Public Finance, Fiscal Policy

and Monetary Policy

Mohammad Muslim Chowdhury

Comptroller and Auditor General of
Bangladesh
 What Is Public Finance?

• Public Finance, field of economics concerned

with how governments raise money, how that
money is spent, and the effects of these
activities on the economy and on society
• Public finance studies how governments at all
levels—national, state, and local—provide the
public with desired services and how they
secure the financial resources to pay for these
services.

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 What Is Public Finance? Con..

• In many industrialized countries, spending and

taxation by the government form a large
portion of the nation's total economic activity.
– For example, total government spending in the
Japan equals about 38 percent of the nation's
gross domestic product

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 Economics of the Public Sector
• Mercantilist view – govt. promotion of trade
and industry (colonies)
• Adam Smith –invisible hand guides markets to
provide goods and services, competition weeds
out inefficiency
• Subsequent recognition of market failures-
barriers to entry/exit, public goods,
externalities, incomplete markets, information
and coordination problems, macro-
disequilibrium (Stiglitz)

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 Adam Smith on the Role of the State
• The three duties of the sovereign –
– protecting society from the violence and invasion of
other societies – by maintaining a standing armed
force
– protecting every member of society from injustice or
oppression by others – by establishing an exact
administration of justice
– erecting and maintaining those public institutions and
public works which, though they may be in the
highest degree advantageous to a great society ..the
profit could never repay the expense of any individual
or small number of individuals .. to erect or maintain.
• chiefly for facilitating commerce (roads, bridges, canals,
harbors, etc.) and for promoting education 5
 Adam Smith on the Role of the State
• So Smith anticipated public goods but not other
forms of market failure (externalities, incomplete
markets, etc.)
• No mention of social protection or transfers

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 Role of Modern Government
• To use regulation, taxation and public
provision/financing to correct for market failures,
improving the efficiency of the economy and overall
growth
• To use public policy instruments to improve equity
and protect the vulnerable
• Need to take into account the scope for government
failure
• Political and economic ideology determines size and
scope for government (welfare state, urbanization,
health pandemics, regional conflicts, ODA)

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 The Theory of Public Finance
• Government functions: allocation, distribution and
stabilization (Musgrave)
• Revenue is needed to finance public goods and services, to
redistribute income, and to regulate macroeconomic balances
• Raising revenue is not costless – disincentive effects of
taxation and administrative costs of collection
• Efficiency requires taxing goods that are inelastic, tax
consumption rather than labor or capital, use broad based
taxes
• Debt is a form of deferred revenue raising (Ricardian
equivalence)

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 Public spending
• Theory offers some general principles for
expenditure policy
– Public expenditure is inefficient if it crowds out
private expenditure
– Some kinds of goods and services would be
welfare and growth enhancing – those that
markets fail to produce
– Equity can be enhanced by public provision of
good&services to the poor or other target groups

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 Why Public Finance Is Needed?
• Governments provide public goods—
government-financed items and services such
as roads, military forces, lighthouses, and
street lights.
• Private citizens would not voluntarily pay for
these services, and therefore businesses have
no incentive to produce them.

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 Why Public Finance Is Needed?
• Public finance also enables governments to
correct or offset undesirable side effects of a
market economy.
• These side effects are called spillovers or
externalities.
– Example: households and industries may generate
pollution and release it into the environment
without considering the adverse effect pollution
has on others.

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 Why Public Finance Is Needed?
• Pollution is a spillover because it affects
people who are not responsible for it.
• To correct a spillover, governments can
encourage or restrict certain activities.
– For example, governments can sponsor recycling
programs to encourage less pollution, pass laws
that restrict pollution, or impose charges or taxes
on activities that cause pollution.

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 Why Public Finance Is Needed?
• Public finance provides government programs
that moderate the incomes of the wealthy and
the poor.
• These programs include social security,
welfare, and other social programs.
– For example, some elderly people or people with
disabilities require financial assistance because
they cannot work.

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 Why Public Finance Is Needed?
• Governments redistribute income by
collecting taxes from their wealthier citizens to
provide resources for their needy ones.
• The taxes fund programs that help support
people with low incomes.

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 Public Spending
• Each year national, Provincial, and local
governments create a budget to determine
how much money they will spend during the
upcoming year.
• The budget determines which public goods to
produce, which spillovers to correct, and how
much assistance to provide to financially
disadvantaged people.

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 Public Spending
• The Executive Head of the government—such as the
prime minister, governor, or mayor—proposes the
budget.
• The legislature—such as the parliament, Provincial
council, or Municipality council—ultimately must
pass the budget.
• The legislature often changes the size and
composition of the budget, but it must not make
changes that the chief administrator will reject and
veto.

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Public Sector Spending Across the World

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Government Spending in Bangladesh
(% 0f GDP)

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Composition of Expenditure in Bangladesh

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Spending in Bangladesh in FY19
0, 0%
Development
179669,
38.6% Non-ADP
6669,
1.৪%

ADP Recurrent
173000, Total Budget 251668,
37.2% 4,64,573 54.2%
Crore Taka

Loan, Advance and

Food Capital Operating
2489, 0.5% 30747, 282415,
6.6% 60.8%

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Expenditure by Sector

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 Public Revenue
• Governments must have funds, or revenue, to
pay for their activities.
• Governments generate some revenue by
charging fees for the services they provide,
such as entrance fees at national parks or tolls
for using a highway.
• However, most government revenue comes
from taxes, such as income taxes, capital
taxes, and sales and excise taxes.

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 Public Revenue

• An important source of tax revenue in most

industrialized countries is the income or payroll tax,
also known as the personal income tax.
• Income taxes are imposed on labor or activities that
generate income, such as wages or salaries.
• In the United States, income taxes account for about
half of the total revenue of local, state, and federal
governments combined.

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 Public Revenue
• Another important source of government revenue is
the capital tax.
• Capital includes items or facilities that generate
profits, such as factories, business machinery, and real
estate.
• Some types of capital taxes are known as “profits”
taxes.
• One kind of capital tax used by the federal
government in the United States is the corporate
income tax.
• A property tax is a capital tax used by state and local
governments. Property taxes are levied on items such
as houses or boats.
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 Public Revenue

• Sales and excise taxes are also a major source of

government tax revenue.
• Many state and local governments levy a sales tax on the
purchase of certain items.
• Consumers usually pay a percentage of the sales price as
the tax.
• Excise taxes are used by all levels of government.
• An excise tax is levied on a specific product, such as
alcohol, cigarettes, or gasoline.
• In Canada and many European, South American, and
Asian countries, a value-added tax (VAT) provides
significant revenue.

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 Public Revenue (Cont.)
• The VAT is levied on the value added to a product
during production as its components are assembled
into final goods.
• For example, a clothing manufacturer might spend
$500 on fabric, thread, zippers, and other goods
required to make dresses. The manufacturer then
adds $1000 to cover the costs of labor and the use of
machines and equipment and sells the dresses for a
total of $1500. The value-added tax is paid on this
$1000.

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Revenue Mobilization Across the
World

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Revenue Mobilization in Bangladesh
(% of GDP)

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Sources of Revenue in Bangladesh

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 Government Deficits
• When the government spends more than it
receives, it runs a deficit.
• Governments finance deficits by borrowing
money.
• Deficit spending—that is, spending funds
obtained by borrowing instead of taxation—
can be helpful for the economy.

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 Example
• When unemployment is high, the government can
undertake projects that use workers who would
otherwise be idle.
• The economy will then expand because more money
is being pumped into it.
• However, deficit spending also can harm the
economy.
• When unemployment is low, a deficit may result in
rising prices, or inflation. The additional government
spending creates more competition for scarce
workers and resources and this inflates wages and
prices
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Budget Deficit and Financing in
Bangladesh

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Debt Profile in Bangladesh

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 How Public Finance
Affects the Economy?
• Government spending and taxation directly affect
the overall performance of the economy.
• For example, if the government increases spending
to build a new highway, construction of the highway
will create jobs. Jobs create income that people
spend on purchases, and the economy tends to grow.
• The opposite happens when the government
increases taxes. Households and businesses have less
of their income to spend, they purchase fewer goods,
and the economy tends to shrink.

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 What is Fiscal Policy?
• Fiscal policy refers to the government choices
regarding the overall level of government
purchases and taxes;
• Fiscal Policies are reflected in the Government
Budget ;
• A budget shows, for a given fiscal year, the
planned expenditures for government
programs and the expected revenue from tax
and non-tax sources.
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 What is Fiscal Policy?
• A government budget typically contains a
list of specific programs (education, health,
defense, etc.) as well as tax sources

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 Objectives of Fiscal Policy
• Stability
• Growth
• Poverty Alleviation and Equitable
Distribution
• Market correction
• Complement monetary policy and
exchange rate policy to achieve
national goals

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 FP Components: Revenue/Tax
 Revenue/Tax policy
 Core to fiscal policy
 A specific policy, declared at the beginning of the FY (subject to
change time to time)
 Components (tax- direct and indirect)
 Revenue sources (Tax: NBR & Non-NBR, and Non-Tax)
 Types of Taxes (progressive, proportional and regressive)
 Role of Tax Policy
 Taxes free up resources for public expenditures
 Reduce the purchasing power of taxpayers
 Resources are freed from production of the goods of services that
they would otherwise use

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 FP Components: Expenditure
Role of Expenditure Policy
 A tool the government uses to reach its objectives
 Public expenditure increase aggregate demand as
well as aggregate supply
Public Expenditure includes (recurrent and capital
expenditure)
 Non-development expenditure
 Development expenditure: ADP, Non-ADP projects,
FFW
 Others
Budget Deficit: Gap between revenue and expenditure

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 FP Components:Revenue/Tax
• Revenue/Tax policy
– Core to fiscal policy
– A specific policy, declared at the beginning of the
FY (subject to change time to time)
• Revenue sources (Tax and Non-Tax)
• Types of Taxes
– direct and indirect

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 FP Components:Revenue/Tax
• Role of Tax Policy
– Taxes free up resources for public expenditures
– Reduces the purchasing power of taxpayers
– Resources are freed from production of the goods
of services that they would otherwise use
– Create fiscal space for providing public
goods/utilities
– Redistributes the income in favor of the poor

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 FP Components: Expenditure
• Role of Expenditure Policy
– A tool the government uses to reach its objectives
– Public expenditure increase aggregate demand as well as
aggregate supply

• Public Expenditure includes (recurrent and capital

expenditure)
• Budget Deficit: Gap between revenue and
expenditure
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 FP Components: Expenditure (Cont.)
• Different sources of deficit financing have
different macroeconomic consequence
• Total Expenditure (TE) – Total Revenue (TR )
= -Deficit
= Financing
= Foreign source (grant + loan)+ Domestic
source (Bank+Non-bank)

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 Types of Fiscal Policy

• Discretionary Fiscal Policy

• Non-Discretionary Fiscal Policy
• Expansionary
• Contractionary

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 Types of Fiscal Policy (Cont.)
• Discretionary Fiscal Policy is deliberate changes of
government expenditures and/or taxes to achieve
particular economic goals
• Non-discretionary Fiscal Policy refers to the changes
in government expenditures and/or taxes that occur
automatically without (additional) Parliamentary
action

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 Expansionary Fiscal Policy
• Expansionary fiscal policy refers to increases in
government expenditures and/or decreases in
taxes to achieve macroeconomic goals.
• When actual output is less than potential output,
expansionary fiscal policy is applied
• Expansionary fiscal policy influences output,
employment and price level by changing
aggregate demand

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 Expansionary Fiscal Policy (cont.)

• Changes in aggregate demand depends on

two factors:
– Multiplier effect
– Crowding out effect

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 Multiplier
• The multiplier is the amount by which
equilibrium output changes when
autonomous spending increases by 1 unit
• Government purchases are said to have a
multiplier effect on aggregate demand.
• Each unit of money spent by the
government can raise the aggregate
demand for goods and services by more
than a unit of money.

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 Crowding out
• Crowding out occurs when expansionary fiscal
policy causes interest rate to rise, thereby reducing
private spending, particularly investment
• Crowing out may happen because of the direct
substitution of public services for consumer
spending or private investment may be reduced
because of higher interest rates

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 Contractionary fiscal policy
• Contractionary fiscal policy attempts to
decrease government expenditures and/or
increases in taxes to achieve macroeconomic
goals.
• Contractionary fiscal policy is appropriate
when actual output is above potential output
• It is mainly applied for inflation control

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 Policy timing

Contractionary Expansionary Contractionary

Policy Policy Policy

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 Changes in Taxes
• When the government cuts personal income
taxes, it increases households’ take-home
pay.
– Households save some of this additional income.
– Households also spend some of it on consumer
goods.
– Increased household spending shifts the
aggregate-demand curve to the right.

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 Fiscal policy and aggregate supply
• Short run macroeconomic effects of
fiscal policy work primarily through
aggregate demand
• But in the long run fiscal policy action
can influence aggregate supply as well.
– A tax cut can cause to shift AS to the right
by providing incentives to work
– Government spending on capital formation
can also increase AS at each price level and
hence can cause to shift AS to the right

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 Monetary Policy
• Monetary policy refers to the policies of
central bank or monetary authority of a
country by which output and employment are
influenced by changing money supply;
• Changes in money supply is associated with
interest rate.
– When money supply increases interest rate goes
down which stimulates investment and thereby
output;
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 Monetary policy instrument
• Direct Instrument:
 Interest rate controls,
 Credit ceilings,
 Directed lending policy
• Indirect Instrument:
 Legal reserve requirement,
 Open market operations,
 Repurchase operations,
 Repo and reverse repo
 Discount window

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 Monetary vs fiscal policy:
Relative effectiveness
• Relative effectiveness of monetary and fiscal policies
depend on the exchange rate regime and degree of
capital mobility

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 Interaction between Monetary
and Fiscal Policies
• Fiscal policy can affect monetary policy both in direct and
indirect channel
• Direct effect relates to composition of deficit financing and
government revenue
• Many indirect channels such as perceptions and expectations
of large budget deficits and resulting large borrowing
requirements may cause a lack of confidence in the economic
prospects. This may become a risk to the stability in financial
markets.

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 Impacts of Fiscal Policy action on
Monetary Policy (Deficit Finance)
Total Expenditure (TE) – Total Revenue (TR )
= -Deficit
= Financing
= Central Bank+ Commercial Bank + Non- Bank + Foreign
 Central Bank Printing Money Inflation and real
appreciation
 Commercial Bank and Non-Bank Availability of
loanable fund Interest rate
 Foreign source Net foreign asset ER and
Sterilization cost

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Impacts of Fiscal Policy action on Monetary
Policy (Composition of Revenue)
Total Revenue (TR)= Direct Tax Revenue (DTR)+ Indirect
Tax Revenue (IDTR)+ Grant (Gr)
 Increase in IDTR will have a direct impact on prices
 Wage-price spiral may be created and permanent
inflationary expectations may be formed
 Increase in Grant may lead to ER appreciation and
increase sterilization cost

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Thank you

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