Lecture Notes VII Theories on Government Spending

Jai Leonard I. Carinan

Lecture Notes VII

Theories on Government Spending

Public Spending- is one of the instruments of modern fiscal policy employed

by government to prevent or mitigate economic fluctuations

Sources of funding for the expenditure of the public sector

a. taxation
b. borrowings- pump priming and short and long-run compensatory
spending
c. sale of government assets, goods and services “privatization”

Basic Premises of Public Spending Policies

a. Fiscal policy and public spending is the production depends upon the
total effective demand for goods and services currently produced (that is,
aggregate expenditure on consumption and investment)

Where: Y= C + I + G + X-m

b. The primary goal of government spending is to raise aggregate

consumption. Due to the higher level of government spending, income of
consumers will expand, and consequently consumption expenditure will rise.

c. This is so because when we view the economy as an integral whole,

income and expenditure are exactly one and same thing;

“Every transfer of money is at the same time income to the individual

who receives it and expenditure for the individual who parts with it”

Individuals who are the recipients of the government’s expended

money naturally find their money income increased, and accordingly step up
their rate of spending. These rounds of spending will, in turn, increase the
incomes of the recipients who are now in a position to increase their
expenditures.

The chain relationship of income creation and expenditure growth, of

each increase in expenditure results indirectly in an in increase in income
larger than itself, provided, of course, that the increase in expenditure
persists.

The increase of government funds into this state of economy would

assure the flow of disposable income sufficient to stimulate demand and
production.

Deficit financing for stability and Full Employment

3 types of deficit financing

1. Deficit financing for offsetting depression
 Lecture Notes VII Theories on Government Spending
Jai Leonard I. Carinan

2. Deficit financing for compensatory inadequacy of private investment

3. Deficit financing for defense expenditure

The concept of pump priming

-it refers to the injection of government funds into the income stream in
sufficient quantities and under proper circumstances in order to reverse the
trend of anticipations and to generate recovery

- this emergency tool is a temporary device to restore the balance in the

economic system during the cyclical downturn, after which the system is
expected to operate under its own power, this implies that the multiplier
effect will come into play and the accelerator will reinforce the increases in
income, consumption and investment

Different stages in pump priming process

Injection of funds by the

government into the income
stream

The income stream adds the

purchasing power of the nation,
First Stage
(relief, wages, grants plus payment,
subsidies)

Leads to primary and

secondary employment

The extension of
Second Stage government loan to financial
institution and business firm

Stimulation of net private

investment, our pump
Third stage
priming scheme shall have
achieve its goal
 Lecture Notes VII Theories on Government Spending
Jai Leonard I. Carinan

Compensatory spending in the short- run

- is a deficit spending scheme resorted to by government to offset the

inadequacies in private spending during periods of falling prices and
rising unemployment
- Deficit spending –mean incurring expenditure excess of revenue

Such an excess may result from:

a. Reduction in tax receipts at time when expenditure remains the same,

it indicates an unbalanced budget wherein the proceeds from taxation
fall short of budgetary requirement.
b. Government spending on public investment ( infrastructure, hospital or
subsidies)

Compensatory spending in the long-Run

- is undertaken by the government to offset the deficiency in private

spending.

- It refers to the use of government outlays as a means of counteracting

the alleged long-run tendency on the part of the economy to operate at
levels well below full employment

- Government outlay for capital and non capital goods and services will
be directed primarily into non competitive area where increased
activity may favorably affect the private sector of the economy.

- Government participation must be considered as the continuing activity

to counter balance the long run deficiency of private net capital
formation.

- When there is anticipation of economic contraction, compensatory

expenditure must be in deficit expenditure

o 1st- Expenditures find their way to the low income earners or

unemployed
o 2nd- Most of them will spend this for their consumption
o 3rd –The increased in consumption would lead to higher
production and transmitted to investment for replacement or
expansion of existing productive capacity.
- Keynesian economics’ proposition is that only an expanding economy
can provide full employment and increased use of natural resources.
o A continuing high level of employment must be maintained only
by injecting new purchasing power into the economy in a steady
 Lecture Notes VII Theories on Government Spending
Jai Leonard I. Carinan

manner. The instrument for this would be series of fiscal

measures for deficit spending.

Budget Program for Stability and Full employment

a. Annually Balanced Budget

-this principle calls for a budget that maintains an exact balance between
expenditures and revenue each year.

b. Swedish Budget or the Cyclically- Balanced Budget Policy

- This advocated by the Committee for Economic development an

organization of outstanding business leaders
-budget should recognize the need for counter cyclical fiscal policy,
namely surpluses during prosperous period and deficits in times of recession.
-the stabilizing budget program, calls for a fixed tax rates is so devised
as to create a budget balance when 93% of the labor force is employed. At
full employment the fixed tax rates structure should yield a surplus in the
cash budget.
- The basic rule is that tax revenue will rise during boom and fall during a
depression
- Budget should become an automatic stabilizing instrument, with tax
rates kept stable, the governments revenue from taxes will rise when the
national income rises and fall latter falls
- Booming economic conditions mean high personal incomes, high
corporate profits and high sales volumes (large tax base)
- When economic activity continues to decline, the surplus diminishes,
the budget would balance and then justifiable deficit would appear.

c. Formula Flexibility

-is a system of counter-cyclical variations in tax rates, on the one hand

and in government expenditures, on the other hand, with these variations
automatically going into effect when certain designated indices rise or fall.
-the so called peril points, these changes in selected indices example
rise or fall in the level of employment. CPI etc

d. The managed Compensatory Budget Program

- This policy attempts to fit the budget to the changes in the business
cycles, when the national income and employment are expected to fall, the
program calls for a combination of expenditure increase and tax reduction in
the amount necessarily to minimize instability.
- If economic activity is on upswing tax rates would be increased and
expenditures pruned to siphon off excess purchasing power, the surplus
generated can be utilized for debt reduction.
 Lecture Notes VII Theories on Government Spending
Jai Leonard I. Carinan

The Growth of Public Spending

a. Wagner’s Law- “ The law of Ever- increasing State Activity”

- It was formulated by Adolph Wagner a German economist 1883

- It states that demand for social goods and services tends to Increase
elative to the demand for private goods as real per capita incomes rise.
- In a low income economy, people utilized their real income on
consumption of basic private good (food, clothing, shelter). As the economy
advances, as the society’s wealth increases, and the basic wants have been
largely satisfied, new need arise, most of it are public gods ( police, fire
protection, highways, education)

b. Parkinson’s Law

- it was formulated by C. Northcote Parkinson

- This law of organizational growth, which is especially pronounced
among administrative staff, is based on two premises: (1) the psychological
desire f individual officials to have more and more subordinates(but not rivals)
and (2) the phenomenon that the personnel of an organization perform work
for one another
- The law provides a realistic explanation to the rising cost of
government, specifically the pyramiding organization of several government
agencies.

c. Somer’s Principles of Government expenditures

-These are suggestion of Professor Harold Somer in arriving at

appropriate expenditure policies.

1. Principle of Minimum expenditure

The government should spend the least it possibly can,
consistent with the protection of its citizens.
The criterion may be set up in terms of the maintenance of law
and order.

2. Principle of Minimum Interference with Private Enterprise

Government spending should have a little interference with
private enterprises.
It should not provide public works that would compete with
established private firms
The government should not set up retail stores and factories.

3. Principle of Maximum Employment

The aim of the government expenditures is sometimes to raise
the level of employment as high as possible.
 Lecture Notes VII Theories on Government Spending
Jai Leonard I. Carinan

4. Principle of Maximum advantage

Maximum advantage should be achieved at all times. The
implication is that each should spent where the marginal social utility is
the greatest
Harold D. Smith presented his “Budgetary Commandments” in 1944. “The
Budget as an instrument of legislative Control and Executive Management.”
Public Administration Review IV (Summer 1944) 181-188

These historical budget principles are substantially as follows:

1. Publicity – The main stages of the budget process, which include
executive recommendation, legislative considerations and action, budget
execution, should be made public.
2. Clarity – The budget should be understandable to every citizen. As
was said by a British writer in 1764: “The Administration has condescended…
to explain the budget to the meanest capacity”
3. Comprehensiveness – The budget should contain expenditures and
revenues on a gross basis, reflecting all governmental activities without
exception, and should show the surplus available for debt retirement or the
deficit to be met by new revenue legislation or borrowing
4. Budget Unity – All receipt should be recovered into one general
fund for financing all expenditures. This principle condemns ear marking of
revenue for specific purposes of expenditures, except incases of trust
accounts, or in cases where a special and direct relationship exists between
receipts and expenditures.
5. Detailed Specification – Receipts and appropriations should be
expressed in detailed specifications. Transfer of items should be permitted
only in exceptional cases.
6. Prior Authorization – The budget should be submitted, considered,
and acted upon in advance of the period during which the expenditures are to
made, it should include estimates for all foreseeable needs, thus reducing as
far as possible request for supplemental and deficiency appropriations.
Budget execution should stay strictly within the legislative authorization and
should be checked by an auditing agency reporting to the legislature.
7. Periodicity – Appropriations should be authorized for a definite
period of time. An appropriation not used at the end of the period should
generally lapse or be re-appropriated with the specific amount and purpose
detailed.
8. Accuracy – Budget estimates should be as accurate as possible and
there should be no “padding” of expenditures estimates or providing for
hidden reserves by underestimating revenue.

Reference:

Romualdez, Eduardo Sr. E., Yoingco, Angel Q. and Cosem, Antonio O.

Philippine Public Finance, Manila, Philippines, G10 Enterprise, 1994
Lecture Notes VII Theories on Government Spending
Jai Leonard I. Carinan