CHAPTER ONE: BASICS OF PUBLIC FINANCE

Chapter Objectives

After the completion of this chapter, the students will be able to:


 Define public finance
 Understand the scope of public finance
 Distinguish public finance from private finance
 Discuss the role of government to the economy and society
 Realize the role of fiscal policy
1.1. Definition of public finance

Public finance is a very old science and different economists have defined in different ways.
Some of the most commonly used definitions of public finance are shown as follows:

“Public finance is concerned with the income and expenditure of public authorities and with
the adjustment of one to the other.” Huge Dalton

“Public finance deals with the provision custody and disbursement of resources needed for
conduct of public or government functions.” Lutz

“Public finance is a science which deals with the activity of the statement in obtaining and
applying the material means necessary for fulfilling the proper functions of the state.” Carl
Plehn

“Public finance is the study of the principles underlying the spending and raising of funds of
public authorities.” Findley Shirras

“The government, considered as a unit, may be defined as the subject of study of public finance.
More specifically, public finance studies the economic activity of government as a unit.”
Buchanan

“Public finance deals with expenditure and income of public authorities of the state and their
mutual relations as also with the financial administration and control.” Bastable

Most of the authors argued that public finance is a study of income and expenditure of the
central, state, and local governments. Government performs many functions which the
individual cannot or do not perform. Therefore, rising of funds for the expenditure and their

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disbursement constitutes the subject of public finance. It is also known as fiscal operations of
the treasury. Thus, fiscal operations and fiscal policies are integral part of public finance.

Activity
Question 1: What is public finance?
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1.2. Scope of Public Finance

The scope of the science of public finance are divided into five categories of financial activities
of the government:

1. Public Revenue
2. Public Expenditure
3. Public Debt
4. Financial Administration and Control, and
5. Economic Stability
A. Public Revenue

Under this division, the sources of the public revenue, principles of taxation, effects of taxes
on the economy, methods of raising revenue and the like are included. Public revenue includes
all incomes irrespective of the source they are obtained from. There are various sources of
public revenue and these sources can be categorized in two major classes;

i. Tax revenues
ii. Nontax revenues

Increasing activities of the government are the cause of increasing public expenditure. Methods
of public revenue and their volumes have significant impact on production and distribution of
wealth and income in the country. It has effects on the nature and the volume of economic
activities and on employment.

i. Tax revenue

Taxes are compulsory payments to government without expectation of direct return or benefit
to tax payers. It imposes a personal obligation on the taxpayer. Taxes received from the
taxpayers, may not be incurred for their benefit alone. Tax revenue is one of the most important
sources of revenue.

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Taxation is the powerful instrument in the hands of the government for transferring purchasing
power from individuals to government. The objectives of taxation are to reduce inequalities of
income and wealth; to provide incentives for capital formation in the private sector, and to
restrain consumption so as to keep in check domestic inflationary pressures.

Generally, taxation has the following elements:

 Taxes are compulsory
payments to government
a. It is a compulsory contribution without expectation of direct
b. Government only imposes taxes return or benefit to tax payers.

c. In payment of tax an element of sacrifice is involved

d. Taxation is aimed at welfare of the community
e. The benefit may not be proportional to tax paid
f. Tax is a legal collection.
ii. Non-tax revenue

This includes the revenue from government or public undertakings, revenue from social
services like education and hospitals, and revenue from loans or debt service. To sum up, non-
tax revenue consists of interest receipts, dividends and profits, fiscal services and others.
Activity
Question 2: List the tax and non-tax revenues?
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B. Public expenditure

The term “public expenditure” is used to refer the expenditure of government- central, state
and local bodies. It differs from private expenditure in that governments need not pay for
themselves or yield a pecuniary profit. Public expenditure plays the dual role in administration
and economic achievement of a nation.

Wise spending is essential for stability of government and proper earnings are a prerequisite
for wise spending. Hence planned expenditure and accurate foresight of earnings are the
important aspects of sound government finance.

Through public expenditure, the government contributes to the financial flows of the economy
and conditions the demand and supply patterns. Public expenditure is also used as a tool for
implementing welfare, growth, stabilization and other policies, by the government.

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Public expenditure is done under two broad heads viz., developmental expenditure and non-
developmental expenditure. The former includes social and community services, economic
services, and grants in aid. The latter mainly consists of interest payments, administrative
services, and defence expenses. Expenditure can also be classified into revenue and capital
expenditure.

C. Public debt

A government can obtain income through loans and public borrowings. The loans raised in a
particular year constitute receipts or revenues for that year. It is an income of a capital nature,
while the provision for repayment of the capital sum for the year constitutes expenditure of a
capital nature. The study of public debt includes the methods and objectives of public
borrowings, management of public debt and burden of public-internal and external.

Methods of public debt are an important instrument of not only raising funds but also, for
meeting increasing government expenditure, for securing economic stability, increasing public
borrowings during the periods of inflation and liquidation of public debt during the period of
depression, borrowings from the people during inflation and borrowings from banks during
depression and so on. Public debt can be classified as internal and external debt.

a. Internal debt

Increasing need of government for funds cannot be fully met by taxation alone in under
developed and developing countries due to limited scope of taxation. Government therefore
has to resort to alternate sources. Rising of debt is one such source. Debt, though involves
withdrawal of resources by curtailing private consumption, has certain advantages. Transfer of
funds from public to government is voluntary. Loans do not reduce the wealth of the lenders.
Debt raised for productive purpose will not be a burden on the economy.

There are many objectives of creation of public debt. Debt may be raised to meet the normal
current expenditure, exigencies like war, finance productive government enterprise, finance
public social welfare and economic development. Capital receipts mainly consist of market
borrowings, small savings and external loans and recoveries of loans.

b. External debt

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In under developed and developing countries, internal sources are limited. Under developed
and developing countries, therefore go for external debt. The transfer of capital at international
level may take the form of financial aid through grants and loans, commodity aid and technical
assistance.

External debt is an immediate source of funds for development. However, such debt has
following drawbacks. i) Political subordination ii) Other obligation iii) Excess supply of goods
and services in debtor country. However, such external inflows help to achieve faster growth.

D. Financial administration and control

The scope of public finance is not confined only to public revenue, public expenditure and
public debt. We have to examine the mechanism by which the above processes are carried on.
Without a study of relevant dimensions of financial administration, the subject of public
finance remains incomplete.

Thus, financial administration and control include the following: (i) Study of budgets and their
procedure. (ii) Budget as an instrument of securing certain objectives, such as promotion of
employment, economic growth with stability, welfare of the weaker sections, infrastructural
development for promoting private investments etc. (iii) Financial and physical controls
through different fiscal tools for controlling private expenditure in the economy to avoid the
effects inflation deflation, recession etc.

Note: The main scope of public finance may be summarized as revenues, expenditure, debt,
financial administration and economic stabilization.

E. Economic stabilization

The study of public finance includes fiscal policy of the government in dealing with
inflationary and deflationary situations, instability of the price level, promotion of full
employment, growth of economy, welfare of the people, etc.

Economic stabilization is of recent origin. It has a wide scope to play especially in the less
developed countries. The main task of this section is to frame and look after the implementation
of various policies required for economic stabilization and growth.

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1.3. The role of the government in the economy and society
A. Economic Significance

Economic stability and maintenance of full employment are the two main goals of public
finance in advance countries like the U.K. and the U.S.A. For developing countries economists
argued that the fiscal policies should be formulated for the rapid economic development. Public
finance occupies great significance in under developed or developing country. According to
R.J. Chelliah, “Public Finance has a positive and significant role in the context of economic
development.” The importance of public finance in under developed/developing country are
discussed as follows:

a. Capital Formation

The first and the foremost aim of public finance is to promote capital formation because the
economic development of the country depends on the rate of capital formulation. In developing
countries, the government’s economic policy should concentrate on production and fiscal
policy should act as a tool of capital formation. For rapid capital formation, the government
should incur expenditure on the establishment of basic and heavy industries, infrastructural
development, such as power projects, transport sector, means of communications etc.

b. Economic Stabilization

Economic stabilization is yet another economically significant responsibility of the

government. The problem arises whenever there is economic instability such as inflation,
deflation and recession. Public finance may be, therefore, used to secure economic stability or
to remove economic fluctuations in the economy.

c. Increase employment

Public finance plays an important role in increasing employment. In underdeveloped or

developing country, major problem faced by the people is the problem of unemployment. This
problem leads to low standard of living, poverty, backwardness, ignorance etc. It is the function
of public finance to provide employment opportunities. Therefore, expenditure should be
incurred by the government for increasing employment and for achieving full employment. To
generate employment, public expenditure should be incurred on setting up new industries,

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encouraging small-scale and cottage industries through financial subsidies, expenditure on
training schemes etc.

d. Balanced Regional Development

For the economic development of a country, balanced regional development is very essential.
Balanced regional development is possible by setting up private industries in backward areas
instead of in urban areas. To encourage this diversification, the government should provide
fiscal or tax concessions in the form of tax holiday, communication facilities should also be
provided. If the private industries fail to divert to backward regions, should be taxed heavily.

e. Reduction in Economic Inequalities

One of the major problems of developing countries is the unequal distribution of income and
wealth. There is a gap between the rich and the poor. Public finance has an important role to
play in this context. To bring about equitable distribution of income and wealth, the
government should follow the system of progressive taxation. In other words, the government
should impose heavy taxes on the richer section of society and the amount realized from the
rich should then be spent on the poor by way of providing them social services such as free
education, medical facilities, public utilities like road, water facility, recreation facilities etc.

f. Mobilization of Resources

Mobilization of resources is another important role of public finance. The government can
mobilize or raise resources by imposing taxes on the people and industries, by encouraging
savings through various saving schemes, surplus of public enterprises and borrowings and
making them available for investment for the rapid economic development of the developing
country.

g. Optimum Utilization of Resources

Optimum utilization of scarce resources is very essential for the economic development of the
least developed countries. In developing country, it is not uncommon to find non-utilization or
destruction of scarce resources. The solution of this problem lies in the optimum utilization of
available resources by means of adopting planned monetary and public finance policies. The
state can direct the flow of consumption, production and distribution in the right direction by
adopting balanced budgetary policy.
 The roles of the government can be
summarized as allocation, distribution and
stabilization roles. 13
 B. Social Significance

2. Social justice or equitable distribution of income and wealth: is another responsibility of

the government in its public finance operations. There is a wide gap between the rich and the
poor in the least developed countries. In other words, luxury items purchased mainly by the
rich should be subjected to higher rates of taxation, and necessary items should be exempted
from taxation.
Social justice also requires investment expenditure on the establishment of enterprises in the
public sector. By doing so, the government would be able to produce goods of mass
consumption to make cheap goods available to the people.
3. Satisfaction of social wants and merit wants: another significant point of public finance
is the satisfaction of social or collective wants and merit wants. Wants are divided under three
heads: private Wants, Social Wants or Collective Wants and Merit Wants.
a. Private Wants: private wants are those wants which are satisfied by individuals according
to their personal incomes. Degree of satisfaction depends upon their respective incomes. Wants
for houses, food, clothes, entertainment or recreation etc. are satisfied according to individual
preferences.
b. Social Wants or Collective Wants: Social or collective wants require public goods which
are demanded by all members of society equally whether the people have the capacity to pay
or not. Wants like defense, education, public health, flood control provisions, weather
forecasting bureaus, research centers, police protection, social overhead capital like roads,
bridges, etc. are collective wants which must be available to all the people, irrespective of
whether they are rich or poor, whether they can afford to have them or not. In other words,
consumer is supreme. Public expenditure on these heads is necessary to satisfy social or
collective wants. Since nobody is ready to pay for them, therefore, taxes are imposed on the
people to meet expenditure for the satisfaction of these wants.
c. Merit Wants
Merit wants are essential private such as food, clothing, housing etc, which are satisfied by the
government at low prices for the poor due to their low level of income. Merit wants are, thus,
provided by the government for the benefit of the poor. These wants are satisfied by the
government for the up liftmen and progress of the poor. Such wants are food, clothing, low
cost housing (e.g. condominium), free nutritious means to school children, free education to
the children of the poor, low priced milk to the poor, old age pensions and social security

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measures, maternity benefits etc. Satisfaction of these wants for the poor increases their
productivity efficiency and there by their income.
4. Fiscal Policy to Curb or Prevent Undesirable Wants: another important aspect of public
finance is that the government not only satisfies social wants and merit wants, but also
discourages and curbs certain undesirable wants of the people from the social point of view.
Undesirable wants are cigarette smoking, liquor drinking, chewing of opium and tobacco etc.
Such harmful wants are discouraged and curbed by imposing heavy taxes and spending large
amount on publicity, health measures for the affected people, etc.

Activity
Question 3: Write the roles of the government in social aspects?
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4.1. Similarities and difference between Public Finance and Private Finance

Finance in general means public as well as private finance. Public finance relates to the money-
raising and income-expenditure functions of the government. Private finance refers to the
income-expenditure phenomenon of an individual or private business firm. By private finance
we mean the financial problems and policies of an individual economic unit. It is a convention
to look into similarities and dissimilarities between the two so as to provide an analytical
foundation for the decision-making aspects of public finance.

Similarities

a. Satisfaction of human wants: Both the public and private finance have the same

objective, i.e., the satisfaction of human wants. Public finance is concerned with the
satisfaction of social or collective wants, whereas private finance is concerned with the
satisfaction of personal or individual wants.

b. Maximum advantage: Both the public finance and private finance try to secure maximum

advantage or maximum benefit. An individual or a corporation or a private business firm tries

to obtain maximum advantage from his expenditure. Similarly, the government also tries to
obtain maximum good of the people by incurring expenditure on the society.

c. Borrowings: Another similarity between the public and private finance is that many times

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both have to be obtained from the market in the form of borrowings whenever the expenditure
of either the government or any individual or firm exceeds their income/revenue.

d. Engagement in similar activities: Both the private and public sectors are engaged in

activities that involve lots of purchases, sales and other transactions. Similarly, they are
engaged in production, exchange, saving capital accumulation, investment, and so on. In order
to finance these operations, the government, creates money, raises loans and makes payments
etc. Similarly, a private economic unit lends, borrows, receives payments, makes payments
and so on. In these respects, therefore, both the public and private finance are quite similar to
each other.

e. Problem of economic choice: The scarcity of resources is also an important factor which
is common to both. They have unlimited objectives, whereas the resources are limited.
f. Balancing income and expenditure: Both individual an Government have incomes and
expenditures and trying to balance each other.

 Public finance and private finance are similar in satisfaction of human wants, maximum advantage,
borrowings, engagement, problem of economic choice and balancing income and expenditure.

Differences

i. Nature of resources: In private finance the individuals have limited resources. They
cannot raise the income, as they like. They do not have the power to issue paper currencies.
But, in the case of public finance the government has enormous kinds of resources. Besides
the administrative and commercial revenues, the government can get grants-in-aid and borrow
from other countries. The government can print currency notes to increase its revenue.
ii. Motive of expenditure: In private finance, an individual expects return in benefit from the
expenditure made. But, the government cannot expect return in benefit from various
expenditures made. The profit or benefit is the motive of private finance whereas the social
welfare and economic development is the motive of public finance.
iii. Allocation of resources: In private finance, the individual can allocate or distribute his/her
income to various expenditure in such a way to get the maximum satisfaction. But it is not
possible in the case of public finance; government cannot aim at maximum satisfaction on the
expenditures made.
iv. Adjustment of income and expenditure: In private finance, an individual first considers
his/her income and then decides about his/her expenditure. However, in public finance, the

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government first estimates the volume of expenditure and then tries to find out the methods
of raising the necessary income to satisfy these expenditures. Thus, private finance tries to
adjust its income to expenditure, whereas the public finance tries to meet the expenditure by
raising income.
v. Nature of benefit: The private finance aims at individual benefit i.e. the benefit of an
individual or a household. But the public finance aims at collective benefit, i.e. the benefit of
the nation as a whole.
vi. Postponement of expenditure: In private finance, the individual can postpone or even
avoid certain expenditure, as he/she likes. But, in public finance, the government cannot avoid
certain commitments like social welfare measures and cannot postpone the certain expenses
like relief measures, defense, etc.
vii. Influence on expenditure: The expenditure pattern of private finance is influenced by
various factors such as customs, habits, culture, religion, business conditions etc. But, the
pattern for expenditure in public finance is influenced and controlled by the economic policy
of the government.
viii. Nature of Perspective: In private finance, the individual struggles for immediate and
quick return. Since his/her life span is definite and limited, he/she gives emphasis for present
or current needs and allots only a little portion of income for the future. But the government
is a permanent organization and is the caretaker of the present and the future as well. Thus,
the government allots a considerable amount of its income for the promotion of future benefits.
Therefore, private finance has a short-term perspective whereas the public finance has a long-
term perspective.
ix. Nature of Budget: In private finance individuals prefer surplus budget as virtue and a
deficit budget is undesirable to them. But, the overnment does not prefer a surplus budget. If
the government bring surplus budget, it will create negative opinion on the government. This
is because surplus budget is the result of high level of taxation or low level of public
expenditure both of which may affect the government adversely.
x. Coercion: Individuals and businesses cannot use force to raise their income whereas the
government (public finance) can use in the form of imposing taxes to get income i.e. taxes are
compulsory in nature. It is an obligation of the tax payers. No one can refuse to pay taxes if
he/she is liable to pay them. In addition, the government can undertake any of the existing
private business by way of nationalization, which is not possible in the hands of individuals.
xi. Publicity: Individuals do not like to disclose their financial transactions to others. They
want to keep them secret. But the Government gives the greatest publicity to its budget
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proposals and the allocation of resources to different heads. Publicity strengthens the
confidence of the people in the government.
xii. Audit: In the private finance, audit of the financial transactions of the individuals is not
always necessary. But, the accounts of the governments are subject to audit and inspection.

 Note: Nature of resources, motivation of expenditure, allocation of resources, adjustment

of income and expenditure, nature of benefit, postponement of expenditure, influence on
expenditure, nature of perspective, nature of budget, coercion, publicity and audit are the major
differences between public finance and private finance.

4.2. Fiscal policy

Fiscal policy is also called budgetary policy. In broad term, fiscal policy refers to the segment
of national economic policy which is primarily concerned with the receipts and expenditures.
It includes raising financial resources and spending them. Resources are obtained through
taxation and borrowing from both internally and abroad. Spending is done mainly for defence,
development and administration activities. Financial accounts of the income and expenditure
position are shown in budgetary statement. Budget can act as an important tool of economic
policy. The state by its policy of taxation-regulated expenditure can influence the economic
activities and development.

Fiscal policy relates to taxation, government spending, government borrowing and

management of government debt government’s decision makings. Fiscal policy in these
different decisions deal with the flow of funds out of the private spending and saving stream
into the hands of government and the recycle funds from government into the private economy.

Fiscal policy deals directly with matters which immediately influence consumption and
investment expenditure. Therefore, it influences the income, output and employment in the
economy. Fiscal policy is primarily concerned with the aggregate effects of public expenditure
and taxation on income output and employment.

Fiscal policy should balance the economy by sustaining the consumption in the economy for
developed countries and help for rapid economic development and an equitable distribution of
the income between rich and poor in developing countries.

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Chapter summary

Public finance is a study of income and expenditure of the central, state, and local governments.
Fiscal operations and fiscal policies are integral part of public finance. Public revenue, public
expenditure, public debt, financial administration and control, and economic stability are the
financial activities under the scope of public finance.

Capital formation, economic stabilization, increase employment, balanced regional

development, reduction in economic inequality, mobilization of resources and optimum
utilization of resources are the roles of the government in the economy. While, social justice
or equitable distribution of income and wealth, satisfaction of social wants and merit wants,
merit wants, fiscal policy to curb or prevent undesirable wants are the social roles of the
government.

The similarities between public finance and private finance can be summarized as satisfaction
of human wants, maximum aadvantage, borrowings, eengagement in similar activities,
problem of economic choice, balancing income and expenditure. Nature of resources, motive
of expenditure, allocation of resources, adjustment of income and expenditure, nature of
benefit, postponement of expenditure, influence on expenditure, nature of perspective, nature
of budget, coercion, publicity, audit are the differences between public finance and private
finance.

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