CHAPTER ONE

REASONS FOR GOVERNMENTAL INTERVENTION

A. WHAT IS PUBLIC FINANCE ?

At a first glance, the term public finance seems to be a subject focusing attention on
the financing of government activity. Although obtaining revenue for the realization of
governmental activity is an important issue, it is only a part of it, because public finance
covers governmental expenditures besides their sources of financing. It may be said that
public finance is the study of the financial activities of governments and public authorities.
Financial activities cover revenue gathering, expenditures and budgeting.

The study of public finance may be divided into three categories:1

a - Knowing what activities the public sector engages in and how these are organized
(that is, revenue gathering and expenditures)

b - Understanding and foreseeing the full consequences of these governmental

activities

c - Evaluating alternative policies.

The above distinction shows that there is both a normative and a positive side to
public finance. The positive side describes the activities of the public sector, explains the
reasons of the programs in existence and also analyzes the consequences of government
policies (a and b stated above). The normative side, on the other hand, is concerned with
designing new policies that meet certain objectives. In other words, normative economics

1
Joseph E. Stiglitz, Economics of the Public Sector, W. W. Norton, New York, 1988, p.12-13.
judges how well various policies work and determines which models meet the objectives.

The two approaches are complementary, because, in order to make judgements about
what activities the government should follow, one must know the consequences of
government activities. Economists dealing with public finance both analyze actual policies
and develop guidelines for government activities.

In some cases, public finance is named as public sector economics. Public sector
economics is concerned with the microeconomic aspects of governmental activity which
include the allocation of existing resources and the distribution of income, whereas public
finance covers both the micro and macroeconomic aspects of governmental activity which
include growth and stabilization besides the above stated functions. Recently, public finance
has shifted its direction to public sector economics. The macroeconomic functions of
government - the use of taxation, spending and monetary policies that effect the level of
unemployment, the price level and growth - are usually taught in separate courses such as
macroeconomics, monetary theory and monetary policy.

B. THE ECONOMIC FUNCTIONS OF GOVERNMENT

A most logical point of departure in explaining the reasons for governmental activity
is the main economic problem of scarcity. The resources (labour, capital and natural
resources) available to any society are limited and there is an unlimited scope to human
wants. Scarce resources should be efficiently allocated among competing and unlimited
wants.

In a mixed economy the decisions of allocation are made by the private sector and the
public sector. Thus, by the allocation function of government, we mean the activities
involving the provision of various governmental services to the society. The responsibility of
the government is to ensure that the resources of the society are used efficiently for the
satisfaction of the wants of its members.

The distribution function of government covers the activities involved in the

redistribution of income. Distribution means the sharing of national income by individuals in
a society. If factor owners receive the amount of money in return for their productivity to the
national income, distribution will be equitable. This is equity in economic terms. But the
question of distribution and redistribution is an ethical one. In this sense, the least
advantageous individuals should receive at least a reasonable amount of income for their
standart of living.

W. D. Gardner examines the question of distribution from various points of views:2

"There is an ethical dimension to the question of how much inequality is

acceptable or tolerable. But there is also a political dimension to the distribution
question, since stability of the system and the character of the social order itself
may be related to the degree of income inequality that prevails within it. To what
extent do extremes of income inequality strain the fabric of society and create
unrest and dissention that can damage the welfare of all? Finally, there is an
economic dimension to the distribution question. The quantity of goods and
services that will be produced from a given resource base is not unrelated to the
kind of incentive system used to motivate resource owners to engage in
productive activities, and the quest for income (and perhaps the quest for income
greater than that enjoyed by others) apparently is an important element in the
incentive system."

In short, it is possible to note that the responsibility of the government in the

distribution of income is to seek a redistribution of income regarded as equitable by the
society.

The stabilization function of government is an aggregate economic performance, that

is, a major macroeconomic function of the government. Stabilization means that aggregate
demand and aggregate supply should be in equilibrium in order to ensure economic stability.
If demand exceeds supply, or vice versa, instability will arise. There will be inflationary or
deflationary tendencies in the economy. The market by itself may fail to produce the degree
of stability in price levels and unemployment. That is why one function of government has
been accepted to be moderating the inflation and unemployment effects on the economy.

Lastly, the growth function of government is concerned with activities aimed at

ensuring an adequate rate of growth. Growth is achieved by increasing national income at a
satisfactory rate each year. This will mean more welfare to the individuals within the society.
The precondition for an increase in the growth rate is savings. Savings should be channelled
to investment (in the form of human and physical capital). The rate of capital formation may
2
W. D. Gardner, Government Finance, Prentice-Hall Inc.. Englewood Cliffs. New Jersey, 1978, p.8.
be too high or too low to achieve what is thought to be an acceptable rate of growth. Thus,
government intervention may be needed to change the parameters that affect the rate of
growth - saving, investment, productivity, the rate of growth of the labour force and so forth.
That is why public investments, especially investments on infrastructure, are considered to be
a function of government in achieving a satisfactory rate of growth and development.

We have discussed the four functions of an economic system and the role of
government in attaining these functions. The scope and role of government in covering these
activities varies from country to country. Governments in West European countries exercise
more activities than do governments in the United States of America. In the former Socialist
countries governments carried on most of the activities of production. In developing countries
the role of government is generally larger than the developed countries. But in any case,
every government is to some degree engaged in the activities mentioned above.

We will now explain in more detail each governmental function and the institutional
means the government uses to achieve these functions.

1. The Allocation Function of Government

We know that in the real world the market mechanism alone cannot perform all
economic functions. Market failures arise because markets may be imperfectly competitive,
production may be subject to decreasing costs, consumers may lack sufficient information or
be misled by advertising, etc.... Government policy is needed to guide, correct and
supplement these limitations of the market mechanism.

Two theorems exist in market economies. The first theorem dictates that the
competitive market, through the price mechanism, leads to efficient allocation. The second
says that, if initial efficient allocation is not achieved, then governmental redistribution may
again lead to Pareto optimum.

Pareto efficiency is a state resulting in an improvement in welfare of

one or more individuals without adversely affecting the welfare of others.
When a point is reached where impoving the well-being of someone will
cause a loss in welfare to others, we are said to have reached a Pareto optimal
point. Thus, a Pareto optimum is a state such that no one can be made better
off without at the same time making at least one person worse off. A Pareto
optimal allocation of resources among uses exists if it is not possible to
 reallocate resources so as to improve the well-being of one person without
making at least one other person worse off.

Governmental functioning should aim at Pareto optimum by the above four articles; in
order to realize social welfare. In this way, an optimal intersectoral (between private and
public sector) resource allocation will be attained.33

The allocative function means correcting the market failures explained above. The
government has the following means to achieve this goal. These are the major alternative
techniques that the government can use to influence resource allocation:

a. Public Goods and Services

b. Semi-Public Goods

c. Public Economic Enterprises

d. Economic Regulations

a. Public Goods and Services

Public goods and services (pure public goods) are the goods which have the
characteristics of non-rivalness and non-excludability.

Non-rivalness (joint consumption): These are goods the consumption of

which is nonrival. One person's consumption of these goods does not reduce the
benefits derived from them by all others. The same benefits are available to all, they
are indivisible. Joint consumption refers to the idea that there are some goods the
benefits of which can be enjoyed by more than one person at the same time. A
classical example of a jointly consumed good is national defense. It is not divisible;
once supplied at a certain level, it is jointly consumed equally by every person in the
society. Here exists a nonrivalry in consumption between the consumers of the public
good or service.

Non-excludability: In addition to non-rivalry, these goods are not priceable. The

exclusion principle does not apply to these goods. It is technically and practically
3
Of course, in some cases government intervention may be inefficient as well, introducing its own distortions.
Stiglitz names this state as government failure, as a contradiction to market failure. He has determined four major
reasons for the failure of government to achieve its objectives. These are: limited information, limited control
over private market responses, limited control over bureaucracy and limitations imposed by political processes.
Stiglitz, p.5-6.
 impossible or very costly to price these governmental goods and services because you
are not able to detect the real size of the benefit received by the consumer. For
example, it is not possible to take a charge for pavements where you have to install
turnstiles and force everyone who passes to use a token.

Because of the properties of joint consumption and non-excludability, individuals will

not voluntarily pay a price to use a public good, but will behave as free-riders. For exactly
the same reason, they will not be willing to reveal their preferences for public goods if they
will be coercively taxed according to the preferences they reveal.

The existence of these pure public goods having the above mentioned characteristics
provides the strongest reason for government (or public sector) intervention.

b. Semi-Public Goods

Semi-public goods, which are also called quasi or impure public goods, are neither
private nor purely public goods but somewhere in between these two categories. In this type
of goods we are faced with the concept of externalities.

Externalities are external gains or losses accruing from one's consumption or

production and spreading over to others. They are sometimes called "spillovers" or
"neighborhood effects" because the costs and benefits of an individual's choice spills over to
others or is shared with neighboring producers or consumers.

Two agents exist in externalities: (a) the initiating agent who is the producer or
consumer causing the externalitiy; (b) the recipient agent who is the producer or consumer
receiving the externality.

As can be understood from the definition of the term (external gains and losses) there
are two types of externalities: negative and positive externalities.

Negative externalities (external diseconomies): If one's consumption or

production may harm or give damage to others consumption or production, we are
faced with a negative externality. Sometimes the activities of an individual or firm
may damage or produce disbenefits to other parties. For example, a firm
manufacturing steel might pollute the air and water with dangerous chemicals and
toxic fumes. As a result, the profits of the producers in a nearby recreational industry
and the welfare of residents living in that area may be reduced. Pollution by factories,
 automobiles, airports, noise, smoking are all examples of negative externalities.

Positive externalities (external economies): If one's consumption or

production may benefit others consumption or production, we are faced with a positive
externality. One example of positive externality is education (which is accepted as one
of government's main responsibilities). The benefits of education spill over from
students to others: as a result there will be a society with more educated people, people
who have basic skills. Health services, such as preventive health care, preventing
infectious diseases possess a positive external character, too. Housing services, the
firms allocation of resources to the discovery of knowledge and inventions, the
training by firms of labour are also examples showing positive external characteristics.

It can be seen that externalities keep the market from reaching allocative efficiency
because the gains or losses generated are external to the pricing system; they are unpriceable.
The transaction costs of externalities (the costs of identifying, valuing and selling of costs and
gains) are very high. The result is a misallocation of resources or a failure of the market
economy to generate a Pareto optimum. This is why government intervention in the economy
occurs.

In the case of positive externalities there are mainly three types of interventions the
government may engage in:

(i) Subsidies: Subsidies are monetary payments, through the government budget, for
beneficial positive external goods, to lower their prices. Long-term, low-interest loans and tax
reductions are also examples of subsidies.

(ii) Government production at lower prices (at socially optimal prices): In this case
we have a direct governmental influence on allocation because the government itself
undertakes the responsibility of the production of the positive external good. It usually
supplies it at a lower price, in some cases free of charge (e.g. The State Opera and Theatre
Institutions in Turkey).

(iii) Compulsion. Government may also make the use of certain beneficial goods and
services compulsory. For example in most countries basic education is compulsory and
parents have to send their children to school for a certain period of time.

In the case of negative externalities, which basically arise from harmful production
and consumption, there are also several instruments the government may use. These are:
 (i) Tax penalties or legal punishments to limit the production or consumption of a
good. e.g. outlawing pollution, discouraging drivers to drive when drunk by the way of high
fines and imprisonment.

(ii) The government may impose excise taxes on goods so as to discourage their
consumption or production. These are known as sumptuary taxes, e.g. taxes on the
consumption of alcoholic drink and tobacco products. Similarly, scarce energy supplies may
lead to energy taxes to discourage their wasteful use.

(iii) The government itself may supply these type of goods and sell them at a very
high price (e.g. alcoholic drinks, tobacco products).

Who will decide on the benefit or merit of these goods? On behalf of the
society, the representative government (chosen by voters in general and local elections) will.
So, it must be borne in mind that these activities of the government have a political nature,
too.

c. Public Economic Enterprises

These are publicly owned companies which produce private type goods. 4 In this case,
the government is directly involved in the provision of private or marketable goods. For
example, the government may operate in the field of energy, communication and
transportation. This is because the private sector does not provide the optimal amount of
these goods and services. There are two main reasons for this. The first one is natural
monopolies (also referred to as nationalized industries). Some industries are natural
monopolies in the sense that they exhibit increasing returns to scale. In this case Pareto-
optimum conditions are violated; so these industries must be owned by the government on
the grounds of efficiency. Here, the government may charge a price for these goods and
services that is lower than the average cost and the deficit (in some cases a huge amount of
loss) will be covered from general tax revenues, that is from the government budget. In this
way social welfare will be maximized and consumer surplus will be larger, as shown below.

The other reason for the provision of these goods by public economic enterprises
(PEEs) is the externalities generated from these goods and services. We have already
discussed this matter and emphasized the role of government in services like education and
health.
4
The term should not be confused with public utilities which are generally municipality owned, local type of
enterprises. For example İSKİ and İETT are the public utilities of the Istanbul Greater City Municipality.
 Price

consumer surplus

consumer surplus resulting in the price fall

(p1abp2)

In Turkey, PEEs comprise of two distinct institutions:

(i) Public Economic Corporations (Kamu İktisadi Kuruluşları). This group produces
private goods which have very strong public characteristics, e.g. Turkish Electricity
Corporation, Turkish State Railways, Turkish Airlines, TEKEL ....

(ii) Economic State Organizations (İktisadi Devlet Teşekkülleri). These type of

institutions refer to pure private companies which produce pure private goods, e.g.
Sümerbank, Türk Demir Çelik, Makina Kimya Endüstrisi, Et ve Balık Kurumu, SEK....

In recent years, "privatization" has been a term closely related with PEEs. Although
the concept has been a subject of great debate, no single, universally accepted definition has
been made. It has been used in many different senses in the world but it is possible to group
these into four categories:5

(i) The privatization of financing a service that continues to be produced by the public
sector (new or increased user charges for services).

(ii) The privatization of the production of a service that continues to be financed by

the public sector (contracting out, education vouchers).
5
Kenneth Wiltshire, Privatization: The British Experience, Longman Cheshire, Melbourne, 1988, p.15.
 (iii) Denationalisation, meaning the sale of public enterprises and transfer of
government functions to the private sector.

(iv) Liberalisation, meaning relaxation of any statutory monopolies or licensing

arrangements that prevent private sector firms from entering markets previously supplied by
the public sector (that is, removing controls to allow private firms to compete to supply
services).

It is apparent from all of the above that there is no commonly agreed upon definition
of privatization. It covers several actions, all of which shift activity from the public sector to
the private sector. But it may be said that privatization is most commonly and most generally
defined as the transfer of government-owned industries to the private sector.

The aims and objectives of privatization may be listed as follows: (i) raising revenue
for the government; (ii) the promotion of competitiveness and increasing of efficiency; (iii)
the promotion of a wider share of ownership both by the employees and the public. It is
argued that with privatization PEEs will be free of government intervention and protected
from political pressures.

In the case of privatization, the government should take into careful consideration the
type of the institution to privatize and it should retain the golden share. This share, which
may also be considered as a priviledged share or a special rights share, has vital importance
for the economy: it allows the government to retain specific powers over the future
ownership, control or conduct of a privatized company, thus maintaining its right to act in
behalf of the national interest. This is how privatization has been applied in Great Britain. 6

d. Economic Regulations

Economic regulations are rules and procedures established by the government for the
working of a fair market structure. Setting safety standarts for products such as food,
automobiles, children's toys and for production activities on air and for water pollution
(establishing consumer protection agencies); restricting entry to professions and industries via
the issuance of charters, franchises, patents or licenses; setting general anti-trust regulations
are the types of economic regulations the government may apply and in doing so may change

6
For further information on privatization see K. Wiltshire, Privatisation; Dexter Whitfield, The Welfare State,
Pluto Press, London, 1992; Attiat F. Ott and Keith Hartley, Privatisation and Economic Efficiency, Edward Elgar,
Hants, England, 1991; TOBB Özelleştirme Özel İhtisas Komisyonu Raporu, TOBB Yay., Ankara, 1993.
the pattern of resource allocation. These rules are designed with the aim to have a fair
competitive market structure.

The US economy is an economy of regulation rather than one in which the

government itself is directly involved in the provision and thus allocation of goods and
services. The latter, that is direct involvement of government in the provision of goods and
services, is more common in European countries.

2. The Distribution Function of Government

It is generally agreed that government must take redistributive measures to make

society achieve an ethically acceptable income distribution. The aim of government is to
obtain a more equitable distribution of income in society.

The distribution function of government is based on two views: Utilitarianism and

Rawlsianism.

The utilitarian view, led by Jeremy Bentham (1784-1832), contends that government's
role is to maximize total societal utility. According to this view of maximum total welfare,
income should be distributed so as to achieve the greatest sum of happiness (utility). Society's
welfare is the sum of utilities of individuals which may be expressed as:

W = U1 + U2 + ….. Un

This view is also referred to as the additive social welfare function.

On the other hand, the Rawlsian view, led by the Harvard professor John Rawls,
argues that the welfare of the society depends on the welfare of the least advantageous
individual. The government's role should be to make redistribution activities so as to
maximize the utility of the worst-off. This social objective is also called the maximin
criterion because the objective is to maximize the utility of the person with the minimum
utility.7 According to this view, a minimum standart of living should be provided to the poor.
The Rawlsian view is more commonly argued today and, clearly, it is very much open to the
considerations of poverty. The income level chosen to define poverty is a relative concept and
it depends upon the general standart of living in the country under consideration. For
example, some argue that the income of the lowest one fifth is the portion in society that
should be levelled up.
7
Harvey S. Rosen, Public Finance, Irwin, Homewood, Illinois, 1988, p.153.
 Government can be effective in the redistribution of income through its policies of
taxation and expenditure and through its macroeconomic policies to promote growth and full
employment. The instruments of government in its redistribution policy may be listed under
three broad headings:8

a. Economic Growth

Economic growth alters the distribution of income and wealth in an indirect manner.
Government has the function of promoting growth (which will be explained later in this
chapter) and as economic growth increases the economy's ability to produce goods and
services, it will make both the rich and the poor better off. Will this improve the distribution
of income? Economic growth reduces poverty because it improves the standart of living of all
groups in the society - the rich and the poor. But economic growth doesn't necessarily
improve the relative distribution of income. The gap between the rich and the poor may grow
larger because, while both groups are better off, the rich may gain more than the poor. 9 In
addition, economic growth is often encouraged by promoting savings and investment. This
means supplying production incentives to high income groups. That is, the rich get helped
first and as the economy grows, the poor benefit, too.

b. Direct Redistribution

Governments have the authority to force individuals to engage in transactions in

which they would not engage voluntarily. This unique power enables the government to take
income from some individuals (through progressive taxation) and transfer it directly to others
who are highly eligible to have the transfer (that is, to the poor, to low-income families). This
procedure may also be called a tax-transfer mechanism.

How is this transfer made from one group to another? It is either made in cash (the
social security system for example collects taxes from today's workers and provides direct
payment to the retired), to be spent as the recipients wish or in-kind, that is, in the form of
goods or services (for example giving dairy products, foodstamps, medical aid to the poor).

There is a great deal of debate over cash and in-kind transfers. Many economists
prefer cash benefits to in-kind benefits. First of all cash benefits have less administrative
costs. Secondly, cash payments are more responsive to the preferences of the individuals who
8
Michael Veseth, Public Finance, Reston Publishing Company, Reston, Virginia, 1984, pp.91-95.
9
Many people justify the redistribution function of government on the grounds that it provides
social stability. A highly unequal distribution of income may give rise to undesirable social
tensions such as crimes, riots etc...
receive them. It is argued that these benefits suit the principle of consumer sovereignty,
which holds that each individual is the best judge of his/her needs and wants. On the other
hand, in-kind payments provide the goods and services that givers think the poor want or
need. Critics of in-kind welfare payments criticize these programs for being paternalistic.10
The government wants to ensure that the money that is transferred is spent on good uses such
as housing, food and medicine. The supporters of this view claim that the main objective of
these programs is to improve the well-being of the poor and their children and cash grants
may not be as effective in achieving this as in-kind benefits.

c. Indirect Redistribution

Many government policies alter distribution in an indirect way. Governments collect

taxes and make certain expenditures with these revenues. These sources are allocated to
provide public goods and services to all the individuals in the society. In this way,
government provides merit goods, which are goods the governments forces individuals to
consume because they generate positive externalities, such as elementary education, social
housing, electricity .... For example, education and training programs do not directly put
money into poor persons' pockets, but they increase their chance of earning higher wages.

Setting minimum wage laws is also an example of indirect redistribution by

government. In this way, by forcing firms to pay higher wages, the incomes of workers will
increase.

A suggested device to channel income payment to the poor has been "the negative
income tax". Under this concept, which has attracted widespread interest since the 1960's,
taxes should be collected from people who earn income above a certain level, but a subsidy
should be paid to individuals who earn below this level. Firstly, a minimum subsistence
income level will be set by the government and then the difference between the actual income
of the poor and the minimum acceptable income level will be transferred from the
government. In this way, low-income families or families with no earned income would be
guaranteed a certain payment.

3. The Stabilization Function of Government

10
The belief that adults may be short-sighted and need guidance from the government is called
paternalism. This belief provides the basis for a variety of governmental activity. Stiglitz, p.94.
 Economic stability means that total resources and total expenditures are in an
equilibrium; that is, aggregate demand is equal to aggregate supply. Adam Smith and the
classiccal economists argued that the market, by itself, would maintain stability by an
"invisible hand". But after the Great Depression of 1929, John Maynard Keynes in his work
The General Theory of Employment, Interest and Prices, has proved that government could
undertake an important role in the maintenance of stabilization in a country.

The government may take over a stabilizing function in order to keep unemployment
and price instability within tolerable limits. All persons seeking employment should be able to
find jobs according to their talents and capabilities. Full employment is said to exist when no
more than 5 percent of the labour force is unemployed. An allowance is made due to such
factors as changing jobs, unemployment arising from seasonal jobs, technological change.... 11
Price stability means that the purchasing power of money should not change severely over a
certain period of time. People should be able to hold their wealth without fearing that the real
value of these holdings will be eroded by inflation. A yearly 3-5 percent increase in prices is
generally accepted as a stable condition but in cases where this percentage is higher, it is
accepted that there are trends of economic instability.

Fluctuations in the rate of unemployment and in the level of prices are likely to occur
in an economy. A growing population, wars, large changes in the money supply, dramatic
technological advances and waves of optimism and pessimism are bound to produce some
economic instability.12 The excess of aggregate supply over aggregate demand causes a
deflationary gap; and the excess of aggregate demand over aggregate supply causes an
inflationary gap. It is widely believed that the government should take an active role in
reducing aggregate demand in inflationary periods, and in increasing it during recessionary
periods.13

There are two basic instruments available to government in carrying out the
stabilization responsibility:14 (1) The ability to increase or decrease the stock of money,
which can increase or decrease aggregate demand and influence the rate of interest; (2) The
ability to influence spending, savings, investment and output decisions in the economy
through alterations in the composition of government expenditures or in the tax system.
11
There may be structural changes in the economy that may cause differences between the skills
possessed by the unemployed and the skills demanded by the employers. When this situation
occurs, it is said that there is structural unemployment.
12
J. Richard Aronson, Public Finance, McGraw-Hill Book Company, New York, 1985, p.20.
13
A more complex period in an economy is stagflation. This is a situation where the economy is in recession
but there still is inflation.
14
Gardner, p.7-8.
 The government uses two instruments, through budgetary procedures of taxation and
expenditure, in achieving the objectives of full employment and price stability: automatic and
discretionary fiscal stabilizers.15 An automatic fiscal stabilizer is designed to function in a
countercyclical way to improve the performance of the economy, without the necessity of ad
hoc adjustments in response to an immediate economic problem. For example, when incomes
drop, as a result of a recession, the average tax rates also drop; individuals are faced with
lower tax rates because their incomes are lower. On the other hand, when income increases,
the average tax rate increases, too. An unemployment insurance program is also a major
automatic stabilizer. In times of unemployment payroll tax collections decline and
unemployment benefits increase; thus, by increasing the purchasing power of the private
sector, a positive effect will be processed against recession. A discretionary fiscal stabilizer
refers to a direct budgetary change responding in an ad hoc fashion to a recognized economic
problem. Deliberate changes in either tax rates or tax bases or the adoption or deletion of a
tax, or deliberate changes in governmental spending or/and taxing can be rationally directed
toward the improvement of the performance of the economy.

The government prescription for the inflationary gap would first be to obtain a
balanced budget and then a budgetary surplus. This will be accomplished by a decrease in
government spending and/or an increase in tax revenues. In the case of a deflationary gap, the
government should establish a deficit budget in order to expand the economy under
conditions of depression. This will be accomplished by a reduction in tax revenues and/or an
increase in expenditures. In this way, investment will be stimulated and unemployment will
be avoided.

4. The Growth Function of Government

In an economy, the amount of productive resources and the national income these
resources create grow year by year. Government can function in this growth procedure and it
can provide a satisfactory rate of growth.

The growth rate of the economy is the rate at which real Gross National Product
(GNP) is growing. GNP is the value of all final goods and services produced in the economy
in a certain period of time. What causes the real GNP to grow over time? 1) The available

15
Bernard P. Herber, Modern Public Finance, Richard D. Irwin Inc., Homewood, Illinois, 1979, pp.101-
102, 400.
amount of resources in the economy changes (labour and capital). The labour force, consisting
of people either working or looking for work, grows over time and thus provides one source
of increased production. The capital stock, including buildings and machines, likewise, rises
over time, providing another source of increased output. 2) The efficiency with which factors
of production work may also change. Over time, the same factors of production can produce
more output. These result from changes in knowledge; as people learn through experience,
they perform familiar tasks better.

Government can also function to increase production. What are the fiscal instruments
of government to provide growth; to ensure a satisfactory rate of growth? To put the question
in another way, what are the major tax and expenditure instruments which can be employed
by the public sector to promote economic growth? These can be put under two headings:

a. Public infrastructural investments. The government could directly increase its

own investment and could do this by investing on infrastructure. There is increasing evidence
that government investment on infrastructure can have a positive effect on aggregate growth
rate. That is, infrastructure investments seem to have a high social return.

There are two types of public infrastructural investments.

(i) Social infrastructure investments. Education and health are examples of these
types of investments. The public sector investment in education provides for growth in
literacy and knowledge which increases economic productivity and consequently leads to a
higher rate of economic growth.

(ii) Economic infrastructure investments. These are investments made by the

government in making dams, highways, harbours, communication facilities, airports etc....
These types of investments provide an output that is integral to the economic growth process.
All these lead to greater private sector production and thus to a higher level of private
consumption goods. For example, if the government provides electricity to some place in the
country, more televisions and other electric equipment will be used. Or, if government
constructs highways to some region in the country, factories may open in those places.

b. Incentive systems. Government may induce private investment in an indirect way

which is called incentive systems. Tax incentives are ways of promoting private investment
through reducing taxes. It is supposed that a high correlation exists between reduced taxes and
higher investments. One way of doing this is the investment tax credit, which allows firms to
deduct from their taxes a certain fraction of their investment expenditure each year. Thus, a
firm spending 600 thousand TL for investment purposes in a given year could deduct 10
percent of it, or 6 thousand TL from the taxes it would otherwise have to pay to the
government. The investment tax credit reduces the price of a capital good to the firm, reduces
the rental cost of capital (that is, it reduces the cost of using one more unit of capital in
production) and as a result increases the stock of capital.

Accelerated depreciation, and tax holidays during which profits from new enterprises
are tax-free for an initial period of, say, 5 to 7 years, are also devices used to promote
investment. Credit incentives, that is giving low-interest, long term credits to investment at
certain places or to certain production activities, are also ways of increasing investment and
thus growth. A tax structure designed to encourage research and development efforts will also
tend to promote economic growth. The ability of businesses to write off research expenditure
as costs in the calculation of net profits and taxable income is significant.