“BABEŞ-BOLYAI” UNIVERSITY, CLUJ-NAPOCA
FACULTY OF POLITICAL, ADMINISTRATINE AND
COMUNICATION SCIENCES
DEPARTAMENT OF PUBLIC ADMINISTRATION
ECONOMICS AND PUBLIC FINANCE
Cluj-Napoca
2012
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CONTENT
CHAPTER 1 PUBLIC ECONOMY AND PUBLIC SECTOR
3
1.1. Introductive elements regarding public economy and public sector
3
1.2. General data about the main economists
4
1.3. Basic notions in economy and public finance
9
1.4. Aspects of law from the public sector
13
1.5. Public sector functions
14
CHAPER 2 THE STATE AND THE ECONOMY
18
2.1. Economic revolution
18
2.2. Economic thinking and state intervention
21
2.3. A new economic approach
26
2.4. Interventionism today
38
2.5.Market failure and the state intervention
44
CHAPTER 3 MARKET FAILURES
50
3.1. Market failures in economic theory
50
3.2. Premises that determine market failures
52
3.3. Manifestations of market failures
54
3.4. Market failures and the role of the state
60
3.5. Market failures and the public sector
67
CHAPTER 4 PUBLIC GOODS, PRIVATE GOODS, EXTERNALITIES
70
4.1. Aspects regarding public goods
70
4.2. Types of public goods
74
4.3. Different categories of public goods: club goods and joint goods
80
4.4. Optimum provision of public goods
81
4.5. Externalities
84
CHAPTER 5 PUBLIC CHOICE
90
5.1. General aspects regarding public choice
90
5.2. The decision-making process
96
CHAPTER 6 PUBLIC SECTOR REVENUES
98
6.1.General aspects regarding public revenues
98
6.2. Characteristics of budgetary revenues in European Union
104
6.3. Study case regarding total revenues in E.U. between 1999-2010
108
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6.4. Study case- Economic crisis and fiscal trends in E.U. Member States
113
CHAPTER 7 PUBLIC EXPENDITURES
126
7.1. Aspects regarding the public expenditures
126
7.2. The main expenditures at E.U. level
131
7.3. Study case regarding total expenditures in E.U. between 1999-2010
132
REFERENCES
139
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CHAPTER 1
PUBLIC ECONOMY AND PUBLIC SECTOR
Objectives:
 Understanding Public Sector
 Familiarization with technical aspects of field
 Identifying main tasks in Public Sector
Key words: public sector, public administration, public goods, public choice
1.1. Introductive elements regarding public economy and public sector
The term economics comes from the Greek where the word "oikos" = house, household
and "nomos" = law is used to mean housekeeping, family heritage. The word “economy” over
time joined other concepts to show the purpose: public economy, services economy, social
economy (the management of human relationships science), economics (science city
administration). There were other categories: economy branches, investment, government,
etc. What in fact is only part of the complex study of political economy. The great
philosopher Friedrich von Hayek uses a different concept to give a larger perspective of this
science and that is the concept of catalaxy which means changing a thing with something else,
another mentality, an enemy with a friend. Any good has a value only through its exchange
value. He said that the exchange price is determined through the game of supply and demand
and aims distribution or allocation of resources that satisfy human needs. We can speak of an
exchange economy and a prices economy. For the first time the term economics was used by
William Jevones and was taken over by the great economist Alfred Marshall in 1890 when he
published his book Principles of Economics.
Even though the first ideas about the economy appeared in ancient times, we can say
that economics as a science is relatively modern. In ancient times, the first references were
made by Xenophon who said that the economy should provide a set of rules to ensure the
proper administration of individual household. Aristotle later develops the concept and says
that the amount of individual household is in fact the state or society and economy means
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their management company. Also Aristotle said that the economy must be based on farming
to achieve wealth, increase number of animals, development of trade.
In ancient Rome wrote about economics Seneca, Pliny the Younger and the Elder,
Collumella who also argue that wealth is achieved by exploiting the land and livestock, not
through trade or war seizures.
Adam Smith presents economy in The Wealth of Nations (1776) as a science of
creating and managing wealth. For mercantilist, wealth means an important amount of
precious metals owned by state or nation and with a value established through trade. For
physiocrats, the signification was that of creating wealth through land cultivation and not by
trade. Classics (Adam Smith, David Ricardo, Jean Baptiste Say) say that wealth is achieved
by increasing production. Production may increase due to higher productivity and at its base
were the division of labor, specialization of labor and capital respectively. For neoclasics
(Fridriech von Hayek, Viennese school) wealth is achieved through exchange and the decisive
role in this case is the price. Pricing is subject to the law of supply and demand.
In modern times, contemporary economics became a science of effective laws which
currently has multiple definitions such as: economy can be understood as the science for
allocation of material goods to satisfy personal needs. Economics is the science of allocating
scarce resources due to the existence of a unlimited demand, insufficient resources
management science amid the existence of competing demands.
Public economics is a branch of economics that examines the role and behavior of the
state (politicians and officials). Public economy also studies its impact on national and
international economy and on welfare.
The public sector is that part of the economy where public property is present. We can
identify the subjects of public property agencies, government departments and public
companies producing or distributing public goods, private or mixed public property and the
object can include not only public goods but also some private and mixed property (which
loose the characteristics of public goods in certain market conditions).
Thus public sector economy should answer the following set of questions:
- What type of goods should be produced? In what quantities and for what purpose?
- How to produce?
- For whom to produce?
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1.2. General data about the main economists.
Fracis Ysidro Edgeworth (1845-1926)
Professor of political economy at Oxford University, is considered the father of mathematical
approach to economics with his book "Mathematical Physics" in 1881.
Milton Friedman (1912 -)
Professor at the University of Chicago, Friedman worked in the U.S. Ministry of Finance
during 1941-1943. In 1946 he won the Nobel Prize for economics. His theory is based on the
idea of a free market and advocated for the elimination of universal programs to combat
poverty. Milton belongs to the ideology known as "monetarism" (ideology developed at the
University of Chicago. It argues that laws guaranteeing minimum income, drug prohibition,
and monopoly regulations and other policies and welfare state ideology exploit the poor.
Some of his most important works include: "Quantity Theory of money" (1956), "Monetary
History of the United States."
Friedrich A. Hayek (1900-1992)
Hayek was born in Vienna, was professor and director of the Austrian Institute of Economic
Research. He taught economics at several prestigious universities in the country and abroad:
London, Chicago, and Freiburg. He follows the philosophy of Hume, a liberal, considering
that the company can develop only if each individual pursues his own interest. In 1974 won
the Nobel Prize for economics. Among his most important works we can mention: "Slavery
Road" – (1976), "Capitalism and its history" (1963), "Fatal idea" (1988)
W. H. Hutt (1899-1988)
He studied economics at the University of London and in 1931 was appointed dean of Trade
Faculty in Cape Town. Hutt was a follower of classical liberal economic theory and criticism
of Keynesian one, saying that these ideas are used in the interest of politicians and not people.
His main work containing: "The Keynesianism-Review and Prospects" (1963), "A review
Keynesian Episode" (1979).
Keynes, John Maynard (1883-1946)
He attended university in his hometown of Cambridge. His first work was on probability
theory. He worked in the Ministry of Foreign Affairs, the Ministry of Finance and then
returned to academic and research activities focusing primarily on the economic effects of
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World War. From this, he develops theories and predictions that are embodied in the
European economy. Keynes provides new ways to control economic cycles, it supports the
establishment of both national and international organizations to create and implement fiscal
policies together, Keynes also says that state budget shouldn’t be used only for planning state
revenues and expenditures, but be used as a tool for planning the economy. It draws attention
to the need for policies to regulate the periods of economic boom and the recession. His main
idea behind his theories is that economic balance can be restored and maintained by state
action. This idea reverses the laissez-faire policy. Among his main works are: "The economic
consequences of the Peace" (1919), "Treatise on Money" (1930), "General Theory of
Employment", "Interests and Money" (1936).
Harley Leist Lutz
Professor of Finance at Princeton University. In his "Public Finance" (1947), he draws
attention to the effects of budget deficits and paves the way towards the budget balance.
Francois Quesnay (1694-1774)
He was founder of the French school of thinkers who have made in 18th-century economics
first full main system of economic science. He began his economic studies in 1756, and was
under the protection of the royal court. Home work "Economic Table" (1758) explains the
natural law of economy. Quensnay belongs to physiocrat economic ideology which supports
the need for absolute freedom of exchange to ensure the most beneficial result.
Schumpeter, Jos. A.
He was an Austrian-American economist. In his main work published in 1942 "Capitalism,
Socialism, and Democracy", seems the most pessimistic approach to the future of capitalism.
Adam Smith (1723-1790)
He is considered the world's first economist, founder of classical economic theory. He
attended Oxford University and in 1751 became professor of logic at the University of
Glasgow. One of his work "Theory of Moral Sentiments" in 1759, was quickly recognized in
France and Germany. Smith leaves in 1760 to France with his good friend David Hume,
where he meets some of the physiocrat ideologists. In 1776, his work is published "An
Inquiry into the nature and causes of Wealth of Nations". He developed the theory of the
invisible hand behind the classical economic theory.
Alfred Marshall (1842-1924)
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Born in London in 1842, Alfred Marshall attended Cambridge University where he became
professor of economics in 1868. He started writing his main work (Principles of Economics)
in 1881, and first appears in Volume II 1890. The volume focusing more on foreign trade, tax
regime, cash flow has not been published. Alfred Marshall is considered the greatest
economist of his time. Contribution to the economy is extremely important. The first
economist who developed the theory of price formation based on market supply and demand.
Also introduced terms such as marginal utility of the product, consumer surplus, producer
surplus. Among his most important publications, there are the "Principles of Economics",
"Industrial Economy", "Trade Theory", "Money, Credit and Commerce" (1923).
David Ricardo (1772-1823)
David Ricardo started working since the age of 14 years on the London Stock Exchange.
Soon he became a wealthy businessman. He joined the English Parliament where he was more
interested in economic issues such as debt payments, taxes, etc. Between 1810 and 1811 he
wrote a series of articles which together form the so called "classical theory of money". One
of his most important publications, "Essay on profits" appears in 1815. In this paper he
introduced the rent theory and the theory of distribution in exchange economy. The work of
1817 "Principles of political economy and taxation", Ricardo developed the theory of value
distribution in an exchange economy, the main idea of this theory says that good’s market
prices are determined by working hours corresponding to the respective goods. David Ricardo
gave shape to the classical theory of economics that was then continued by other prominent
economists. Among his numerous works we mentioned: "Protectionism in agriculture"
(1822), "Project for establishment of National Banks" (1824), "Notes on Malthus's political
economy princes" (1820).
Paul A. Samuelson
Samuleson was one of the greatest economists of the world. He opened the way for
introducing mathematics in economics. Samuleson was part of the '30s generation who
studied at Harvard under the guidance of Schumpeter. His main work "Principles of
Analytical Economics" (1947) opened the way to neoclassical economic theory. Among its
main contributions of economic theory can be mentioned: the modern theory of production,
cost functions, capital, and methods for measuring utility. Samuelson is the one who uses the
term "public goods". In terms of macroeconomics, Samuelson has large financial domain
contributions (through his work on speculative market prices, he predicts market efficiency
theories), the money market one, Cuba Phillips. Among his major publications: "Aspects of
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the Theory of Capital" 1937, "Explanation of utility measurement", 1937, "Explanation on the
theory of consumer behavior" 1938, "Evaluation of Net National Product" etc..
Joseph Alois Schumpeter (1883-1950)
Born in Trest (now Czech Republic), Schumpeter became professor of economics at the
University of Czernowitz, he worked at the Austrian Ministry of Finance between 1919 and
1920, then was professor at the University of Bonn, and later, in 1925 at Harvard. Schumpeter
encouraged the introduction of mathematics in economics although he was not a
mathematician. His best known book is "Capitalism, Socialism and Democracy", where he
predicts that capitalism will be replaced with socialism. His ideas on economic cycles,
economic development, and innovation found its echo even in today's economic theories (EU
innovation programs based on Schumpeter's ideas).
Friedrich Engels (1820-1895)
He was born in Barmen Germany and never followed any university courses. His main
contributions to the economy are closely linked to his association with Karl Marx. His first
important work is "State of Working Class in England" published in 1844. His other works
mainly confined to working with Karl Marx (Communist Manifesto, Capital). Engels has
dedicated his entire life explaining Marxist theory.
Karl Marx (1818-1883)
He was born in Trier in Germany; he attended the University of Bonn and Berlin where he
studied law. His first important paper "Communist Manifesto" was published in 1848, the
main idea developed in this paper is that the working class and bourgeoisie differs from others
only because they have other interests and these interests will result eventually in a revolution
that will end in victory for the proletariat. But the most famous publication of Karl Marx is
"Capital", whose first volume was published in 1867. "Capital" is a detailed analysis of
capitalism, its effects on the working class in particular, but also a prediction that capitalism
will destroy itself being taken by communism. The main contribution to the economy of
Marx's Capital, was his critique of capitalism, and a number of terms and theories that he
introduces: value added tax, division of labor, unemployment.
Jean Jacques Rousseau (1712 -1778)
Rousseau was born in Geneva and at age 16 moved to Paris. His ideas underlie all liberal
theories today. It was more a philosopher than an economist, but his philosophical ideas on
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education, private property, state functions underlying modern concepts of education, public
choice, individual freedom, etc.
James Mill
James Mill was born in Scotland, attended the University of Edinburgh. Mill wide criticized
Malthusian theory, advocating a balance between supply and demand. He is a supporter of
classical economic theory, one of the founders of classical Ricardian school (David Ricardo).
The most important publication on social economy "Elements of Political Economy" (1821) is
the main text of the Ricardian economic doctrine. It is known for being more than the father
of one of the greatest economists of the 19th century, John Stuart Mill.
John Stuart Mill (1806-1884)
He was born in London where he received a good education so that at the age of 16 years was
a powerful economist. In the economic field he is known as the author of "Principles of
Political Economy" published in 1848. He underlines the importance of differentiation in
what measures the economy and what people really appreciate as important in environmental
protection, and establishment of cooperative workers. Also he is a major proponent of the
utilitarian theory.
Thoresein Bunde Veblen (1857-1929)
Veblen attended Yale University and is best known through his work "liberal class theory"
(1899), contributing to neoclassical marginalist theories of consumption and production.
Another important contribution was known as the "veblenian dichotomy” (a custom version
of instrumental value theory of John Dewey).
1. 3.Basic notions in economy and public finance
Microeconomics comes from the Greek word mikros-small and refers to that part of
economics that deals with the allocation of resources, organization of production, distribution
of goods and services, consumption goods produced by individual economic agents. It refers
to all relations and economic flows that occur between businesses on the one hand, between
businesses and individuals and between individuals and individuals and institutions involved
in these flows.
Macroeconomics refers to relations and financial flows of all economic units and individuals
treated per whole economy.
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Central public administration includes all institutions who mainly deal with government
and ministries activity. At this level, authorities are represented by:
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Parliament
-
Presidency
-
Govern
-
Ministeries
-
Law institutions
-
Institutions and central public services
Local public administration oversees all local government institutions that have
administrative functions and are operating at a local level: common, city / town, county. At
this level, authorities are represented by:
- Municipal, town and county councils;
- Mayors;
- The authorities of municipal subdivisions;
- Prefecture;
- Public institutions of the central administrative power in units at local level ;
- Local public services.
Intercommunity development associations - structures of cooperation with legal, private
and public utility, established according to law, by administrative units for the joint
development of projects for regional or local interest or the provision of common public
services;
Deliberative authorities - the local council, county council, the General Council of
Bucharest Municipality, local councils in territorial administrative subdivisions of
municipalities;
Executive authorities - mayors, cities, municipalities, territorial administrative subdivisions
of municipalities, Bucharest general mayor and chairman of the county;
Local councils - municipal councils, town councils, municipal councils and territorialadministrative subdivisions of municipalities;
Companies and independent administration of local or county-autonomous companies and
established or reorganized by the decisions of deliberative authorities;
Territorial-administrative subdivisions of municipalities - Bucharest Municipality or other
subdivisions of municipalities which are divided and organized by law;
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Territorial administrative units - communes, cities and counties, some cities under the law
can be declared municipalities;
Metropolitan area - intercommunity development association established on the basis of
partnership between the Romanian capital or rank 1 municipalities and administrative units in
the immediate area.
Local collectivity means all people in the administrative-territorial unit.
Local autonomy is only administrative and financial.
Associative structures of local public administration are the following ones:
a). Association of Municipalities of Romania
b). Association of Towns in Romania
c). Association of Communes of Romania
d). National Union of Romanian County Councils
Administrative capacity - all the material, institutional and human resources available to a
political subdivision and the actions they carry in order to apply the law. Administrative
capacity is assessed and determined by law;
Delegation - the exercise by local authorities or other public institutions of power on behalf of
central government authority within the limits set by it;
Decentralization - the transfer of administrative and financial powers from the central
government to local government level or private sector;
Quality standards - quality indicators to be achieved by local authorities in providing public
services and public utilities;
Cost standards - legal costs used to determine the amount of resources allocated to local
budgets to provide public services and the public at a certain level of quality;
Transparency of decision - full access of citizens and other stakeholders to information on
the development and implementation of decisions by administrative authorities, including the
revenue collection process and execution of accounts of local authorities at all levels.
Externalities are indirect collateral effects that are generated by an economical agent activity
upon other economical agents. Can be positive or negative (negative: pollution; positive:
pollination)
Public goods – goods or services that are offered for free to any person that is willing to
benefit from it in a quantity that doesn’t decreases by the consumption level.
Modern public choice – political and institutional mechanism study that circumscribes to
individual and state behavior (McNutt, 1996, p.1).
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Tax (impozit) – a forced levy at state’s disposal without direct counterpart immediate and
with irrecoverable title from a part of individuals and companies income or fortune, regarding
some public needs coverage.
Tax (taxa) – amount paid by an individual or company usually for services provided to him
by an economical agent, a public institution or a public service.
State budget – a list of incomes and expenditures registered and compared regarding their
balance and after that submission to Parliament for authorization.
Budget - the document that is provided and approved every year for revenues and expenses
or, if appropriate, only the costs, depending on the system of financing public institutions;
Local budget - the document that is provided and approved every year for revenues and
expenses of territorial administrative units;
Budget commitment - the act by which a public authority under the law affecting public
funds to certain destinations, within approved budget appropriations;
Loan Commitment - the maximum expenditure that can be employed during the financial
year in approved limits;
Credit budget - the amount approved in the budget, representing the maximum to which you
can order and make payments during the budget year for commitments entered during the
financial year and / or previous years for multiannual operations, that can engage, the order
and make payments the budget for other actions;
Budget deficit - the part of budgetary expenditures that overcomes the budgetary incomes in
a budgetary year.
Budget balance - equality between budgetary incomes and budgetary expenditures in a whole
budgetary year.
Budget surplus - the part of budgetary incomes that overcomes budgetary expenditures in a
budgetary year.
Deducted amounts from budget incomes - deducted amounts for balancing local budget and
deducted amounts with a special destination for financing some decentralized public service
or some new public expenditure.
Deducted quota from some incomes of state budget - the percentage established from some
incomes of the state budget that is allocated to local budgets.
Treasury approval communicated by the main credit, which can be performed within
budget appropriations and distributions of cash payments from local budgets
Co-financing - financing a program, project, subproject, target and others, partly through
budgetary loans, partly through financing from other sources
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Working capital - part of the annual surplus of the final local budget, that is formed in each
administrative unit and is used under the present law;
Budget reserve fund – the fund related to the expenses part of the local budget
Local grant – commitment of a local public authority, as guarantor, to pay at a due date
obligations of guarantor for, economic operators and public services in its subordination under
the law;
Insolvency - the inability of an administrative unit to pay its obligations amount and due,
except those who are in contractual disputes
Fiscal policy - is the policy through which economic relations in cash form are made,
relations that arise in the distribution of the gross domestic product in connection with
carrying out state functions and tasks.
Budgetary incomes are the needed ways to form monetary funds. Other authors define
budgetary income different. They consider that budget incomes are cashed funds from
administrative territorial units that are used to cover public expenses and participations in a
direct way or another to realization of different economic policies. This influences behavior of
individuals and companies.
The public expenses refer to social-economic relations in monetary form, existing between
the state, on one side and individuals and on the other side, with the occasion of distribution
and use of financial state resources with the purpose to fulfill its functions. The public
expenses ends in payments effectuated by the state from mobilized resources on different
ways (Buchannan J.,1990: 341).
Treasury is an office of state that keeps and administrates the public exchequer.
1.4. Aspects of law from the public sector
The basic laws with incidence over the public sector are the following:
– Law 188 /1999 of public functionary status, as amended and completed by local public
administration law no.215/2001
– Law no. 286 from 29 Jun 2006 for amendment of law 215/2001 regarding local public
administration.
– Law of no.500/2002 regarding public finance with subsequent amendments and
completions.
– Law no.273/2006 regarding local public finance, with subsequent amendments and
completions.
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– Law no.195/2006, regarding decentralization with subsequent amendments and
completions.
1.5. Public sector functions
Adam Smith in his book “Nation whealth”1776 point to the fact that division of work lead
to growth of productivity and lead to the need of mutual help and to a dependence of each
member of the society. This mutual aid and cooperation between society members result from
public property and free economy. If the society members try to accomplish their own interest
they are driven by an invisible hand for the general society interest as a whole
accomplishment.
For instance some special situations are the monopoly and oligopoly. In these cases there
are no competitive markets with more buyers and sellers. Like in telecommunication,
electricity and other natural monopolies state intervention is justified in order to control the
monopoly and protect the population from prices determined by market monopolies. The state
intervention is also well received when the intervention is needed upon the environment or in
the case of companies that produce harmful products.
In order to determine how many public goods have to be produced the state has to
compare benefits with costs and on the other hand population’s preferences have to be
considered. With this being said it is hard to decide which is the precise quantity of goods that
has to be produced.
Usually in democratic countries decision is made by vote while in non-democratic
countries not. For instance in U.S.A. we can see a set of public goods and services (defense,
space exploration) upon the central government can decide if they are produced or not.
Richard Musgrave highlighted the fact that the state has the following functions (Musgrave,
1939, p. 213-237):
1. the state has to assure price stability
2. the state has to assure efficient resource allocation
3. the state has to assure the fact that acceptable levels of wealth distribution and
market access are maintained
4. all these functions are accomplished by the following one: the state has to assure the
fact that acceptable levels of wealth distribution and market access are maintained
All of these functions are accomplished through public sector functions.

Distribution

Stabilization
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
Allocation
Distribution of public incomes. This function of public sector refers to state
involvement in economy by adjusting the incomes and wealth produced from economic
transactions. Some people own a significant fortune and can satisfy their needs different one
from another. These differences can come from market failures. Even if income distribution
happens related to state productivity, some ethics considerations may ask for a different
distribution of income or wealth, different than the one based on economic principles.
Creating a fair distribution of incomes and wealth is another reason for state intervention in
economy. This redistribution can be done through taxes or through transfers. Progressive
taxation and luxury goods taxation can be pointed against people whit lower incomes.
Through their vote citizens can influence the way in which fortune and income are distributed
according to some equity standards. There are a set of measures through which the state help
people whit lower income. Are well known in our country heat subvention, agriculture
subvention, some deductions, state housing offer some vouchers and table tickets. The whole
fiscal policy regarding expenditures, taxes, different fiscal laws have a direct and indirect
influence on income distribution. The distribution function accomplished by taxes and public
expenses, becomes necessary as long as income and wealth distribution between individuals
and companies (influenced by the redistribution of production factors and forms of property)
is not in accordance with social needs and social justice.
Stabilization is the last function of public sector and it regards the creation of the legal
frame for optimal deployment of public economic transactions. Among the problems that
Romania faced after 1989 it can by mentioned increase of prices, unemployment increase and
external debt increase. Stabilization shows that the role of the state is to ensure stable prices
and stable jobs. This can be done through monetary policy and proper fiscal policy.
The stabilization function follows to reach a higher degree of labor force occupation,
stable prices, a solid situation of external balance of payments, also an economic growth.
Economic growth is a process that appears as a consequence of economic
consolidation and is reflected, synthetic, trough total production per capita increase that
expresses growth of gross domestic products per capita. Even if the state interferes in the state
economy it should have a clear legislation, non interpretable in Romania, at this point we
think that is a lot of work until we will have expected result.
From ANOFM data at the end of 2012 January, the rate of registered unemployment
on national level was 5,26% higher with 0,14 pp then the same period of the 2011. Total
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number of unemployment at the end of January was 473.569 persons, grew with 12.556
persons more than in the previous month.
We can often see that budgetary expenses and taxes are used to stabilize economy and
real economy growth. The growth of taxes can stimulate the economy. The growth of taxes
can also have an opposite effect, also financing deficit of the state with contracting of doubts.
It has been proved that a low deficit can stimulate the economy. The interaction between the
budget and the economy is a complex one and that’s why we have to take into consideration a
set of variables: income elasticity on internal demand, imports etc.. If the income tax increases
faster than the GNP the result will be a fiscal imbalance. Fiscal policy of a state is very
important for the smooth run of the economy and that’s why each decision from this domain
has to be well analyzed. Otherwise we will encounter effects such as aggravation of recession
and inflation. Targets as absence of unemployment and price stability are hard to reach. Since
1940 it is well known that USA uses credits in order to finance its expenditures. It seems that
USA tried to follow the principle of John Maynard Keynes who suggested the use of deficit
expenses in order to stimulate the economy (Gianaris 1989, pp.6-10).
The wars that USA was part of and the oil crisis led to a double inflation. Different
imbalances as the Katrina hurricane led to considerable growths of the oil price with almost 1
$ per gas gallon. When the objective of one economy is the economy growth the investments
have to be encouraged because this growth is based on capital establishment. When the
private sector can’t reach this task the private sector involvement is necessary for capital
establishment or for investments in public projects. A suitable combination between fiscal and
monetary policies is the success recipe in reaching and increasing economic growth.
Allocation. The allocation function refers to the fact that goods and services are
allocated in sufficient quantities either through the market or through the provision of these
quantities by the state.
An efficient allocation can be made in different ways from a good or a service to
another. If we think about examples of goods or services from the national defense domain a
lot of actors like Olson and Zeckhauser(Olson, Zeckhauser , 1966, pp.266-279) reminded the
fact that the most efficient allocation in the defense domain can be reached by the state and
not by the private market which has no interest in this domain. Through the allocation
function services that have a special characteristic are distributed by public authorities that
assure special needs satisfaction (culture, education, justice, national defense).
Is well known that the state owned resources that went to the private sector allocation, is still
a problem (Olson, Zeckhauser, 1966, pp.266-279). If we think about the way that the forests
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are being exploited since 1989 we can ask ourselves if their transfer to the private sector was a
good decision or not. Some resources owned by the state is not the same thing with owning by
the private sector.
Coase theorem, named after the economist Ronald Coase tries to explain how
resources can be allocated efficiently. When there is no impediment in creating a profitable
business, the business happens and resources are allocated by using them at their highest
value. To explain what this high value means we’ll consider two examples. Let’s consider that
a tailor has a workshop for a certain period of time. At a time a doctor opens a cabinet near
the tailor’s workshop. The space owned by the doctor has a room that separate the cabinet
from other rooms used by the doctor (Coase, 1960, pp. 1-44). Each of this two business works
normally until the doctor decided to use some unused space that separates this two business in
the same building. The problem is that the doctor is disturbed by the noise produced by the
tailor’s machine. In this case we will consider two scenarios in which the doctor gains another
100$ per day by using the unused room and the tailor gains only 80$ per day from his
business. In this case using the room, by the doctor, has a greater value, is more important.
There will be another scenario in which the tailor deals with the doctor and offer him 90$ per
day and this way both of them will gain 10$, this, of course if none of them decide to sell the
property.(Halcombre,1996,pp. 58-60)
The first two functions are more efficient if they are accomplished by the state while
the last one is more dependent by the characteristics of the good (Voorhees, 2005, p.105).
Housework:
1. Define the following terms: public economics, public finance, public sector, public
administration, and public goods?
2. Highlight the differences between local and central public administration?
3. Which are the public sector functions?
18
CHAPTER 2 -THE STATE AND THE ECONOMY
Objectives:
■ presenting state interventions in the economic activity
■ familiarization with technical aspects economic thinking
■ identifying main tasks in economic mechanism
Key words: economic efficiency, economic equilibrium, monopoly, competition
Freedom leads to excessive taxation; the outcome of excessive taxation is
slavery.1
2.1. “Economic revolution”
A broad range of answers to the current problem of state intervention or nonintervention in the economic activity, how much and by what means should it be done, can be
found in the economic literature from us or elsewhere. This is neither surprising nor
accidental, if we take into account the strong consequences of this issue on our daily life. The
effort to discuss and try to clarify these issues should be minimized at all, as it worth making
any efforts just because this matter is so important. Moreover, we could affirm without being
extremely out of line that this subject is the main issue of economic science. Even if economic
science “does not represent the most developed type of philosophy, surely there is no other
more exciting and more important” (Heilbroner, 1994, p. 17). If the core of economic science
is represented by the search of order and scopes of social history, the relation between state
and economic activity represents the cornerstone of economic science.
During the entire development of economic sciences, the subject regarding a normal
relation between economic activity and the state has been a central issue, with multiple and
different solutions. Certainly, a relevant matter, which must be always kept in mind, is that all
circulated theories and ideas must be considered from a historical perspective – otherwise,
some of the ideas advanced maybe not so much time ago, might seem today really ridiculous.
1
(Charles Louis de Secondat, (1689-1755), http://www.tax.org/quotes/quotations.htm)
19
It should be underlined that many of the ideas discussed strongly depend on and are
significantly influenced by the time when they were conceived and that was, implicitly,
envisaged by them.
Providing a solution, even a partial one, to this problem, could be somehow easier and
more comfortable if solutions proposed by different authors wouldn’t be so different and, in
some cases, antagonistic. Everything would seem easier if the passage of time wouldn’t be
accompanied by such a fast development and evolution of economic activities, by a change of
mentalities and approaches.
In this section of the current paper, we aim to outline the main directions, indicated by
economic theory and practice, for solving the issue of state intervention in the economy. We
aim to review the reasons behind state intervention in the economy, to identify the convenient
options and the unavoidable limits of each of them. Our analyze aims also to underline the
most appropriate mechanisms, methods, ways or means to achieve this objective.
We won’t start our journey with preconceived ideas, but it is necessary to mention, from the
very beginning, that most of experts, in today’s state of play, agree with the state intervention
in the economic life. Subsequent controversies are related to the reasons of such intervention,
to its extension, limits and characteristics of certain mechanisms, to the (real or fictive)
failures generated in the overall economic mechanism.
It’s not wrong to say that, from the early days of humanity, the human has faced the
problem of survival and not as an isolated individual, but as member of a group. Somehow,
always, more or less conscious, the human has faced the problems of ensuring its existence
and has thoroughly analyzed them. In very few cases, humans couldn’t find in the natural
environment, directly and without any further processing, material and spiritual goods able to
satisfy their needs. In order to satisfy such needs, human beings were constrained by life to
develop a social-economic activity, more or less sophisticated and, for this reason, they had to
make choices for their current and future existence. (See also Sută-Selejan Sultana, 1992,
introduction)
Over the time, humans managed to survive, in one way or another, only due to their
socially cooperative nature. The survival problem is much more difficult, for the human race,
than the previous affirmation could express, because human being is not genetically equipped
with social instincts. It seems to have been gifted with an egocentric character.
Consequently, we should understand that, if his relatively low physical abilities force human
individual to collaborate with his fellows, genetic impetus always endangers the solidarity
with other people. For these reasons, when people don’t pull together any more, exclusively
20
for survival goals, ensuring the perpetuation of human race becomes a delicate matter. The
fact that today we have reached such a high level of human civilization development becomes
a remarkable social success, hardly to explain, by any means.
As revealed by historical research, it seems that, over the centuries, human being has found
the following three ways to prevent the disaster of decomposition of human community:

A first way by which people have ensured their co-operation and continuity was
organizing the society around tradition, based on customs and unwritten laws. For
example, “in Ancient Egypt, according to a religious principle, every man was obliged
to take over the profession of his father, while changing it with another one would
have been considered as the most horrible sacrilege”.(Adam Smith, apud Heilbroner,
1962, p. 21)

Another modality was the use of a “ruling whip”, the force of ruling authority. Both
the example provided by ancient and middle-age societies, and the one of socialist
countries, illustrate the operation of this system. Putting aside any political judgments,
those societies ensured their economical survival through “orders” and sanctions,
established by such supreme authority.

For the surge of the third solution, an amazing invention had to come up, through
which the society ensured its own perpetuation by means of human solidarity, this
time allowing for each individual to make whatever he considers appropriate, as long
as he complies with some basic rules. Such “composition” was called market system,
where each individual does whatever brings him more financial (and not only) profits,
but in the same time the mirage of gaining determines each one to fulfill his social
function. In other words, the mixed game of personal interests leads to the
accomplishment of functions needed by the society.
If we were judging today such a solution, (the last of the ones presented) it would
seem that it is, on one hand, the most appropriate and, probably, that human race didn’t took
to much time to discover and to implement it. Nevertheless, the history shows that human race
has moved for centuries on the “comfortable” road (not the best one) of tradition and
command. In order to abandon this security and “comfort” area in favor of the “odd and
hidden” mechanism of the market system, a true “revolution” was needed. It was probably the
most important “revolution” for the birth of current human society.
The birth of market economy has not been as easy as we could imagine nowadays,
considering the advantages of this system, as well as human beings have not always been
ready for such a change.
21
The idea of the need of a system based on individual gains didn’t arise easy and
instantly. Especially if we consider that it had to serve for the accomplishment of certain
social objectives. Although (sometimes) it seems hard to believe, the strive for profit has the
same age as modern human individual, even if notions like richness or greed do exist almost
from the early days of human life. For example, as long as religious ideas were governing the
entire human society – whereas the dominating concept was the one that life on Earth is just a
preamble of Eternal Life – the enterprising behavior was not encouraged at all. It’s easy to
argue, if we recall many situations when religion damned the “immoral” gains obtained by
some individuals as a result of undertaking activities that nowadays we are referring to as
“business”.
Even if exchanges exist since (almost) always, these cannot be mistaken with the
system of market economy. This is due to the fact that market system is not a simple tool for
exchanging goods, but a mechanism for the support and perpetuation of the entire society.
On the other hand, even if it seems hard to believe, land, labor and capital, as production
factors, have also the same age as modern human beings. The birth of market system has
began in the XIII century and lasted until the beginning of XIX century, while it is important
to mention that “probably there has never been a less understood and less planned revolution”
(Heilbroner, 1994, p. 21).
The factors that led to the emergence of the market system are:
- Gradual establishment of national political entities in Europe;
- Gradual fall of religious behavior, under the impact of skeptical, inquiring and humanistic
ideas of the Renaissance;
- Material changes that took place during the development of middle-age economy, of which
we mention just a few: the establishment of one thousand cities over a time interval of five
hundred years, the money which became a permanent item of daily life, selling and buying
became usual activities, the development of accounting, the fostering of scientific
curiosity.
2.2. Economic thinking and state intervention
Since the very beginning, we should remind one of the observations in the previous
paragraph: a true economic revolution took place late on the scale of human society
development. It is an important conclusion from the perspective of economic thinking
development, because it should be mentioned that a genuine economic activity didn’t always
exist, in the early days of human race. Economic ideas are a relatively recent intellectual
22
occupation and this is due to a very simple reason: there were other issues (maybe even much
more important) that have dominated human thinking. While the significant amount of
attention dedicated to state intervention in the economy are unavoidably related to the
development of economic ideas.
Perceiving, understanding and solving economic problems are conditioned by several factors
(Sută-Selejan Sultana, 1992, p. 18):

Level of bio-social development of human race individuals;

Structures and organizational forms of human collectivities and, maybe, first of all by
their sophistication. Economic thinking of “homo sapiens” (if there was such thing in
those days) must have been totally different than economic thinking of modern human
beings “bound” in sophisticated and different relations with the entire society.

Natural environment where human develops his economic activity will also strongly
influence the economic thinking. Economic ideas when nature seems to be more than
plenty for satisfying human needs are different than those arising when nature becomes
increasingly scarce or when nature “exploitation” becomes increasingly costly.

Information in the hands of human society regarding economic “past”, the capacity to
synthesize and to use such information.
At this point, we should table another generally applicable observation. There is
always a discrepancy between economic reality and economic ideas within the same time
period. This observation is needed considering the philosophical truth that reality is only one
(objective), while human perception and understanding could differ (even significantly).
It’s true that for modern human beings such discrepancy is less and less noticeable and
real, but for previous eras, on which we concentrate now, this observation was utterly
important.
For example, we can illustrate this aspect by reminding the early days of market system: thus
it can be noticed a less sophisticated economic life (comparable with nowadays reality),
relatively clear of major convulsions, but where certain disruptions where present, as episodic
cases of economic crisis. On the other hand, liberal economic approach (pure state of
liberalism) didn’t take into account the entire size of these realities and didn’t notice that,
notwithstanding a (relatively) flourishing and stable economic activity, were arising signals of
less benefic and wanted phenomena.
From the above mentioned, there could be drawn the conclusion that economic ideas
and approaches are strongly dependent on the sophistication degree of economic life, which at
23
its turn is influence by the development of human society. Thus, on one hand, economic ideas
are permanently exposed to a strong pressure of historical depreciation, while, on the other
hand are strongly depending on the level of economic development of the period they are
related to, or in which they were conceived. Therefore, it shouldn’t surprise us that an
economic approach that seemed normal and viable at the beginning of market economic
system, it becomes nowadays too simple and unsuitable. An idea dated fifty years ago cannot
be adequate anymore for the current times, when economic life (and not only) has become so
complex, inter-related, when the national scenery has become too “small” for the size of
events. Moreover, as time goes by, our “endowment” of economic knowledge (and actually
any kind of knowledge) becomes increasingly rich and what once might have seemed
reasonable, now becomes too simple, arguable, and even false.
Having in view the above mentioned, it becomes even clearer why we won’t waste too
much time on a long period in the development of human society, the period preceding the
emergence of market economy system2" For example, the first economic concepts and
knowledge are dated before the birth of Christ, being the ones foreseen by the Hamurabi code,
in second millennium B.C. Also, the Bible contains several economic reflections. During the
middle-age, even if the society advanced a lot overall, for economic thinking this time period
was not much more different than the ancient period. During the following period – the period
of mercantilism – the first genuine economic ideas were shaped. The periods briefly
mentioned, although represented a long period of accumulations and progress for the human
society, for economic thinking were quite insignificant. Accepting the risk of repeating some
of the above mentioned, there must be underlined that economic thinking could really be
consolidated only when economic life would have represented a major concern for daily life,
when the market economic system was finally shaped; it would be highly improbable to find
ideas concerning the state and the economy during those periods (see also Sută-Selejan
Sultana, 1992, p. 18, pp. 50-54; Popescu, 1993, pp. 3-9).
“For a long time, economic information, knowledge and ideas were accidental,
fragmented and mixed with information, knowledge and ideas from other areas of human
knowledge and activity” (Sută-Selejan Sultana,1992, p. 18).
Advancing in time, we can find more elaborate activities dedicated to economic
thinking, while the economic thinking is more and more transforming itself in an economic
science.
24
Passing too fast over this period, that truly represents economic thinking, is at least
extremely difficult if not impossible. Moreover, ideas and theories developed during this
period have remained, in a certain way, the basis of economic thinking in future periods.
During XV – middle of XVII centuries, major economic transformations take place
that would eventually lead to an increased relevance of economic knowledge and to the
corresponding development of economic thinking. Such economic transformations are mainly
related to: the extension of market economy against natural economy, increase and
sophistication of money economy, development of external trade.
Ideas related to “natural economic laws” are shaped now and will dominate economic
thinking for a long time, until the current century. “Economists (from that times) worked hard
to discover immediate or more distant reasons behind economic processes, links between
different economic categories, between different groups of economic agents, as well as long
term constant features of such links, i.e. “natural” or “objective” economic laws.
Considering the above mentioned, we are getting closer and closer to what we call today
economic thinking, the first period when economic thinking becomes substantial, as well as
economic reality.
Let’s recall that, on the map of human society development, we have reached the
period when economic life is broadly present, at a level where it is governed by multitude of
generous ideas of human liberalism – especially, the economic one. From the economic point
of view, this period represents the realization of what we called “economic revolution”,
leading to the establishment of the market economy system. This is an economic system
where “each individual does exactly what he considers appropriate, with the condition of
observing several basic rules” (Heilbroner, 1994, p. 21).
As we were mentioning before, in this period, economic approach is governed by the
existence of “natural” laws that are also governing the economic area. This idea is very
important in this matter, as it clearly underlines the approach behind the economists’ attitude
towards state intervention in economic activity.
Our choice to skip quite rapidly a significant period of economic thinking without
dedicating more time to economic concepts from that time might seem at least awkward at the
first sight. It should be underlined that from the point of view of economic thinking it’s
impossible to ignore the differences between physiocrats and classic liberals or the ones
between first liberal analysts and the ones from the beginning of our century. Nevertheless,
there is one common characteristic for all these economic thinkers: all of them considered as
25
inappropriate the state intervention in the economy. This common feature allows us to
approach them together.
Regardless of the perspective we could have on economic history, liberalism must be
considered the main mega-tendency of modern and contemporary economic thinking, that is
from the past three or four centuries.
“Natural” economic laws are only one of the features of the liberal economic system.
Generally speaking, the liberal paradigm "The most simple definition of paradigm could be
the following: all principles and methods describing a current of economic thought, Kuhn Th.
S., 1981, p. 87-96". is the following ( See also, Sută-Selejan Sultana, 1992, pp. 60-62):
1. Aspiration for freedom of movement in all areas, inclusively in the economic one, that
practically means the establishment of the idea that free initiative and competition among
economic agents is a fundamental value;
2. Individualism – the belief that most efficient and correct decisions can be taken by private
economic agents, separately and in contrast with the state. Economists from the XVII
century have indicated that the upmost human goal has always been and it still is the
pursue of his own interest” (Popescu, 2000, p. 132).
3. Private property is considered the natural cornerstone of each economic system;
4. The idea regarding the existence of a “natural order” in the economy, stronger than will
and subjective wishes of humans. Thus, liberal economists were giving total priority to
objective factors, while totally downplaying the subjective items. „Adam Smith has settled
and developed its entire approach and thinking on a philosophy that provided the binding
accomplishment of „natural economic order”, even when individuals do not aim for it and
everybody acts just following his own interest” ( Popescu, quoted papers, p. 132).
5. Hedonism – it’s a version of the human behavior principle adapted to the economic agents
provides that, in their activity, they aim to satisfy current needs and interests, against the
long term ones. This principle could be synthesized by the expression „live your
moment”. In a much more general perspective, hedonism (coming from the Greek
“hedone” – pleasure) is very well described by the Greek philosopher Epicure (340-271
B.C.) which affirmed that „indeed, we saw that pleasure is our first and own good. It is the
starting
point
of
every
choice
and
of
every
aversion...”
(
http://www.politice.ro/2morala.pdf, p. 3).
6. Market mechanism has an ad-hoc automatic self-adjustment capacity of the economy,
based on individual actions of economic agents, without their knowledge, through the
26
“clash” of their interests on the market. The main mechanism envisaged is the one of
market prices, free prices, established on the basis on demand and offer.
Briefly, the central concept behind the liberal economic doctrine is that the “free game of
individual interests and competition lead to an overall balance, that is to the adjustment of
production and consumption, of a trade regime, of prices and remuneration, of services
required exactly by needs and market” (Mireaux, 1988, p. 10).
In what regards the state intervention in economy a useful observation is that “if
liberal economists reduce the state intervention in the economy that is because they accept
that natural economic laws impose themselves and are much more effective when they
operate freely than when we pretend to fight against them” (Colson, 1931, p. 18).
In conclusion, even if the ideas of economic liberalism had an increasing trend, even if initial
justifications have changed (or proved to be obsolete) or have been replaced by others, the
idea of a market economy, free of any kind of state intervention, was prevailing and broadly
accepted by economists. Yet, as usual, realities had proved to permanently be exposed to
change.
Maybe today every economist would wish to be a supporter of economic liberal
doctrine, but realities of current economics force him to be more cautious in accepting ideas
elaborated in a less sophisticated framework. It’s hard to believe, and even much harder to
prove, the existence of “ad-hoc” economic mechanisms that would automatically, absolutely
and totally adjust all imbalances of such a complex economic life as the one from nowadays.
Although maybe we would like to believe in the existence of “homo economicus” it seems
that he “is just a theoretical construction – human by nature is a subjective being, that doesn’t
always access the best information " Author’s remark: or even if human beings could get such
perfect information, it’s possible that such information could only be obtained at a high or
prohibitive cost ", , while human decisions are not always the most rational ones. And, last but
maybe not least, it should be mentioned that it’s hard to believe or to accept that human
society is, always and totally, governed by purely economic arguments”(Sută-Selejan Sultana,
1992, p. 65).
2.3. A new economic approach
Having in view the conclusions in the previous paragraph, the question “why do we
need a new economic doctrine, where state intervention in the economy would be the
prevailing concept?” might seem redundant. From the arguments presented so far, the answer
seems too simple, inexplicit and, consequently, insufficient.
27
To be able to understand the broad framework we are referring to, we should mention
that our brief analysis has reached a point in time somewhere before the start of the Great
Economic Crisis (1929 - 1933), because, until then, practically the sole and prevailing
economic doctrine was the liberal one. Fundamental elements of this economic doctrine were
already presented in the previous section. In order to continue our analysis, we should
undertake a review of the main characteristics of the economic like of that period.
Just a few data and we will be able to state: “Signals of prosperity could be seen
everywhere” (Heilbroner , 1994, p. 268). For example, towards the end of the ’20s, America
had found employment for forty five millions of its citizens, paying them around seventy
seven billion dollars in wages, rents, profits and interests. (See also quoted papers, pp. 265275) Optimistic characters of that age do not seem to exaggerate when affirming that: “With
the help of God, the day when poverty will be kicked out of this country (USA) is not so far
away” (Hoover, apud Heilbroner, 1994, p. 268) or “Everybody has to be rich” (Raskob,
1941,p. 268).
This was happening everywhere in the world. Who could not say in those times that
liberal economic doctrine was the only normal approach? Who could have thought that state
could somehow be involved in economic problems? Everything seemed perfect (maybe even
too good to be true).
Regarding what happened next, it barely worth insisting. We could provide the US
example: “During the terrible week of end October („Black Thursday” – October 24th, 1929)
stock markets have fallen. For two crazy months, the market has lost all advances achieved
during two previous years: total values of 40 billion dollars were purely lost. As dramatic as it
was, it wasn’t the sudden fall of stocks that had the hardest blow on the confidence of a
generation that was firmly convinced by the endless prosperity, but what actually was
happening in the households. In 1930, national income had a sharp decrease, from eighty
seven billion dollars to seventy five billion dollars, whereas in 1933 American nation
wouldn’t have any kick left – national income had dropped to thirty nine billion dollars. On
the streets, there were around fourteen million unemployed. The worst thing to cope with was
unemployment.” (Heilbroner, pp. 265-275) „It dropped by 85 percent, by the exit from the
stock market crisis, in USA.” (Samuelson, Nordhaus, 2001, p.599). „In 1932 consumption
goods production of USA was barely equal to 25% of the levels from 1929, while national
income was just 2/3...” (Popescu, 2000, p. 891).
Consequently, a legitimate question that many economists started to ask arises: “What lies
behind the oscillation prosperity - depression?” Initially, it was considered that economic
28
cycles are some kind of mass nervous disorders. Moreover, some of older explanations have
searched for an answer outside the economic process. For example, there were authors who
were blaming even the spots on the Sun.( See the studies of W. Stanley Jevons)
Economic researches trying to explain this phenomenon were coming back to an area
indicated, initially, but only intuitively, by Thomas Robert Malthus. This is the case of
savings that might somehow result in a “general oversaturation”. Such intuition was almost
completely ignored by succeeding economists. That was for an obvious reason: affirming that
savings might be a source of trouble, imbalances or even crises, means to ignore a human
quality considered as an honor: MODERATION. This might seem immoral, if not a
profanation. Actually, even Adam Smith was saying that: “whatever represents caution in the
behavior of each household individually, it cannot be foolhardiness at the country level”
(Smith, apud Heilbroner, 1956, p. 285). Thus, Keynes has reached the conclusion that savings
and investments are made by different individuals and they don’t have to be of equal size,
they are not automatically, always and necessary in a state of equilibrium.
Nevertheless, it will be proven later on that microeconomic judgments are inadequate,
most of times, for macroeconomic level (the other way around is also true). „Central
objectives of macroeconomic policy have been modeled mainly in order to mitigate the fear
of a new crisis, an event that remained carved in the memory of everyone who got a taste of
it” (Samuelson, Nordhaus, 2001, p.469). Undeniably, in order to have an image on the
economic thinking, generally, and, particularly, of the one typical for this period, there is one
name frequently referred to: John Maynard Keynes (05.06.1883-21.04.1946).
That is mainly due to the fact that the main paper of Lord John Maynard Keynes,
“General Theory of Employment, Interest and Money” (Book translated into Romanian at Ed.
Ştiinţifică, Bucharest, 1970), has launched “a message that nobody could have ignored”
(Schumpeter, 1963, p. 1181).
We could recall, as well, the forecasts of the author itself (forecasts that have proven to be
quite realistic): “A book on economic theory that will strongly shake up, not immediately I
suppose, but during the upcoming ten years, the way people are judging economic issues”
(Keynes, apud Harrod, 1966, p.134). Such considerations and remarks could be cited, drawing
up a really imposing list.
These remarks would be enough to make us pay an important attention to such an
economist and to his writings. Also, we could mention that this economic theory is mainly
focused on providing answers to multiple practical issues, emerged during this period.
29
The author itself affirms that: “economists are aiming to a rather easy target, without
utility, if during such tumultuous times they can only say us that when the storm will be well
passed, ocean waters will be calm again” (Keynes, apud Harrod, 1966, p. 66).
Same idea in a more concise phrasing: “for Keynes practical advices were the scope and
headlight of analysis” (Schumpeter , 1966, p.273). Keynesian theory represented “an attempt
to create an acceptable political economy in a period when people felt the need for action and
not only for analysis”(Seligman, 1962, p. 746).
Maybe there should be underlined the famous quotation of a fierce and prestigious
economist: “In a certain way, today we are all Keynesians” (Friedman, 1968, p. 15).
Contents of Keynesian doctrine. It’s often mentioned that the most important issues
that must be solved by economic thinking are the following:
1. Prices: what are they, on which grounds are they established, what determines their
fluctuation and development and many other similar issues;
2. Revenue: what do revenues of different economic agents represent, what conditions and
factors determine their size, how is established the quantitative ratio between them, etc.;
3. Overall economic equilibrium: are there any chances for a balanced development of
modern economy, at national or global level, i.e. uncertainties, defaults and economic
crisis must be accepted as a fatality.
Such major economic issues forming “the sides of magical triangle” can be found,
abundantly, in Keynes works. In his work, J.M.K. makes a double attempt of methodological
circumscription (Cristescu, 1984, p. 54):

A revival of mercantilism, of several “pre-classical” theses, against all classical,
traditional theories;

To exploit certain theses within “classical” theories.
In his works, the authors has identified in the contemporary world just two main deficiencies:
o
Mass unemployment;
o
Inequity in the distribution of wealth and revenues.
In order to solve the issue of wealth – poverty oscillation, one must start from
understanding the way the prosperity of a nation is measured. Prosperity and poverty
respectively, do not depend on past glory, but on current achievements. Consequently, the
state of a nation is estimated on the basis of collected income, on the basis of national income
and not by national wealth.
30
Whenever most of us, individually and collectively, have high income, then the
country is also rich. Whenever our total individual (or national) revenue decreases, we found
ourselves in poverty, in a phase of economic depression.
There should mentioned that national income is a dynamic concept – the main
characteristic of all economies is, actually, the savings flow, passing from one hand to
another. Through this permanent process of money transfer the economy is revived. In other
words, for a sound economy, a permanent flow of revenues is essential.
Such process of revenue flow is mainly realized naturally and without any blockings.
Due to the fact that humans must fulfill their current needs, they are forced to spend their
revenues, regularly and constantly. Yet there is a part of revenues that is not sent directly to
the market in order to become somebody else’s revenue – these are the savings.
Normally though, the flow of revenues is not dangerously interrupted because those
money are not treasured" Maybe just the extreme situation of Hagi Tudose would be an
example of savings that, implicitly, involves hoarding, that is extracting the money from its
regular flows ", but are converted into shares, bonds or bank deposits, creating therefore the
possibility of being reused.
It seems that, at this point, we must focus a little bit: the channel between savings and
investments doesn’t operate automatically by any means. At this point disruptions might
occur. A community will always try to save a part of its income, but economic agents are not
always in the position to expand their activity, to make investments and to give, therefore, a
destination (consequently, to use) the accumulated savings. For example, the extension of
economic agents seems quite unlikely when their future appears as uncertain, even if there are
enough resources saved and made available on the market.
If savings are not used for investment purposes, such as the expansion of activity of
economic agents, revenues of those agents making such savings will unavoidably decrease.
That’s due to the fact that, as there are not enough investments to generate future revenues,
savings cannot be remunerated, a situation similar to the one when these savings would have
been treasured.
The fact that destiny of a human society is so vulnerable confronted with such a
fluctuant ratio between savings and investments can represent, in a certain measure, the price
that must be paid to ensuring the economic freedom.
In a market economy system, economic activity is not governed anymore by tradition
and “central” authority, while, consequently, savings and investments are left at the discretion
of economic agents and members of the society. As such decisions are not restricted
31
sometimes they can be discordant: it might occur that investments would be too small for
being able to absorb the savings of households or that the savings volume would be too small
to support the investments. From this reason, it can be stated that: economic freedom is a
desirable and normal state of play, but during economic recession or boom we must be ready
to face any of its possible outcomes.
These were not completely unknown before the books of John Maynard Keynes were
published, but before him they had never been presented in such a clear and coherent fashion.
His first far-reaching scientific book, “Treaty on money”, was a brilliant exposure on the
balance between savings and investments. Not all ideas exposed were original, but no one
before had exposed them in such a systemic manner.
This theory on variations of savings and investments had an important shortfall: it
didn’t explain how an economy could remain in an extended state of depression. That’s
because the two elements of the economic activity – Moderation and Enterprising Spirit ( As
they are referred to by an author, Heilbroner, 1994, p.20) - are mutually linked, in a certain
manner.
These elements are in a strong connection established on the money market: savings,
like any commodity, have their own price: interest rate. In the lowest point of economic crisis,
the price of such savings (interest rate) should decrease and, consequently, the incentive to
invest would, very probably, rise.
Thus, we could draw the conclusion that, in a more synthetic manner, all papers that
preceded the “General Theory…” “Focused their attention on pricing instead of national
income, while the key element of pricing is the interest rate, ensuring the balance between
savings and investments” (Blaug, 1992, p. 691).
The disruption in Keynes’ thinking is marked, firstly, by the return to real production
based on pricing, as central variable that must be explained and, secondly, by the fact that
fluctuations of production or income, more than interest rate fluctuations, are acting towards
an equaling of savings and investments. Together with these changes, a new idea surged
according to which income changes are influenced by investments and not by savings.
Thus, the theory of savings – investments balance started to indicate that within the economic
cycle mechanism is incorporated a “safety device” ensuring that when too many savings are
accumulated, their borrowing becomes cheaper, representing therefore an incentive for the
entrepreneurs to invest.
Considering the above mentioned, it seems that exactly this thing didn’t occur during the
Great Economic Crisis – the interest rate was dropping and, yet, nothing was happening.
32
Right in this sensible point of the economic theory, from those times, the remarkable value of
an extraordinary book “General Theory of Employment, Interest and Money” strikes out. This
is a brilliant book: “the book was revolutionary; it produced an essential resettlement of
economic science, comparable with the ones made at their time by “The Wealth of Nations”
and by “Capital” (Blaug, 1992, p. 691).
In this book, the author reaches a surprising and alarming conclusion: there is no automatic
safety device that would adjust savings and investments. The reasoning of the automatic
safety device is affected by an important deficiency: “at the bottom of depression, the wave of
savings is blocked” (Heilbroner, 1994, p. 293).
While the economy is getting deeper into the crisis, revenues drop and, subsequent to
their decrease, savings are also reduced. Thus, saving activities become a luxury that people
can’t afford in difficult times.
But the savings decline has a broader and more important consequence than the loss of
individual material security, due to the fact that economy is placed in state of “paralysis” just
when it needed more impetus. “That’s where the antinomy of poverty in middle of abundance
and the abnormality of people and machines that do not work as there is nothing to work for
comes from”.( Heilbroner, quoted paper, 1994, p. 294).
In other words, when a crisis has reached its lowest point, there is an interesting contradiction
between a critical need for goods and the insufficient production. It seems that this is an
“entirely moral” contradiction, because the economy doesn’t produce in order to satisfy needs
(that are always as big as dreams), but produces to comply with the demand, while the
demand is conditioned by consumers’ revenues. Once investments fall off and economic
activity shrinks, social problems emerge.
As Keynes was indicating, this situation is transposed not into an effective social
“misery”, but into a tragedy that nobody can be blamed for: “Society cannot be blamed for
making savings, while savings are, obviously, a personal virtue. Not even businessmen can be
blamed for not making investments, while they would be happy to do it, as no else wouldn’t,
if they could foresee a reasonable opportunity of succeeding”(Keynes, apud, Heilbroner,
1994, p. 294).
Yet, this is not a moral difficulty any more, but a technical one, and its price is extremely
high, the disuse of labor, unemployment. Moreover, entrepreneurs’ availability to invest
doesn’t last forever, because, in any moment, a certain industry is limited to the size of market
for which it produces.
33
Thus, investments are following a standard path: firstly, the enthusiasm of taking advantage of
the slightest of opportunities, followed by caution of the fact that the enthusiasm could lead to
an over-expansion, and followed by inactivity, when the market have been satisfied for the
moment.
The fact that human needs are big doesn’t mean that any investment will be a
profitable one. Most of times, in order to start an investment the incentive of optimistic
forecasts is not enough, while something more concrete is necessary, such as: an invention, an
improvement, an unexpected product, etc. " A brilliant exposure on this subject can be found
at Drucker Peter F., “Innovation and entrepreneurial system. Practice and principles”, 1993,
pp. 21 - 96"
Starting from all these observations, more or less inauspicious, the following remarks can be
drafted:
 An economy in depression can remain in this state. There is no item within the economic
mechanism that would take it out of such state. The state of equilibrium can also be
reached in conditions of unemployment and even in conditions of mass unemployment;
 Prosperity of a nation depends on investments. If expenditures with production factors
decrease, a convolution of economic contraction is initiated. Only an increase of capital
investments could be followed by an economic expansion;
 For the economy, investments are an uncertain driving force. It’s not the certainty, but the
uncertainty that forms the core of market economy. The investor – entrepreneur is not
guilty for the fact that economy is constantly threatened by saturation and, consequently,
by decline.
Thus, were reached quite revolutionary conclusions on the development of economic
thinking, even ignoring other aspects that might be found in the Keynesian theory. There are
some relevant remarks, such as: “Even if Lord Keynes would have brought anything else to
the “dot” of economic sciences, there is still the outstanding idea that the income level of
equilibrium, where savings are equal to investments, is not necessarily the level of income
where all job opportunities are fully occupied” (Blaug, 1992, p. 698). Definitely, all such
conclusions and judgments form a worrying perspective (if not an apocalyptical one),
especially if we consider that, by that point, economic theory only had promoted optimistic
forecasts.
Nevertheless, “General Theory on Employment, Interest and Money” wasn’t intended by its
author, by any means to be book that would predict the fatalistic disappearance of market
economy. On the contrary, it included a promise and proposed a cure” (Heilbroner, 1994, p.
34
296). If we consider it carefully, this “cure” had started before the scientific explanation and
recognition of the “prescription”. In the US scenario, that’s the case of “New Deal” policy
that was applying the willful stimulation of investments by the state assuming the role of
investor.
That was a new situation, never met before, an action “damned” even by economic theory
from up to that moment. The central idea was that there should be identified something
capable to turn on the “investing engine”, that, subsequently, would restart the economy,
taking it out of the crisis.
Keynes was hoping that such an incentive could have been represented by governmental
expenditures. That’s why it seems that this book didn’t bring on a new, complete and radical
economic program, but it was reconfirming an action that was already in place. The remedy
proposed by the author was perfectly logical and relatively easy to implement: if private
entrepreneurs were not able to support the economic development, the state was the one that
had to take over the initiative. If a direct stimulation of investments was not possible, a second
option might handy as well – stimulation of consumption.
In other words, if investments represent the “moody item” within the economic system, the
consumption constitutes the core of economic activity. Consequently, projects of public works
had to approach the issue of economic revival, from a double perspective:

directly contributing to an increase of purchasing power of people who would have lost
their jobs under crisis conditions;

by stimulating demand, there were created incentives for the revival of production, as
well as for investments.
However, Keynesian revolution had marked the end of “laissez - faire” doctrine, as it
named one of his studies. (The End od Laissez-Faire, 1926) „It is not true that individuals
have a natural freedom... There is no contract... World is not lead in such a way that
individual and social interests would always correspond. It’s incorrect to draw the conclusion
that achieving someone’s own interest operates in public interest as well... it’s not true that the
individual interest is always achieved.” (Popescu Gheorghe, 2000, p. 900) Nevertheless,
Keynes’ ideas were not exactly a revolution in economic thinking, because the idea that
governments can fight against depression and unemployment, through “discreet”
governmental expenditures and taxation is not a new one. Though, being based on such
recommendations it is really an important step forward. " E.g. “Report on the minority of
commission on the law of poor people”, drafted in 1909, was recommending to spend
budgetary resources on public works when unemployment had reached 4% of total labor
35
force; Pigou A.C. in his works, “Wealth and Welfare” (1912), “Unemployment” (1913) was
affirming that “… true outcome of public works is the quantitative decrease of
unemployment"; (see also Blaug Mark, quoted paper, pp. 691-715).
The novelty brought by Keynes’ works is the fact that he advocated for public
expenditures that would adjust cyclical oscillations and would stabilize the entire economic
community. Thus, the standard opinion of economists after World War One and before J.M.
Keynes was that some additional public expenditures can lead to additional job opportunities,
but only if, simultaneously, the velocity of money is also increased. Consequently, one can
draw the conclusion that the remedy for unemployment must be found in direct adjustment of
credit. Although it seems that such ideas weren’t totally shared by Anglo-American
economists, it must be underlined that most of them agreed with practical measures that must
be adopted in depression phases, but didn’t agree with the theory on which such political
conclusions were based. That’s why, maybe, Keynesian theory was so successful: it reached
political conclusions that most of economists wanted to support. Keynes has reached such
logical conclusions on the basis of a solid mix of ideas that composed a coherently composed
theory.
The main goal of political economics, according to Keynes, is not the study of
distribution (as David Ricardo was affirming) but the study of economic equilibrium. His
concept (of Lord John Maynard Keynes) of economic equilibrium is a dynamic one, based on
macroeconomic analyses. In order to explain it, no individual units of measure are being used
(at the enterprise level) but global units of measure (at the level of national economy) as a
general assembly, such as: income, savings and investments. Macro analysis has helped
Keynes to explain several psychological factors that public authorities had to consider, as they
were playing a fundamental role in the operation of economic mechanism.
Classical economic school didn’t have a general theory on unemployment. It was
considering only one situation – full use of labor force, while economic equilibrium can
(only) be achieved under this condition. Unemployment had a volunteer nature and
represented a factor of disequilibrium.
Contrarily to the above mentioned Keynes determines that economic equilibrium can
also be reached for different level of employment – also called underemployment equilibrium.
Due to the fact that it took into consideration different forms of unemployment and different
levels of economic equilibrium, the author appreciated his theory as general. In fact, Keynes
theory is not general, because doesn’t take into account all forms that unemployment might
36
take at a certain moment and because it hasn’t studied the factors that influence on the long
term the use of labor force.
In his work, the author doesn’t ignore the currency, but explains the employment level
through currency, using for this purpose the interest rate.
To support these affirmations, we could recall here the remarks of a great American
economist: “General theory is a book badly written, poorly organized… It is full of fuzziness
and confusions… A relative definition paves the way for an unforgettable rhythm. And when
it’s finally ready, we find out that his analysis is clear and new, in the same time… Briefly,
this is the work of a genius” (Samuelson, apud Blaug, 1992, p. 691).
In social-economic policy, especially in financial-monetary policy, a special role is given to
the state, which, according to Keynes, would be placed above social classes and whose
interventions in economic life would be in the interest of the entire society. He shows that a
real therapy must be based on macroeconomics (and not on microeconomics, as it was the
case until then), because certain items and measures with negative impact at microeconomic
level become desirable at macro level, and vice versa.
State intervention in economic life would primarily target a maximum level of
employment that would generate positive economic, financial and monetary effects. In order
to achieve this objective, savings should be discouraged, while promoting a policy of
incentives for spending targeting the increase of effective demand.
Measures that should be adopted:
1.
Stimulating individual consumption by all means, consequently increasing the
predilection for investments. According to the author, savings are a depressing
phenomenon;
2.
A complementary measure consists in redistribution of income in favor of categories
willing to spend such revenues and not to save them. The reason of such measure is not
linked to social justice;
3.
Interest rate plays an essential role. The decrease of interest rate, below the marginal
efficiency of capital, as the result of an expansionary monetary policy decoupled from
the gold standard, is able to stimulate the predilection for investments. According to
Keynes, inflation, which he refers to as absolute, is only emerging when an additional
quantity of money is launched on the market (additional to the one normally needed),
when an increase of effective demand takes place, without determining an increase of
37
production, but instead appears a cost increase proportionally with the increase of
effective demand;
4.
Provision of public works, even if it involves unproductive spending and even if such
expenditures have a wasteful character, because they could contribute to the increase of
wealth and decrease of unemployment, (only) “if the path to better solutions is
inaccessible”;
5.
In the financial area, Keynes foresees the decoupling of money standard from gold
standard, the use of budgetary deficit for financing public expenditures, an increase of
taxes levied from households, and the subsequent investment of such resources into the
economy through different channels. Keynes recommends the use of custom protection
and the harmonization of national interest rate policies in different countries.
Economic thinking retained, especially, one solution – governmental expenditures – on which
we will focus in the upcoming paragraphs.
Most probably, in this issue, no one could provide more clarifications than the author
itself: “For me, the recovery issue arises from the following perspective: How fast normal
economic activity will be recovered? At which level, how and for how long unusual
governmental expenditures are recommended?” (Keynes, apud Heilbroner, 1994, p. 299).
It should probably be kept in mind, extremely careful, the concept used by the author unusual. It justifies the remark that the author has considered governmental programs as
temporary aid, which should be provided to a system deflected from its normal path and that
can’t recover by itself. Moreover, even if Keynes was supporting the need for state
intervention in the economy, he wasn’t at all an enemy of private initiative, a defender of the
command economic system. In this regard, he speaks out explicitly and illustratively: “It’s
better for somebody to harass his bank account than to harass his fellow citizens” (Keynes,
apud Heilbroner, 1994, p. 301). It’s true that he was anticipating the “socialization” of
investments, at least on a temporary basis, but with the exclusive purpose to save the overall
economy.
Notwithstanding the above mentioned, in fact, it seems that solutions provided by
Keynes didn’t quite have the entire estimated outcomes. Nevertheless, economists claim that
provided solutions are correct, but:

The governmental expenditure program never had the magnitude required for reaching a
level of total employment of labor force. The most common explanation resides in the
resilience of citizens to such massive economic governmental projects aiming to socialize
the economy. In other words, such measures haven’t been considered unwanted
38
considering their economic effects, but only from the political and ideological point of
view;

Authorities responsible with the implementation of such economic governmental
programs didn’t take into account that, even if these actions were conceived as an
incentive for the development of the private sector, private entrepreneurs, targeted by
these programs, were considering them as a threat.
2.4. Interventionism today
In the economic literature, debates on state intervention in the economy never reached
a conclusion to be relatively unanimously accepted. On the contrary, it seems that debates
have been intensified, especially during past decades, when Keynesian measures were
broadly, yet imperfectly, implemented, while inflation has become a major economic
challenge. Maybe inflation is one of the negative side effects of Keynesian oriented economic
policy.
Nevertheless, we should understand that the state must be an active and permanent
presence in modern economic life. Maybe, it would be good if economic life was totally
free, but it appears that economic realities proves that economic liberalism has certain limits
and disadvantages or that in order to ensure the economic freedom, the presence of the state in
economy is required.
Yet, highlighted remarks do not provide justifications for interventionist activities and
do not indicated the degree in which these actions are strictly required. These explanations are
needed because even if state intervention in the economy is broadly accepted in general,
current economic approaches differ a lot on the intensity appreciated as necessary for such
intervention, on the situations when such intervention is required and also on the most
adequate solutions, etc.
We consider that, principally speaking, we should accept as ideal the situation when
economic liberalism is prevailing. Yet, we cannot ignore the fact that liberalism, internally,
involves certain unwanted and unacceptable reactions and also that in order to properly react
and operate, this doctrine requires the fulfillment of certain operating conditions.
Measuring the proper and necessary degree of state intervention in the economy becomes
much more complicated as exceeding a certain limit involves a major danger: “Once corrected
the obvious inequalities in the society, we arrive in a point where state intervention generates
as many anomalies as it removes” (Didier, 1994, p. 17).
39
It is generally accepted that the basic role of the state, its main function in the
economic sector, consists in the establishment and consolidation of “the rules of economic
game”. These rules are strictly necessary for the economic liberalism to become operational.
The minimum package of “rules of economic game” includes: legal constraints for contract
enforcement; rules on default cases; laws defining (and confirming) the property right; there
should be done a special comment on property. It has always been agreed that one of the
fundamental functions of the state is to maintain and stabilize the private property relations,
representing the basis of market economy.
Most frequently, the justification of state presence in economic like starts from
theories and practices concerning the behavior of economy in the absence of state intervention
in economy, that would, hypothetically, represent an (absolutely) free market economy.
The development of pure state (absolute) economic liberalism is based on the
assumption (otherwise proven) that an economy of this kind will ensure the general welfare.
That’s why is not accident that such an economy is also called “general welfare economy”.
This happens exclusively when two essential prerequisites are fulfilled: the economy is
perfectly competitive, or in other words there is a perfect competition; the market is perfect,
complete.
Supporters of free market economy, in order to justify economic liberalism, appeal to
the “theory of invisible hand”. According to this theory, whereas each individual is following
its own interest, within free markets, the sum of individual behaviors leads to the overall
economic equilibrium. On every market, the price level allows the equality between quantities
offered and demanded. This demonstration it operates only if the following conditions are
fulfilled:
a) Each consumer knows in every moment the overall offer presented to it, that is all
possible ways of using its time and money and it is capable to establish a hierarchy
of its preferences;
b) Each entrepreneur knows all production techniques and organize its activity in
order to maximize its profits;
c) Trading is free, both on commodities markets and on labor market, whereas no
consumer or producer is strong enough to distort competition, everybody being
perfectly informed on the state of market and prices.
All these are vital conditions, while the materialization of general equilibrium theory –
the “Paretian” equilibrium theory depends on their fulfillment and existence. When all such
conditions are fulfilled, it can be presumed that social decisions are based on individual
40
welfare, while individuals know better than the state “what makes them happy”. If this is the
case, then state’s presence in economic life it’s not necessary anymore for ensuring economic
efficiency.
Free market economy system has real virtues and qualities that recommend it as an
ideal. This system provides the existence of a correct and perfect competition, through the
game of prices, between orientations of production and consumers’ preferences. Competition
channels productive investments to the most profitable options, from the economic point of
view.
All these with a minimum pre-requisite: the competition should be perfect and it should
be correctly and fully operational. In this regard, sellers should accept the game of perfect
competition and none of them should have powers that would “counterfeit” this game. The
access on the market must be free, while producers should not “block” the access of new
producers in that respective field. Each “actor” of economic life must take its own decisions
freely; buyers must acquire goods while choosing the cheapest one and producers must
produce at the lowest cost and sell their commodities at the best price. On the other hand, it is
supposed that the market is transparent, information flows freely and correctly, at a cost
accessible for everybody. Finally, but not lastly, competition must be effective and loyal. (See
also Didier,1994, p. 78). In conclusion, free market economy system (absolute economic
freedom) it’s an ideal, providing “general welfare” in the context of a “general economic
equilibrium”," Literally, “free market economy provides happiness for each individual and for
all individuals, without harming anyone”" whereas the state can only take care of his
traditional responsibilities, of which most important could be: defense, social, cultural."
Although the system seems ideal, at least at the first sight, this economic doctrine has several
inconveniencies that we are trying to introduce briefly in the following paragraphs (See also
Atkinson, Stiglitz, 1982; Baker, Elliot, 1990).
1. The efficiency of general economic equilibrium based on competition is
questioned, as it doesn’t provide a distribution of income and wealth in
accordance with the principles of social equity.
As very often mentioned, sometimes the market gets “weird”, due to the fact that “if we don’t
undertake any action, the prevailing logic is the one of the market with all its ferocity and
injustice” (Didier, 1994, p.78). Consequently, we can draw the conclusion that first
responsibility of the state must be to provide a redistribution of revenue, of resources
generally speaking, ideally through measures that wouldn’t affect the natural efficiency of
private property and competition. The dualistic problem, equity-efficiency is essential for
41
economic life, while its implementation involves the identification of a compromise,
otherwise hard to achieve due to the antagonistic character of these two elements.
2. Economy is not perfect, competition is not perfect. In economic reality, it is
possible to monopolize certain market segments or sub-sectors of economic
activity.
An economic agent, allowed to operate freely, will have a “natural” (intrinsic) tendency to
monopolize the activity undertaken by it. That’s due to the fact that in the “rush” for
maximizing its profits, the easiest way seems to be the monopoly. It will lead to a breach of
operating conditions involved by economic liberalism and, thus, the loss of its efficiency.
In order to return to the conditions required by liberalism, anti-monopoly (anti-trust) measures
must be put in place. It seems that the most appropriate institution to do so is the state and the
easiest way (without being also the most efficient) is legislation.
Another particular case, here, is represented by the so called “natural monopolies”, where a
certain degree of concentration is required in order to ensure the economic efficiency needed
for reaching an optimal level of economic performances imposed by the market and
obtaining, therefore, a monopolistic position. In this situation, possible solutions are either
transforming them in “state monopolies”, either indirectly controlling them by the state.
Another example that should be mentioned at this point is the one of scientific research. If
technical and applied research is undertaken by private entrepreneurs as an operation and
profitability condition, fundamental research through its characteristics (high costs, great
uncertainty, long term or unlikely materialization) will only represent a sporadic activity. A
possible solution would be once again the involvement of the state, if not by directly
undertaking such activities, but at least by financing them, even partially.
Briefly, above observations envisage competition’s predilection for self-destruction. “Seller’s
interest is always to expand the market and to restrict competition among sellers” (Smith,
1962-1965, p. 165), as it was underlining one of the “pioneers” of economic thinking. The
evolution starts with “perfect competition” followed by “imperfect competition” and then by
“monopolistic competition”.
In order to highlight disadvantages of monopoly and, implicitly, the reasons (at least)
returning to competition, we have made the following comparison:
Comparison between monopoly and competition
Criteria \ Situations
MONOPOLY COMPETITION
Selling prices
high
low
42
Commodity consumption
restricted
expanded
Economic agents’ profits
high
low
Economic agents’ initiative low
high
3. Market is not complete and perfectly segmented, without any risks (or at least
with measures for limiting such risks), and without perfect information.
All these items lead to a breach of principles of perfect competition, creating the possibility
for monopolies to emerge. In this situation, state intervention in economy envisages the
“correction” of such deficiencies. In other words, even in this case state intervention doesn’t
mean the ruling out of economic freedom, but specifically the establishment of necessary
condition for its development and deployment of positive effects.
4. Economic theory of the free market involves reaching and maintaining a
general economic equilibrium.
Though, daily economic reality proves that national economies are faced with the under-use
of resources and with several imperfections: mass unemployment, relative absence of some
professions on labor market, imbalances of balance of payments, regional problems and
unpredictable inflation. In such cases, the need for state intervention is different: this is the
case of important economic problems, but with serious consequences (unbearable at a certain
point), either there are problems that could be solved by means of private initiative, but on an
unacceptable long term, either there are reasons of national security.
In these cases, “macroeconomic policy is focused on state support, which in imperfect market
conditions would provide equilibrium opportunities and tendencies through state intervention.
Thus, state undertakes a stabilizing goal, usually, through fiscal and monetary tools.” (Basno,
1994, p.25).
5. Even if economy would find itself in perfect economic equilibrium, with
maximum economic efficiency, its outcome might be inefficient due to underlying
“externalities” ( Samuelson, Nordhaus, pp. 55-56, 330, 422-436).
Generally, „externalities or effects on external environment arise when companies or people
generate certain costs or benefits for people from outside the market” (Samuelson, Nordhaus,
p. 330). Or else „externality is considered to be any situation when an individual or a
company acts and, consequently, affects other individual or company, without paying or being
paid for such effects” (See also Basno, 1994, p. 25-30). There are many examples of actions
of individuals or companies that affect other people, but indirectly, not by price. Due to the
fact that such economic agents consider only the items corresponding to their target –
profitability – they will ignore those effects that do not impact on their price or production
43
conditions." A handy example, in this case, is the issue of pollution. Let’s take the hypothetic
example of an economic agent that must choose between two equipments, with similar
characteristics, differing only by the ratio of cost to one piece of final good. Assuming that
other differences, even if they might exist, are totally insignificant, the entrepreneur will
choose the equipment with the lowest ratio of cost to one piece of final good, because he will
consequently get higher profits. At this point we will slightly adjust our example: the
equipment with the lowest ratio of cost per one piece of final good is polluting, while the
other one no. Under this circumstance, the economic agent will choose the same equipment
(with the lowest cost per piece), even if this one is polluting, whereas pollution doesn’t affect
its profits. Profitability of the equipment with the lowest cost per piece will be only affected if
the state promotes certain measures imposing a cost for pollution through regulatory
measures. Moreover, in order to provide incentive for the entrepreneurs to use non-polluting
equipments, the state should impose such costs for pollution that would cancel the
technological advantage of cost, corresponding to polluting equipments."
Generally, solutions provided for externalities are targeting: ■ “unitization” – transforming
such externalities in facts affecting the entities generating them; ■ conclusion of
commitments, arrangements between entities generating externalities and entities affected by
them; ■ establishing rules concerning social sanctions for entities generating negative
externalities.
6. Solving the issue of public goods, such as: national defense, social security,
legislation, issues of community interest.
The particularities of such goods reside in the fact that consumption of these goods by certain
individual do not affect the others, these are “goods for which individual consumption do not
prohibit the consumption or do not limit consumption opportunities of another individual” (
See also Basno, pp.18-21). Also these are goods representing individual needs of the vast
majority, but those needs are satisfied only by consumption at a social level and not at
individual level, while, consequently, in order to satisfy such needs there is an objective
requirement of state presence in the economy.
7. Social goods (and respectively anti-social goods).
These are a category of goods very close to public goods, sometimes being even mistaken for
them. Such goods are also called, not by accident, “quasi-social goods” “they are defined as
representing those needs that can be satisfied with private goods, either with public utilities”
(Văcărel, 1996, p. 38 – 39). These are goods considered and labeled by public authorities, on
the basis of social criteria, as social, anti-social and neutral goods. In the situation of first two
44
categories, the state will get involved in the production and consumption, providing incentives
for social goods and discouraging the use of anti-social goods.
Of course, there is still an interesting issue related to the underlying ethics for those
considerations. In this regard, could be provided examples such as: education, culture, health.
In this case, state involvement is required by the social importance of these sectors, when the
particular impact of such activities requires at least the “provision of support” for private
initiative.
2.5. „Market failure” and the state intervention
From the above mentioned, we can draw the conclusion that even if free market
economy comes with several advantages, its lack of success is obvious due, in particular, to
market imperfectionOne of the failures of free market economy was generated by the absence
of perfect competition among economic agents. This situation is referred to in dedicated
literature as market failure (Adaptation from Samuelson, Nordhaus, 2001, p. 330-331;
Gheorghe, 2000, p. 1025-1029) and had two reasons:
♣ Market structure (failure by market structure) – it arises when, in a certain sector,
it doesn’t exist a competition among several producers. We could present some
examples in this regard by recalling the communications market, the electricity or
water distribution markets.
♣ Pricing mechanism (failure by incentive) – when costs of production factors are
different for certain producers.
Regarding state intervention in the economy we can affirm that the state can get
involved, on one hand, at microeconomic level, acting as a regular economic agent. In this
case, it could appear as producer, consumer or trading partner. On the other hand, state
intervention in economy, at macroeconomic level, can also be underlined through the
deployment of its responsibilities of market regulating authority.
Several aspects as the autonomy of public administration bodies, free initiative of
economic agents and political influence in economic life provide a limited character to the
state intervention. At microeconomic level, state intervention is materialized through the
establishment of minimum wage, price regulation, imposing minimum thresholds for prices,
provision of aids, etc., while at macroeconomic level state can intervene through a set of
policies aiming to eliminate or at least to reduce the inflation and unemployment levels.
Instruments used by the state to influence economic life are the following:
45

Taxation that state can use to provide incentives or, on the contrary, to discourage several
activities;

Expenditures that, in a certain way, encourage economic agents to produce just certain
goods and services;

Regulations that do not allow to individuals to undertake certain activities or to undertake
them just partially.
We cannot discuss state intervention in economy without reminding the four main
functions of the state (Samuelson, Nordhaus, 2001, p. 339): 1. establishing an adequate
legislative framework; 2. enhancing the economic efficiency; 3. distributing incomes in the
most equitable manner; 4. ensuring the economic stability through macroeconomic policies;
If the intervention is necessary that doesn’t necessary mean that state involvement in
economic issues is, automatically, a proper approach. When state intervention in economy and
also adequate sectors and instruments are being decided upon, there should be ensured a
compromise between the efficiency and objectiveness of the market system and between
social commandments that would claim the distortion, at least in a small manner, of private
initiative and property.
The behavior of economic agents is influenced by various variables acting on the
market, in the economic life appearing consequently a set of phenomena and processes.
Participants to economic life must observe market and competition laws when they act on the
market.
State intervention is considered welcome in order to stimulate economic efficiency and
to ensure the fairness among economic agents in what regards the production and distribution
processes. Thus we can affirm that the most important elements for the assessment of an
economic system are efficiency and fairness.
Economic efficiency of an economic agent is given by the outcome it achieves, by the
volume of goods and services produces by the respective economic agent. In order to achieve
higher efficiency it is necessary to obtain maximum outcomes with lowest costs and efforts.
In this regards, an economic agent must get efficiency both in the production and distribution
processes, while the consumer must be fully satisfied, if possible. Any company is efficient if
it gets a high output by mixing production factors with minimum costs. Graphically,
production efficiency is reflected by the production possibility frontier (Graph no. 1).
46
Graph no. 1: Production possibility frontier
Production possibility frontier (Adaptation from Samuelson, Nordhaus, 2001, p. 28-31, 36-43
and Harvey, 2002, p. 32-35) is a graphic tool that expresses the total number of combinations
of goods (A and B) that can be achieved while maximally using available resources.
Increasing the production of good A is possible on the account of a decrease of production of
good B and vice versa. A combination of goods placed on the production possibility frontier
(point A) is considered efficient from the point of view of resource allocation and use. In
change, a type X combination of goods is possible, but inefficient as there will still be unused
resources available for this purpose. A type Y combination of goods is impossible to achieve
in the same technical conditions, but an intensive development and upgraded technologies that
would change the production possibility frontier would allow the achievement of this
combination also.
An important aspect of production efficiency is the comparative advantage, which
takes into account the opportunity cost of an action. Thus, any decision or action has not
simply a monetary value, but also a comparative one. The strictly monetary value is
represented by the sum of expenditures generated by such action. The comparative value is
represented by the cost of the best other action sacrificed. In this regard, for example, a land
apparently without utility for construction activities can represent a value for the company if it
is located in an interesting natural area.
In what regards production efficiency, state can get involved by trying to ensure as
much as possible the fairness among economic agents both regarding access to resources and
their acquisition price.
y
Economic
agent
47
Economic
agent
y
P goods
Graph no.2
v
u
u
Economic
agent
x
N goods/year
Thus, after having identified existing conditions on the market according to Edgeworth
Box method the state should get involved in economic activity in order to achieve Pareto type
efficiency, as much as possible.
“In graph no. 2, the Os line represents the total volume of n goods in the economy, Or line
represents the total volume of p goods in the economy. The quantity of goods consumed by
economic agent x is measured starting from point O; the quantity of goods consumed by
economic agent y is measured starting from point O`. For example, in point v, Economic
agent x consumes Ou of p goods and Ox of n goods, while Economic agent y consumes O`y
of n goods and O`w of p goods. So, any point from inside the graph (Edgeworth Box)
represents the allocation of goods n and p between economic agent x and economic agent y.
Now, let’s assume that the preference for goods n and p of economic agents x and y
are represented by a set of indifference curves. In graph 3, both sets of indifference curves are
showing us the allocation of goods according to Edgeworth Box method. Economic agents x
are noted with X1, X2, X3, while economic agents y are noted with Y1, Y2, Y3. Indifference
curves with higher numbers shows higher degrees of satisfaction. Economic agent x is more
satisfied when placed on curve X3, less satisfied on curve X2 and least satisfied on X1, while
Economic agent y is more satisfied on curve Y3, less on Y2 and, respectively on Y1. Generally,
utility of economic agent x increases simultaneously with the shift of its position towards SW,
while utility of economic agent x increases simultaneously with the shift of its position
towards NE.
48
Graph no.3
Economic
agent y
P goods/year
Economic
agent x
N goods/year
Let’s assume an arbitrary distribution of goods n and p – considering point g in graph,
whereas Xg is the indifference curve of economic agent x, passing through point g and Yg the
curve of economic agent y. Now we can ask ourselves the following question: Is it possible to
reallocate goods n and p, between economic agents x and y in order to have economic agent x
more satisfied, without reducing the level of satisfaction of agent y? If we consider it
carefully, we can notice that such an allocation is possible in point h. Economic agent x is
more satisfied because the indifference curve Xh represents a higher level of utility for him
than curve Xg. On the other hand, economic agent y is not less satisfied in h, because it is
situated on the initial indifference curve, Yg.
Can economic agent x be even more satisfied, without economic agent y being less
satisfied? It is possible, as long as economic agent x can be shifted on the indifference curves
towards NE, while economic agent y remains on Yg. The process can be continued until the
indifference curve of economic agent x touches Yg, which is happening in point p. The only
possibility of placing economic agent x on a higher than Xp indifference curve will place
economic agent y on a lower curve. An allocation similar to the one from point p, where the
only way of increasing the satisfaction of one agent, without decreasing the satisfaction of the
other one, is called Pareto type efficiency point.3" Named after an economist from the XIXth
century Vilfredo Pareto." Pareto efficiency is often used as a standard in the assessment of
interest in resource allocation. If an allocation is not and Pareto type efficiency point, than it is
49
„inefficient”, i.e. it’s only possible to increase the satisfaction of one agent by decreasing the
satisfaction of the other one. Whenever economists are using the word efficiency, they bear in
mind the Pareto efficiency.
In our case, Pareto improvement involves a reallocation of resources that increases
the utility of an economic agent without modifying the one of the other. In the previous graph,
the shift from point g to h is an improved Pareto, as well as the shift from point h to p.
Point p is not only a Pareto efficient allocation that could have been reached starting
from point g, but it is analyzing the possibility of increasing the utility of economic agent y
without decreasing the one of economic agent x. We can notice that a shift of economic agent
y on the indifference curve towards SW, so that resource allocation would stay on X g. In this
regard, a point like p1 is being isolated. In p1 the only way of increasing the utility of
economic agent y is to move economic agent y on a lower indifference curve. Thus, by
definition, p1 is a Pareto efficient allocation.
Until this point, we have analyzed only shifts that have increased the utility of one economic
agent, maintaining the same utility level for the other economic agent. We consider that
reallocation from point g places both economic agents in a more favorable position. For
example, in p2, economic agent x is in a more favorable position than in point g (Xp2 is further
away towards NE than Xg), while economic agent y is also in this situation (Yp2 is further
away towards SV than Yg). Point p2 is Pareto efficient because in this point it is possible to
put one economic agent in a more favorable position without decreasing the utility of the
other economic agent. Now it should be clear that starting from point g, an entire set of Pareto
efficient points can be identified” (op.cit.Harvey, 2002, p. 32).
Homework:
1. Which are the factors that led to the emergence of the market?
2. Which are the most important issues that must be solved given Keynesian doctrine?
3. Which are the functions of state?
50
CHAPTER 3
MARKET FAILURES
Objectives:
∆ Creating a vision among market failure
∆ Highlighting the causes of market failures
∆ Creating a vision given roll of state in economy
Key words: market failure, comparative advantage, equity, monopolies, public goods,
externalities, informational asymmetry
3.1. Market failures in economic theory
From birth to death our lives are affected by government activities. This is confirmed
only if we think that most of us are born in hospitals subsidized by the state, most of us follow
a state school, and at some point in life we receive money from the state aid unemployment,
social security, etc.. This idea can be continued if we think that all of us pay taxes, if we
consider that every day we use roads, and not last we remember that the entire state through
its representatives has the control pollution in cities.
Interventionism economy was and is a subject of fierce dispute between different
authors, both old and contemporary. Thus, in the 18th century is a familiar criticism of Adam
Smith over the current mercantilist. The mercantilists felt that the state should exercise strict
control over economic policy, especially trade. But, the liberal ideas of the economist Adam
Smith had strong influence on many economists of the 19th century, such as John Stuart Mill
and Nassau Senior. They quickly embraced the doctrine of laissez – faire, the fact that the
state should intervene as little as possible economic activity, leaving decisions at the expense
of operators on the market. New followers of liberal current (Milton Friedman) emphasizes
the importance of personal freedom and they think that people need to realize their own
interests and desires, the state will be limited to ensure internal order and national security,
51
and traditionalists demand that the state should allow markets to work miracles with the
standard of living (Samuelson, Nordhaus, 2001, p.319-335).
In 1776 Adam Smith says in his book "Wealth of Nations" that the competition will
have the effect those individuals pursuing their own interests by them will achieve the public
interest through the invisible hand. From Smith's idea there are more points of view on the
role of government in the economy. The mercantilist in 17 and 18 centuries claimed that in
order to achieve the public interest is important that the state has an active role in the
economy, namely industry and commerce.
Smith popularized the laissez-faire doctrine of Francois Quesnay, a prominent French
economist. The work of Adam Smith in "Wealth of Nations" was a detail of the laissez-faire
adaptation to support free market, including here free trade and global market (op cit.
O’Connor, 2004, p. 52).
In some countries with large implications in the economy, the achievement of public
interest was not successful, while in other countries where the state has less influence public
goods and services were better provided. This contradiction led Adam Smith to analyze the
causes of issuing some statements such as the public interest can be achieved when each
person pursue his own interest. Private interest to each individual is most obvious feature of
human nature than care to do something good and thus provide a more solid organization of
society. In addition individuals more easily identify what is better for them than what is best
for society.
The significance of Smith's ideas can be found in the following words: if there are any
goods or services that individuals appreciate and desire, but are not currently produced they
will be when they will be willing to pay for them. In their quest for profit their movement is
based on this aspect of human behavior. So if the value attributed by the individual for a
product is higher than necessary costs to get that product can appear the possibility of
obtaining a profit and companies will produce that product. Similarly if there is a way to
produce something cheaper than the way business is done with current mechanisms it will
overcome its competitors and profit. In this view no government has to decide whether to
produce a good or not, the market should do so. There is competition to reach high market
efficiency, which is an important incentive for innovation. Crisis of 1930 showed that the
market does not work as perfectly as liberal economic theorists predicted.
52
On the other hand, even if the free market economy has some advantages, however, is
obviously due to its failure, in particular, market imperfections.
Not all economists of the 19th century were influenced by the ideas of Adam Smith.
Economists such as Karl Marx, Sismondi and Robert Owen thought that all "evil society" is
due to private ownership. All that was seen by Adam Smith as quality was seen by them as a
vice. With the increasing role of the state and increased its influence in economic life (Stiglitz,
2000, p.6). Both private property, capital, major private companies and state control over
production factors are driving forces in the international economy.
Why the government is involved in some activities and not others? Why it’s role has
changed and why the state has different roles in different countries? Is the state involved too
much? Could it fulfill its economic role more effectively? These are just some of the
questions facing the public sector.
In classical economic theory supports non-intervention in the economy due to market
capacity to self-regulate only through its mechanisms. Crisis of 1930 and not only
demonstrated that this theory cannot be valid for an unlimited period of time and the state
must intervene in the market with some regulations to regulate market forces.
We know that the market fails to self-regulate, so certain market failures occur, known
as "market failures" and to justify state intervention in the market. In order to talk of market
failures, and how can they be controlled by state action we have to analyze how market
failures occur, how they can manifest and determine their causes.
3.2. Premises that determine market failures
Through market failure (in theory allocation), we understand the failure of one or more
systems of "price-market Institutions" in support of desirable activities, or to stop undesirable
activities (op. cit. Bator, 1988, p.35).
Economic behavior is influenced by different variables that occur on the market; the
economic life appeared as a series of phenomena and processes. Those who participate in
economic life must respect the laws and market competition when the market works.
State intervention is considered desirable to promote economic efficiency and to
achieve equity among businesses regarding the production and distribution.
We can say that the base of the evaluation of an economic system rely in efficiency
and equity. Economic efficiency of an undertaking is given the result of this, the amount of
53
goods and services made by that company. In order to obtain high efficiency is necessary to
achieve maximum results with costs as low as possible. To achieve this, a company must
achieve efficiency both in production and in distribution and consumer has to be fully
satisfied if possible. Any firm is efficient if done by combining high output with minimum
cost of production factors. Graphics efficiency in production is reflected by curve (frontier) of
the production possibilities. (Graph no. 1).
Production possibilities frontier
Production possibilities frontier is a graphical tool that expresses the combination of
goods (x and y) can be achieved in conditions to make the most of available resources. A
good output growth x is possible to reduce production due to good y, and vice versa. A
combination of property located on the production possibilities frontier (point A) is
considered effective in terms of resource allocation and use. Instead, a combination of goods
of the type B is possible, but inefficient, leaving unused resources available for this purpose.
A combination of goods of type C is impossible to achieve the same technical conditions, but
an intensive development and superior technologies that would change the production
possibilities frontier would also allow the realization of this combination.
An important aspect of efficiency is the comparative advantage that takes into
account the opportunity cost of an action. Thus, a decision or action has a value not only
money but also a comparative. The amount is strictly monetary costs of this action. The
comparison value is the best of the other actions slaughtered. In this respect, apparently
useless land for construction activity may be a value to society that is a natural area of
interest.
Equity shows how the economic outcome is distributed in society. This means that an
economic system in general, can achieve high performance in terms of production volume,
54
but it may be low vision plan company if the company fails to provide a fair allocation of
goods and services produced. Equity is a principle often essential in making economic
decisions. It expresses a measure fairness or justice or economic interventions. Equity should
not be confused with equality or economic balance, it is necessary and conditions or,
especially, in terms of economic inequality.
In terms of production efficiency where the state may involve in the attempt to ensure
as far as possible, an equity among businesses both in terms of access to resources and the
purchase price.
3. 3. Manifestations of market failures
Even if the free market economy has some advantages, however, is obviously due to
its failure, in particular, market imperfections. One of the failures of free market economy was
caused by the lack of perfect competition between traders. This arises in the literature as the
market failure and experienced two cases (Samuelson, Nordhaus, 2001, p. 330):
• market structure (failure by market structure) - this competition occurs when several
producers in a particular field is not present. A series of examples in this way can be seen in
the field of telecommunications, electricity distribution, and water.
• price mechanism (failure by incentive) - when input costs are different for some
producers.
We know that the market fails to be regulated, so certain market failures occur, known
as "market failures" and to justify state intervention in the market.
There are four categories of market failures that determine state action, namely:
 monopoly
 public goods and services
 externalities,
 information asymmetry.
1. Monopolies, known as the failure of competition, are among the most controversial
issues of market failure and efficiency.
Efficiency requires the existence of a perfect competition, so there should be a
sufficient number of firms on the market so none of these companies has the power to
influence market prices. But in some areas, such as the production of computers, aluminum,
tobacco, one or two companies have the monopoly. When there is only one company on the
market in one field, there is a market monopoly and where there are few companies on the
55
market in a certain domain, there is a oligopoly. If there are several companies that produce
similar goods on the market, thus recording a decline in demand for their product, we face a
monopolistic market competition. In all these cases there is no perfect competition where
prices are not influenced by companies.
A Pareto efficiency requires certain conditions such as a certain degree of competition,
exchange, production, and these conditions can be met only if each of the companies acting
on the market believes that it has no influence on price.
There may be several reasons why the competition is not perfect. For example, the
cost of production increases if the production is increased; large companies have no advantage
over small ones. There may be a large natural monopoly, when it is cheaper if only one
company produces the necessary quantity of a good or service, instead of more companies.
The cost of transport has the main effect that the goods sold in a particular location may have
be sold a higher price in another location. Also some companies may seek strategies to
discourage competition. There may be some agreement among producers to reduce prices if
new producers would try to enter that market, so they will be discouraged to enter that market.
The imperfect competition may arise from governmental actions. For example,
although innovations patents encourage innovation and competition on markets, but not on the
prefect ones. Of course, a patent for invention ensures that an inventor has knowledge and
information that others do not have access to.
The imperfect competition generates economic inefficiency. In a perfect competition
the marginal profit equals the marginal cost, while in imperfect competition when the
companies earn extra income; the marginal income equals the marginal cost. This additional
income gives them advantage over the other companies that want to enter that market, and in
this way they become increasingly powerful, covering in time a growing market segment.
The monopoly situation may not be avoided. There are goods on the market, as
mentioned above, that are more efficiently used by a single producer instead of more, even if
it is able to control that market segment. The monopoly situation is sometimes created
intentionally to control a particular market sector. This is not always viewed as a negative
aspect of market functioning; the most common intended monopoly refers to the state
monopoly for the production of certain goods and services. The state’s argument for such
monopoly is easily deduced from the following example. We take as example the case of a
thermonuclear plant, weapons production, to see what might happen if such goods and
services would be produced and delivered in accordance with market principles and market
efficiency. Of course, the market would find entrepreneurs willing to offer such goods, which
56
would have the financial capacity to enter the market and to destroy the state monopoly, but
the question is if such sensitive issues should be left for the open market.
The monopoly situation can also have beneficial effects on market. The fact that "a
giant" has monopoly on a market segment that enables him to control the price and the supply
and demand in that market encourages innovation. If a company wants to enter in a monopoly
market it must find new technologies and working methods that could provide an advantage
to be exploited in the future. Also, because the monopoly situation often leads to higher prices
and an increasing sense of dissatisfaction from consumers, it determines the future emergence
of substitute goods and services besides the ones from the monopoly market.
2. Public goods. Their particularities are also a cause of market failures. There are
some goods that cannot be offered by the private market, but only by the public one (e.g. the
national defense) and even if offered they are insufficient. They are called public goods.
Public goods have two important characteristics: basically, the marginal cost for consuming
additional quantities of a public good is 0. The second characteristic is their indivisibility, so
no one can be excluded from their consumption.
Mikesell (Mikesell, 2003 , p.4-5) as public goods: national defense, pollution control,
control of various diseases, insects killing. Common characteristics of these services are:
- “non-exclusion
- no competition.”
Public goods are known as manifestation of market failure for some basic needs.
Normally in a market economy when there is a demand for certain goods and services, the
market players try to meet this demand by offering on the market the needed volume of
production, at the price determined by the market. Public goods form a category of objects
that behave unlike any other property on the market, mainly due to their characteristics
mentioned above.
Thus, the evolution of the society generated more varied needs and a quantitative
increase of the needs of the society. Each business provides to the private market the quantity
of goods requested on the market, but also follows its own interest, that is to obtain profit. For
these two reasons, the pursuit of self-interest by entrepreneurs and the increasing complexity
of the society’s demand, there is a time when the market appears even if there is a demand
increasingly higher for a particular good or service that no longer may be provided by the
private sector. This is because the production and supply of those goods and services by the
57
private sector would be too high and therefore their profits would be diminished. This request
is satisfied by the public sector.
3. Externalities. There are cases when certain actions or activities of an individual or
an agent influence the actions of other individuals or agents acting on the market. This
influence can occur through the imposition of acting on the market for other costs or benefits,
costs and benefits which other actors on the market do not take into account as they cannot
predict them and internalize their result. This creates externalities.
An externality is a benefit or cost that is a „by-product" of an economic activity, but
which is allocated outside the market system. The internalization of an externality refers to
incentives and exchange of the parts involved so they act as if there is a market for external
costs or benefits (Halcombre, 2006, p.69-70).
Where burden is generated to other market participants, negative externalities can
appear (such as water or air pollution) even when the benefits seem to generate positive
externalities (flower planted in front of homes, building an access road by a firm to their
headquarters and other companies receiving area, etc.).
As long as the resources are market externalities, they cannot be effective and
therefore the intervention of the state is required. In this situation, the state has to intervene to
internalize the benefits from these activities to the ones who generate them.
Speaking of externalities, Bator said: "externality shows any situation where a number
of costs and benefits remain external Paretiene cost and to decentralize revenue cost
calculations in dealing with prices"(Bator, 1958, p. 72). He wanted to classify cases of market
failures without tackling a specific problem. It is the lack of private property one of the causes
of failure of markets.
Causes of market failure include (op.cit. Papandreou, 1994, p. 34):
•”externalities "ownership" of problems occurring in this institutional arrangements.
• technical externalities: the problem in this case is given by the indivisibility, leading
to production non-convexity.
• externalities of public goods: public goods’ nature was treated by non separate
factors”.
On the other hand, Howard shows that when externalities are internalized the marginal
value of the externality is an indication of price (the marginal private costs of achieving social
activities are equal with the cost result of this activity). (Howard, 2001, p. 18).
58
4. Information asymmetry. The information asymmetry means the failure occurring
mainly due to the fact that the operation on the market has different interests which are often
opposing, and the content of information and the message is perceived differently by
operating on this market and pursuing their own interests .
The most striking examples of information asymmetry are the insurance market and
the capital markets.
Capital markets want the creditor part to recover the loan (plus the interest accrued).
But they do not know in advance which of their customers are able to pay the amount
requested (this problem is a problem in the U.S. especially for loans for tuition fees). Banks
generally have the following dilemma: if the interest rates rise, the demand for loans on the
market falls, and those who would take a loan at high interest rates might also fail to repay the
loan. If the interest rate is too high the bank may face a situation where market customers
refuse to borrow at an interest rate that is too high.
When there are information asymmetries and financial problems for financial defaults,
those markets may not exist. The reasons for the disappearance of markets affect how
government can act to remedy these deficiencies. The state may also face problems such as
information asymmetry costs, although differently from the private sector. Within such
programs on loans or capital market interventions, the state must keep in mind that most of
the times it is less informed than the ones who borrow.
In another concept, there is a more detailed classification of market failures .There are
six basic market failures as follows (Stiglitz, 2000, p.85-86):
- “imperfect competition,
- public goods
- externalities,
- incomplete markets,
- incomplete information (information asymmetry) and
- unemployment and other macroeconomic imbalances”.
The concept of incomplete markets explains that there are other public goods than
those that the private market does not offer even if the cost of producing those goods is less
than the price that the individuals would be willing to pay to buy those goods. It’s the case of
insurance market and credit market (loans). For example in the U.S. since 1933, following the
Great Depression, the state has intervened in the banking market through the bank deposit
insurance. So until that year, the market has had no guarantee for bank deposits, and the state
59
had to intervene by establishing a mandatory reserve fund for banks that provided bank
deposits if a bank became insolvable. So the regulations were established in our country all
because of unpleasant events (Dacia Felix and Caritas, etc.). The U.S. government had to
intervene on the health insurance market especially in terms of older people, assuring fire
hazard and the latest security protection against the effects of inflation. Borrowing is a
delicate situation. Another example, U.S. had to intervene by law in 1965 to facilitate the
opportunity to give credit to finance education. This type of credit in our country is still not
functional, although there are projects on this theme.
The problem of the insurance market and the credit that does not always work, leading
to an efficient state intervention has been widely debated.
Also on incomplete markets we must refer to problems that arise due to additional
markets. In order to understand this phenomenon we give the following example: Let’s
suppose that everybody likes coffee with sugar. Since sugar is not produced, an entrepreneur
who wants to produce coffee will not do so because he realizes that there is no market for his
product. In exchange, an entrepreneur who wants to produce sugar would not do so because
he believes there is no one to sell to. If the two producers would be able to work together to
learn from one to another intention, the two goods would be produced and a market for both
entrepreneurs would appear.
Thus, each entrepreneur acting alone would fail to deliver what is required on the
market, but together they would thrive. This example demonstrates that the coordination on
the market can take place without government interference by the simple coordination
between the two potential producers, but there are situations where their individual actions are
not sufficient to merely provide what is necessary on the market and therefore the state
intervention is needed to coordinate their work for a longer period and at a larger scale.
(Stiglitz, 2000, p.85).
Another problem on private markets that determines the state’s intervention for
regulating the market forces is represented primarily by unemployment and other imbalances
that occur at a certain time on the market. The increased inflation and the unemployment have
multiple causes and remain a challenge for economic policies of any country in terms of their
control. These phenomena occurring due to economic cycles cannot be controlled and
regulated only by market mechanisms, such as the intervention of the stable to keep them
within acceptable limits.
60
These types of failures do not necessarily occur separately, and on the contrary, it
often happens that a category represents the cause of another failure (e.g. information
asymmetry may be a cause of incomplete markets).
Market failures prove once again that even when the requirements are met for the
effective functioning of the market, it is impossible to provide the full range of goods and
services with maximum efficiency.
3.4. Market failures and the role of the state
Why the government is involved in some activities versus others? Which is the
purpose of its activity and why does the state play different roles in different states? Does the
state get involved too much? Is it able to fulfill more efficiently its role? These are only some
questions that the public sector has to answer.
Market failures occur when the free markets use inefficiently the resources and
generate negative effects (pollution, inadequate information). (O’Conno, 2004, p. 63).
We try to answer these questions and offer a higher level of comprehension about the
intervention or nonintervention opportunity in the economy by offering some examples.
When we talk about USA, we can say that it is based on a mixed economy. The main
argument is that the biggest parts of the activities are developed by private companies, while
the others are developed by the state. The American economy suffered in time many
transformations, for instance some years ago when some highways and railroads were
privatized and that process was also developed in other domains. The biggest reforms were
realized in domains such as: banking system, telecommunications and electricity, domains
with great market competition. The economic crisis from Asia in 1997 and the economies and
loans system fall in USA showed once again the market regulation importance. With regard to
the problem of privatization we can talk about giving back to the private sector activities that
belonged to the state. This action was more developed in Europe because some
telecommunications services, roads, airlines and public utilities were privatized. This aspect
was determined by the fact that the USA had few enterprises, maybe showing a lack of
interest for privatization.
The most important but controversial privatization was the one of the United States
Enrichement Corporation that was the governmental agency responsible for enriching
uranium. Privatization of the corporation generated serious implications in terms of national
security.
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On the other hand, if we take the example of the former Soviet Union, we can say that
most activities were carried out by the state. This is common in North Korea and Cuba. If we
think of economies belonging to the former Soviet Union, we can say that the situation has
changed somehow, but only to a small extent. There was even made a series of privatizations,
but the companies that acquire too much power are gradually removed from the market
through political intervention in the economy (e.g. Yukos concern). In terms of Western
European states, we can say that the state played a more important role than in the U.S.
economy. We support this assertion by the example of France, taking into account that the
state was involved in producing cars, planes and electricity. After 1980, most state owned
enterprises were privatized.
With regard to our country, it is well known that until 2000 the privatization was
achieved slowly. This situation has changed, meaning that a number of enterprises (Sidex,
Resita), banks (Agricultural Bank, Romanian Bank for Development) were privatized and
there began the liquidation of a number of state enterprises and autonomous enterprises, but
there are still some important steps to be made in the utilities sector.
Although Romtelecom was privatized, the situation is not very good, because they
started from a state monopoly of fixed telephony in Romania; shifting to a private one (the
other operators have a segment of less than 5% of fixed telephony market).
With regarding to the government intervention, we can say that the state can get
involved at the micro level by acting as an economic trader; in this case it may act as a
producer, consumer, and exchange operations partner. On the other hand, government
intervention may be reflected by its performance attributes as market regulator. The State’s
intervention can be both at micro and macro level. A number of issues like the state’s
administrative autonomy, free initiative enterprise, political influence over economical life
give the state intervention a limited nature. At a microeconomic level, the state intervenes by
setting minimum wages, prices, by fixing minimum price limits, granting of aids, etc. At a
macroeconomic level, the state intervenes through a series of policies to attempt to eliminate
or even reduce inflation and unemployment.
Halcombre shows that that government intervention should be focused in several
directions (op. cit. Halcombre, 1996, p.115-129):
 “Protection of citizen rights. The defense of citizen rights in a market economy
there are involved three major institutions such as: police, national defense and
justice. Police is to prevent violation of the rights of a citizen by another. The
62
national defense is to defend the rights of the citizens of a country, and also to
defend them from various attacks from outside the country. And justice is to
settle disputes between different people. The question in this case is when this
protection is optimal? Many economists believe that the resources for this
purpose should be increased until marginal cost equals marginal benefit of
additional protection. In theory the answer is correct but in practice things are
a little different. Let’s think for example about the United States who spend a
lot of money in defense for actions abroad. Here a question arises: do the
citizens consider that by these actions their rights are better protected even if
the expenses on national defense grow.
 Production of goods and services. Often on the market there is a necessity of
state’s intervention in the economy. The situations may be different, for
example: externalities, public goods, unclear definition of property rights, etc..
State’s intervention does not mean just laws related to private sector and
government intervention through public production. Externalities and public
goods are the main reasons of public production. National defense is a public
good, which protects the rights of citizens. Public education is another good
example in this respect, too.
 Setting framework. It often happens that resources are allocated inefficiently
because manufacturers have no incentive to consider the social costs of their
actions. In other cases it happens that the market participants allocate resources
better, with the necessary information. So the information supplied by the state
and a well-established legal framework based on intervention are sometimes
fold.
 Redistribution of income. Redistribution often occurs directly between the state
and the taxpayer. Sometimes this occurs through the public health, education,
etc.. The reasons for the state to redistribute the income are obvious, but after
making a careful analysis we can say that there are several reasons for
redistribution. These reasons have political implications, which differ in
various points. One reason is to use the public policy to ensure a decent life for
all members of the society. On the other hand, the society needs a greater
equality. I some cases it is made for political redistribution from middle class
to middle class.
63
 Stabilize the economy. Stabilization is another important aspect which should
be focused by the state’s intervention. The great economic crisis form the '30s
was one of the biggest challenges in this regard. Monetary and fiscal policies
are the main instruments used in stabilizing the economy”.
W. Mitchell noted several reasons why government intervention is suboptimal:
1. Proposals that benefit in the distant future are taken only if costs are unknown
or can be interrupted.
2. Proposals that benefit on short-term (apparent) are more likely to be adopted.
3. Proposals that focus on the distribution of benefits and costs have higher
chances to be adopted.
4. Proposals that would reduce public spending are unlikely to be adopted. The
citizens are turning to politicians who come up with new programs or to those
who extend existing ones.
5. Packages of proposals are more likely to be adopted, although individual
proposals within the package would be approved.
6. Direct transfer programs, which explicitly specify the recipient of money or
incentives, are unlikely to be adopted.
7. Proposing an inefficient tax system, complex, with multiple sources would
have preferred to a simple, direct taxation.
8. Proposals that charge efficiency are more likely to pass than a reward.
Proposals are preferred to limit consumption to encourage production.
Proposals that protect consumers from producers are restricted to the preferred policies that
improve consumer awareness.
Instruments used to influence state economic life are:
→taxes through which the state can encourage or discourage rather a series of activities;
→expenses are somewhat business to produce only a set of goods and services. Transfers
from the budget provide part of the household income;
→regulations do not allow people to carry out a series of activities, or allow them to perform
only in a certain extent.
We cannot talk about government intervention without mentioning the four main
functions of the state:
◘ creating an appropriate legal framework;
◘ improve economic efficiency;
◘ distribute income in an equitable manner;
64
◘ stabilize the economy through macroeconomic policy.
If intervention is necessary, it does not necessarily mean that the state’s interference in
economic matters is automatically correct. In conclusion, we decide that when government’s
intervention, methods and appropriate means, make a compromise between efficiency and
objectivity of the market system and between the social headquarters it would require
damaging, initiative and private property.
Economic behavior is influenced by different variables that occur on the market, and
the economic life appears as a series of phenomena and processes. Those who participate in
economic life must respect the laws and market competition when the market works.
The State’s intervention is considered desirable in order to promote economic efficiency and
to achieve equity between businesses in the process of production and distribution.
However, the most viable argument to state intervention in the economy is the
motivation for state intervention to correct market failures.
Monopolies, for example, offers a rationalization of the state’s intervention because
the monopoly market is a market with imperfect competition, unable to effectively provide
certain goods and services on the market, so the state must intervene to remedy this situation
by antitrust policies (when it comes to monopolies and collusive agreements, two or more
firms with market power have secret agreements on keeping prices at a level to discourage
competition and dominate the market segment) and antimonopoly. There is also another side
of the state’s intervention in terms of monopolies and imperfect markets, when the state often
encourages by his actions monopoly and imperfect competition (by granting of patents and
grants for various inventions), and the State has a monopoly on a particular market segment.
Public goods also determine the state’s intervention in the market. Since the private
market cannot provide certain goods and services or even when it does, it is insufficient
compared to the demand for those goods and services, and this makes the state to intervene
again for providing goods and public services, but not limited to, State intervene and complete
the private market in order to provide certain goods that are not pure public goods but goods
which can be provided by the private market too but not in a sufficient quantity.
With regard to externalities, the rationality of the state intervention to correct this
market failure was explained and consists mainly in the need to internalize costs and benefits
generated by a firm to other firms through its activity, the generating company.
In terms of incomplete markets, there are several issues to be discussed. It should be
understood first that the insurance and credit markets do not function effectively. The same
author (Stiglitz, 2000, p. 82) considers the following: a first reason is the technological
65
development, namely innovation. Every day more and more efficient products appear, so that
on the insurance market innovations related to insurance policies arise.
The emergence of such products is related to the second reason, namely the transaction
costs, whether it is expensive to launch new products on the market, new insurance policies
without thinking if there are "buyers", even if there is some demand for these new products
(although quite small), if not increasing the demand for newly created insurance, we are
dealing with a failed investment in innovation.
As for the credit market, there is explained above the case of loans for education in the
U.S. This failure occurs because of credit market information asymmetry. In case of a loan,
the lender knows from the beginning that of the applicants are not able to repay the amount
borrowed. Thus, it does not know how to act because of this lack of reliable information. If
the interest rate increases to hedge the credit risk against those who cannot repay, there is not
likely to have loan application to a higher interest rate, on the other hand, this decision will
not affect all those who would not repay the loan in any case. But if they do not increase
interest rates, they may not recover the money. These issues result in the absence of markets
that are in demand and so the state must intervene with offer. Although the public sector is
facing problems on information asymmetry or transaction costs, these are much different from
the public sector to the private one.
With regard to complementary markets and the need for coordination between
individuals acting on the market to provide goods and services, this can be done without
government intervention, but there are situations, especially in less developed countries where
state intervention is required to a larger scale to ensure this coordination. For example, if any
urban programs require coordination between all stakeholders, namely: manufacturing, retail
shops, and others, coordination must be ensured by the state.
Another problem of market failure that generates disputes, especially about whether
the state should intervene or not is the failure of information. There are regulations concerning
the obligation of providing certain information (e.g. the interest rate, the commission charged,
the labeling of products, etc.). Opponents of these regulations state that they are irrelevant,
costly and unnecessary. On the other hand, arguments on the need for state intervention with
such regulations are in fact based on the idea that a certain amount of information is a public
good (not exclusive). Moreover, even the law effectively requires that information is freely
distributed on the market with accuracy and the only accepted charge for providing the
information is the cost of transmission, the information content must be accessible to all free
and free of charge.
66
In terms of unemployment and market imbalances, the state is only able to handle
economic cycles by long-term economic policies, which can reduce the impact of crises of the
market and society.
The fact that the private economy is inefficient provides arguments for the state to
intervene to adjust the failures of the private economy. However, even if the economy is
operating effectively, there are two other arguments that require state intervention in the
market.
The first argument is the income distribution: a competitive market may generate an
unequal distribution of income. The main function of the state in this case is to provide
income distribution.
The second argument refers to the decisions made by the market entrepreneurs. Even
if they are well informed, they often take wrong decisions contrary to the principles of
efficiency. It appears as a controversy regarding the state’s intervention in such situations, in
which individuals act in their interest and take wrong decisions. In this case, the government’s
intervention is not limited to mere information, but the imposition of clear rules (e.g. seat belt
wearing, compulsory primary education, etc.). Such goods which the State’d intervention
requires us to "eat", are called "merit goods".
Economic theories support the idea that in case of the welfare state, in the absence of
market failures and merit goods, the state should intervene only in redistributing income. But
if market failures occur, then the state must intervene to correct them. However, there are two
aspects that deserve consideration. First, it should be noted that at least in theory, a way to
make a good intervention is without harming someone else, this term referring to "Pareto
improvement" (Stiglitz J. E., 2000, p. 91), and secondly, it should be noted that the current
system of state organization is able to correct market failures and achieve Pareto efficiency. In
this respect, there are two approaches, namely: the normative approach that focuses on what
government has done and the positive approach based on the description and explanation of
methods of state intervention and the consequences of its action. In reality, there is a pretty
big difference between government policy and what it is intended by the policy or program
and how it was designed for implementation. The link between institutions must help to
implement a real program and the program objectives can be inferred from the way the
program is formulated and implemented, and then by comparing them with the objectives
stated in the regulations that provide the programs necessary for recognition to be
implemented.
67
The controversy on positive and normative approach has a tendency to give greater
credit to the positive approach; most economists say they should pay more attention to
describing the consequences of government’s programs, the typology of political processes
than on what the state should do. In addition, it is necessary to make an analysis of the
institutional arrangements by which the policy decisions are formed and how they affect the
formulation and implementation of a program.
The existence of market failures shall be a motivation to correct these failures, but it
does not mean that a government program designed to correct market failures is necessarily
desirable
and
also
that
it
is
the
only
way
to
correct
that
failure.
Thus, in order to evaluate a government program it should consider not only its proposed
objectives, but especially how this program is implemented.
3.5. Market failures and the public sector
The State’s intervention in certain sectors of the economy is beneficial to adjust the
imperfect market mechanisms. I also said that the state intervenes to provide certain goods
and services that can be provided by the private market. These goods and services are known
as public goods.
State intervention through the provision of such goods is not always the best solution to
complement the private market failure to provide certain goods. Thus, in some cases even
when the state "fails" to provide these goods, it is forced to seek for the private market to
provide them: services such as sanitation, water supply, infrastructure, which although they
are considered public goods they are offered on the market by private companies. This is
because a higher efficiency is achieved in the provision of such goods due to increasing
competition between companies operating to provide that good, so the company having this
opportunity is in a favored position on the market. The possession of a privilege by a firm on
a particular market segment which is positioned in an efficient economy is preferable to the
situation where the state has complete monopoly on this market. (Samuelson P., Nordhaus
W., 2001, pp.319-335).
This is preferred as under a tendering procedure, a private firm to provide this type of
goods and services for a certain period of time. Thus, if the company that wins the tender
doesn’t fulfill its contract for providing goods and services of maximum quality and
efficiency and effectiveness, then it is unlikely to continue with it after the expiration date of
the contract. So, in comparison with a situation where only the state provides these goods, it
68
would have a permanent monopoly, but by providing them by a private company that
monopoly is not guaranteed indefinitely and it is subject of effective work.
If public goods state always ignores current market demand. There is a certain
category of goods that are offered to the public even if there is no specific request for them.
Examples of such goods are the mandatory education, issuing of IDs, etc..
Also there are some goods that are offered first as public goods and then, because of
the diversification of needs and of the increasing demand for these goods, the private market
interferes and provides these goods. The appropriate pension system in Romania. In Romania,
today, there is a public pension system which can be supplemented by a private financial
opportunity. There is however a proposal to shift from the public to the private pension
system.
As noted above, the public market "fails" also in providing certain goods and services.
The society keeps growing and becomes more and more complex, so the needs are
increasingly diverse and constantly growing. The public market offers the goods and services
that meet the widest possible market area. But it is difficult to standardize all the needs of
increasingly complex people to offer goods or services accordingly. Marketplace cannot
satisfy the entire demand for goods and services.
It should prioritize these requests and include them in certain categories. Special needs
such as child protection, disabled persons can be provided by the public sector to the extent
required, so that the NGO sector intervenes to complete the public market, as the private does
not provide services which are not profitable.
Another issue that worth addressing is the "economies of scale". The public sector is a
very important concept and requires a good collaboration between several governmental
levels. Take for example a service or a public good, such as the introduction of local heating.
Such investments involve high costs for that area in preparing implementation. The highest
costs for such a project are fixed costs. If the administration of this locality would associate
with other nearby towns for the service to be offered at a larger scale, the initial (fixed) costs
of this investment would be lower for each of these localities, because the costs are shared
between more.
Such economies of scale are generated by providing goods or services to a larger scale
to reduce fixed costs. Economies of scale once again demonstrate how the action of a single
individual - in our case a local government - is less efficient than if it acts in collaboration
with other individuals (local government). Hence the need for better organization and
collaboration between all administrative levels in order to satisfy public needs as effectively.
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Homework :
1. How you define market failure, efficiency and equity?
2. Highlight the contradictions between efficiency and equity.
3. Which are the categories of market failures that lead the state involvement?
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CHAPTER 4
PUBLIC GOODS, PRIVATE GOODS, EXTERNALITIES
Objectives:
∆ Explanation notions regarding public goods, private goods, externalities
∆ Highlighting the types of externalities and goods
∆ Presentation of methods to provide public goods
Key words: public goods, private goods, externalities, common good, the taxable good
4.1. Aspects regarding public goods
The concept of public good is used in various forms in the literature (pure and impure
public goods, collective public goods, social goods, common property, property tax,
international public goods, national and local goods, mixed goods,) "clubs" goods, "joint"
goods, but the most commonly used form is the public good. To better understand this term of
public good, we will study each word separately.
Good as an adjective comes from Anglo-Saxon word “good”, which means on the one
hand, the sample and on the other hand enjoyed, pleasant4. As a noun, it refers to goods and
personal property 5.This term was also used as detrimental good6, an example is pollution 7.
Public comes from the Latin publicus8 , meaning adult, which in our case is related to
citizens. Also, this term designates belonging to a state, to a community as a whole. The word
public also refers to things that are available to all. On the other hand, the opposite of the
word public, private9, comes from the Latin “privation” and means to dismiss. This word has
a significance which belongs to the state, the public. If you associate the two terms, they
designate goods, benefits that belong to all citizens, or community.
4
Webster New International Dictionary of English Language, 2nded, Unabridged. Springfield, MA:GC Merriam
Co,1942, pg.1078;
5
Webster’s II New College Dictionary, Boston: Houghton Miffin Co, 1995, p.480;
6
Musgrave RA.- “The nature of the fiscal State: the roots of my thinking, In Public Finance and Public Choice:
Two Contrasting Visions of the State, EDS. Cambridge, MA:MITpress,1999, p.41;
7
Hyman DN-“ Public Finance: A Contemporary Application Of Teory to Policy, Ed a &-a, Fort Worth,
TX:Harcourt, 2002, p .136;
8
Webster New International Dictionary of English Language, 2nded, Unabridged. Springfield, MA:GC Merriam
Co,1942, p.2005;
9
Webster’s II New College Dictionary, Boston: Houghton Miffin Co, 1995, p.895;
71
Some authors define public goods as those “goods which are given by the public
sector “(Ulbricht, 2003, p.67 and Heikkila Ej, 2000, p.103). Randal G. Halcombre defines
public goods as those “goods that are produced by public sector”(Halcombre, 1996, p. 96).
Goods are not rivals, meaning that an additional person can consume without reducing
the product for another consumer benefit. Once the product or service is produced, the
marginal cost of an additional consumer is 0. Public goods cannot be excluded, meaning that
if a person consumes a good, it does not reduce the possibility for that good to be consumed
by other people, because the consumption of such goods does not get right on their property.
The traditional example of a good that has both properties is the national defense. Haveman
defines public goods as those “goods which are not subject to exclusion principle” (Haveman,
1970, pp. 26-27).
Once a region is protected, in that region there is no additional cost when others
appear there as an individual or a person in the region cannot be excluded in order not to enter
the protection program. Another example is the lamp used to guide ships. Once a lighthouse is
functional, a new ship may be further guided by the light lighthouse, besides those already
using it. It can be very expensive (if not impossible) to impose a fee for vessels that use
lighthouse. Sidgwic (1883) in his book "The Principles of Political Economy" was the man
who invented the “lighthouse example”, as a public good. (Papandreou, 1994, p. 27).
If a good is not rival to another, the marginal cost of adding a consumer is 0, then the
efficiency has a value 0. Of course, a 0 price will not be a revenue to cover the fixed costs, so
the property assets will be provided in an effective amount by private firms. Examples of
goods that are not "rivals" include a range of goods such as a uncirculated street, bridge, park.
If a park is not busy, then another person can use that park without diminishing the fun and
benefit of another person.
It is obvious the governmental potential in providing non-rival goods. Its task is to
collect revenue to cover the fixed costs of services (cost of developing, operating, park
operation), while maintaining the price for each use of the park equal to 0, which is equal to
the marginal cost. The Government may use general taxes to pay fixed costs and because the
general tax does not depend on the use of the service, by paying the price each use is 0. It is
important that public goods could be found as non-rival as in the special case of externality. A
non-rival good for which a consumer may be added at no cost for others is a good of special
externality. A non-rival good for which a consumer may be added at no cost for others is a
good of beneficial externality. Everyone can benefit if a consumer provides a non-rival good,
such that the benefit externality is high compared to the private benefit reached only by buyer.
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From this perspective, in sense of efficiency, the major difference between a non-rival good
and an external benefit is the relative impact of private versus public impact.
In the classical approach, public goods are those goods in particular that everyone has
access, meaning that consumption of the good by a person does not bother other people
consuming it (Samuelson P. 1957, p. 387). “Goods have a particular potential to be public, if
they are non-rival and non excluded” (op.cit. Kaul, Mendoza, 2003, p.87). Goods are in fact
public if they are not excluded and can be consumed by everyone. (This definition tries to
draw attention to the temporary property assets. Some may belong to the private sector today
and tomorrow this situation may change. Public goods are not market failures and are not
really produced only by the state. The consumption of public goods can be volunteer: some
may want to watch a sunset, some not. In other cases the contrary is required, if we think
about traffic rules) (Kaul, Mendoza, 2003, p.88-89). Sandmo believes that “a state that works
well is a public good” (Sandmo Agnar, 1987, cap.4).
Stretton and Orchard believe that the goods are called public because “they cannot be
given to anyone without being available to all, and users of these goods may have to pay for
them. These are goods that can be offered by the market, while others are provided by the
state at very low or no cost: education, public transport. There are also goods that usually are
not taxable: bridges, weather forecasting, public libraries, national parks” (op.cit. Stretton,
Orchard, 1994, p. 54).
When making the distinction between public goods and private goods, we must first
explain the economic significance (which means the market) of the word good (product). The
word "good" by definition involves the economic concept of scarcity on the market - both the
public and private – as we refer to goods when it comes to rare goods and not the free (which
are on the market in unlimited quantities and for which not have to pay any price to get them,
e.g. air, ocean). Scarcity of goods is the feature that gives them a certain amount and makes
consumers to abandon part of their income to get them. The production of goods is thus held
to the needs and preferences of consumers and the value that they give to the goods (value
that materializes in the price paid). Such market producers produce those goods in such
quantities so they meet the consumers’ needs. But the market occurs and the need for goods
(Note: When referring to goods we include services also) in whose production no one is
interested (because the costs are very high and the income very low or absent) e.g.
environmental protection, even if on the market offering these goods the requirements are too
high for it to cope, education also.
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I remember at least two reasons for the state’s intervention in providing certain goods
and services on the market, referred to public goods, but perhaps the most important reason
for the need for the supply of goods by the state is the very special nature of certain goods,
namely those services and goods relating to security and safety of the individual that any rule
of law must ensure.
What would happen if issues of national defense, personal protection services (police,
army) would be left to the private market? The decisions are taken on the amount of the
services offered, the price of such services and to whom they should be offered, how long and
in what time they can be left at the discretion of the decision makers from the private space,
but not on the citizens’ demand.
As we have already argued about the need for public goods, it is necessary to have a
brief clarification of the two types of goods: public goods and private goods. If you make a
more detailed analysis of the public and private property, it can be observed that the
distinction between the two is not always very accurate and also on the market these two
types of goods are often in a complementary relationship.
Thus, we can say that we have goods on the market that are offered for the public and
social interest and it is normal that the state holds monopoly in providing these goods
(defense, police, nuclear plants, etc..). But there are goods and services most of which are
offered by the public and private sector involved in their production and supply. This is
caused by the increasing complexity of the development needs of its society. Thus the public
sector cannot meet the growing needs of the public, and the private sector comes to fill them
(e.g. providing fixed telephony services, central heating as an alternative for central heating,
etc..). There is also a situation where the private sector is the one that anticipates and meets
the needs of their citizens as a better alternative to those offered by public service (e.g. the
pension system where citizens can choose between private and public).
Another issue related to public goods is the amount of these goods to be offered to the
market. How does the government know how to provide national defense and many health
services? The private market is determined by the market demand, but in the public sector this
problem cannot be left to citizens as they are not allowed to make such decisions that affect
the society. In addition, there are public goods and services for which there is a clearly
expressed demand but they still exist and must be provided (population). The problem of
public goods and services, related to when, who decides, how and at what price these goods
are offered will be subject to a later chapter.
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Also, just for a good distinction between public and private shows and not by what is
offered in the market sector. It can be considered a public good offered by the private sector
(health services are generally offered by private companies, although the problem in a
community clean is public). On the other hand, a private good can be provided by the public
sector (health care).
4.2. Types of public goods
As previously mentioned, public goods are those goods which meet two conditions:
they are non-rival and non-excludable. These two concepts allow us to differentiate public
goods from other categories of goods.
As a general rule, 4 categories of goods can be delimited (op.cit. Trogen, 2005, p.176178):

“Public goods;

Private goods;

Common goods;

Taxable goods.”
Non-rival goods in consumption
Rival goods in consumption
Excludable goods
Taxable goods: cable TV, various courses
Private goods: chewing gum, juices
Non-excludable goods
Public goods: National Defense, radio Common goods: fish, air, water
waves, fireworks, lighthouses
Public goods are non-rival and non-excludable in consumption. Examples: fireworks,
lighthouses, National Defense (Buchanan, 1970, p. 25), the justice system (Mikesell, 1995, p.
4), air waves (Halcombre , 1996, p. 97), environment protection (Buchanan, 1970, p. 26),
public lighting (Stretton, Orchard , 1994, p. 54). Such goods can be used by more citizens at
the same time. It is also impossible to prevent the citizens who don’t pay for these goods to
use them.
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Private goods are opposed to public goods, in the sense that they are rival in
consumption and excludable. Mikesel mentioned “food and clothing among private goods”.
( Mikesell, 1995, p. 4). Most of the private goods are sold on the free market. Most of the
goods sold on the market are private goods. Such an example is the coffee sold at the vending
machine. Coffee is a private good in consumption because only one person can drink from
one particular cup and also it is excludable because you must pay for the coffee at the vending
machine in order to be able to drink it.
Common goods are rival in consumption but non-excludable. An interesting definition
is given by Steiner (1974): “any collective good delivered publicly is a public good”.(Steiner,
P.O,1974, p.247) A more detailed approach to the concept can be found in Adrienne Hertier’s
book „Common Goods Reinventing European and International Governance”. The first
chapter treats the subject of public goods at length. The author defines them by making a
distinction between the sociological definition of ”welfare”, which does not refer to the
individual but to the social system. Common goods are generally considered a subcomponent
of “public welfare”.(Mayntz, 2002, p.15-29) Mankiw uses for instance the idiom “common
resources” when referring to common goods.(Mankiew, 1998, p. 227) Such goods are
numerous and accessible, which makes them non-excludable. The difference between
common goods and public goods lay in the fact that common goods are rival in consumption.
Examples of common goods: “fish in the ocean, environment (ibidem), crude oil reserves”
(Mikesell, 1995, p.4).
Taxable goods are non-rival in consumption but are excludable.(Weimer D.L., Vining
A, 1999, p.80) An alternative term may be the natural monopoly. Examples: cable TV, toll
bridges. They are exclusive because if you don’t pay the toll you cannot cross the bridge.
Pure Public Goods, Impure Public Goods and Impure Private Goods Table
International Public Goods
Pure Public Goods
National Public Goods
Local Public Goods
Impure Private Goods
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Excludable Public Goods
Impure Public
Goods
Congestible Public Goods
Mixed Public Goods
Impure Goods
Impure Private
Goods
Private Goods with Externalities
Mixed Private Goods
Private Goods Publicly Delivered
Pure public goods, in their classic form, meet two properties: “non-rival benefits and
non-exclusion of debtor”. (op.cit. Sandler, 2003, p.132) “Pure public goods can be defined as
goods for which only the public dimension is relevant”.( op.cit. Shmanske, 1991, p .99). “Pure
public goods “are the kind of goods and services non-rival in consumption and for which
exclusion is impossible”. The consequence of such non-rivalry is that “there is no additional
cost for any additional consumer”. (op.cit. Stiglitz, 2000, p.128, p.132).
“This type of goods is available for all members of the society. One product unit
produced delivers more units for consumption, which are somewhat identical. Non-exclusion
is applied in extreme cases. Additional consumers can be added at a zero marginal cost. This
definition is restrictive and therefore criticized by many economists”. (op cit. Buchanan,
1968, p.49) “The National Defense” (Musgrave, 1986, p. 49) is probably the best example of
pure public goods.
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Pure public goods are divided into:
 International Public Goods;
 National Public Goods;
 Local Public Goods.
International Public Goods. While the last two words were defined at the beginning of
this chapter, it remains to study the term „international”. In a broad sense, the term suggests
that the entire world population benefits from those public goods. In a narrow sense, things
are completely different. Let’s take malaria for example. In practice, for most people the risk
of being infected with malaria is almost zero. The conclusion Oliver Morissey, Dirk Willem
Te Velde and Adrian Hewitt reached is that (an International Public Good is a benefit which
delivers a utility available in principle to everyone on the Globe). (Morissey, Dirk Willem te
Velde, Hewitt, 2002, p.34-35). International Public Goods include, among others:
environment, knowledge, international security.
Environment protection is an issue discussed more and more often; considering that
societies’ demands are perpetually growing , wood exploitation is often impossible to control
(as a sole example, we can consider Romania’s deforestation process in the past 15 years), air
pollution is continually rising and the global warming is no news any longer.
International security has become priority especially after the events on September 11,
2001 and the 2004 bombings in Spain. When considering USA’s example alone, it is clear
how much damage can the international insecurity determine.
Knowledge may very well be the most common non-rival good. Millions of people
benefit from discoveries made thousands of years ago (fire, wheel). Such knowledge is also
non-excludable because the society does not pay for such innovation.
National Public Goods. National Public Goods are pure public goods, non-excludable
only within the borders of the respective country. Public goods include: national defense,
justice, and education. Such goods are non-excludable and non-rival only for the people in a
certain country. More often than not, several countries may benefit from the advantages of a
national public good (e.g. nuclear security), or on the contrary, they may feel threatened
(countries neighboring the ones in conflict).
Local Public Goods. These are pure public goods because they are non-rival and
everyone must pay for them. Pure public goods only refer to a determined area. For instance,
a theatre in open space is a pure public good, but others may also benefit, such as the people
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living in the area. Local public goods are available to people without them having to pay a
certain price but with the condition that they benefit from them. Of course, there are
similarities, as well as differences between international and local goods; it is why some may
tend to include a certain product within local goods and others may consider it to belong to
international goods.
However, local public goods are completely non-rival and non-
excludable.
Impure Goods are divided into:

Impure Private Goods;

Impure Public Goods
Pure Private Goods are fully rivals in consumption and at the same time they are
excludable, because those who don’t pay for such goods may not use them. In the category of
pure private goods we can include: a pair of socks, a piece of chewing gum, a cup of coffee
from the vending machine. Such goods are rivals in consumption because they can be used
(consumed) by one person at a time; they are also excludable because one must pay in order
to use them. In conclusion, pure private goods may only be consumed by those who pay for
them.
Impure Public Goods. Different economists have proposed various alternatives to
these less pure goods: impure public goods, mixed public goods. Each of these alternatives
somehow infringes the conditions a good must fulfill in order to be called “pure”.
Public Goods can be divided as it follows:
♣ “Excludable Public Goods. They are public goods that can be excluded.
An example of excludable public good is “club” good” (Buchanan,1965,
pp.1-14). ,”Club goods are non-rival goods that are available only to the
members of this club”(Cornes, Sandler, 1986, p.24). The distinction
between the “,club” goods and the local goods is the fact that local goods
are available to those that wish to consume them and the ,,club” goods are
available only to the members. The concept of ”club” goods will be
detailed in the following pages. Halcombre said that an example of a
”club” good is a pool maintained by the residents of a building
(Halcombre, 1996, p.122), while Rosen reminded about surrounded
communities which are in fact many houses on a certain surrounded area
where the access is granted only to the residents (Rosen, 2002, p.475).
Another example could be the “broadcasting of a TV program”. This
program can become an exclusive one if transmitted by cable.
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♣ Congestion Public Goods. These are public goods that are non-rival if
moderately used but become congestion goods if contrary (e.g.: highways).
Each additional user adds another cost (Hyman, 2002, p. 139) to another
user.
♣ “Mixed Public Goods. Public goods can be combined with other types of
goods, resulting impure public goods. An example of this kind of good is
the radio commercials. Radio programs are both non-rival and nonexcludable. They are non-rival because it can be listened by everyone
without restrictions (compared to a program listened by a person that
cannot be listened by someone else.), and non-exclusive because it can be
searched without paying something in exchange. All in all, radio
commercials are rival private goods and non-exclusive. Radio commercials
are exclusive from the point of view of the one that makes the publicity.
Two commercials can’t be transmitted in the same time on the same
program. At the same time, they are exclusive because if the one wishing to
benefit from the commercial doesn’t pay the radio program for the time
dedicated to his publicity, the commercial will no longer be broadcasted.
The mixed good is created when we have a good that is private and for
those that make publicity and another one that is dedicated to the listeners.
So we can say that the ones that make publicity are indirectly paying for a
public good” (op.cit. Trogen, 2005, p.189-199).
Impure Private Goods are the most rarely used goods. As we all well know, pure
private goods are completely rival in consume and completely exclusive. So a private good
becomes impure when each of its characteristics are not accomplished.
Impure Private Goods are classified in the following way:
♦ Private Goods with externalities. The concept of externality was
discussed at the beginning of this chapter and we are not going to present
again the issue of defining externalities. An externality appears every time
a transaction between two actors sets the costs or benefits for a third actor
that is not a participant at the transaction. If we think about negative
externalities we can say that a cost is imposed to a third actor. Negative
externalities are a reason for state intervention in order to establish a
control upon the negative phenomenon. This is why a transaction is not a
pure private one, a statement that is also true in the case of positive
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externalities. In the case of negative externalities some people activities
generate cost upon another. The result is inefficient allocation of resources
because the resource is overused. The measures that can eliminate negative
externalities are taxes.
In the case of positive externalities the situation is different and that’s why
the activities that generate them are encouraged trough grants in order to
obtain an increase of their production towards the optimum level.
♦ Private Mixed Goods. They are similar to public goods but begin as
private ones. If we intend for instance to eradicate a disease trough
vaccination we can say that this is a private good because the vaccine is
rival and non-exclusive, but the result of that vaccine becomes public
because it is non-rival and non-exclusive.
♦ Public Provided Private Goods. It is a good provided by the state rarely.
An example could be the houses provided by the state. It is a rival good in
consumption and on the other hand exclusive because if the residents don’t
pay the rent for their house, they lose the access to that good.
4.3. Different Categories of Public Goods:”Club Goods” and ”Joint” Goods
As we reminded before the ”club” goods are non-rival goods that are available only
for the ones that are part of a certain ,,club” (Cornes, Sandler, 1986, p.24). The origin of the
”club” theory comes from Pigout (1920) and Frank Knight (1924). Both authors took into
consideration two examples: a crowded road, without potholes and well maintained but very
narrow and another one not crowded, wider, with multiple lanes but of poor quality and with
potholes. Both of them solved the ,,clubs” problem by restricting the access on congested
roads. Charles Tiebout (1956) shows how the size of local authorities’ jurisdiction can be
determined. In the Tiebout model, the amount of public goods that must be shared is precise
and distinct for each local community. Tiebout specified the fact that a decentralized decision
mechanism can reach Pareto efficiency for public goods.
This model is similar to the situation of mixed population, where individuals are
divided into clubs with homogenous members. In the case of private goods, Wiseman (1957)
examined the clubs principles in which they highlighted that “the costs of those that benefit of
utilities are divided”. Tiebout and Wiseman were the first researchers that concentrated upon
the rational division of the costs in the clubs situation. The most recent research referring to
clubs was realized by Mancur Olson (1965) and Buchanan. Olson made the distinction
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between total and unique clubs. The general ones (pure public goods) have no restrictions
regarding the dimension while the unique ones (impure public goods) have restrictions
regarding their dimension. Olson didn’t use the term of club for a collective. Buchanan wrote
over 200 articles on the subject of ”club” goods. In his work Buchanan talked about both the
goods providence in the case of clubs and the conditions that have to be accomplished in
order to be a member of the clubs (impure goods situation). The research of these great
authors regarding clubs theory was completed by other authors like Tollison (1972), DeSerpa
(1977), Artle, Averous, Helpman, Hillman and Sandler. (Cornes, Sandler, 1986, p.161-163)
In conclusion, we can find multiple connections between the public and the private
sectors. A good can be produced in some cases both by the public sector and the private one
(e.g.: public and private education). In other situations, a good can be produced only by the
private sector (e.g.: clothing, food) or sometimes only by the public sector (laws, park
maintenance, streets cleaning, national defense). Solving the congested streets problem the
”club” problem was also solved by establishing some rules regarding the access.
4.4. Optimum Provision of Public Goods
Samuelson was the one that promoted the optimum providence model for public
goods. His work was influenced also by Wickesell and Lindhal. Samuelson argued that in the
situation that we take two goods (A and B) where one of them is public, the optimum
provision requests that:
MRS PpA+ MRS PpB=MRTSPp
where:
RMS- marginal rate of substitution;
MRTS - marginal rate of technical substitution;
P-private;
p-public;
A- good A;
B- good B;
The only difference from the Pareto’s optimum is the fact that goods A and B are private.
MRS PPA+ MRS PPB=MRTSPP
Brown and Jackson (Brown, Jackson, 1990, p. 90) come with a schematic derivation
of the conditions proposed by Samuelson. The efficiency conditions proposed by Samuelson
are restrictive from some points of view, because (op. cit. Howard, 2001, p. 14):
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 “The model supposes the existence of one person that knows how many taxes is
a certain person willing to pay for public goods.
 The model makes suppositions in connection with individuals’ preferences
without taking into consideration the”free-rider” problem.
 The model is the subject to information failure because the cost of collecting
information in a larger group will be prohibited”.
The efficient production of public goods can be demonstrated by remembering that in
conditions of competition, companies produce towards the point where the price is equal to
the marginal cost. The demand curve shows the marginal cost at each level of a certain good
production level:
MRS AB=MCA/ MCB.
MC – marginal cost;
where:
MRS- marginal rate of transformation;
A, B goods.
Because the price of good B PB=1 Leu and the price equals the marginal cost then
MCB= 1 Leu, and MRS
AB=MCA
so we can identify the marginal rate with the marginal cost
which is the same with the demand curve.
When referring to common market, the efficiency conditions should look like (op. cit.
Head, 1974, p.74-75):
“RMS A+ RMS B=MT
For private goods:
Px=MCx,
And for public goods: PYA+ PYB=MCY, where PYA şi PYB are the prices of the goods for
people A and B, and are chosen so that:
RMS YxA= PYA/ Px, and
RMS Yxb= PYB/ Px
As a result we have: RMS A+ RMS B= PYA+ PYB/ Px= MCY/ MCx=MT”
The approaches for providing public goods of Lindh's and Wickesel were based on the
principle of tax benefit, which established that citizens have to pay taxes related to the
benefits they experience from consuming public goods.
There are two ways you can get resources for the production of public goods:
 the voluntary agreement and
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 the compulsory taxation – which is a method often used in the production of public
goods.
The voluntary agreement is a method rarely used in the production of public goods, not
widely used in practice. The problems that occur with this method are related to the fact that
individuals tend to hide their assessment of the public good, so in this case they are
considered non-beneficiaries, thus not obliged to pay. In this situation, they are called illegal
beneficiaries.
The approaches related to the exchange on a voluntary basis were first identified by Knut
Wicksell) who claimed that each public good should be funded by a separate tax, and
secondly that the unanimous agreement of all members of society should be used in the
production decision (what and how) for a public good. Lindahl was the one who developed a
replacement, by making a correlation between the tax rate and the size of the public good.
According to this model, an equilibrium is reached when each individual pays a fee (tax)
equal to the marginal utility afforded that good. The voluntary exchange shows that each
individual consumes the optimal amount of public good to a given tax rate. Unfortunately, in
practice, such a voluntary agreement is complicated by the possibility that individuals do not
express their real preferences and become illegal beneficiaries of the public good.
In Musgrave's conception (Musgrave, 1985 p.13), the Wickesel model starts with a fair
distribution of income to arrive to an efficient and fair distribution of income. On the other
hand, Linhdal's concerns were directed to determine the balance to reflect the tax that is fair
and the output of public goods. This equilibrium is based on the fact that people say the true
preferences, but the problem is to tell these preferences for large groups.
The Tiebout model uses the following assumptions (Tiebout,1990, p.569):
 “The governmental activities don’t produce externalities;
 Citizens are fully mobile and are ready to move to other communities to satisfy
preferences. Each person can move to a community where the public services are
better. On the other hand, every citizen is free to find a job wherever they wish, with
no restrictions on where to settle.
 Citizens have the perfect information about income and expenses related to public
services and community taxes.
 The number of local communities is large so the citizens would find a community to
meet their requirements for public services.
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 For every pattern of community service, which is guided by the preferences of older
people there is an optimal community size.
 Communities that are undersized are trying to attract new residents to a lower average
cost. Those below the optimum size shall reverse and those trying to maintain the
optimum size constant population”.
Oakland has shown that the efficiency conditions for public goods can be applied to the final
intermediate public goods. Public goods “are intermediate inputs in the production of private
companies that produce goods for citizens. According to Oakland's model, each firm produces
the same private good using public intermediate goods, which is the subject of non-rivalry in
its use with another company. Efficiency is obtained by adding the marginal evaluation of
companies using the public good inputs. Sandler and Tschirhart also argued that the theory of
"club" can be used to determine the optimal size of a community, while Buchanan said that a
club is divided between benefits and costs” (op. cit. Howard, 2001, p. 15-16).
This chapter attempts to give an overview of public goods on the one hand, and on the
other hand of externalities, presenting how each author approaches the concept of externality
and public goods. Also in this section there is a classification of externalities and public
goods. Of course, the issue of externalities could be discussed more, but the purpose of this
chapter is only to give a picture of the two notions.
4.5. Externalities
The processes taking place both in the public and the private production and
consumption generates some effects known as externalities. Externalities can be defined as
"when the activity of an agent brings the market costs or benefits of another agent acting on
the market independent of their will"(Fisher, 1987, p.30). The proper term of externality was
first used by Alfred Marshall in "Principles of Economics". He recalled on one hand the
"external Economies", and on the other hand the "internal Economies". Marshall referred to
"external Economies" reminiscent of goods which are dependent on the general development
of industry and the "internal Economies"(Marshall A , 1920, p. 266) reminiscent of those
dependent on household, business, and also their management efficiency. Marshall and Pigou
were those who argued that "forces" of the market cannot rely solely on the efficient
allocation of resources and the subsidized industries increase the optimal outputs. “Of course,
over the ideas of Marshall and Pigou there have been various criticisms and additions,
mentioning only Clapham, Robinson, Young, Knight, Viner. Clapham did not agree on the
value of sorting industries. Marshall spoke of "external economy" as a general development
85
of industry associated with the entry of new firms. Allyn Young (1913) also raised doubts that
the demand curve (oblique) would be a question of competitive balance Abarim the social
optimum. Knight (1924) also shows that decreasing returns are not a concern. This example
shows that the optimal choice between two roads, which is basically a case of free choice of
limited resources. Viner was the one who divided externalities into two types: pecuniary and
technological”.( op cit. Papandreou, 1994, p. 27).
Buchanan and Stubblebine gave an operational definition and easily usable to
externalities. They define that an external effect, an externality occurs when
UA= UA(X1, X2, ..., Xm, X1)
“Thus, the usefulness of an individual, A, depends on the activities (X1, X2, ..., Xm),
which are exclusively under his control or authority, but a single activity, Y1, which is by
definition, under the control of another individual B, which supposedly is in the same social
group. Warren Samuels (1972) interpreted the definition of Buchanan and Stubblebine in a
general sense and described the externality as a general interdependent”(op cit. Papandreou,
1994, pp. 35-36).
Using the terminology from Pigou, where an externality is present there is a
confrontation between private and social costs. Dahlman interprets this definition by stating
that although all voluntary contractual arrangements entered the market through various
transactions, some transactions remain to be internalized. Without any interference in the
price mechanism, some beneficial transactions were not made. Since market forces are unable
to eliminate market failures, the state’s action is needed. The state may cause firms to take
into account the effects caused by them. The question that may arise in this case is why are
those actiions on the market incapable to determine the issuer of externalities to internalize
the costs of its actions? The answer is that the transaction’s cost is higher than the expected
benefit (Dahlman, 1988, p.209-210).
Externalities also indicate the presence of transaction costs. The transaction cost was
first introduced by Coase and Pigou. It is well known the Coase's article (1960) "The Problem
of Social Cost"(Coase, 1960, pp. 1-44). It seems that the economist Coase has not made any
connection between the concept of externality and the problem of social cost in his works.
In order to better understand
the concept of externality, Andreas Papandreou
presented this concept from various perspectives (op. cit. Papandreou, 1994, p. 44-45):
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 “Externality seen as an environmental aspect. The externality seen as from an
environmental perspective was very much discussed in the early 1960s. The
association of externality with pollution created the idea that externality was a
distinct category of this phenomenon.
 Externality regarded as an aspect of Balance - General. Many economists have
viewed the problem of externalities in terms of Balance - General. This led to
the notion of "missing markets", trying to achieve a more rigorous
classification of market failure. Externality is seen primarily as a cause of
market failure.
 Externality regarded as an institutional aspect. This concerns various issues
related to training institutions. Many economists needed to create models in
this respect for answering specific questions on this issue”.
Baumol and Oates presented a definition of externality, which is made up of two
conditions (op. cit. Papandreou, 1994, p. 46-47):
• “An externality is present whenever the utility of different individuals (I) or production
relationships include real variables (non-monetary, whose values have been chosen by
corporations, individuals, State, without giving attention to individual welfare effects (I)”
• “The decision-maker whose activity affects others' utility levels does not receive any
financial benefits from such activities, and there results an amount equal in value to the
marginal benefits.”
The two conditions were used by authors wishing to make a clear distinction between
the notion of externality of different types of inefficiency. Baumol and Oates emphasized that
the first condition determines the existence of an externality, while the second condition is a
combination of the concept of externalities with that of inefficiency.
On the other hand, Buchanan and Tullock use the term externality with different
meanings ( Papandreou, 1994, p. 58-59):
o (They equal externality with the general interdependence: any potential impact that the
decision of an agent has on another agent is an externality.
o Second, they equal externality with the inefficiency, or the potential benefit of trade,
as the private voluntary behavior is a way to eliminate the externality.
o Third, the major externality’s costs and benefits (direct or indirect) differ by the
presence of general interdependence.)
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An externality occurs whenever an individual's action affects the utility of another
individual. As we will see in the following pages, externalities are of various types: positive,
negative, pecuniary, non-pecuniary, marginal, inframarginal, Pareto relevant or irrelevant, etc.
An externality occurs when the action of an economic agent affects the economic situation
of another agent, independent on the changes in price or the market production. Externalities
can be positive (when they generate gains to the other agent on the market) and negative (case
in which it will increase his costs).
Pollution, for example, is the most common form of negative externality. Pollution of a river
causes negative effects and costs for those who use the river’s water. These costs were not
projected because their existence was not
Types of externalities
Positive externalities
Negative externalities
Producer-producer externalities
Producer – consumer externalities
Consumer – consumer externalities
Monetary or pecuniary externalities
known, but they must be covered by the
same amount of revenue. Here is where
the state must intervene. It is not normal
that the action of an agent should produce
adverse effects on others, to generate cost
and that economic agent to profit from its
activity without taking into account other
costs they incur. The State tries to balance
this disparity. The state imposes taxes on
the polluting agents which reduce the
effects of pollution and other costs of the
Technological externalities
Marginal externalities
agents on the market.
But there are positive externalities that
make the work of an agent have adverse
Inframarginal externalities
Positive and Negative inframarginal externalities
effects on other agents on the market
without having them to pay something for
these benefits. But the activity through
which the economic agent generates certain benefits, involves some costs that are not shared
with others who benefit from its activities.
For example, if a person installs a device in the yard to kill the mosquitoes, it kills the
mosquitoes in the area, so the person's neighbors will benefit from the effects of this device
(Example from Rosen, 2002, p. 81). This example of positive externality can be used to
highlight the difference between a positive externality and public good. If in the example
88
above the mosquitoes killing device is installed throughout the community then there is not a
positive externality but a public good. But if only a part of the community (neighbors)
benefits from the effects of this device seems, there is a positive externality. In reality, it is
quite difficult to make a clear distinction between public goods and positive externalities, but
this distinction has a practical importance.
Externalities can make an activity ineffective, because costs or external benefits
generated by a company are usually not considered. While generating costs (the case of
negative externalities), the producer or consumer underestimates the social cost of that
activity and offers, in terms of society, too much of that activity. In the case of positive
externalities the situation is reversed: the producer underestimates the benefits he produces
and those benefits are not taken into account so that it will produce less than the population
requires.
It should be noted that externalities are not only produced by companies carrying
business on the market, but also by individuals (as shown in the example given above about
positive externality).
The so called internalization process of these effects may reduce the effects of externalities.
This means that some of the costs they generate on others, the activity of an agent to be borne
by the agent that it generates. This can be done by the state through financial mechanisms,
namely, imposing a tax on the activity that produces negative effects on other economic
agents. Thus, money from these fees will be used to reduce negative externalities caused by
that economic agent or individual.
The effects of externalities’ internalization may also take place in the case of positive
externalities. In such case, state intervention ensures that part of the benefits generated by an
agent for the activity of other agents on the market return to the generator agent. However,
here the state uses a financial mechanism different from taxes – it subsidies various tax
reliefs.
Three major types of externalities are presented below (Howard M, 2001, p. 18):
1. (Producer on producer externalities – it appears when a company’s inputs
and outputs affect a different company, without expressing the cost of it. A
hotel placed on the beach may affect marine resources as well as fishing
industry.
2. Producer on consumer externalities – when a consumer’s functional utility
depends on the producer’s output. This type of externality rarely occurs in
89
practice; however, a good example would constitute noise pollution made
by airplanes.
3. Consumer on consumer externalities – when a consumer’s activity affects
another consumer’s utility, without expressing the cost of it.)
Dasgupta and Pearce also talk about pecuniary externalities and technological
externalities (Dasgupta A.K., Pearce D.W.Pearce, 1972, p. 120). We talk about pecuniary
externalities or pecuniary effects on a different industry if the products made by the two
industries are related to each other. For a better understanding of the concept, let’s consider
the sunflower. A big production of sunflower oil will lead to price decreases and to substantial
changes on olive oil market and other vegetable oils markets. Technological effects may
appear for example if the pesticides used on the land near a river pollute the river’s waters,
thus leading to an increase in the price of fish in the area. Such technological effects may also
be positive – for instance, the chemicals used to spray one kind of plants may have beneficial
effects over other plants in the area.
Halcombre mentions two other types of externalities: marginal externalities and
inframarginal externalities. In the case of inframarginal externalities, the marginal utility of
the external activity is zero). These types of externalities do not necessarily involve efficient
distribution of resources. Inframarginal externalities can be:
1. Positive (e.g.: An educated category of the population is a positive externality for
the entire population), or
2. Negative (e.g.: A company polluting a lake leads to the death of fish as well as to
the impossibility to swim in that lake. Even if the company reduces pollution level
of the lake, it would be too polluted to swim in it or for fish to live in it. This is
when we talk about inframarginal externalities).
Homework:
1. Define the following concepts: public goods, private goods and externalities.
2. Which are the types of externalities?
3. Which are the four types of categories of goods?
4. Mention and define the two different categories of goods.
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CHAPTER 5
PUBLIC CHOICE
Objectives:
 Understanding public choice and private choice
 Creating a vision among triple marginal rates
 Presentation of decision-making proces
Key words: public choice, private choice, impossibility theorem
5.1. General aspects regarding public choice
Public choice theory studies how the decisional factors make decisions referred to the
tax level, public consumption and budget transfers. Theories that refer to state’s role in this
area have been issued since 1942, when the paper “Capitalism, Socialism and Democracy” by
Joseph Schumpeter was published, paper that is the base of public choice. Modern public
choice is a study of political and institutional mechanisms that circumscribe the individual’s
and state’s behavior (McNutt, P.A., 1996, p.1).
Muller defined public choice as “an economic application of political science”. The
same author defined public choice as “an economic study of non-market decisions” (op. cit.
Muller, 1989, p.1).
Economic life works according to certain rules: demand, supply, price, competition.
But sometimes the state intervenes on the market, market failure is avoided, citizens benefit
from public goods and services.
Often, the simple expression of desires does not bring satisfaction to participants in the
economic process. Therefore, state intervention is a permanent element in economic activity.
In this way, society benefits from public goods, market failure is avoided, the system price is
also influenced, and participant’s interests from the market are better satisfied.
The choice in general, whether in private or public display appears as a necessity of
limiting resources, whatever their nature. Economy wants to administer better economic
resources to meet as many needs as possible. Resource use in economic activity is subject to
decision-making process that entails a choice.
Contradiction stems from the very economic decision-resource needs, and means
choosing a resource recovery option considered to be the best according to used objectives
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and criteria. Since resources are always limited, by using more resources for an activity it is
automatically generated a resource decrease for other directions. All possible combinations of
products or activities can be achieved with a given amount of resources is emphasized by the
production possibilities frontier.
Therefore, a choice features are:
♦ contradiction between the needs and capabilities;
♦ decision- making process involves a person that decides a contractor and an
environment.
The contradiction between the needs and capabilities applies to every field and
industry. While the needs are unlimited, resources are insufficient, even if they are drawn
from other sources than their own. Only unreasonable subjects may find areas where the ratio
needs-resources is less than 1. Of course, at the level of an individual, a particular need can be
fully met when it reaches the saturation and marginal utility is zero. But, even individually, in
order to have all needs satisfied, whether it is a typical individual with a myriad of needs and
not atypical who considers that no longer needs anything, there should be infinitely resources.
As this is impossible, the needs-resource ratio is higher than one, whatever the sector or its
intended subject is. Decision making is a process by which a decision is sought, or otherwise
the use of criteria on which to compare alternatives for recovery of resources in order to
achieve the objectives through the implementation of the decision, that is the best alternative
choice in practice.
This argument of choosing applies also to public sector. Also here, resources are
limited. It can be said that investment in social welfare or education competes with investment
in transport and public parks, because the development of the first areas can be realized only
if it is reduced the investment in other segments of public interest, the amount of resources
being given.
In contrast, public choice has several features in addition to private:
a) it has a collective character, which means that the decision is adopted by
governments or public groups with public sector decision-making authority;
b) it is characterized by what is called optimal Pareto. This occurs when resource
allocation is made in such a way that when the allocation of resources changes for increasing
their capitalization effects on an individual, the satisfaction of another is not diminished.
a) In these circumstances, public choice becomes a social choice, by its collective
nature. In economic theory, there was often asked the question to see how the public choice
reflects the preferences of individuals. So, the national wealth or welfare appears as a function
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of the allocation of resources, namely the level of utility experienced by individuals. National
wealth is the base of decision rule for public choice. They say that public choice is reasonable
when the following criteria are met:
 collective rationality _ depending of the choice between alternatives, without
neglecting the preferences of individuals
 Pareto principle _ states that if every individual prefers situation A to B, then
option A is superior to B and assessed to social scale;
 independence of significant alternatives _ through which social choice from
many alternatives is up to individual preferences regarding those alternatives.
So, if the alternatives analyzed are A, B and C, individual preferences matter to
them, their reactions on other cases is insignificant;
 non-domination _ showing that there is no individual whose preferences to
dominate and dictate other preferences automatically.
Basically, these conditions can’t be met simultaneously by any rule or decision. It is
what is called impossibility theorem. In other words, a public choice cannot satisfy all
people, cannot be perfect. In a market economy, public choice is part of an area of "possible",
in which at least one of those specified criteria is less satisfied.
b) In the Pareto optimum there can be improved the allocation of resources and
increase the satisfaction of an individual without decreasing another’s. In this way, production
possibilities curve is no longer working in the traditional way. Paretian criterion can be
interpreted in the sense that a person knows there is an additional effort on another, since
resources are not changing in volume. And then, it involves the principle of distributed
fairness and test compensation. Distributed equity seeks fair distribution of production
between individuals, including wealth. Test compensation takes into discussion disposition of
the one that lost in a transaction towards the compensation of the loss felt if by such
compensation the winner increases its advantage. In practice, compensation is not met, but
equitable distribution occurs through the intervention of public power.
Pareto optimum is usually generated by triple marginal rates:
∆ marginal rate of substitution in consumption, as a ratio in which a consumer
can change a good with another without recording a change in satisfaction,
respective in utility; these substitutes in consumption goods are situated on the
same indifference curve. This rate should be the same for all consumers regardless
of the two goods;
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∆ marginal rate of technical substitution, as a ratio that can replace an input to
another, without modifying the production; it applies in particular to minimize
costs, when an expensive factor is replaced by another less expensive. This rate
should be the same wherever there are factors of production employed;
∆ marginal rate of transformation, as a ratio to be waived in the production of a
good economy in exchange for another production increase. This rate should be
equal to the marginal rate of substitution in consumption of both goods.
In conclusion, public choice is a social option based on a collective decision, and it is
the choice of several individuals on public property or other aspects of social life that
influence the behavior of more groups of individuals. Its general features are the needs,
resources and elements of decision making - decision-maker, performer, environment - and as
specific features, Pareto optimal and collective character.
In 1957 the "Economic theory of democracy" paper was published by Anthony
Downs(Downs A., 1957) in which he insists on the political aspect that decisions of
politicians have, politicians that follow through their decisions more “political purposes” (to
be re-elected). Median voter theorem is the main focus of Downs model. Political parties
should identify the median voter’s preferences in order to maximize votes. This goal is
achieved through economic policies which convince the median voter. However, we must
remember that voters are not always properly informed about the budget results, and on the
other hand politicians do not know who is the median voter. It is also necessary to know the
probability of voter turnout median of votes, to obtain the majority of votes as the ultimate
goal. Nobel laureate James Buchanan argues in the volume written in collaboration with
Gordon Tullock the idea of unanimity in policy-making according that unanimous decisions
do not compel anyone and do not involve any cost, also support the idea of control and
balance of executive power (checks and balances) (Howard, 2001, p. 41).
Public sector decision-making process on what to produce, how much, and for whom,
has a more complex component. This component is derived from many regulations
characteristic of this sector, the complexity and status of participants, the objectives of the
participants that affect their decisions in one direction or another. Political decisions must
correspond to a large extent the electoral system and system of government characteristic of
that State; in a democracy the most important rule to be followed in making decisions is that
decisions are made by elected representatives. As for public market that market participants
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come to meet some other requirements. Thus, voters “play the role of consumers whose needs
must be met by democratic society ".
Politicians must consider the overall demand for goods and try to provide them. In the
private sector, producers are motivated by profit growth, public market and politicians have
some reasons, primarily related to their ideology in an attempt to survive as long as they can
on the political scene without giving up their fundamentals on how a nation should be headed.
They act so that their chances to be reelected grow, so their interest is to get as many votes as
in the private market for producers trying to achieve profit maximization. Along with the
electorate and elected representatives in policy decisions there are involved other categories,
such as: interest groups that are designed to influence political decisions in favor of solving
problems and bureaucrats who have the necessary expertise for political decisions in a more
favorable environment. Whatever the policy problem would be, in its implementation it
should take into account the tools who have defined it, at their disposal to implement it in
their absence, leaving just a political statement.
Within the public choice process, many individual preferences are combined in the
collective decisions. The problem is the aggregation of millions of individual decisions in a
single decision. Unlike private decisions, public choice is indivisible, so each decision is
unique to each problem.
Public choice theory concerns the positive determination of public goods. In the
collective choice and public choice, theory works with government decision to substantiate
economic and social policies as effective for society. Public choice theory analyzes the
mechanism of choice and how the voters’ decisions affect government behavior in
formulating economic and social policy objectives. Those who vote, people can put pressure
on government to reduce taxes. Boadway and Wildasin defined public choice "that treating
political mechanisms, particularly voting behavior as a mean by which individual preferences
for public goods are sent to those who make rational public policy". All this emphasized that
public policy is an extension of economic analysis in political decisions (op. cit. Boadway,
Wildasin, 1984, p. 138).
Public choice differs from private choice. Public choice theory examines the behavior
of individuals, participating in public and collective elections. Elections, once selected, apply
to all members of that community. Individual take decisions for the public, the community,
from where he takes part. In the private election, individual behavior appears on an idealized
market. If a person acts as a buyer or seller in a fully competitive market, not feeling that its
behavior influences in some way the environment of other people. It behaves as if it would
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generate changes only in his "private" economy. What is certain is that in the welfare
economics this idealized behavior of individual mentioned above is impossible. When a
person is able to modify the behavior of others through his behavior, and you may recognize
this, welfare economists refer to the externality (op cit. Buchanan, Tollison, 1972, p. 15).
Actions are developed by public organizations and have the desired effect by pushing
out limited production possibilities of the economy. So, just as in the private sector, they must
find the possible combination between factors of production to ensure more efficient use of
existing resources, while providing some goods and services in quantity and quality needed
by citizens.
Collective actions based on their effect can be divided into three categories:
●harmful
●effective
●redistributive.
The harmful actions occur when the action of the state whose effects occur throughout
society, worsen the situation leading to a total failure (e.g. a governmental policy to push the
country into a conflict). Effective actions leading to improvements in satisfaction of entire
society members will have the effect of improving the situation of all members of society;
these actions are also quite rare. Examples would be the creation of satellite communication,
vaccination against diseases such as smallpox, etc.
Finally, in a democratic state, most political decisions have redistributive character.
This means that the company can make decisions as a group to pay taxes in order to ensure
the benefits of another group, or duty may be imposed on a product, which may be for
producers in a given industrial branch and disadvantageous to some consumers.
As regards decisions on taxation in general state faces three major problems:
¤ The structure of fees and taxes;
¤ The level of budgetary expenditure;
¤ Allocation of revenue necessary to carry out expenditure required by those who pay these fees
and taxes.
The majority of individuals may have different expectations for the same type of
service. This may be due to a large extent to the fact that they have different income, or
simply that they have different rating systems for the same type of good or service.
In the neoclassical model price tender, individuals and firms pursue their own
interests, companies wishing to maximize profit and individual’s the utility. (Howard, 2001,
p. 42).
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Buchanan together with Tulloch and Flowers talks about the concept of fiscal
constitution (Buchanan, Tulloch, 1962; Buchanan, Flowers, 1975). With Tulloch, Buchanan
tried to capture the economic aspects of the American Constitution, stressing the economic
implications of different voting rules. On the other hand, together with Flowers they applied
the notion of fiscal Constitution. Jackson considered the concept of the fiscal constitution as a
set of tax rules, limited set of concepts of justice and freedom (Jackson, 1993, p. 26).
5.1. The decision-making process
The decision-making systems of different countries are based on tradition or on
monarchy power. However, most contemporary decision-making systems are based on a
representative Government. Public decision-making involves certain particularities, derived
from the specifics of public decisions, the need to accept those decisions at personal level.
Thus, in the case of public decisions, each member of a group has different preferences with
regard to selecting the best alternative. Also, these preferences should be linked with the
objectives of the whole group so that the preferences of each individual in the group do not
affect the general welfare of the group and its general objectives.
In the case of public decisions there must be taken into account both the interests of
individuals and especially the general objectives of the society. From the point of view of
politicians when it comes to making decisions, collective public interest takes precedence
over the individual.
The public sector is an alternative organization of economic activity. Decisions taken
in the public sector will reflect the choices of individuals that act as:
■ The voters;
■ Politicians;
■ Tax payers;
■ Lobbyists;
■ Bureaucrats.
Candidates seek to offer programs that voters want. Voters will prefer candidates who
reflect their own views and interests. Voters will prefer collective action for two reasons: in
order to reduce waste and inefficiencies of uncompetitive markets, externalities, public goods;
and to change the distribution of income. Thus, the public sector can get involved many times
in order to increase the efficiency and well-being of the community (Voorhees, 2005, pp. 137138).
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Homework:
1. Which are the triple marginal rates that are generated by Pareto optimum?
2. Which are the differences between public choice and private choice?
3. Which are the types of collective actions?
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CHAPTER 6
PUBLIC SECTOR REVENUES
Objectives:
∆ Explaining the concept of public revenue
∆ Understanding the budgetary revenues in European Union
∆ Presentation of case studies regarding revenues in E.U countries
∆ Presentation of most important measures that were taken by Member States in the period of
the economic crisis.
Key words: public revenue, tax revenue, non-fiscal revenue, economic crisis, fiscal policy, EU
Member States, fiscal burden, fiscal measures, economic solutions
6.1. General aspects regarding public revenues
In order to better understand revenue budgetary policies we consider necessary to
clarify various aspects of budget revenues (see Văcărel, etc., 2006, p.338-428; Dracea,
Berceanu, Sichigea, Ciurezu, 1999, p.223-347; Fisher, 1987, p.15). Budget revenues are
means training funds that made money from where the public expenditures are made. Other
authors (Aronson, Schwsrtz, 1996:87-90) define different revenues. They believe that public
revenues are revenues of the territorial administrative units, which are used to cover public
expenditures and participate directly or indirectly to achieve various economic policies,
influencing the behavior of individuals and businesses. On the other hand, public revenues are
considered as means formed as a result of economic relations, from physical and legal
persons, under the fiscal sovereignty of the local community. Another definition states that
public revenues are "taking of wealth" used to cover public expenditure (Lowry& Ferreal,
1998, p.811-828). Public financial resources are financial resources that procure them a public
authority to perform its functions.
Now, given that our country joined the European Charter of local autonomy, for legal
regulation, and for determination of the income of local budgets, have operational meaning,
even formal view, the local resources contained in the Charter. Of its contents and expressly
in the article "Local authorities financial resources”, we notice, referred on revenues of local
budgets, the following concepts:
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- The right of local collectivities on own resources, which can have free, in exercising
their attributions
- At least one part of local financial resources can come from fees and local taxes
whose percentage to be determined by them within the legal permitted;
- Local authorities consultation on procedures for redistribution of resources, to
protect local collectivities that are weak from a financial point of view, promoting a financial
adjustment to correct the effect of potential sources of funding inequality, without reducing
the discretion of the legal community (according to art. 9 points 1-6 of the European Charter
of local autonomy).
Above concepts are contained in the European Charter on local autonomy and
autonomous exercise of local power and more or less found in the regulations on local
budgets incomes that were adopted and applied in recent years in our country, especially after
the appearance of Local Finance Act.
Due to the social needs increasing, in recent years is seen an increased demand for
resources at the state budget. The need to increase state revenues from year to year is
influenced by the dynamics and structure of budgetary expenditures (Manolescu, 1997,
p.171). Factors that may influence the dynamics of demand for resources from the state
budget can be economic, social, demographic or financial. Economic factors influencing the
size of state budget revenues may cause some development of gross domestic product which
can lead to increased taxable income. Monetary factors that transmit their influence by
increasing prices of resources may increase taxes. Social protection policies, health lead to
significant redistribution of state budget resources. As previously mentioned perhaps the most
important engine of growth need resources from the state budget is the size of public spending
deficit affecting the size of public resources which require additional coverage.
In the classification of these revenues can be summarized as follows:
Depending on the regularity of their mobilizing
ordinary
extraordinary
In terms of current economic content
Current
Capital
amounts deducted and transfers
In terms of national origin
Internal
External
Depending on their nature, current incomes fall under: Tax and non-tax revenues.
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Tax revenues are reflected in taxes and contributions levied on budget, with binding
irrecoverable. In the tax revenues are collected:
 taxes and direct contributions, where the real bearer is considered to be their
own subject;
 indirect taxes, where the real bearer payer does not coincide with the subject.
Non-tax revenues are those that return the state as the owner of the capital advanced in
the economic reproduction, the government mobilized directing autonomous and public
institutions and other miscellaneous income.
Tax revenues (Fisher,1999, p.101-115; Buchanan,1970, p.113; Văcărel, etc.2006, p.
342; Tulai, 2003, p.38; Talpoş,1995, p.178-182). Tax revenue is the biggest part of the
resources of the state budget. The fact that the level of tax revenue is limited and less flexible
that they can constitute an effective instrument to influence the size of state resources by
increasing their budget when required. Receipts from taxes does not increase quickly because
of the tax increase in the level of resources is based on changes in the tax system, and
increasing rates of taxation requires the approval of Parliament, which determined the
Government to turn to other resources to cover the need of income at a time. Income tax shall
be treated as policy with fiscal policy, and the most important aspects of this will be dealt
with below.
Tax policy is all fiscal decisions which the state takes to ensure financial resources
necessary for carrying out its tasks (Musgrave R., Musgrave P., 1984, p.642-650). Speaking
of fiscal policy Dan Grosu Şaguna said that ”largest and most prudent taxation promoted by
scientists of the Government is to know how to ensure the state 's revenues without this is a
burden or serious harm to the interests of the individual and private property of individuals
and legal entities” (Şaguna,1996, p.50). Fees and taxes are the leverage tax of the fiscal policy
(Prahoveanu, 2002, p. 283-286; Genser, Haufler,1996, p.411–433). When is necessary the
economic revival, taxes and fees are reduced and they lead to revenue growth of economic
agents and encourages consumption and investments. In the reverse situation is increasing
taxes and fees.
Levy budget of money has become with the increase of state intervention in the
economy, a lever, a means of adjusting and balancing inquiry report for providing a relatively
stable economic growth. Tax policy (Axellroad, 1995, p.82) is an important tool in adjusting
national economic activity and the influence of external economic relations. Role of the state
in the economy is played by two major tax approaches (Friedman, 1962, p.22-37; Fisher,
1999, p.183). This theory was developed during the period of the economic neoclassicism
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represented mainly by Milton Friedman (Friedman M., Friedman R., 1980, p.2-14). Another
approach relates to increasing State intervention in the economy. Fiscal policies in providing
an important increase in the intervention of the State both economically and in the
redistribution of income in certain periods have had a favorable effect: they are generally
well received by the Office and even loosens some imbalances in the structure of
consumption are applied for limited periods of time and is a longer period for the application
of liberal fiscal policies (Musgrave R., Musgrave P.,1984, p.102-127; Cohen,1997, p.188-193;
Grartney, 1976, p.165-184). The economic role of the State is especially important as regards
the implementation of infrastructure investments (through partial or total financing from the
budget) and those projects that require large amounts of investment and economic multiplier
effect, indirectly (that is felt on other economic activities and not on the investment as such).
The two theories concerning the role of the State in the economy were criticized by the
literature both in terms of their effects and the method of their application. With tax reforms
that took place in most European States, and the first guest appeared related to the
shortcomings of the neoclassical approach. They focused mainly on the effect of reducing the
taxation resulted in the reduction of income from taxes on budget deficits increase deficit
given that reducing taxes could not be correlated with reduction of budgetary expenses. Thus
increasing budget deficits have a negative impact on the monetary, financial and exchange
rate.
Observations of neokeyenesiene economists were justified. However substantive issue
was that no tax reduction theory proposed that the role of the State in the economy was
damaged, but its partial implementation only on the level of taxation without referencing the
reduction of public expenditure. Peculiarities of transition economies require a more radical
approach to policy choices in revenue. Economies in transition that are not in the situation to
be accumulated in a period prior to the actual financial resources, which may be subject to
policies of redistribution with access, has led to the emergence of an area particularly
restricted options: either you choose for stimulation of economic development with the killing
of social, pending the necessary resources to address these issues and you can choose to
maintain social protection schemes, with the price reduction-speed economy and with direct
effect in time including opportunities to support social protection systems.
When the economy is in recession and he is in opposition with imbalances at the level
of macroeconomic indicators, the role of fiscal policy is that to be a factor of stimulating
development and not as a way for the distribution of budget revenues.
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Size of the taxable base and its implications on the distribution of the tax burden on
the taxpayers of the economy has a major impact on the way for the formation of State
incomes and opportunities to spend in transitional economies. The absence of modern
infrastructure available to tax authorities led to the adoption of some modern tax systems,
flexible and allowing the tax base widened to train many years, in some cases they
contributed to the adoption of a tax law, with adverse consequences leads to the creation of
non-unitary tax systems, in which fiscal levers to influence economic behavior could not be
often used their real capacity. The delay of adoption of fiscal systems to allow widening of tax
base led to the development of tax systems in the tax burden was distributed unevenly the
specific weight of the pressing mainly on businesses and on the population employed, with
drastic consequences of the reduction in capital and investment opportunities, reducing
individual consumption and finally non-stimulation of creative work and blocking economic
development processes. In addition the use of such tax systems, led in the conditions under
which many countries in transition are redistributive social policies are declarative, the
impossibility of establishing a consistent asset classes like number and deepening gap
between income, creating a social categories and numerous large income and a majority (first
category wage) with a capacity of consumption reduced to cover vital needs.
This was the reason that many countries with economies in transition and focused
efforts to generate tax systems with degrees of taxable base as possible. The need to create a
database of domestic capital investment as the engine of development, and the need to
stimulate individual consumption table was considered essential for stimulating economic
specify output from the crisis of the beginning of the transition. But they demanded a
reduction in real terms of tax burden on enterprises and middle-income wage categories
considered both theoretically and practically any engines of balanced economic development
process.
The fact that simultaneous with the percentage reduction of taxes imposed on
businesses and families, the state didn′t have the possibility of a budgetary rata expenditure
(they could not be reduced beyond the level at which the administrative body and the office
cease to function in normal parameters) and that deficits could not, however, financeable
limits in a inflationary mode, led to the creation of infrastructures, focusing efforts towards
the necessary for enlarging the tax base, to compensate for the revenue side of the budget
increases the tax burden reduction achieved through the subjects which was the engine of
economic development. Countries in transition which have delayed the adoption of tax
systems that allow enlarging the tax base (Bulgaria, Romania, most of them former
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Communist States) were required on the one hand to a fiscal policy that focuses on increasing
the taxation of enterprises and employed population.
Over time, practice has shown that indirect taxes constitute the surest source of
revenue for the state budget, is very hard to avoid when compared to direct taxes.
This fiscal policy has been applied in Romania in early 1998, when the economic
environment of Romania was characterized by the lack of further economic restructuring
program, production and domestic consumption in decline. The new fiscal policy had the
effect of lowering the budget revenue on the one hand, and on the other hand entering a
vicious circle in which the budget problems have spurred the growth of production and
consumption, and the latter have led to a reduction in budgetary revenues onwards.
The situation mentioned above was partially solved by the introduction of a single
share. Fiscal loosening brought the flat tax solved one of the biggest problems of Romania
after 1989, namely underground economy. Sustained economic progress of Romania in the
last period, requires somewhat Romania to continue on the same path, to promote the
development of human capital, infrastructure, financial and banking system (Dăianu,
Vrânceanu R., 2002, p.25).
On the other hand, brings a 16% share and other advantages the Romanian economy
by attracting foreign investments. An essential component of fiscal policy is linked to tax
evasion because it has connection with tax revenue. Combating tax evasion was always a
difficult phenomenon and it cannot be eradicated. Tax evasion is deficient as a result of the
wording of the legislation in force, and on the other hand as a result of faulty application of
the laws relating to tax evasion. It should be remembered here that the causes of tax evasion:
incoherence and affordability law; the implementation of the tax administration; the behavior
of the taxpayer; corruption of tax bodies. This phenomenon is accentuated by the real and
objective disability of the tax to drive a process of tracking tax efficient and on a scale that
would prevent the phenomenon to rise. Negative effects of tax avoidance, led some authors to
be skeptical about the abolition of tax evasion. Tax evasion is one of the diseases of modern
societies, along with the shadow economy, corruption and others. Tax evasion causes are
primarily of excessive taxation, the level of corruption.
Non-fiscal revenue (Fisher, 1987, p.101-116; GianaKis G.,McCue, 1999, p.101-118;
Pigou,1947, p.49-57; Tiebout, 1956, p.16–24). Non-fiscal revenues, should be considered as
important as the tax revenue are limited, you can get additional income.
According to Order no. 1954/2005 for approval of public finance indicators
classifications tax revenues fall in property income and income from sale of goods and
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services. In the category of income from the property are the most important component of
net profit of payments by authonoums companies, national companies and firms, and the
income from the concessions and rentals. The economic activities of the state must be carried
out under conditions of profitable, so they bring large income to the budget as possible.
Economic resources of the state can be much more effective in circumstances where the level
of fines to the various collections would be much higher and not 20%-30% as it is currently.
Another important category of non-fiscal revenue is the income from donations and
sponsorships. As O.N.G important resources sites obtained therefore and the state should have
several concerns in this respect it may be collaboration with the nonprofit sector in cases of
provision of less profitable services.
If up to now we have discussed in detail about the budgetary policy of income, below
we will move on to another important component of budgetary policy and the budgetary
policy of expenditure.
6.2. Characteristics of the budgetary revenues in European Union
The purpose of my approach is to analyze the budgets of the E.U. countries compared
to the budgets of Romania during 1999-2010 period, highlighting the evolution of the
budgetary incomes and the budgetary expenses. After studying the literature regarding the
budgets of the E.U. member states I have actually made the analysis of their budgets (see Făt,
2007; Donath, 2007; Filip, 2003; Matei,1998). Our study also aims at analyzing the main
trends and budgets of the E.U. states, which is done through the calculation of some indices,
reported both income and expenditure of the extracted data: indices with fixed base, chainbased indices, minimum, maximum, mean values recorded at the level of states, weights and
values of total GDP. Through this study case, we aim to create a good presentation of the E.U.
state members, an image of the percentage modification related to a base year, achieved by
the main budgetary components from year to year (from practical issues we do not consider
necessary to present, in extenso, the analyzed data and their processing).
The data needed for analysis were taken from the European Union website
(http://epp.eurostat.cec.eu.int), in compliance with the standard classification. These data were
extracted and processed in March 2009 and March 2012. Our approach begins with the
analysis of the income policy, namely one of the most important categories of income, the tax
on production and imports (D2). This kind of tax is achieved through cash payments or in
nature, that are collected by the public institution or by the E.U. institutions, in what concerns
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the production and the import of goods and services, workforce or land owning or other goods
utilized in the process of production. These taxes are payable without taking into account if
there is a profit or not.
The taxes on production and imports are divided into:
a) The taxes on products including: V.A.T., taxes on products excluding V.A.T. and the
import duties on products;
b) Other taxes on production.
A. Taxes on products
This kind of tax is paid per unit of good or service produced or transacted. The tax
may be formed from a sum of money paid per unit of a good or service or may be calculated
ad valorem as a percentage of price per unit or value of goods and services produced or
traded.
The Value Added Tax is a type of tax that falls on the goods or services collected in
stages by enterprises and ultimately borne entirely by consumers.
The taxes and duties on imports excluding VAT comprise compulsory payments
levied by general government or the EU institutions on imported goods, excluding V.A.T., in
order to allow free movement within the economy and the services provided by units resident
and resident units to buyers.
The taxes on products excluding VAT and import duties (D214) consist of taxes on
goods and services that become payable as a result of production, export, sale, transfer,
leasing or delivery of such goods or services, or from the use of these goods or services for
own consumption or own capital formation.
Other taxes on production consist of all taxes that enterprises incur as a result of
employment in production, regardless of the quantity or value of goods or services produced
or sold. These types of taxes can be paid on land, fixed assets or labor employed in production
or in certain activities or transactions.
B. Current taxes on income, wealth etc. (D5), these taxes cover all compulsory payments in
cash or in kind levied periodically by general government on income or wealth of institutional
units and some periodic taxes which are assessed neither on income nor on wealth. This tax is
divided into:
a) Tax on income;
b) Other current taxes.
106
The taxes on income (D51) consist of taxes on income, profits and capital gains. They are
assessed at the real value or at the presumed value of the incomes that belong to individuals,
households, corporations, etc.
The taxes on income comprise the following:
 Individual income taxes on household taxes (income from employment, property,
pensions, etc.);
 Taxes on income or profit companies;
 Taxes on gains from holdings;
 Taxes on earnings from lottery or gambling.
Other current taxes (D 59) include:
 current taxes on capital which consist of taxes payable periodically, based on the
ownership or the use of land or buildings, by owners and current taxes on net wealth
and other assets (jewelry, other external signs of wealth) with exceptions under D29
(which are paid by enterprises as a result of employment in the production process)
and those referred to D51 (income tax);
 taxes for the registration, elections, charged per adult or per household, regardless of
income and wealth;
 consumption tax, demandable in the total personal or household expenses;
 payments made by households for licenses to use their personal vehicles, ships,
aircraft (not used for business purposes) or hunting license;
 Taxes on international transactions (travel abroad, foreign investment, etc.) except
those payable by producers and import duty paid by households.
C. Social contributions
The social contributions are transfers to households in cash or in kind, intended to
relieve the financial burden of a number of risks or needs, made through collective
organization, or outside these organizations through schemes, used by government units,
which include payments from the government to producers or other social categories. The list
of the risks and needs, that may create some social benefits, refer to: sickness, invalidity and
disability, accident or occupational disease, old age, maternity, unemployment, housing
education, general poverty.
The social benefits (http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/),
include:
107
 Current transfers, lump, from systems-covering contributions, out of which the entire
community can benefit, or large sections of the community, and are imposed and
controlled by government units (social security systems);
 Current transfers, lump transfers from organized systems of enterprises (business
systems) – contributions that can be made by employees or employers, or can be made
by independent persons;
 Current transfers from government units - they are not subject to previous
contributions (assistance).
The social security system is a system where workers are forced, or encouraged by their
employers or the state to sign insurances against certain risks that could adversely affect their
welfare or their dependents. Social security systems can be classified as:
 Social security systems that cover the whole community or larger sectors of the
community that are imposed, controlled or financed by the governmental units;
 The private systems that comprise systems that are not established (unfunded), where
the employers pay social benefits for their employees or their dependents out of their
own resources without creating special resources for this very purpose.
 The social insurance schemes organized by state units for their employees are
classified as private or unfunded systems as appropriate and not as social security
systems. Contributions may be divided into actual contributions payable for the first
two categories of systems mentioned above, and required contributions, payable under
unfunded schemes.
 The social contributions can be divided in effective payable contributions to first two
categories of systems mentioned above and imposed contributions that are payable
(required by the state and must be paid) in the case of the unfunded systems.
The social contributions can also be divided in mandatory (imposed by the law) or not
mandatory.
The effective social contributions (D611) include:
 Employers' actual social contributions (D6111), which correspond to D121 class. The
social contributions are paid by the employers to the social security funds, insurance
enterprises, autonomous or non-autonomous pension funds, administering social
security schemes to provide social benefits for their employees;
 Employees' social contributions (D6112) are social contributions payable by
employees to social insurance, private funds or other funds unincorporated;
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 Social contributions paid by persons that carry on with independent activities (D6113)
The required social contributions (D612) is the counterpart to social benefits (less
employees' social contributions) paid directly by the employer to employees or former
employees and other eligible persons. When the employers provide social benefits directly to
their employees, former employees or their dependents, from their own resources without
involving an insurance fund, an insurance enterprise or autonomous pension fund or creating
a special fund or a special reserve for this purpose, beneficiaries can be considered as being
protected against various needs or circumstantial, even if payments are made to cover them.
6.3. Study case regarding total revenues in E.U. between 1999-2010
In the analysis of the budget revenues for E.U. 27, we shall start to explore the income
in the period 1999-2010 (having in sight the big picture), and then we shall perform an
analysis of the E.U. budget revenue structure, components, dynamics, and the main causes
that led to the development.
The total revenues consist of total taxes (including direct taxes, indirect taxes), social
contributions and other income. Indirect taxes consist of: D2, Taxes on production and
imports, which at their turn are composed of D21 and D29 Taxes on production and other
taxes on production. Taxes on production are composed D211Taxa value added taxes on
imports excluding VAT D212's and D213 Taxes on production, excluding VAT and customs
duties.
In order to understand further the various influences on all the income’s components,
we have undertaken a statistical processing of data equivalent to a quantitative treatment. To
achieve the above mentioned, we chose a number of factors that influence a state budget such
as population, production index and gross domestic product (GDP).
The first factor, the population, influences a lot the total incomes, or revenues. We can
see that based on the Pearson correlation, the number of the population substantially affects
total revenues and is a significant link. For this to be a strong correlation sum stated in Annex
3 in the line "Pearson correlation" should be above 0.50, and for this correlation to be a
significant amount stated in the line "sig" to either 0 or very close to 0.
The next factor to be considered is the production index. Unlike the previous indicator,
this index indicates that the production does not substantially affect total revenues. From the
analysis we can see that this correlation is not significant because the number entered in the
line "sig" is far more than 0 or 0.
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The last indicator studied is the gross domestic product. The influence of this indicator
on total income is strong in most cases. The correlation is significant.
The direct taxes have the following composition: D5 Current taxes on income, wealth
and D91 Taxes on capital. D5 Current taxes on income, property taxes are made up of D51
and D59 other taxes on current income. D51 Taxes on income consist of: Personal income tax
D51A, D51B income tax or profit companies, D51C tax income securities, D51C tax on
lottery and gambling winnings, D51E, other taxes on income.
We can see that the total revenues from the E.U. 27 level increased from 3,933,492
million Euros in 1999 to 5,570,635 million Euros in 2008, when they peaked, followed later
by reductions for 2009 and 2010.
Following the available data, we could observe an increase in the total revenues in
most E.U. 27 countries. The exception is Poland where we have found that the total revenues
have fluctuated in the period analyzed, increasing from 1999 to 2002, from 63.628 million
Euros, decreased to 73,552.4 million Euros in 2003 and increased to 143,497 million Euros in
2008. In 2009 and 2010, the amounts deducted, with the values of 115,356.1 million Euros,
respectively 132,948.2 million Euros. The same is true for Romania where saw increasing
trends between 1999-2000 from 16,040.9 million to 17,673.7 million Euros, falling back to
16,490.3 million in 2001, increasing again in 2002 to 18,197.4 million Euros and then
decreased to 16,872.3 in 2003 and will increase to 46.966 million Euros in 2008, followed in
2009 and 2010, by a decreasing trend to the value of 37,939.2 million, respectively 41.405.8
million Euros. (See Graphic (a) nr. 36, which is to be found in the annex graphic).
From our analysis, based on the available data, we found out that the major increases
in total revenues compared to 1999 were registered in 2009, 3.04 times in Estonia, in Latvia
by 3.09 times, 2.76 times in the Czech Republic in Romania by 2.93 times, 2.40 times in
Hungary, in Lithuania of 2.88 times in 2008, 2.04 times in Ireland, Slovakia 2.30 times in
2010 and in Cyprus 2.44 times in 2008. Further on, we consider that it is of the utmost
importance, to follow the evolution of the total incomes or revenues from one year to another.
The greatest increase from one year to another at the level of E.U. 27 appeared in 2006 over
2005 of 1.31 times. (Inceu, Lazăr, Zai, Babici, 2009, pp. 129-145).
The total budgetary revenues in the E.U. 27, reached a maximum of 5,570.635 million
Euros in 2008, while the minimum value of 3,933.492 million Euros, was scored in 1999.
From 2002 to 2008, the total revenues represented a slight but continuous increase. The
average total income in the E.U. 27 is 4,814.070 million Euros in the time period that was the
110
subject of our analysis. In 2008, the highest values of total income were recorded in Germany
(1,088.200 million Euros) France (965,398 million Euros), U.K.
Table 1
revenues, at: total tax, social contributions
and other revenues or incomes:
Total tax:
85,90% (2005)
Denmark
Social
41,40% (2004)
Germany
Euros)
18,43% (1999)
Estonia
Source: Personal processing of the data extracted from the
Eurostat
in
2007,
Italy
(723,428 million Euros) in
2008 and Spain (431,121
million Euros), all in 2007.
The
contribution:
Other incomes:
(853,889.million
The maximum percentages out of the total
existence
of
total
income so high in these
countries is normal given
the fact that EU GDP rose
by
2.3%
compared
to
2006.
In Germany, between 1999 and 2000, the revenues increased by 1.02 times, after
which, between 2000 and 2001, the revenues increased by 0.98 times, and from 2001 to 2007,
came a period of continued growth in total revenues, reaching the peak in 2008. This is the
reason why in 2001, the total revenues were in a slightly greater percentage than the previous
year, due to the fact that in 2000 there was a surplus of 1.5% of G.D.P. On the other hand, we
must bring into discussion the effect that the unification of Germany had on the economy of
this country, and secondly that, nowadays, Germany is also feeling the effects of accession to
Table no.2
The minimum percentages out of the
total revenues,
at: total tax, social
contributions and other incomes
Total tax:
32,69%(1999)
Estonia
Social
3,30% (2008)
Denmark
contributions:
Other incomes:
the European currency. The
year 2001 was the year to
implement the third stage of
tax reform and tax revenue
that was expected to cost
about 1% of G.D.P. After
2001, Germany experienced
5,21% (2003)
Belgium
Source: Personal processing of the data extracted from the
Eurostat
a period of prosperity, so
that in 2008, the total
revenues peaked. Germany
is the E.U. member state with the largest number of population 82.2 million inhabitants. We
strongly believe that it is rather important to recall that the European Union in 2007 and even
in 2008, was going through an economic positive period.
111
Based on the data available regarding Romania, we can observe that its revenues, in total
amounts, started to grow in absolute amounts from 16,040.9 million Euros in 1999 to
46,966.4 million Euros in 2008, scoring in this year an increase of 2.93 times compared to
1999. The only decreases in the levels of the total revenues in Romania were recorded in 2001
compared to 2000, from 17.673 million to 16.490 million Euro, and in 2003 compared to
2002, from 18.197 million to 16.872 million Euros. The most significant increase of 1.30
times was registered in 2005 over 2004, and in 2007 over 2006, with same value. If we make
a comparison with Bulgaria, who joined in the same year as Romania, to the European Union,
we noted that the maximum total revenue recorded in Romania is 3.5 times higher than the
maximum registered in Bulgaria in 2007. On the other hand, mention that the maximum
recorded in Romania is about 0.6% of the maximum of the E.U. 27. The averages of the total
incomes that are really close to the value of 20,000 million Euros, were scored in Hungary
with an average of 30,000 million Euros, 35,000 million Euros in Czech Republic and
Luxembourg, Slovakia and Slovenia with 10,000 million Euros. In the structure of Romania's
budgetary revenues, the largest share in the revenues they had social security contributions
and V.A.T., this situation is very similar to the European Union. The minimum values of the
total revenues in 1999 were identified in the following countries: Malta (1,293 million Euros),
Estonia (1,965 million Euros), Latvia (2,585 million Euros), Cyprus (2,975 million Euros).
These countries recorded the lowest values of total income as they have recently joined the
European Union (in 2004) and have few inhabitants and a relatively small geographical area.
For this reason they have remained low, if we talk about total revenues compared to other
older members, even founders, who had the possibility of economic development since
joining the European Union.
Denmark has the highest share of total revenues (85.90%) in 2005, and the minimum
share of social contributions in total revenues is found again in the same country (3.37%) in
2007. Maximum and minimum share of other income in total income is insignificant.
The average percentage of the total taxes out of the total of the budgetary revenues at
the E.U. 27 level is of 58.57%, the social contributions of 31.15% and 11.69% regarding other
incomes. In Belgium, Germany, France, Luxembourg, England, the total tax share is over
50% out of the total revenues of these countries, and the social contributions are more than
25-30% out of the total revenues, while in the rest of the other countries, the percentages of
these two components in their total budgetary revenues is above 15-20%. A two fold increase
over total revenue in 2007, 2008, 2009 and 2010 compared to 1999 is observed in Estonia,
Cyprus, Latvia, Lithuania, Romania, Slovakia and Czech Republic. The average share of total
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income E.U. 27 is over 45% of P.I.B. The highest average total income in the E.U. 27
member countries, from 1999 to 2007 appears in the following countries: Germany with
1,000,421 million Euros, France with 842,597 million Euros, 698,093 million Euros in
England, Italy with 630.592 million Euros, and Spain with 330,231 million Euros. Out of the
total average income in the E.U. 27, these five countries have about 75% of total revenue
(about 4,000,000 million). It is not surprisingly, the fact that these five countries are those that
have the greatest number of people among the member states of the Union. The total
population at the E.U. level is of 492.881.583 inhabitants. Only in Germany, France, England,
Italy and Spain there are an estimated 311,005,022 people, with other words 63% of the entire
E.U. 27 population.
Table no. 3
Average total taxes, social
The
lowest
values
of
the
contributions, other incomes
average total incomes in the period that
in E.U.
is the subject of our study were in
Total taxes:
58,57%
Malta (1.293 million Euros), Estonia
Social
31,35%
(1.966 million Euros), Latvia (2,586
million Euros), Cyprus (2.975 million
contributions:
Other incomes
0,18%
Euros), and Lithuania (3,819 million
Source: Personal processing of the data extracted
Euros). In terms of population, these
from the Eurostat
countries are on the last places in the
E.U. 27, also because of low values
mentioned before.
Table no. 3 shows the main components of the total income averages in the period. Making a
comparison between the first five E.U. countries in what concerns the number of people and
last five countries, we can see the differences between these states, however as economic
forecasts, small countries have high growth potential despite their size.
After analyzing the above indicators can draw several conclusions:
The oldest E.U. member states have reached a point of maturity in terms of revenues
and economic development compared to new members; The relatively new E.U. member
states enjoy the benefits of membership transient. There are founded new companies and new
jobs in the labor market; The new members benefit from the European Funds, which
ultimately drive to an economic growth.
The highest share in total revenues is taken by the total taxes, followed by the social
contributions and other incomes.
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The global average tax pressure exerted in the EU27 in the period is about 45-46%.
The highest overall average tax pressure were recorded in the Nordic countries with values
close to 50%, and the lowest one, in Romania, Lithuania, Latvia with values close to 30%. It
is remarkable that out of all the former communist countries, which are now E.U members,
Romania is the country with the lowest tax burden, which is determined by the new tax rate
measures on the individual's income, the profit tax rate by reducing the tax base. At the
calculation of the average tax pressure, take part in approximately equal shares the social
contributions, direct taxes, indirect taxes, and the most insignificant proportion represented by
other incomes. The low tax burden (European Commission, 2007, pp. 6-9) occurs in
developing countries, in an attempt to stimulate economic development and attract
investment, increase employment and labor productivity. On the other hand in developed
countries meets a high tax, because they need tax incentives to encourage investment.
6.4. Study case- Economic crisis and fiscal trends in EU Member States
Economists have seen the economic crisis both like a challenge as well as an
opportunity to search and find the “cure” for the world economies. Beginning with 2008 most
of the EU Member States were rolling in unsure fiscal policy. This situation continued in
2009, when the EU 27 deficit reached at 6.8% from Gross Domestic Product (GDP), while
GDP declined with 4.2% compared to 2008. Since 2011, 24 of the 27 Member States were
subjects of the excessive deficit procedure and have received recommendation from the
Council to reduce deficit below 3%.
Most analysts believed that the causes for the emergence and development of the
current economic crisis, as was determined by overheating. Marek Dobrowski in ‘The Global
Financial Crisis: Lessons for European Integration’ discusses that the main causes for the
overheating of the crisis are due mainly to the following sectors: the real estate market both in
terms of housing and commercial buildings in the U.S., Ireland, UK, Spain, Greece and the
Baltic countries, the capital market and not least the oil market overheating, agriculture and
food industry (Dobrowski, 2009, pp.7-13).
EU Member States are preoccupied in dealing with the trade-offs between tax
subsidiary and fiscal neutrality—the two lodestars that should guide the tax coordination
debate with respect to taxes on consumption, labor and capital. Tax subsidiary
114
involves/requires a large measure of tax autonomy, while fiscal neutrality appears to require a
substantial degree of harmonization (Bovenberg, Cnossen and de Mooij, 2003, p. 619).
U.S. tax policymakers have become increasingly aware that significant steps must be
taken in order to maintain the United States attractiveness as a place for investment and
prevent further erosion of the U.S. tax base. The U.S. corporate tax system continues to be
burdened by overwhelming complexity and one of the highest statutory rates in the world
(Joe, 2009; Buchanan, 1970; Halcombre, 1996; Harvey, 2002).
Double taxation, the lack of tax harmonization, tax-related hindrance of business
restructuring and enormous compliance costs are just some barriers to a more competitive and
open European market (Göndör, 2011, pp. 151-158; Bank , 2010, pp. 207-232).
Most of the EU Member States recorded an increase of their public debt, the main
reason being the effort to save the banking system, so that in 2010 the UE 27 public debt
reached 80.3% of GDP, while in 2008 the public debt was/cumulated to only 62,3%. Taking
a stance was necessary, so the Member States began to take some measures in order to reduce
the deficit and to set the economy going. In 2009 some states Ireland, Lithuania, Estonia and
Latvia already started to do something in order to re-launch the economy and to reduce the
deficit (Buchanan, 1967; Fisher, 1987; Mikesell, 2003).
Each country started its fight against the economic crisis in its own way, some of
them with discretionary measures to induce an increase of the public revenues and a decrease
of public expenses, while others chose policies centered around on fiscal consolidation. Most
of the measures regarding the increase of public revenues were focused, in the majority of
member states towards increasing the fiscal revenues. And what better way of increasing
fiscal revenues than fiscal burden?
But what does it mean to increase the fiscal burden? Most of the time, the fiscal
burden is often seen by most of the people as increasing some of the tax rates. But the
increase of fiscal burden also means raising the tax base and introducing new taxes. The
economic crisis was a tough test for EU member states regarding the fiscal policies as a
concern for the increase of fiscal burden. We also can discuss the possibility of decreasing
fiscal burden in order to stimulate investors and to help the existing ones take into
consideration the crisis period. It can be used also for the reduction of fiscal evasion. Tax
evasion is one of the diseases of modern societies, characterized by the shadow economy,
corruption and other methods. The causes of tax evasion are given primarily by excessive
taxation and corruption.
115
Fiscal trends in EU27 in the context of economic crisis
Both economists and economic researchers argue that raising the corporate tax,
personal income tax and social contribution are the most damaging decision that can be taken
during the financial and economic decline. This is explained by the fact that income tax
reduction stimulates investment, while reducing income tax and social contribution leads to
increased demand and labor supply with direct effects on reducing unemployment (Eggert and
Goerke, 2004, pp.137-167; Coase, 1960, pp.1-22). The solution seems to be at first sight very
simple: do not increase personal income tax, corporate tax and social contribution so that the
premises of economic evolve. But what solution can be found when EU Member States
simultaneously have to confront on one side the effects of economic crisis and on the other
excessive deficits? How can they cover their deficits? These kinds of issues had to be
confronted by countries like Greece, Spain, and Portugal which in 2011 raised their taxes:
corporate tax and personal income tax. Eurostat data reveals that Greece, Portugal and Spain
have raised their personal income tax rate in 2010 and 2011. In 2011, Spain reached a 45%
personal income tax rate from a 43% rate in the period 2008-2010. In the same period, Greece
increased its personal income tax rate to 45% in the middle of the crisis (2010, 2011) while
Portugal increase these rates from 42% in 2008 to 46.5% in 2011. In its attempt to reduce the
deficit and to rise the fiscal revenues Portugal intensified its fiscal measures by increasing the
corporate tax rate from 26.5% in 2008 and 2009 to 29% in 2010. Have these countries
managed to reduce their deficits by increasing the fiscal burden? Apparently not. Increasing
the fiscal burden does not necessary imply reducing the deficit by collecting more fiscal
revenues to the budget.
All the measures focused on reducing the budgetary deficit must be correlated with
measures focused both on revenues (which does not necessary imply increasing the fiscal
burden) and also on expenses (which does not imply only reducing the budgetary expenses).
Some E.U. Member States strengthen their fiscal measures with measures focused on: better
tax collection, fighting against fiscal fraud, redirection of public expenses towards key areas
such as investments and work stimulation (Esteban and Kranich, 2002; Bagchi., Bird andDasGupta, 1995; Oates, 1999; Sobel and Holcombe, 1996).
Taxes on labor, more precisely social contributions, represent another category of
taxes considered and used by some states as inputs for economic recovery and job creation.
High rates of social contributions are detrimental to people with low incomes (Arrow, 1950,
pp. 328-334). These rates can be used by each state as a tool to stimulate job creation
Siekierski, 2011, p. 3; Monterio,, 2011, pp.56-61).
116
However, a number of Member States such as Ireland and Latvia have increased taxes
even in 2011 in terms of labor taxation, some by increasing social contributions rates, and
others by increasing tax bases, namely: Bulgaria, Cyprus, Lithuania, Portugal, Slovakia and
even Romania. Bulgaria chose a more complex measure in terms of labor taxation, namely
reducing social contribution rates and increasing the tax base, while Hungary reduced the
rates of social contributions in 2011.
As noted previously in 2010 and 2011 personal income tax was increased in multiple
states by increasing tax rates or by increasing the tax base. In addition property tax rate was
higher in countries like the Czech Republic, Germany, Greece, Portugal in 2011 compared
with 2010. Some countries have increased taxes in financial sector in 2011, namely: Austria,
Denmark, Hungary, and Portugal.
The main taxes as a share of GDP are represented in most European countries by the
personal income tax, corporate and among indirect taxes, value added tax. The Financial crisis
caused changes in tax rates among EU Member States and beyond. According to Eurostat data
for the period 2008-2011 there have been some changes in the tax rates in most EU Member
States so as to increase their rates and also to decline the rates in some cases.
In regard to personal income tax which was highlighted in the period 2008-2011 most
Member States have ensured stability of this type of tax at least in terms of tax rate. This can
be seen in the chart below Schmalbeck, 2010, pp .63-93; Mehrotra, 2010, pp.25-61).
Figure 1: Personal income tax rate in EU 27 between 2008 and 2011
We can highlight the fact that a few countries, namely Greece, Spain, Luxembourg,
Portugal, have used this type of tax by raising the tax rates in order to grow budget revenues.
117
Still, some member states like Lithuania, Hungary, and Poland have tried to lower personal
income tax rates. Lithuania reduced personal income tax rate from 24% in 2008 to 15% over
the three years, while Hungary after its attempt to increase the personal income tax rate in
2010 with 0.6 pp, in 2011 it lowered the personal income tax from 40.6% to 16%. Poland also
reduced personal income tax rate from 40% in 2008 to 32% from 2009 to present.
In regard to the corporate tax, we can say that it was quite stable in most of EU
member states in the period 2008-2011 with slight decrease in some states. Just 9 Member
States had decreased the corporate tax rate most significant being in the UK (from 30% in
2008 to 27% in 2011), Czech Republic (from 21% in 2008 to 19% in 2011) and Sweden from
28% in 2008 to 26%, 3% in 2011.
These studies indicate that the potential efficiency gains from corporate tax rate
harmonization, although positive, are fairly modest. The distribution of the welfare gains,
moreover, is highly uneven across the EU, which suggests that tax harmonization is likely to
be difficult from a political standpoint Zodrow, 2003, pp. 653-657; Stiglitz, 2000; Stillman,
1994).
The corporate income tax coordination is likely to cause different effects on the
Member States in terms of growth rate of GDP and the level of corporate income tax receipts,
but these effects cannot be estimated with certainty (Pirvu, Banica, Hagiu, 2011, pp. 91-102;
McLure Jr.,2010, pp. 327-339; Ryan., 2010, pp. 275-326). As seen in the chart below the only
EU country which raised corporate tax rate during the economic crisis is Portugal from 26.5%
in 2008-2009 reached at 29% corporate tax rate in the years 2010 -2011.
Figure 2: Corporate tax rate in EU 27 between 2008 and 2011
118
If tax rates of the most significant direct taxes did not registered fluctuations in the
European Union except for some countries, in terms of indirect taxes and especially taxes on
consumption, their evolution is more oscillatory. Watching over the most significant tax on
consumption, value added tax, in terms of share of GDP, we can say that more than half the
EU member states have changed VAT tax rates during the economic crisis.
Mintz and Weiner described two methods of consolidated base taxation with formula
allocation under consideration in the European Union. The first method, common
(consolidated) base taxation (CCBT), would allow companies to choose a single tax base for
their EU wide operations. This tax base would be common throughout the participating
member states. The second method, Home State taxation (HST), would also allow companies
to choose a single tax base for their EU-wide operations. But, unlike with CCBT, the tax base
would be defined according to the rules in the company’s residence, or “home,” state. The
conclusion is that common base taxation, either under CCBT or HST, is fraught with
economic uncertainties and administrative pitfalls (Mintz and Weiner, 2003, pp. 695; de
Mooij and Nicodème, 2006; Genser and Haufler, 1996, pp. 411-433).
Changes have mostly focused on increases in VAT rates even though some states have
tried for a relatively short period to decrease VAT rates and then increase them again. Thus
Great Britain in 2009 decreased the rate of VAT to 15%, in 2010 returned to 17.5% the level
in 2008, and in 2011 increased VAT rate to 20%. The most impressive growth of VAT rates
was registered in Hungary, Greece, Portugal, Romania, Lithuania, and Latvia. Hungary has
already increased the VAT rate since 2009 from 20% to 25% and then to 27% which would
result in the highest VAT rate in the EU member states. Greece increased VAT rate in 2010
from 19 to 23%. Lithuania and Latvia have increased the VAT rate from 18% in 2008 to 21%
in 2001. Romania has also raised VAT rate in 2010 from 19% to 24%. Evolution of VAT
rates in the period 2008-2011 is shown in the chart below.
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Figure 3: VAT rates in EU 27 between 2008 and 2011
Tax changes during the global economic crisis are needed in each member state. This
does not necessary mean that every country needs to change tax rates or to introduce new
taxes. As was previously shown, tax changes should be made, especially in periods of
economic crisis. Such changes should be added to fiscal consolidation measures, efficiency
and effectiveness of the fiscal status, the creation of new jobs, investments and finally adding
value to the economy through and increase GDP (Inceu, Lazăr, Zai and Babici, 2009, pp.
129-145; Keen and, Ligthart, 2005, pp. 81-110; Carone and Schmidt, 2007).
Eurostat analysis of the data available can offer some conclusions regarding the most
significant direct and indirect taxes as share of GDP on the period 2007-2009. We will focus
more on developments in 2009 compared to 2008, years of economic crisis and to ensure
comparability of data.
We can see from the chart below that in 2009 the personal income tax as share of GDP
has registered significant differences from state to state. The country with the lowest rate of
personal income tax is Slovakia 2.4%. Simultaneously it has the highest share of GDP the
personal income tax with 26.5% well above the European average of 8% registered 2009.
This is somewhat understandable given that Denmark like the other Nordic countries
(Sweden, Finland) are known as the countries with the highest tax rates. We note however,
that although these countries have not increased their personal income tax rate they still
recorded in 2009 an increase as share GDP, namely: in Denmark the share of personal income
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tax to GDP rose from 25.3% in the year 2008 to 26.5% in 2009, while Finland despite the fact
that it slightly decreased the personal income tax rate from 50.1% in 2008 to 49.1% in 2009,
still recorded an increased personal income tax as share of GDP from 13.3% GDP to 13.4% in
2009. In contrast to these states is Italy. In 2009 Italy raised the personal income tax rate with
0.3 percentage points from 44.9% in 2008 to 45.2% in 2009 while in the same period it
registered a decrease of personal income tax as share of GDP from 11.8 in 2008 to 11.7 in
2009. The decrease is not significant but shows that an increase in tax rates for certain taxes
does not necessary mean an increase of that tax increase as a share of GDP.
Regarding the decreasing evolution as a share of GDP of personal income tax we can
say that in countries such as Latvia, Lithuania, Poland, which decreased the tax rates of
personal income tax in 2009 there was also a decrease of personal income tax as share of
GDP. Lithuania registered a significant decrease in tax rates of personal income tax from 24%
in 2008 to 15% in 2009 which determined a decrease of personal income tax as share of GDP
from 6.6% in 2008 to 4.1% in 2009. A country with a decreasing trend of personal income tax
as share of GDP is Cyprus which has not changed the tax rates but registered a drop GDP
from 5% in 2008 to 3.9% in 2009.
We conclude therefore that only Finland had found "the right formula" on changing
tax rates in respect to personal income tax and has also taken the correlative and appropriate
related measures by decreasing the personal income tax rate it still registered an increase of
personal income tax as share of GDP. Meanwhile Denmark and Netherlands by maintaining
personal income tax rates constant also succeeded in raising their share of GDP.
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The evolution of the GDP share of personal income tax in the EU member states can
be analyzed in the Figure 4 below:
Figure 4: Personal income tax as share of GDP
The evolution of corporate tax as share of GDP in the years 2007-2009 shows the
economic crisis and economic downturn manifested in the bankruptcy dynamics registered in
the time of the full crisis. Looking at Figure 5 below we can say that most EU Member States
have registered a decrease of corporate tax as share in GDP except for two states: Malta and
Estonia. Malta by maintaining the corporate tax rate at 35% in 2008 and 2009 has also
maintained the corporate tax as share of GDP for the same period at 6.7%. But Estonia and
Luxemburg recorded the best results among EU Member States, in terms of corporate tax as
share of GDP. Estonia, during a period of full economic crisis maintained the corporate tax
rate at 21%, but has increased corporate tax as share of GDP from 1.7% in 2008 to 1.8% in
2009. Meanwhile Luxemburg reduced the corporate tax rate in 2009 with a percentage, and
has registered an increase of corporate tax as share of GDP from 5.1% in 2008 to 5.5% in
2009.
At the opposite end of the spectrum a series of countries such as France, Latvia,
Finland, Slovenia, the Netherlands have registered the largest decrease of corporate tax as
share of GDP in 2009: France from 2.8% to 1.3%, Latvia from 3.2% to 1.6%, Finland from
3.5% to 2%, Netherlands from 3.4% to 2.1% and Slovenia from 2.5% to 1.8%. From all these
countries only Slovenia has lowered the corporate tax rate in 2009 by one percentage, the
others have maintained the rates from the previous years. In regards to the corporate tax we
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can conclude that only Luxembourg has succeeded to increase the corporate tax as share of
GDP in 2009 by decreasing the corporate tax rate in the same period. The evolution of
corporate tax as share of GDP can be analyzed in Figure 5 below.
Figure 5: Corporate tax as share of GDP in EU 27 between 2007-2009
Evolution of VAT as a share of GDP shows once again that the economic crisis is
lowering consumption. So there is a tendency for decrease of VAT as share of GDP in 2009
in most of the EU member states with a few exceptions such as Germany, Estonia,
Luxembourg, Hungary, Austria, Finland and Sweden (Terra and , Wattel, 2008; Ebrill, Keen,
Bodinand Summers, 2001; Godvin, 1998, pp. 541-545).
The most significant growth of VAT as a share of GDP took place in Estonia,
Hungary Finland and Sweden. While Estonia and Hungary have registered increases of VAT
in GDP because they have increased their VAT rate in 2009 (in Estonia from 18% to 20%, in
Hungary from 22% to 25%) Finland and Sweden have registered significant increases of VAT
as share of GDP in 2009 (Finland from 8.4% in 2008 to 8.8%, in 2009 and Sweden from 9.3%
to 9.7%) by maintaining constant the VAT rates. Moreover Austria, Germany and Luxemburg
have also registered a slight increase of VAT in GDP while maintaining the rate of VAT
from 2009. Bulgaria, Ireland, Greece, Portugal, Spain, Latvia, Lithuania, Cyprus and Romania
are the countries that in 2009 have registered the most significant decreases of VAT as share
of GDP. The most significant decrease was in Cyprus from 11.3% share of VAT in GDP in
2008 to 9.1% in 2009, while the country did not alter the rate of VAT. The situation was
actually more difficult for other countries, namely Latvia and Lithuania which have h
increased the VAT rate in 2009 from 18% to 21% and from 18% to 19% they are still among
the states that in 2009 recorded the largest decreases of VAT as share of GDP. The other
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states mentioned above (Bulgaria, Ireland, Greece, Romania) with significant declines of
VAT as a share of GDP had this development while maintaining the VAT rates in 2009.
Britain is the only country among EU member states which in 2009 decreased the VAT rate
from 17.5% to 15% and has registered a quite small decreased of VAT as share of GDP in
that year (from 6.4% to 5.8% VAT in GDP). This does not take for a long time because in
2010 Great Britain returned to original VAT rate of 17.5%.
The evolution of VAT as share of GDP across EU member states can be analyzed in
Figure 6 below:
Figure 6: Value Added Tax as a share of GDP between 2007 and 2009
Regarding Romania we can see from the Eurostat data that our country has maintained
tax rates for personal income tax and corporate tax and only in 2010 has changed the VAT
rate from 19% to 24%. But the effect of VAT rate change on GDP cannot be analyzed yet
because of the availability of Eurostat data. The position of our country can be compared with
the EU member states so that we can say that Romania's position regarding tax rates is below
the EU average, at least for personal income tax corporate tax and income and VAT. With
regard to the tax share of GDP, in 2009 Romania, ranked 20 position among the EU member
states regarding VAT, place 25 regarding personal income tax and eight place regarding
corporate tax with the reference to their share of GDP. A short analysis regarding the share of
GDP of VAT and personal income tax compared with the European average for 2007-2009
shows us that Romania is slightly above the European average in terms of share of GDP
excluding VAT in 2009 when Romania is slightly below the European average in terms of
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GDP share for corporate tax and well below European average (about 5 percentage points) in
terms of personal income tax. This is somewhat understandable because in both cases,
personal income tax, and corporate tax, Romania is well below the European average (by
about 7 percentage points for corporate tax and over 20 percentage points for personal income
tax) regarding the tax rates. In case of VAT rates Romania has a VAT tax system close to the
EU average.
Although increasing tax rates should be reflected in the increase in GDP share of those
taxes, this has not happened in the case of countries such as Latvia, Lithuania which increased
their VAT rates in 2009 and have registered a decline as a share in GDP of VAT. For
example Italy has increased the personal income tax rate in 2009 by 0.3% while it registered a
decrease of this tax as a share in GDP from 11.8% in 2008 to 11.7% in 2009. Countries such
as France, Latvia, Finland, Netherlands have registered the largest decreases among EU
member states in reference to the corporate tax GDP in 2009, in the same period in which
they did not changed the corporate tax rates. Examples such as Italy, Latvia, Lithuania, France
show us once again that the increase of fiscal burden in these cases by increasing the tax rates
does not necessarily lead to increases in GDP. Therefore, increasing revenues is not achieved
or at least not only achieved by increasing taxation. Instead, the examples of states such as
Denmark, Finland prove to us that with a decrease in tax rates growth in GDP of those taxes
can still be achieved. For example in 2009 although Finland had a slight decrease of VAT rate
with one percentage it still registered in same year a slight increase of VAT as a share of
GDP. Denmark managed to increase the personal income tax and corporate tax in GDP while
maintaining tax rates. That shows that these countries have managed to take some measures in
terms of fiscal revenue to increase tax shares in GDP, having a more efficient effect than
increasing taxation.
Conclusions The issue of taxation in EU Member States reflects tax diversity among
these countries. Nordic countries have high shares of direct taxes, while Portugal and Greece
predominantly focused on indirect taxation. It is therefore natural that the reactions of these
states to fiscal trends have different views. Achieving and sustaining a healthy situation of
public finances is essential to cope with economic crisis and ensure a stable economic
recovery. Reducing public debt and budget deficits is a requirement for all EU Member
States, leading to lower inflation and encouraging investments. European Union has a number
of documents (Maastricht Treaty, the Stability and Growth Pact) which are focused on
financial stability to prevent new financial crises and aimed for actions to ensure fiscal
discipline among member states. With these requirements, a particularly important concern of
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each member’s state on the political agenda should be a strong and healthy fiscal policy.
Fiscal policy of each member state must ensure on one hand public services funding, and it
must also assume its
economic leverage ability to influence the functioning of the real
economy by encouraging employment, and investments.
Homework:
1. Define the following terms: revenue, tax revenues, non-fiscal revenue, fiscal policy.
2. What comprise the taxes on income?
3.Compare revenues trends of developing countries with revenues trends of developed
countries.
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CHAPTER 7
PUBLIC EXPENDITURE
Objectives:
 Explaining the concepts of public expenditure
 Understanding the budgetary expenditures in European Union
 Presentation of role of public expenditures and the main expenditures at E.U. level
Key words: public expenditure, expenditures policy, central administration, regional
administration, local administration , social assistance funds
7.1. Aspects regarding the public expenditures
Public expenditure refers to the social and economic relations in monetary form,
which manifests itself between the state and individuals and legal entities in connection with
the distribution and use of financial resources of the State in order to carry out its functions.
Public expenditure is completed payments performed by the state of the resources deployed
on different paths (Buchanan, 1970, p.341). However, they do exist; their increase is a feature
of the temporal evolution of society and the needs of members of the latter. State expenditure
policy is based on the increase, during the recession, spending from the budget, with the aim
of increasing global demand, production and revenue.
The main categories of expenditure of the state having regard to the role of these
expenditures can be divided into: the maintenance and functioning of the public
administration and the device (at central and local level); national defense; education; culture;
health protection; insurance and social assistance; urban development; social activities
(Musgrave R., Musgrave P.,1984, p.113-153).
The expenditure shown in the budget of state of Romania has the following
destinations: public authorities; defense; public order and national security; education; health;
culture, religion and sport activity action and youth; allowances, social assistance, pensions,
allowances and benefits; public services, development and housing; environment and waters;
industry; agriculture and forestry; transport and telecommunications; other economic
activities; scientific research; other actions; transfers; interest payments on public debt; loans
granted.
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In the modern conception of the public finances, public expenditure is researched and
assessed, first, in the light of its nature; what matters is not so much the size of them,
especially the effects they induce in the socio-economic life (Fölster, Henrekson, 2001,
p.1501–1520). The modern’s finances define the notion of public expenditure by the notion of
private expenditure. Thus, all costs it makes the state as state authority are public expenditure.
All other charges made under contract to private expenditure of the state. By choosing the
citizens budget policies in the field of revenue and expenditure of the political class is
reflected (Harrington, 1993, p.27–42; Bosch, Suarez, 1993, p.233–238;Wagner, 2001, p.149–
173): citizens ' preferences for different forms of taxation and for different levels of taxation,
such as the ability of certain specific groups to move the burden on others; how these policies
affect the economy through tax and income levels of public expenditure; the relative strength
of the different individuals and interest groups to influence budgetary expenses. Studies on
foreign authors (Rogers, D., Rogers J. H., 2000, p.1–21; Besley, Case, 1995, p.769–798)
show the fact between budget expenditures and policy makers there is a link. Model
"Leviathan" (Caplan, 2001, p. 825-847) points out that the existence of a competition between
political forces reduce the size of the public sector and thereby costs. On the other hand the
model "Partisan" reveals that a left-wing governments prefer public sector higher, increasing
taxes and expenses, while right-wing governments are doing exactly the opposite. When the
trail has been in power in the last election, left-wing governments increase the level of
expenses, revenues and the deficit, while the right-wing governments fall. The coalition
Government reacts faster to this limit election, unlike the situation in which the Government
would be composed of a single party and have higher levels of tax, spending and the deficit.
In our opinion the models mentioned above depend from country to country, the specifics of
the country concerned by the political situation in each country, this being evidenced by the
political situation in Romania after 1989.
Over time the concept of the content and the role of public expenditure has evolved
(Aronson, Schwartz, 1996, pp. 81-87; Kienzle, 1989, pp. 117-140). Classical conceptions
consider public expenditure as being the starting point of their lives. The state spends first and
they determine the level of income needed to cover expenditure. In the classical conception of
the structure of public expenditure is not a financial problem but a political choice; what is the
volume of expenditure prevail over and not their content. In the modern approach, on the
other hand, the nature of the expenditure that take precedence, it must first determine the
income which they can mobilize and only then to size the cost taking into account the social
and economic effects which they may give rise. “The classical financiers had a concept
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fundamentally quantitative in respect of public expenditure, while modern financiers have a
concept essentially qualitative" (Drăcea etc., 1999, p.57).
Public expenditure policies used as levers of state purchases, orders and investments.
Purchases and orders increase in particular in periods of economic recession, such a claim are
to be passed through its effect on economic operators concerned. Public expenditure have a
heterogeneous nature (Tridimas, 2001, pp.299–31). If you are judged by their effect on the
social and economic life when these expenses could be ordered into three groups: negative
charges; positive charges; neutral expenses. Negative expenditures are actual consumption
and use of national income and do not have a subsequent effect on future GDP. These are
represented by the maintenance costs, maintenance of state apparatus and military equipment,
interest payments on foreign loans of State etc. and are called and the actual expenditure. The
positive expenditures are those made both in the economic field and of those carried out in
the field of socio-cultural, and effects farther or closer to economic growth. Among those in
the industry we can remember: various investments, subsidizing certain activities of economic
agents, etc. In the field of positive socio-cultural expenses are those which, in one way or
another, affect future growth, even if their effects are not in a physical form in the immediate
future: expenditure for education or health. Neutral expenditures are not a consumer actually
GDP but have no influence on subsequent growth. Here we find various social expenditures,
interest on domestic debt, etc.
Public expenditures are the consequence of the exercise of the functions of the state.
Public expenditure in public utilities materializes in the form of financing of social protection,
education, defense, etc. We consider important public goods approach, whereas public
services provides public goods. In terms of how coverage with public resources, assets are
divided into pure public goods: public goods, private goods mixed.
Expenditure policy must determine the size, destination, optimal expenditure structure,
to set objectives and to define methods and tools to be used, with a minimum of effort. Size
the size of the expenditure must take into account the absolute and relative size. Expenditure
policy involves maintaining our country public expenditure within the limits of the resources
that can be mobilized, without recourse to the heavy and unjustified credit. Setting the
destination of public expenditure should be carried out taking into account the real needs of
society, and the use of resources must be carried out under conditions of maximum efficiency.
The paper “Anticorruption and Governance Strategy” (2007 World Bank) succeeds in
proving the existent correlation between the governance and its role in the economic
development.
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According to the survey done by the World Bank, it has been shown that an
administration role is not simply the allocation of resources in order to implement some
public policies but rather the state to be involved in the implementation and monitoring of
money allocated to achieve the desired results. A simple allocation of funds is not sufficient
for a successful program because the involved institutions, in the program may not work
properly so that the state's role in improving performance and efficiency of public spending is
enlightening. A number of authors including Rajkumar and Swaroop (2007) attempt to show
the relationship existing between the level and the impact of public spending and the results in
different sectors of the economy.
Thus, they succeed to demonstrate that governance is central in determining the
effectiveness of the public spending. Their study shows in theory that an increase of 1% of the
health expenditure in the G.D.P. reduces premature mortality by 32% in those states with an
appropriate level of governance, to 30% in countries with high governance and no impact in
countries with weak governance. In terms of education spending, the same authors show that
a 1% increase in public spending on education in the G.D.P. has the effect of reducing the
primary failure by 70% in countries benefiting from good governance. Efficiency of public
spending is an issue of credibility for the government and for government to be credible it is
necessary to boost governance, transparency and establish performance-based budgets. A
government whose objective performance takes into account the allocation of resources,
cooperation and coordination, there must be formed a system of rewards and sanctions. This
requires cooperation among all state bodies, ministries, trade unions, civil society, taxpayers,
and beneficiaries of the public funds in decision making aimed at increasing the welfare.
Both, at central government and every public entity in the public sector must conduct
themselves properly to improve performance and efficiency of the public spending. This
behavior has a positive role in the economic development of a state. The governance helps the
organizations to achieve their objectives by enforcing the law. If these rules / laws are not
imposed, there are some negative effects such as waste of funds, corruption, tax increase, etc.
Also, on the same idea of the influence that the public finances have upon the
economic development, Easterly and Rebelo (1993) conducted a study that succeeded to
demonstrate that the public investments made in transportation and communications in
emerging markets have a positive effect on the economic growth. Other studies (Gupta 2001)
show that the relationship between the public spending and health of the poor is stronger in
countries with low income per capita.
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The majority of the studies in the literature succeed to demonstrate at least on a
theoretical level, that there is a link, either positively or negatively, between the public
expenditure and the components that characterize the degree of the development of a state.
Such studies show that good governance in public spending leads to better economic results in
this respect studies, conducted by Kaufmann (1999, 2004) insists that certain indicators of
governance: economic stability, tax burden, rule of law, government effectiveness, have a
negative impact on infant mortality. Other authors such Croix and Delavallade (2006) argue
that countries with high levels of corruption orient public spending towards more investment
in housing and physical capital (infrastructure) than in education and health.
The desired growth of any state can be achieved through budgetary policies, more
precisely with spending. The development of a quality public service that leads indirectly to
economic growth depends largely on the public expenditure management. Effective
management of revenues leading to growth may be achievable in terms of public spending
and increasing efficiency in the public sector performance.
The studies conducted by Kaufman and Segura Ubiergo, (2001), Rudra, (2002)
support the idea that there were some negative effects of the globalization on the social
welfare, arguing that the trade liberalization and the capital flows lead to a conservative fiscal
policy aimed at reducing the public expenditure. Other authors such as Rudra and Huggard
(2005) believe that the political regime of a country affects the social policies of the state.
Thus, at least in theory, it was concluded that developed countries attach more importance to
social policy, while developing countries are less developed in the social policies’ field, due
to the fact that they are characterized by a unconsolidated democracy. Cameron (1978) and
Katzenstein (1985) conducted a series of studies demonstrating the relationship between the
fence opening of a state economy and the public expenditure on the public policy of the state.
Furthermore, authors like Quinn, (1997); Rodrik (1997,1998) came alongside them, with
studies that have shown that the exposures of a state economy to external shocks were the
main factors for increasing social welfare for the developed countries. This can be explained
by the fact that the democratic governments were encouraged to meet the potential risks posed
by the economic opening by the Keynesian countercyclical policy or social policies more
expansive. However in developing states, the studies conducted by Kaufman and Segura
Ubiergo (2001), Rudra (2002) showed that the economic openness of a state has a negative
effect over the expenses with the social protection.
The size of the administrative sector represents a factor of influence over the economy
of any state. Yavas (1998) conducted a study and his conclusion was the fact that the growth
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of the administrative sector in the case of the developing countries, has an effect of
economical growth, while in the already developed countries, the effect is the opposite. He
explained the effect like this: in the developing countries, the greatest amount of expenses is
oriented towards the construction and the development of the economic infrastructure, in
order to stimulate the production in the private sector. In the developed countries there is
already a developed economic infrastructure so many government spending programs are
aimed at different types of social protection and social programs, so that the effect of these
programs on the economic development will not be as high as the costs with the
infrastructure.
7.2. The main expenditures at E.U. level
The budget expenditures are included in the government sector. This sector includes
all institutional units other than market producers whose output is intended for the individual
or the collective consumption and mainly financed by compulsory payments made by units
belonging to other sectors and / or all units mainly engaged institutions in the national income
and wealth redistribution.
The Public administration sector is divided in four sub-sectors:
 Central administration (S1311)
 Regional administration (S1312)
 Local administration (S1313)
 Social assistance funds (S1314)
1) The central administration (S1311) includes all the administrative departments of the
State and other central agencies whose membership extends normally over the whole
economic territory, excluding local social insurance funds. In this sub-sector are also
included the non-profit institutions controlled and mainly financed by the central
government and whose competence extends over the whole economic territory.
2) The regional administration (S1312) consists of administrations that are separate
institutional units, exercising some of the functions of the government at a level lower
than the central and higher compared to the local institutional units other than social
security fund management. This sub-sector includes those non-profit institutions
controlled and mainly financed by the regional governments and whose competence is
limited to the economic territory of the regions
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3) The local administration (S1313) includes those types of public administrations
whose competence extends only at the local level, in addition to the local agencies of
the social security funds. Here are also included those non-profit institutions
controlled and mainly financed by the local governments and whose competence is
limited within the local government sphere of action.
4) The social assistance funds (S1314) include all the central institutions, regional, and
local, whose main purpose is to provide social benefits and which fulfill each, the
following two criteria:
By law or regulation certain groups of people are obliged to participate in the scheme or to
pay contributions;
The central government is responsible for the management of the institutions in what
concerns the settlement or approval of the contributions and independent benefits of their own
goal, as a supervisor.
Usually there is no direct link between the amount of the contributions paid by
someone and the risk at which that individual is put under.
The analysis of the data on expenditure classification was made taking into account the
costs of the governmental functions (COFOG) as follows:
- General public services;
- Defense;
- Order and public safety;
- Economic affairs;
- Environment protection;
- Housing and community amenities;
- Health;
- Recreation, culture and religion;
- Education;
- Social protection.
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7.3. Study case regarding total expenditures in E.U. between 1999-2010
This part of the study presents the evolution of the total spending in absolute amount
in the European Union countries, the evolution of the maximum, minimum and the average of
the E.U.27, as well as the share in the G.D.P. The expenses related data that belong to the
E.U. 27 were extracted and processed in March 2009 and in March 2012. We can see that the
maximum spending lies around 1,200,000 million Euros, with an absolute maximum in 2010
of 1,185,750 million Euros. We should note that the line maximum E.U. 27 development
overlaps with line development expenditures incurred by the Germany, meaning that each of
the 12 years analyzed, Germany spends the highest amount of money in the E.U.27. This is
due to several factors, namely: Germany is the country with the largest population in the
European Union, is among the largest countries in terms of area, and not least, is the most
developed country or one of those countries which is economically, more developed.
We can observe the evolution of the total expenditure over the period, the five most
developed E.U. countries namely: Germany, France, Spain, Italy and Britain. Earlier I
referred to the fact that Germany has the highest costs in the European Union in each of the
12 years analyzed, namely an average of 1,051,156 million Euros per year. The situation of
Spain is quite interesting because, although in terms of the population size and the surface, it
should be among the first countries, however, Spain outlays slightly above the EU average,
from 231,202 million Euros in 1999 to an amount of 484,759 million Euros in 2008,
representing its peak value. The average spending in Spain was 350,203 million per year. The
explanation could be that Spain joined the European Union in 1986, relatively recent, so it's a
growing country (in course of development). It should be noted that in each country we
analyzed, the total budgetary expenditures increase approximately with the same rate in
absolute amounts, but the largest percentage growth rate is in Spain, a country where the
spending increased by more than 50% in 2008 compared to 1999.
If we refer to the lowest expenses that were incurred during the analyzed period in the
European Union, we see that they are around 1,900 million Euros, with a minimum of 1.575
million Euros in 1999 and a maximum of 2643, 8 million Euros in 2010. Making a brief
overview of developments in expenditure for public order and safety, we can see that the
minimum line of the E.U.27 evolution coincides with the line of the government development
expenditure in Malta. As in the case with Germany, Malta’s case is explained by demographic
and geographic reasons. Thus, Malta is the country with the smallest population, with a total
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of 400,420 people; also Malta is the smallest E.U. member country with an area of 316 km2.
The Maltese Government has spent an average of 2,643.8 million Euros in the period.
In the E.U.27, was spent on average around 200,000 million Euros over the period
1999-2010. The highest amount spent on average was in 2007, when the expenses reached
211,043.5 million Euros. Conversely, the year 2000 is the year, when the countries spent an
average of 183,056.5 million Euros. Interestingly is the fact that the line of the development
costs in the E.U.27 has average that is closer to the minimum level of expenses, compared to
the maxim level of expenses, although, normally it should be at the equal distance from the
two lines. This is explained by the fact that the European Union countries has among the 27
members, 6 countries very large, which although, are rather developed, they are not even
close to the level of the expenses made by the first 6. (Zai, Inceu, Mara, 2008, p. 268-279).
There are also data which are presented with the goal to explain the evolution of the
total budgetary expenditures in 9 countries, that recently joined the European Union, among
which, Romania is to be found. We can see that all these countries are below the average
government spending from the E.U. member countries. Out of these 9 states, we considered
that the highest level of spending is reached by Latvia, a country that in just ten years, almost
tripled its government spending, from Euro 2,848.6 million Euros in 1999 to 8933.4 million
Euros in 2008. Also, we can see that the Czech Republic and Hungary have a fairly large
increase, reaching the end of the analyzed period, the costs of approx. 50,500 million Euros.
Romania comes rapidly from behind and in only four years recorded a significant percentage
increase by about 70%, spending up to 45,296.6 million Euros in 2007. The highest value that
Romania achieved in this chapter took place in 2008. The other analyzed countries (Cyprus,
Lithuania, Latvia, Luxembourg, Slovenia, Slovakia) also recorded steady growths, but the
expenditure of these states exceed 10,000 million Euros only in Slovenia, Slovakia and
Luxembourg with a maximum of 26,347.5 million for Slovakia in 2010.
An important aspect of the analysis of the evolution in total government spending of
European Union member countries is to calculate the indices with fixed base, and the
interpretation of their results. Thus these indices give the largest and the smallest increases
reported to the base year (1999), the average growth in the European Union is also reported at
1999. On average, in 2000 the states spent 5% more than in 1999. In 2008 the according to the
same graphics, the biggest expenses occur throughout the studied period (1999-2010),
followed in 2009 and 2010 by a decrease of the budgetary expenses.
Also, we have analyzed data regarding the chain based indices for the period 19992010. Thus, we shall present the smallest and the biggest increases of the expenses as a total;
135
at the E.U. 27 level (the Department of Statistics of the I.M.F. revised the 1996 edition of
Handbook of Statistics Finance Government. The new manual presents a system of
Government Statistics (GFS) harmonized as far as was possible with the System of National
Accounts, 1993.), respectively, the average growth recorder in the every single year. We
noticed that with the exception of the years 2002 and 2005, in each year there are registered
decreases in the government’s spending in several member states. Thus, in this period,
Germany (2000), Poland (2003), Sweden (2001), Malta (2004) recorded decreases in total
costs compared to the previous years. A significant increase was registered in Hungary in
2002 when the spending increased 1.46 times over 2001 l, rising from 28,144.4 million in
2001 to 36,284,000 Euros in 2002. (Pulpanova, 2004, pp.22-24).
The total expenditure in the E.U.10 has doubled in comparison with the accession
(2004) and increased by 2.4 billion Euros, reaching a value of 11.5 billion or almost 12% of
total expenditure in the E.U.25. The main beneficiaries of these increases were: Poland (5.3
billion Euros, 1.3 billion more than last year), Hungary (1.8 billion Euros) and the Czech
Republic (1.3 billion). In addition, an amount of almost 1.1 billion Euros went to Romania
and Bulgaria as a pre-payment. In the past seven years, Spain was the biggest recipient of the
E.U. funding (99.5 billion Euros for the entire period), followed by France (89.6 billion),
Germany (79.1 billion), Italy (70, 2 billion) and UK (50.2 billion).
General public services expenditure. At the first sight, we can observe that the
maximum of the expenses for the general public services, at the E.U. 27 level, varies between
122,000 million Euros and 150,000 million Euros, with a yearly average of 132,000 million
Euros. In 8 out 12 years studied, Germany allocates the most money for this type of
expenditure, with an average of 132.605 million Euros for the period analyzed.
Romania has also an interesting situation, because in 2003 there were general public
services expenses lower than in 2002, with about 5%, then there has been a steady increase,
reaching a value of 4.408, 4 million Euros in 2007, but the maximum was reached in 2008
with a value of 6533.40 million Euros.
Defense expenses. England, Germany, France, Italy and the Netherlands are the
countries where we find the largest expenses in this regard. We can see that the U.K. is clearly
distanced from the other countries, the government spending on average 42,791.61 million
Euros, with a maximum of 49,793.9 million Euros achieved in 2006, and a minimum of
33,246.8 million Euros reached in 1999. It can be considered a surprise that the U.K. spends
more on defense, because it is considered the most developed member state, but if we think
that this country is involved with both significant forces in Iraq and Afghanistan, this is
136
explained. In the second position of the volume lies France with defense costs, on average in
the period we analyzed, in quantum of 32,931.17 million Euros. The most significant
percentage increase in defense spending took place in Romania, where in a single year; they
increased from 1354.5 million to 2280.4 million Euros. Significant increases above 10% were
also registered in the U.K. (18%), Portugal (16%), Czech Republic (12%) and Luxembourg
(10%).
The expenses with the public safety and order. The average of the expenses with the public
order and safety at the Union’s level remains constant for the whole period around the value
of 7,000 million Euros, to be more specific 7,600.40 million Euros. If we take a look at the
share these taxes hold as expenditures in the total government spending, we can say that they
have a share of approximately 4% in the European Union. On average, the most money that is
spent on public order and security is in Bulgaria, where such expenses go up to 7.34% out of
the total spending, and the least amount of expenses, was in Greece, where the share does not
exceed 1.5%.
Economic affairs expenditures. The Czech Republic, Romania and Malta are the
countries with significant percentages of over 6% of the G.D.P. spent on economic affairs.
The maximum of 25% occurs in Ireland in 2010, while the minimum of 2.2% in England in
2000. The minimum is recorded due to higher international oil prices. The trend to reduce
these costs in Europe was due to the privatization of the industry and the lower percentage of
investment. Like the previous category of expenditure here too are some factors that influence
the growth and the reduction of the expenses.
Environment protection expenditures. The average share in the total expenditures
for environmental spending at the E.U. level lies around 1.61% in all the twelve years we
analyzed. It is a relatively small proportion compared to other types of expenditures. But in
some countries(Sweden, Romania) are not even allocated the value of 0.5% out of the total
budget for the environmental protection.
The expenses regarding the housing and community amenities. These expenses
include expenses for the housing development, community development, water supply, street
lighting and others. We can observe that the average housing expenses with the comfort in the
European Union ranges from 4000 to 5000 million Euros. The countries that spend the most
money in this respect, France, Germany and England, these costs start from 23.000 to 38.000
million Euros. At the opposite pole we have countries that spend small amounts of such
expenses, Estonia, Lithuania, Latvia and Malta, well below the European average.
137
The expenses with the health system. The average annual cost of these expenses is
between 25,000 and 30,000 million Euros in the E.U. 27, with an average on the twelve years
of approximately 28 billion Euros. The largest amounts spent on health range from 123 and
178 billion Euros, with a maximum of 157.290 billion reached in 2010 in the E.U. 27. Next,
we shall analyze the evolution of the data in absolute amount, only in those states where we
have high costs on health, compared with average of the E.U. These countries are: Germany,
Spain, France, Italy and Britain. Other countries where the share of health spending is above
the E.U. average are: Romania, Portugal, Czech Republic, Slovenia and United Kingdom.
Expenses for recreational activities, culture and religion. The expenses incurred by
E.U. states’ governments for recreation, culture and religion are not as great as value. We
noted that the annual average is somewhere around 4,000-5,700 million Euros, with a
minimum average reached in 2000, namely 4,114.03 million, and an average peak in 2007, of
5,743.88 million Euro.
The expenses for education. The education is or should be very important for all the
countries, so the analysis of the expenditures incurred in this field is very important, both, as
structure and as evolution. We can see that the E.U. average ranges between 20,000 and
23,000 million Euros, with a maximum of 27,106.35 million Euros achieved in 2010. In
contrast, stand the small population countries that have spent around 200 - 400 million Euros,
annually for education. The countries with values above the E.U. average are: Germany,
Spain, France, Italy and Britain. It is surprising that the largest amount was spent on education
in England, in all the twelve years we analyzed. We can see that Romania and Slovenia are a
separate case in comparison with the other countries, with annual averages of 3,705.87
million Euros, respectively 1,857.38 million Euros. The lowest amounts spent on education,
across the E.U., in all the twelve years we have analyzed, were registered in Malta.
Social protection expenditures. We also noticed that in: Denmark, Austria, Sweden,
Germany, and France appear the highest share of the G.D.P. spending on the social protection
(20%) out of the G.D.P. In Ireland, Cyprus, Luxembourg, Lithuania, Latvia, Estonia is
observed the lowest share of the G.D.P. spending on the social protection. The average social
protection expenditure share of the G.D.P. in the E.U. 27 is 16.19%. The maximum of these
shares in E.U. 27 is 25.40% and was registered in Denmark in 2010, while the minimum was
7.8% in Ireland in 2000 and in Cyprus with the same amount in 1999.
138
Homework:
1. Which are the main types of expenditures?
2. Which are the three groups of expenses?
3. Which are the sub –sectors of the public administration at E.U. level?
139
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Documents:
1. Anuarul Statistic al României
2. Strategia fiscal bugetară 2012 –2014
3. Raportul Băncii Mondiale- Afacerile în 2006.
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