MODULE:ECU 08606 PUBLIC FINANCE

• ACADEMIC YEAR:2023-2024

• SEMISTER II

• BACHELAR DEGREE IN ECONOMICS AND FINANCE:

YEAR III-BBF3

• MODULE FACILITATOR: VALENTINA PLACID CHIDI

 Topics covered in this module

1.Concepts of Public Finance. ( in government provision)

2. Market failure and the rationale for government intervention.

3. Knowledge on control of government failure

4. Concepts of Government expenditure in economy

5. Knowledge on Welfare Economics

6. Cost-benefit analysis in decision making

7. The Framework for Tax Analysis in Tanzania

 1.0. The subject matter of public finance
And overview on fiscal function
Explain subject matter of Public Finance

Explain Fiscal Functions of Government

Explain different attitude towards government

Distinguish between normative and positive economics as tools of public finance

1.1The meaning of public finance

(i) The subject that deals with the economics of the public sector. It concerns with
financing activities, allocation of resources use as well as the distribution of income
in the society.

(ii) The economy that is owned and controlled by the government.

(iii) Is the part of macroeconomics which deals with public expenditure and public
revenue

(iv) It’s the branch of economics dealing with taxing and spending activities of
government.
Cont.

(v) In a conclusion we can say is the subject which deals with the roles of the
government in the economy. It analyzes actual policies and develop guide lines for
government activities.

• Public finance will ensure efficiency and equity in the program and activity of the
government by providing information and knowledge on how the government
spends the taxes they are collecting
1.2. The branches of public finance
1. Public Revenue, which deals with the method of raising funds and the principles
of taxation, canons and justification of taxation, the problem of incidence and
shifting of taxes, effects of taxation, Thus, within the purview of public revenue,
we take up the classification of public revenue, etc.

2. Public Expenditure, which deals with the principles and problems relating to the
allocation of public spending. Here we study the fundamental principles governing
the flow of public funds into different channels; classification and justification of
public expenditure; expenditure policies of the government and the measures
Cont.

3. Public Debt/ borrowing, which deals with the study of the causes and methods of

public loans as well as public debt management.

4. Government budget. Which deals with the budget allocated to different sectors of
the economy, surplus budget, deficit budget, and balanced budget. etc
1.3. Economic / Fiscal Functions of Government

i. Allocative function: Certain goods, social or public as distinct from private

goods cannot be provided for through the market system. In some cases market
fails entirely while in others it can function only in inefficient way.

ii. Distributive function: Among various fiscal devices, redistribution is done most
directly by a tax, transfer scheme and progressive income tax system .
Cont.

iii. Stabilization function: As an instrument of macroeconomic policy, budget or

fiscal policy may be designed to maintain or achieve the goals of high employment,
reasonable degree of price stability, soundness of foreign reserve and acceptable
rate of economic growth. (full employment and price stability do not come about
automatically in a market economy, but require public guidance).
Cont.

iv. Regulative and Coordination function: Government regulation has four main
purposes: unfair advantage of workers prevents business from taking advance of
consumer ignorance, Protecting consumers-effect of the economy on citizens
(pollution, externalities). Promoting competition-creating and anti-trust laws (no
monopolies).
1.4. Public Finance and Attitude towards Government

When public finance economist develop guideline for government activities, are
influenced by attitudes toward.

• The role of government in society;

• The relationship between the individual and the state.

Political philosophers have distinguished two major approaches.

Cont.
1. Organic View:

Society is conceived as a natural organism. Each individual is part of this organism,

and the government can be though as its heart. The individual has significance only
as part of the community, and the good of the individual is defined with respect to
the good of the whole. Thus, the community is stressed above the individuals.

The goals of the society are set by the state, which leads society towards their
realization. Because societal goals can differ, a crucial question is how they are to
be selected.
Cont.

2. Mechanistic View:

In this view, government is not an organic part of society. Rather, it is a contrivance

created by the individuals to better achieve their individual goals. The individual
rather than the group is at the center.

Accepting that government exists for the good of the people, we are still left
with problem of defining

• What good is and

• How the government should act to promote it.

1.5. Tools of Public Finance

1. The tools of economics includes:

(1) Positive economics

(2) Normative economics

1. Positive economics

Is a body of systematized knowledge concerning what is, was, will be ( depends on

facts). It describe how the circumstances occur.
Cont.

• The ultimate goal of a positive economics is the development of a theory or

hypothesis that yield valid and meaningful.

• If one examines economics in the light of this statement, one finds that a part of
economic science studies the economic phenomena as they exist, find out the
common characteristics of economic events, specify cause and effect relationship.
Cont.

• The dual tasks of economists are to explain how the economy works.

• In principle, positive analysis does not require value judgments, because its
purpose is descriptive. Positive economics is objective, free of value judgments, it
describes how system works and it can be tested against the facts.
Cont.

(2) Normative economics/ Regulatory science

• Is a body of systematize knowledge relating to criteria of what out to be and hence depend

on value judgement as to what is good or bad. It concerned with ideal as distinguished from

the fact/ actual. It state how the circumstances should occur.

• This examine real economic events from moral and ethical angles and to judge whether

certain economic events are desirable or undesirable. It involves value judgment.

Cont.

• It primarily deals with economic goals of a society and the policies to achieve
these goals. It also prescribes the methods to correct undesirable economic
happenings.
Cont.
• Determine whether or not it’s producing good result. Normative analysis on the
other hand, requires an ethical framework, because without one, it’s impossible to
say what is good or bad. It’s subjective and the aim is not to reveal the facts, e.g
measuring utility among people

• Although some time it’s difficult to keep the positive and normative from getting
entangled, most economics agree that the distinction is worthwhile.
1.6. Importance (Significance) of Public Finance:

There is great socio-economic significance of public finance, both in developed and

developing countries.

1. In developed countries,

• Price-stability and

• Full employment are the main economic goals of public finance.

Cont.

2. In developing countries,

• Rapid economic development through capital formulation and creation of

infrastructure are the important goals of public finance operations.

• Socially equitable distributions of income,

• Reduction of inequalities in income are some important functions of public

finance operations.
1.7.The importance of public finance can be clarified from
the following functions. (general)

i. To Increase the Rate of Saving and Investment: Most of the people spend their
income on consumption. Saving is very low so the investment is also low. The
government can encourage the saving and investment.

ii. To Secure Equal Distribution of income and Wealth: Unequal distribution of

income and wealth is the basic problem of the under developed countries. The
rich are getting richer and richer while the poor are becoming poorer and
poorer. So for the equal distribution of income and wealth there is need of
government
Cont.

(iii) Optimum Allocation of Resources: Fiscal measures like taxation and public
expenditure programmers can greatly affect the allocation of resources in various
occupation and sectors.

(iv) Promoting Economic Development: The state can play a prominent role in
promoting economic development especially through control and regulation of
economic activities. It is fiscal policy which can promote economic development.
Cont.
(v) Capital Formulation and Growth: Fiscal policy will be designed in a manner to
perform two functions as of

• Expanding investment in public and private enterprises and

• By diverting resources from socially less desirable to more desirable investment

channels.

(vi)Infrastructure Building: Public finance helps to build up well-development

physical and institutional infrastructure
Cont.

(vii) Implementation of Planning: Under democratic planning fiscal policy plays

crucial role as financial plan is as much important as physical plan and the
implementation of the financial will obviously depend upon the uses of fiscal
measures.
2.0. Market Failure and Rational for Government
Intervention (Why Do We Need a Public Sector?)

(2.1)Explain the problem of externalities

(2.2)Explain pure theory of public goods

(2.3)Explain how asymmetric information result into market failure

(2.4)Explain how monopoly result into market failure

2.1. Understanding Market Failures

• Market failure occurs when the price mechanism fails to account for all of the
costs and benefits necessary to provide and consume a good.

• These are market inadequacies or areas that the market or private sector of the
economy fails to address and fail to satisfy all the needs of the society.

• The market will fail by not supplying the socially optimal amount of the good.

• Causes of market failure (May occur for several reasons)

2.2. Externality:

• A cost or benefit from production or consumption activities that affect people who
are not part of the original activity.

• A cost or benefit resulting from a transaction that affects a third party that did not
decide to be associated with the benefit or cost.

• It can be positive or negative.

Cont.

• A positive externality provides a positive effect on the third party. For example,
providing good public education mainly benefits the students, but the benefits of this
public good will spill over to the whole society.

• Also called external benefit (positive externality)– benefit from consuming a

good/service going not to consumers but to others.

Example of positive externalities includes:

1. Knowledge spill over of inventions and information (most other forms of practical
information) is discovered or made more easily accessible, others benefit by exploiting the
invention or information.
Cont.

2. Copyright and intellectual property law is mechanisms to allow the inventor or

creator to benefit from a temporary, state-protected monopoly in return for
“sharing” the information through public actions or other means.

3. In some cases, the actions of an individual or firm confer (uncompensated)

benefits on others, like for example a home owner whom a internships property;
including planting attractive flowers in front, and provide a positive externality.

• A negative externality is a negative effect resulting from the consumption of a

product, and that results in a negative impact on a third party.
Cont.

For example,

1. Cigarette smoking is primarily harmful to a smoker, it also causes a negative

health impact on people around the smoker.

2. Pollution from cars and motor bikes

3. Litter on streets and in public places

Cont.

4. Noise pollution from using cars e.g. tereosorghetto-blasters

5. Negative externalities created by alcohol abuse
Cont.

Externalities and Market Inefficiency(why externalities are market failure)

(1) Externalities are market failures because market prices do not accurately reflect
society’s preference for these activities. (the inefficiency of the market to
capture everything. Price of goods and services)

• The price of chemicals, e.g. do not take into account the damage being done to 3 rd
parties.

• The price of education or vaccines do not take into account the benefits enjoyed
by 3rd parties
Cont.

(2) Externalities create market failure (allocative inefficiency), how? Markets over
produce goods/services with external cost and under produce goods/services with
external benefits.

Note:

Negative Externalities: Pollution

Environmental problems can be divided into air pollution, water pollution, and land
pollution. The trends in air pollution show generally decreasing pollution.
Cont.

• With Positive Externality:

MTB= MPB + MSB

• However economic agent considers only the MPB

With negative externality

TMC = MPC + MSC

However an economic agent considers only MPC

Cont.

Marginal private cost (MPC)—the cost of producing an additional unit of a good

or service that is paid by the producer of the good or service.

Marginal external cost (MEC)—the cost of producing an additional unit of a good

or service that falls on people other than the producer.

Marginal social cost (MSC)—the marginal social cost incurred by the entire
society, by the producer and by every one else on whom the cost falls.
Cont.
Private Solution to Externalities

Sometimes economic efficiency can be attained without resort to government

intervention.

1. By establishing sufficiently large economic organizations, the externalities can be

internalized.

2. By establishing clear property rights, private parties can bargain toward an

efficient solution.
Cont.

3. Coase theorem

If the property rights are established and transaction costs are low, there will be
efficiency. The costs imposed on people who are not part of the original activity can
be recovered through the legal process and thus be paid by those involved in the
activity. The costs will become internal (private).
Cont.

• Coase theorem suggests that we may be able to do even better, If property rights
are fully assigned, then the regulatory body should not, in theory, have to be
involved. Instead, parties Will negotiate among themselves to and the lowest cost
solution to correcting the externalities.
Cont.

4. By using the legal system, imposers of externalities can be forced to compensate

victims.

The legal system can provide protections against externalities. Our system of
common law does not allow one party to injure another, and “injury” has been
interpreted to include a variety of economic costs imposed on others.
Cont.
Public Solutions to Externalities (Government intervention)

• Fines and Taxes

In general, whenever there is an externality, there is a difference between the social

cost and the private cost, and between the social benefit and private benefit.

A properly calculated fine or tax presents the individual or firm with the true social
costs and benefits of it suctions.
Cont.

• Fine of this sort—designed to make marginal private costs equal marginal social
costs, and marginal private benefits equal to marginal social benefits-are called
corrective taxes, or sometimes Pigouvian taxes.

• Subsidizing pollution abatement

Rather than taxing pollution, the government could subsidize pollution abatement
expenditures. By providing a subsidy equal to the difference between the marginal
social benefit (MSB) of pollution abatement and firm’s marginal private benefit
Cont.
• Control and Regulation- It has set emission standards for automobiles; put for the
detailed regulations relating to the

1. Disposal of toxic chemicals;

2. Out lawed smoking on domestic airline flights;

3. Imposed laws requiring oil companies with wells in the same oil pool to unitize
their production;

4. Imposed restrictions on fishing and

5. Hunting to reduce the inefficiencies as associated with excessive utilization of

these common resources.
2.2. Public Goods

1. Non -rival in consumption; the fact that one person benefit from this good does
not prevent another person from doing the same simultaneously, e.g. National
Defense and light house.

2. Non excludable. For a public good the marginal cost of providing it to an

additional person is strictly zero and where it is impossible to exclude people from
receiving the good.
Cont.

• Its most common example is fish in a lake. Anyone can catch and eat it but no one
has an exclusive property right over it.

• It means that a common property resource is non-excludable (anyone can use it)
and non-rivalrous (no one has an exclusive right over it). The lake is a common
property for all fishermen.
Cont.

Two Basic Forms of Market Failures (Inefficiency come in two forms)

• Underconsumption- Charging a price for non-rival goods prevents some people

from enjoying the good, even though their consumption of the good would have
no marginal cost, thus resulting to inefficiency due to under-consumption.

• Undersupply- If there is no charge for non-rival goods, there will be no incentive

for supplying the good, and In this case inefficiency takes the form of under
supply.
Cont.
Free Rider Problem

• Free rider problem-The reluctance of the individuals to contribute voluntarily to

the support of public goods because every individual would believe that he would
benefit from the services provided regardless of whether he contributed to the
service, he would have no incentive to pay for the services voluntarily. That’s
why the government has to compel people to pay taxes to finance these public
goods
Cont.

Paying for Public Goods

• User Fees- If exclusion is possible, even if consumption is non-rival, government

often charges fees in these form, to those who benefit from a publicly provided
good or services, e.g. airline ticket tax. Toll fee (a charge payable to use bridge or
road)
2.3. Market control / Monopoly

• Market control occurs when either the buyer or the seller possesses the power to
determine the price of goods or services in a market.

• The power prevents the natural forces of demand and supply from setting the
prices of goods in the market.

• On the supply side, the sellers may control the prices of goods and services if
there are only a few large sellers (oligopoly) or a single large seller (monopoly)
Cont.

• The sellers may collude to set higher prices to maximize their returns. The sellers
may also control the quantity of goods produced in the market and may collude to
create scarcity and increase the prices of commodities.

• On the demand side, the buyers possess the power to control the prices of goods if
the market only comprises a single large buyer (monopsony) or a few large buyers
(oligopsony).
Cont.

• If there is only a single or a handful of large buyers, the buyers may exercise their
dominance by colluding to set the price at which they are willing to buy the
products from the producers.

• The practice prevents the market from equating the supply of goods and services
to their demand.
Asymmetric information in the market:

• Market failure may also result from the lack of appropriate information among the
buyers or sellers.

• This means that the price of demand or supply does not reflect all the benefits or
opportunity cost of a good.

• The lack of information on the buyer’s side may mean that the buyer may be
willing to pay a higher or lower price for the product because they don’t know its
actual benefits.
Cont.

• On the other hand, inadequate information on the seller’s side may mean that they
may be willing to accept a higher or lower price than the actual opportunity cost of
producing it.

• Information asymmetric result into the problems of adverse selection and moral
hazard.
Cont.
General Solution to Market Failure

During market failures the government usually responds to varying degrees.

Possible government responses include:

1. Legislation: Enacting specific laws. For example, banning smoking in

restaurants, or making high school attendance mandatory

2. Direct provision of merit and public goods: governments control the supply of
goods that have positive externalities. For example, by supplying high amounts
of education, parks, or libraries.
Cont.
3. Taxation: placing taxes on certain goods to discourage use and internalize
external costs. For example, placing a ‘sin-tax’ on tobacco products, and
subsequently increasing the cost of tobacco consumption.

4. Subsidies: reducing the price of a good based on the public benefit that is gained.
For example, lowering college tuition because society benefits from more educated
workers. Subsidies are most appropriate to encourage behavior that has positive
externalities
Cont.
6. Extension of property rights: creates privatization for certain non-private goods

like lakes, rivers, and beaches to create a market for pollution. Then, individuals get
fined for polluting certain areas.

7. Advertising: encourages or discourages consumption.

8. International cooperation among governments: governments work together on

issues that affect the future of the environment.

Question: Market failure is a necessary but not a sufficient condition for

government intervention (Discussion within the lecture)
Cont.
“Market failure is a necessary but not a sufficient condition for intervention.

• First, To be truly worthwhile, a government intervention must outperform the

market or improve its functions.

• Second, the benefits from such intervention must exceed the costs of planning,
implementation, and enforcement, as well as any indirect and unintended costs of
distortions introduced to other sectors of the economy by such intervention.