Public finance fundamentals, second edition

Table of contentsForeword vi Section 1 Public money and government 1.1 Money defined in relation to finance 21.2 Money defined in terms of its conceptual properties 31.3 Money defined in

Second Edition

kabelo moeti (editor)

public finance fundamentals

Public Finance Fundamentals second edition presents a comprehensive

understanding of the way that government manages its finances The scope

of the book reaches beyond the specifics of legislation and policy, with the

focus resting on fundamental principles, procedures and methodologies of

public finance These fundamentals are relevant not only to the South African

experience, but can be applied globally

This edition has been updated to reflect changes in legislation, policies and

practices relevant within the current Public Management environment

Features include:

• clearly presented chapters

• learning outcomes and summaries

• illustrations, tables and figures

• interactive online supplementary material containing the relevant

pieces of legislation referred to in the text

Public Finance Fundamentals second edition will equip both students and

practitioners with generic analytical skills of public finance and will provide

them with an understanding of the relevant legislation, policies and regulations

about the editor:

Kabelo Moeti specialises in Public Finance and Public Sector Economics

He holds a bachelor’s degree in Finance from Georgia State University, a master’s

in Science Administration from Central Michigan University and a doctorate

in Administration from the University of Pretoria He currently serves as an

Associate Professor at Tshwane University of Technology (TUT) in Pretoria

Public Finance Fundamentals

Second Edition Kabelo Moeti (editor)

Public Finance Fundamentals

First published 2014

Print published 2007

Second edition published 2014

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Table of contents

Foreword vi

Section 1 Public money and government

1.1 Money defined in relation to finance 21.2 Money defined in terms of its conceptual properties 31.3 Money defined in terms of its physical properties 41.4 Key characteristic of money – acceptability 51.5 Defining money as M1, M2 or M3 5

2.3 The South African Reserve Bank and monetary policy 132.4 Comparing monetary policy instruments 14

2.6 The theoretical reality of the Phillips curve 162.7 Institutions responsible for monetary and fiscal policy 17

Chapter 3 Public provision of goods and services, and key sources of

3.1 The provision of goods and services by the state 19

Public Finance Fundamentals

Chapter 4 Role players in public financial management (S Nsingo) 44

4.1 Public financial management 444.2 Key role players in financial management 464.3 The executive authority and public financial management 524.4 The administrative authority and public financial management 554.5 The Reserve Bank and public financial management 57

Section 2 The relationship between accounting and finance

5.3 Generally accepted accounting principles (GAAP) 63

Section 3 Intergovernmental fiscal relations (IGFR)

Chapter 6 Organisation and functioning of government in terms of

inter-governmental fiscal relations (IGFR) (T Khalo) 74

6.2 Legislative framework for revenue collection and allocation 796.3 Factors necessitating allocation of revenue sources 826.4 Sources of revenue for spheres of government 846.5 Intergovernmental fiscal relations 86

Section 4 Contemporary reforms to South African public financial

7.5 Programme budgeting and multi-year programme budgeting 101

Chapter 8 Safeguarding ethics and accountability in the public sector

8.1 Concern about unethical and unaccountable conduct 1128.2 Categories of unethical conduct: Conflict of interest 1148.3 Institutional bodies for combating unethical conduct in the

Chapter 10 From procurement and tendering to supply chain

10.2 Decentralisation of tendering as a reform 143

10.4 Social policy goals of procurement 146

Chapter 11 Local government financial management in South Africa

11.1 Background to local government challenges in South Africa 15211.2 The need for financial management in local government 15211.3 Democratic principles and local government finance 15311.4 Legislative framework for municipal financial management in

11.5 The cycle of local government financing 15811.6 Structures involved in local government finance 15811.7 Budgeting process in local government 16211.8 Local government financial reporting and auditing 164

Public finance, the subject of this book, is one of the most important areas of public administration What public money is spent on, and how efficiently and effectively that money is spent, are key determinants of economic development and social progress A sound understanding of public finance

is a priority for students, analysts, government officials, taxpayers and citizens alike

South Africa’s Public Finance Management Act recognises that managers throughout the public service exercise trusteeship over public resources and must be held accountable for the use of public funds Our budget reform programme has sought to locate financial responsibilities where they can best be exercised, and to strengthen the quality of information about public service delivery on which resource allocation decisions must rest It is therefore critical that students of public administration should be equipped with a well-rounded understanding of public finance

Public Finance Fundamentals provides an introduction to the challenges of public finance policy,

management of public funds, intergovernmental fiscal relations and some of the key reforms underway in South African public finances Students are encouraged to apply the concepts and ideas

of public finance management to the practical problems of providing education and health services,

of managing municipalities and public transport networks, and of ensuring that policing and the courts of law are soundly administered Progress in public administration depends on these ideas, how they are debated in the classroom and how they are given practical effect in a wide array of public service careers

Trevor A Manuel, Minister in the Presidency

Pretoria, April 2007

Management, both in the public and private sectors, usually employs accounting and financial experts in an advisory and reporting capacity As a result, many managers, supported as they are

by financial experts, believe they themselves do not need knowledge or experience of finance as a discipline This is far from the truth: an understanding of financial management empowers managers, enhancing their ability to recognise and assess problems and opportunities, to interpret information received from accountants and auditors – and to communicate information to them – as well as providing the tools and methods with which to tackle numerous types of organisational problem, most of which have financial implications

Financial experts often seem to hold a monopoly over the link between financial information and financial decisions However, managers who understand financial information, and particularly those who understand it from the perspective of those schooled in the finer points of finance, find themselves in a much stronger position to deal with organisational problem solving and decision making

The aim of this text is to help the reader understand how financial information is gathered, analysed and thereafter used in management decisions The sequencing of the chapters may, in some instances, appear linear – for example starting with the definitions of money, finance and public finance, and then dealing with sources of money, etc – but the design is such that each chapter can stand on its own and the order

in which chapters are covered depends entirely on the reader and/or instructor

In today’s legally complex environment, it is imperative to possess a working knowledge of the legislation that governs and regulates one’s professional domain The supplementary material, available for LMS dissemination, provides detailed information on all relevant Acts, as published in the Government Gazette

This gives interested readers an opportunity to scrutinise the full legislation for themselves and develop

a thorough understanding of the topics and arguments presented in the text

The title Public Finance Fundamentals was decided upon to encompass the notion that students,

practitioners and others would benefit most from the type of financial knowledge that is fundamental, the type of knowledge that is a lasting tool for problem solving

Kabelo Moeti

Pretoria, August 2013

Editor’s dedication

This work is dedicated to the memory of Dipuo Seisa-Moeti, my beautiful wife of 12 years, who tragically and unexpectedly passed away on 27 November 2012 She dedicated her life

to me and her children in all that she did She gave me four beautiful daughters and taught

me what it means to love and be loved She will be missed

Introduction to the section

Government exists to attend to the collective needs of society Worded differently, governments would not be needed if all individuals (and even groups) were able to provide for all of their own needs and desires This scenario, of a society in which members meet their own needs as well as those of their group, is plausible only to a very limited extent Individuals, families, churches and other groups may well be able to provide for themselves

in terms of food, clothing, shelter, etc, but they would probably not be able to provide adequately for every need that might arise What about those members of society who cannot provide even basic necessities for themselves? What about the rights of weaker individuals and communities in a world where individual members and groups have to compete and seek only to meet their own immediate needs and requirements? And what about the security of the nation?

It should be noted that there exists a large array of political, social and economic problems (such as potential invasion/attack by neighbouring states, crime, infectious diseases, poverty and illiteracy) that can be minimised only through collective action As a result, civilised societies choose to empower governments to use taxation (amongst other strategies) as a means of providing a range of collective services and products, such as national defence, police services, public health care, welfare programmes, education and waste disposal The provision of all government goods and services requires that they have one thing in common, and that is money

Later sections of this text deal with government taxation and other sources of government income, as well as the problem of allocating scarce resources to their most efficient, effective and equitable purposes, and budgeting Section 1 deals more generally with money and public money, for example the definition of terms and explanation of concepts; the examination of government use and management of public money, with specific reference to monetary and fiscal policy; the classification of services provided, based on revenue sources; and the identification of the responsibilities of particular governmental role players charged with managing public money

Section 1

Public money and government

Defining money

K Moeti

1

By the end of this chapter, you should be able to:

■ explain the term finance in relation to money

■ provide four definitions of money, based on its conceptual properties

■ define money on the basis of its physical properties

■ define, understand and use the term liquidity

■ define money in terms of liquidity, vis-à-vis M1, M2 and M3

■ define, understand and use the term public money

■ discuss, briefly, the terms public interest and public benefit

Before proceeding with particular public finance topics, it is important to define

adequately the terms money and public money These definitions will go some

way towards helping us to grasp the magnitude and scope of the economy In later chapters we will use these definitions in our examination of the role of government

in the economy

1.1 Money defi ned in relation to fi nance

To define the term finance as ‘anything to do with money’ would be overly simplistic,

but not incorrect As we will see in more practical applications in later chapters,

finance has to do with the management of money This may include either using

money to make more money (investing) through a process of analysing the economy,

financial markets and/or individual companies; or using financial data and financial

management tools to manage the monetary1 affairs of a company or a public institution In each of these descriptions, finance is equated to money

1.2 Money defined in terms of its conceptual properties

In addition to being defined in relation to finance, money can be defined in terms of

its key conceptual properties, namely as a:

■ unit of account

■ means of paying off debt

■ medium of exchange, and

■ store of value

We will now look at each of these properties in turn

1.2.1 Money as a unit of account

In an economy where goods and services are tradable with each other or for money, there needs to be a way of attaching a price to such goods and services Money serves as an abstract measure of value, in the same way as kilograms and pounds are abstract measures of mass/weight, and litres and gallons are abstract measures of volume Whether in terms of dollars, rand, yen or whatever currency, this

measurability characteristic of money is referred to as a unit of account.

1.2.2 Money as a means of paying off debt

In all financial transactions, a good or service is provided and a debt created Thereafter, this debt can be terminated only by way of the payment of money In a simple purchase transaction at a supermarket, for example, the moment the goods that you have selected are given to you by the cashier, a debt has been created At almost the same instant, you terminate that debt by paying for those goods In this respect, money can therefore be defined as a means of settling debts.

1.2.3 Money as a medium of exchange

In ancient times, before money came into use, goods and services were exchanged

on the basis of bartering Bartering as a system was highly inefficient as, for example,

a man who specialised in making shoes could only get the other goods he needed (say, bread) by finding and trading with a person who needed shoes and specialised

in making bread This may not have been all that problematic in small societies, but

in today’s densely populated towns, cities and metropolitan areas, people could not possibly get all their needs for goods and services met through the bartering system

Simply put, without money, goods and services would have to be exchanged for other goods and services Based on the unit of account property of money (discussed above), goods can be ‘priced’ and sold The proceeds of such sales can then be

Public Finance Fundamentals

4

used to purchase other goods Thus, by putting money into the exchange equation, efficiency is created as all traders should readily accept money in exchange for the goods and services they have to offer, and in turn, all traders could use this money

to buy any other good or service The shoemaker who needs bread does not have to worry about whether the breadmaker needs a pair of shoes By referring to money as

a medium of exchange, we are saying that money is generally accepted in exchange for goods and services and/or for settling debts.

1.2.4 Money as a store of value

Money not only has utility (usefulness) for today’s purchases, but can also be used for future spending That is, people do not always want to spend all of their money

in the present, and they will therefore save some for a rainy day The setting aside of money through an investment is most commonly done to hedge against unforeseen maladies, such as the loss of a job, loss of an income-earning loved one, a sudden disability, saving/investing for children’s future university studies, or loss of a house

by fire In this respect, the money put away for future spending can be (among

other things) in the form of stocks, bonds and insurance policies, all of which are

considered money, even though there may be some lag time to convert them into

cash Money thus also serves as a store of value, meaning that future purchases can

be made from money set aside today

1.3 Money defined in terms of its physical properties

Money may also be defined in terms of its physical properties In ancient times, when the system of barter was the norm, money embodied any physical form that

had value for someone Thus bread, shoes, animals, and even stones were exchanged and accepted as currency The two most common physical forms of money in contemporary society are coins and paper currency – and in the not-so-distant past

(spanning the period of bimetallism through the period of the gold standard, circa

1792 until 1933)2, gold and silver were also used as physical forms of money.Interestingly, bartering – which opens up infinite possibilities in terms of physical items that could be considered to be money – is still not so uncommon in our modern times Prison inmates, for example, may choose to exchange cigarettes for other goods As a second example of modern-day bartering, it can be noted that cigarettes were also widely used as a medium of exchange in Europe after World War II due, in large measure, to the fact that the war had left many official European currencies practically worthless

1.4 Key characteristic of money – acceptability

Whether speaking of money’s conceptual or physical properties, any item must meet one important characteristic in order to be defined as money That characteristic

is that it must be generally accepted, such that it maintains relative stability in

value over time Thus, for example, cigarettes may be considered to be a form of money by prison inmates, but in an environment where a large number of people are non-smokers, cigarettes cannot be thought of as ‘generally acceptable’ and a form of money The typical non-smoker, for instance, would not accept cigarettes

as payment for anything, so cigarettes could not then be considered as a form of money/currency

In terms of maintaining relative stability in value over time, using the same example, most prison inmates would think twice about accepting cigarettes in exchange for other goods today if there were pending legislation seeking to ban smoking

in prisons

1.5 Defining money as M1, M2 or M3

Another important way in which money is often defined is in terms of its liquidity

Liquidity refers to the ease or ‘speed’ with which an asset can be converted into cash (with minimal loss) Thus, on the balance sheet (to be discussed in greater detail in

Chapter 5), assets are grouped in two different categories: current assets (that are relatively liquid) and long-term assets (which are relatively illiquid) Current

assets are normally further broken down and ranked according to liquidity (speed

of transferability into cash), such that cash will be the first item listed under current assets, followed by marketable securities, and lastly inventories

Additional categorisations of money according to liquidity are M1, M2 and M3 These classifications are important for Reserve Bank and National Treasury officials in the performance of monetary policy (to be discussed in the next chapter), as the proper definition of money can affect how money in the economy is measured and managed.The broadest definition of money is M3, which includes the most illiquid measures of money in the economy, as well as M2 and M1 (ie M3 = the most illiquid measures

of money in the economy + M2 (which includes M1))

Less inclusive a measure of money than M3 is M2, which includes relatively illiquid measures of money in the economy and M1 (ie M2 = relatively illiquid measures of money in the economy + M1)

Public Finance Fundamentals

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Lastly, M1 is the most liquid measure of money in the economy for monetary policy purposes (refer to Table 1.1) Economists often disagree as to what the exact components of each of these measures of money should be, but most generally accept that M1 should include cash, cheque deposits and travellers’ cheques which are not held at the Reserve Bank or National Treasury

■ M3 normally consists of M2 plus institutional savings and cheque deposits above

a specified amount (for example US$100 000), and institutionally owned money market and unit trust accounts (Klein, 1986: 11)

The central bank and economic analysts need to monitor trends in all three monetary aggregates, and generally pay particular attention to credit extension to the private sector as an indicator of potential spending power in the economy There is considerable complexity in calculating or assessing the larger monetary aggregates however, as financial institutions are continuously adapting their products and services to changing economic conditions

Table 1.1 Typical components of M1, M2 and M3

Currency outside of the Reserve

Bank, National Treasury, and

vaults of commercial banks

Currency outside of the Reserve Bank, National Treasury, and vaults of commercial banks

Currency outside of the Reserve Bank, National Treasury, and vaults of commercial banks Travellers’ cheques Travellers’ cheques Travellers’ cheques

Other checkable deposits Other checkable deposits Other checkable deposits

Savings deposits Savings deposits Time deposits Time deposits Money market deposits Money market deposits Unit trusts Unit trusts

Institutional time deposits Institutionally held money market deposit accounts

Institutional unit trusts

Source: Adapted from Klein, 1986: 9–11

1.6 Defining public money

Money can be either:

■ privately owned, in the hands of private individuals and private institutions, and

spent to advance private interests

■ publicly owned, managed and controlled by the State on behalf of the people of

the country and spent to advance the public’s interests

The key focus of public finance, and thus of this book, is public money (ie publicly owned money)

It is important to stress that ‘public money’ under the control of government is held collectively by the state on behalf of the people, to be used in the public interest

In democratic countries, the public elects the government, and this government exists (and is remunerated) only to provide the goods and services that the public wants, but for which the public is unable to provide for itself on an individual basis Through taxation (as the main instrument used by government to gather revenue), government is supposedly able to gather from the public the necessary funds to provide public goods and services

Public money must be used to provide public goods and services in the public interest and for public benefit This is important to note, as it is easy to claim (mistakenly) that only taxpayers should benefit from public money, since taxpayers are the key contributors of that money This is an invalid claim in any democratic country, as the principles of public interest and public benefit would apply, as discussed below

1.6.1 Public interest

Public interest is the idea that although communities/countries are made up of

individual citizens (taxpayers and non-taxpayers alike) with their own peculiar needs,

it is in the interest of the community as a whole that a collective effort (especially through government) be made to provide essential goods and services to all, regardless of their actual contribution to the system or their ability to pay

This is consistent with the now famous tax principles espoused by Adam Smith (1723–1790), namely benefits received and ability to pay Adam Smith believed that the amount of tax each person should pay should take into account both the benefits received from public expenditure and an individual’s ability to pay

Public Finance Fundamentals

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The public interest as a concept takes cognisance of the fact that a country has to take care of all of its people – not just some of its people – in order to make the country more governable and perhaps even more developed In a country such as South Africa, where the unemployment rate was just over 40% in the early 1990s, this is an important principle; with almost half the population out of work, one could expect crime, drug abuse, infectious diseases and other social ills to affect (directly

or indirectly) all citizens (rich and poor alike) In this case, government should make

an effort to alleviate unemployment and poverty with the expectation that a better life for the underprivileged will translate into a better life for all

1.6.2 Public beneft

In short, public benefit is the idea that government spending of the money entrusted

to it by the public must take place in the most efficient and cost-effective

manner In other words, government must spend public money in such a way that

the public receives and experiences value for money

One set of definitions needs clarification at this point, these being efficiency, effectiveness and economy These terms are often used interchangeably, but in order

to understand the language of the latest and most comprehensive South African legislation in respect of public finance (the Public Finance Management Act (PFMA), and the Local Government: Municipal Finance Management Act (Act 56 of 2003) (MFMA)), the distinctiveness of these terms must be recognised:

■ Efficiency has to do with inputs and outputs We are said to be efficient if we can

produce the maximum amount of output for a given and fixed amount of input(s)

■ Effectiveness, on the other hand, has to do with meeting objectives We can be

very productive, efficient and economical, but all for naught if we do not meet our objectives, or if we satisfy the wrong objectives Thus, regardless of whether

we are efficient or not, we shall have to measure our effectiveness by the extent

to which our objectives are met

■ Economy, lastly, has to do with least cost Where all else is equal (for example

quality of goods that have to be purchased by a manager), we must decide on the least costly option

Further important terminology, with respect to how public money is to be managed and spent, is the term ‘appropriateness’ According to the PFMA and MFMA, public money is considered to have been inappropriately managed or spent if instances

of unauthorised expenditure, fruitless and wasteful expenditure, and/or irregular expenditure are present Each of these terms deserves further attention:

■ Unauthorised expenditure, as defined by the PFMA, refers to overspending and/or

spending that is not in accordance with the mandated purpose of appropriated funds

■ Fruitless and wasteful expenditure refers to unnecessary expenditure that should

have been avoided if reasonable care had been exercised

■ Irregular expenditure refers to authorised (as opposed to unauthorised) expenditure

that happens to be in contravention of other applicable legislation

Contrast the definition of irregular expenditure with the definition of unauthorised expenditure above, and it can be seen that irregular expenditure is actually authorised expenditure that is in violation of some or other procedural requirement

An example would be the situation in which a senior manager is authorised by legislation to make the final decision about which contractors to use to service the needs of his or her department Any decision the manager makes in this regard is authorised, but may violate Treasury regulations (and thus be considered irregular expenditure), which exist to ensure that all eligible contractors receive an equal opportunity to do the work

Summary and conclusion

In this chapter it has been argued that the definition of money is important and fundamental to public finance for a number of reasons First, it is important to understand that finance is essentially anything to do with money As such, money can be defined in terms of what it includes and what it excludes Thus, for example, there must be a differentiation between public and privately owned money When speaking of public money, it is also critical to realise that public money belongs to the people of the country and not to those who manage and spend these funds in the public interest

It is important to note that ‘public finance’ refers to the money controlled on behalf

of the public by the government, which should be managed with due regard to economy, efficiency and effectiveness in pursuit of the public interest

Self-examination questions

1 Compare and contrast the conceptual and physical properties of money

2 Discuss M1, M2 and M3 monetary aggregates

3 Compare and contrast the terms public interest and public benefit in the context

of public financial management

Monetary policy and fiscal policy

K Moeti

2

By the end of this chapter, you should be able to:

■ define monetary policy

■ define fiscal policy

■ differentiate between monetary and fiscal policy

■ identify the institutions that deal with monetary and fiscal policy

■ identify the goals, proximate targets and instruments of monetary policy

■ explain how monetary policy’s goals, proximate targets and instruments work together as a system

Although primarily defined as government taxing and spending for the provision

of public goods and services, fiscal policy also refers to government taxing and spending in order to influence economic conditions (unemployment and inflation) Monetary policy, on the other hand, attempts to influence the same economic conditions, but through different means

As the name may suggest, monetary policy is concerned primarily with the nation’s money supply That is to say, monetary policy is that branch of economic policy that attempts to meet economic stabilisation objectives through the management of the

money supply in circulation (mostly M1 money) Interest rate manipulation by the monetary policy authorities (Reserve Bank and National Treasury) is also considered

an indirect means of affecting the nation’s money supply and thus stabilisation

At least three different monetary policy instruments are available to policymakers This chapter aims to explain the key policy instruments of monetary policy and the relationship between fiscal and monetary policy

Stabilisation policy: Policies of government that are aimed at maintaining moderate

to low levels of unemployment and inflation, whilst stimulating economic growth The two broad categories of stabilisation policy are fiscal policy and monetary policy

GoALS

Full employment

Economic growth

Price stability

Balance of payments equilibrium

Exchange rate stability

PRoXiMAte tARGetS

Money supply

Interest rates

inStRUMentS

Open market operations

Control of bank reserves

Reserve Bank lending to commercial banks (discount window)

Figure 2.1 Goals, proximate targets and implementing instruments of monetary policy

Source: Adapted from Chick, 1977: 13

The goals of monetary policy cannot be directly attained with the use of monetary policy instruments; instead, monetary policy goals are met by first influencing,

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in the desired direction and magnitude, proximate targets The attainment of these proximate targets is then expected to translate into the attainment of monetary policy goals after a relatively predictable ‘lagged’ period

More specifically, the instruments of monetary policy are designed to directly affect the money supply in the economy and/or affect the level of interest rates (proximate target) in order to attain the goals of monetary policy, as depicted in Figure 2.1

The discussion now turns to a brief exposition of the instruments of monetary policy, which include (among other things) open market operations, reserve requirements and the discount window

2.2 Open market operations

Open market operations deal with central bank (South African Reserve Bank) sales to

or purchases from the general public, of government securities (bonds and treasury bills) in order to affect the amount of money in circulation in the economy When the central bank purchases the government securities that pension funds hold, for example, then the fund managers receive cash which they can invest by lending

to businesses or buying shares The central bank’s open market purchase results

in an increase in the amount of money in circulation encouraging spending and

an expansion of economic activity Conversely when a central bank sells securities (stocks and/or bonds) to the general public in exchange for cash, the amount of money in circulation is decreased (and the amount of securities held by the public increases concomitantly)

Table 2.1 Open market operations: conditions, actions, effects

economic

conditions

Action taken by central bank

effect on amount of money in circulation

Inflation Sell government securities Decreases

Recession Buy government securities Increases

It can further be deduced that since open market operations change the amount of money in circulation, they can also influence inflation, interest rates, investment and savings, and even employment

With respect to bringing inflation under control, open market operations change the amount of money in circulation, as indicated in Table 2.1 Inflation is characterised

by unnaturally high prices, and is most often brought about by excess demand for

goods and services in relation to supply Excess demand in turn results from the situation in which there is too much money in circulation In the situation in which inflation is unacceptably high, central bankers will quite often use open market operations to sell government securities to the public, thereby reducing the amount

of money in circulation and reducing the inflation rate Likewise, the purchase of government securities will be considered by central bankers when economic activity

is slow (ie recessionary) and inflation is low (refer to Table 2.1)

Although open market operations are limited to the sale and purchase of government securities, they do affect the amount of money in circulation, and thus interest rates Thus, with respect to interest rate levels and employment, in inflationary times, excessive amounts of money in circulation will tend to lower interest rate levels, as the cost of borrowing must naturally be reduced when there is an abundant supply

of money Lower interest rate levels in turn – according to the traditional Keynesian view – stimulate investment, which then translates into employment creation, thus attaining yet another of the goals of monetary policy

While interest rates can be affected by open market operations, manipulation of interest rates is not one of the mechanisms of open market operations Instead, interest rates are more directly related to ‘discount window’ policy (to be discussed later in the chapter)

2.3 The South African Reserve Bank and monetary policy

In South Africa, the main responsibility of the central bank with respect to monetary policy is to protect the value of the rand (s 224(1) of the 1996 Constitution) This refers to the purchasing power of the rand as measured by consumer prices, which

is sometimes referred to as the ‘internal’ value of the currency, to distinguish it from the ‘external’ value which is measured by the rate of exchange of the rand for other currencies

The South African government has adopted an ‘inflation targeting’ approach to monetary policy This means that the Reserve Bank is obliged to pursue monetary policy measures aimed at maintaining inflation in the agreed target range The present target set by the Minister of Finance is 3–6% a year, measured by the 12-month increase in CPIX, or consumer prices excluding mortgage interest costs

According to this rationale, in order to combat inflation, the value of the currency needs to be protected The reverse of this is that too little money in circulation (recession) is indicative of scarcity of the currency, which results in an upward

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valuation of the currency and downward pressure on inflation If the inflation rate is below a specified target range, it can safely be increased by devaluing the currency (this may occur, for example, when trade policy requires an improvement in export performance) This strategy (referred to broadly as ‘accommodation policy’) of the South African Reserve Bank is related to open market operations, as influencing the external value of the currency is done mainly through buying and selling in the currency market4

2.3.1 Discount window

The discount window/repo rate5 refers to the interest rate at which central banks lend money to commercial banks, who in turn lend money out to the general public at a rate of interest referred to as the prime interest rate (or prime + a smaller percentage) Adjustment of the repo rate will surely have an impact on the amounts of money borrowed and put into circulation The rationale of the discount window is that the more expensive it is for commercial banks to borrow money from the central bank, the more likely it is that commercial banks will pass the increased costs of borrowing

to the general public This, in turn, will lead to lesser amounts of money being taken out of the banking system and put into circulation When a situation of high inflation exists, central bankers will consider increasing the repo rate; when the economy is in a recession, central bankers will consider decreasing the repo rate

2.3.2 Reserve requirement

Cash reserve requirements refer to the amount of money all commercial banks are required to set aside (usually a percentage of cheque and savings deposits) and cannot use for transaction purposes (making loans, etc) When the Reserve Bank increases this ‘reserve requirement’, banks have less money available to inject into the economy by way of loans (and vice versa)

2.4 Comparing monetary policy instruments

Open market operations are thought to be a more effective tool for manipulating the economy than changes in reserve requirements Reserve requirements are thought

to have an extraordinarily strong effect, such that small changes in this percentage lead to a more than proportional change in a bank’s ability to loan, invest and create money Thus, for example, an increase in an existing reserve requirement from 2,5%

to just 3% of deposits translates into an astronomically large increase, and restriction

on the banking sector’s ability to make loans and investments, when one looks at the total volume of money involved In many cases, an open market operation (sale

or purchase of securities) may have to be used to dampen and moderate the effects

of reserve requirement changes

In addition, some economists have argued that changes in reserve requirement ratios are not practical measures to use for short-term stabilisation of the economy, because banks have to be given time to adjust their financial structures and there may be delays in the intended effect on changes in the amount of money in circulation.

Table 2.2 Comparison of monetary policy instruments

open market operations* Discount window/repo Reserve requirement

Decreases repo rate

Increases required ratio

Decreases required ratio

Increases money supply

Decreases money supply

Increases money supply Increases

inflation

Decreases

inflation

Decreases inflation

Increases inflation

Decreases inflation

Increases inflation Decreases

interest rates

Increases

interest rates

Increases interest rates

Increases interest rates

Increases interest rates

Decreases interest rates

*(Not necessarily in sequential order of occurrence)

2.5 Fiscal policy

Fiscal policy refers to changes in government taxing and/or spending6 Although the primary basis of fiscal policy is the provision of public goods and services,

fiscal policy also refers to government taxing and spending in order to influence

economic conditions such as unemployment and inflation This is so because government taxation will, at the end of the day, determine the amount of disposable income available to private individuals and businesses In this regard, an increase in taxes will, to some extent, reduce the money supply (thus also reducing the demand for goods and services) and thereby reduce inflation Employment can be affected

by taxes in that a tax increase will cut into profit margins of private businesses, who may then choose to offset this loss of income by retrenching the workforce The opposite can also be expected, that is, that a tax cut will provide private businesses with the extra capital needed for business expansion, which may in turn require employment creation

Alternatively, government spending can stimulate private investment, private income and private spending as private businesses are awarded government contracts for providing goods, services, projects and programmes Such spending creates employment and increases the amount of money in circulation, which in turn puts upward pressure on inflation A reduction of government expenditure can be expected to have the opposite effect

Public Finance Fundamentals

16

In contrast to monetary policy, which is the main responsibility of central banks, usually in consultation with the National Treasury, fiscal policies are normally determined by Treasury and/or parliament/congress In addition to being classified

as tax or expenditure, fiscal policy can also be categorised as either expansionary or contractionary, depending on whether such policy aims to reduce inflation, deal with

a recession, or create employment, as shown in Table 2.3 below

Table 2.3 Effects of expansionary and contractionary fiscal policy

Tax cuts Increased government

expenditure

Tax increases Decreased government

expenditure Create employment Create employment Reduce inflation Reduce inflation

Mitigate recessions Mitigate recessions Increase unemployment Increase unemployment

Unlike government expenditure, tax rates can take effect relatively quickly and have therefore been the main focus of fiscal policy where short-run stabilisation objectives needed to be met Government expenditure, on the other hand, has proven to be better suited to meeting long-run fiscal objectives as most government expenditure programmes (for example building roads and hospitals) take a long time to plan and complete

A key difference between fiscal policy and monetary policy is the fact that fiscal policy is far more amenable to governments’ redistribution goals In this regard, South Africa’s tax structure is progressive to begin with, and changes in tax rates tend to further favour the poor Similarly, government expenditure on social and developmental programmes is strongly in favour of the poor

2.6 The theoretical reality of the Phillips curve

There is one major reality check with respect to attaining the shared goals of monetary policy and fiscal policy (vis-à-vis controlling inflation and unemployment) According to the Phillips curve, whenever unemployment is low, inflation tends to

be high and whenever unemployment is high, inflation tends to be low This inverse relationship between inflation and unemployment is depicted in what economists refer to as the Phillips curve (see Figure 2.2)

This inverse relationship between inflation and unemployment presents a bit of a dilemma for policymakers as efforts to reduce inflation increase unemployment, and efforts to decrease unemployment increase inflation Government policy must thus aim for some middle ground where the levels of both unemployment and inflation are present, but within an acceptable range

Inflation rate

Unemployment rate

Figure 2.2 The Phillips curve

2.7 Institutions responsible for monetary and fiscal policy

One of the key differences between monetary and fiscal policies inevitably rests on which institution develops these policies Monetary policy is typically developed and implemented by a central bank, whereas fiscal policy decisions are the responsibility

of the national government In the case of South Africa, there is a constitutional requirement that the Minister of Finance and the Governor of the Reserve Bank must consult one another whilst carrying out their respective functions (Gildenhuys, 1993: 119–120; see also s 224(2) of the 1996 Constitution) This requirement of ongoing consultation may go a long way towards ensuring that monetary and fiscal policies complement each other

As monetary and fiscal policies both strongly affect the economy of a country, they must be coordinated with each other (Klein, 1986: 257–258) Klein (1986) suggests that in all corrective instances, both monetary and fiscal policy measures must be used together, or at least coordinated (such that the left hand knows what the right hand is doing and does not get in its way) – and states that ‘ both monetary and fiscal policy must be carefully implemented in almost any type of economic maladjustment, be it recession, inflation, slow growth, or any combination of the three’

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Summary and conclusion

This chapter dealt with yet another fundamental area of government economic policy, that is, the area of monetary and fiscal policy, collectively referred to as stabilisation policies

Fiscal policy refers to government taxing and spending in order to first provide public goods and services that society desires and, secondly, influence economic conditions such as inflation rates and unemployment Monetary policy, on the other hand, attempts to influence inflation and unemployment through manipulation of the money supply (mostly M1 money, as discussed in Chapter 1) Three of the most commonly used monetary policy instruments, ie open market operations, discount window/repo rates and reserve requirements, were discussed in this chapter It was also emphasised that monetary policy works in stages such that the intermediate objectives of monetary policy must first be met before main objectives can be attained

Self-examination questions

1 Compare and contrast monetary policy and fiscal policy

2 Compare and contrast open market operations and reserve requirement

Public provision of goods and services, and key sources of government revenue

S Nsingo

3

By the end of this chapter, you should be able to:

■ outline the fundamental rationale for the state to provide goods and services

■ describe the various categories of service provided by the state

■ describe the different sources of revenue for the state

■ define and briefly explain the terms:

to the state, and attempt to match these to the types of service (collective, particular

or quasi-particular) the state provides

3.1 The provision of goods and services by the state

In most modern economies, be they free-market systems or planned economies, decisions to provide goods and services are taken by both the private and the public sectors This means that the state has a role to play in the economic well-being of

a country In fact, the economic role of the state has become part of our daily lives Governments spend large sums of money to provide us with a plethora of services,

Public Finance Fundamentals

20

such as health, education, technology, roads, railways, defence and security These services are not ordinarily provided by the private sector, although the state may decide to take on private sector partners to expedite the delivery of these services

It is significant to note that the untenable economic conditions during the apartheid era led to the development of a dual economic system, popularly referred to as the ‘first economy’ (a modern free-market economy) and the ‘second economy’ (basically a rural economy embedded in the peasant mode of production) It is only through state action that the two economies can be integrated and the playing field levelled for a unified economic system geared towards fair allocation and distribution of resources throughout the country The fact that South Africa is a developmental state means precisely that government has to manage the economy so as to offer a visionary economic transition that benefits all South Africans, particularly the marginalised societies who need expanded government services that were denied them during apartheid rule

As can be seen, the government of South Africa, just as with any post-colonial government, has several challenges to address in order to build the national economy For it to succeed in this agenda, the government needs a large outlay of financial resources This means that the government should be able to raise enough revenue to provide the multitude of services expected of it, thus the raising of revenue becomes the first major challenge that a developmental state faces And this is to be done mainly – but not exclusively – through taxation, as discussed in section 3.11

3.2 The scarcity factor

According to Plato (427–347 bce), government exists to enhance social welfare and make life good for members of society It should promote the public interest and ensure that all of society stands to benefit from the scarce resources at the disposal

of the nation, thus the state is needed to manage the scarce resources and make sure these are utilised efficiently for maximum benefit From the outset, we can see that the state’s presence in economic affairs is justified largely on the basis of the effective management of scarce factors of production (land, labour and capital) This means that the scarcity factor (together with the need for state provision of

collective goods) dominates the argument of the role of the state in the economy, thus government action within the national economy is seen as a matter not only of choice, but of necessity (Visser & Erasmus, 2002: 22)

The scarcity factor underlines the economic problem that ‘resources are scarce yet the people’s wants are unlimited’ South Africa has not been spared this problem as, especially under the system of apartheid, already scarce resources were centralised

and rationed to only a few South Africans based on ethnic factors Democracy, in

1994, opened up the economic system to competition and increased demand on these resources The current challenge with which the South African government

is faced is to meet the demands of the majority of the people in the face of little increase in available resources to do so

3.3 Market failure

In a utopian world without government(s), private markets would provide all of

the goods and services needed by the populace In the real world, however, this is not the case, as private markets provide only those goods and services that can be produced and sold for a profit Private producers do not invest in the production

of goods and services that are unprofitable, and thus many essential goods and services desired by the public will never be produced privately This situation, in the

language of public finance and public sector economics, is referred to as market

failure Governments attempt to resolve market failure by taking on the production

and/or provision of those essential goods and services desired by the public but not produced by the private sector

Market failure exists as a result not only of the unwillingness of private producers

to provide publicly needed goods and services; the inability of private producers is also an issue, as are the issues of externalities and public goods The discussion that follows addresses each of these in turn

3.4 Increasing, constant and decreasing returns to scale

The inability of private businesses to produce certain publicly demanded goods and services is captured by the concept of increasing returns to scale The

concept of increasing returns to scale can be better understood when contrasted to

decreasing returns to scale and constant returns to scale.

With decreasing returns to scale, the amount of production/output is limited to

a certain point, after which further production begins to accrue less and less profit The profit may even become increasingly negative (losses) if production is allowed

to go too far beyond the critical point (refer to Figure 3.1) An example of a product that exhibits characteristics of decreasing returns to scale is a factory that has a fixed amount of machinery, equipment and manpower For such a factory there will be a limit (ie the maximum amount) to how much of the particular good can be produced

It may be possible to push production beyond this limit, but the cost of doing so (by, for example, paying workers for overtime) may actually make it unprofitable

Public Finance Fundamentals

22

Maximum output

Production

Figure 3.1 Decreasing returns to scale

The constant returns to scale model, on the other hand, is characterised by a

production process in which output gains are always proportional to input costs (refer to Figure 3.2) Thus with constant returns to scale, there is no real limit to the amount that can be produced, and profits can be expected to grow in direct proportion to production costs

Production

Figure 3.2 Constant returns to scale

It follows then that increasing returns to scale is the situation in which it is more

than proportionally profitable to increase production The relationship is exponential and thus cannot be depicted by a straight line (refer to Figures 3.3 and 3.4), thus any increase in production costs is more than offset by increases in profit Large organisations with excess and under-utilised factory capacity may find themselves in this situation For such organisations, it is in fact less profitable to produce too little of

a good for which plant and equipment are under-utilised and for which demand exists

Public Finance Fundamentals

of this example would not break even in the short to medium term, and thus would not survive in this industry (see Table 3.3 on page 31) Government, mainly through its statutory taxing powers and access to tremendous resources, is in a position to enjoy increasing returns to scale on such essential and publicly demanded goods as water and electricity The productive characteristic of increasing returns to scale makes it quite affordable for government to provide some of the goods and services that the private

sector has an inability to provide.

Natural monopoly: The term used to refer to industries that are characterised

by increasing returns to scale Alternatively stated, industries in which it is only possible/feasible for one large organisation to be the sole producer of a good (as smaller organisations would not be able to produce the good on a cost-effective basis) are referred to as a ‘natural monopoly’

3.5 Externalities

Market failure, as discussed above, not only has to do with the unwillingness or inability of private businesses to provide unprofitable goods and services demanded

by the general public; market failure is also characterised by the intervention of

government in the marketplace to provide these goods and services.

In addition, externalities are yet another condition related to market failure in which government will intervene in private markets to ensure that publicly demanded goods and services are provided – on the basis of efficiency

Although defined in various different contexts, efficiency is defined here as technical/engineering efficiency in which goods and services are provided by the private sector

on the bases of least cost and prices being reflective of their true costs Externalities are present where technical efficiency does not exist More specifically, externalities are external costs or external benefits that are not accounted for in calculating the cost of production or the price to be charged consumers Externalities can be positive

or negative, as discussed below

it has a chance to spread to other farms benefits all farmers in the area, although only farmer J had to pay to deal with the weed In the ideal situation, all farmers in the affected area should bear some of the costs of eradicating the weed As it may not necessarily be human nature for the other farmers to compensate farmer J, governments normally intervene in such cases by subsidising farmer J In other words, governments

normally subsidise the producer of a positive externality in order to assist him or her to

deal with the costs involved in creating what is essentially a public benefit

to use in their own production processes

In the case of negative externalities, governments normally intervene by taxing the producer of the externality and using those funds to deal with the external effect (for example restoring the water to its original condition)

Governments borrow in order to finance the deficit between revenue and expenditure as well as the annual interest (debt services) costs and past debt

Public Finance Fundamentals

3.6.3 Non-apportionable

This means that it is not possible to divide up the good or service into measurable units that can be priced and sold Although water and air are both public goods, there is an important difference with respect to public versus private provision Water

is apportionable, as it can be measured in litres, gallons or by weight, and sold per unit as is the case with bottled water Water can thus be either privately or publicly provided Clean air, however, cannot easily be measured, packaged, priced and sold

It is therefore non-apportionable and therefore must be publicly provided

3.6.4 Monopolistic

The term ‘monopoly’ is used to refer to an organisation that is the sole producer

or supplier of a given good or service This condition guarantees the organisation excessive control over prices and the supply of the good or service As can be imagined, a monopoly is usually not ideal for consumers of such goods and services – however, as discussed above, natural monopoly is the situation in which it is actually more efficient (and beneficial for consumers) for a large, well-equipped organisation

to operate as the sole producer A number of publicly demanded goods and services (collective goods) are provided by government on the basis of natural monopoly

3.6.5 No direct quid pro quo

Quid pro quo is the term used to signify that consumers know what (ie how much

of a certain good or service) they will get for an amount spent With collective goods there is no direct quid pro quo, as they are provided through taxes, and most

taxes and fiscal spending tend to be progressive There can be no assurance from government that the public goods and services that we will receive are proportional

to the amount of tax we pay With privately provided goods and services, on the other hand, there must be a direct quid pro quo.

Public sector borrowing

The fiscal deficit (or surplus) that results from the difference between government revenue and expenditure can have a significant impact on the overall macroeconomic performance of a country Government borrowing to finance a deficit results in debt service costs, and excessive borrowing therefore leads, over time, to a reduction in revenue available to spending on public services Interest

on debt is a ‘first charge’ against revenue, and has to be provided on the annual spending budget A budget surplus, on the other hand, allows debt to be repaid, resulting in reduced annual interest costs

The appropriate balance between revenue, spending and borrowing depends on economic circumstances Some countries follow the so-called ‘golden rule’ that borrowing should not exceed investment in new capital assets, which should in turn contribute to economic growth and revenue to service the resulting debt Some countries try to balance their budgets over the business cycle, which means that the excess of revenue over spending during boom years should offset deficits during years of slower growth or decline

The effects of excessive public sector borrowing include rising interest rates, lower private investment and reduced growth, and undue strain on markets and the domestic financial system as a whole If a budget deficit cannot be financed through government borrowing, then the central bank may be obliged to ‘print money’ to meet the government’s spending commitment If this persists, then it leads to accelerating inflation and a general loss of confidence in both the value

of money and prospects for economic development

3.7 Particular goods

In direct contrast to collective/public goods, particular goods are best suited to provision by the private sector and have the following characteristics (which are exactly the opposite of the characteristics of public goods):

Public Finance Fundamentals

3.8 Quasi-collective goods and services

‘Quasi-collective’ refers to goods and services that may have characteristics of both

collective and particular goods and services Quasi-collective goods and services can be

provided exclusively either by the private or the public sector They can also be provided

by the private sector under government contract and government subsidisation.Electricity, health and education are just a few examples of quasi-collective goods

At the same time, electricity has a few characteristics of a particular good, such as the fact that it can be measured, apportioned and priced, and it is also possible to exclude non-payers from using it

Health is another example of a quasi-collective good that has most, if not all, of the characteristics of a particular (privately provided) service, but is most often provided

by the public sector as it is in the public interest to do so

Education is similar to health when it comes to the issue of the public interest For health, it is in the public interest that the prevention of infectious diseases is prioritised, regardless of the potential profits, and it is also in the public interest to ensure that a minimal level of health care is available to all, regardless of their ability

to pay With education, it is in the public interest to have a well-educated population,

as the development and future prosperity of the country depend on it

Table 3.1 Summary of characteristics of collective, particular and quasi-collective goods

Sector responsible for

3.9 Market failure due to lack of market access

The free-market system works on the basis of the laws of supply and demand Consumers express a demand for a commodity and are prepared to pay a certain price for it Suppliers respond by making this commodity available at a ‘fair’ price However, the supply and demand equation is rather individualistic and does not cater for socially oriented products Additionally, failure of the free-market system

can be observed in the fact that members of society have unequal access to the

market as a result of economic position In some cases, consumers have no access

to information on what goods and services are available for them As a result they cannot participate in the consumption of such goods and services This shortage

of information may be deliberate (especially during the apartheid days) or may

be due to technological advancement (particularly computer technology) and the unavailability of such technologies in the rural areas Thus, most rural communities are likely to be marginalised in terms of consumption of both public and private goods and services

Poverty-prone communities are increasingly dependent on government assistance in both collective (such as defence, clean air, law and order) and quasi-collective (such

as education, health and water services) goods, as well as in strictly oriented goods and services The presence of the state becomes critical in such instances South Africa is a case in point, where the new democratic government has to address issues of poverty, disease, malnutrition and education This means that government is under tremendous pressure to expend incredible amounts of resources in order to mitigate market failure The latter sections of this chapter deal with the financial resources government may secure towards this end

free-market-Table 3.2 Summary of market failure

intervention

Public goods/

collective goods

Goods which are non-rival and non-excludable

and capable of creating free riders

Defence, street lighting

Public provision

Externalities Actions of individuals or firms capable of

affecting others’ private and social costs and

benefits, although the cost or benefit is not

reflected in the value of the transaction

Pollution, road congestion

Taxes or subsidies to equate

Asymmetrical

information

A situation where buyers and sellers have

different sets of information

Health care, used vehicles

Regulation of quality, compulsory pooling

of insurance

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Public Finance Fundamentals

Public ownership; private monopoly

Source: Adapted from Connolly & Munro, 1999: 3

3.10 A classification of the services provided by government

It has thus far been established in this chapter that the state provides a variety of services to the public The rationale for determining which goods and services are to

be provided by government and which services are to be left to the private sector to provide was also discussed We now focus first on classifying government services and then deal with the financial resources available to government for carrying out its mandate

Government services are classified in a number of ways Economists, including renowned economist Richard Musgrave, choose to categorise the economic functions/services of government that are related to government expenditure as follows:

■ Allocation: Government determines what goods and services to produce, and

the quantities of these goods to produce, mainly in response to market failure (to recap briefly, the term ‘market failure’ refers to the need for government intervention when private producers are unable or unwilling to produce publicly demanded goods)

■ Distribution: Government decides who should benefit from government

expenditure

■ Redistribution: Government redistributes resources from the rich to the poor

through, for example, progressive taxation

■ Stabilisation: Monetary and fiscal policy (‘fiscal policy’ refers to government

taxing and spending) concerned with making the economy stable and capable of competing globally

■ Regulation: Government policies and structures put in place to ensure efficiency

in private production

A second classification scheme, the one most commonly used in public administration,

is according to the activities that the state performs These are divided into the following categories (although they are not always mutually exclusive):

■ Community services: The provision of goods and services that have collective

characteristics Examples include street lighting, clean air and defence

■ Order and protection: The provision of goods and services in the public interest

that ensure the physical and psychological well-being of the people Examples include defence, police, justice and civil protection

■ Social welfare: The provision of goods and services in the public interest that

seek to provide access to minimum basic social services for the people Examples include health, pensions, education and training, housing, sport and recreation

■ Economic welfare: The regulation of the economy; stimulation of economic

development; maintenance of economic order; provision and maintenance of economic infrastructure to support the private sector

Table 3.3 shows the different classes of service, the major characteristics of the service category, examples of the types of service in each class and, finally, the most common sources of revenue to support each class

Table 3.3 Classification of services provided by government

commonly used

Community services ■ Pure public goods

■ Collective consumption

Fuel levy, local government taxes, national income taxes

Social welfare services ■ Quasi-public goods

■ Can be provided by individual providers

■ Government enters to fulfil its distribution role

■ Costs can be apportioned to individuals

■ Individual consumption is possible

■ Government can provide in full or subsidise

Roads, health, education, water, electricity

Fuel levy, national income taxes, user charges, nominal levies

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