Public Finance and a Review of Basic Concepts
The Main Functions of the Public Sector
Public finance normally considers four main functions of the public sector. The first two deal with microeconomic aspects of public finance, while the other two deal with macroeconomic aspects of public finance. It is useful to consult basic textbooks on public finance such as Rosen (2014) and Stiglitz (2015) although these textbooks mainly deal with microeconomic issues of public finance.
The first part of this chapter explains the main functions of government and the basic concepts and techniques that are useful to know when studying public finance. The second part of this chapter explains the public sector and the budgetary process in Japan.
Why does a government impose taxes and provide public spending such as public consumption and public investment? Why does it also conduct many transfers? According to the fundamental theorem of microeconomics, as long as the private market is perfect, the price mechanism automatically adjusts demand and supply so that demand and supply are equalized and resources are efficiently allocated. In this regard, the private market provides any goods that people want. See Sect. 2.2 for a simple explanation of the optimality propositions of the market mechanism.
If people always consume private goods that can be provided efficiently in the private market, private firms take the lead. Intervention by the government is unnecessary. The provision by the government of the same goods as those of the private sector is not the government’s role. When the market is perfect and private agents maximize their own interests, the private sector works more effectively than the government. In such a scenario, when and why would government intervention become desirable? This is the fundamental question in public finance.
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T. Ihori, Principles of Public Finance, Springer Texts in Business and Economics,
In reality, the private market often fails because of several reasons such as externality, asymmetric information, and imperfect competition. In particular, the private market cannot provide some goods and services efficiently. These are called public goods and services. Public goods and public services have different properties compared with private goods and private services in the private market.
In this context, let us define public goods in accordance with two properties. As explained in Chap. 11, firstly it is impossible to exclude an agent from consuming goods, a situation that we call non-excludability. All agents living in a community can equally consume such goods. Further, the consumption of one agent does not reduce the consumption opportunity of another agent. We call this non-rivalness.
Consequently, non-excludability and non-rivalness are two main properties of public goods. If these two properties remain perfectly consistent, this situation is called the pure public good. Defense spending, diplomacy, the basic legal system, and measures against national disasters are examples of pure public goods.
These public goods are not well provided in the private sector. Because the benefit of public goods has positive externalities, such goods are provided too infrequently in the market. If agents voluntarily provide these goods, others can consume the benefit without paying for the burden. This is the free rider problem. Thus, the government is required to provide public goods as appropriate (see Chap. 11).
Since the market is inefficient with respect to the provision of public goods, the government should provide public goods as appropriate. This is the standard function of the public sector. Public finance investigates how and when the government should intervene in resource allocation in the market. In this regard, some argue that the government should only provide microeconomic measures such as the provision of public goods and improvements in the event of market failure. These measures are considered the main role of small government. Such an approach is also called cheap government or small nation, names that emphasize the efficiency criterion.
In order to provide public goods, the government needs to collect tax revenues. Imposing taxes in the private sector produces a burden on private agents, thereby harming economic activities. This is called the distortionary effect of taxation. With regard to the revenue side, public finance investigates how the government should collect taxes in order to minimize the distortionary effect of such taxes. This is an important topic of optimal taxation and tax reform. See Chaps. 8 and 9.