outcomes of market and so raise social welfare.

• However, basic principles of economics apply to actions of government as to actions of the private sector.

• Principles of demand and supply and role of markets are essential to understanding and assessing consequences of public policies.

Chapter 2 Government in Practice

• Legal Basis of Government

• Measures of Government Size

• Government Regulation

• Government Expenditure and Revenue

• Government Budgets: Deficits, Debt and Assets

• International Comparisons

• Determinants of Government Expenditure

Legal Basis of Government

Commonwealth of Australia Constitution Act 1900

• Monetary policy – Commonwealth exclusive power

• Taxation – Commonwealth and states may levy income tax

• External trade and excise taxes– Commonwealth has exclusive control

• Trade between states to be free

Legal basis of government (cont.)

• Uniform law for commerce across Australia• Labour markets – Commonwealth can intervene if

across states• Redistribution of public monies to the states –

discretionary after transition arrangements• Redistribution of public monies to individuals – 1946

referendum increased Commonwealth powers

• Note: almost all changes have increased powers of central government.

Size of Government

• Size is most often measured by general government expenditure (GGE) as % of GDP

• GGE = expenditure on goods and services and transfer payments financed through annual budget. It excludes expenditures by PTEs except for subsidised components.

• In Australia, GGE/GDP in 2007-08 = about 31% (see Table below).

• Note distinction between expenditure on goods and transfer payments.

General Government Expenditure in Australia in 2007-08

2007-08 $ billion % of GDPExpenditure on goods and services

Current expenditure 200.1 17.7Capital expenditure 19.3 1.7Total 219.4 19.4

Transfer paymentsSubsidies 16.2 1.4Personal benefits 87.2 7.7Interest payments 15.1 1.3Other transfers 30.0 2.7Total 133.5 11.8

Total general government expenditure 352.9 31.2GDP 1132.2

Source: ABS Cat. 5204.0, Table 30

Alternative measures of size of government

• Government expenditure on goods and services / GDP

• GGE + PTE capital outlays / GDP

• Total government employment / total employment

• Total tax revenue / GDP

Government as regulator

• Regulations can have more impact on resource allocation than public expenditure.

• Regulations include price and quantity controls, import controls, product standards, labour market regulations, environmental standards.

• Expenditure substitutes: coerced private expenditures, eg. Super, workers compensation

• Tax concessions: have similar effect to expenditures, eg, family tax credits or allowances

Government Expenditure and Revenue: Trends

More expenditure trends

Source: ABS Cat. 5204.0

0

4

8

12

16

20

24

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

% G

DP

Final consumptionexpenditure

Social benefits in cash to residents

Interest payments

Capital expenditure

General Government Consumption Expenditure by Function

2007-08, $billion Commonwealth State and local Total Government % of total expenditureGeneral public services 7.1 9.5 16.7 8.3Defence 18.6 0 18.6 9.3Public order and safety 1.7 14.8 16.4 8.2Education 8.0 29.6 37.5 18.8Health 24.1 33.0 57.0 28.5Social security and welfare 12.0 5.4 17.4 8.7Economic services 5.9 16.5 22.4 11.2Other 2.8 11.3 14.1 7.0Total final consumption expenditure 80.1 120.0 200.1 100.0

Source: ABS Cat. 5204.0, Table 35

Sources of General Government Revenue

2007-08, $billion Total government % of total revenueTaxation revenue 340.5 82.7Sales of goods and services 34.8 8.4Grants and subsidies received 1.5 0.4Interest received from public non-financial corporations 0.1 0.0Interest received from public financial corporations 2.6 0.6Interest received from other 3.8 0.9Other receipts 28.5 6.9Total 411.8 100.0

Source: ABS Cat. 5504.0, Table 30

General Government Taxation Revenue2007-08, $billion Commonwealth State and local Total government % of total revenue

Taxes on incomeIndividuals 128.0 128.0 36.7Enterprises 78.6 78.6 22.5Non-residents 2.0 2.0 0.6Total 208.6 208.6 59.8

Employers payroll and labour taxes 0.4 16.0 16.4 4.7Taxes on the provision of goods and services

General taxes (sales taxes) 1.1 1.1 0.3Goods and services tax (GST) 44.4 44.4 12.7Excises and levies 24.3 24.3 7.0Taxes on international trade 6.1 6.1 1.7Taxes on gambling 4.9 4.9 1.4Taxes on insurance 4.3 4.3 1.2Total 75.9 9.2 85.0 24.4

Taxes on the use of goods and performance of activitiesMotor vehicle taxes 6.4 6.4 1.8Other 0.6 0.6 0.2Total 6.9 6.9 2.0

Taxes on propertyLand taxes 4.3 4.3 1.2Municipal rates 10.2 10.2 2.9Taxes on financial and capital transactions 15.5 15.5 4.4Other 1.0 1.0 0.3Total 31.0 31.0 8.9

Other 0.8 0.8 0.2Total taxation revenue 285.7 63.1 348.8 100.0Percentage of total (%) 81.9 18.1

Source: ABS Cat. 5506.0, Tables 1,19

Government Budgets: Deficits, Debt and Assets

Key budget concepts• Accrual and cash accounting

– Expenses– Revenue

• Net operating budget (NOB): operating revenue minus operating expenses including depreciation

• Net capital investment (NCI): capital expenditure on new assets less depreciation

• Overall budget balance = operating revenue minus operating and capital expenses = NOB – NCI

Australian Budget: 2009-2010

Budget figurea Basis $ billion Comments

Total revenue Accrual 290.6 Includes all current revenues

Total expenses Accrual 338.2 Effective (real) operating espences

Net operating balance (NOB) Accrual -47.6 The real operating balance

Net capital investment (NCI)b Accrual 5.5 Capital expenditure - depreciation

Fiscal (budget) balance Accrual -53.1 The net lending balance = NOB - NCI

Underlying cash balancec Cash -57.6 (Underlying) fiscal balance on a cash basis

Headline cash balance Cash -59.8 Includes financial purchases and sales

(a) Excludes GST revenues and equivalent payments to the states(b) Net capital investment is the net acquisition of non-financial assets(c) Underlying cash balance excludes expected Future Fund earnings Source: Treasurer, Budget Strategy and Outlook, Table 3, Statement 3, Budget Paper No. 1, p. 3-9.

Key balance sheet conceptsAssets/liabilities Definition/components

Assets Are controlled and provide future economic benefits

Financial assets Cash, advances paid, investments, loans, other financial assets

Non-financial assets Land and fixed assets, equity in PTEs, other non-financial assets

Total assets Financial plus non-financial assets

Liabilities Amounts owed to other parties

Financial liabilities Deposits held, advances received, borrowing

Other liabilities Unfunded employee entitlements, other provisions

Total liabilities Financial plus other liabilities

Net measures

Net public debt Financial liabilities less financial assets

Net financial liability Total liabilities less financial assets excluding PTE equity

Net public worth Total assets less total liabilities

Balance sheet trends

0

10

20

30

40

50

60

70

80

90

100

% G

DP

Net debt

Net worth

Source: ABS Cat. 5204.0

GGE / GDP by country

International Comparisons

• Australia at low end of GGE/GDP ratios.

• This reflects mainly low transfer payments rather than low expenditures on goods and services

• Reasons include income targeting, demographic structures, mandated private expenditures, and tax concessions.

• Australia traditionally a relatively regulated economy. Possibly less so today.

Explaining Government Expenditure

• The basic equation: goods (g), welfare payments (w) and other transfer payments (OTP).

• Drivers are quantities and unit costs.

• Economic and political determinants

Economic determinants of government expenditure

Four main economic variables:

1. Quantity of consumption goods demanded

2. Unit costs of government consumption goods

3. Quantity of transfer payments

4. Unit costs of transfer payments

• Capital formation and interest payments are not generally significant in Australia.

Determinants of government expenditure: economics and politics

• Demand and supply framework

• Increased demand for goods (1) does not appear to be a major factor

• Increased unit costs (Baumol hypothesis) more political than economic

• Increased quantity of welfare payments partly socio-economic

• Increased dollar value of welfare payments political.

• Summary: political factors appear more important than economic ones.