Public Finance

Public Finance

 Public finance is both a name for government finance - the way governments secure and manage their revenues - and the name of a branch of ECONOMICS that studies the public sector of the economy. Government finances its expenditures through TAXATION, the borrowing of funds by the public sector (see PUBLIC DEBT) and the printing of money (see MONETARY POLICY). This article is concerned with the pattern and role of government expenditures.

The relative importance of government expenditures in the Canadian economy has risen dramatically over the past 70 years, from 15% of the Gross Domestic Product (GDP) in the late 1920s to 40% of GDP in 1980 and 50% in the early 1990s. This rise has reflected a gradual trend which was interrupted by World War II when government expenditures reached a peak of 45% of GDP, largely because of the war effort. In recent years, this trend has reversed as governments at all levels have reduced expenditures in the face of budget deficits: by 1996, the ratio of government expenditure to GDP had fallen to 46%. Of the 1996 expenditures, 44% can be accounted for by federal government expenditures, 39% by provincial governments and 17% by local governments.

Total government expenditures are of 2 fundamentally different types - those on goods and services, and those on TRANSFER PAYMENTS. Government expenditures on goods and services represent the diversion of productive resources from the private sector to governments (only these expenditures are included in the GDP), while transfer payments financed by taxes represent the shift of purchasing power from one group of individuals to another. Upper level governments also transfer some of their revenues to lower levels to assist them in meeting their financial responsibilities (see INTERGOVERNMENTAL FINANCE).

In 1996 expenditures by all levels of government on goods and services was 17.4% of GDP (a figure slightly lower than that of 1970 but significantly higher than the early postwar figure of 14%), of which the federal government was responsible for only about one-fifth. More than one-half was spent by the provinces and largely comprised expenditures for education and health. Municipalities accounted for the remaining 30%. Government expenditure on transfers was about 19% of GDP. It accounted for about 80% of the growth in government expenditures over the 1970s and 1980s. In 1970 only 13% of GDP comprised transfer payments; by 1985 the proportion was over 20%. This rapid growth resulted primarily from the expansion of transfers to families, transfers to the elderly and EMPLOYMENT INSURANCE payments.

Rationale for Government Expenditures

In mixed economies such as Canada's, the private sector is generally viewed as the "engine of growth" and is left to undertake those activities for which its profit-oriented behaviour is theoretically suited. The public sector is made responsible for tasks the value of which it is felt should not be judged solely on the basis of whether they will generate profit. Economists usually identify 5 different components which make up the rationale for public-sector intervention into the markets of the economy, but the rationale for public expenditures is not always economic in nature.

Provision of Public Goods

The goods produced and sold by the private sector are called "private goods" (eg, food, clothing, shelter). "Public goods" by their very nature (eg, defence, general government, justice, external affairs, police protection, penal services, communications) provide services to many or all households simultaneously. These goods could not be provided by markets, so they must be provided collectively. Some are provided by the federal government, others by provincial or local governments.

Externalities

Another phenomenon, closely related to public goods, occurs when activities undertaken by consumers or producers generate significant unpriced effects, or "externalities," to those other than themselves. Although the undertaking of such activities could be left to private markets, those undertaking them would lack the incentive to purchase the amounts that would be warranted by the social benefit generated by their consumption or production. For example, the benefit to an individual of purchasing an inoculation against a communicable disease would be significantly less than the benefit to society as a whole; the individual benefits from his or her own safety from the disease, while others in society benefit from the reduction in the risk that the person will spread the disease. Similarly, research activities or manpower training by firms can generate advantages (knowledge, a trained work force) that benefit firms other than those bearing the cost. Individuals or firms acting out of self-interest would not have an incentive to acquire the socially desirable amount or might not procure it at all, which is one reason children are forced by regulation to obtain immunization before they can go to school.

Governments encourage the production and consumption of goods generating externalities in 2 ways. On the one hand, the private sector may be left to undertake these activities while being encouraged by subsidies (or tax concessions) to involve itself more fully than it would otherwise choose to do. For example, financial assistance is provided to encourage INDUSTRIAL RESEARCH AND DEVELOPMENT, manpower training and regional development. On the other hand, the government may simply assume responsibility for the provision of such goods, for example, certain health services and education at all levels. There is some dispute over whether the public provision of such goods is always appropriate.

Natural Monopolies

Some goods, eg, those provided by UTILITIES and by the transportation or communications industries, can be provided more cheaply by one or a few large firms rather than by several competing small firms. However, if the private sector were allotted sole responsibility for the provision of these goods according to the criterion of profitability, prices could be set too high and outputs too low, because no effective competition would exist to induce firms to provide services to consumers at the lowest possible price. In response to these "natural monopolies," governments may create public or CROWN CORPORATIONS, eg, CANADA POST and the CBC (see PUBLIC OWNERSHIP). Alternatively, they may choose to leave the enterprises in private hands but regulate the prices they may charge (see ECONOMIC REGULATION). In recent years, many Crown corporations have been privatized, including Air Canada and the CNR.

Redistribution

Governments also transfer incomes among persons, partly because the distribution of income would be far more unequal if it were determined solely by the operation of markets in the private sector. Income is redistributed partly through the tax structure, especially the progressive income tax, and partly through transfers to low-income earners. These transfers can include welfare schemes operated by provincial and local governments ( see PROVINCIAL GOVERNMENT), payment to low-income families by the federal government, and income-related pension payments by federal and provincial governments; but they can also include transfers that incidentally redistribute income, having been designed primarily for other reasons. Redistribution can also take place through public services rather than cash transfers. Examples include day care for low-income families and nursing homes for the needy elderly.

Social Insurance

Some transfer payments are designed to supplement an individual's income at times of abnormally low earnings or abnormally high expenditures and therefore act as a sort of insurance. Employment insurance represents income transfers made by the federal government to persons temporarily out of work; WORKERS' COMPENSATION payments are made by provincial governments to those who have ceased working because of injury incurred on the job; public PENSION payments, including the universal payments by the federal government to all persons over the age of 65 and payments made by the federal government to the retired and disabled under the contributory CANADA PENSION PLAN (or by Québec under the QUÉBEC PENSION PLAN), are transfers to persons who have lost income because of retirement. These pension payments are partly related to past earnings and contributions and are made to contributors and to their surviving dependants.

Another type of social insurance covers medical care and hospitalization; payments to cover both are made on behalf of all residents and are financed by the provincial governments with some assistance by the federal government. Governments also operate various forms of insurance in the agricultural sector to assist farmers whose incomes have fallen temporarily due to market conditions.

The CONSTITUTION ACT, 1867, outlines the expenditure responsibilities of the federal and provincial governments. Generally, expenditures for services which are national in scope (eg, defence, trade and commerce, external affairs, the money and banking system, criminal law, penitentiaries, postal service, fisheries, employment insurance, and a number of lesser matters which tend to affect residents in more than one province) are designated as federal responsibilities, while those primarily affecting residents within a province are allocated to the provinces. In turn, the provinces themselves delegate certain responsibilities of a purely local nature to the municipalities within their jurisdiction.

The provincial governments' most significant spending responsibilities are health, education and welfare (see PROVINCIAL GOVERNMENT). The provinces administer the system of hospitals and health care; provide primary, secondary and post-secondary education; and administer social programs, including the welfare and social services for the poor and disabled. Provinces are also responsible for natural resources within their boundaries, the administration of justice, property and civil rights, local works and transportation, municipalities and other matters of a purely provincial or local nature.

The provinces tend to delegate to the municipalities responsibility for providing local services such as garbage pickup, fire and police protection, water and sewage, maintenance of local streets and recreational facilities. The municipalities also help in the local administration of provincial programs such as primary and secondary education, welfare assistance and hospitals (see LOCAL GOVERNMENT).

Finally, there are areas, such as agriculture and immigration, in which both the federal and provincial governments may exercise concurrent power. One other important area of joint responsibility is that of OLD-AGE PENSIONS. A constitutional amendment in 1951 permitted the federal government to enact old-age pension legislation, provided it did not affect the operation of provincial old-age pension legislation.

All of these designated responsibilities of the federal and provincial governments give rise to government expenditures. The largest categories are social services, education and health, which together comprise about 30%, 16% and 15% of total government expenditures, respectively. About two-thirds of social service expenditures are at the federal level, mainly for employment insurance, transfers to the elderly and transfers to families with children. These constitute two-thirds of federal government program expenditures. Almost one-quarter of federal government expenditures are made up of transfers to the provinces, while defence makes up just under 10%. The federal government is also responsible for large interest payments on the national debt, which make up about one-quarter of total federal expenditures (seePUBLIC DEBT).

On the other hand, almost all health and education expenditures are at the provincial level, and these make up close to half of provincial expenditures. Social services expenditures, mainly for welfare programs, constitute about one-fifth of expenditures by provinces and their municipalities. The financing of all these major provincial expenditure responsibilities in the areas of health, education and welfare have been assisted by federal transfers to the provinces, especially to those that are less well off than the average. Provincial and local governments also spend a considerable amount (14% of expenditures in 1996) on interest payments on their debt.

See also PUBLIC EXPENDITURE.