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  • Writer's picturePeak Frameworks Team

Public Finance 101: How Governments Manage Money

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What is Public Finance?

Public finance deals with the revenue and expenditure of government entities. This field of study is vital, as it touches the lives of every citizen, affecting areas such as infrastructure development, healthcare provision, and education.

Public finance relates to how a government generates revenue and how it disburses these funds to fulfill societal needs. In essence, it is the study of the government's role in the economy. The key components of public finance include tax policy, expenditure policy, debt policy, and fiscal policy, which includes adjusting the other components to affect macroeconomic variables.

The field differs significantly from private finance as it focuses on the budgeting process and financial regulations in a public setting, with the scope extending beyond individual or corporate financial management to consider broader economic effects.

Public Finance
Source: eduCBA

Government Revenue: The Backbone of Public Finance Role of Taxes

Taxes, as many of us are acutely aware, represent the primary source of government revenue. Different types of taxes are levied by the government to finance its activities. For instance, the US Internal Revenue Service (IRS) collected over $3.5 trillion in taxes in 2019, accounting for about 95% of the total federal revenue. Some of the key tax types include:

  • Personal Income Tax: This is the tax levied on individual earnings. For instance, the top income tax rate in the US was 37% in 2020.

  • Corporate Tax: This is the tax charged on company profits. In 2017, the US reduced the corporate tax rate from 35% to 21% under the Tax Cuts and Jobs Act.

  • Sales Tax: This is the tax on the sale of goods and services. The sales tax varies by state in the US, with Oregon, Montana, New Hampshire, Delaware, and Alaska having no state sales tax.

Non-tax Revenues

Non-tax revenues refer to government earnings that are not derived from taxes. These include domestic and international borrowing, foreign aid, and revenues from public enterprises. For instance, the US Treasury issues Treasury bonds to finance public debt domestically. Also, revenues are earned from public enterprises such as the Postal Service and Amtrak.

The National Budget: Allocation of Public Resources

The national budget is an important part of a government's fiscal policy. It details how revenues, derived mainly from taxes and other sources, are allocated to public expenditures.

The Process of Budgeting in Government

The process involves a budget proposal, budget approval, and budget implementation. Notably, in the US, the President usually submits the budget proposal to Congress for approval. The proposal outlines the federal government’s revenue and spending plans for the upcoming fiscal year. President Obama, for instance, proposed a budget of $4.1 trillion for the fiscal year 2016, the largest to date in US history.

Categories of Government Expenditure

Government expenditure is generally divided into:

Capital Expenditure

Types of Capital Expenditure
Source: Happay

This includes spending on infrastructure and other long-term investments. The 2009 American Recovery and Reinvestment Act, which provided an $831 billion stimulus package for sectors including infrastructure, education, health, and renewable energy, is an example.

Recurrent Expenditure

This includes the ongoing costs of running the government, such as civil servant salaries, maintenance of government buildings, and other operational costs.

Public Debt: Borrowing and its Implications

Public debt arises when government spending exceeds revenue. It is a common tool used by governments to generate funds beyond what they collect in taxes. As of the end of 2020, the US public debt surpassed $27 trillion. This unprecedented level was driven by the economic measures taken to mitigate the impact of the COVID-19 pandemic.

Debt management and ensuring debt sustainability are crucial in order to prevent negative economic consequences, like inflation or higher taxes.

Public Finance Management: Accountability and Transparency

Public Finance Management Cycle
Source: Slide Player

Sound public finance management is pivotal in ensuring efficient, effective, and accountable use of public resources. Transparency and accountability in public finance management can help reduce corruption, improve service delivery, and foster trust.

In the US, the Government Accountability Office plays a crucial role in promoting financial integrity in government operations, which includes auditing, and investigation activities.

Challenges and Opportunities in Public Finance

Public finance, while a vital cog in the machinery of a nation, also faces numerous challenges such as the implications of an aging population on social security spending, technological change, and environmental concerns. However, opportunities also abound.

For instance, technology's role in enhancing public finance management cannot be underestimated. Furthermore, the rise of green bonds and the concept of sustainable finance opens a new arena in public finance.

Conclusion

Understanding the role and function of public finance is not just about being aware of tax obligations or where public money is spent. It is also about understanding how public finance affects the economy as a whole and, indeed, the world of private finance. By considering public finance in their decision-making processes, finance professionals can make more informed decisions that can drive both corporate and national growth.

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