Public Finance

It is the part of economics that looks at government revenue and expenditure

Andy Yan

Reviewed by

Andy Yan

Expertise: Investment Banking | Corporate Development


September 20, 2023

What is Public Finance?

The study of public finance is about how the government affects the economy. It is the part of economics that looks at government revenue and expenditure and how to change things to achieve great results.

Public finance is concerned with the revenues and expenditures of governments. 

However, it has a broader scope as it also examines the effect of government decisions on the economy.

It plays an essential role in economic growth because it provides an overview of how public finance is managed, leading to improved performance and boosting transparency, resulting in better outcomes for the nation.

It covers a diverse range of topics, including the following:

  •  Examination of macroeconomic trends.

  •  Analysis of revenue and expenditures.

  •  Assessment of economic risk.

  • Developing new revenue-generation strategies.

The primary goal is to manage and offer the basic requirements of the population, such as food, shelter, health, infrastructure, and education. 

Properly managing public resources by allocating and using these resources efficiently and effectively results in the country’s development and growth.

Managing public finance

The correct administration of public resources, along with the distribution and utilization of those resources in a manner that is both efficient and effective, leads to the expansion and development of a country. 

The public financial management process focuses on:

1. The efficient allocation of available resources

Allocative efficiency is when the price of a product sold on a market is the same as the marginal value consumers place on it and the same as the marginal cost.

In other words, resources are allocated efficiently when it is impossible to provide more of one good or service without sacrificing another valued more highly.

2. The distribution of income among citizens

Income distribution in economies is a distribution of a country's total GDP among its people. Unequal income distribution leads to economic inequality, a problem in almost every country worldwide.

Societies with high levels of economic inequality have lower long-term GDP growth rates, higher crime rates, poorer health, and lower average levels of education than those without such extreme economic inequality.

3. The stability of the economy

Economic stability is when the macro economy doesn't change too much. For example, the economy is stable when steady output growth and inflation stays low.

 A country's economy is considered unstable if it has big recessions, high or changing inflation, and financial crises.

Government expenses

There are three categories of government expenditures categorized as follows:

1. Government consumption

Government spending on products and services for immediate use.

2. Government investment

Government purchases goods and services by the government that are supposed to generate future benefits.

3. Transfer payments

Government expenditures are not purchases of commodities or services but represent money transfers such as social security payments.

There are different examples of government expenses, including but not limited to:

a. Income distribution

Some ways the government spends money refer to moving money from one group to another under specific conditions. For example, the government gives money to people lost because of natural disasters. 

b. Income Security

Income security is a form of government support designed to ensure that all members of a society can meet their basic needs, like food and housing.

It is a support program for the elderly, maintenance of children, medical care, parental and sick leave, unemployment and disability compensation, and support for individuals who have suffered workplace injuries.

Income security (welfare) comes in different forms, such as social insurance, universal, discretionary, and Means-tested

c. Employment insurance

Employment Insurance (EI) is a federal program that provides unemployed workers short-term financial aid while seeking jobs or improving their skills.

The EI program covers Employees who take off time from work due to significant life events such as illness, pregnancy, nurturing a baby, or recently adopted child.

d. Health Care

The government sets a good amount of money to support the healthcare system that aims to keep people healthy or improve their health by preventing, diagnosing, treating, easing, or curing disease, illness, injury, and other mental problems.

A well-functioning healthcare system can significantly contribute to a country's economic development.

A country with a healthy society means a high work production rate, fewer workers on leave due to health issues, and a low rate of using healthcare sources. In other words, economic development correlates well with society's well-being.

Financing government expenditures

Government expenditures finance in different ways include the following:

1. Taxes

Tax is an obligatory financial charge imposed on the taxpayer, whether an individual or legal entity, by a government agency to raise funds for the government and various general expenditures. 

The government uses taxes to pay for administration, social services, infrastructure investments, etc., and reduce income and wealth inequalities through overall economic development. 

Taxes make up the majority of revenue for the government.

There are different types of taxes, including taxes based on an individual’s income, while others are based on the value of their property/investments or the value of the goods and services they buy. 

Most nations have a tax system to fund public needs and government operations. Some apply a flat percentage tax rate on personal annual income, although the vast majority of scale taxes are progressive based on yearly income bands. 

The majority of nations impose a tax on both individual and corporate income.

2. Debt

Governments can take out loans, issue bonds, and make financial investments.

Debt is the total amount owed by the federal government. Due to government deficits in the past, the government's debt has increased over time. When a government's expenditures surpass its revenues, it is in deficit. 

The government may owe money to both domestic and non-domestic parties. This amount is included in the country's external debt If it is owed to citizens of other countries.

Most government budgets are calculated on a cash basis, meaning that revenues are recorded when they are collected, and expenditures are recorded when they are paid.

3. Seigniorage

Seigniorage is the net revenue generated by currency issuance. It is the difference between the face value of a coin or banknote and its production, distribution, and eventual retirement costs. 

4. Fees

For various objectives, the government collects fees from individuals and organizations. For example, the government may require a factory to buy a manufacturing license before it can begin producing specific categories of items.

The quantities required for these fees are frequently unrelated to the government's costs, resulting in colossal excess—the surplus generated by these levies that is a source of revenue for the government.

Similarities between public and private finance

These concepts are distinct, although they seek to benefit and fulfill desires. The main distinction is that the first benefits the public, whereas the second benefits individuals.

The first one involves the financial management of the state government, while private finance involves the financial management of a company or an individual. 

Similarities are:

1. Scarcity of resources

Both have limited resources, so they maximize the utilization of limited available resources. 

They must balance their revenue and expenses to make the most use of limited resources. Both must work on sources allocation and sources generation activities.

Currently, both support sustainable activities with fewer resources, waste, and pollution so that they efficiently use the available resources without compromising the ability of future generations to meet their needs.

2. Financial status

Both must review their income statement to maximize profits and decrease expenses.

Operational efficiencies can be achieved by better inventory management or investments in improving the frictional costs of manufacturing, wastage, logistics, etc. Once set up, they can have a positive impact on the margin.

3. Loans

Both may borrow to cover expenses and expand their operations. However, some governments and private parties are bankrupt because they can't repay the loans. It can put off paying back loans for a while, but it is still required to repay them.

Remember that companies use loans to finance growth rather than cover expenses. If a business relies on loans to cover its expenses, it is time to consider mergers, acquisitions, or even closure.

Public Finance vs Private Finance

Some of the notable differences are:

1. Objective

  • The objective of the first one is to benefit society, while the private finance objective is to make profits for private parties. 

  • The first one studies government revenue and expenditure and how government decisions affect the economy. On the other hand, private finance studies individuals’ expenses and payments.

  • Individuals or businesses care primarily about their needs or profits, while the government tries to improve society's well-being.

2.  Budget

  • The government desires a deficit budget to increase the company's production power. In private finance, private entities are willing to maintain a balanced or surplus budget.

  • A deficit budget is often used to pay for economic development, whereas a surplus budget does not support economic activity.

3. Motive of expenditure

  • The first one makes a transaction to fulfill people's requirements, while the private one makes transactions for their profits without considering people's needs.

  • State finance adjusts its income to expenditure while the private one adjusts expenses to pay.

In other words, The government usually makes a budget of expenditures and then looks for ways to get the funds it needs to pay for those expenses.

However, private entities prepare their expenditure budget according to their expected income so that their expenditure rate varies according to their income.

4. Long-term investment

Public finance is more likely to invest in long-term investments that benefit society for a long time without considering the investment revenue. They make investments that serve society for future generations regardless of their return.

However, private finance is more likely to invest for their shareholders and bottom line without considering society’s needs.

5. Ways of raising resources

  • Government finance has more options to raise funds than private finance. One of the ways that the government use to get more fund to cover its expenses is tax.

  • Government has the power to charge people tax that contributes to funding government expenditures, while private firms cannot force people to pay them money.

Key Takeaways

1. Public finance examines how government influences the economy. It mainly examines government revenue and expenditures and how to improve things for outstanding results.

2. The primary goal of the public is to manage and offer the basic requirements of the population, such as food, shelter, health, infrastructure, and education.

3. It covers various topics, including examining macroeconomic trends, analyzing revenue and expenditures, and assessing economic risk.

4. The public financial management process focuses on:

  • The efficient allocation of available resources.
  • The distribution of income among citizens.
  • The stability of the economy.

5. Government expenditures are categorized as follows:

  • Government consumption.
  • Government investment
  • Transfer payments

6. Government expenditures finance in different ways include the following:

  • Taxes.

  • Debt.

  • Fees.

  • Seigniorage.

  • Surplus of the public sector.

7. Even though public and private finance concepts are different, they both seek to benefit and fulfill desires. The main difference is that the first benefits society, whereas the second benefits individuals.

The first one involves the financial management of the government, while the private one involves the financial management of a private party such as a company or individuals. 

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Researched and authored by Khadega Bazarah | Linkedin

Reviewed and Edited by Aditya Salunke I LinkedIn

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