Public Finance and Fiscal Policy
Core Concepts
Public finance covers government revenue (taxation), expenditure, and debt. You must understand tax principles (ability-to-pay, benefit principle), tax incidence, deadweight loss of taxation, public goods, externalities, and fiscal policy (automatic stabilizers, discretionary policy). Budget deficits, public debt sustainability, and fiscal federalism are also key. In Bangladesh, VAT, income tax, and supplementary duty are major revenue sources.
Common Traps
- Confusing tax incidence with tax burden on the statutory payer; incidence depends on elasticities.
- Assuming all government spending is productive; distinguish capital vs. recurrent expenditure.
- Forgetting that public goods are non-rival and non-excludable, leading to free-rider problem.
- Misunderstanding deficit financing: borrowing vs. money creation (inflation tax).
- Overlooking the crowding-out effect of government borrowing on private investment.
Worked Example / Rule of Thumb
Rule of thumb: Tax incidence: the burden falls more heavily on the less elastic side of the market. If demand is inelastic and supply elastic, consumers bear most of the tax. Deadweight loss of a tax is approximately 0.5 * t^2 * (Q/P) * (1/|Ed| + 1/Es) for small taxes, where t is the tax rate.
Example: Suppose the demand for a good is Qd = 100 - 2P and supply is Qs = 3P. Equilibrium without tax: 100 - 2P = 3P → 5P = 100 → P = 20, Q = 60. Now impose a tax of 5 per unit on consumers. New demand: Qd = 100 - 2(P+5) = 90 - 2P. Set equal to supply: 90 - 2P = 3P → 5P = 90 → P = 18, Q = 54. Consumers pay 18+5=23, producers receive 18. Tax revenue = 554 = 270. Deadweight loss = 0.55*(60-54) = 15. This shows how tax distorts quantity.