Public finance Course 1 Framework and tools

PSE – Public Finance – Sandrine Duchêne1

Public financeCourse 1

Framework and tools


Introduction

What is public finance ?

Study of the taxing and spending activities of a government Something misleading: because not financial (= not related to money) Economics of the public sector, public economics

“micro” functions : allocation of resources, distribution of income

“macro” functions : use of taxing, spending and monetary policies to affect overall level or GDP or unemployment => usually taught in separates courses (A. Epaulard). Here special look : linkages between public finances and the business cycles (European framework for public finance analysis)


Introduction

Not in our field, but quite important => regulatory policies, which have important effects on resource allocation

Sometimes, goals can be achieved by regulation or by tax and spending instruments.

3 examples:

i. Environmental considerations : caps, permits, market instruments, taxation

ii. Labor market : economists admit that regulation/institutions can have a great influence on employment : labor contract, labor duration/ tax cuts diminishing labor costs

iii. Purchasing power : direct subsidies (especially to the poor)/ stimulating concurrence on the goods markets.


Introduction

Program

I The « macro » framework : why monitoring public finance ?

1. Data, facts and concepts2. Public finance and the business cycle3. Do we care about long term ?4. Are budgetary rules useful ?

II The « micro » tools and main issues for reforms

1. Tax policy: some theoretical concepts2. Reforming our tax system: some issues3. Public expenditure: public goods, education, social insurance


Introduction

Chapter I-1 Data, facts, and concepts

1. The role of the public sector: current issues2. Public finance in EMU: an overview3. Example: the French situation (what is the problem ?)4. To practice: some calculation5. Concepts and data; procedures.

1- Role of the public sector/current issues

What is public finance ? By tradition (Musgrave), three roles devoted to the public sector :

Allocation : Public good provision Redistribution : social transfers, progressivity in the tax system Stabilization : “automatic stabilizers”

Do these 3 objectives conflict ? The answer is yes. Trade-off efficiency/equity Room for macroeconomic stabilization when there are pressures

for a fiscal adjustment ?




Illustration: Public expenditure breakdown

France UE-25 Germany Spain Italy Poland UK Sweden

1 General public services 7,4 6,7 6,3 5,1 8,8 5,9 4,7 8,2

2 Defence 1,9 1,7 1,2 1,1 1,5 1,2 2,7 2,1

3 Public order and safety 1,3 1,7 1,6 1,8 2,0 1,7 2,5 1,4

4 Economic affairs 3,2 4,0 3,9 4,3 4,1 3,3 2,9 4,9

5 Environmental protection 0,8 0,7 0,5 0,9 0,8 0,6 0,7 0,3

6 Housing and community amenities 1,8 1,0 1,1 1,1 0,7 1,5 0,6 0,9

7 Health 7,2 6,7 6,3 5,1 8,8 5,9 4,7 8,2

8 Recreation, culture and religion 1,4 1,0 0,7 1,4 0,9 0,9 0,6 1,1

9 Education 6,4 5,4 4,2 4,4 5,1 6,1 5,7 7,3

10 Social protection 22,0 19,1 22,5 13,0 17,9 19,0 16,1 24,7

11 total expenditure 53,4 47,6 48,4 38,3 48,1 44,5 43,2 58,2Source INSEE, 2003


Allocation

Justifications for the State intervention in the provision of public goods are well known: the very nature of public goods, externalities, endogenous growth … justice, defense, security, education, health…but also direct interventions to corporations and individuals.

Questions : Cost/effectiveness of public policies? Efficiency of public spending? What is the good production model? Distinguishing between financing and

producing (delegation, agencies models): education, health, defense are concerned.

Public intervention proper area? Public coverage for expenditure (education, health).

Quality of public finance, allowing better growth in the long term? Public policy evaluation



Distribution

Social insurance, horizontal and vertical distribution.

Difficult to disentangle from the third function (stabilization): insurance aims at avoiding hysteresis effects in bad times (unemployment insurance, on-the-job training, minimum benefits)

Current re-visited (old) questions : Justification for the public action? “Minimalist” State avoiding economic

distorsions, flat tax in Eastern European countries… Rooms for manoeuvre: how to deal with the increase in the age-related

expenditures? Acceptable inequities in a society? Efficiency/equity dilemma. Fiscal

competition issues. “New” social contract: “rights and duties” issues



Stabilization

Size and effectiveness of automatic stabilizers

Justifications for discretionary action along the business cycle

Questions Effectiveness of automatic stabilizers revisited in the context of fiscal

retrenchments (keynesian/non-keynesian effects). Effectiveness of discretionary policies has been questioned

At the European level, leave enough margins to let automatic stabilizers play (“mimimum benchmark”)

Fiscal policy in the current crisis and discretionary policy: framework has to be adapted


2- Public finance in Europe : an overview

The budgetary framework: initial framework (up to 2005)

Treaty (Maastricht 1992, then Amsterdam 1997)

•Member states have to avoid excessive deficits, with respect to deficit and debt reference values

•These references are defined in an annexed protocol (n°20): 3% of GDP and 60%.

Stability and Growth Pact endorsed in 1997:

•Two regulations: preventive arm, corrective arm

•Stability programs

•Definition of medium term objectives (MTO): “close to balance or in surplus”



Main Issues for the conduct of fiscal policies in Europe

One common fiscal framework = common rulesTreaty and the reference valuesStability and Growth Pact (amended in 2005)

Addressing heterogeneous situations (as concerns deficit levels, cyclical conditions or sustainability conditions)

In the short run, enforce the whole play of automatic stabilizers (preventive arm of the Pact), better interpret the cyclical conditions (preventive and offensive arm), prevent “pro-cyclical biais”. This view is currently challenged by the huge economic downturn (Pact is suspended)

In the long run, address the problem of an increasing age-burden : achieving budgetary consolidation (stability programs)



The initial budgetary framework: strongly critized

From a theoretical point of view: lack of economic bases. Nominal

targets independent on cyclical conditions, and on specificities of the countries (“one size fits all”)

From a practical point of view (crisis in 2003)

Economic reflexion had already started in 2001-2002, continued till 2005.

Reformed SGP in 2005 Better attention paid to cyclical evolutions (course 2) Better attention paid to the long term and sustainabitity questions, with

linkage to the MTO (course 3)




Fiscal heterogeneity in Europe: crossing data on the level of public deficit and debt :



Consolidation efforts in 2007: dispersion





Long term sustainability conditions

3- The French situation : what is the problem ?

France: the pathologic case? A brief look at some facts

Public deficit: still high, around 3% Public debt: increasing Public expenditure: high compared to other countries (reflects social

choices) Tax ratio: high level in the context of fiscal competition

All these elements are linked together Expenditure monitoring is not stringent enough (compared to GDP

evolutions) No room for fiscal adjustments No room for significant tax cuts








Public expenditure: long term trend and composition



Expenditure level : a French exception ? High level, compared to other countries Stability since 10 years



Since 20 years, public expenditure in line with GDP growth => no room for budgetary adjustment


3- The French situation : what is the problem ?(iii) Public receipts

Tax ratio

Source : OCDE

10

15

20

25

30

35

40

45

50

55

1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

Allemagne Italie

Espagne Royaume-Uni

10

15

20

25

30

35

40

45

50

55

1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

Etats-Unis France

Suède UE à 15


4- Some calculation

Question 1You just have been elected at the Presidency. You are discovering the budgetary situation. What is the current deficit ? The primary balance ?

Assumptions

GDP = 2000 Md€ Expenditure level = 50% of GDP Receipts level = 48% of GDP Debt level = 60% of GDP Nominal interest rate : 5%


4- Some calculation

srb

% of GDP Md€Spending 50 1000including interest payments 3 60Public receipts 48 960Balance -2 -40primary balance 1 20debt 60 1200

déficitb

surplusb

0

0

dri

ibalanceprimaryb


4- Some calculation

Question 2

You are building the budget law for 2008.You forecast : GDP growth : 2,5% Inflation rate : 1,5%

Suppose the public receipts are in line with GDP growth.

Just after your election, you meet your “peers” at the Ecofin Council. You claim that you will respect the Pact. So you announce that you intend to reduce public deficit by ½ percentage point of GDP next year.

What must be the for the growth rate of public expenditure ? What will be the deficit and debt ratio next year ? What is the stabilizing deficit ?


4- Some calculation

Notations

B: general government balance (Md€)b: general government balance (% of GDP)[Public deficit = - b]

R: public receipts (Md€)r: public receipts (% of GDP)

S: public spending or public expenditure (Md€)s: public spending or public expenditure (% of GDP)

g: GDP growth in real termsπ: inflation of GDPg+ π: GDP growth in nominal termsgs: spending growth in real terms

t

tt

t

tt

t

tt

GDP

Ss

GDP

Rr

GDP

Bb

ttt

ttt

srb

SRB

tt

tt

SgsS

RgR

)1(

)1(

1

1


4- Some calculation

Equation for deficit variation :

GDPS

GDPR

GDPB

t

t

t

t

t

t

1

1

1

1

1

1

GDPS

GDPRb

t

t

t

tt g

gs

g

g

)1(

)1(

)1(

)1(1

srb tttggs

))()(1(

1

sbbb ttttgsg

)(11

srb tttggs

))1)(1(

1

First order approx

ssrb ttttggs

)(

1

0,5 in Europe, 0,35 in the US


4- Some calculation

)(5,01

gsgbt

GDP growth in real terms

Expenditure growth in real terms

= MARGIN for deficit reduction

Here :0,5=(2,5-gs)*0,5Gs=2,5-1=1,5

If gs<g : deficit reduces If gs>g : deficit increases

Very practical« back on the envelop »

formula


4- Some calculation

Equation for debt accumulation :

GDPB

GDPD

GDPD

t

t

t

t

t

t

gg

)1()1(1

1

1

)1()1(11

gg bdd ttt

bdd tttg

11)(

deficitgstabilizindeficitdt 1

Stab def = 60%*0.04=2,4Def =1,5Debt variation = -0,9

bddd ttttg

11)(


4- Some calculation

Question 3

Your administration presents you the “technical” forecasts.

Clearly the claimed evolution of expenditure is not realistic : medium term trend is rather 2% in volume per year.

What will the “true” deficit be ? What can you do (to make the public finance forecast more presentable) ?

To help you, you use the “elasticity” of the receipts with respect to GDP

tt

t

tt

t

tt

RgR

GDPGDPGDP

RRR

))(1(1

1

1


4- Some calculation

technical forecastsgeneral government balance -2,0general government balance t+1 -1,75deficit variation 0,25spending growth (in real terms) 2receipts elascticity 1public debt variation -0,65


4- Some calculation

Equation for deficit variation :

srb ttt g

gs

g

g

)1(

)1(

)1(

))(1(1

srb tttggsgg ))()(1())()(1(

1

)()()1(5,01

gsggbt

srbb ttttgsgg )()))(1((

1

5.0 sr tt


4- Some calculation

technical forecasts elasticity>1general government balance -2,0 -2,0general government balance t+1 -1,75 -1,50deficit variation 0,25 0,50spending growth (in real terms) 2 2receipts elascticity 1 1,125public debt variation -0,65 -0,90


4- Some calculation

Question 4

In addition you are fulfilling you campaign engagements.

You decide tax cuts to support activity and employment : “paquet fiscal” amount = 1 point of GDP%.

What do you do ??? Describe several options : “technical” “fulfilling European commitment”

(expenditure/elasticity options)

pb ttgsgg

11)()()1(5,0


4- Some calculation

technical forecasts (1) spending growth (2) elasticity>1

general government balance -2,0 -2,0 -2,0general government balance t+1 -2,75 -1,50 -1,50deficit variation -0,75 0,50 0,50

tax cuts (% of gdp) 1 1 1spending growth (in real terms) 2 -0,5 2receipts elascticity 1 1 1,625

public debt variation 0,35 -0,90 -0,90

Scenarios fulifilling european comitments


4- Some calculation

Question 5

Finally you decide announce a stabilization of the deficit next year, at its current level.

You choose 1,2 for the elasticity of receipts with respect to GDP.

Describe the key figures of the forecasts Prepare your arguments for the journalists !


4- Some calculation

technical forecasts official forecasts

general government balance -2,0 -2,0general government balance t+1 -2,75 -2,0deficit variation -0,75 0

tax cuts (% of gdp) 1 1spending growth (in real terms) 2 1,3receipts elascticity 1 1,2

public debt variation 0,35 -0,40


4- Some calculation

Question 6

Bad luck, GDP growth collapses during 2008.

Finally : GDP growth is 1%. Elasticity (which is a bit cyclical) is 0,8. Expenditure rate is 2% in real terms.

What is deficit and debt ratio ?

You decide privatizations during the year (1% of GDP) : what are the final deficit and debt ratio ?


4- Some calculation

technical forecasts Final results

general government balance -2,0 -2,0general government balance t+1 -3,50 -3,75deficit variation -1,50 -1,75

tax cuts (% of gdp) 1 1spending growth (in real terms) 2 2receipts elascticity 1 0,8

public debt variation 2,00 2,25


4- Some calculation

Conclusion

In April 2009, you notify the 2008 results to the European Commission

Observing that you are above 3%, the Commission launches the excessive deficit procedure against your country.

Well done !!

5- Concepts, data, and procedures

What is a budget?

Distinguishing budget preparation (ex ante), vote, and execution (ex post)

Juridical dimensions: authorization, vote by the Parliament. Strictly defined and bounded. Main issues: to allow information and control from the Parliament.

Procedure dimensions: elaboration of the budget law, voting rules and procedures. Technical questions: bottom-up or top-down procedures? How to better involve the Parliament?

Questions about accounting systems: reliability of the figures, accrued/cash presentations. Defining principles inspired by the rules applied to the private sector (if possible?)



Two Finance laws voted each year (october-december)budget law for the stateSocial Security budget law3 types: LFI, LFR (“collectif budgétaire”) , loi de règlement

Two organic laws establishing the budgeting rules, recently revisedLOLF (2001), “ordonnance de 1959”Organic law for the Social Security (2005)

Local budget are adopted by the local executives. Financial autonomy delivered by our constitution, but limitedVote of tax rates (but not tax bases), expenditure, debt



Principles for budgeting: the four “classic” principals

1- “Annualité”

• authorization is given for one year.

• Strongly criticized for a form of short sight (at the broad level, in the global monitoring of public finance/ at the “micro” level, for the managers who are in charge of structural reforms)

• Current issues: pluriannuality. In september 2008 vote of a multi-annual budget for the state, covering a 3-year period (2009-2011)

2- “Unité”

• One document for one procedure.

• To ensure transparency and coherence of the budgeting elements. To make the political choices or trade-offs more explicit. (exceptions: comptes spéciaux du trésor, budgets annexes).

• Current issues: “débudgétisations”.PSE – Public Finance – Sandrine Duchêne45


Principles for budgeting (continued)

3- “Universalité”

• Double design Avoiding contraction between receipts and expenditures, describing all the

flows in the budget law No receipt affected to some identified expenditure

• Current issues: affectation of receipts can be justified : environmental taxes ; willingness to pay (health care)

4- “Spécialité”

• Budgetary credits have to be affected to a precise expenditure

• Specialisation by nature or objective of the public expenditure

• Current issues: adoption of the new budget constitution (LOLF) in 2001, fully applied in 2006



Emergence of new budgetary guidelines

1- “Sincérité”

• Ex ante: growth forecasts, receipts forecasts, realist evaluations for expenditures. Respecting budgeting rules (“charte de budgetisation”)

• Ex post: accounts (LOLF)

• Guidelines for budgetary transparency (IMF, OECD)

2- Equilibrium

• 1959: an abstract reference (“equilibre économique et financier”).

• Golden rule for the local governments

• Since Maastricht: a juridical constraint, enshrined by the SGP=> margins for interpretation. A target for the medium term.

• Currently debated: reforming the budget constitution and introducing an equilibrium constraint (for the State or the Social Security)

3- Performance/efficiency of public expenditure



The LOLF innovation

A new architecture for the budget Missions (34)/programmes/actions, reflecting economic

concernsBetter reflecting the government priorities of public policies,

and have a complete view of the amounts devoted to certain objectives Role of the Parliament enforced: examines the whole budget, and not

only additional measures. Better reporting of the government to the Parliament

Introduction of performance indicators for each program Better implication of the public managers Reform of the public accounts, certification process by the Cour des

Comptes



Budget law is composed of two parts

• First part: « conditions générales de l’équilibre financier »

– authorization to perceive taxes

– debt authorization

– fiscal measures applying to the year

– spending ceilings

– Equilibrium article

• 2d part:

– vote on the different expenditures (vote unity=mission)

Evaluative/limitative expenditures or receipts

Joined documents: text in itself+ “bleus” (“voies et moyens”, missions, RESF)+ “jaunes”, report on expenditure evolutions, report on taxes



Elaboration of the budget laws

ActorsDirection du Budget/Direction de la sécurité sociale: central roleMatignon: coordination between the Ministry of Finance and the

ministries, crucial arbitration roleDGTPE (macro and public finance forecasts)Direction de la législation fiscale: fiscal measuresThe « spending » ministries/ Social security agencies

Main issues:Ensure coherence between both processes (PLF and PLFSS) =>

creation of the Ministry of Public Accounts steps up in this direction.Allow discussions at the technical level between administrations



Elaboration of the budget laws (continued) Schedule

In January, « lettre de cadrage » send by the Prime Minister to the Ministers

Feb/march: « conférences d’économies structurelles »April/may: « conférences de budgétisation »June/July: expenditure ceilings decided, « lettres-plafond »June: « Débat d’orientation budgétaire » at the ParliamentJuly/August: macro forecasts and receipts forecasts. Public Finance

forecasts covering the whole general government (Maastricht form), final decisions concerning State and Social security

September: Conseil des Ministres

Main issues: improve articulation with the European commitments, with a better linkage between national targets and the stability program.



Accounting notions

Several accounting systems: public accounting systems/national accounts

Each sector has its own accounting system and rules

State Budgetary accounts, budget execution

oOutcome: “solde budgétaire”= solde du budget général+ solde des comptes spéciaux du trésor (CAS privatisations, CAS

pensions, compte de dette)+ solde des budgets annexesoLimits: neither an operating result or gross saving, nor a net

lending or borrowing result. Consolidation? State guarantees?General public accounting (LOLF)



Accounting notions

Social securityHarmonization started in the 90’s, now certified by the CdCSocial accounts on an accrued base“Commission des Comptes” in June (N-1) and September (N, N+1)Mostly reported: “solde du régime général”

Local governments“M14” accounting systemSpecific presentation in two parts:

oThe operating section: current charges and receipts (including taxes and transfers from the State)

oThe investment sectionMain limit: no consolidation



State budget balance



Social Security balance (Régime général)



Social Security balance (social risks)- Social Budget Law



National accounts

ESA95: harmonized system of accounts in Europe, allows comparability between countries (Maastricht criteria, annexed protocol)

Strict definition for public entities: combines control and activity (excludes public corporations like EDF or SNCF, public financial corporation like BDF or CDC)

4 sub-sectors; State, Other central government (900 entities: CNRS, CEA, FRR, CADES, universities…), Local government, Social security (larger than the PLFSS field, unemployment insurance and hospitals)=> large coverage

Consolidation between all sectors Accrued basis approach Economic approach: see Musgrave approach Non financial (B9)/financial accounts Usual aggregates: value added, EBE, gross savings, net lending/borrowing

balance (B9). For analysis expenditure/receipts approach is convenient



Elaboration of public finance national accounts

Responsibility = INSEE (annual, quaterly accounts) Notification to Eurostat: twice a year (1st April N, 1st October N),

INSEE for the past data (until N-1) Government for forecasts (year N)

march N= “Compte provisoire” for the year N-1 First outcome for the year N-1 Involves 3 actors: DGCP (treatment of public accounts for a lot of entities),

DGTPE (because missing elements have to be evaluated), and INSEE (validation, decisions about treatments, coherence)

Links between usual agregates (“solde budgétaire”, “solde du Régime général”, and the “B9”)

Data are revised the years after (“compte semi definitif”, “compte definitif”)

Final judge=Eurostat



Non Financial Accounts


2003 2004 2005 2006 2007public deficit 4,1 3,6 2,9 2,4 2,7public debt 62,9 64,9 66,4 63,6 64,2expenditure ratio 53,3 53,2 53,4 52,7 52,6tax ratio 42,9 43,2 43,6 43,9 43,5Source INSEE

Public finance ratios

2003 2004 2005 2006 2007State -62,0 -52,8 -52,2 -47,4 -39,2Other central entities 4,8 9,5 7,1 10,5 -2,6Local govenrment 0,5 -2,4 -3,3 -3,2 -7,2Social Security -9,0 -14,6 -2,8 -3,3 -1,6General governement -65,7 -60,2 -51,1 -43,4 -50,6Source INSEE



Structure of expenditure and receipts

Total, of which 956,9 Total, of which 910,5

Intermediate consumption (P2) 94,0 taxes on production and imports (D2) 275,9Wages (D1) 234,7 taxes on income and wealth (D5) 211,8Interest payments (D41) 46 social contributions (D6) 328,1Social transfers 420,1 property income (D4) 12,2Gross fixed capital formation (P51) 60,1 production receipts (P11) 59,5

Source INSEE, 2006

Expenditure Receipts



Public expenditure at different levels (2006)

Comptabilité nationale

Md€ en %

Dépenses APU 956,9

ÉTAT 380,6 39,8%

ODAC 62,2 6,5%

APUL 199,3 20,8%

ASSO 437,0 45,7%

Total sous-secteurs 1079,1 112,8%




Financial/Patrimonial accounts (2007)

• Register all public assets and liabilities.

• Public debt= sum of financial liabilities

• Maastricht debt=financial debt in nominal value, gross debt, and consolidated between all sub-sectors

• Net public debt

• Net value


total of assets (1) 2104,1

Non financial assets (3) 1462

Financial assets (4) 742,1Currency and deposits (AF2) 73,6Securities other than shares (AF3) 40,9Loans (AF4) 49,9Shares and other equity (AF5) 392,4other accounts receivable/payable (AF7) 185,3

Financial liabilities (2) 1427,5Currency and deposits (AF2) 68,5Securities other than shares (AF3) 1028,2Loans (AF4) 182,2other accounts receivable/payable (AF7)+AF6148,6

Net financial debt (2)-(4) 685,4

Net value (1)-(2) 676,6Source INSEE


Advantages Provides a complete view on public accounts (consolidation), on an accrued

basis No “free lunch”: some measures improving the situation of certain sub-

sectors deteriorate the situation of another one Financial links between State and local governments, State and social

securityMeasures to respect the State expenditure target

In theory clear distinction between operations “above the line” and “under the line”

Limits Limits of accounting systems used as inputs “grey zones”, especially concerning the relationships between State and

Public corporations: dividends/patrimonial operations, injections of capital, State guarantees. Or securitization operations.


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Public finance Course 1 Framework and tools

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