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Luke Phillips
Luke Phillips

Cullis and Jones Public Finance and Public Choice: The Latest Developments and Debates



Introduction




Public finance is the branch of economics that studies how governments raise revenue, spend money, and manage debt. Public choice is the branch of economics that applies the tools of rational choice theory to analyze how political actors make decisions. Both fields are essential for understanding how public policies are designed, implemented, and evaluated.




Cullisandjonespublicfinanceandpublicchoicepdf



Public finance and public choice are also closely related. Public finance provides the normative framework for evaluating whether public policies are efficient and equitable. Public choice provides the positive framework for explaining whether public policies reflect the preferences of citizens or other interests. Together, they offer a comprehensive perspective on the role of government in society.


One of the most influential books on public finance and public choice is Public Finance and Public Choice by John Cullis and Philip Jones. The book was first published in 1992, with a second edition in 1998, and a third edition in 2009. The book provides a solid foundation in contemporary public economics, analyzing different theoretical approaches and contextualizing them with relevant and up-to-date examples. The book also incorporates insights from behavioural public finance, a new field that examines how psychological factors affect economic decisions.


In this article, we will review some of the main topics covered by Cullis and Jones' book. We will start by defining public finance and its main objectives. Then we will discuss some of the key issues in public finance, such as public goods, externalities, taxation, redistribution, public expenditure, and cost-benefit analysis. Next, we will define public choice and its main assumptions. Then we will explore some of the major themes in public choice, such as voting, collective decision-making, bureaucracy, government failure, interest groups, rent-seeking. After that, we will define behavioural public finance and its main insights. Then we will examine some of the important concepts in behavioural public finance, such as bounded rationality, heuristics, framing effects, nudges, social preferences, and fairness. Finally, we will conclude by summarizing the main points of the article, highlighting the contributions of Cullis and Jones' book, and suggesting some directions for future research.


Public Finance




Public finance is the study of how governments raise revenue, spend money, and manage debt. Public finance has two main objectives: efficiency and equity. Efficiency means that resources are allocated in a way that maximizes social welfare. Equity means that resources are distributed in a way that is fair and just. Public finance tries to balance these two objectives, which often conflict with each other.


Public Goods and Externalities




One of the reasons why governments intervene in the economy is to provide public goods and correct externalities. Public goods are goods that are non-rivalrous and non-excludable. Non-rivalrous means that one person's consumption does not reduce the amount available for others. Non-excludable means that no one can be prevented from consuming the good. Examples of public goods are national defense, law and order, and public parks. Because public goods are non-excludable, people have an incentive to free-ride on others' contributions. Because public goods are non-rivalrous, markets tend to underprovide them. Therefore, governments need to step in and provide public goods through taxation and spending.


Externalities are costs or benefits that affect third parties who are not involved in the production or consumption of a good or service. Externalities can be positive or negative. Positive externalities occur when a third party benefits from an activity without paying for it. Negative externalities occur when a third party suffers from an activity without being compensated for it. Examples of positive externalities are education, vaccination, and research and development. Examples of negative externalities are pollution, congestion, and noise. Because externalities are not reflected in market prices, markets tend to overproduce goods with negative externalities and underproduce goods with positive externalities. Therefore, governments need to intervene and correct externalities through regulation, subsidies, taxes, or property rights.


Taxation and Redistribution




Another reason why governments intervene in the economy is to raise revenue and redistribute income. Taxation is the compulsory payment of money to the government for public purposes. Redistribution is the transfer of income or wealth from some groups to others for social or economic reasons. Taxation and redistribution affect both efficiency and equity.


Taxation affects efficiency by creating distortions in the market. Distortions are changes in behaviour that result from taxation. For example, income taxes reduce the incentive to work and save, consumption taxes reduce the incentive to spend and invest, and corporate taxes reduce the incentive to produce and innovate. Distortions reduce social welfare by creating deadweight losses, which are losses of surplus that are not captured by anyone. Therefore, taxation should be designed to minimize distortions and deadweight losses.


Taxation also affects equity by influencing the distribution of income and wealth. Equity can be measured by two criteria: horizontal equity and vertical equity. Horizontal equity means that people who are in similar situations should pay similar amounts of taxes. Vertical equity means that people who are in different situations should pay different amounts of taxes according to their ability to pay. Therefore, taxation should be designed to achieve horizontal and vertical equity.


Redistribution affects efficiency by altering incentives and creating moral hazard. Moral hazard is the tendency of people to behave more recklessly or irresponsibly when they are insured or protected from the consequences of their actions. For example, unemployment benefits may reduce the incentive to look for work, welfare payments may reduce the incentive to work hard or save money, and bailouts may reduce the incentive to avoid risk or manage debt. Moral hazard reduces social welfare by creating inefficiencies and waste. Therefore, redistribution should be designed to avoid moral hazard.


Redistribution also affects equity by influencing the distribution of income and wealth. Equity can be measured by two concepts: absolute poverty and relative poverty. Absolute poverty means that people do not have enough income or wealth to meet their basic needs. Relative poverty means that people have less income or wealth than others in their society. Therefore, redistribution should be designed to reduce absolute poverty and relative poverty.


Public Expenditure and Cost-Benefit Analysis




A third reason why governments intervene in the economy is to spend money on public services and projects. Public expenditure is the amount of money that the government spends on goods and services for public purposes. Public expenditure can be classified into three categories: current expenditure, capital expenditure, and transfer payments. Current expenditure is the spending on goods and services that are consumed within a year, such as salaries, pensions, health care, education, defense, etc. Capital expenditure is the spending on goods and services that are used over a longer period of time, such as infrastructure, equipment, buildings, etc. Transfer payments are the spending on income transfers to individuals or groups, such as social security, unemployment benefits, welfare payments, etc. Public expenditure affects both efficiency and equity.


Public expenditure affects efficiency by providing public goods and correcting externalities, as discussed above. However, public expenditure also creates inefficiencies by crowding out private investment, creating rent-seeking opportunities, and distorting relative prices. Crowding out occurs when public borrowing increases interest rates and reduces the availability of funds for private investment. Rent-seeking occurs when individuals or groups seek to obtain benefits from public expenditure without contributing to its costs. Distorting relative prices occurs when public expenditure affects the allocation of resources by changing the relative prices of goods and services.


Public expenditure also affects equity by influencing the distribution of income and wealth. Equity can be measured by two indicators: progressivity and incidence. Progressivity means that public expenditure benefits more the poor than the rich, or reduces income inequality. Incidence means that public expenditure benefits more the intended beneficiaries than others, or reduces leakage. Therefore, public expenditure should be designed to be progressive and well-targeted.


How can governments decide whether a public expenditure project is worth undertaking? One method that has been used is cost-benefit analysis. Cost-benefit analysis is a technique that compares the present value of the future benefits and costs of a project to society. Present value is the value of a future amount of money in terms of today's money, using a discount rate that reflects the time value of money and the risk of the project. Benefits and costs are measured in terms of willingness to pay and willingness to accept compensation, which reflect the preferences of individuals. If the present value of benefits exceeds the present value of costs, the project is considered socially desirable. If not, the project is rejected.


Cost-benefit analysis has several advantages and limitations. The advantages are that it provides a systematic and consistent framework for evaluating public projects, it helps to identify and quantify the relevant benefits and costs, and it helps to compare alternative projects and rank them according to their net benefits. The limitations are that it requires a lot of data and assumptions that may be uncertain or controversial, it may not capture all the intangible or non-market benefits and costs, such as environmental or social impacts, and it may not reflect the distributional effects or ethical values of society.


Public Choice




Public choice is the study of how political actors make decisions in the public sector. Public choice applies the tools of rational choice theory to analyze the behaviour of voters, politicians, bureaucrats, interest groups, and other agents involved in politics. Public choice has two main assumptions: methodological individualism and rational self-interest.


Voting and Collective Decision-Making




One of the topics that public choice examines is voting and collective decision-making. Voting is the process by which individuals express their preferences over alternative outcomes in an election or a referendum. Collective decision-making is the process by which a group of individuals aggregates their preferences into a social choice or a collective action.


Voting and collective decision-making raise several questions and problems that public choice tries to answer or solve. Some of these are: How do individuals form their preferences over political issues? How do they acquire information about candidates or policies? How do they decide whether to vote or abstain? How do they express their preferences through voting systems or mechanisms? How do voting systems or mechanisms aggregate individual preferences into social choices or collective actions? How do social choices or collective actions reflect the preferences of individuals? What are the sources and consequences of voting paradoxes or anomalies?


Public choice provides various models and theories to address these questions and problems. Some of these are: The median voter theorem, which states that under certain conditions, the outcome of majority voting will reflect the preference of the median voter, who is the voter whose preference lies in the middle of the distribution of preferences. The rational ignorance hypothesis, which states that voters have little incentive to acquire information about political issues because their vote has little chance of affecting the outcome of the election. The Condorcet paradox, which states that there may be no candidate who can win a majority vote against every other candidate. The Arrow impossibility theorem, which states that there is no voting system that can satisfy a set of desirable properties for collective decision-making.


Bureaucracy and Government Failure




Another topic that public choice examines is bureaucracy and government failure. Bureaucracy is the administrative structure of the government that consists of officials who implement public policies and deliver public services. Government failure is the situation where the government fails to achieve its objectives or causes more harm than good.


Bureaucracy and government failure raise several questions and problems that public choice tries to answer or solve. Some of these are: How do bureaucrats behave and what are their incentives and constraints? How do politicians control and monitor bureaucrats? How do bureaucrats influence and manipulate politicians? How do bureaucrats interact with interest groups and citizens? How do bureaucracy and government failure affect the efficiency and equity of public policies and services?


Public choice provides various models and theories to address these questions and problems. Some of these are: The principal-agent model, which analyzes the relationship between politicians (principals) and bureaucrats (agents), and how they deal with issues of delegation, information, and incentives. The budget-maximizing model, which assumes that bureaucrats seek to maximize their own utility by increasing the size of their budgets, subject to the constraint of political demand. The Niskanen model, which derives the optimal size of bureaucracy from the interaction between a budget-maximizing bureaucrat and a demand-revealing politician. The rent-seeking model, which assumes that bureaucrats seek to extract rents (excess profits) from their monopoly power over public policies and services, at the expense of social welfare.


Interest Groups and Rent-Seeking




A third topic that public choice examines is interest groups and rent-seeking. Interest groups are organizations or associations of individuals who share common interests or goals and seek to influence public policies or outcomes. Rent-seeking is the activity of seeking to obtain rents (excess profits) from public policies or outcomes, without creating any value for society.


Interest groups and rent-seeking raise several questions and problems that public choice tries to answer or solve. Some of these are: How do interest groups form and what are their objectives and strategies? How do interest groups lobby and persuade politicians and bureaucrats? How do interest groups compete or cooperate with each other? How do interest groups affect the efficiency and equity of public policies or outcomes? What are the costs and benefits of interest group activity for society?


Public choice provides various models and theories to address these questions and problems. Some of these are: The collective action model, which analyzes the problem of free-riding among potential members of an interest group, and how it can be overcome by selective incentives, group size, or ideology. The Olson model, which argues that small, homogeneous, and privileged groups are more likely to overcome free-riding than large, heterogeneous, and latent groups. The rent-seeking model, which assumes that interest groups seek to obtain rents (excess profits) from public policies or outcomes, such as tariffs, subsidies, regulations, licenses, etc., by expending resources on lobbying or other forms of influence. The Tullock model, which derives the social cost of rent-seeking from the dissipation of rents due to competition among rent-seekers.


Behavioural Public Finance




Behavioural public finance is a new field that examines how psychological factors affect economic decisions in the public sector. Behavioural public finance challenges some of the assumptions of traditional public finance and public choice, such as rationality, self-interest, consistency, etc., by incorporating insights from behavioural economics, psychology, sociology, etc. Behavioural public finance has two main insights: bounded rationality and heuristics. Bounded rationality means that individuals have limited cognitive abilities and resources to process information and make decisions. Heuristics are simple rules of thumb or mental shortcuts that individuals use to simplify complex problems and make decisions quickly.


Bounded Rationality and Heuristics




One of the topics that behavioural public finance examines is bounded rationality and heuristics. Bounded rationality and heuristics affect how individuals form their preferences, acquire information, and express their choices in the public sector. Bounded rationality and heuristics can lead to systematic deviations from the assumptions of traditional public finance and public choice, such as consistency, transitivity, completeness, etc.


Bounded rationality and heuristics raise several questions and problems that behavioural public finance tries to answer or solve. Some of these are: How do individuals form their preferences over public goods, externalities, taxation, redistribution, etc.? How do they acquire information about candidates, policies, services, etc.? How do they express their choices through voting systems or mechanisms? How do bounded rationality and heuristics affect the efficiency and equity of public policies or outcomes?


Behavioural public finance provides various models and theories to address these questions and problems. Some of these are: The prospect theory, which assumes that individuals evaluate outcomes in terms of gains and losses relative to a reference point, rather than in terms of absolute levels of utility. The prospect theory also assumes that individuals are risk-averse for gains and risk-seeking for losses, and that they overweight small probabilities and underweight large probabilities. The availability heuristic, which states that individuals judge the likelihood of an event by how easily they can recall or imagine examples of it. The availability heuristic can lead to biases such as the salience effect, the recency effect, the vividness effect, etc. The representativeness heuristic, which states that individuals judge the probability of an event by how well it matches a stereotype or a prototype. The representativeness heuristic can lead to biases such as the base-rate neglect, the conjunction fallacy, the gambler's fallacy, etc.


Framing Effects and Nudges




Another topic that behavioural public finance examines is framing effects and nudges. Framing effects are the influences of how information is presented on how individuals perceive and respond to it. Nudges are subtle interventions that steer individuals towards certain choices or behaviours without restricting their options or imposing significant costs.


Framing effects and nudges affect how individuals form their preferences, acquire information, and express their choices in the public sector. Framing effects and nudges can lead to systematic deviations from the assumptions of traditional public finance and public choice, such as rationality, self-interest, consistency, etc.


Framing effects and nudges raise several questions and problems that behavioural public finance tries to answer or solve. Som


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