KENYA METHODIST UNIVERSITY

Distance Learning Material

SCHOOL OF BUSINESS

DEPARTMENT OF BUSINESS ADMINISTRATION

FINA 431

FINANCIAL MANAGEMENT IN THE PUBLIC SECTOR

Published by Kenya Methodist University
P.O. Box 267 – 60200, Meru
Tel: 254 – 064 – 30301, 31146

1
Market Failure
Market failure occurs when the free market fails to allocated resources in an optimum and
efficient manner. There are four main sources of market failure:

1) Externalities
Externalities occur when some of the costs or benefits associated with production or consumption
of goods and services spill over onto third parties.
When market failure is present, allocative efficiency is achieved when MSB=MSC

Positive externalities Negative externalities

Occur when society benefits from the Occur when costs are imposed on society
consumption or production of a commodity from the consumption or production of a
or service commodity or service
Education, vaccination etc. Pollution, smoking etc.

Merit goods Demerit goods

Goods that society values and judges that
everyone should have whether the individual
wants them or not.
Underconsumed due to imperfect
information – individuals are unaware of
long-term benefits and positive externalities
Consumption of merit goods is believed to
generate positive externalities (MSB exceeds
MPB)
Healthcare, education, public libraries
Goods that society values and judges to be
bad for and individual
Overconsumed due to imperfect information
– individuals are unaware of long-term
detriments and negative externalities
Consumption of demerit goods leads to a fall
in social welfare (MPB exceeds MSB)
Alcohol, cigarettes, drugs, addiction to
gambling

2) Zero Provision of Public Goods

A public good is a good/service which is
1. Non-rivalrous – its benefits are not depleted by an additional user

2
 o MC = 0, for allocative efficiency, P = MC = 0
o Public goods have to be provided at no charge
2. Non-excludable – impossible (or difficult) to exclude people from its benefits
o ‗Free rider‘ problem arises – no one will pay for what he can get free
o Private firms will not provide public goods (unable to charge for consumption)
o Public goods, therefore, have to be provided by the government
Examples of public goods include streetlamps and public libraries
Note: a private good is one that is both rivalrous and excludable – automobiles, clothing, food
etc.

3) Imperfect Competition
Prefect competition does not always exist in real markets, and more often than not, free market
forces do not lead to optimum efficiency in resource allocation. One example is the monopoly: the
monopolist‘s output is not allocative efficient as it produces at a point where P > MC, creating a
DWL of both consumer and producer surplus.

4) Inequity
The problem of inequity is distinct from that of inequality. Equity refers to a distribution of income
that is considered fair – a normative issue. An equitable distribution is thus not the same as an
equal distribution. While to some extent, some degree of income inequality is desirable – as
incentives to work hard etc., a very unequal distribution of income has negative repercussions
especially on the socioeconomic front.The solutions to inequity are briefly discussed under
―Dealing with Inequality and Inequity‖

3
Government Intervention
Problem Intervention
Zero Direct provision of public goods
provision of
public goods
Negative Financial intervention: taxes
externalities (equal to the monetary value of the
MEC) are imposed on individuals
or a firm, internalizing ECs
Legislation: laws and
administrative rules are passed to
prohibit or regulate behaviour that
imposes an EC, e.g. pollution
permits
Education, campaigns and
advertisements solve the problem
of imperfect information by
allowing the external costs to be
made known to the consumer,
discouraging demand
Positive Financial intervention: subsidies
Evaluation
Advantages
 Leaves space for market forces to
interact
 Provision of revenue for the
government
Disadvantages
 Difficulty in valuating EC
 Overvaluation means output is below
social optimum, as with
undervaluation means that output is
not sufficiently lowered (ie, society‘s
welfare is not always maximized)
 Effectiveness of tax dependent on
PED
Enforcement is difficult and expensive
Benefits must outweigh the costs of
implementation.
A lot of time may be needed for
effects to be felt
Advantages
4
externalities made to the producer or consumer  Considered the most effective way of
solving underconsumption as it is
easily implemented
Disadvantages
 Like taxes, the valuation of EB is
difficult
 High government expenditure is
required
 Okun‘s leaky bucket: each dollar
transferred from a richer to a poorer
individual, results in less than a
dollar increase in income for the
recipient. Leaks arise as a result of
administrative costs, changes in work
effort, attitudes etc. arising from the
redistribution
Legislation include regulation Enforcement requires constant
seatbelt usage, compulsory checking which may translate to high
education etc. costs.
Non provision There is a need to produce merit goods (which are naturally
of merit underconsumed) at low prices or for free due to four reasons
goods 1. Social justice: they should be provided according to need and not ability
to pay
2. Large positive externalities, for example in the provision of free health
services helps to contain and combat the spread of disease
3. Dependants are subject to their guardians decision which are not
necessarily the best, therefore the provision of services like free
education and dental treatment is needed to protect dependants from
uninformed or bad decisions
4. Ignorance: The problem of imperfect information makes consumers
unaware of the positive externalities and benefits that arise from

5
 consumption
Imperfect Imposition of a lump-sum tax on a monopolist (shifts AC upwards), and
markets supernormal profits are taken as tax. Governments may also regulate
MC/AC pricing for monopolies.
Government may impose regulations to control a monopolies
1. Forbidding the formation of monopolies (e.g., antitrust laws)
2. Forbidding monopolistic behaviour (like predatory pricing)
3. Ensuring standards of provision.
4. Ensuring competition exists (e.g., deregulation)

6
Nationalization and Privatization
Nationalization refers to the public (governmental) ownership of certain firms to provide goods or
services sold in the market, that is, public corporations engaged in commercial activities.
Governments often take over natural monopolies to prevent monopoly pricing and examples
include public utilities.
Advantages Disadvantages
Consumers protected from high prices Cross inefficiency may arise
Ensuring social costs and benefits are taken No profit motive may lead to nationalized
into account when production decisions are enterprises being allocatively inefficient
made

Privatization refers to a change in ownership of an activity from the public to the private sector.
State owned companies having lost money may privatize to give new owners the responsibility of
restructuring the enterprise.
Forms of Privatization
1. Denationalization: Privatization of ownership – sales of assets or shares. The government
may retain some shares in the enterprise, and acts as a regulator in this case to ensure that
public interest is protected.
2. Franchising: Gives the private sector a right to operate a particular service/activity for a
given length of time. May be exclusive or competitive
3. Privatization of production: Government buys goods and services instead of producing
them
o Refuse collection services being contracted to private firms
4. Privatization of financing: Government relies on consumer charges rather than tax
revenue to subsidize operations. (e.g., independent school fees)
5. Deregulation: Liberalization of regulation to promote competition through the removal of
barriers to entry (creation of contestable markets)
o Telecommunications, financial industry, airline (US ‗open skies‘ policy)
Evaluation of Privatization
For Against
Revenue for the government – reduces Long term revenue loss – future profits

7
public-sector borrowing requirement. Allows
the government to make tax cuts without
reducing spending. Revenue might come in
from higher corporate tax receipts from the
privatized companies
Increased competition due to contestable
markets and profit motives which translates
to
Benefits for consumers in the form of lower
prices, wider choices and better qualities as
X-inefficiency is reduced (see
Nationalization)
Increased efficiency and flexibility as
private companies are normally more
successful in raising capital, lowering prices
and cutting out waste. Little governmental
interference allows the company to respond
to market forces, and make commercially
sensible decisions and investments
Wider share ownership increases
accountability to the public
Cost-push inflation is reduced. Private
firms are less willing to accept inefficient
working practices. Wage raises have to be
justified by higher productivity.
from industries are lost by the state
Natural monopolies are best left to the
public sector as duplication of services is
unnecessary – wasteful and inefficient and
not in the best interests of consumers
Competition may not increase replacing a
public-sector monopoly with a private-sector
one does not increase competition as firms
are still able to act like monopolists
Market forces may not ensure greater
efficiency – like before, remaining as private-
sector monopolies are likely to earn
supernormal profits even if they are
inefficient. Large firm size also prevents
firms from being taken over
Private-sector firms may not act in public
interest as they do not take into account
negative externalities (like resultant
unemployment) and are unlikely to base their
output and pricing on social justice and
equity
8
Dealing with Inequality and Inequity
The tax system can be used to reduce inequalities in income and wealth.
 Progressive taxes: people earning higher incomes are taxed a higher percentage of their
income
o Reducing income differentials
o May create disincentives to work with excessive progressivity
 Direct tax imposition on wealth (e.g., inheritance taxes)

Monetary provision: money raised through the tax system is paid to low-income groups to
increase YD
 Means-tested benefits are paid to those that fit certain criteria
 Unemployment benefits
o Might create disincentives to work
o Not always claimed by those for whom they are designed
o Expensive to administer
o Low take up rates: bureaucracy and social stigma
 Universal benefits are paid out to everyone in certain categories regardless of
income/wealth
 State pensions, child benefits
o May imply paying out money to those who do not need it
o More expensive
Direct provision of goods and services are also financed through the tax system. Free provision
means that if services are used equally by all, lower income groups gain more advantage, reducing
inequality
 Healthcare and education
o Subject to market failure, but justified by inequity
Government Failure
Government failure arises when government intervention in the market to improve market failure
worsens the situation: increases market distortions and reduces welfare and economic efficiency
instead of otherwise.

9
Reasons for Government Failure
Problem of incentives: undesirable incentives may create inefficiencies
 Taxation distorts incentives
o Disincentives to work harder with progressive tax
o DWL of a tax may cause a disincentive to consume and produce
 Politicians motivated by political power rather than economic imperatives
o Policies designed to retain power rather than maximize efficiency
o Political pressures dominates societal welfare
 Taxes that reduce externalities may be unpopular are avoided
 Inappropriate incentives of public enterprises
Problems of information arise as, just as the markets lack information, more often than not,
governments do too. The government may not know the full costs/benefits of policies even though
it wishes to work to the interests of the consumer
 Imperfect information about the true value of a negative externality
o Difficult to trace the source of a negative externality
o Problems of taxation – difficult to put a figure to EC (see Government Intervention)
 Imperfect information about the level of consumer demand
o Public goods provided may not be needed, or produced are wrong quantities
Problems of distribution arise as policies may affect different groups of people differently
Bureaucracy and inefficiency arise when policies are wide reaching and detailed, more people
and resources will be involved. Inflexibility due to bureaucracy leads to a lack of fine-tuning
(governments respond more slowly to problems when circumstances change)
Time lags in planning and implementation of policies cause policies to be ineffective, irrelevant,
or come too late to solve a mounting problem
Frequent shifts in government policy may cause economic efficiency to suffer as firms find it
difficult to plan without knowledge of tax rates, subsidies, wage controls etc.
Vicious circle of government intervention

Economics of market failure

Market failure has become an increasingly important topic for students at A level .There is a clear
economic case for government intervention in markets where some form of market failure is

10
taking place. Government can justify this by saying that intervention is in the public
interest. Basically market failure occurs when markets do not bring about economic efficiency.
Government intervention occurs when markets are not working optimally i.e. there is a Pareto
sub-optimal allocation of resources in a market/industry. In simple terms, the market may not
always allocate scarce resources efficiently in a way that achieves the highest total social welfare.

EXAMPLES OF POTENTIAL MARKET FAILURE

There are plenty of reasons why the normal operation of market forces may not lead to economic
efficiency.
Public Goods
Public Goods not provided by the free market because of their two main characteristics
 Non-excludability where it is not possible to provide a good or service to one person
without it thereby being available for others to enjoy
 Non-rivalry where the consumption of a good or service by one person will not prevent
others from enjoying it
Examples: Street lighting / Lighthouse Protection, Police services, Air defence systems, Roads /
motorways, Terrestrial television, Flood defence systems, Public parks & beaches. Because of
their nature the private sector is unlikely to be willing and able to provide public goods. The
government therefore provides them for collective consumption and finances them through
general taxation.

Merit Goods
Merit Goods are those goods and services that the government feels that people left to themselves
will under-consume and which therefore ought to be subsidised or provided free at the point of
use.Both the public and private sector of the economy can provide merit goods & services.
Consumption of merit goods is thought to generate positive externality effects where the social
benefit from consumption exceeds the private benefit. Examples: Health services, Education,
Work Training, Public Libraries, Citizen's Advice, Inoculations
Monopoly

11
Few modern markets meet the stringent conditions required for a perfectly competitive market.
The existence of monopoly power is often thought to create the potential for market failure and a
need for intervention to correct for some of the welfare consequences of monopoly power.
The classical economic case against monopoly is that
 Price is higher and output is lower under monopoly than in a competitive market
 This causes a net economic welfare loss of both consumer and producer surplus
 Price > marginal cost - leading to allocative inefficiency and a pareto sub-optimal
equilibrium.
 Rent seeking behaviour by the monopolist might add to the standard costs of monopoly.
This includes high (possibly excessive) amounts of spending on persuasive advertising and
marketing.
 Libenstein's X-inefficiency may also result if the monopolist allows cost efficiency to drop.
An upward drift in costs because of a lack of effective competition in the market-place can
lead to consumers facing higher prices and a reduction in their real standard of living

Externalities
Any exam question on market failure must make some reference to externalities. What are the
potential market failures arising from externalities?
The social optimum output or level of consumption diverges from the private optimum.
Main problem is the absence of clearly defined property rights for those agents operating in the
market. When property rights are not clearly defined, market failure is likely because producers &
consumers may not be held to account
Don't forget that positive externalities can also justify intervention if goods are under-consumed
(social benefit > private benefit)

Inequality
Market failure can also be caused by the existence of inequality throughout the economy. Wide
differences in income and wealth between different groups within our economy leads to a wide gap

12
in living standards between affluent households and those experiencing poverty. Society may
come to the view that too much inequality is unacceptable or undesirable.
Note here that value judgements come into play whenever we discuss the distribution of income
and wealth in society. The government may decide to intervene to reduce inequality through
changes to the tax and benefits system and also specific policies such as the national minimum
wage
GOVERNMENT INTERVENTION AND MARKET FAILURE
Government intervention may seek to correct for the distortions created by market failure and to
improve the efficiency in the way that markets operate
 Pollution taxes to correct for externalities
 Taxation of monopoly profits (the Windfall Tax)
 Regulation of oligopolies/cartel behaviour
 Direct provision of public goods (defence)
 Policies to introduce competition into markets (de-regulation)
 Price controls for the recently privatised utilities

EXTERNALITIES
what are externalities?
Externalities are common in virtually every area of economic activity. They are defined as third
party (or spill-over) effects arising from the production and/or consumption of goods and
services for which no appropriate compensation is paid.
Externalities can cause market failure if the price mechanism does not take into account the full
social costs and social benefits of production and consumption.
The study of externalities by economists has become extensive in recent years - not least because
of concerns about the link between the economy and the environment.
PRIVATE AND SOCIAL COSTS
Externalities create a divergence between the private and social costs of production.
Social cost includes all the costs of production of the output of a particular good or service. We
include the third party (external) costs arising, for example, from pollution of the atmosphere.
SOCIAL COST = PRIVATE COST + EXTERNALITY

13
For example: - a chemical factory emits wastage as a by-product into nearby rivers and into the
atmosphere. This creates negative externalities which impose higher social costs on other firms
and consumers. e.g. clean up costs and health costs.
Another example of higher social costs comes from the problems caused by traffic congestion in
towns, cities and on major roads and motor ways.
It is important to note though that the manufacture, purchase and use of private cars can also
generate external benefits to society. This why cost-benefit analysis can be useful in measuring
and putting some monetary value on both the social costs and benefits of production.
MARKET FAILURE AND EXTERNALITIES
When negative production externalities exist, marginal social cost > private marginal cost. This
is shown in the diagram below where the marginal social cost of production exceeds the private
costs faced only by the producer/supplier of the product. In our example a supplier of fertiliser to
the agricultural industry creates some external costs to the environment arising from their
production process.

Why do externalities lead to market failure?

If we assume that the producer is interested in maximising profits - then they will only take into
account the private costs and private benefits arising from their supply of the product. We can
see from the diagram below that the profit-maximising level of output is at Q1. However the
socially efficient level of production would consider the external costs too. The social optimum
output level is lower at Q2.

14
This leads to the private optimum output being greater than the social optimum level of
production. The producer creating the externality does not take the effects of externalities into their
own calculations. We assume that producers are only concerned with their own self interest.
In the diagram above, the private optimum output is when where private marginal benefit =
private marginal cost, giving an output of Q1. For society as a whole though the social optimum
is where social marginal benefit = social marginal cost at output Q2.The failure to take into
account the negative externality effects is an example of market failure.
NEGATIVE CONSUMPTION EXTERNALITIES
Consumers can create externalities when they purchase and consume goods and services.
o Pollution from cars and motorbikes
o Litter on streets and in public places
o Noise pollution from using car stereos or ghetto-blasters
o Negative externalities created by smoking and alcohol abuse
o Externalities created through the mis-treatment of animals
o Vandalism of public property
o Negative externalities arising from crime
In these situations the marginal social benefit of consumption will be less than the marginal
private benefit of consumption. (i.e. SMB < PMB) This leads to the good or service being over-
consumed relative to the social optimum. Without government intervention the good or service

15
will be under-priced and the negative externalities will not be taken into account. Again there will
be a deadweight loss of economic welfare.

In the example shown in the chart above we illustrate the potentially negative effects of people
consuming cigarettes on other consumers. The disutility (dis-satisfaction) created leads to a
reduction in the overall social benefit of consumption. If the cigarette consumer only considers
their own private costs and benefits, then there will be over-consumption of the product. Ideally,
the socially efficient level of cigarette consumption will be lower (Q2). The issue is really which
policies/strategies are most appropriate in reducing the total level of cigarette consumption!
Public goods
In economics, a public good is a good that is non-rivalrous and non-excludable. Non-rivalry
means that consumption of the good by one individual does not reduce availability of the good for
consumption by others; and non-excludability that no one can be effectively excluded from using
the good. In the real world, there may be no such thing as an absolutely non-rivaled and non-
excludable good; but economists think that some goods approximate the concept closely enough
for the analysis to be economically useful.
For example, if one individual visits a doctor there is one less doctor's visit for everyone else, and
it is possible to exclude others from visiting the doctor. This makes doctor visits a rivaled and
excludable private good. Conversely, breathing air does not significantly reduce the amount of air
available to others, and people cannot be effectively excluded from using the air. This makes air a
public good, albeit one that is economically trivial, since air is a free good. A less straight-forward
example is the exchange of MP3 music files on the internet: the use of these files by any one

16
person does not restrict the use by anyone else and there is little effective control over the
exchange of these music files and photo files.
Non-rivalness and non-excludability may cause problems for the production of such goods.
Specifically, some economists[by whom?] have argued that they may lead to instances of market
failure, where uncoordinated markets driven by parties working in their own self interest are
unable to provide these goods in desired quantities. These issues are known as public goods
problems, and there is a good deal of debate and literature on how to measure their significance to
an economy, and to identify the best remedies. These debates can become important to political
arguments about the role of markets in the economy. More technically, public goods problems are
related to the broader issue of externalities.
Graphically, non-rivalry means that if each of several individuals has a demand curve for a public
good, then the individual demand curves are summed vertically to get the aggregate demand curve
for the public good . This is in contrast to the procedure for deriving the aggregate demand for a
private good, where individual demands are summed horizontally.

Terminology, and types of public goods

Excludable Non-excludable

Common goods
Private goods (Common-pool
Rivalrous food, clothing, toys, resources)
furniture, cars fish, hunting game,
water, arterial roads

Club goods Public goods

Non-rivalrous satellite television, golf national defense, free-to-
courses, cinemas air television, air

17
Paul A. Samuelson is usually credited as the first economist to develop the theory of public goods.
In his classic 1954 paper The Pure Theory of Public Expenditure, he defined a public good, or as
he called it in the paper a "collective consumption good", as follows:
...[goods] which all enjoy in common in the sense that each individual's consumption of such a
good leads to no subtractions from any other individual's consumption of that good...
This is the property that has become known as Non-rivalry. In addition a pure public good exhibits
a second property called Non-excludability: that is, it is impossible to exclude any individuals from
consuming the good.
The opposite of a public good is a private good, which does not possess these properties. A loaf of
bread, for example, is a private good: its owner can exclude others from using it, and once it has
been consumed, it cannot be used again.
A good which is rivalrous but non-excludable is sometimes called a common pool resource. Such
goods raise similar issues to public goods: the mirror to the public goods problem for this case is
sometimes called the tragedy of the commons. For example, it is so difficult to enforce restrictions
on deep sea fishing that the world's fish stocks can be seen as a non-excludable resource, but one
which is finite and diminishing.
The definition of non-excludability states that it is impossible to exclude individuals from
consumption. Technology now allows radio or TV broadcasts to be encrypted such that persons
without a special decoder are excluded from the broadcast; however, an unencrypted Many forms
of creative works have characteristics of public goods. For example, a poem can be read by many
people without reducing the consumption of that good by others; in this sense, it is non-rivalrous.
Similarly, the information in most patents can be used by any party without reducing consumption
of that good by others. Creative works may be excludable in some circumstances, however: the
individual who wrote the poem may decline to share it with others by not publishing it. Copyrights
and patents both encourage and inhibit the creation of such non-rival goods by providing
temporary monopolies, or, in the terminology of public goods, providing a legal mechanism to
enforce excludability for a limited period of time. For public goods, the "lost revenue" of the
producer of the good is not part of the definition: a public good is a good whose consumption does
not reduce any other's consumption of that good.
The economic concept of public goods should not be confused with the expression "the public
good", which is usually an application of a collective ethical notion of "the good" in political

18
decision-making. Another common confusion is that public goods are goods provided by the
public sector. Although it is often the case that Government is involved in producing public goods,
this is not necessarily the case. Public goods may be naturally available. They may be produced by
private individuals and firms, by non-state collective action, or they may not be produced at all.
The theoretical concept of public goods does not distinguish with regard to the geographical region
in which a good may be produced or consumed. However, some theorists (such as Inge Kaul) use
the term global public good to mean a public good which is non-rival and non-excludable
throughout the whole world, as opposed to a public good which exists in just one national area.
Knowledge has been held to be an example of a global public good.
Collective good
Collective goods (or social goods) are defined public goods that could be delivered as private
goods, but are usually delivered by the government for various reasons, including social policy,
and finances from public funds like taxes.
Note: Some writers have used the term public good to refer only to non-excludable pure public
goods. They may then call excludable public goods club goods.
Examples
Common examples of public goods include: defense and law enforcement (including the system of
property rights), public fireworks, lighthouses, clean air and other environmental goods, and
information goods, such as software development, authorship, and invention. Some goods (such as
orphan drugs) require special governmental incentives to be produced, but can't be classified as
public goods since they don't fulfill the above requirements (Non-excludable and non-rivalrous.)
The provision of a lighthouse has often been used as the standard example of a public good, since
it is difficult to exclude ships from using its services. No ship's use detracts from that of others, but
since most of the benefit of a lighthouse accrues to ships using particular ports, lighthouse
maintenance fees can often profitably be bundled with port fees (Ronald Coase, The Lighthouse in
Economics 1974). This has been sufficient to fund actual lighthouses.
Technological progress can create new public goods. The most simple examples are street lights,
which are relatively recent inventions (by historical standards). One person's enjoyment of them
does not detract from other persons' enjoyment, and it currently would be prohibitively expensive
to charge individuals separately for the amount of light they presumably use. On the other hand, a
public good's status may change over time. Technological progress can significantly impact

19
excludability of traditional public goods: encryption allows broadcasters to sell individual access
to their programming. The costs for electronic road pricing have fallen dramatically, paving the
way for detailed billing based on actual use.
There is some question as to whether defense is a public good. Murray Rothbard argues, "'national
defense' is surely not an absolute good with only one unit of supply. It consists of specific
resources committed in certain definite and concrete ways—and these resources are necessarily
scarce. A ring of defense bases around New York, for example, cuts down the amount possibly
available around San Francisco." Jeffrey Rogers Hummel and Don Lavoie note, "Americans in
Alaska and Hawaii could very easily be excluded from the U.S. government's defense perimeter,
and doing so might enhance the military value of at least conventional U.S. forces to Americans in
the other forty-eight states. But, in general, an additional ICBM in the U.S. arsenal can
simultaneously protect everyone within the country without diminishing its services."
The free rider problem
Public goods provide a very important example of market failure, in which market-like behavior of
individual gain-seeking does not produce efficient results. The production of public goods results
in positive externalities which are not remunerated. If private organizations don't reap all the
benefits of a public good which they have produced, their incentives to produce it voluntarily
might be insufficient. Consumers can take advantage of public goods without contributing
sufficiently to their creation. This is called the free rider problem, or occasionally, the "easy rider
problem" (because consumer's contributions will be small but non-zero).
The free rider problem depends on a conception of the human being as homo economicus: purely
rational and also purely selfish—extremely individualistic, considering only those benefits and
costs that directly affect him or her. Public goods give such a person an incentive to be a free rider.
For example, consider national defense, a standard example of a pure public good. Suppose homo
economicus thinks about exerting some extra effort to defend the nation. The benefits to the
individual of this effort would be very low, since the benefits would be distributed among all of the
millions of other people in the country. There is also a very high possibility that he or she could get
injured or killed during the course of his or her military service.
On the other hand, the free rider knows that he or she cannot be excluded from the benefits of
national defense, regardless of whether he or she contributes to it. There is also no way that these
benefits can be split up and distributed as individual parcels to people. The free rider would not

20
voluntarily exert any extra effort, unless there is some inherent pleasure or material reward for
doing so (for example, money paid by the government, as with an all-volunteer army or
mercenaries).
In the case of information goods, an inventor of a new product may benefit all of society, but
hardly anyone is willing to pay for the invention if they can benefit from it for free.
Possible solutions
Assurance contracts
An assurance contract is a contract in which participants make a binding pledge to contribute to
building a public good, contingent on a quorum of a predetermined size being reached. Otherwise
the good is not provided and any monetary contributions are refunded.
A dominant assurance contract is a variation in which an entrepreneur creates the contract and
refunds the initial pledge plus an additional sum of money if the quorum is not reached. (The
entrepreneur profits by collecting a fee if the quorum is reached and the good is provided.) In
game-theoretic terms this makes pledging to build the public good a dominant strategy: the best
move is to pledge to the contract regardless of the actions of others.
Coasian solution
The coasian solution, named for the economist Ronald Coase and unrelated to the Coase theorem,
proposes a mechanism by which potential beneficiaries of a public good band together and pool
their resources based on their willingness to pay to create the public good. Coase (1960) argued
that if the transaction costs between potential beneficiaries of a public good are sufficiently low,
and it is therefore easy for beneficiaries to find each other and pool their money based on the
public good's value to them, then an adequate level of public goods production can occur even
under competitive free market conditions. However, Coase (1988) famously wrote:
"The world of zero transaction costs has often been described as a Coasian world. Nothing could
be further from the truth. It is the world of modern economic theory, one which I was hoping to
persuade economists to leave."
In some ways, the formation of governments and government-like communities, such as
homeowners associations can be thought of as applied instances of practicing the coasian solution
by creating institutions to reduce the transaction costs.
A similar alternative for arranging funders of public goods production, which is especially
applicable to information goods, is to produce the good but refuse to release it to the public until

21
some form of payment to cover costs is met. Author Stephen King, for instance, authored chapters
of a new novel downloadable for free on his website while stating that he would not release
subsequent chapters unless a certain amount of money was raised. Sometimes dubbed holding for
ransom, this method of public goods production is a modern application of the street performer
protocol for public goods production. Unlike assurance contracts, this relies on social norms to
ensure (to some extent) that the threshold is reached and partial contributions are not wasted.
Government provision
If voluntary provision of public goods will not work, then the obvious solution is making their
provision involuntary. This saves each of us from our own tendency to be a free rider, while also
assuring us that no one else will be allowed to free ride. One frequently proposed solution to the
problem is for governments or states to impose taxation to fund the production of public goods.
This does not actually solve the theoretical problem because good government is itself a public
good. Thus it is difficult to ensure the government has an incentive to provide the optimum amount
even if it were possible for the government to determine precisely what amount would be
optimum. These issues are studied by public choice theory and public finance.
Sometimes the government provides public goods using "unfunded mandates". An example is the
requirement that every car be fit with a catalytic converter. This may be executed in the private
sector, but the end result is predetermined by the state: the individually involuntary provision of
the public good clean air. Unfunded mandates have also been imposed by the U.S. federal
government on the state and local governments, as with the Americans with Disabilities Act, for
example.
Subsidies and joint products
A government may subsidize production of a public good in the private sector. Unlike government
provision, subsidies may result in some form of a competitive market. The potential for cronyism
(for example, an alliance between political insiders and the businesses receiving subsidies) can be
limited with secret bidding for the subsidies or application of the subsidies following clear general
principles. Depending on the nature of a public good and a related subsidy, principal agent
problems can arise between the citizens and the government or between the government and the
subsidized producers; this effect and counter-measures taken to address it can diminish the benefits
of the subsidy.

22
Subsidies can also be used in areas with a potential for non-individualism: For instance, a state
may subsidize devices to reduce air pollution and appeal to citizens to cover the remaining costs.
Similarly, a joint-product model analyzes the collaborative effect of joining a private good to a
public good. For example, a tax deduction (private good) can be tied to a donation to a charity
(public good). It can be shown that the provision of the public good increases when tied to the
private good, as long as the private good is provided by a monopoly (otherwise the private good
would be provided by competitors without the link to the public good).
Privileged group
The study of collective action shows that public goods are still produced when one individual
benefits more from the public good than it costs him to produce it; examples include benefits from
individual use, intrinsic motivation to produce, and business models based on selling complement
goods. A group that contains such individuals is called a privileged group. A historical example
could be a downtown entrepreneur who erects a street light in front of his shop to attract
customers; even though there are positive external benefits to neighboring nonpaying businesses,
the added customers to the paying shop provide enough revenue to cover the costs of the street
light.
The existence of privileged groups may not be a complete solution to the free rider problem,
however, as underproduction of the public good may still result. The street light builder, for
instance, would not consider the added benefit to neighboring businesses when determining
whether to erect his street light, making it possible that the street light isn't built when the cost of
building is too high for the single entrepreneur even when the total benefit to all the businesses
combined exceeds the cost.
An example of the privileged group solution could be the Linux community, assuming that users
derive more benefit from contributing than it costs them to do it. For more discussion on this topic
see also Coase's Penguin.
Another example is those musicians and writers who create music and writings for their own
personal enjoyment, and publish because they enjoy having an audience. Financial incentives are
not necessary to ensure the creation of these public goods. Whether this creates the correct
production level of writings and music is an open question.

23
Merging free riders
Another method of overcoming the free rider problem is to simply eliminate the profit incentive
for free riding by buying out all the potential free riders. A property developer that owned an entire
city street, for instance, would not need to worry about free riders when erecting street lights since
he owns every business that could benefit from the street light without paying. Implicitly, then, the
property developer would erect street lights until the marginal social benefit met the marginal
social cost. In this case, they are equivalent to the private marginal benefits and costs.
While the purchase of all potential free riders may solve the problem of underproduction due to
free riders in smaller markets, it may simultaneously introduce the problem of underproduction
due to monopoly. Additionally, some markets are simply too large to make a buyout of all
beneficiaries feasible - this is particularly visible with public goods that affect everyone in a
country.
Introducing an exclusion mechanism (club goods)
Another solution, which has evolved for information goods, is to introduce exclusion mechanisms
which turn public goods into club goods. One well-known example is copyright and patent laws.
These laws, which in the 20th century came to be called intellectual property laws, attempt to
remove the natural non-excludability by prohibiting reproduction of the good. Although they can
address the free rider problem, the downside of these laws is that they imply private monopoly
power and thus are not Pareto-optimal.
For example, in the United States, the patent rights given to pharmaceutical companies encourage
them to charge high prices (above marginal cost) and to advertise to convince patients to persuade
their doctors to prescribe the drugs. Likewise, copyright provides an incentive for a publisher to act
like The Dog in the Manger, taking older works out of print so as not to cannibalize revenue from
the publisher's own new works. The laws also end up encouraging patent and copyright owners to
sue even mild imitators in court and to lobby for the extension of the term of the exclusive rights in
a form of rent seeking.
These problems with the club-good mechanism arise because the underlying marginal cost of
giving the good to more people is low or zero, but, because of the limits of price discrimination
those who are unwilling or unable to pay a profit-maximizing price do not gain access to the good.

24
If the costs of the exclusion mechanism are not higher than the gain from the collaboration, club
goods can emerge naturally. James M. Buchanan showed in his seminal paper that clubs can be an
efficient alternative to government interventions.
On the other hand, because of the inherent inefficiency of club good provision, it is sometimes
preferable to treat even naturally excludable club goods as public goods, and produce them by
some other mechanism. Examples of such "natural" club goods include natural monopolies with
very high fixed costs, private golf courses, cinemas, cable television and social clubs. This
explains why many such goods are often provided or subsidized by governments, co-operatives or
volunteer associations, rather than being left to be supplied by profit-minded entrepreneurs. These
goods are often known as social goods.
Joseph Schumpeter claimed that the "excess profits," or profits over normal profit, generated by
the copyright or patent monopoly will attract competitors that will make technological innovations
and thereby end the monopoly. This is a continual process referred to as "Schumpeterian creative
destruction", and its applicability to different types of public goods is a source of some
controversy. The supporters of the theory point to the case of Microsoft, for example, which has
been increasing its prices (or lowering its products' quality), predicting that these practices will
make increased market shares for Linux and Apple largely inevitable.
A nation can be seen as a club whose members are its citizens. Government would then be the
manager of this club. This is further studied in the Theory of the State.
Social norms
If enough people do not think like free-riders, the private and voluntary provision of public goods
may be successful. A free rider might litter in a public park, but a more public-spirited individual
would not do so, getting an inherent pleasure from helping the community. In fact, one might
voluntarily pick up some of the existing litter. If enough people do so, the role of the state in using
taxes to hire professional maintenance crews is reduced. This might imply that even someone
typically inclined to free-riding would not litter, since their action would have such a cost.
Public mindedness may be encouraged by non-market solutions to the economic problem, such as
tradition and social norms. For example, concepts such as nationalism and patriotism have been
part of most successful war efforts, complementing the roles of taxation and conscription. To some
extent, public spiritedness of a more limited type is the basis for voluntary contributions that
support public radio and television. Contributions to online collaborative media like Wikipedia and

25
many other projects utilising wiki technology can also be seen to represent an example of such
public spiritedness, since they provide a public good (information) freely to all readers.
Groups relying on such social norms often have a federated structure, since collaboration emerges
more readily in smaller social groups than in large ones (e.g. see Dunbar's number). This explains
why labor unions or charities are often organized this way.
Efficient production levels of public goods
Imagine that someone came to your door and asked you to pay twenty euros towards the cost of
powering the street lamp out in the street for another year. The collector argues that the street lamp
provides you with light to help you see at night when you are driving or walking home.
A public good is provided efficiently at the level where the combined marginal rate of substitution
of all individuals is equal to the marginal rate of transformation. (The marginal rate of substitution
is the rate at which an individual is willing to exchange a private good for a public good, the
marginal rate of transformation is the quantity of a private good which the society has to give up in
order to produce one unit of a public good).
When should a public good be provided? To illustrate the basic principle, consider a community
composed of just two consumers. The government is considering whether or not to provide a park.
Arthur is prepared to pay up to £200 for use of the park, while Julia is willing to pay up to £100.
The total value to the two individuals of having the park is £300. If it can be produced for £225,
there is a £75 gain on its production since it provides services that the community values at £300 at
a cost of only £225.
Regardless of the method of providing public goods, the efficient level of such provision is still
being subjected to economic analysis. For instance, the Samuelson condition calculates the
efficient level of public goods production to be where the ratio of the marginal social cost of public
and private goods production equals the ratio of the marginal social benefit of public and private
goods production.
"If the amount of a public good can be varied continuously, the optimal quantity to produce is that
quantity for which the marginal cost of the last unit is just equal to the sum of the prices that all
consumers would be willing to pay for that unit." This equilibrium guarantees that the last unit of
the public good costs as much to produce as the value that it gives to all of its consumers.

26
PUBLIC EXPENDITURE

Significance

Public expenditure is the value of goods and services bought by the State and its articulations.
Public expenditure plays four main roles:
1. it contributes to current effective demand;
2. it expresses a coordinated impulse on the economy, which can be used for stabilization, business
cycle inversion, and growth purposes;
3. it increases the public endowment of goods for everybody;
4. it gives rise to positive externalities to economy and society, the more so through its capital
component.
With its prioritised structure and its peculiar decision-making processes, it substantiates the
prevailing kind of State.
In democracy, public expenditure is an expression of people's will, managed through political
parties and institutions. At the same time, public expenditure is characterised by a high degree of
inertia and law-dependency, which tempers the will of the current majority.

Public expenditure can be financed through taxes, public debt, money emission, international aid.

Composition

First, public expenditure can be classified in terms of the kind of goods and services bought, also
with very general items:
1. capital goods;
2. consumption goods;
3. personnel expenditure.
By contrast, public expenditure in national accounts does not comprehend mere transfers among
social groups, as it is the case of pension schemes. Payments of interest on public debt are not
comprehended as well.

27
Second, public expenditure can be classified according to the official body and organization from
which budget it is paid, as for example:
1. the central state and its ministries;
2. regional and local authorities;
3. separate public bodies;
4. international organizations.
Here we should note that public expenditure usually does not consolidate state-owned firms. Their
capital goods expenditure is added to investment.
Third, public expenditure can be classified according to the macro-function at which it is directed:
1. justice and public order;
2. infrastructure (roads, railways,...);
3. military system;
4. education system;
5. health care;
6. support for the poor, the old, the disadvantaged;
7. support for firms, export and production in general;
8. special policy expenditure (foreign aid, integrated fight against drugs,...).
In different places and over time, those macro-functions have largely changed their level of
priority and even the social acceptance of the idea that it is the State that must care of them.
In particular, as a very sketched framework, one may distinguish at least three general models of
state to which public expenditure corresponds:
1. the minimal state, where only justice, public order, foreign policy and some other basic
functions should be carried out by the state, relying on private initiative for the others;
2. the welfare state, where the State cares about the people's well-being directly, also through
expenditure in schooling, health, support for the poor, the old, the disadvantages;
3. the developmental state, where the State takes the responsibility of fostering economic
development, also through expenditure in infrastructure, support for firms, innovation, export and
production in general.
Both the welfare and developmental state include the items of the minimal state. Military
expenditure and special policies are common traits of the three models, maybe in different
proportions.

28
Comparing macro-function shares in public expenditure, one can get insights in the kind of state
under analysis.
Needless to say, the State does not exert its influence on economy and society through public
expenditure only, but also for example through laws.

Determinants
Public expenditure is determined by political will of the leading forces in the state: their priorities,
their desired state model, and their interpretation of current economic and political phase. Past
choices have relevant impact on public expenditure because of inertia and incrementalism.
Bureaucracy may play an important decision role for the actual expenditure.
Sometimes considered as a completely exogenous variable, the public expenditure would thus be
fully in the hand of political decision-makers without dependency from the economic context.
Yet, policy makers may turn out to follow an anti-cyclical broad control of public expenditure.
Automatic stabilizers may be at work, as with the case of support schemes for unemployment: in
this case, higher unemployment and disappointing GDP growth would lead to higher public
expenditure through unemployment benefits and financial support to firms.
In a different political and institutional context, public expenditure may, instead, positively
respond to state revenues. Higher revenues (and maybe even a public surplus) may lead to higher
public expenditure. Symmetrically, if there is an upper limit to public deficit and, because of a
recession, tax revenue fall, the State may be forced to cut public expenditure. In this context,
public expenditure would turn out to be pro-cyclical.
Lawmakers facing elections are sensitive to the public opinion. Usually, low-income social groups
are in favour of expanding public expenditure in social issues, as stimulus for jobs, and provision
of free or subsidised services. The rich tend to use less public services and to be more worried by
the amount of tax necessary to fund public expenditure. The middle class is ambivalent and will
react depending on the specific frame that will be proposed by politicians.
Specific expenditure categories and items have their favourable and opponent constituencies.
Certain large-scale projects can be the subject of a national debate and the decision can depend on
its outcome.
The process of public budgeting is crucial to influence the outcome, e.g. with the sequence of
decisions being capable of "leaving no money" for the "last" choices. The current level of public

29
deficit or surplus is ambivalently used to influence changes in the level of public expenditure. For
those who desire a more or less balanced budget, the surplus is an invitation to spend, a deficit to
cut. However, the same surplus can instead be directed to tax cut and the deficit gap can be filled
in by new taxes or more incisive fight to tax evasion.

Impact on other variables

A GDP component as it is, public expenditure has an immediate impact on GDP. An increase of
public expenditure rises GDP by the same amount, other things equal. Moreover, since income is
an important determinant of consumption, that increase of income will be followed by a rise in
consumption: a positive feedback loop has been triggered between consumption and income,
exactly as in the case of shocks in export, investment or autonomous consumption.
The full extent of this mechanism will depend, however, by the reactions of the other economic
agents. Firms have to decide whether to increase production or prices in response to demand.
Moreover, if consumers interpret the increase in public expenditure as a fall in their disposable
income (i.e. after-tax income), consumption may fall accordingly.
Public expenditure is also told to crowd-out investment, possibly through an interest rate increase,
further leading, in a floating exchange rate regime, to a currency appreciation. Exports would then
be displaced as well.
In more microeconomic terms, public expenditure may be directed to consumer goods and thus
substitute families' expenditure, as with the case of health drugs. By contrast, in other cases, as
with education, public expenditure may trigger further consumption (books and all the other goods
whose consumption depend on culture levels).
Long-term trends
In developed countries, it has always grown, whatever the political orientation of the government.
Just the tempo can change. With a few exceptions, only under extremely strong constraints has
public expenditure been cut in absolute terms.
Wars are episodes of extremely high public expenditure, followed usually by a return to normality.

Business cycle behaviour

30
Public expenditure may turn out to be pro-cyclical or anti-cyclical depending on the political and
institutional attitude toward public deficit.
During recessions, tax revenue tends to fall, public budget usually degradates. Some governments
react by reducing public expenditure and freezing employment and wages in the public sector.
Other decide to spend more to stimulate the economy.
The former risks to worsening GDP dynamics and engendering a vicious cycle, which can be
broken by international trade dynamics, financial inflows or other variables.
The second would provoke a deep public deficit, waiting for GDP rebound and, possibly, new
taxes.
Still, real world data show often little reaction of public expenditure to the cycle. Most cycles show
public expenditure as a stabilizing tool just keeping the same dynamics when the rest "goes
wrong".

The budget process

31
Introduction
Understanding the way budgets are put together is a crucial first step in influencing decision
making. The budget is the result of a process. The priorities and choices it embodies reflect the
power of various actors in this process. Those who are effective in influencing the budget succeed
in having their choices and priorities included.
This chapter provides a general outline of the budget process. While the details will differ from
country to country, there are also important similarities across most public budgeting systems.
Based on a simplified and generalized discussion, the following sections look at the stakeholders in
the budget process, stages of the budget process, and how annual budgeting can be guided by a
medium-term expenditure framework.

Actors in the budget process

Within the executive, the role of a finance ministry or treasury is to coordinate and drive the
budget process in accordance with a schedule. The finance ministry has the
economic expertise to prepare macroeconomic projections. These are important in order
to assess the amount of money that will be available for spending. The finance ministry
also plays a crucial role in formulating fiscal policy, guiding the drafting of the budget,
and later in monitoring budget implementation. Various spending departments are
ultimately responsible for expenditures within their jurisdiction, such as health,
education, agriculture and so on. Spending departments will often try to extract as many
resources as possible, whereas the role of the finance ministry is that of the guardian of
the public purse.

Democratic constitutions require taxation and public spending to be approved by

parliament. Therefore, the role of the legislature is to scrutinize and authorize revenues
and expenditures, and to ensure the budget is properly implemented. The nature and
effect of legislative engagement vary. Some legislatures write the budget; others
approve executive budget proposals without changes. In some legislatures most of the
debate around the budget takes place on the floor of the house; elsewhere the
emphasis is on discussion in committees. Some legislatures fragment decision-making

32
power in the budget process across various committees; others have a single financial
committee that dominates the process. Ultimately, the final vote takes place in the
chamber. However, where committees play a strong role, the house tends to be guided
by committee reports in approving financial legislation. Legislators are aware of their
constituencies‘ priorities and needs when considering the budget.

Independent supreme audit institutions such as auditor generals or audit courts carry
out an audit of government accounts in order to determine whether government did in
fact implement that budget as passed by the legislature. Some of them also consider
whether this was done efficiently and effectively. While this basic task is similar across
different systems, there are differences in the institutional design of supreme audit
institutions. For instance, some are directly linked to the legislature, while others have
judicial independence. There are also differences with regard to capacity, resources, and
types of audit conducted. The role of supreme audit institutions and their interaction
with parliament is considered in detail in another unit.
The potential contribution to the budget process of civil society organizations, covering
the full spectrum from think tanks to community-based organizations, is increasingly
appreciated. Civil society organizations can provide independent research from a
perspective that is not covered by conventional analyses. One example is the work on
the impact of the budget on vulnerable groups such as women or children that civil
society groups have pioneered, sometimes in collaboration with the legislature. In some
countries where the legislature has limited research capacity, think tanks and
universities can ensure access to sound technical analysis of fiscal issues. Civil society
input to the legislature is promoted when committee and chamber debates are open to
the public, legislative information is freely available, and when committees conduct
hearings and receive submissions on legislation and budgets.

The media has an important role to play in ensuring that the central issues in budgetary
debates are widely understood. In order to play this role, journalists require full access
to the legislature and its committees, and all relevant documentation should be available
to them. Training and capacity building can help journalists to maximize the quality of

33
their reporting on the budget, and there have been instances where media institutes or
civil society organizations have provided such opportunities. A later unit discusses the
role of civil society and the media during the budget process.

International financial institutions and donor agencies play a powerful role in the budget
process of poor countries with particularly high levels of foreign debt. When
international financial institutions and donors attach stringent conditions to loans, the
legislature‘s role may be severely diminished to rubberstamping budgets that reflect
prior agreements between lenders and the executive. To be supportive of sound budget
practices, donor funding needs to be transparent and predictable, and full information
on such funding should be given in the budget. Increasingly, the negotiations around
debt and new financing involve a wider range of state and non-state actors. Consultative
Group Meetings, as they are called, have become important opportunities for the private
sector and civil society groups to make their voices heard on economic and budget
policy issues.

Stages of the budget process

Budgets have to be passed regularly, usually on an annual basis, in order to ensure that
the government continues to operate. The budget process is governed by a timeline that
typically can be separated into four different stages:
▪ Drafting
▪ Legislative
▪ Implementation
▪ Audit and evaluation
This basic sequence is applicable for many if not most countries whose governments are
built on democratic principles. But across countries there are many differences in the
influence of various actors and the timing of the process. The following paragraphs look
at a simplified version of public budgeting in the form of a generalized overview of the
process of preparing, approving, implementing and auditing a single budget.
It is important to remember, however, that in real life budget cycles overlap. At any one
time a number of different budgets are at different stages of the budget process. For

34
example, while one budget is being drafted, another budget might be awaiting
legislative approval, yet another might be in the process of being implemented, and a
fourth one that has already been implemented might be subject to audit and evaluation.
This means that the legislature concurrently has to deal with several different budgets at
different stages in their process. The overlapping nature of budgeting means that the
maintenance of fiscal oversight can be a complex challenge.
▪ Budget tabled in the legislature
▪ Consideration by parliamentary committee(s)
▪ Parliament accepts, amends or rejects the budget
▪ Finance ministry or treasury issues guidelines to spending departments or agencies
▪ Spending departments submit draft budgets
▪ Negotiation and final decisions by executive
Stages of the annual budget process
The drafting stage is concerned with compiling a draft budget that can be submitted to
the legislature. This stage is mostly internal to the executive, but it does not have to be
a secretive affair. The first step is to set fiscal policy and estimate available revenues in
order to establish the total resource envelope that will be available for spending. Based
on the policy framework of the government the finance ministry issues indicative
expenditure ceilings for each department. This leads up to negotiations between
spending departments and the finance ministry about the allocation of funds across
different functions. A consolidated draft budget has to be reviewed and approved at the
highest political level, such as the president or cabinet, which will also make final
decisions on especially contentious issues that could not be resolved before.

Once a comprehensive budget has been drafted, it has to be approved by the legislature
to become effective. During the legislative stage, parliament scrutinizes the expenditure
and revenue proposals of the executive. Its options are to approve or reject the budget,
to amend it, or, in a few cases, to substitute the draft tabled by the executive with its
own budget. In some countries, the legislature passes separate legislation for
appropriations and changes to the tax code; in others it considers a unified budget bill.
The exact form of legislative approval is less important than the fact that it must be

35
comprehensive. Legislative authorization of all public spending and taxation ensures the
rule of law in public finance.

The duration of the legislative stage is an important element of variation between

budget processes of different countries. The United States Congress spends about eight
months and sometimes more on deciding the budget, while some legislatures only have
about a month. Budget scrutiny takes time. A good rule of thumb, therefore, is that the
more time the legislature has to review the draft budget, the greater its overall potential
influence. A national legislature requires a minimum of three months for effective
consideration of the annual state budget.

Implementation of the budget commences with the beginning of the fiscal year. The
execution or implementation stage of the budget process is mainly in the hands of the
executive. The finance ministry or treasury usually plays a leading role in assuring that
funds are apportioned to spending departments in line with the approved budget.
Sometimes, however, in many developing countries, cash constraints lead to certain
expenditures being cut below voted and other unplanned adjustments to approved
spending. Funds might be shifted to purposes other than those that were approved.
Improvised budget cuts tend to adversely affect vulnerable groups that have a weak
political voice, and who are most dependent on government initiatives. Frequent
adjustments to budgets can reflect the uncertainties that are characteristic of the
macroeconomic environment, but ‗continuous‘ or ‗repetitive budgeting‘ is also a
symptom of a weak and ill-disciplined budget system. To ensure that its authority is not
undermined by excessive adjustments, the legislature might find it useful to keep a close
eye on implementation through scrutiny of actual spending during the fiscal year. Any
significant adjustments to the budget should be captured in adjustment or supplemental
appropriations that are tabled in the legislature for approval. In-year adjustment
decisions need to be made in a transparent manner and should be subject to the same
scrutiny carried out at the budget formulation stages.

All countries are exposed to fiscal risks inherent in a continuously changing economic

36
environment and even with high quality forecasting many new and urgent pressures on
public spending are impossible to anticipate and can emerge suddenly. For instance,
infrastructure reconstruction might unexpectedly become necessary due to natural
disasters such as floods or storms. To ensure that the budget remains authoritative even
during difficult economic times, a budgeting system needs to cope with uncertainty
(Crippen 2003). This is the function of contingency reserves, which set aside an amount
for adapting the budget to changing circumstances or emergencies. However,
contingency reserves need to be clearly accounted, decisions about their use should be
a transparent and approved by the legislature, and they should not be excessive in size.
Otherwise, they can easily deteriorate into ‗slush funds.‘

There are other potential challenges to the proper implementation of annual budgets.
Ordinary legislation introduced during the course of a financial year can have budgetary
implications, for example by creating or increasing entitlements such as social grants.
This might bring such legislation into conflict with the constraints of the approved
budget or medium term expenditure plans. For this reason, the process of drafting
ordinary legislation should include a consideration of its implications on the budget in
both the short and medium to long term. This information should be available to the
legislature during the law-making process, so that it can be subjected to independent
and open scrutiny.

During the audit and evaluation stage, an independent audit institution, such as an audit
court or auditor general, analyses government accounts and financial statements. In
most countries, the audit of accounts is followed by the consideration of audit findings
by the legislature. If the process is effective, any recommendations based on audit
findings are reflected in future budgets, which allows for continuous improvements in
public spending and generally public financial management. Audit reports need to be
produced and tabled in the legislature as speedily as possible to ensure their relevance
and accuracy. Long delays undermine accountability, because officials who are
responsible for a loss of public money may have moved on or retired by the time an
incident receives attention. Delays may make it more difficult to pursue disciplinary

37
measures. The interest of the public is also likely to focus on more current matters. The
timely submission of audit reports requires that departments produce their financial
statements in time for the audit institution to meet the deadline. The relevant financial
management legislation usually prescribes when and in what form the necessary
information has to be submitted by departments to the auditors.

Budgeting is a process rather than an event, and budget cycles are ongoing and
interconnected. The role of parliament should not be restricted to budget approval and
the review of audit findings. For instance, in a number of countries parliamentary
committees ask government to report on the process of drafting an upcoming budget
yet to be tabled, and legislators might request certain documentation that is used in the
drafting process. During budget execution, the legislature should have access to actual
revenue and expenditure data on an ongoing basis. In this way, it will be able to keep
track of the progress that is being made in implementing the approved budget. This
provides an opportunity to pick up problems at an early stage, before they result in
significant deviations between the approved budget and actual revenues and spending.
When parliamentarians follow the entire budget process as it unfolds they will be in a
position to acquire relevant expertise and to keep track of emerging issues. Legislative
effectiveness in budget scrutiny is enhanced by continuous oversight.

Budgeting for the medium term

With budgeting on a year by year basis, new policy initiatives stand little chance of being
sufficiently accommodated because there is a bias towards existing programs. Since the need for
particular programs can shift over time, unnecessary expenditures may be carried over year after
year, leaving insufficient funds to address more pressing new
needs and priorities. Also, many aspects of budgeting require more than an annual time
horizon. For instance, when planning for large scale capital expenditure projects or
substantial restructuring of service-delivery agencies, the planning period stretches over
a number of years. Many countries have introduced a medium-term expenditure
framework (MTEF) to support strategic prioritization and sustainable fiscal planning
beyond the horizon of annual budgets.

38
The purpose of an MTEF is to indicate the size of the financial resources needed during
the medium term, usually between three to five years, in order to carry out existing
policy. The MTEF concept differs from multiyear budgeting, which involves fixed
appropriations for a certain number of fiscal years. Usually, only the first year of an
MTEF is approved by the legislature as the annual budget, whereas the outer years are
nonbinding projections of the future cost of existing policy. The firmer these projections
become, the more they move to the centre stage of the budget process and form the
basis for the annual negotiation of allocations, resulting in a system of ‗rolling budgets.‘
All OECD countries have medium term frameworks, and many developing countries have
implemented, or are in the process of implementing, similar tools.

While the details will differ, there are some basic steps that need to be carried out in the
process of compiling an MTEF. The first step involves the setting of aggregate and
sectoral spending ceilings, based on realistic revenue projections and fiscal policy. The
guidance of the finance ministry is important at this stage. The second step involves
policy planning within the spending ceilings that have been established. This requires
departments to cost programs and consider their linkage to strategic objectives. There
will always be contentious issues and difficult trade-offs that have to be negotiated. The
third step, therefore, is to make a binding political decision involving final negotiations
and the approval of medium term spending choices by cabinet.

Medium term budgeting has been implemented in many countries, but with varying
degrees of success. Highest level political commitment is crucial in ensuring that such a reform
takes root. When medium term planning is widely considered to be a ‗technical‘ exercise for
bureaucrats, and politicians do not buy into the process, the framework is unlikely to acquire the
status and authority that it needs in order to become entrenched and deliver improvements. To
enhance debate on public spending MTEFs should be tabled and discussed in parliament. Another
ingredient of success is to clearly link medium term spending and revenue figures to government
policy, for instance by linking the MTEF with a medium term budget policy statement. It is only

39
with narrative information on the content and direction of budget policy that the medium-term
figures can be adequately interpreted and assessed by parliament.

Conclusion
For parliamentary budget researchers and committee staff thorough acquaintance with the actors
and process of budgeting is essential. This unit looked at a simplified and
generalized summary of budgeting in the public sector. Core participants in a typical budget
process are the executive, including finance ministries and spending departments; the legislature
and its committees; and supreme audit institutions. Media reporting and civil society participation
enhance transparency and public debate. Most budget processes in the public sector go through
drafting, legislative, implementation, and audit stages. Medium-term budgeting frameworks are
increasingly used to guide annual budgeting and to provide a broader planning horizon that is
necessary for many tasks in budgeting. Successful medium term planning requires political
commitment to the framework, rather than being a technocratic add-on to the budget process.

ZERO BASE BUDGETING

ZBB is defined as a method of budgeting which requires each cost element to be specifically
justified, as though the activity to which the budget relates were being undertaken for the first
time. Without approval, the budget allowance is zero. Zero based budgeting is so called because it
requires each budget to be prepared and justified form zero, instead of simply using the last year‘s
budget as a base. Incremental level of expenditure on each activity is evaluated according to the
resulting incremental benefits. The available resources are then allocated where they can be used
most effectively.

Characteristics of zero based budgeting

1. The technique deals practically with all the elements of the budget proposals.
2. A critical evaluation of all the ongoing activities is also done afresh together
with new proposals.
3. It provides a manager a combination of choices for arranging proposals in order
of preference according to its criticality to the organization.

40
Zero based budgeting is superior to the traditional based budgeting in the following manner
1. It provides a systematic approach for the evaluation of different activities.
2. It ensures that the function undertaken are critical for the achievement of the objectives
3. It provides an opportunity for the management to allocate the resources to
various activities after a proper cost benefit analysis.
4. It helps in the identification of wasteful expenditure and then their elimination
5. It helps in the introduction of management by objectives

Process of zero based budgeting

The process of zero based budgeting involves the following steps
1. Determination of a set of objectives is one of the pre-requisites and
essential step in the direction of the ZBB technique.
2. Deciding about the extent to which the technique of ZBB is to be applied whether
in all areas of an organization‘s activities or only in a few selected areas on a trial basis
3. Identify those areas where the decisions are supposed to be taken
4. Developing decision packages and ranking them in the decision of the orders
5. Preparation of a budget that is translating decision packages practicable units/items
and allocating financial resources
In real terms, the Zero based budgeting is simply an extension of the cost benefit, analysis method
to the area of corporate planning and budgeting. It however produces provides a number of
benefits to the organizational efficiency and effectiveness.

Planning, Programming and Budgeting System (PPBS)

The Chartered Institute of Public Finance and Accountancy defines Planning, Programming and
Budgeting System as:
―Primarily, a system associated with corporate management which identifies alternative policies,
presents the implications of their adoption and provides for the efficient control of those policies
chosen. It embraces several established concepts and analytical techniques within the framework
of a systematic approach to decision making, planning, management and control. The principal
features of planning programming and Budgeting system are that it relates to objectives, it relates
to output, it emphasise the choice.‖

41
It is a budgeting approach which is based on systems theory, output and objective orientation, with
substantial emphasis on resource allocation on the principle of economic analysis.
The technique is not based on the traditional organisational structure but on programmes which
involve grouping of activities which have common objectives. The resources which are available
to public sector organizations are limited when compared with the demands for them.
Consequently, choices have to be made to make sure that the meager resources are distributed
fairly to maximize benefits,
The main steps in planning, programming and budgeting system
a. Identification and enumeration of goals and objectives of the organization.
b. Defining the total system in detail, including objectives‘ environment, available resources, the
programmes and their objectives, e.t.c.
c. Planning and analysis. These involves continuous process of developing, comparing and
analyzing alternative programmes, so as to evolve the most appropriate package for the
organization.
d. Development of the appropriate measures of performance for the programmes of the
organisation.
e. Programming and budgeting: the agreed package of ―programmes‖ complete with resource
requirements and expected results are expressed in the form of ―programmed budgets.‖
f. Reporting and controlling; Planning, Programming and budgeting System requires
sophisticated information service which is able to monitor the process made towards meeting
the organisational objectives. Performance, therefore, emphasizes the attainment and non-
attainment of the desired objectives, rather than the amount spent which is the focus in
traditional budgeting system.
(g) Development each year of a multi-year programme and financial plan.

Advantages of Planning, Programming and Budgeting System

These are:
(a) The technique provides information on the objectives of the Organisation
(b) It lays emphasis on long-term effects.
(C) It achieves effective use of budgeted resources and anticipated performance.

42
(d) The technique ensures rational decision-making and forces those seeking budgetary allocations
to consider alternatives.
(e) It leads to rapid economic development.

Disadvantages of Planning, Programming and Budgeting System

The system is associated with the following disadvantages/problems:
(a) Natural resistance to change, particularly among the very Senior Officers in the Governmental
hierarchy.
(b) Transitional problems at the introductory stage.
(C) Problem of staff shortage.
(d) Paucity of data.
(e) Re-orientation of the old accounting system to cater for the requirements of the new concept.
(f) Problem of data collection and physical monitoring.
(g) Planning, Programming and Budgeting System is difficult to install.
(h) It makes heavy demand on resources.
(i) The uncertainty of the future makes long term planning difficult.

Principles of Taxation

Is a compulsory contribution to support government activities, projects, programs and to support

public services need.

I. Forms of Taxation
Two Broad Categories

Direct taxes-characterized by being paid directly and shouldered by the tax payer

 Individual income tax

 Payroll tax- Social security, PAGIBIG, Philhealth
 Corporate tax-tax on the net income of companies
 Estate & Gift tax- tax on inherited wealth from one generation to the next

43
  Real Property tax-tax imposed by local government for land ownership

Indirect taxes- tax paid that can be shifted or pass on to others by the tax payer

 Custom duties (tariffs)- levied on imported goods

 Excise tax- taxes on goods like tobacco, alcohol, telephone services, air travel, luxuries
 Sales tax (VAT)- a flat percentage tax on all retail sales of a broad category of goods
 Privilege or Fixed tax-tax imposed on any company engaged on business or any person
pursuing an occupation or profession
 Others ( Gross receipt tax, documentary stamp, amusement tax)

II. Five Desirable Characteristics of Tax Systems

ECONOMIC EFFICIENCY
- The tax system should not be distortionary
- The tax system should not interfere with the efficient allocation of resources

Economic Impact of Taxation

 Behavioral effects
- Work, education, retirement
- Savings, investment, risk taking
- Energies devoted to avoiding taxes instead of creating wealth
- Marriage and divorce
 Financial effects
Fringe benefits
Financial structure of firm
 Organizational effects
Corporations versus unincorporated enterprises
Discourage and encourage economic activity from taking place within
corporations, thereby changing the degree of risk taking in the economy

44
  General Equilibrium effects
Reduce savings and capital stock and in turn reduce the productivity of
workers and their wages
Increase in the degree of inequality
 Announcement effects and Capitalization
Future taxes on an asset reflected (capitalized) in the price of the asset at
the time the tax is announced

Taxes and Economic Efficiency

 Distortionary- are associated with actions an individual takes to avoid tax

 Non- distortionary- (lump-sum taxes) are taxes that are fixed and cannot be altered by any
action that the individual can take

 Corrective taxes- taxes imposed to both raise revenue and improve the efficiency of
resource allocations
- Taxes on activities that can caused negative externalities (pollution)

ADMINISTRATIVE SIMPLICITY
- The tax system ought to be easy and relatively inexpensive to administer
- Reducing administrative cost and increased collection efficiency (BIR)

FLEXIBILITY
- Tax system ought to be able to respond easily to changed economic
circumstances

POLITICAL RESPONSIBILITY

45
 - The tax system should be designed so that individuals can ascertain what they are
paying, and evaluate how accurately the system reflects their perspective
(transparency)
FAIRNESS
- The tax system ought to be fair in its relative treatment of different individuals
 Horizontal Equity- individuals who are identical should be treated the same, and pay the
same taxes

 Vertical Equity- individuals who have greater ability to pay or who are better off or receive
greater benefits from government services should pay more taxes

 Income is the most often used as a basis of taxation, an indirect and imperfect measure of
both ability to pay and economic well being

 Lifetime consumption is equivalent to lifetime income, this is fairer basis than annual
income

 Lifetime consumption/income is a flawed measure of ability to pay: it unfairly

disadvantages individual who chooses to work hard rather than enjoy leisure: its not a real
measure of one‘s opportunity set

 Benefit taxation is hindered by difficulties of measuring benefits, especially for pure public
goods

III. Approaches to Taxation

1. Benefit Approach- the payment of taxes is based on the benefits received by the taxpayer from
public services
2. Ability to pay approach- support of government functions should be provided by the taxpayers
on the basis of their relative abilities to shoulder the tax burden.
a. Three sacrifice doctrines

46
i. The minimum sacrifice principle- this sacrifice doctrine provides for the imposition of a tax
which would entail the lowest possible aggregate sacrifice in the community, ie, the minimum
sacrifice principle is one way of allocating the tax burden in such a manner that the sacrifice of the
tax payers taken as a whole would be at the lowest possible level.
ii. Proportional sacrifice doctrine- each individual should contribute his tax share to the
government such that the ratio of the utility he foregoes by paying the tax to the total utility of his
pre tax income, is equal to the same ratio with regard to every other individual tax payer
iii. Equal absolute sacrifice doctrine- this sacrifice doctrine is akin to the equal marginal
sacrifice principle but, in the former the equality of sacrifice requires that the total utility to be
foregone by an individual taxpayers must be equal to what every taxpayer should forego.

IV. Tax Policy and Its Implication

Tax base- This is the item or the unit on which the tax is imposed
Rate of tax – the tax rate is expressed in terms of percentage

Regressive tax- is when the tax rate is higher on the smaller base compared to the bigger base, thus
as the tax base increases, the tax rate becomes smaller
Example. Value Added Tax

Proportional tax- it exist when the tax rate does not change as the size of the tax base varies
There is a constant proportion between the amount of tax and the tax base.

Progressive tax- when the tax rate changes in the same direction as the changes in the tax base
Example. Income Taxation

47
Degressive tax – is a tax wherein the tax rate does not increase as fast as the increase in the tax
base or it is a progressive tax in which the tax rate is increasing at decreasing rate, or that the rate
increases in a decelerating manner

V. Shifting and Incidence

The theory of shifting and incidence is a field in public finance that deals with the
distribution of tax burden. In ot her words, it deals with how much each taxpayers or
group of taxpayers contributes to the government, given the tax system of the
economy.

The burden of the tax is defined as the amount of the tax involved

The subject of the tax is the individual who must pay the tax (also termed as the statutory
taxpayer)

Shifting- is the process of passing on, or transferring part or all of, the tax burden from
the subject of the tax to another individual

The burden of the tax is the tax rate. However, if the manufacturer or importer need
not carry the burden and he can pass on the tax to his customers in terms of a higher price,
customers eventually shoulder part or the entire tax burden. This is an example of shifting.

A given tax may be shifted forward or b ackward, or may be absorbed by the

statutory taxpayer.

a. Tax is absorbed by the statutory taxpayer- shifting has not occurred and the
incidence is on the subject of the tax
b. Forward, shifting takes place when the price of the taxed commodity was
increased.
Example. If the price of beer rises because of the 27.5 -centavo tax

48
 c. Backward shi fti ng - when the price paid for the factors of production
involved in the manufacture of the taxed commodity has decreased
Example. If m anufa cturers of beer have been able to decrease the salary of their
emp l o ye e s o r t h e p r i c e a t w h i c h t h e r a w m a t e r i a l s h a s b e e n r e d u c e d b e c a u s e
o f t h e t ax .

Incidence- - refers to the final resting or settling down of the tax burden
- It describes who actually bears the tax

VI. The Incidence of Taxes in Competitive Markets

In competitive markets, incidence depends on the elasticity of demand and supply

A commodity tax is not borne at all by consumers if the demand curve is perfectly elastic or by
producers if the supply curve is perfectly elastic.

Its is borne completely by consumers if the demand curve is perfectly inelastic, or by producers if
the supply curve is perfectly inelastic

The Effect of Elasticity

Elasticity of Supply and demand: tax borne by consumers

a) Perfectly elastic supply curve- the price rises by the full amount of the tax, the entire burden
of the tax is on consumers
b) Perfectly inelastic demand curve- the price rises by full amount of the tax, the entire burden
of the tax is on the consumers

49
The steeper the demand curve or the flatter the supply curve, the more tax is borne by consumers

Therefore the less elastic then demand curve, and the more elastic the supply curve, the more tax
will be borne by consumers

CANONS OF TAXATION
The term ―taxation‖ comes from Latin word ―Taxation‖. It means too determine he payable
quantum on estimate. Taxing authority determines tax to be payable by the assesse. So Tax is the
revenue collected by the Government from persons and organizations under different taxing Acts.
In other words, it is a liability imposed upon the assesse who may be individuals, groups of
individuals and other legal entities. A charge imposed by a government on a service, product, or
activity in order to raise revenue. Tax can be levied on business or personal income.

According to Justice Holmes, the price to the Govt. for living in a civilized society is the tax.
According to Taylor, taxes are the compulsory payments to Government without expectation of
direct benefit to the tax payer.

A tax system in order to achieve its various objectives, needs to adhere certain principles. But in
view of the fact that the objectives of taxes are many and some of them are conflicting, the writers
of public finance have generally chosen and prescribed certain principles which a good tax system
may adhere. In this connection, Adam Smith gave four principle of taxation which he called
Canons of Taxation. Some other writers have also prescribed some other principles/canons.

Adam Smith’s canon of taxation:

1. Canon of Equality:
―The subjects of every state ought to contribute towards the support of the government, as nearly
as possible, in proportion to their respective abilities; that is in proportion to the revenue which
they respectively enjoy under the protection of the state.‖ This canon tries to observe the objective
of economic justice.

50
2. Canon of Certainty:
This canon describes that ―The tax which the individual is bound to pay ought to be certain and not
arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought all to be
clear and plain to the contributor and to every other person,‖ the tax-payers should not be subject
to arbitrariness and discretion of the tax officials, in which case there will be a scope for a corrupt
tax administration.

3. Canon of Convenience:
This canon takes into consideration the interest of the taxpayer the view of payment of tax. It
emphasizes that the mode and timings of tax payment should be, so far as possible, convenient to
the tax-payer. This canon recommends that unnecessary trouble to the tax-payer should be
avoided; otherwise various ill-effects may result.

4. Canon of Economy:
Every tax has a cost of collection. It is important that the cost of collection should be as minimum
as possible. It will be useless to impose taxes which are too widespread and difficult to administer.
Productivity of taxes has been given important in this canon.

An analysis of these canons indicates that Adam Smith was basically concerned with the ways in
which economy could increase its productive capacity, and thereby achieve a higher rate of
economis growth and at the same time he considered the convenience of the tax payer and
economy in tax collection.

However, in view of the wide spread recognition of many other objectives of the economic
philosophy of the Govt. and modern state, some additional principles have also been suggested by
some other authors. Now a brief description about them follows:

5. Canon of Productivity:
It is also called the canon of fiscal adequacy. According to this principle, the tax system should be
able to yield enough revenue for the treasury and the Government should not be forced to resort to

51
deficit financing. The canon is thus also called canon of adequacy.

6. Canon of Diversity:
In line with canon of productivity, canon of diversity also gives importance to adequate collection
of tax through diversification. Thus it stresses to the fact that it will not be a happy situation if the
state depends upon few revenue inequitable as between different sections of the society. On the
other hand, if the tax revenue comes from diversified sources, then any reduction in tax revenue on
account of any one is likely to be very small on total tax revenue. However, too much multiplicity
of taxes is also to be avoided. That leads to unnecessary cost of collection and violates the canon of
economy.

7. Canon of Simplicity:
The tax system should not be too complicated. That makes it difficult to administer and understand
and breeds problems of difference in interpretation and legal disputes.

8. Canon of Flexibility:
It should be flexible so that it becomes possible for the authorities without undue delay, to revise
the tax structure, both with respect to its coverage and rates, to suit the changing requirements of
the economy and of the treasury.

9. Canon of Social Objectives:

In this canon control and achieving social goal is emphasized. According to this canon, charging
and collecting taxes always need to be in line with social and economic policy of the Government.

10. Canon of Functional Efficiency:

Tax policy needs to be efficient, operative and objective. According to Prof. Dew, the tax laws and
regulations must be such as easily understandable to the assesse, easily administraitable and

52
Public-Private Partnerships (PPPs)
Key words: ‘privatisation’, ‘PPPs’ and ‘PSP’
Ideology and words
The terminology used to describe the involvement of the private sector in public services has
become complicated over the last 20 years. Ideology has been a crucial factor in these linguistic
developments.

In the early 1980s the Thatcher government in the UK embarked on a political strategy to
restructure the private sector, in which privatisation was seen as a positive radical development.

53
The term ‗privatisation‘ was used to cover all forms of private involvement, from the sale of
national industries to the simple sub-contracting or outsourcing of functions such as refuse
collection or office cleaning. In other EU countries, where sub-contracting co-existed with direct
public provision, these contracts were not seen as part of the ideological development of
privatisation, and so have not usually been described as ‗privatisation‘.

In CEE countries, as the former centralised state apparatus was broken up, ‗privatisation‘ was used
to refer to any action which removed a function from the control of central government, including
the re-allocation of responsibilities, such as water, to local authorities. The political importance of
this decentralisation ignored the need to distinguish this act of municipalisation from the further
act of delegating such functions to private sector companies.

As privatisation became politically controversial, even in the UK, new terms were introduced.
‗Public-private partnership‘, abbreviated as PPP, was created to present the same forms of
involvement of the private sector as more a collaborative, technical exercise rather than an
aggressive transformation of relations. A similar term, ‗private sector participation‘ (PSP) has also
been widely used, especially by the World Bank and others in the context of developing countries.
In both cases, the term is not a legal or technically exact phrase, but rather a replacement for the
old general Thatcherite use of the word ‗privatisation‘. The vast majority of PPPs, for example,
are not partnerships in any legal sense, but simply contractual relationships.

Other terminology does have more technical origins, and therefore specific meanings. The oldest
of these is ‗concession‘, which has broadly the same meaning everywhere, of a public authority
assigning to a private company the right to exploit a monopoly service by charging users, usually
through making investments at its own risk (“à ses risques et perisl”). More recent acronyms such
as PFI and BOT (see below) also have quite precise meanings. All of these however, and more, are
also covered by the vague general terms of PPP and PSP. The different words, and the different
perceptions of them, have made a common understanding more difficult. It is more helpful to re-
focus on the concrete relationships and issues involved.

EU: no formal definition of PPP

54
The EU does not have any formal definition of a PPP. The procurement directives governing
works, supply and service contracts explicitly address contracts which provide for a service to be
provided, or a construction contract to be carried out, but public service concessions (on the French
model of delegated management) have so far been excluded from their coverage.

Different types of PPPs

Four elements
In terms of getting an overview and an international comparison, it is useful to divide the elements
that can make up a PPP scheme into four parts: Construction, Operation, Finance and Ownership
(see Table 1 below).

Outsourcing of services just involves a contract to operate a specific service, e.g. refuse collection,
without any construction or financing of a capital investment. Under UK PFI schemes (private
finance initiative)a private company designs and builds specific investments on the basis of finance
provided by it, and recoups the money by a contract to provide services for a period of years,
usually decades, while the asset itself remains owned by the public sector. Concessions e.g. in
water are similar, but the finance is recouped through charges to the users. With leases (affermage
in French) the company does not make its own investments but operates and maintains the system
for the municipality, financed by charging users. Under BOT schemes (build, operate, transfer.),
the investment asset is built and owned by the company for the period of operation, and later
transferred to the public sector.

Concessions and PFI are described in more detail below.

These different forms of PPPs all affect the structure of public services, but also concern trade
unions because the common element of private operation of services affects jobs and conditions of
workers. This restructuring of their employment relationship is often a key element in generating
savings to make the financial mechanism worthwhile.

Table 1: Elements of different PPP schemes

Out- PFI Concession Lease BOT
sourcin

55
 g
Operation Operation of X X X X X
service
Finance Capital X X X
investment
financed by
private operator
Recouped by X X
user charges
Recouped by X X X
contract from
municipality
Construction Construction of X X X
asset by private
company
Ownership public during X X X X
and after
contract
private during X X
contract, public
after
Private
indefinitely

Other variations
There are a range of other terms used to describe variations of the BOT, PFI concession type of
PPPs. These include:
 DBFO Design, Build, Finance and Operate
A contract let under the principles of the private finance initiative whereby the same supplier
undertakes the design and construction of an asset and thereafter maintains it for an extended
period, often 25 or 30 years

56
 DB Design and Build
A contract where a single supplier is responsible for designing and constructing a built asset.
 FM Facilities Management
Management of services relating to the operation of a building. Includes such activities as
maintenance, security, catering and external and internal cleaning.
 O&M Operation and Maintenance Contract
These projects involve the private sector operating a publicly-owned facility under contract with
the Government.
 LDO Lease Develop Operate
This type of project involves a private developer being given a long-term lease to operate and
expand an existing facility.
 BOOT Build Own Operate Transfer
Projects of the Build-Own-Operate-Transfer (BOOT) type involve a private developer financing,
building, owning and operating a facility for a specified period. At the expiration of the specified
period, the facility is returned to the Government
 BOO Build Own Operate
The Build-Own-Operate (BOO) project operates similarly to a BOOT project, except that the
private sector owns the facility in perpetuity..

Other non-contractual privatisation terms

Other terminology relates to forms of involvement of the private sector which are not based on
contracts. ‗Liberalisation‘ of a sector changes the structure in such a way that private companies
can enter and compete as they wish, without being contracted to do so. The various forms of sale
of public companies similarly involve transfer of ownership, but may not be attached to any
subsequent contract (though they may be subject to statutory obligations to provide services). Joint
ventures between municipalities and private companies, usually created by the sale of part of the
shares in an organization, may also sometimes be given a contract e.g. in the form of a concession.

Liberalisation Refers to the opening of a sector to competition. This usually takes the form
of the break-up of public sector monopolies and the subsequent opening-up
of markets. Used at EC level in industries e.g. Energy, also national level

57
 initiatives
Asset sale Selling all or part of a public company
IPO Initial Public Offering - the first sale of shares in a company to the public
Trade sale Where a state asset is sold to a private company without a public share
offering.
Joint venture A company partly-owned by a municipality and partly by a private
company.

Beyond definitions: a continuum of cases

Attempts at defining terms invariably fail to capture the full range of the possible ways of
involving the private sector in the provision of public services. The table below illustrates some of
the different options available in the involvement of the private sector in one public service -
hospitals.

Option Private sector responsibility Public sector responsibility

Co-location of private Operates private wing (for Manages public hospital for public
wing within or beside private patients). May provide patients and contracts with private
public hospital only accommodation services wing for sharing joint costs, staff,
or clinical services as well. and equipment.

Outsourcing nonclinical
support services
Provides nonclinical services Provides all clinical services (and
(cleaning, catering, laundry, staff) and hospital management.
security, building
maintenance) and employs
staff for these services.

Outsourcing clinical Provides clinical support Manages hospital and provides

support services services such as radiology and clinical services.
laboratory services.

58
Option Private sector responsibility Public sector responsibility

Outsourcing specialized Provides specialized clinical Manages hospital and provides most
clinical services services (such as lithotripsy) clinical services.
or routine procedures (cataract
removal).

Private management of Manages public hospital under Contracts with private firm for
public hospital contract with government or provision of public hospital
public insurance fund and services, pays private operator
provides clinical and for services provided, and monitors
nonclinical services. May and regulates services and contract
employ all staff. May also be compliance.
responsible for new capital
investment, depending on
terms of contract.

Private financing, Finances, constructs, and Manages hospital and makes phased
construction, and owns new public hospital and lease payments to private developer.
leaseback of new public leases it back to government.
hospital

Private financing, Finances, constructs, and Reimburses operator annually for

construction, and operates new public hospital capital costs and recurrent costs for
operation of new public and provides nonclinical or services provided.
hospital clinical services, or both.

Sale of public hospital as Purchases facility and Pays operator for clinical services
going concern continues to operate it as and monitors and regulates services
public hospital under contract. and contract compliance.

59
Option Private sector responsibility Public sector responsibility

Sale of public hospital for Purchases facility and Monitors conversion to ensure
alternative use converts it for alternative use, adherence to contractual obligations.
depending on sales agreement.

Source: Taylor and Blair 2002

French and UK models

Most PPP proposals in Europe are referred to either the French model of delegated management,
or the current UK model of PFI. Brief accounts are set out below.

The French model: concessions and delegated management

In France there is a long-standing use of concessions and leases for certain public services, notably
water. The generic term is ―delegated management‖ (gestion déléguée) , which applies to a
contract concluded for the delivery of a public service, where the remuneration of the delegatee is
largely dependent on operating results, and where management of the service is entrusted to a legal
entity which can be a private company, individual, local semi-public company, association,
another local authority or a public corporation not controlled by the delegating local authority
(Adhémar P and Dumont J-L).

In theory, there are three main variants of concession (Hall):

 a concession in the strict sense (“concession” in French) when the private company has
complete responsibility for operating the system, and making the necessary investments in
the infrastructure, and takes responsibility for financing them at its own risk (“à ses risques
et périls” in French). Build-operate-transfer (BOT) concessions are usually of this type.
 an operating concession (“affermage” in French), whereby the private company has to
operate the business and carry out maintenance at its own risk, depending on revenue from
water charges - but the commune remains the owner of the infrastructure, and is
responsible for investment in the system.

60
  management contracts (“gérance” in French), in which the company is paid a flat fee to
manage the system, without taking any responsibility or risk for investments.

In practice, concessions do not always fit neatly into a single category. However, the technical
distinction between concessions and affermages may be of great significance in respect of rules on
public finances and tendering. According to the French state audit office, Cour des Comptes, if the
contract is a concession in the strict sense, then the rules on public works contracts (“Code des
marchés publics”) do not apply - and so works contracts involved do not have to be tendered. This
means that other companies in the same group can enjoy privileged access to the contracts without
having to compete for them.

UK PFI model
The Private Finance Imitative (PFI) was introduced by the UK Conservative government in 1992.
It has been maintained by the new Labour government since 1997.

PFI projects are usually long-term contracts for services that include the finance and construction
of associated facilities or properties. Under the contract, the private sector entity will have
responsibility for financing and constructing the building or facility and maintaining and servicing
it throughout the contract term. It is used mainly for the construction of new buildings such as
hospitals, prisons, or waste disposal plants, but also for software systems – the UK‘s national
insurance system is being redesigned under a PFI contract with Accenture (formerly Arthur
Andersen).

The private sector finances the project and receives a regular payment over the lifetime of the
contract. The actual contract may not be to provide the main service – in the case of hospitals and
schools, for example, the contracts concern ‗building services‘ such as cleaning, maintenance,
catering etc, while the medical and nursing services remain in the public sector.

One of the attractions for the UK Treasury is that under PFI, capital expenditure does not count as
public expenditure (as this is incurred by the contractor), although the payments to the contractor
do. This ‗off-balance-sheet‘ financing reduces the government‘s public expenditure totals today

61
but increases future liabilities. The ownership of the asset may remain with the contractor at the
end of the contract or pass to the public sector dependent on the terms of the contract.

PFI was described in a House of Commons Library Research Paper as:

―a form of public private partnership (PPP) that marries a public procurement programme, where
the public sector purchases capital items from the private sector, to an extension of contracting-
out, where public services are contracted from the private sector. PFI differs from privatisation in
that the public sector retains a substantial role in PFI projects, either as the main purchaser of
services or as an essential enabler of the project. It differs from contracting out in that the private
sector provides the capital asset as well as the services. The PFI differs from other PPPs in that
the private sector contractor also arranges finance for the project.‖

International Usage
With few exceptions, English abbreviations such as BOT are used internationally, sometimes
accompanied by a literal translation. Thus these terms are recognisable in many languages, and the
concepts described are usually close to English usage. The following sections identify some terms
used in other European languages.

62