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Public Finance and Taxation Essay

There are varying definitions of what public sector economics is and what topics it covers. In a layman’s language Public economics is the application of economics to the activities undertaken by the state. Black et al. defines public sector economics as “the field of economics which studies the nature, principles, and economic consequences of government expenditure, taxation, financing and the regulatory actions undertaken in the non-profit making government sector”. Thus it looks at the efficiency of various approaches used by government in its day to day operations. For the government uses economic policy instruments which are designed to influence economic behavior in order to achieve certain outcomes. The government has various goals which it pursues they include; i) Macro-economic stability

ii) Enhanced economic growth
iii) Balance of payment stability
iv) Income distribution.
The ultimate goal of these policies is to improve people’s welfare. As already mentioned government uses instrument of fiscal and monetary policy to achieve its goal. The use of government expenditure and taxation to influence economic outcome is referred to as fiscal policy. Fiscal policy is often outlined through the annual budget which is presented to parliament every year. The budget outlines its objectives in the budget and how these are going to be achieved. On the other Monetary policy is aimed at influencing the supply of money and consequently economic growth. The central Bank is an independent arm of the state which is mandated with running the monetary policy. In Zambia, monetary policy is the responsibility of the Bank of Zambia. In public sector economics we study the impact of instrument of fiscal policy on economic efficiency. Instruments of fiscal policy include; i) Expenditure

ii) Taxation
iii) Financing
iv) Regulations
The first two involves the procurement and spending of the government funds on various programs such as public infrastructure, education, health and public security. Example the government collects revenue using tax and spends the revenue on education, health, roads etc. in economic terms the use of these two constitutes the direct mobilization and allocation of scarce resources. In contrast, regulation entails a law or administratively proclaiming an enforceable instruction that leads to a different allocation of private sector resources than would apply in the absence of government intervention. That is allocation resources are influenced indirectly. Example the government through the Environmental Council of Zambia has put regulations to curb environmental damage; this has lead to increased investment in environmentally friendly technology by private firms. This is something the profit seeking private sector would not have done if there was no government intervention. PUBLIC FINANCE AND IDEOLOGY

Opinions on how government should function in the economic sphere are influenced by the ideological views concerning the relationship between the state and the individual. Political philosophers have distinguished two major approaches. These approaches are the organic view and the mechanistic view of government. Organic View of Government

In this view society is considered as a natural organism and the government is the heart of such an organism. Society is an organic whole, just as the human body. Each individual is a constituent part of the organism just like a body part. In this view an individual has significance only as a part of the community and the good of the individual is defined with respect the good of the whole. A person’s action is seen as important if it leads to the improvement of the wellbeing of society. In Plato’s view, ‘an activity of citizen is only desirable if it leads to a just society’. In this view, the goals of society are set by the state which attempts to lead society, toward their realization. The goals of society do differ from one state to another. For example Plato conceived that the goal of government was the achievement of a golden age in which human activities would be guided by
rationality. In short society strived to achieve a state in which the decisions of all individuals and the state were rational. So society was support all activities which would lead to the achievement of this goal. In Adolf Hitler’s view, the state’s goal was the achievement of social purity. He envisaged the creation of a supper race. To achieve this goal the state supported all activities which were aimed removing human impurities. They include bizarre actions such as extermination of Jews, physically disabled people and invasion of all countries to ensure that his goals are achieved over the world. The Grand Ayatollah Khomeini argued that the goal of society is to create good believers. Thus all actions of individuals and the state should be aimed at creating a cadre of believers. Closer home, Kaunda envisaged that the goal of society was the attainment of a just society. He coined the concept of human centered development or Humanism. In this ideology he argued all the actions of individuals and government should be aimed achieving a society in which all persons are equal to each other. Proponents of the organic view argue that certain goals are natural for the societal organism such as pursuit of sovereignty over some geographical area. From a policy perspective, the organic view emphasizes combating poverty and equity issues notably redistribution of income as justification for government intervention. In addition, this view tends to support existence of a large government. That is government has a large part to play in of the nation’s activities. Mechanistic View of Government

In this view government is not an organistic part of society, but it is a creation of people to better achieve their individual goals. Here government is seen as a reflection of individual preferences or tastes. In short, society is a mirror of individual wants and needs. In this case, government intervention is only justifiable if it leads to individual welfare maximization. An individual will only support a government if it helps him/her to achieve their individual goals. Example government should protect individuals from violence. To do so the individuals gives government coercive power. In Adam Smith view, Government should protect society from violence and invasion from other states. This view advocates for government intervention only to correct market failures and letting the market decide who gets what. In addition, the role of government should be limited to
certain public works such as roads, bridges, sewer, and airports. These are infrastructures which make society function.

There are several divergent views within the mechanistic view. Some of these are; i) Libertarians View which argue against any further role in the economy beyond providing justice and protecting individual liberty. ii) Social democrats believe that sustained government intervention is need for the good of individuals. These interventions can be as diverse as safety regulations at work place, banning racial discrimination, welfare payments to the poor.

In totality, the mechanistic approach focuses relatively more on the efficiency of markets and economic growth.

1. Equity and Efficiency Principles

Pareto Efficiency-occurs when it is not possible to improve the welfare of some people without making the welfare anyone worse.
An economic system that is not Pareto efficient implies that it is possible to change resource allocation without making any one worse off. Example if an economic system is not Pareto Optimal it is possible to increase consumption by one group and reduce for others without making them feel worse off. This is known as Pareto Improvement.

Pareto improvement occurs when a change to a different allocation makes at least one individual better off without making any individual worse off. To make us under this lets assume that; i) There are two individuals A and B,

ii) There are two goods X and Y,
iii) There are two factors of production Labor (L) and Capital (K) iv) We assume that we have a static economy such that XA+XB=X and YA+YB=Y
Exchange Efficiency or efficiency in consumption
Efficiency in consumption is achieved when the marginal rates of
substitution are equal for all persons;
The Marginal Rate of Substitution is simply the slope of indifference curve.


If you have a utility function: uX,Y=U0 totally differentiating MUxdX+MUydY=0

In the Edgeworth box efficiency is achieved where the indifference curves are tangent;

Lets pick a point such as ‘e’. At point ‘e’ it is possible to make person A better without making person B worse off. This can be done by moving along Indifference Curve no B2 to point d. At point‘d’ the welfare of person A improves because he moves from a lower indifference curve A2 to a higher indifference curve A3. The improvement for person A continues until point ‘c’ where the indifference curves are equal. At point ‘c’ it is not possible to make any Pareto improvement. At point ‘e’ we have MRSXYA>MRSXYB

This also true for point ‘d’.
This outcome of Pareto efficiency is only possible under perfect competition. This is because in perfect competition all consumers face the same market prices for these goods. That is they equate the marginal rate of substitution to the same price ratio. MRSXYA=MRSXYB=PxPy

Each individual maximizes their utility function subject to the budget constraint. That they maximize the following function U0=uX,Y subject to I=XPx+YPy therefore the langrangian L=UX,Y+λ(I-XPx-YPy)

First order conditions
∂L∂X=MUx-λPx=0 and ∂L∂Y=MUY-λPY=0
MUX=λPx and MUy=λPy solving simultaneously we getMUxMUy=PxPy=-dYdX=MRS Therefore, each person will equate their MRS to the price ratio. Production Efficiency
Production efficiency requires that the marginal rates of technical substitution are equal in the production of good X and good Y. That is

In the Edgeworth box this requires this occurs where the isoquants are tangent to each other. The marginal rate of technical substitution is simply the slope of the isoquant. K

Given an isoquant QL,K=Q0 totally differntiating we get MPldL+MPKdK=0

Lets have a factor Edge worth box to make our illustration easier. Remember from our study of micro-economics we defined an isoquant as a curve that represent the combination of labor and capital which give the same level of output. In the diagram below production of X uses labor from point X to the right and capital from X upwards. For good Y it is the opposite of good X.

All points along XPY are Pareto efficient in the sense that it is not possible to improve or increase the output of good X or good Y without reducing either of them. To under this lets pick point ‘a’ which is not along XPY. This point is not Pareto optimal because it is possible to improve the production of X without reducing the output of good Y simply by moving along the isoquant no Y2 output of good X improves/increases to X2 from X1. Pareto efficiency is only possible under a perfectly competitive market system because all produces face the same factor prices (PK and PL). Thus Pareto Optimality condition reduces to: MRTSLKX=MRTSLKY=PKPL

Q0=QL,K subject to C=LPl+YPy
therefore the langrangian L=QL,K+λ(C-LPl-KPk)
First order conditions
∂L∂L=MPl-λPl=0 and ∂L∂K=MPk-λPk=0
MPl=λPl and MPK=λPK solving simultaneously we getMPlMPk=PlPk=-dLdK=MRTS Therefore all firms will be minimizing their costs while facing the same factor prices. OVERALL EFFICIENCY
This requires that the production possibility frontier (PPF) and the social welfare function are tangent. That is; MRSXY=MRTXY. X

The PPF shows the maximum quantity of good X and good Y that can be produced using the existing technology and resources. An increase in the amount of labor and capital available or an increase in the level of technology will make the PPF to move outwards to the right. All points inside the PFF are attainable but not efficient and all points the right of the PPF are not attainable. To achieve, the Marginal Rate of Substitution for society (slope of SWF) must be equal to the PxPy and the marginal rate of transformation (slope of PPF) must be equal to the MCxMCy or resources must be fully utilized. In perfect competition, P=MC. Hence it is possible to achieve the following outcome; MRSXY=PxPy=MRTXY=MCXMCY. Thus a perfectly competitive outcome results into a Pareto optimal allocation of resources. It is important to note that Pareto optimal allocation may not be the best outcome in the sense that it does not consider equity. That is there is no equity consideration. Equity is the fair distribution of resources in sources. There are two concepts of equity used in economics horizontal and Vertical Equity. Horizontal equity means that people in similar positions/situation must be treated equally. Example if two people have HIV and the same level of CD4 count they should have equal access to ARVs. The only condition is that they are positive and have the same CD4. Vertical equity means that people in different economic situations must be treated differently from a poor person when allocating resources. This is because treating them in the same manner is not equitable. MARKET FAILURE

A market failure occurs when the market fails to allocate resources according the Pareto criterion. In other words, a market failure is a situation in which the market fails to allocate resources efficiently according to the Pareto Criterion. Fundamental Theorem of Welfare Economics

Welfare economics is the systematic method of evaluating the economic implications of alternative resource allocation. It answers the following questions; i) Is a given resource allocation efficient?

ii) Who wins and looses under various allocations?
First Fundamental Theorem of welfare Economics- It states that if there is a perfectly competitive market and consumer tastes are convex then any equilibrium will be a Pareto optimal allocation of resources. In short, the competitive market allocates resources efficiently without any need for government intervention. Further, the theorem states that the price from the perfectly competitive market induces selfish individuals independently maximizing their welfare, to bring the economy to a socially optimal state. That is prices rise in response to excess demand and they fall in response to excess supply. Normatively this theorem says that use free market system to allocate resources. The Second Fundamental Theorem of Welfare Economics states that “society can attain any Pareto optimal allocation of resources by making a suitable assignment of initial endowment of resources and then letting the people freely trade with each other as in the Edgeworth box.” To help us understand this lets relook at the contract curve which gives the Pareto Optimal outcomes.

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