FIN702: Public Finance

Lecturer Notes Introduction Economics: The study of economics is the study of how individuals or decision making units (DMUs) make decisions in a world where resources are scarce and limited. The scarcity of resources leads DMUs to exercise choicechoice, that is, with regard to how, in order to maximise returns, the resources are to be allocated amongst alternative uses. These returns are linked to human wants. In the public sector, the DMUs are confronted with the same problem, that of deciding how to allocate the limited resources amongst alternative and competing uses in a way that will ensure that its social and economic objectives are maximised. The process of decision making in the public sector differs slightly from that in the private sector, as depicted in Figure 1.1. In general, the public sector focuses primarily on public consumption: the supply of public goods and services by spending government tax income, as opposed to the consumption of individual goods by the citizens. The social aspect of the public sector, which is inherent in its very nature, makes it fundamentally different from a private sector organisation. First, the public sector leaders in charge of running public institutions are elected or chosen by those who have themselves been elected by the democratic process to represent the people who are governed and served.

 In contrast, those responsible for the running of the private institutions are self appointed and represent their own interest. Secondly, governments are endowed with certain rights of compulsion that private sector organisations do not have, such as the right to collect taxes.

Figure 1.1: Public and Private Sector Resource Path

Scarce and Limited Resources

Public Sector

Private Sector

Public sector allocation of resources => Budget

Private sector allocation of resources => Market

Pricing => Political process

Pricing => Demand and supply

Provision => Public good

Provision => Private good

Public wants

Private wants

The Economy/Society

The social aspect of the public sector makes it fundamentally different from private sector; Public sector leaders are elected via democratic process represent public interest; Private sector are self appointed and therefore represent own interest. Mixed economies: Private and Public sector provide a combination of goods. Private sector=> private good Public sector => public good Figure 1.3: Production Possibility Frontier
Private Good

. .. A

Public Good

This interface between public sector and private sector brings to light many issues that need to be examined to ensure a smooth interplay between the two. One area of crucial importance is Public Finance.

 Sharp and Sliger state that it is an . . . inquiry into the facts, techniques, principles, theories, rules and policies shaping, directing, influencing, and governing the use of scarce resources of government. It examines government spending, taxing, borrowing, and managing the public debt (Sharp and Sliger, 1964:33). Gunning (2001): states that Public Finance began as the study of how government could raise revenue for three purposes: (1) to supply the basic services needed to maintain a market economy, including the policing of property rights and defence against foreign invaders; Three arms of government: a) Legislature b) Judiciary c) Executive (2) to supply particular services; and, (3) to enrich the sovereign. Given the political dimensions of decision making and resource allocation, public sector economics also lies within the realm of political economy. Adam Smith (1776) wrote: Political economy, considered as a branch of the science of a statesman or legislator, proposes two distinct objects: first to provide a plentiful revenue or subsistence for the people, or more properly to enable them to provide such revenue or subsistence for themselves; and secondly to supply the state with revenue sufficient for the public services.

Roles/Functions of Government The question of whether a government should intervene does not arise. Rather, the question is to what extent and in what areas and when should that intervention occur. In 1776, Adam Smith wrote his path breaking book Wealth of Nations, in which he argued for a limited role for government. Smith attempted to show how competition and the profit motive would lead individuals, while pursuing their own private interests, to serve the public interest. The profit motive would lead individuals in competition to supply at competitive prices the goods and services that other individuals wanted. The economy, he argued, would operate as if led by an invisible hand: he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. (Smith, 1776:345)

In fact, all governments have involved themselves in activities to preserve justice and good order; provide for defence; and engage in activities leading to the improvement of the standard of living of the general population. Because the resources utilised by government are generated by the general public, the state has to engage in activities that are in the best interests of the public. Provision of infrastructure to foster economic growth is also of utmost importance to any government. The general approach to these objectives depends to a large extent on the ideology on which the government operates. Ideologies include those held by people of Classical, Neoclassical/Monetarist, Keynesian and Post-Keynesian persuasion.

 A summary of the difference in the key assumptions among these schools of thought is provided in appendix 1. Appendix 1: Summary of Assumptions in Classical, Neoclassical/ Monetarist, Keynesian and Post-Keynesian Economic Theory. Assumption Classical s Explanation Wage equals of ent Allocation governed by Savings subsistence wage; unemploym K<Kf Equalisation of by marginal equivalence s out of P=1 s out of W = 1 Savings Investment Causation Real financial linkages s out of R = ? Savings determine investment Exogenous money supply: Classical dichotomy One function: optimisation over time Savings determine investment Exogenous money supply determines absolute price level; inflation is a monetary Role of the State State has no prominent function phenomenon State has a limited of laws and institutions conducive to the operation of market State has an secure full employment Investment determines savings Money market determines the rate of interest Md=L(r)=Ms Investment determines savings Money supply adapts to demand (Kaldor); Inflation is a real phenomenon (costpush, sectoral mismatches, distributive struggles) State has a role in generating fuller employment and securing balanced growth 0 < mpc < 1 Neoclassical/ Monetarist Natural rate of unemployment (frictional) Perfectness of markets Keynes Insufficient effective demand Uncertainty; external effects Post-Keynesians (Cambridge) Mismatch between sectors producing different types of goods Imperfect competition; uncertainty; increasing returns to scale; complementarities Classical assumption

of resources profit rates; not

social role (creation obligation to

forces) Note: K stands for capital stock, M for money stock, mpc for the marginal propensity to consume, P for profits, R for rent, r for interest rate, s for the savings rate and W for wage income. Source: Naastepad (1999:327). Classification of Roles of Government The roles and functions of government can be classified in a number of ways. Bailey (2000) provides a classification under the following headings: a) the allocative role; (b) the distributive role; (c) the regulatory role; and (d) the stabilisation role. a) The allocative role concerns governments ability to allocate the scarce and limited resources in a manner that maximises economic welfare. b) The distributive role comes into play when in any country inequality in terms of income and resource endowment is prevalent and the government engages in other measures, such as provision of social security, health and education and housing assistance, and the creation of employment opportunities, to ensure improvement of the standard of living of those with low income and those who are marginalised. Government engages in taxation, which garners the resources used for distributive purposes. c) The regulatory role is seen when the government, with apparent economies of scale, legislates and enforces laws of contract and property rights, and provides an efficient judicial system and defence. This is to ensure that citizens feel secure in living and investing, thus allowing the economy to function well and grow. d) The stabilisation role comes into play when government makes efforts to ensure that inflation and unemployment are low and the macroeconomic climate is stable. To enhance this, the government uses its fiscal and monetary policies. Government could, for instance, change money supply targets and adjust tariffs and exchange rates.

Furthermore, it could embark on discretionary or built-in changes in fiscal policy. Discretionary changes are deliberate changes in expenditure programs and the tax structure, while built-in changes are primarily tax and transfer changes.

Rationale for Government Intervention => based on the assumption that markets do fail. => When resources are fully employed, economic welfare can be maximised in a purely competitive market. In such markets, firms are competitive, such that they buy inputs at the lowest cost and sell their product for a competitive price, thus making only normal profits (price equals marginal cost). Competition in factor markets allows least-cost combination of input and competition in the product market allows quality products sold at competitive prices. That is to say, we achieve economic efficiency. Fundamental Theorems of Welfare Economics Two fundamental theorems in welfare economics explain how economic efficiency could be achieved. 1st Theorem: states that in a competitive market where there is a large number of buyers and sellers with no individual having the power to affect the market price, we have a Pareto efficient allocation of resources. 2nd theorem states that every point on the utility possibilities schedule can be attained by a competitive economy, provided we begin with the correct distribution of resources. However: => in developing countries, all markets do not operate on a purely competitive basis.

=> Markets are small and institutions are either absent or not functioning well or badly governed. Causes of market Failure a) when price does not equal marginal cost in all sectors of the economy. => perfect competition may fail to exist because producers have monopoly power and can therefore control prices. => This results from potential monopoly arising out of a small, underdeveloped economy. Competition could be potentially restricted in other ways too, for instance if markets are not contestable or as a result of imperfect information. b) The second reason is the failure of prices to incorporate all costs and benefits. Perfect competitive market equilibrium will be distorted when individual consumers make poor judgement of their own welfare, thus not consuming the optimal level of the commodities. Table 3.1: Forms of Distortion and Market Failure. No. Distortion Effects Domestic Product Market 1. Consumption Private consumption levels that externality 2. Monopoly sellers exceed or fall short of socially optimal levels. Price in excess of marginal cost, leading to private production and consumption at levels that are 3. Production externality socially sub-optimal Private production levels that exceed or fall short of socially optimal levels. Domestic Factor Markets 1. Monopoly Wages in excess of marginal

suppliers of 2. labour Interest rates in excess of social 3. discount rates Surplus labour

revenue, leading to employment below the socially optimal level. Investment levels below the socially optimal level. Wages in some sectors above their social opportunity cost, leading to underemployment in those sectors

International Product Markets 1. Market power Unexploited gains from trade available to the large country. Source: Greenaway and Milner (1987:44). Externalities Market failure also arises from externalities, existence of public goods and natural monopolies. The Principles of Public Finance There are, in general, six principles of public finance. In postulating them, Von Justi (1760) stated that these six form the normative core of public finance. These principles are: 1) The ability of the citizen to pay a tax. Citizens must be able to take the burden without being compromised in their ability to enhance the welfare of the state. Given that this is an objective criterion, von Justi (1760) states that only so much should be taken by taxation that the economic process is not impeded at all. Therefore, tax should not incite any tax resistance. 2) Equity and fair proportions. Equal treatment before law has been turned into one of equity, as fairness serves as the moral underpinning and argument for redistribution.

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3) Welfare and civil liberty. Von Justi (1760) states that each and every measure of the state must be shown to enhance the welfare of the citizenry and it must not infringe on civil liberties. 4) This principle requires each measure of the state, notably those that entail burdens, to be established in tune with or according to the nature of the state in question and the form of its government. 5) This principle requires certainty and a broad legal and constitutional basis of every state measure, particularly with respect to taxation. 6) The last principle refers to the implementation of all state measures, particularly those of taxation. The tax must be levied in the easiest and the most convenient way available from the point of view of the citizens.

Theory of Public Finance and Public Expenditure Growth Public finance can be studied by examining five theories: 1) The Theory of Revenue Extraction 2) The Theory of Externalities 3) The Theory of Public Goods and Natural Monopolies 4) The Theory of Macroeconomic Stabilisation 5) The Theory of Public Choice. The Theory of Revenue Extraction To carry out functions of government, government needs finance and thus extracts revenue. Therefore, the theory of revenue extraction is the study of the means through which a government obtains money. Governments major sources of finance are borrowings and taxation.

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The Theory of Externalities The theory of externality refers mainly to negative externalities as defined earlier and governments role in internalising this externality. Market failures have been attributed to externalities. An externality arises when the production or consumption process of one person or activity affects the production or consumption process of another individual or activity. The production or consumption process may lead to both positive and negative externality. Positive externality is one where the second person may benefit from an effect on the production or consumption process into which this second person has had no input. For example, a bee farmer raising bees for honey production provides a benefit from this process to the neighbouring orchid farm, whose flowers the bees pollinate. A negative externality is one where the production or consumption process affects negatively another persons production or consumption process and in the process results in a loss to the society, as illustrated in Figure 3.2. Figure 3.2: Effect of Negative Externality on Quantity Produced and Price.

Price

S2

S1

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P2

P1 D1

Q2

Q1

Quantity

In this market, under initial supply and demand conditions, output Q1 and price P1 exist. If all costs are fully identified and measured, then the new supply curve S2 results in output Q2 < Q1 and price P2 > P1. With external costs (negative externality) too many units are produced at a price below the one that would prevail if all costs were identified and factored into the market process. Case Study of Internalising Negative Externality Both these cases could be resolved if government were to intervene. Bailey (2000) lists five options if we assume that a private industry dumps untreated industrial waste in rivers that another company uses for drinking water. a) Internalise the negative externality. The second company would incur substantial costs in purifying the water to make it potable. If these two companies merge, then the negative externality is internalised.

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b) Prohibit the negative externality: This tends to be the most common governmental response. Anti-dumping legislation is passed and violators are prosecuted and fined. c) Regulate the negative externality: This is the case where a maximum limit is set for discharge by the first company, to the point where the social marginal cost (SMC) is equal to marginal revenue (MR). d) Tax the negative externality: This is an alternative to c) above, which could achieve the same objective but with some revenue for government. Under this case, the tax is equivalent to an amount that will reduce production to a level where SMC is equal to MR. This is at q1. e) Introduce a trading scheme in negative externality licences. To limit the output, licences are issued on the pollution levels each company could emit. Companies investing in technologies can sell their licences to other companies and recover their investment costs. However, as Bailey (2000) suggests, companies should only be allowed to sell a portion of their licences. Expenditure research over the last four decades expanded on Pigous work by identifying different types of externalities and the necessary government interventions to correct externality problems. (i) In general, government can ignore distribution issues when addressing externalities, even when externalities can affect one group of consumers or producers more than others. (ii) (iii) To correct externalities, government needs only to concentrate on the markets with the externalities. The best policy option for government to deal with externalities is through a direct tax, of the sort proposed by Pigou on the good or factor causing the externality. The form of tax will vary but for an externality caused by production of a particular product, the optimal tax is a commodity tax on that good that equals the sum of its external effect on the margin. (iv) Subsidies or indirect taxes on other commodities will either not solve the problem or will lead to unrealistically complex taxation on all other commodities.

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The Theory of Public Goods and Natural Monopolies Theory of Public Goods => pure public good as those goods that a number of people could use simultaneously without diminishing their value (non-rivalry), and once these goods were provided, it was infeasible to exclude people from their use (non-exclusion). That is, the benefits of the good or service were said to be enjoyed by all consumers. The provision of public goods arises when markets fail to exist for public goods because they are both non-excludable and non-rival in consumption. If they are non-excludable, use of them by those who are not paying for them is not prevented; and they are non-rival in consumption if one persons consumption does not affect the level of consumption for another person. o Common examples of such goods are national defence and lighthouses. o Other examples where there is a degree of non-rivalry in the consumption include police protection, public parks, etc. Common property resources are not a pure public good because while property rights cannot be assigned to any one individual, the collective consumption of such resources can deplete the resource or exhaust the good (note the tragedy of the commons example) thus violating the non-rival aspect of the good. National defence, street lights, etc. are examples where an individual cannot be excluded from consumption of the good. Stiglitz (1986) explains public goods using different terms but with the same meaning. => Pure public goods have two critical properties: first, it is not feasible to ration their use; and secondly, it is not desirable to ration their use. =>By the first he means that it is impossible to exclude individuals from the consumption of such a good simply because it is indivisible. Using the second property, he states that because the marginal cost of supply for the good or service to an additional individual is zero, it is not desirable to ration the use. Table 3.2: Key Efficiency Conclusions from Normative Expenditure Theory Marke Conclusions Policy Implications

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t Failur e Exter nalitie s Private market provides goods with externalities inefficiently Policy solution needs to be with externality The best policy option is tax (in direct proportion to marginal impacts) or vouchers Subsidies or indirect taxes Public are not efficient tools Private market will underGovernments need to take the lead role in correcting externality Can establish separate agencies (pollution, health) Government should use pollution tax (or vouchers) instead of absolute standards

concentrated only on market government regulatory

Government needs to produce or regulate provision of public goods Preference revelation mechanisms are not generally useful Except in the case of complex government auctions Survey methods (e.g. CVM) that ask citizens to reveal demand for public goods are used in costbenefit analysis Government needs to provide or regulate

Goods provide public goods

Efficient provision requires knowledge of consumer demand for public good Consumers have no incentive to reveal their preferences accurately Accurate preference revelation will require a carefully designed two-part tax (or voting) scheme

Natur al

Private market (monopoly) will under-provide and

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Mono polies

over-charge for this good Optimal pricing is based on marginal costs; deficits should be made up with a lump-sum tax If utility must break even, then a Ramsey pricing rule or multi-part pricing should be used to determine prices Rate of return regulation leads to over-utilisation of

natural monopolies such as utilities Most present utility regulation is not consistent with economic recommendations Economic analysis has raised concern about rate of return regulation.

capital. Source: Duncombe (1996:30) The Theory of Macroeconomic Stabilisation The main objective of stabilisation policy is to ensure that output levels are close to the potential while inflation and the current account deficit are kept at acceptable levels. A set of co-ordinated financial management of government resources is required. Baptiste (1980) identifies three schools of thought with respect to governments financial management of an economy: the Keynesian, Monetarist and New Cambridge schools.

Keynesian School Demand Side Effects of Fiscal Policy: Keynes, in his book The General Theory, states that an expansionary fiscal policy (increased government spending) in times of depression or recession could be a means to raise aggregate levels of income and

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employment without a corresponding increase in the general level of prices. The simplest Keynesian model assumes price rigidity and excess capacity, so that output is determined by aggregate demand. Keynes argues that demand can be managed by changes in public expenditure and revenue and by stimulating investment. He argues that a fiscal expansion has a multiplier effect on aggregate demand and output. Using the extended Keynesian model, one can show the crowding out effect through induced changes in interest rates and the exchange rate, along with the direct crowding out that occurs when government goods and services substitute those provided by the private sector. The standard model used for the analysis of stabilisation policy in an open economy is the Mundell-Flemming model. This model describes the short-run fluctuations in an open economy. a) b) Fiscal expansion with a fixed level of money supply will shift the IS curve thus pushing up the interest rates. The resulting capital inflow will result in an increase in the exchange rate, which in turn will reduce the demand for domestically produced goods, thus reducing the initial fiscal expansion. c) d) However, there is a net positive effect from expansionary fiscal policy under a fixed exchange rate. With a push to increase the exchange rate resulting from expansionary fiscal policy, money supply should be increased to neutralise the push, thus realising the fiscal expansion (readers should refer to any standard macroeconomics text to obtain a detailed treatment of the MundellFlemming Model). Supply-Side Effects of Fiscal Policy: The analysis of Keynesian theory mostly examines the demand side effects of fiscal policy, which are mostly the short-term effects. => However, the longer-term supply-side issues also need to be considered. Institutional Aspects of Fiscal Policy: Institutional factors can affect the fiscal policy impact in a number of ways.

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Ricardian equivalence: One of the fundamental assumptions of the Keynesian approach is that consumption is related to current income. However, let us include some microeconomic fundamentals that are generally ignored by the Keynesian approach. Let us assume that consumers are forward looking and are fully aware of the governments intertemporal budget constraints. That is, they are Ricardian in a sense. In such a case, consumers will anticipate that a tax cut today, financed by borrowing, will result in higher taxes being imposed on their families in future. Therefore, if we take permanent income into account, it remains unaffected and therefore, there will be no change in consumption. => This equivalence between taxes and debt (borrowing) is known as Ricardian equivalence. => It implies that a reduction in government saving resulting from a tax cut is fully offset by higher private saving with no effect on aggregate demand Monetarist School of Thought The Keynesian position denies the classical view according to which persistent high unemployment will lead to ongoing deflation of wages and prices; the resulting decline in the transaction demand for money (causing an excess supply of money) will lead to a reduction in the rate of interest, which in turn will stimulate investment, causing aggregate output and employment to rise, thus returning the economy to full employment (Naastepad, 1999). As an extension of this, the monetarists argue that it is monetary policy rather then a fiscal measure that will stabilise the economy during a recession and thus monetary policy rather then fiscal policy should be the main tool for stabilisation of an economy (Baptiste, 1980). They argue that the use of monetary policy will keep the resources fully employed without any effect on prices, citing the quantity theory of money, which states that the volume of money in the hands of the public largely determines total spending in nominal terms and by its extension, the level of output and prices. Therefore, controlling money supply can in many ways be the key stabilisation instrument.

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 Monetarists argue that the manner in which the deficit budget is financed is critical. If it involves borrowing from bank credit or public, then private borrowers will get less credit, thus increasing the cost of borrowing (interest rates). This will have a negative effect on investment. However, an alternative would be for the Reserve Bank to expand bank reserve assets to allow financing of the deficit. In such a case, there would be an overall increase in bank credit and the volume of money in the system. The public and the banks would now be in a better position to lend more to private borrowers. Interest rates would remain unaffected, with an expansionary effect on the economy. The New Cambridge School of Thought The New Cambridge school of thought suggests that there is a direct relationship between the public sector deficit and the current account of the balance of payments in an open economy: the larger the public sector financial deficit the larger the deficit on the current account of the balance of payments (BOP) (Baptiste, 1980). This relationship can be further explained if one examines the New Cambridge School proposition that the net acquisition of financial assets by the public, private and overseas sector (i.e. BOP on CA) plus net transfers must total zero. Along with this, the assertion that the private sectors net acquisition (personal and company sectors) is stable, suggests that any change in the budget or public sector borrowing requirements must be reflected in the BOP on the current account. A major implication coming out of this is that any government that carelessly follows a principle of deficit financing to boost the economy of a small open economy can end up destroying the balance of payments in the long run. However, Jansen (2004) argues that fluctuations in economic activity in developing countries are often due to exogenous supply shocks such as natural disasters or international commodity prices.

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 She argues that if the supply shock is expected to be temporary, then fiscal intervention is justified and it will stabilise the fluctuations in output and the exchange rate over time. Under these circumstances, fiscal policy is more effective than monetary policy (Bird, 1998). However, if the supply shock is expected to be permanent, then fiscal intervention is undesirable as it would hinder the adjustment to the new situation (Jansen, 2004). External shocks from the international financial market, such as sudden change in capital flows, in global interest rates or in the alignment of major currencies, can lead to substantial fluctuations in economic activity in developing countries (Jansen, 2004). Heller (1997) argues that cautious fiscal policy should accompany such capital inflow. There are other studies as well that suggests prudent macroeconomic management in the face of large capital flows. The inflow will stimulate economic activity, leading to a rise in tax collection, and with unchanged expenditure, will lead to improvement in the fiscal balance. Jansen (2004) argues that fiscal contraction beyond this automatic adjustment will be required, o (i) to limit the expansionary pressures in the economy, o (ii) to reduce the liquidity in the financial market and o (iii) to limit the appreciation of exchange rate caused by inflow of capital. => However, during periods of capital outflow, contractionary fiscal policy is required. => A contractionary policy would help in reducing domestic absorption and creating current account surplus necessary to finance the capital outflows and to maintain confidence of the investors, thus minimising capital outflow.

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Public Finance in New Growth Theory The Theory of Public Choice Worldwide, a trend towards democratic government is being established, with gradual reduction in the numbers and power of autocracies. Democratic governments receive advice from many people in a bid to make collective decisions. Given that this advice comes from many and varied sources, decisions are costly to make and may result in inefficient resource allocation. However, the current literature is still grappling with the problem of aggregation of individual preferences and how the political process transmits the preferences of the citizens to the government through the voting process. Several voting models, such as the Optimal Constitution Model, the Bowen-Black Majority Voting Model, the Buchanan-Tullock Model and the Downs Model, 1 have been developed to provide some insight into this area. They fall into two categories, direct democracy and representative democracy. Direct democracy refers to citizens voting directly upon decisions, say by a referendum; and representative democracy refers to voting for representatives who then vote on behalf of the voters on decisions. Dickenson states that in a democratic society, people have the opportunity to decide how much they wish to provide for themselves and how much they want the state to provide for them. Their individual preferences can be expressed by putting a vote in the ballot box at the next election for a political party whose manifesto most closely reflects their views. It is the majority vote, which is the aggregate of individual preferences, that gives the government the mandate to carry out its policies. (Dickenson, 1996: 77) => At a general election, people give a block vote to a party and a manifesto package containing various proposals. => They do not have a choice with regard to individual issues in the manifesto and thus not all proposals in the manifesto may be acceptable to them. => Sometimes, though rare and costly, a referendum is carried out; if it is done during an election, costs are minimal.
1

For further information on these models refer to Robin W. Boadways Public Sector Economics, Winthrop Publishers, Cambridge, 1979, p. 467.

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Model of Public Expenditure In a static analysis of government expenditure, the ability of a government to spend in a democratic society depends in the long run on (i) (ii) (iii) national resources (national income), the level of taxation required to finance spending; and the acceptability of the public expenditure programmes to the electorate.

The Ballot Box Theory states that in a democratic society, people have the opportunity to indicate how much and what they wish the state to do for them via their individual preferences, that is by putting a vote in the box at the next election for a party whose manifesto reflects their views as closely as possible. The dynamics of public expenditure growth could be explained by examining two categories of model, the micro- and macroeconomic models of public expenditure. Brown (1990) examines in great depth these two types of models. Produced below is a summary of his presentation, along with other writers. Macro-Models of Public Expenditure Under this category, three models are commonly cited. These are the development models of public expenditure, Wagners law of expanding state activity, and Peacock and Wisemans hypothesis. Development Models of Public Expenditure The Rostows stages of growth model is quite useful in explaining the pattern of public sector expenditure change. => Early stages of growth, the state plays a very important role in investment, employment, law and order, health, education and infrastructure development. Therefore, public sector investment as a proportion of the total investment is quite high. => As the economy grows and expands, the private sector increases its role in the economy, as both an employer and an investor. At the same time, the public sector plays a complementary role, declining gradually, particularly in investment and employment.

Wagners Law of Expanding State

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Adolf Wagner, a German economist, was the first scholar to propose a theory explaining the share of GNP that is taken up by the public sector. Over the years, researchers have termed his proposition Wagners Law. Wagner (1893) stated that as per capita income in an economy grows, the relative size of the public sector will grow also. Wagners proposition was based on empirical work using data from a number of European countries, Japan and United States. Wagner suggested the relationship after seeing three main reasons for the increased government involvement. o First, said Wagner, industrialisation and modernisation would lead to a substitution of public for private activity. o Furthermore, the relationship between the expanding markets and the key actors in these markets would become more complex. With this complexity, the role of the state would increase. o Wagner also expected that the emergence of legal services, police services and other public services (public goods) would increase. o Secondly, Wagner argued that as income grows, income-elastic cultural and welfare expenditures such as on education and health will also expand, requiring increased public sector expenditures. As real incomes in a country increase, public expenditures on these services would rise more than in proportion, which would account for the rising ratio of government expenditure to GNP. o The third reason forwarded by Wagner was that economic development and changes in technology required government to take over the management of natural monopolies in order to enhance economic efficiency (Henrekson, 1990). Peacock and Wisemans Analysis => Using the political economic literature, Peacock and Wiseman provided an analysis of the time pattern of public expenditure.

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=> They state that governments like to spend more money, that citizens do not like to pay more taxes and that governments need to pay some attention to wishes of their citizens. => Peacock and Wiseman explain that as an economy grows, government income will increase (with constant tax rates). => With increasing revenue, the government can make more expenditure on public goods. => Peacock and Wiseman also explain the displacement effect that takes place in unforeseen circumstances. During these circumstances, such as natural disasters or war, public expenditure is displaced upwards and for the period of the crisis, displaces private expenditures. Peacock and Wiseman also explain the inspection effect, which arises from social problems that may be raised by the voters. =>To attend to this, the government needs to expand its expenditure . Micro-Models of Public Expenditure The micro-models are used to identify the variables that directly influence the demand for and supply of public sector outputs, thus explaining changes in public expenditure. The main categories of actors in a society are voters, politicians, bureaucrats and pressure groups. The behaviour of each of these actors, which affects the supply and demand for public sector outputs, has an impact on public sector expenditure. Public sector outputs require public sector inputs. Therefore, public expenditure levels are based on the derived demand of the public sector inputs.

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