Public finance is one of the main subjects in economic studies. It deals with the financial activities of a government. That is, how it collects revenues, how it spends public funds, as well as the debt operations and their effects on the economy. The government plays a major role in economic growth and development by offering guidelines for sharing of public resources. Households, government bodies, and corporate bodies are the three main bodies that make up a market for goods and services. Their relationship is crucial to the strength of that market, and it reaches its peak when each entity is satisfied.
Households provide demand for the goods and services supplied by firms. The government comes in to create and implement policies for the good of the aid market. If anything goes wrong within the market, causing a risk of market failure or economic failure at large, there is a need for government intervention, which aims to create a perfect environment for these parties to coexist mutually. There would be chaos in the economy without government intentions, although some economists believe that government intervention is not necessary for any stage of economic development.
Public finance is the main aspect that connects the government to all economic activities. It seeks to analyze the impacts of the activities mentioned above on individuals and firms. It encompasses fiscal and monetary policies, which explain the government’s cause of action regarding revenue generation through taxation and means, as well as in deciding the pattern of expenditure that should be applied. Many of the fiscal policies of most countries are carried in the budget, and such policies tend to have a direct and major impact on the general economy.
Consider, for instance, when the 2008-2009 Great Recession hit the global economy. Many economies were caught unawares, leading to the failure of many markets. This forced policymakers to sit down and create policies that could reverse the situation or reduce the effects of such economic shocks. Economic cycles are a normal aspect of a growing economy. At times it is high, and at times it falls low. Positive growth is seen as something good as it means the economy is going well, but it can also be dangerous and lead to inflation if the government does not have proper policies in place to put a brake on things. Hence, you will not that interest rates in financial institutions go high, prices of goods increase, and taxes are hiked. This is all in an attempt to reduce the effects of an economic bubble until it picks where it cannot grow any further. On the other hand, when there is a recession, the government acts by reducing the interest and tax rates. This encourages more borrowing from financial institutions, and firms are incentivized to reduce prices on commodities, which encourages more spending.
Public finance aims to achieve accountability in sharing limited resources with an ever-increasing population. Human needs are unlimited, which causes a scarcity of resources. People don’t get everything they need to lead a happy life, which means they have to find other ways of achieving happiness. Markets are the source of these alternative methods, where they share goods and services from various entities. Public finance is needed for the government to create budgets, achieve expenditure, and deal with the public debt. It aims to achieve the following important tasks:
– Price stabilization. Public finance is applied to maintaining stability in the prices of goods and services, hence, preventing constant potential fluctuations and inflations and deflations. These factors tend to destabilize the economy of any country.
– Equal distribution of wealth. Equitable wealth distribution is where every member of an economy is given a fair consideration of the national wealth. In this case, income and wealth are equally distributed among all the members of an economy. For instance, the government may come up with a policy to implement more tax on the rich and use the money to help the poor. This way, everyone is seen to contribute equally to the general economic growth and development.
– Satisfaction of needs. Another main objective of public finance is the satisfaction of collective needs. When a community is not exposed to enough education, the government creates ways to build more schools or invest in other education features to improve this situation. Hence, it helps to satisfy the needs of a community. They may not be handled 100%, but it tries to bring things to a more desirable status.
– Allocation of resources. As stated above, human needs are unlimited, and yet the resources they rely on are limited. As such, the government uses public finance policies to determine the best ways of allocating these resources. Some communities may require more resources than others, which is why there must be policies that form a foundation for fairness. Also, both the public and private sectors receive a fair share of these resources in an attempt to push forward the economy.
– Full employment. Unemployment is one of the biggest threats to economic growth. People who are not employed cannot pay taxes to the government, and yet they depend on government support through different initiatives. Public finance provides full employment opportunities to citizens of a country. This can happen by creating flexible policies and conditions for economic operation. They make it easy for foreign entities to invest in the economy, creating employment opportunities. Many employment opportunities are an indication of positive economic growth.
– Maintenance of favourable balance of payments
It is not only through taxation that a government can collect the needed funds to run its activities. It also uses tariffs and other fiscal policies which maintain a balance of payments in a country. Too many fluctuations can out a huge impact on this balance, causing market failures and other effects. Public finance offers a way put by develop a framework to review and control all payment systems. It makes things easy and functional for interested parties, enabling them to work out better relationships with everyone within the markets.
Fiscal policy is a term used in economics and political science to mean how the government uses revenue collection and expenditure to influence the growth of their economies. In macroeconomics, using government revenues and expenditure can influence the variable that emerged from the Great Depression. At this time, previous laissez-faire became unpopular. The fiscal policy and its application are founded on the theory of Maynard Keynes, who was a British economist. His Keynesian approach to economics theorized that the government changes in the levels of taxation and government spending influence aggregate demand and the extent of economic activities. Today, it is known around the government’s fiscal and monetary policies are crucial to economic development. They are the main strategies applied by governments and the central bank to achieve their economic objectives. The two policies can be used together to target inflation and boost employment. A good inflation rate is supposed to be in the range of 2 to 3%. Anything above this is a danger to the economy and has to be regulated. The policies are also designed to keep the GDP growth at 2% to 3%, while the natural unemployment rate is kept at 4% to 5%.
In other words, fiscal policy is crucial in stabilizing the economy over the cause of an economic cycle. Every economy goes through a full cycle from the trough on the recession side to a peak on the positive side. There is a need to keep things in the natural order, whether there is a shock in the economy or not. For instance, a bubble may cause many people to desire to borrow money, which can quickly lead to inflation. The government comes up with policies to increase taxation and lending rates, hence discouraging too much borrowing. When there is a recession, the economy requires a boost, which comes from doing the opposite.
Any change in the level and composition of taxation and government expenditure can impose a huge impact on macroeconomic variables, including aggregate demand, saving and investment, income distribution, and resource allocation. We can tell fiscal policy from monetary policy in terms of the exact functions. The fiscal policy is concerned with taxation and government spending, and a government department often implements it. On the other hand, monetary policy is dealing with the supply of money and issues of interest rates, and the central bank handles it. Despite these differences, they are all crucial influencers in the performance of a country’s economy.
Aims of fiscal policy
Fiscal policies are created based on the economy’s current state, and they may reach different objectives. On one side, it is implemented to restrict economic growth where unhealthy growth is imminent by mediating inflation. It can also increase economic growth where there is a need by decreasing taxes, encouraging spending on various projects that stimulate economic growth and ensuring borrowing and spending. Economic growth and sustainable development depend on these factors, which play a major role in improving a country’s status. Each economy faces its own upsides and downsides, which calls for policymakers to act appropriately and shield potential negative effects on the said economy.
Fiscal policy is presented in three stances, which are:
Neutral fiscal policy
This is usually applied when the economy is at equilibrium, neither in a recession nor in an expansion. At this point, the amount of government deficit spending, which is the excess that is not financed by the tax collected, is approximately the same as it has been overage over a specified period. Hence, there are no major changes happening that can impact economic activity. This fiscal policy is used to keep things in line and ensure that it can only be to take the economy on an upward scale if anything happens.
Expansion fiscal policy
From the contraction phase, an economy can either face worse times or improve depending on policymakers’ actions. In this case, the expansive fiscal policy is applied when a government balances this phase. When the government decides to spend above the tax revenue by more than what was initially planned for, it usually comes during a recession. For instance, a government can decide to increase spending on public works through projects like building schools and offer the residents of that economy tax cuts to encourage more consumption of goods. There is a decrease in demand at this point, which can have a negative impact on the GDP. Fiscal policy is needed in this case to incentivize more spending, and in turn, boost the economy.
Contractionary fiscal policy
This is a measure to increase tax rates and decrease government spending. As you may have already guessed, this is a policy that is applied during the peak expansion phase of the business cycle. It is used when the government deficit spending is lower than normal. This also means that public debt is crucial to the growth and development of an economy. If the inflation caused by a huge increase in aggregate demand to the supply of money is above normal, there is a possibility of a reduced rate of economic growth. Hence, the government implements policies to reduce the aggregate amount of income for that economy; as a result, reducing the available amount for consumers to spend. Hence, we can conclude that the contractionary fiscal policy approaches are used in view of unhealthy economic growth that can lead to inflation, high prices for investment, recession, and unemployment beyond the health levels.
Even though these aspects of fiscal policy have been defined, they can be misleading because cyclic fluctuations of the economy can have similar effects on tax revenue, even where there are no changes in spending or tax laws, hence, affecting deficit situations, which are not necessarily considered policy changes. As such, one has to be very careful when using these definitions.
The government spends money on many different things. From military and police services to healthcare and education, they are all under public finance. Such expenditure can be funded through ways such as taxation, seigniorage, borrowing money, using fiscal reserves, and the sale of fixed assets. Fiscal policy is used to influence the level of aggregated demand to meet certain goals, which include price stability, full employment, and economic growth, among others.