2.3.1 Public choice theory
The public choice theory explains how government and politicians work using the methods and tools of economics. This theory also provides a mechanism for allocating resources (Buchanan, 1999; Stiglitz, 2000). There are two sides to the argument in public choice theory. On the one hand, some researchers have indicated that the government is not concerned with the trade-off theory; therefore, they may be willing to collect more tax or cut
spending to reduce the deficit. On the other hand, if the government confirms the role of the trade-off theory, it always tries to grow and will attempt to collect more tax and spend less. At present, we do not clearly know which argument is more helpful for policymakers. Furthermore, Stiglitz (2000) indicated that governments always think that increasing public expenditure will make their countries richer. The evidence of government spending in developing countries from 1996 to 2016 supports this argument (see figure 1.5). Additionally, developing countries try to grow, inevitably trading off their expenditure or land to develop infrastructure, agriculture, and human capital (Kanter et al., 2016; Liu, 2017; Beauchamp, Clements and Milner-Gulland, 2018.) All we may know that tax revenue decides the cost of public goods and services. Therefore, political making decision is a complex process. The fiscal process always poses a double choice: one choice or decision related to a size of public spending and the other a choice or decision on the rates of taxes (Buchanan, 1999.)
Furthermore, this theory also poses a challenge for future research due to the persistence of the link between tax revenue and government expenditure. Each individual has a different preferred level of public spending.
Additionally, total tax revenue is based on multipliers between the total type of tax base and tax rates, which may drive the activities of all people in an economy. Furthermore, the popular government often refers to what people want to make decisions. How does the government make its decision since different people prefer different things (Buchanan, 2009; Kaul and Conceiỗóo, 2006; Stiglitz, 2000)? Until now, the public choice theory may not fix this issue. That is why we should try to analyze the long-run relationship between total tax revenue and government expenditure as well as the correlation between public finance and economic growth.
2.3.2. Cost-benefit theory of taxation
Dasgupta and Pearce (1972) noted that cost-benefit analysis (CBA) relates to the term of social gains and losses. However, real benefits and costs may be both direct and indirect. Direct costs and benefits are those related to project objectives, whereas indirect benefits and costs reflect the nature of products (Musgrave and Musgrave, 1989). Schmid (2004) indicated that cost- benefit analysis is a set of economic tools for evaluating budget size, public spending, and regulation. Following cost-benefit analysis, we know that a deficit may be a big challenge, which hinders creating a budget (McGee, 2008). To better handle a deficit, government should thoroughly understand the relationship between tax revenue and government spending. Meltzer and Richard (1981) assumed that in an economy, people have different choices of work or leisure and consumption. These activities affect wages, income tax, and the way government pays for public goods, so they showed that government should balance the amount of government spending and the collection of taxes. However, this study evaluated only the relationships among individuals’ labour choices, income tax, and government expenditure.
To evaluate the full capacity of government, we should investigate total tax revenue and total expenditure.
Based on cost-benefit theory, there is a large body of theoretical research on the relationship between government expenditure and growth of economies, but the arguments are too complicated. Barro (1990) debated that the source of government spending is equal to tax revenue: = = . = . . ∅( ), where g is government spending, T denotes tax revenue, and is the income tax rate. However, governments create budgets from tax revenue based on government expenditure and household spending, so = ( . + . ℎ) , where h is household expenditures. Based on Barro’s argument, the confusion is that government expenditure depends on tax revenue, but we can collect tax revenue after the government and households make expenditures.
This debate is a reason for future research, which more clearly defines his idea and to answer the question: “How do tax revenue, expenditure, and the economy relate to each other?"
In addition, Barro Sala-i-Martin (1992) confirmed that in an endogenous growth model ( = 1− , where G is government purchase). The government’s selection of tax rates and expenditure level is a key cause of different long-term growth. Based on their argument, investors are sensitive to the tax rate. Investment is a crucial element in a growth model. This study argued the role of government in leading private investment as well as providing public goods or services through its spending and taxes. However, Barro and Sala-i-Martin (1992), and Johansson et al. (2008) verified only a part of taxes. Additionally, government spending affects both consumption and production markets. Taxes, which include both direct and indirect taxes, are known to be an effective tool used to finance public goods. When people earn income, they pay a direct tax. When people spend their income, they pay indirect taxes (Hillman, 2009). He also indicated that tax revenue is a multiplier between the tax rate and tax base. Based on his argument, we know that politicians are sensitive to the Laffer curve, so tax rates or tax bases depend on their preference. If a politician prefers to spend more, he will increase the tax rate, while other politicians who want to increase revenue should reduce the tax rate or expand the tax base. A lower tax rate attracts investors because they understand that when investment grows, tax revenue will also rise. There is much literature on the role of public spending, and it is also ambiguous (Dzhumashev 2014). In more detail, Samuelson (1954) disputed that in each economy, there are two types of goods: private consumption goods and collective consumption goods. If individuals prefer both types of goods, then each individual tries to maximize his or her utility.
The government expenditure affects gross domestic economic growth depending on the way those expenditures are made. Most research showed the
method of growth affects public finance and governance quality through aggregate demand or supply. Based on utility function, previous researchers have argued that public finance or governance quality impacts individual consumption of public and private goods, and these independent variables continue to affect the aggregated outcome of the economy.
In short, until now, cost-benefit theory has posed a challenge to academic researchers, who are interested in verifying the relationship between tax revenue and expenditure. Most previous studies did not clearly confirm the hypotheses of relationship between total tax revenue and general government expenditure in both developed and developing countries. Therefore, these are also key tools to support government control of deficits to maintain stable economies.
2.3.3. Governance theory
Governments play an important role in the organization of society and law, as well as increasing economic growth. However, attaining a balance between income and spending always constitutes a big challenge for them.
Stiglitz (2000) indicated that the government is concerned with all economic activities and devises and maintains a legal framework that covers all transactions within an economy. Hillman (2004) reviewed the existing studies, and revealed that public finance is a tool that helps government in low-income countries increase economic growth and reduces poverty. He proved that corruption in these countries makes governments ineffective in spending and in collecting taxes. He also indicated that corruption might come from government regulation, taxation, procurement, and public spending for private benefit. Nevertheless, this research tries to describe the way that corruption affects society and economies. First, corruption has an inverse link with low wages for government officials. Second, corruption is a means of helping leaders or rulers support their authority. Third, rent seeking and corruption
make distribution of natural resources more distorted. Fourth, corruption inhibits economic development because it reduces the effectiveness of private investment and discriminates against small enterprises or start-up companies.
Fifth, corruption reduces tax revenue and makes public spending ineffective.
Sixth, he also posed the argument that there may be more or less corruption in fiscal decentralization, which is a debate that should be further investigated in future research. Seventh, corruption shows the inequality in income distribution and affects taxation. Last, he also confirmed that governments in transition economies should reform their policies to reduce the corruption perception index to improve their governance. In summary, this study revealed that the role of corruption in the effectiveness of public finance and inhibition of economic development in developing countries needs to be verified in future research.
Dzhumashev (2014) performed theoretical research on both sides of corruption, such as households and politicians, and mentioned that corruption has a close relationship to the quality of governance. Corruption can shift the difference of the optimal size of government and become a useful factor to enhance economic growth. Countries with poor governance could spend more than the optimal level, so corruption can support them in developing their economy. This finding shows the limitation of research that studies the role of corruption in an economy without the linkage between quality of governance and government size with corruption.
Applying the Nash equilibrium to analyze the Greek economy, Litina and Palivos (2016) noted that a good way to keep a unique equilibrium is to impose a strong moral cost on corrupt politicians and tax evaders, two agents who try to gain more individual benefits.
Célimène et al. (2016) indicated a different way that households and politicians used refunds from tax evasion. Private investors can re-invest their
gains from tax evasion to develop production, which can increase the economy. However, the benefits gained by politicians from household bribes can be used only for individual purposes. From this debate, we can learn that corruption has different effects depending on how transactions of corruption benefit both politicians and households in a society.
In summary, governance theory confirm the linkage between quality of governance, government size, and corruption, so to verify the role of corruption in economic growth, researchers should care about both sides of an economy; in other words, the private sector and politicians. In addition, corruption and quality of governance also lead to activities in the private sector as well as the public sector, like tax revenue and government expenditure. Until now, these theories have only considered the role of corruption and governance in an economy, or in the composition of taxes or spending. However, total tax revenue and spending are two major factors in creating government budget and in establishing inputs for production. These factors also represent the full capability of government, and the relationship between them and economic growth in the presence of corruption and governance needs to be clarified.
2.3.4. Economic growth theory: Exogenous and endogenous growth theory Barro and Sala-i-Martin (2004) confirmed that a small rate of economic growth plays an important role in increasing standards of living;
however, the way governments choose policies could affect long-term growth rates. These authors also indicated that in the mid-1980s, due to the complex definition of capital, the neoclassical or exogenous theories become unsatisfactory tools for determining long-run growth. This study also considers that economic activities depend on the actions of firms and government decisions in creating budgets and spending. Furthermore, these decisions may affect standards of living, which affect the quality of human
capital as well as technological capital. These two capital resources can increase or reduce aggregated total productivity in a society. Based on this argument, endogenous growth theory can help researchers explain growth better than exogenous theories.
Acemoglu (2009) mentioned that the differences in growth rates many times make a country become richer than other countries. Therefore, understanding growth theory is necessary for today’s policy makers to increase income per capita. Acemoglu (2009) also revealed that previous researchers emphasized that specific characteristics of a country may relate to economic growth, such as investment, physical and human capital, technology, policies, culture, and exogenous environmental factors.
Aghion and Howitt (2009) also argued that economic growth was measured by GDP per capita, so neoclassical theory did not explain the changed rate of technological progress. The endogenous growth model can enable researchers to correct this issue and determine growth in a long-run relationship with endogenous factors. These researchers presented the AK model, which adds more explanation of the accumulation of knowledge of human capital in determining the growth of an economy.
In addition, tax revenue steers the provision of public goods, which drives economic growth more than capital accumulation (Cerqueti and Coppier, 2011.)
Furthermore, Aghion et al. (2016) proved that the less effective governance reduces the positive impact of taxes on growth. The effectiveness of governance also increases tax rates, which has a U-shaped effect on growth equilibrium.
Célimène et al. (2016) explained that tax evasion and tax corruption affect private capital and public spending, which are two inputs in the production function. This argument supports the role of taxes and corruption in driving economic growth.
Additionally, tax revenue and public expenditure are two major factors in the production function. Total tax revenue and total expenditure can indicate the capacity of a government. Currently, endogenous growth theory continues to require more verification of the relationships among tax revenue, government expenditure, and economic growth.