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In promoting development, the state functions as a provider of goods and services in some areas and plays the role of a facilitator to the private sector in others. Governments undertake expenditures to pursue a variety of economic, social and political goals. Two common social and economic goals are: poverty alleviation and creating an enabling environment for the private sector. Besides the targeted programs of food and housing subsidies, access to and provision of basic levels of education (primary and secondary) and preventive health care services have been recognized as central to increasing the welfare of the poor. The enabling environment consists of adequate, properly regulated, well-maintained and efficient infrastructure of airports, roads and ports, electricity, telecommunications, water, waste disposal and other similar facilities. Therefore, an appropriate mix of public spending is needed on equity and efficiency grounds.
In practice there is no optimal/unique prescription for either the design or the size of the public sector. Some broad principles for public sector involvement, however, can be developed on the basis of general administration, market failures and distributional considerations that apply across countries. Generally, beyond the core public sector activities, the design and implementation of public expenditure priorities and the associated public-private mix require detailed assessment and careful tailoring country by country. Within a sector, a sensible rule of thumb is to examine the competing needs of different programs. Publicly stated objectives of the government, potential spending trade-offs, and the existing economic and social output indicators--miles of paved roads, irrigated land areas, access to drinking water and sanitation, school enrollments, infant mortality and life expectancy--could be used as inputs in determining competing needs across sectors. The Role of the State  Assessing the appropriate role of government requires recognition of the need for and the limitations of government action. Economic theory provides valuable guidance on the appropriate role of the state: market failure and distributional equity are the two frequent reasons for government intervention. In practice, a state’s capabilities are often as important determinants of its actions as the theoretical rationale. When a market economy fails to allocate resources efficiently, market failure occurs. One such example is the case of "externalities." Governments can curb negative externalities (e.g., pollution) and promote positive externalities (e.g., primary education) by means of regulation, taxation or subsidy, or public provision. Similarly, the justification of government provision of pure "public" goods is clear. The nonrival and nonexcludable (and the consequent inability to charge for) characteristics of these goods imply that the private sector will lack the incentive to supply them. National defense and to a certain extent, roads, have these features. In many cases, equity reasons lead governments to provide private goods--those that are disproportionately consumed by the poor--as a means of transferring resources to the needy in a targeted manner. A market-based economy may distribute income in socially unacceptable ways and it is often the case that governments intervene to protect the vulnerable. Food and housing services are some of the antipoverty programs offered by many governments. Government intervention is also needed to provide an enabling environment for the private sector. In his keynote address to the Annual World Bank Conference on Development Economics, 1996, Stiglitz argued that government needs to play six important roles in providing "rules of the game." Much of the role of government can be viewed as establishing infrastructure in its broadest sense--educational, technological, financial, physical, environmental, and social. Since markets cannot operate in a vacuum, this infrastructure is necessary for markets to play their central role in increasing wealth and living standards. Because constructing the broad infrastructure is beyond the capacity or interest of any single firm, it must be primarily the responsibility of government. Government intervention, however, does not necessarily provide a guarantee that society will benefit from such action. Government failure may be as common as market failure. Tight budgets, high cost of raising revenue (particularly the administrative and distortionary costs of taxation), and a multiplicity of claims on the public purse dictate that government activity demonstrate its ability to add tangibly to the economy. Governments in many countries--more in developing than in industrialized--have limited resources and low capability for effective intervention (see the World Development Report 1997 for a lucid treatment of this issue). Countries differ in their ability to play an active role in addressing market failures. For example, the ability to establish and enforce laws and regulate financial markets varies considerably. Very few developing countries have successfully created long-term stable credit markets. Similarly, the capacity of developing countries to address social equity also varies. At the lower end of the spectrum, countries struggle to provide the very basics--food and shelter--to the poor and needy. The delivery is made mostly in a non-targeted and costly way. Expecting countries with low capability and few resources to undertake more complicated redistributive functions such as providing social safety nets (health care and retirement) could be a tall order to fill. Improving government performance requires, among other things, sustained commitment of and political support from key governmental and societal players and a realistic time frame to carry out appropriately sequenced reforms. Incremental changes are better than no changes, but far-reaching institutional reforms take time. While the principles of market failure and distributional equity provide some guidance on the role of the state, the actual intervention should be a function of the state's ability and available resources. The above guidelines provide framework for the role of government. However, they do not translate into a unique prescription for either the design or the size of the public sector in a country. These are complex matters requiring detailed assessment and careful tailoring country by country. This framework may imply different prescriptions for countries at different stages of development (or in different situations). Public Spending and Budget Deficits Both theory and evidence suggest that persistently large fiscal (budget) deficits pose real threats to the stability and growth of the economy. Excessive budget deficits could lead to a combination of inflation, exchange rate crises, external debt crises, and high real interest rates. Restoring fiscal balance usually requires a reduction in public spending and in most cases this may be the correct way of reducing deficits. Before embarking on such a program, however, a few key questions need to be addressed as part of a broader assessment of a country’s fiscal policy. How is the deficit measured? What is the composition of deficit financing? How much of the deficit is being financed through foreign grants? What is the sustainable amount of fiscal deficits? Can the level of taxation be increased without introducing too many disincentives to private economic behavior? Is it less costly to curb public spending? Is the public spending composition geared towards enhancing growth and reducing poverty? (Subject briefing on other important debt management issues such as contingent liabilities, valuation of explicit and implicit guarantees, and off-budget items is not included here. Information on these and related topics can be obtained from the Poverty Reduction and Economic Management (PREM) Network’s Economic Policy: Fiscal and External Sustainability.) A conceptually right way of measuring deficits is to look at the change in public sector’s net worth (assets minus liabilities). In practice, however, such a measurement is quite difficult, if not impossible, in most countries. The difficulty lies in the valuation of public sector assets. Partly due to this problem, the conventional deficit measure captures the change in public sector liabilities. In the conventional way of measuring deficits, the inflation-corrected, consolidated public sector deficit is the most comprehensive and correct measure of public deficit. It represents the total excess of expenditure over revenue for all government entities (including public enterprises and the central bank). In countries with high inflation, part of the borrowing by the public sector is offset by the decline in the real value of their existing debt. A measure of the current policy is the primary deficit, also called the "non-interest deficit." (For a discussion of analytical and methodological issues in the measurement of deficits, see Blejer and Cheasty [1991] and Eisner [1984].) According to Fischer and Easterly [1990], public sector deficit can be financed in four basic ways: printing money; running down foreign exchange reserves; borrowing abroad; and borrowing domestically. Each of these mechanisms could lead to at least one potential problem: printing money acts like a tax, but the associated inflation exacts a heavy toll on social cohesion; drawing foreign exchange reserves could lead to a balance-of-payment crisis; borrowing abroad could precipitate a foreign debt crisis; and domestic borrowing might crowd-out private investment by raising interest rates. There is, however, no optimal composition of deficit financing. The latter is a complex issue which requires detailed assessment and careful tailoring on a case by case basis. The economics of budget deficits tells us that the amount of deficit that can be sustained (without exacerbating the macro indicators) depends, among other things, on the future course of the debt to GDP ratio, and on the relationship between the real growth rate of the economy and the real interest rate. The concept is a bit technical and involves a formula to determine the level of sustainable fiscal deficit. Interested readers should look at the article by Fischer and Easterly [1990]. Deficits can be reduced by cutting spending or increasing revenue. A conceptually right way to decide on this issue is to compare the marginal cost of raising a unit in revenue with the marginal benefit of expenditure. In practice, there might be problems in relying on this rule because no reliable estimates exist for either the cost of mobilizing extra tax revenue or the benefit of marginal public spending. Experience from developing countries, however, suggests that spending cuts are often needed to restore fiscal stability. Recent empirical studies have shown that lasting fiscal adjustments are primarily based on expenditure cuts (World Bank, 1992). Any restructuring of public spending, however, should ensure adequate funding for key expenditure programs for growth and poverty alleviation. In other words, the composition of spending is as important, if not more, as the level. If and when necessary, spending cuts should be complemented by tax reform to increase revenue.  | | |
Public Spending in a Market Context: The Efficiency Issue As discussed in the section, The Role of the State, public economics proposes two different sorts of justification for government interventions--improving either the distribution of income or the efficiency of the economy. Any proposed public expenditure should be expected to demonstrate its ability to contribute to either goal. Here, the focus is on public expenditure to improve economic efficiency. (The discussion of public spending to improve the distribution of income is in the section on Public Spending for Equity: The Distributional Dimension.)
The following paragraphs provide a brief summary of the issues: 1 Â What is the justification for public intervention?
2. What is the appropriate instrument for public intervention?
3. What are the fiscal costs associated with public intervention?
4. What is the net impact of public intervention?
5. Can there be government failures
1. What is the justification for public intervention? The first step in evaluating efficiency effects is identifying the market failure that the public intervention is expected to correct. Why, precisely, is the private economy unable to achieve an efficient outcome? The usual set of reasons include: public goods; externalities; competition failures; asymmetric information; and missing markets. The mere existence of a market failure, however, is not sufficient justification for public expenditure. There are few, if any, examples of perfect markets. With budget constraints, competing claims on public money need to be evaluated by how large these market failures are--by how much these problems reduce welfare. The problem is quantitative, not qualitative. The problem, of course, is that while the types of market failures are known, they are rarely measured except by occasional research efforts. Whether accurately measured or not, the impact of public expenditure depends on the precise extent of the gap between social and private benefit. Indeed, these quantities needs to be approximated or argued over when decisions are made. 2. What is the appropriate instrument for public intervention? The existence of a market failure is a necessary but not sufficient reason for public spending. There may be other, and better, ways of correcting them. In the case of a harmful externality, for example, private markets may work perfectly well with only the addition of a tax which takes in money as opposed to spending to offset the differential between social and private costs. Alternatively, regulation of private markets may be sufficient. Anti-trust enforcement, for example, may correct the breakdown of competition. While an expenditure in itself, anti-trust law enforcement does not require provision or direct subsidization of the commodity at issue. 3. What are the fiscal costs associated with public intervention? Related to the choice of instrument, it should be pointed out that public funds come at a premium. In order to spend money, governments must tax to obtain revenues. Most taxes have a cost in terms of inducing inefficiencies in the economy. For example, income taxes may reduce work effort, or savings, and trade taxes lead to lower consumer welfare. Proponents of particular public expenditures should have to demonstrate that the gains in welfare the expenditure produces over market allocations is at least as great as the welfare loss of raising the taxes to cover them. 4. What is the net impact of public intervention? If it is determined that public spending, per se, is the appropriate means of intervention, it is still necessary to determine the actual effect of the expenditure item. For non-traded goods, increased public supply may not translate directly into increased consumption of items for which there is a private market. Substitution between public and private sectors may lead to a reduction in the amount supplied privately, leaving a smaller net gain in consumption than publicly provided. This may partially undercut the value of the expenditure. 5. Can there be government failures? Just because a market failure exists does not necessarily mean that governments can do better. This should be a matter of analysis and judgement and not simply a foregone conclusion. Market failures refer to systematic reasons why incentives guiding the behavior of the private sector may lead to bad social outcomes. By the same token, government failures might also be analyzed with regard to the incentives built into government structures. A problem common to many countries is the difficulty of ensuring that services by teachers, doctors etc., are provided in rural areas. The degree to which we want to pursue a particular policy or provide a particular commodity or service should depend on whether or not government structures can support the attempt. Public Spending for Equity: The Distributional Dimension While most of us would prefer to see less inequality and poverty, individually we do not have much of an incentive to act as a large share of the benefits go to others. Thus, an important case can be made for public intervention to help improve distributional outcomes. The right public spending can help, but budgets are limited. Other things besides equity will be underprovided without public action. Governments therefore face competing demands, as well as intense scrutiny of whether distributional objectives are indeed being met by expenditure practices. Issues: 1. What are the key distributional objectives of public spending?
2. How can public spending best meet these objectives with limited resources?
3. How do we assess the welfare impacts of public spending?
1. What are the key distributional objectives of public spending? - Promote pro-poor growth. There is clearly a role for government to provide certain types of physical and human infrastructure that would otherwise be underprovided and yet are key to assuring that economic growth fully includes those among the poor who are capable of participating.
- Assist those left behind during the process of economic growth. It may take a long time for some sub-groups in society to participate in economic growth; some, such as the elderly and disabled, may never participate directly. Others may well be hurt in the short run by policy reforms which are pro-poor in the longer term. There may be related concerns about regionally unbalanced growth.
- Help deal with vulnerability. Incomes can be highly variable over time, particularly in poor rural economies; consumption smoothing is also imperfect. So, the poor can be vulnerable to uninsured risk caused by uncertain weather, relative price shifts or the collapse of community-level support systems during a crisis.
2. How can public spending best meet these objectives with limited resources?
The answer often given to this question is "targeting." Those left behind, or vulnerable to risk, can arguably be reached most cost effectively by concentrating limited public resources on narrowly defined "target" groups within society. In practice, approaches to targeting fall under two categories. The first is broad targeting. This approach does not target poor directly as individuals. Rather, the poor are reached by targeting services or commodities consumed heavily by the poor. Targeting basic social services--such as primary education and primary health care--and on basic infrastructural services--such as safe water and sanitation--are common examples. Another is targeting rural development activities. The second approach, narrow targeting, targets benefits to specific individuals or families explicitly identified as poor. Examples include food-based schemes such as foodstamp schemes targeted to poor mothers; cash transfers such as family allowances and means-tested social assistance; micro-credit schemes targeted to rural landless women; public employment schemes and poor area development programs focused on poor geographical areas. Each approach has costs and benefits. The approaches differ on how much reliance is made on administrative targeting versus self-selection -- which is based on the behavioral response to the incentives built into program. The costs of targeting stems from administrative demands, behavioral responses by beneficiaries and non-beneficiaries and political economy characterizing the environment in which these programs are implemented. There are no hard and fast rules about which specific policies to pursue or whether broad or narrow targeting is better. A combination is usually most effective. Within each, the appropriate policies depend on the poverty profile, the policy objective, and on country specific circumstances such as the degree of administrative capacity, infrastructural development, political economy, and other constraints on policy instruments. 3. How do we assess the welfare impacts of public spending? Information on distributional impacts, particularly the extent to which the poorest strata benefit, can help in making public spending choices. Economists and others routinely evaluate the distributional impacts of public spending policies. Many policy decisions are now based on quantitative assessments of the impacts of public spending on living standards, particularly of the poor. How reliable are such assessments? The methods most often found in practice can be classified into "benefit incidence studies" (see Demery 1997, van de Walle 1998a) and "behavioral approaches" (see Grossman 1994, and van de Walle 1998a for reviews). Hammer et al. (1995) provide an example of using the two approaches in a complementary way. Both approaches have strengths and weaknesses. For example, benefit incidence analyses focus on average benefits of public spending whereas policy conclusions on spending reform are based on impacts at the margin. Lanjouw and Ravallion (1998) propose one way to get around this problem using the benefit incidence method. Comparisons of incidence over time also provide information on marginal impacts (see Hammer et al., and van de Walle 1995). Behavioral approaches use either econometric or experimental methods. Econometric evaluations are often plagued by program endogeneity issues leading to biased estimates of program impacts. Strauss and Thomas (1995) provide a review. Jalan and Ravallion (1998) discuss the issue as it arises in assessing impacts of geographically targeted development programs in China. Fiscal Federalism and Public Spending A federal system has a multitiered structure of decision making governments. In such a governance structure, different types of public services are customarily provided by different levels of government. The decentralized decisionmaking structure provides greater proximity to the people and forces the governments to be more responsive to its citizens' preferences. In analyzing public spending in a federal system, the most important issue is that of expenditure assignment. How should expenditure responsibilities be assigned among the different levels of governments enabling them to deliver public services efficienty and equitably? Of course, a closely related issue is the assignment of revenue generation. One could argue that from the point of creating the right incentives for delivering public services, these issues are inseparable. A good analysis of intergovernmental fiscal relations in developing and emerging market economies is provided by Shah (1994).
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