Public economics unit 2- public expenditure

6th semester

Public expenditure theories

Wagner’s Law of Increasing State Activity theory

Proposed by Adolph Wagner (19th century German economist).

As an economy develops, government expenditure increases faster than national income.

Mathematical Representation G/Y↑

Where
G = Government expenditure
Y = National income

This means public sector size grows with economic development.

Reasons for Wagner’s Law

1. Administrative and protective functions

   • Defense

   • Law and order

   • Judiciary

2. Social welfare functions

   • Education

   • Healthcare

   • Social security

3. Economic and infrastructure development

   • Roads

   • Railways

   • Public utilities

Criticism

• Not universally true

Peacock–Wiseman Hypothesis

Developed by Alan Peacock and Jack Wiseman (1961).

Main Idea

Government expenditure increases in jumps rather than gradually.

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Displacement Effect

During crises such as:

• wars

• economic crises

• natural disasters

government increases taxes and expenditure.

After the crisis ends, public expenditure remains at the higher level.

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Three Effects

1. Displacement Effect

   • Public tolerance for higher taxes increases.

2. Inspection Effect

   • People become more aware of government spending.

3. Concentration Effect

   • Government centralizes more economic activities.

Baumol’s Cost Disease theory

Baumol explained the rising cost of public services.

Example:

• education

• healthcare

• public administration

Productivity growth in these sectors is low, so costs increase faster than private sector.

This leads to higher public expenditure over time.

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Political Economy Theory

Public expenditure may increase due to political incentives.

Governments increase spending to:

• win elections

• satisfy interest groups

• gain political support.

This idea is also discussed in public choice theory.

Samuelson Theory of Public Goods

Developed by Paul Samuelson (1954).

It explains the efficient provision of public goods.

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Meaning of Public Goods

Public goods are goods that are:

1. Non-rival

2. Non-excludable

Examples

• national defense

• street lighting

• public parks

These characteristics make private markets inefficient in providing them.

Samuelson Condition

Samuelson showed that efficient provision occurs when:

MB1+MB2+...+MBn=MC

Where

MB = Marginal benefit of each individual
MC = Marginal cost of public good

For public goods, demand curves are vertically summed.

For private goods, demand curves are horizontally summed.

Each individual consumes the same quantity of public good.

Therefore total willingness to pay is sum of marginal benefits.

Efficient level occurs where:

Total marginal benefit = marginal cost.

Importance of Samuelson Theory

1. Explains optimal provision of public goods.

2. Forms the basis for public finance theory.

3. Shows why government intervention is necessary.

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Limitations

• Difficult to measure marginal benefits
• Free rider problem
• Individual preferences are hidden.

Cost–Benefit Analysis (CBA)

Cost–benefit analysis is a method used by governments to evaluate whether a project should be undertaken.

It compares:

Total Benefits  vs  Total CostsTotal\ Benefits \; vs \; Total\ CostsTotal BenefitsvsTotal Costs

A project is accepted if:

Net Benefit=Benefits−Costs>0

Steps in Cost–Benefit Analysis

1. Identify project alternatives

2. Identify costs and benefits

3. Measure them in monetary terms

4. Discount future values

5. Compare net benefits.

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Present Value Formula PV=Bt(1+r)t

Where

PV = Present value
B = benefit
r = discount rate
t = time period

Types of Costs

1. Direct costs

2. Indirect costs

3. Opportunity costs

4. Social costs

Types of Benefits

1. Economic benefits

2. Social benefits

3. Environmental benefits

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Problems in CBA

• Measuring non-market benefits
• Valuing human life
• Choosing discount rate.

Government Budget and Structure

A government budget is an annual statement of:

• government revenue

• government expenditure.

Components of Budget

1. Revenue Receipts

Money received by government without creating liability.

Examples

• taxes

• fees

• fines.

2. Capital Receipts

Money received through borrowing or asset sales.

Examples

• loans

• disinvestment.

3. Revenue Expenditure

Expenditure that does not create assets.

Examples

• salaries

• subsidies

• pensions.

4. Capital Expenditure

Expenditure that creates assets.

Examples

• infrastructure

• roads

• dams.

Budget Deficit vs Fiscal Deficit

Budget Deficit

Occurs when:

Total Expenditure>Total Revenue

Fiscal Deficit

Fiscal deficit measures government borrowing requirement.

Fiscal Deficit=Total Expenditure−(Revenue Receipts+Non Debt Capital Receipts)

Differences

Feature	Budget Deficit	Fiscal Deficit
Meaning	Total expenditure minus revenue	Borrowing requirement
Scope	Narrow	Wider
Indicator	Budget imbalance	Government debt pressure

Functional Classification of Budget

Major Functional Categories

1. Defense

2. Education

3. Healthcare

4. Infrastructure

5. Social welfare

6. Public administration

This classification helps understand government priorities.

Revenue Deficit

Revenue deficit occurs when:

Revenue Expenditure>Revenue Receipts

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Formula Revenue Deficit=Revenue Expenditure−Revenue ReceiptsRevenue\ Deficit = Revenue\ Expenditure - Revenue\ ReceiptsRevenue Deficit=Revenue Expenditure−Revenue Receipts

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Implications

• Government borrowing increases
• Reduces public savings

• Limits investment.

Government Policy and its Impact

Government policy influences the economy through:

1. Fiscal policy

2. Tax policy

3. Public expenditure policy

Economic Impact 1. Economic Growth

Government investment increases infrastructure.

2. Income Distribution

Redistributive policies reduce inequality.

3. Employment

Public spending creates jobs.

4. Stabilization

Fiscal policy stabilizes economic fluctuations.

Social Impact

Government policies improve:

• healthcare

• education

• social security

• poverty reduction.