Basics

The public sector (i.e. government) does not undertake activities to achieve a profit, but to achieve equity (The definition for equity here is the fair or just distribution between those who gain from a change and those who lose from it). The public sector provides services that are deemed necessary by the community and that are not effectively provided by the private sector because the optimal quality and quantity are difficult to measure and generating a profit is difficult.
Today, most of us think it is the collective responsibility of our governments to ensure each citizen's equality, rights, safety, and freedom by ensuring fairness, transparency, and a healthy balance between private opportunity and the public interest. Based on this perceived social contract, a municipality provides services and goods that would otherwise be difficult for people, acting as individuals, to provide for themselves. It can be argued that municipalities are not only involved in exploiting gains from markets arising from free riding and market failure. But, like it or not, municipalities are also institutions for redistribution. This redistribution occurs in many ways, including through equalizing outcomes, equalizing opportunities, and providing social insurance. All policies then, even those with efficiency objectives, have gainers and losers, and it is impossible to avoid taking account of that somehow.
Given that pure public goods require a social decision, it is the consequences for economic welfare (total surplus), rather than mere profit, that matter. This decision includes notions such as equality of opportunity and capability, fairness, and poverty alleviation. Most individuals are pragmatic and are inclined to favor the organizational form that “works best.” A policy-maker should consider the distribution of burden and benefit across residents in a manner that is consistent with the accepted norms of fairness and equity. These norms typically define fairness according to the relationship between the amount of revenue collected from residents and their respective abilities to pay the tax, charge, fee or assessment along with the benefits received by them from government programs. Three widely-accepted norms of fairness are:
• Vertical Equity. This principle of fairness requires that the amount of revenue collected from residents with different income levels should reflect their respective abilities to pay the tax, charge, fee or assessment. Specifically, the cost of government as a percentage of income should not unduly burden taxpayers with limited ability to pay. Some would view this principle as satisfied by a proportional revenue system, where revenues collected are the same percentage of income for taxpayers at all income levels. Others believe that the principle requires that revenues collected as a percentage of income should be higher for residents with more income than those with less income (a progressive tax burden). To our knowledge, almost no one believes that revenues collected should be a higher percentage of income for less affluent residents than for those with more income (a regressive tax burden).
• Benefits Received. A revenue system may be considered fair if the revenues collected are matched by benefits received by a resident from the government. This principle is most relevant when a cost is charged specifically for the purpose of providing a particular government service to a specific group of residents. Such “benefit charges” are impractical for much of government spending because the “benefits” received cannot be determined for each resident. Therefore, this principle is relevant mainly for certain types of selective fees, charges and assessments which are termed user fees.
• Horizontal Equity. According to this principle, residents with similar abilities to pay a tax should pay comparable amounts of the costs. More generally, the principle of horizontal equity enjoins the government from levying charges that have arbitrary and peculiar distributions of costs across residents or from levying dissimilar tax burdens on taxpayers that are not justified by differences in their ability to pay or by distinctions in the benefits they receive from government programs.