Financial instruments provide governments with an effective method to shape society. Whether it is used in a direct or indirect way, governments can use this instrument to change societal incentive structures, correct market failures and finance directly the production and delivery of public goods.
Fiscal policy enables government to change the financial incentive structures in society in order to make behaviour more or less attractive. Such instruments commonly include subsidies, excises, tax advantages, mandatory contributions and reimbursements. Governments often employ this strategy to encourage consumption of merit goods (goods or services considered to be intrinsically desirable, uplifting or socially valuable for other people to consume, independently of the actual desires or preferences of the consumer himself).
Essentially, government takes two decisions:
1. The decision to modify behavioural patterns. This is often a decision based on policies in other areas, such as healthcare or the environment.
2. The decision how to structure the intended measure. This is an issue of efficiency. For example, great increases in efficiency can be gained by adopting “smart” subsidies, i.e. tied subsidies instead of open-ended subsidies. One can also choose to allow the beneficiaries.
Input financing/Output financing
Especially in welfare states, direct government spending on matters such as public healthcare, education and transport consume a large share of GNP. The paradigm on how to best allocate these resources has gradually shifted from plan economics to liberalised markets. In practice this resulted in a shift away from input financing towards output financing, corresponding to the diminishing of government control over the actual service delivery and goods production. Such systemic change, however, takes a long time to be completed.
Output financing relates to the financing of quantifiable output, be it the rendering of services or the production of goods. It is support on the demand side, rather than supporting the supply side. Examples include the use of vouchers or subsidy allocated by the beneficiary rather than indirectly on his behalf by the government. Such measures encourage competition between supply organisations. However, although these measures might cut inefficiency at the supply side, they create their own inefficiency mainly due to the immense administrative cost of allocating funds on an individual basis and to keep fraud and misuse to a minimum.
Financial steering can also be used to remedy market failure or to enable local governments to hedge risks thus strengthening their capacity to serve the public interest. Common to all these efforts is the need to reduce uncertainty for certain parties. Private parties can be induced to participate in public-private partnerships in order for them to benefit from both government co-financing and exclusive rights to exploitation afterwards, reducing the investment risk . Governments are also able to put up seed money in order to correct market failure.