Lesson Explainer: Components of Public Finance Economics • Third Year of Secondary School

In this explainer, we will learn how to identify public (government) expenditure, revenue, and budget as components of public finance.

Let us begin by recalling that government intervention in an economy is necessary to address the failure of the free market, which is an economy without government intervention, to efficiently allocate certain types of resources. For instance, if left to the firms in the free market, education would not be widely available to the public and society would fail to reap the maximum benefit of education. Also, no individual firm will claim responsibility for national defense, since they cannot prevent free riders from benefiting from the service. Hence, the government needs to intervene in these areas to create a more efficient economy and to ensure that certain national priorities are met.

While the intent of the government is to serve the public good, the government itself is comprised of individuals grouped into divisions of the government. These individuals are from the households in the economy and are supplying their labor factor of production to the government. Then, what is to keep the individuals in the government from seeking their own self-interest? For instance, when deciding on the location of a public park, government officials may want to prioritize their own neighborhoods over others. If these decisions are driven by the benefit of select groups of individuals, they would not be different from the profit motives of the private sector. In this case, the government’s intervention would not be able to address the market failure.

Political democracy serves as a mechanism to prevent the public sector from seeking profits for specific groups of individuals. Most countries with established political democracies require the decisions concerning the government’s fiscal activities, often involving taxation, to be approved and monitored by the body of legislators, that is, the officials in charge of creating laws. Legislators are elected by the citizens, and they represent the will of the citizens who voted for them. We will consider this process in greater detail later in this explainer. This mechanism makes it more difficult for an individual government official to influence these decisions. For this reason, the issues involving collecting and spending taxes are often highly significant in the emergence and evolution of a political democracy.

In our first example, we will consider the role of political democracy.

Political democracy guides the government’s decision-making when it addresses various market failures. This mechanism demonstrates the main difference between the public sector and the private sector. While the private sector is driven by profits, the public sector is driven by the democratic process, representing the will of the people. Therefore, it is important for us, as citizens, to understand the structure of the government’s fiscal activities.

The first component of public finance is public expenditure, which is the monetary spending by the government. The cost of maintaining the government represents a small portion of public expenditure. The largest portion of public expenditure is the cost of public-sector activities designed to correct failures in the free market, for example by providing public education, national defense, infrastructure, healthcare, emergency services, and so on. In the latter sense, we say that public expenditure represents the government’s intervention in the economy.

The principle of maximum social advantage states that public expenditure should be structured in a way that maximizes its benefits to society as a whole. If it disproportionately benefits a specific group of individuals, especially a political group, then other groups will be unfairly disadvantaged. This would break the principle of maximum social advantage. Most democratic countries have special divisions within their governments that are charged with ensuring that public expenditure is distributed according to the principle in order to fairly benefit as much of society as possible.

During the 19th century, it was a prominent belief among economists that public expenditure should be kept to a minimum so that the free market could perform its role. However, opinions significantly shifted after the second world war in favor of increasing the role of the government in national economies. Since then, many countries have seen a continuous and sometimes rapid increase in the sizes of their public expenditures. Parts of this increase can be attributed to an increasing population, but the rate of growth in expenditure often far exceeds that of the population. This means that the roles of governments are increasing around the world. In the modern era, public expenditure in many countries has increased in the areas of national defense, social welfare, and supporting economic growth.

This widespread upward trend in public expenditure over a long period of time is not inevitable and has led to many inefficiencies in government, as well as creating large national debts. The principle of economy states that public expenditure should be structured in a way that minimizes waste. Following this principle, governments in many countries have recently begun to reverse the trend and reduce the size of their public expenditure by improving their efficiency.

The principle of sanction states that no public expenditure may occur without prior approval (sanction) by appropriate government officials. Political democracy requires that public expenditure be approved by elected officials who represent the will of the citizens who voted for them. This principle of sanction also supports the principle of maximum social advantage by guiding public expenditure to benefit the majority of individuals in society. Additionally, it means that public expenditure should be reviewed through a process called audit to ensure that money is spent for the approved purposes only.

Public expenditure can be categorized by the levels of government responsible for the spending. Spending by the national government, which is also known as the central government, is called the central government expenditure. This portion of the public expenditure is often the greatest, and it includes national defense and the construction of national infrastructure. However, some areas of government spending can be achieved more efficiently by the local authorities, such as city or state governments. Fiscal spending by these municipal, or local, governments is known as the local government expenditure. Categories of local government expenditure include education, emergency services, and city parks.

In our next example, we will consider the characteristics of public expenditure in a democratic political system.

The next component of public finance is public revenue, which is the government’s income. The main sources of public revenue are the public sector’s surplus, public debt, fees, and taxes. Additional sources of public revenue include fines, printing of money, and donations, but we will not discuss these sources in detail. Let us examine the four main sources of public revenue:

• Surplus of the public sector: Firms in the private sector are owned by individuals in households, and the profits of the firms are returned to the households as a part of their income. Similarly, the government is the owner of all enterprises in the public sector, so all profits from the public sector are given to the government as public revenue. Like firms in the private sector, the public sector can sell goods and services to its consumers, leading to profitability. Profits made by these enterprises are known as surplus. For instance, the public sector collects payments from consumers for using city buses or for using postal services. Additionally, governments in some countries are the sole producers of major goods such as steel and oil, which often yield a large surplus. Surplus from these enterprises is a source of public revenue.
• Public debt (or national debt): The government can also borrow money from its own citizens, foreign governments, or international organizations. While these debts will be paid with interest using funds from public revenue in the future, the debt is a source of public revenue at the time of borrowing, while payments for these debts, including interest payments, are counted toward public expenditure.
• Fees: The government collects fees from individuals or organizations for a variety of purposes. For instance, an individual in many countries may be required obtain a fishing license in order to enjoy the privilege of fishing. A factory may be required to purchase a manufacturing license from the government in order to begin producing certain types of goods. Often, the amounts required for these fees are not proportional to their costs for the government, and they can produce a large surplus. The surplus from these fees is a source of public revenue.
• Taxes: Taxes are legally required payments for all participants of the economy. There are many different types of taxes that we will discuss below. Some taxes are related to an individual’s income, and some taxes are related to the value of an individual’s properties or the value of purchased goods and services. Taxes are the largest source of public revenue. What distinguishes taxes from other sources of public revenue is that taxes offer no direct benefit to the payers, while other sources are often associated with a give-and-take, known as quid pro quo. The absence of quid pro quo in taxation is a legal requirement in many countries in order to ensure transparency and to help achieve equity in society.

Since taxes are the main sources of public revenue, let us consider them more carefully. The practice of taxation is as old as civilization itself. The first written record of taxation is from year  3000 BC in the Egyptian Kingdom, which required one-fifth of harvested crops from its citizens as tax payments. The economy of the world has grown to be considerably more complicated compared to the agricultural economy of 3000 BC, and the methods of taxation have evolved alongside it.

During the eighteenth century, Adam Smith, an economist from the United Kingdom, formulated the characteristics of “good” taxes, which are known as the canons of taxation. Here, a “good” tax system means that the taxation would be fair to all citizens and be efficient in its collection. We will now consider these canons of taxation:

• The canon of equity states that the burden of taxation should be distributed fairly according to each individual’s ability to pay. This is different from the system of head tax, which demands an equal tax payment from each adult and represents a much greater proportion of a poor person’s wealth than a richer person. Through this canon, Adam Smith emphasizes that taxation must ensure “justice.” The sense in which Smith demands justice in taxation requires the wealthy to bear the heavier tax burdens compared to the poor. Most economists today view the unequal distribution of tax burdens according to one’s wealth to be fair and equitable.
• The canon of economy states that the cost of collecting taxes should be kept to the minimum. Some countries have a very elaborate system of taxation that leads to large costs. At times, the costs of collecting taxes can exceed the revenue received from the taxes. Such a tax system is neither economical nor sustainable and, hence, should be avoided.
• The canon of certainty states that a tax system should be clear to individual tax payers. According to Adam Smith, “the time of payment, the manner of payment, and the amount to be paid ought to be clear and plain to the contributor and to every other person.” Clarity in tax laws helps to make a tax system more efficient, reducing possibilities for errors and omissions in tax payments.
• The canon of convenience states that the collection of taxes should be done in a manner that is convenient for the tax payers. In other words, the process of paying taxes should not lay additional burdens on the individuals other than the payment itself. In today’s society, this is easily achieved by allowing tax to be paid electronically or to be deducted automatically from paychecks.

We can summarize the canons of taxation with the following diagram.

Smith’s four canons of taxation form a foundation of today’s tax systems in many countries. However, it is not rare to see a tax system that does not completely align with the canons of taxation. For instance, tax laws in most countries are too complex for the citizens to comprehend, which violates the canon of certainty. Also, the issues involving justice in taxation are some of the most hotly debated topics in politics, and the canon of equity is rarely to everyone’s satisfaction.

In our next example, we will consider the canons of taxation.

Let us consider different divisions of taxes. Taxes can be divided with respect to their basis. For instance, the head tax is based solely on the persons. Head taxes used to be the primary source of public revenue before the modern era. In the modern age, such a system of taxation has been diminished due to its inherent inequity, as we observed in the previous example. Most systems of taxes today calculate the payments based on funds rather than persons. For instance, income tax is based on a person’s income and property tax is based on the value of one’s properties.

Income tax is divided with respect to how the tax burdens are distributed. Proportional tax is a tax system requiring the same percentage of income from each individual. On the other hand, progressive tax charges a higher percentage of income for individuals with larger income. Poorer individuals spend a much larger share of their income on basic essentials such as food and rent, leaving a very small disposable income compared to richer individuals. The idea behind progressive tax is that people with larger disposable incomes have the ability to bear higher tax rates. Today, many countries use progressive taxation for income tax since it is perceived to be more equitable. In order to determine the tax rate of an individual, the government sets up a series of tax brackets based on ranges of income levels, with each bracket paying a different tax rate. Individuals in higher tax brackets, hence with higher incomes, pay a higher percentage of their income as tax.

Finally, taxes are divided into direct and indirect taxes based on who ultimately bears the tax burdens. Direct taxes are paid directly to the government by the individuals bearing the tax burdens. Examples of direct taxes include income and property taxes, since they are paid directly to the government, which does not then pass the tax burden to others. On the other hand, indirect taxes are the taxes imposed on goods and services whose burdens are passed onto the consumers. For instance, a merchant pays taxes on the value of goods sold in the store, but this burden is passed onto the consumers by increasing the prices of the goods. The buyers of these goods ultimately pay the taxes by making the payment to the merchant, who then passes it on to the government. This method of payment via an intermediary makes it an indirect tax. Import duties and tariffs are also examples of indirect taxes since these tax burdens, initially imposed on the importer, are passed on to the end users who purchase them.

In the next example, we will identify an example of indirect taxes.

The final component of public finance is the public budget, which is the financial budget of the government. Before discussing the government’s budget, let us consider the practice of budgets in a more familiar setting.

In personal finance, we can keep track of our income and our expenses so that we do not end up overspending by a process called budgeting. In our budget, we can record the amounts of income and expenses to keep an accurate understanding of our fiscal activities. Keeping track of our spending and income is also a good way to help plan and save for large purchases, such as a new car or a house. While the future is unpredictable, we can use the information from past records to estimate the amount of income we expect to earn and what we expect to spend. This projection can help us decide whether we can afford to make large purchases.

Another important aspect of a personal budget is the balanced budget, that is, the budget where the income matches the expenses. If the expenses exceed the income year after year, our debts will accumulate beyond our control. A balanced budget does not mean that we have to create an exact balance between income and expenses each year. Rather, savings during the good year can help offset extra expenses during the hard year. Nonetheless, we should aim to have a balanced budget on average so that our debt remains under our control.

Like a personal budget, the public budget helps the government to make sound fiscal decisions concerning public revenue and public expenditure. In short, the public budget is a document containing the projections on the economic activities of the government over a period of time. This period is usually one year, which is called the fiscal year. The fiscal year does not necessarily align with the calendar year. For instance, the fiscal year in Egypt begins on the first of July and ends on the 30th of June in the following calendar year.

The public budget consists of public expenditure and public revenue, which we discussed earlier. We recall a few important points on these topics in the table below.

Public revenue figures recorded in the public budget are merely projections, and the actual figures may differ significantly from what is stated in the budget. Nonetheless, the projected figures for the revenue are used to determine an acceptable level of public expenditure for the fiscal year. Like the example of personal finance, the government should aim to have a balanced budget on average over a long period of time.

There are four phases of the public budget: proposal, approval, execution, and audit. This is known as the budget cycle. Let us examine each phase of the budget cycle:

• Proposal: This initial phase of the budget cycle is also known as the “preparation and submission” stage, since it is where the budget is prepared and submitted for approval. During this phase, divisions in the government provide their estimated income and cost figures to one central location in the government. In many countries, this central location is the office of the chief executive, that is, the president of the national government or the governor of a municipal government. The chief executive then prepares a budget proposal based on data collected from the various divisions of the government. The proposed budget is then submitted to the legislative body for the next phase.
• Approval: We mentioned earlier that a political democracy serves to prevent government officials from seeking their own self-interest. This purpose is served in the approval phase of the budget cycle. During this phase, the proposed budget is brought before the legislative body, consisting of elected representatives. If the legislative body decides that the budget proposal needs to be modified during this stage, the modifications are sent back to the executive body who created the proposal for consent. The executives usually hold the veto power, which enables the president or the governor to reject the modifications. This can lead to a standstill if the budget negotiations between these two bodies fail. An agreement between these bodies must be reached before the start of the fiscal year. The failure to meet this deadline causes the government to shut down its nonessential functions temporarily.
• Execution: This phase of the budget cycle begins at the start of the fiscal year. Funds approved within the public budget are distributed to the respective agencies, generally divided into quarterly payments. A careful record of all expenditures needs to be kept to ensure that the apportioned funds are only used for the approved purposes.
• Audit: The final phase of the budget cycle is to review the expenditures from the past fiscal year. At the end of each fiscal year, the government divisions who had received approved funds during the year are required to submit the final accounts of all expenditures using the apportioned funds to an accounting office. In Egypt, this office is known as the Central Accounting Office. The accounting office reviews (or audits) the submitted records against the public budget to ensure that the funds were spent for their approved purposes. Additionally, the audit phase serves to evaluate the efficiencies of past expenditures so that the government can improve in the future the allocation of funds.

Similar to the canons of taxation that describe the characteristics that “good taxes” should satisfy, there are several features that a “good” budgeting process should possess. Let us consider these principles:

• The principle of annuality suggests that the budget cycle should repeat each year. According to this principle, most countries’ public budgets are drawn up, approved, executed, and reviewed for each fiscal year. Since much of public revenues and expenditures recur annually, the annuality of public budget makes it easier to predict next year’s revenues and expenditures based on the trends from the past years. Also, creating the budget every year allows the government to monitor the economic activities closely. The annuality of the public budget does not prevent the government from funding multiyear projects, since such projects can be apportioned on an annual basis.
• The principle of unity states that both the public expenditures and public revenues should be contained in one document in order to provide a comprehensive view of the government’s activity. The unity principle also means that there should not be separate budgets for specialized goals. Such division of budgets would make a budget less transparent to the legislators who need to make good decisions based on the overall budget. Abiding by this principle leads to the viewpoint of the government’s fiscal activities as occurring from one consolidated fund.
• The principle of universality states that all revenues and expenses should be recorded in the public budget. In addition to this, the principle prohibits links or dependencies between certain costs and revenues within the budget. In other words, a budget should simply contain a list of revenue incomes and a list of expenditures. It should not include costs that are offset by specific revenues, for example saying that the cost of a new tunnel is paid for by certain tax revenues. Such mutual cancellations of individual revenue and expenditure items hide these activities from plain sight when reviewing the public budget. This principle reduces such ambiguities in the public budget by including every revenue and expenditure item independently.
• The principle of balanced budget states that the public budget should be balanced in the sense that public revenue can compensate for the public expenditure within the annual budget. However, as mentioned earlier, it is neither realistic nor practical to have a balanced budget every year. In some years, public revenue may exceed public expenditure, in which case we have a budget surplus. In other years, public expenditure may exceed public revenue, where we would have a budget deficit. This principle suggests that the budget should be balanced on average over a period of years in the sense that the budget surplus can compensate for the budget deficit. Repeating budget deficits year after year would create a large national debt, which can cause economic instabilities.

In our final example, we will consider the principles of the public budget.

Let us finish by recapping a few important concepts from this explainer.