Chapter 3: Fiscal Institutions and Empirical Evidence
The basic postulate of neoclassical theory (that the market mechanism leads to economic efficiency) has been challenged on the grounds that the many imperfections in the markets often make government involvement in economic activity a necessity. Given incompletely defined property rights and imperfectly revealed preferences, the government’s role in attaining economic efficiency is not only limited to ensuring proper functioning of the markets via establishing rules and procedures that regulate the interactions among economic agents. The provision of goods and services that have sizeable externalities, which are public goods, also constitutes a major role of the governments in the market system. The problem of public goods arises from the fact that markets fail to provide some goods and services in optimal amounts in the sense of matching the public’s true preferences. Even though public goods, by definition, benefit the entire society due to their non-excludable and non-rival characteristics, incentives to free-ride often lead to their suboptimal provision.1 Since government is responsible for providing public goods, seeking institutional solutions to the problem of under-provision of public goods also constitutes an important responsibility of the government. The important role of public goods (such as macroeconomic stability) in achieving countries’ development potentials, coupled with the free-riding potential associated with their provision, highlights the fact that generating resources for these essential goods and services is one of government’s most important tasks. For effective public goods 65 66 Macroeconomic institutions and development provision, countries’ developmental objectives and socioeconomic necessities need to be identified and the...
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