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CHAPTER 1
INTRODUCTION
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Defining the Field of Study

“Public Finance is nothing else than a sophisticated
discussion of the relationship between the individual
and the estate. There is no better school of training
than public finance.” Former Czech Prime Minister, Vaclac Klaus.

This book is about the taxing and spending activities of a
government, subject usually called public finance.

Public Finance – the field of economics that analyzes government
taxation and spending policies. Therefore, some authors prefer the
label: Public Sector Economies or Public Economies.

The resources for all government expenditures ultimately must
come from the private sector.
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Defining Public Finance

Public finance may be defined in a general
term "as being concerned with the manner in
which public services are provided.

However, this definition is not clear in
determining the activities of public finance.

This is because there are various criteria that
may be used to confine the framework of
public finance which lead to different
definitions such as:
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Defining Public Finance
1.
2.
3.
4.
The source criterion, which means goods and
services provided through government budget are
public services.
The goods criterion, which means that all nonmarketable goods and services are considered as
public services such as defense and justice.
The consumption criterion, which means that all
collective consumption goods and services are
considered as public services.
The price criterion, which means that free or
subsidized goods and services are considered public
services.
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Public Finance and Ideology

Views of how government should function
in the economic sphere are influenced by
ideological views concerning the relationship
between the individual and the state.

Political philosophers have distinguished two
major approaches:
Organic view of government
Mechanistic view of government
1.
2.
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Organic view of government

Society is a natural organism, each individual is part of the
organism, and the government is the heart of the organism.

In an organic view of sociology, individuals are valued only
by their contribution to the realization social goals. These
goals are determined by the government.

Individuals are important only as part of the society, and the
good of the individual is subordinate to the good of society.

Society or community is above the individual. The objectives
of a society are set by government.
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Organic view of government

The problem is who is to represent government.
• Platon: realization of perfect rationality.
• Hitler: realization of racial purity.
• Lenin: realization of socialism

Social objectives can be distinguished, and the most important
thing is how to choose the objectives of the society.

Still, in spite of the many philosophers, it is not clear what is
natural.
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Mechanistic view of government

Government is not an organic part of society. Rather, it is a
contrivance created by individuals to better achieve their
individual goals.

Government is a contrivance erected to further individual
goals. It is not clear how the government can reconcile
sometimes conflicting individual goals.

At the centre of attention is the individual, not the group, not
the society.

Government exists for the good of the nation, but the problem
is what is good and how government should achieve it.
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Mechanistic view of government

Government is trust and state servants are
trustees, and trust and trustees have been
created for the wellbeing welfare of the
nation.

General consensus: it is good for individuals
when government protects them from violence,
for which reason it must have the power of
coercion, otherwise there will be anarchy.
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Continue …

Adam Smith (Wealth of Nations, 1776) “government should protect a society
against violence and the assaults of other independent societies… and every
member of the society against injustice and oppression from any other
member of the society.”

However, J. S. Mill held that “the only reason for which a government should
use its power to coerce any member of society against his will is to prevent
him injuring others.”

But what is injury to others, and how great must this injury be to justify the
use of state coercion?

The minimum that government should provide is protection and the
infrastructure necessary for the life of society (lighthouses, roads, bridges,
sewers etc.)
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Within mechanical view we
distinguish

Within mechanical view we distinguish:

Liberals, libertarians – for a very limited government and
against any economic role for government.

Social democrats – for the good of the individual, considerable
government intervention is required (benefits to the
unemployed, subsidies for shipbuilding...).

There is no hard and fast division, rather a sliding scale of view
about the necessary scope of government intervention.
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liberal – what is that





Classic liberals - government is legitimate, but alas it oversteps
its boundaries and hence we must be watchful over what
government is doing.
Libertarians – government is not a servant of society that
sometimes errs, rather it is its enemy.
Classic liberals argue for a limited government, for laissez for
laissez faire in combination with a limited but still active
government.
American liberals are on the whole into race and gender
orientation and abortion, while British liberals are really social
democrats.
USA liberals/libertarians – Republicans (Bush and Reagan)
versus the democrats (Clinton, Obama) – taxes, redistribution,
privatization.
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The View Point of the Book

The mechanistic view of government has come to dominate
Anglo-American political thought. However, its dominance is
not total.

The tension between society and the individual is inevitable.

The mechanistic view does not by itself provide us with an
ideology that tells us whether any particular economic
intervention should be undertaken.
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Government at glance

The Legal Framework: Constitution, laws, sub-laws and regulations.

Constitution of Republic of Croatia – entrepreneurial and market
freedoms are the basis of the economic organization of the Republic of
Croatia.

The government makes sure that all enterprises have equal legal status on
the market. The abuse of the monopolistic positions defined by law is
forbidden.

Government encourages economic development and the welfare of the
local governments and takes care of the economic development of all of
its regions.

Rights acquired by the investment of capital cannot be diminished by law
or any other legal instrument.
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…continue

Constitutional and statutory restrictions to government spending, deficits
and public debt.

Division responsibilities for levy taxes and collect revenue

Statutory defined responsibilities for borrowing (E.g. public
debt shouldn't exceed 60% of GDP).

Balanced budget, borrowing only for capital expenditure funding.

Unitary and complex/federal states.
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The role of government

We can be against state intervention as much as we like, but we have to
understand the circumstances in which we live.

For several centuries, there has been an ever increasing degree of complexity in
legislation, regulations, taxation, public services...

It is in vain to expect any considerable reduction in the role of government,
indeed, I am afraid that government intervention and regulation might become
much worse (Victoria Curzon-Price on the EU).

In spite of the tempting and logical thesis that government is actually unnecessary
and that we might live in either anarchy or spontaneous order, it is hardly
worthwhile urging the abolition of government or the state – or indeed of
constantly testing out its legitimacy (Friedrich Hayek – The Road to Serfdom).
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The Size of Government

How to measure the size of government?


Number of workers
Annual expenditures

Types of government expenditure




Purchases of goods and services
Transfers of income
Interest payments
Budget documents


Unified budget: Government itemizes its expenditure in a
document referred to unified budget.
Regulatory budget: The cost imposed on the economy by
government regulations be published in an annual regulatory
budget.
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The size of government

How to measure the size of government?
1.
Measurement via annual expenditure
Purchase of goods and services
Size of transfers (social and subsidy)
Payment of interest
Expenditure of general government
Inflation-adjusted expenditure
Government spending per capita
Government spending as proportion (%) of GDP
2.
3.
4.
5.
6.
7.
8.
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The size of government

All common measures of the size of
government- employees, expenditures,
revenues, etc.- involve some deficiency. In
particular, these items miss the impact of
regulatory costs.

Nevertheless, there is strong evidence that the
impact of the government on the allocation of
national resources has increased over time.
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The expenditures of government

The expenditures of government can go for:
1.
The national defense.
Social security.
Medicare.
Public welfare activities.
Payment of interests on debt.
2.
3.
4.
5.

Entitlement Programs: Governmental programs with
cost determined not by fixed dollar amounts but by the
number of people who qualify.
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The revenues of government

The revenues of government:
1.
Tax
2.
Loans
3.
Changes in real value of debt.
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Changes in the Real Value of Debt

Inflation Tax:
When the government is a debtor and the price
level increases, changes in the real value of the
debt may be an important source of revenue.
E.g. increased inflation reduces the real value of
your debt. (Read example on P.#14).
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State, Local, and Federal Government
to
AdjustingRelative
for
Expenditures (selected years)
Adjusting for
Economy
Inflation
Population
1
2
3
4
2005 Dollars
(billions)*
2005 Dollars
per capita
Percent of
GDP
1960
Total
Expenditures
(billions)
123
655
3,627
24.3%
1970
295
1,201
5,858
28.4%
1980
843
1,749
7,679
30.2%
1990
1,873
2,574
10,289
32.2%
2000
2,887
3,237
11,461
29.4%
2005
3,876
3,876
13,066
31.1%
*Conversion to 2005 dollars done using the GDP deflator
Source: Calculations based on Economic Report of the President, 2006
(Washington, DC: US Government Printing Office, 2006), pp.
280,284,323,379
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Figure 1.1: Government expenditures as a percentage of
Gross Domestic Product (2005, selected countries)
0.6
0.5
0.4
0.3
0.2
0.1
United
States
0
Sweden
France
Germany
United Kingdom
Canada
Japan
Australia
Source: Organization for Economic Cooperation and Development [2006]. Figures are for 2005.
Figure 1.2: Composition of federal expenditures (1965
and 2005)
100%
90%
Note increase in
Social Security,
Medicare and
Income Security
80%
70%
Other
Net interest
60%
Note
Social security
decline in
Defense
Income security
50%
Medicare
Health
40%
Defense
30%
20%
10%
0%
1965
2005
Source: Economic Report of the President [2006, p. 377].
Figure 1.3 Composition of state and local expenditures
(1965 and 2002)
100%
90%
80%
Increase in
public
welfare
Decline in
highways
70%
60%
Other
Public welfare
50%
Highways
Education
40%
30%
20%
10%
0%
1965
2002
Source: Economic Report of the President [2006, p. 383].
Figure 1.4: Composition of federal taxes
(1965 and 2005)
Social insurance
and individual income
tax have become
more important
Corporate and other
taxes have become
less important
100%
90%
80%
70%
60%
Other
Social insurance
50%
Corporate tax
40%
Individual income
tax
30%
20%
10%
0%
1965
2005
Source: Economic Report of the President [2006, p. 377].
Figure 1.5: Composition of state and local
taxes (1965 and 2002)
100%
90%
Individual tax
more important
80%
Other
70%
Grants from
federal
government
Corporation
tax
60%
50%
Inidividual
income tax
40%
Sales tax
30%
Property tax
20%
10%
Property tax
less important
0%
1965
2002
Source: Economic Report of the President [2006, p. 383].
Doing Research in Public Finance

Public Finance journals






International Tax and Public Finance
Journal of Public Economics
National Tax Journal
Public Finance
Public Finance Quarterly
General-interest journals





American Economic Review
Journal of Economic Perspectives
Journal of Political Economy
Quarterly Journal of Economics
Review of Economics and Statistics
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Doing Research in Public Finance

Other sources






Journal of Economic Literature
Brookings Institution’s Studies of Government Finance
Congressional Budget Office reports
National Bureau of Economic Research working papers
Tax Foundation’s Facts and Figures on Government Finance
U.S. Government Printing Office publications





Statistical Abstract of the United States
Economic Report of the President
Budget of the United States
U.S. Census of Governments
Historical Statistics of the United States from Colonial Times to 1970
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Doing Research in Public Finance

Public Finance data available on internet

Resources for Economists on the Internet

U.S. Census Bureau

University of Michigan’s Office of Tax Policy
Research

Urban-Brookings Tax Policy Center
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