Introduction to Public Finance

Public finance can be defined as a branch of economics, studying the theory of taxation and public expenditures. We also add practical aspects of fiscal legislation and administration into this definition. Public finance is handled differently from pure economics because the science of economics is mostly interested in the behavior of the producer (firm) and of the consumer in a market. However, public finance, as it is understood from its name, was born from the necessity of people who live in a society. Musgrave (1959, v-vi) says that the conduct of government is the testing ground of social ethics and civilized living. Intelligent conduct of government requires an understanding of the economic relations involved; and the economist, by aiding this understanding, may hope to contribute to a better society.

There are two basic approaches in public finance. The first is the “positive” approach. The positive public finance approach aims to find out how financial events occur in real life and what factors affect these events. For this purpose, it tries to develop theories and models that explain financial events, and then the validity of these theories and models is tested with surveys and econometric methods.

In the “normative” public fiscal approach, judgments about how events and institutions should be
organized play an important role. Here, different solutions to financial problems are compared. The
normative approach generally adheres to the framework offered by welfare economics for this purpose.

Public finance looks for answers to these four questions (Gruber, 2016: 3):
• When should the government intervene in the economy?
• How might the government intervene?
• What is the effect of those interventions on economic outcomes?
• Why do governments choose to intervene in the way that they do?

Market failure: A problem that causes the market economy to deliver an outcome that does not maximize efficiency.

1- Taxation : To tackle deficiencies within the private market, one strategy the government can employ is manipulating the price mechanism. This involves implementing government policies aimed at altering the price of a particular good or service. This can be done either through taxes or subsidies. Taxation raises the price of goods that are overproduced. Subsidies, though, decrease the price of goods that are underproduced. For instance, governments generally levy a high tax rate for goods such as alcohol and cigarettes to make its demand fall. However, health insurance is subsidized by the government for low-income families. 

2-Restrict or Mandate Private Sale or Purchase: Another approach available to the government is to directly regulate the private buying and selling of goods that suffer from overproduction or mandate the purchase of goods facing underproduction. For instance, countries like Germany and Switzerland enforce regulations mandating nearly all citizens to possess health insurance coverage.

3-Public Provision: Another alternative is to have the government provide the good directly in order to potentially attain the level of consumption that maximizes social welfare. In Turkey, according to the Law No. 5510, GSS premium is not collected if the per capita income in the household is less than one-third of the minimum wage. Hence, premiums for that population are provided directly by the government.

4-Public Financing of Private Provision: Finally, governments may want to influence the level of consumption but may not want to involve themselves directly in the provision of a good. In such cases, the government can finance private entities to provide the desired level of provision. It is possible to talk about two different methods here: the subsidy and the voucher method. The subsidy method involves direct or indirect financial support for the provision of a public service or a change in its production. Direct subsidies may take the form of aid and budgetary support, while indirect subsidies may take the form of tax exemptions and public guarantees. The voucher method is applied when the state, instead of directly providing goods and services such as education, health, transportation, kindergartens etc. to low-income individuals, gives them a voucher covering the cost of the service, making it possible to obtain the service from the private sector.

Thus, while the supply side of the public service is provided by private financing, the demand side is met by public financing. 

When the government provides goods and services, it necessitates resources such as labor, equipment,buildings, and land. The actual cost of government goods and services is reflected in the value of private goods and services that must be foregone when these resources are redirected for government use. When citizens pay taxes, their disposable income decreases, leading them to purchase fewer goods and services for personal consumption (such as automobiles, foods, clothing, housing etc.). These taxes are used by governments to provide public goods such as roads, police and fire protection, and national defense. Hence, there exists a trade-off between public goods and private goods, which can be visualized through a productionpossibility curve. This curve delineates the different combinations of public goods and services and private goods and services that an economy can produce, considering its
available resources, technology, and the assumption of full employment of resources. Private goods and services, such as food and clothing, are typically traded in markets for sale. In contrast, public goods and services like roads, education, and fire protection are typically not exchanged in markets.

The economic system is the set of regulations necessary for the solution of basic economic problems. The economic systems of each society are different from each other. The main features that distinguish economic systems from each other are the distribution of property rights and how economic activities are
coordinated. Property rights are related to the ideological dimension of the economic system and are a key element used to distinguish systems from each other.

The socialist economic system is a system in which the resources of production are given to the property
of the state on behalf of the society. In this system, the state using production resources is the sole decisionmaking central authority. Central planning forms the core of the system. In the central planning, the factors of production are either not made available to the private sector or they are used with the limited permission of the state. The government controls all aspects of the economic production. In other words, the government decides what goods will be produced and how they will be produced. The government decides how resources are distributed and used.

In this system, all production-related decisions are freely made by the owners of the production resources. Property rights belong to individuals and individuals can use these rights as they wish. The market forms the institutional structure of the capitalist economic system. The supply and demand of goods and services to be produced in the market will be determined by the price mechanism that will be formed freely in the market. The price that will be formed in this way is accepted as the equilibrium price. With the equilibrium price, it is thought that there will be no problem in the allocation and distribution of resources in the market. The reason for this is that in the free market system, producers try to maximize their profits and consumers try to maximize their benefits. As a result, an equivalent price arises in the market. In brief, the free-market economy is an exchange economy based on the price mechanism, based on individual interest and freedom.

Classical economist Adam Smith, one of the founders of the capitalist economic system, argued that the reduced economic functions of the public would be solved through the price mechanism in the market. Market actors will regulate their activities through prices in order to achieve the best economic and social results in the market. Thus, both consumers and producers will seek to maximize their benefits and markets will continue to operate without the need for public intervention. Smith argued that by giving everyone the freedom to produce and exchange goods as they pleased (free trade) and opening the markets up to domestic and foreign competition, people’s natural self-interest would promote greater prosperity than could stringent government regulations. Adam Smith calls this free-market force the invisible hand
(Smith, 2006).

The mixed economic system  is formed by the combination of certain features of the two extreme economic systems, as mentioned above. Many countries have adopted the mixed economic system in practice. In this system, property rights belong to both the market and the state. Ownership of the factors of production is shared between the market and the state. In some countries, the state is relatively more salient than the market or vice versa. In this system, the public sector has a regulatory, rulemaking and supervisory role in order for these to work well. To summarize, in mixed economic systems, the market economy still has priority, while the primary duty of the state is to guide and set rules.

Mercantilism was an economic theory and practice that emerged during the early modern period in Europe, spanning roughly from the 16th to the 18th centuries. It was the dominant economic ideology in the era of European colonial expansion and played a significant role in shaping trade and economic policies of various European powers during that time.

Key characteristics of mercantilism include:

1. Trade surplus: Mercantilists believed that a country should export more than it imports, creating a
trade surplus. This surplus was seen as a measure of a nation’s wealth and power.

2. Colonialism and exploitation: Mercantilism supported colonial expansion as a means to access raw
materials, establish markets for manufactured goods, and exploit colonies’ resources for the benefit
of the mother country.

3. Protectionism: Governments implemented protectionist policies such as tariffs, quotas, and other
restrictions to promote domestic industries and protect them from foreign competition.

4. Accumulation of bullion: Mercantilists emphasized the accumulation of precious metals (gold and
silver) as a measure of a nation’s wealth, as they believed that wealth was limited and only attainable
through trade surpluses.

5. State intervention: Mercantilist policies relied on strong government intervention in the economy,
as rulers and policymakers believed that they should actively regulate economic activity to maximize
national wealth.

Over time, mercantilism gradually gave way to other economic theories and practices, such as free trade
and laissez-faire capitalism, as the industrial revolution and changing global dynamics shaped economic
thought in the 18th and 19th centuries.

Physiocracy was an 18th-century economic theory and school of thought that emerged in France during the Enlightenment era. It is considered one of the earliest systematic economic theories and had a significant influence on the development of modern economic thinking.

Key Ideas of Physiocracy:

Natural Order: Physiocrats believed in the existence of a “natural order” in economics, where there was
a harmonious relationship between economic activities and nature. They argued that agriculture was the
only productive and valuable sector of the economy, as it was the source of all wealth.

Laissez-Faire: The Physiocrats advocated for a laissez-faire approach to economic policy, meaning minimal government intervention in the economy. They believed that governments should refrain from
imposing tariffs, taxes, and regulations that hindered the natural functioning of the economy, particularly
in agriculture.

“Productive” and “Sterile” Labor: Physiocrats classified labor into two categories: “productive” labor, which they believed contributed to the creation of wealth (mainly agricultural labor), and “sterile” labor, which included non-agricultural activities like manufacturing and services, which they considered
unproductive.

Single Tax: Physiocrats proposed a single tax on land, known as the “impôt unique” (single tax), to finance government activities. They argued that this tax should be the only source of government revenue and that other taxes should be abolished.

Tableau Économique: François Quesnay, one of the leading Physiocrats, created the “Tableau Économique,” a theoretical representation of the flow of goods and money in a simplified economy. This table aimed to illustrate the circular flow of income between landowners, farmers, and the state.

Although the influence of Physiocracy waned over time, it played a significant role in challenging the prevailing mercantilist economic policies and providing a foundation for later economic theories, such as classical economics and the ideas of Adam Smith. The emphasis on agriculture as the primary source of wealth and the call for minimal government intervention were seminal ideas that continue to resonate in
economic thought today.

Classical economics refers to a school of economic thought that emerged during the late 18th and early 19th centuries, building on the ideas of earlier economists like the Physiocrats and Adam Smith. Classical
economists sought to understand the workings of the market economy and develop theories to explain its dynamics. Some of the key figures associated with classical economics include Adam Smith, David Ricardo, Thomas Malthus, and John Stuart Mill.

Key principles of classical economics include:

Laissez-Faire: Like the Physiocrats, classical economists believed in the virtues of a free-market economy
and limited government intervention. They argued that the market, if left to its own devices, would tend
to reach equilibrium and allocate resources efficiently.

Labor Theory of Value: Classical economists, particularly Adam Smith and David Ricardo, proposed the labor theory of value, which posits that the value of a good or service is determined by the amount of labor required to produce it. This theory played a significant role in early economic thinking but was later challenged by the marginal utility theory developed by later economists.

Theory of Comparative Advantage: David Ricardo introduced the theory of comparative advantage, which explains how countries benefit from specialization and trade even if one country is more efficient in producing all goods. This concept is still a fundamental principle in international trade theory.

Say’s Law: Jean-Baptiste Say, another classical economist, formulated Say’s Law, which asserts that supply creates its own demand. In other words, the act of producing goods and services generates income that, in turn, allows consumers to buy those goods and services.

Equilibrium Theory: Classical economists focused on the idea of general equilibrium, where supply and demand for goods and services, as well as factors of production like labor and capital, interact to determine prices and quantities.

In classical economics, the view on the state budget is generally consistent with the broader principles of limited government intervention and laissez-faire economic policies. Classical economists believed in minimal government involvement in economic affairs and emphasized the importance of free markets to allocate resources efficiently. As such, their perspective on the state budget was one of restraint and simplicity.

Classical economists favored a balanced budget, where government spending would not exceed government revenue (taxes and other income). They believed that running deficits could lead to inflation
and distort resource allocation in the economy. Classical economists also advocated for minimal government spending, particularly on activities that did not directly contribute to the public good or essential services. They viewed excessive government spending as a potential source of inefficiency and waste in the economy. While recognizing the need for government revenue to finance essential functions, classical economists generally supported low and simple tax systems. They favored taxes that were easy to administer and did not create significant disincentives for productive economic activity.

Classical economists opposed protectionist measures, such as tariffs and trade barriers. They believed that such measures interfered with the natural functioning of free trade and could harm overall economic growth. Despite their preference for limited government intervention, classical economists acknowledged
that certain goods and services, such as national defense and infrastructure, were essential and appropriate for government provision. It is important to note that while classical economists advocated for a limited role of the state in the economy, they did recognize some instances where government intervention might be necessary or beneficial. For example, they supported the provision of public goods and services that the private sector couldn’t efficiently provide, and they recognized the need for basic regulation to maintain fair competition and prevent market failures.

Socialism is an economic and political ideology that advocates for collective or state ownership and control of the means of production, distribution, and exchange in a society. The primary goal of socialism is to reduce or eliminate social and economic inequalities by promoting cooperation and shared responsibility in the economy.

In a socialist system, the means of production, such as factories, land, and natural resources, are owned
and managed collectively by the workers, the community, or the state, rather than by private individuals
or corporations. Therefore, socialists often advocate for central planning, where economic decisions are made by a central authority, or worker control, where workers have a say in the management and decisionmaking processes of their workplaces.

Socialism also aims to reduce income and wealth disparities by ensuring that resources are distributed more equitably among all members of society. The goal is to provide a higher standard of living for the entire population rather than concentrating on wealth in the hands of a few. Socialism typically supports the provision of public services such as education, healthcare, and social security to ensure that basic needs are met for all citizens. Socialists often criticize capitalism for its potential to lead to exploitation, wealth concentration, and social stratification. They believe that capitalism inherently fosters inequality and that a socialist system would address these issues more effectively.

There are various degrees of socialism, from moderate forms that advocate for a mixed economy with some elements of public ownership and social welfare programs, to more extreme forms that call for complete nationalization of industries and the abolition of private property. Socialism has been a subject of debate and discussion in the realms of economics, politics, and philosophy for centuries. Throughout history, different countries have experimented with various forms of socialism, each with its successes, challenges, and unique characteristics. The actual implementation and success of socialist ideas have varied widely depending on the specific context and circumstances of the countries or regions in which they have been tried. Finally, we can say that the influence of socialism in the state structure has disappeared today

Keynesian economics is an economic theory and approach developed by the British economist John Maynard Keynes in the 20th century, particularly during the aftermath of the Great Depression. It offers a framework for understanding how economies operate and how governments can intervene to mitigate economic downturns and promote stability.

Keynesian economics emphasizes the importance of aggregate demand—the total spending in the economy—as a driving force behind an economic activity. Insufficient aggregate demand can lead to unemployment and economic stagnation. Keynesians argue that unemployment can arise due to a lack of demand in the economy, particularly during economic recessions. This type of unemployment is seen as temporary and linked to the business cycle.

Keynesians advocate for active government interventions in the economy, especially during the times of economic recession or depression. The government can stimulate demand through increased public spending and tax cuts, called fiscal policy. Fiscal policy refers to the use of government spending and taxation to influence the economy. During downturns, Keynesians recommend increasing government spending and reducing taxes to boost aggregate demand and to encourage economic growth. Keynesians
highlight the multiplier effect, where an initial increase in spending (such as government spending) leads
to a larger increase in overall economic activity as the money circulates through the economy.

Keynesian economics is primarily concerned with short-term economic fluctuations. It suggests that government intervention can be effective in the short run to counteract economic slumps and to promote recovery.

Keynesian economics gained prominence during the 1930s as a response to the challenges posed by the Great Depression. The theory influenced the economic policies of many countries, including the United States, where policies like the New Deal were implemented to counter the economic crisis. While Keynesian ideas were dominant for a certain period of time, they faced criticism and challenges from other schools of economic thought, particularly from those emphasizing the role of markets and the limitations of government intervention. In the latter part of the 20th century, the rise of monetarism and
other economic theories led to a reevaluation of Keynesian principles.

Nonetheless, many of Keynes’s ideas continue to influence the economic policy discussions, especially during the times of economic recession or crisis. Contemporary economic policies often combine elements of Keynesian thinking with insights from other economic theories to address complex economic challenges.

Public expenditure refers to the expenses incurred by the government to provide public services. According to the Public Financial Management and Control Law No. 5018, public expenditures consist
of the following expenses:
• Costs of goods and services received
• Social security contributions
• Domestic and foreign debt interests, borrowing general expenses, differences arising from
discounted sales of debt instruments
• Economic, financial and social transfers
• Donations
• Other expenses

Public revenues include those which the state collects by law, based on its sovereign power to meet public services. Public revenues consist of taxes, duties, fees, betterment levies, parafiscal charges, property and enterprise revenues, and administrative fines.

Taxes constitute the largest part of public revenues. Taxes are the economic values that the state receives from individuals and institutions according to their ability to pay in order to meet public expenditures. In modern states, the share of taxes in public revenues is about 80% (International Centre for Tax and Development, 2023).

The increase in the services provided by the public sector due to the increasing prevalence of the social
state has led to an increase in public expenditures. Financing increased public expenditures necessitates the receipt of public revenues. While public revenues play an important role in financing public expenditures, they play a role as a fiscal policy tool for price stability, reducing inequality in income distribution and economic development, and removing the balance of payments deficit. Therefore, public revenues are used not only to meet public expenditures, but also for economic purposes.

Another important feature in public financing through taxation is that the taxpayer and the person or units benefiting from the service might be different. This creates some problems, mostly due to the difficulties in ensuring tax justice. It is not always the case in which a taxpayer pays more tax and benefits from more public goods and services. In order to solve this problem, generally divisible, marketable, qualified public goods are priced and financed according to the principle of utilization.

The price method can be applied in financing semi-public goods such as education and health. In addition, due to the intensity of its consumption, entrance fees can be applied in lakes, forests, parks and similar areas belonging to the state. There are also some services that only benefit the beneficiaries. These include services such as land registry, court, notary and passport. Although these services are offered to the whole society, only those in need benefit from them

general public services had the largest share in central government budget expenditures in 2022 by functional classification with 25.7%. The share of social security and social assistance services was 17.7%, while the share of economic affairs and services was 21.4%. On the other hand, the share of education and health services in total expenditures was 12.7% and 6.5%, respectively. In this respect, the total share allocated to social security and social assistance services, education services and health services, which are among the basic services provided to citizens, was 36.9% in the central government budget in 2022.

More than half of the budget revenues consist of indirect taxes. The share of direct taxes on income is about 32%, while indirect taxes make up more than half of total the budget revenues in Türkiye.