Address: Near Jivan Jyoti Hospital, Tinsukia College Road; Contact Person: Naveen Mahato, 8876720920

Friday, September 22, 2017

Introduction to Public Finance

Unit – 1: Introduction to Public Finance
Meaning and Definition of Public Finance
Public finance is a study of income and expenditure or receipt and payment of government. It deals the income raised through revenue and expenditure spend on the activities of the community and the terms ‘finance’ is money resource i.e. coins. But public is collected name for individual within an administrative territory and finance. On the other hand, it refers to income and expenditure. Thus public finance in this manner can be said the science of the income and expenditure of the government.
Different economists have defined public finance differently. Some of the definitions are given below. 
According to prof. Dalton “public finance is one of those subjects that lie on the border lie between economics and politics. It is concerned with income and expenditure of public authorities and with the mutual adjustment of one another. The principal of public finance are the general principles, which may be laid down with regard to these matters.
According to Adam Smith “public finance is an investigation into the nature and principles of the state revenue and expenditure”
To sum up, public finance is the subject, which studies the income and expenditure of the government. In simpler manner, public finance embodies the study of collection of revenue and expenditure in the public interest for the welfare of the country
Nature of Public Finance
Nature of Public finance implies whether it is a science or art or both.

a)      Public Finance is a science: Science is a systematic study of any subject which studies casual relationship between facts. Public finance is a systematically study relating to revenue and expenditure of the government. It also studies the casual relationship between facts relating to revenue and expenditure of the government. Prot. Plehn has advanced the following arguments in favour of public finance being science.
1)      Public finance is not a complete knowledge about human rather it is concerned with definite and limited field of human knowledge.
2)      Public finance is a systematic study of the facts and principles relating to government revenue and expenditure.
3)      Scientific methods are used to study public finance.
4)      Principles of public finance are empirical.
Science is of two types: (1) Positive science and (2) Normative science. In positive science one knows about factual situation or facts as they are. It describes “what is”. As against it, normative science presents norms or ideals. It describes “what ought to be” or what is right or wrong i.e. value judgement. By the study of public finance one gets factual information about the problems of government’s revenue and expenditure. Public finance is therefore, a positive science. Study of public finance also reveals what should be the quantum of taxes. Which taxes, direct or indirect, should be imposed. On what items more or on what items less of public expenditure is incurred. Public finance is therefore a normative science. Thus, study of public finance offers suggestions regarding revenue and expenditure of the government as also apprises of their factual position.
b)      Public Finance is an art: In the words of J.N. Keynes, ”Art is the application of knowledge for achieving definite objectives.” Fiscal policy which is an important instrument of public finance makes use of the knowledge of the government’s revenue and expenditure to achieve the objectives of full employment, economic equality , economic development and price stability, etc. To achieve the objective of economic equality taxes are levied at progressive rate. Since every tax is likely to be opposed, it becomes essential to plan their timing and volume. The process of levying tax is certainly an art. Budget making is an art in itself. Study of public finance is helpful in solving many practical problems. Public finance is therefore an art also.
In sort, public finance is both science and art. It is a positive science as well as normative science.
Scope of Public Finance (Subject Matter of Public Finance)
The scope of public finance may be summarised as under:
1.       Public Revenue
2.       Public Expenditure
3.       Public Debt
4.       Financial Administration
5.       Economic Stabilisation
1.       Public Revenue: Public revenue concentrates on the methods of raising public revenue, the principles of taxation and its problems. In other words, all kinds of income from taxes and receipts from public deposit are included in public revenue. It also includes the methods of raising funds. It further studies the classification of various resources of public revenue into taxes, fees and assessment etc.
2.       Public Expenditure: In this part of public finance we study the principles and problems relating to the expenditure of public funds. This part studies the fundamental principles that govern the flow of Government funds into various streams.
3.       Public Debt: In this section of public finance, we study the problem of raising loans. Public authority or any Government can raise income through loans to meet the short-fall in its traditional income. The loan raised by the government in a particular year is the part of receipts of the public authority.
4.       Financial Administration: Now comes the problem of organisation and administration of the financial mechanism of the Government. In other words, under financial or fiscal administration, we are concerned with the Government machinery which is responsible for performing various functions of the state.
5.       Economic Stabilization: Now –a-day’s economic stabilization and growth are the two aspects of the Government economic policy which got a significant place in the discussion on public finance theory. This part describes the various economic polices and other measures of the government to bring about economic stability in the country.
From the above discussion, we can say that the subject-matter of public finance is not static, but dynamic which is continuously widening with the change in the concept of state and functions of the state. As the economic and social responsibilities of the state are increasing day by day, the methods and techniques of raising public income, public expenditure and public borrowings are also changing. In view of the changed circumstances, it has given more responsibilities in the social and economic field.
Importance (Significance) of Public Finance
There is great socio-economic significance of public finance, both in developed and developing countries. In developed country countries, price-stability and full employment are the main economic goals of public finance. In developing countries, rapid economic development through capital formulation and creation of infrastructure art the important goals of public finance operations. Socially equitable distributions of income, reduction of inequalities in income are some important functions of public finance operations. The importance of public finance can be clarified from the following functions.
1. TO INCREASE THE RATE OF SAVING AND INVESTMENT: Most of the people spend their income on consumption. Saving is very low so the investment is also low. The government can encourage the saving and investment.
2. TO SECURE EQUAL DISTRIBUTION OF INCOME AND WEALTH: Unequal distribution of income and wealth is the basic problem of the under developed countries. The rich are getting richer and richer while the poor are becoming poorer and poorer. So for the equal distribution of income and wealth there is need of government.
3. OPTIMUM ALLOCATION OF RESOURCES: Fiscal measures like taxation and public expenditure programmers can greatly affect the allocation of resources in various occupation and sectors.
4. CAPITAL FORMULATION AND GROWTH: Fiscal policy will be designed in a manner to perform two functions as of expanding investment in public and private enterprises and by diverting resources from socially less desirable to more desirable investment channels.
5. PROMOTING ECONOMIC DEVELOPMENT: The state can play a prominent role in promoting economic development especially through control and regulation of economic activities. It is fiscal policy which can promote economic development.
6. IMPLEMENTATION OF PLANNING: Under democratic planning fiscal policy plays crucial role as financial plan is as much important as physical plan and the implementation of the financial will obviously depend upon the uses of fiscal measures.
7. INFRASTRUCTURE BUILDING: Public finance helps to build up well-development physical and institutional infrastructure.
8. TO CONTROL INFLATION: The imbalance between demand for and supply of real resources may lead to inflations to under-development countries inflation ruins the entire economic structure of the national and the process of economic development in these countries comes to stand still. So to check inflation, budgetary policies can be used by the government.
Role of public finance in an underdeveloped country
Public Finance occupies great significance in an underdeveloped 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 an underdeveloped/developing country like India may be summarized as under:
a)      Capital Formation: Since development entirely depends on the rate of capital formation in the country, the first and foremost aim of public finance is to promote capital formation. Students of commerce and economics are well aware of the fact that the burning problem of an underdeveloped or developing country is the low capital formation. In the words of Dr. Baljit Singh, “For an undeveloped country all economic policies and measures in the initial stages must concentrate on production and fiscal policy should act as a tool of capital formation.” Capital formation can be increased through an effective and well-planned taxation policy. In the words of R. Nurkse, “For economic development, it is not the aim of public finance to bring about reduction in inequalities of incomes but its aim is to increase that proportion of the income which goes into capital formation.”
b)      Unemployment Problem: Another major problem of an underdeveloped/developing country is the unemployment problem. Increased income may be eaten up by a large mass of unemployed people. This problem of unemployment leads again to low standard of living, poverty, backwardness, ignorance and above all starvation. It is the function of public finance to provide employment opportunity. In the connection must be remembered that fiscal policies (public finance policies) are most effective tools for tackling of the problem of unemployment.
c)       Planned Economic Development: In underdeveloped/developing countries the productive resources are limited in quantity as well as quality. Public finance renders valuable help in the planned economic development of the country. The entire machinery of planning works through the mechanism of public finance. The principles of public finance have paramount importance in the sphere of rapid economic planning because both of these are the closely related activities of the state. For example, the Government of India is raising necessary funds through taxation etc. for formulation and implementation of its five year plans.
d)      Increase in Income: Capital formation is not an end in itself but only a means of achieving another important end, i.e. increase in income. The object of public expenditure is to increase the income in underdeveloped countries so at to invest funds in such industries and in such an economical and efficient manner that least amount of money fetches the greatest possible output. The Government gives subsidies and grants to industries to enable them to increase production at cheaper rates. This will lead to prosperity and development with an overall increase in the income of the masses.
e)      Reduction in Economic Inequalities: Another problem of underdeveloped or developing countries is the unequal distribution of income and wealth to the public. Public finance has an important role to play in this context. For example, the Government can impose heavy taxes (such as income tax) on the richer sections of the society and spend the income so received on providing cheap food, cheap housing, employment, free medical aid etc. for poorer sections of the society.
f)       Optimum Utilization of Resources: Another major problem of underdeveloped or developing countries is the problem of non-utilization or even destruction of the scarce and limited resources. The solution of this basic problem lies in the optimum utilization of these 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 budget policy.
g)      Problem of Economic Stabilization: Another problem of an underdeveloped and developing country is the economic instability. After 1929-30 worldwide depression, it has been emphasised that public finance (revenue and expenditure process of the Government) may be used to secure economic stability or to remove economic fluctuations and distortion in the economy.
h)      Increase to Savings: The major problem of developing and underdeveloped countries is that savings are very nominal which hinder their economic development. Public finance encourages the accumulation of savings.
Public Finance and Private Finance
Generally, the word ‘finance’ is loosely used for both the public and private finance. By private finance, we mean the study of the income, debt and expenditure of an individual or a private company or business venture. On the other hand public finance deals with income, expenditure and borrowings of the government. There are both similarities and dissimilarities in governmental financial operations as compared to the monetary operations of private businessman. An individual is interested in the utilisation of labour and capital at his disposal to satisfy social wants. In short, both private finance and public finance have almost the same objective of satisfaction of human wants. Again, private finance stresses individual gains whereas public finance attempts at promoting social welfare of the whole community. These two view points are correct to greater extent only because of their similarities as well as dissimilarities between both.
Similarities between Public and Private Finance
1.       Both the State as well as individual aim at the satisfaction of human wants through their financial operations. The individuals spend their income to satisfy their personal wants whereas the state spends for the satisfaction of communal or social wants.
2.       Both the States and Individual at times have to depend on borrowing, when their expenditures are greater than incomes.
3.       Both Public Finance and Private Finance have income and expenditure. The ultimate aim of both is to balance their income and expenditure.
4.       For both kinds of finances, the guiding principle is rationality. Rationality is in the sense that maximization of personal benefits and social benefits through corresponding expenditure.
5.       Both are concerned with the problem of economic choice, that is, they try to satisfy unlimited ends with scarce resources having alternative uses.
Dissimilarities between Public and Private Finance
1.       The private individual has to adjust his expenditure to his income. i.e., his expenditure is being determined by his income. But on the other hand the government first determines its expenditure and then the ways and means to raise the necessary revenue to meet the expenditure.
2.       The government has large sources of revenue than private individuals. Thus at the time of financial difficulties the state can raise internal loans from its citizens as well as external loans from foreign countries. In the case of private individual, all borrowings are external in nature.
3.       The state, when hard pressed, can resort to printing of currency, as an additional source of revenue. In fact, during emergencies like war, it meets its increased financial obligations by printing new currency. But an individual cannot raise income by creating money.
4.       The state prepares its budget or estimates its income and expenditure annually. But there is no such limitation for an individual. It may be for weekly, monthly, or annually.
5.       A surplus budget is always good for a private individual. But surplus budgets may not be good for the government. It implies two things. a) The government is levying more taxes on the people than is necessary and b) the government is not spending as much as the welfare of the people as it should.
6.       The individual and state also differ in their motives regarding expenditure. The individuals hanker after profit. Their business operations are guided by private profit motive. But the states expenditure is guided by the welfare motive.
7.       An individual’s spending policy has very little impact on the society as a whole. But the state can change the nature of an economy through its fiscal policies.
8.       The pattern of expenditure in the case of private finance is often influence by customs, habits social status etc. The pattern of government expenditures is guided by the general economic policy followed by the government.
9.       Private Finance is always a secret affair. Individual need not reveal their financial transactions to anyone except for filing tax returns. But Public Finance is an open affair. Government budget is widely discussed in the parliament and out sides. Public accountability is an important feature of public finance.
10.   Individuals can plan to postpone their private expenditure. But the state cannot afford to put off vital expenditure like defence, famine relief etc.
One of the important principles of public finance is the so – called Principle of Maximum Social Advantage explained by Professor Hugh Dalton. Just like an individual seeks to maximize his satisfaction or welfare by the use of his resources, the state ought to maximize social advantage or benefit from the resources at its command.
The principles of maximum social advantage are applied to determine whether the tax or the expenditure has proved to be of the optimum benefit. Hence, the principle is called the principle of public finance. According to Dalton, “This (Principle) lies at the very root of public finance” He again says “The best system of public finance is that which secures the maximum social advantage from the operations which it conducts.” It may be also called the principle of maximum social benefit. A.C. Pigou has called it the principle of maximum aggregate welfare.
Public expenditure creates utility for those people on whom the amount is spent. When the volume of expenditure is small with a slighter increase in it, the additional utility is very high. As the total public expenditure goes on increasing in course of time, the law of diminishing marginal utility operates. People derive less of satisfaction from additional unit of public expenditure as the government spends more and more. That is, after a stage, every increase in public expenditure creates less and less benefit for the people. Taxation, on the other hand, imposes burden on the people.
So, when the volume of taxation becomes high, every further increase in taxation increases the burden of it more and more. People under go greater scarifies for every additional unit of taxation. The best policy of the government is to balance both sides of fiscal operations by comparing “the burden of tax” and “the benefits of public expenditure”. The State should balance the social burden of taxation and social benefits of Public expenditure in order to have maximum social advantage.
Attainment of maximum social advantage requires that;
a) Both public expenditure and taxation should be carried out up to certain limits and no more.
b) Public expenditure should be utilized among the various uses in an optimum manner, and
c) The different sources of taxation should be so tapped that the aggregate scarifies entailed is the minimum.
Assumptions of this theory:
1.All taxes result in sacrifice and all public expenditures lead to benefit.
2. Public revenue consists of only taxes and there is no other source of income to the government.
3. The govt. has no surplus or deficit budget but only a balanced budget. 
Diagrammatical Explanation of the theory of maximum social advantages

In the above diagram, MSS is the marginal social sacrifice curve sloping upward from left to right. This rising curve indicates that the marginal social sacrifice goes on increasing with every additional dose of taxation.   MSB is the marginal social benefit curve sloping downwards from the left to right. This falling curve indicates that the marginal social benefit diminishes with every additional dose of public expenditure. The two curves MSS and MSB intersect each other at the point P. PM represent both marginal social sacrifice as well as marginal social benefit. Both are equal at OM which represents the maximum social advantage.
Criticism of the theory of Maximum Social Advantages
1. Non measurability of social sacrifice and social benefit: The major drawback of this principle is that it is not possible in actual practice to measure the MSS and MSB involved in the fiscal operation of the state.
2. Non applicability of the low of equimarginal utility in public expenditure: The low of equimarginal utility may be applicable to private expenditure but certainly not to public expenditure.
3. Neglect non-tax revenue: The principle says that the entire public expenditure is financed by taxation. But, in practice, a significant portion of public expenditure is also financed by other sources like public borrowing, profits from public sector enterprises, imposition of fees, penalties etc.
4. Lack of divisibility: The marginal benefit from public expenditure and marginal sacrifice from taxation can be equated only when public expenditure and taxation are divided into smaller units. But this is not possible practically.
5. Assumption of static condition: Conditions in an economy are not static and are continuously changing. What might be considered as the point of maximum social advantage under some conditions may not be so under some other.
6. Misuse of government funds: The principle of Maximum social advantage is based on the assumption that the government funds are utilized in the most effective manner to generate marginal social benefit. However, quite often a large share of government funds is misused for unproductive purposes
7. "The govt. has no surplus or deficit budget but only a balanced budget."- is an invalid assumption.
Economic tests of social advantage as suggested by Dr. Dalton
In view of some difficulties in the way of subjective measurement of social advantage, Dr. Dalton has suggested certain tests which enhance social advantage of the community as a whole. They are objective basis tests which are follows:
1)      Expenditure on Defence, Law and Order: It is the primary duty of the state to safeguard the country and the community from external attack and internal disorders. Internal peace and external security create confidence and promote economic life of the community and, thus enhance social advantage. It is, therefore, essential to maintain army, police, judiciary, prisons etc. so as to meet internal and external threats to the country and the community. Although it is an unproductive expenditure, it is to be incurred by all means. However, Dr. Dalton has suggested that the state should adopt a policy of peace and co-existence for home and abroad otherwise unproductive expenditure on army, police, judiciary, prisons etc. would increase and this may have an adverse effect upon the economic life of the country as well as the community.
2)      Increase in Economic Welfare: Second objective of public finance should be to increase economic welfare. Increase in economic welfare depends upon the following two things:
a)      Increase in Production: The operation of public finance should be in such a way that there is increase in production in the community. Increase in production implies (a) maximum increase in production power with minimum efforts; (b) improvement in the organization of production so as to reduce a minimum wastage of economic resources through unemployment and other causes; and (c) improvement in the composition or pattern of production so as to best serve the needs of the community.
Hence the operation of public finance should aim at securing all these objectives so at to increase production and economic welfare of the community.
b)      Improvement in the Distribution of Income and Welfare: Increase in production is insufficient and ineffective unless it is accompanied with an improvement in the distribution of income and wealth in order to achieve economic welfare in the society. Hence, it is the duty of every state to see that what is produced should be properly distributed among the different sections of the community, i.e. it should reduce the inequalities and fluctuations of income in the community. In the words of Dr. Dalton, “Improvement in distribution resolves itself into (a) reduction in the great inequality in the incomes of different individuals and families; (b) reduction in the great fluctuations between different periods of time, in the income of particular individuals and families, especially among the poor sections of the community.” Thus, proper distribution of income and wealth is also essential for increasing economic welfare.
3)      Economic Stability and Full Employment: Economic instability in the country is the characteristic of free economies and is also the cause of so many evils, such as unemployment, heavy booms and depressions, overproduction, underproduction etc. in the community. If economic stability is maintained in the country, it will provide employment to maximum persons, increase production and promote greater equality of income. Hence fiscal operations should be enforced in such a way so that the undue boom and undue depressions are controlled and employment is provided to maximum persons. For example, fiscal operations can reduce the effects of depression by increasing public expenditure on public works. Similarly, effects of inflation can be reduced by public borrowings, heavy taxation etc.
4)      Provisions of Future: The state has double responsibility of looking after the interests of present generation as well as of future generations. The state should choose a greater advantage of future generations and that of a small advantage to present generation.
According to Dr. Dalton, “The statesman is a trustee for the future, no less than for present. Individuals die, but the community, which they form, lives on. The statesman, therefore, should prefer a larger social advantage in the future to a smaller one of today.” From this point of view, soil conservation, protection of limited and scarce natural resources and expenditure on long-term plans (such as India’s Five Year Plan) is desirable.

To conclude, it is not absolutely wrong to condemn all taxes, nor is it correct to justify all government expenditure. It is necessary to test all fiscal operations on the basis of maximum social advantage. The principle of maximum social advantage is the fundamental principle of public finance.
Various concept/theories of Public Finance
1)      Classical Concept of Public Finance: Classical concept of public finance is based on classical general economic theory. The classical economic theory assumed that supply creates its own demand and, therefore, there can never be any great unemployment or over-production. It assumes full employment, i.e. fuller utilization of public resources. If unemployment by chance happens to exist, it is purely temporary and may be voluntary in nature and that too due to the miscalculations of entrepreneurs. But if it is left to the nature itself; price, wages, interest flexibility could automatically bring equilibrium between supply and demand of commodity, labour and capital. Hence, there is no need of any state intervention in the socio-economic affairs of the country. If the state raises its expenditure by taxation it would be merely a substitution for expenditure by private persons. If the state raises its expenditure through borrowing, it would be competing with private individuals and this would raise price and give way to inflation. It means that they believed that the state would not increase the level of economic activity within the country. Since taxes have always some effect on private savings, a reduction in private savings may result in low level of private investment. Hence, taxes have an adverse effect on accumulation of capital. Therefore, they believed that best budget is small budget. They favoured indirect taxation. A budget deficit will lead to inflation. They believed that the budget should be well balanced. In short, the following are the main points of classical theory of public finance:
a)      The best budget is a small budget.
b)      The budget should be well balanced.
c)       The state should not increase the level of economic activity.
d)      If a deficit cannot be avoided, issue long-term bonds.
e)      Indirect taxation is better as against the direct taxation.
f)       Borrow only for the purpose of productive investment.
On the basis of the above study, we conclude that the scope of public finance was limited according to classical economists.
2)      Keynes’ Theory of Public Finance: Functional Finance Keynes and Hansen have given us the ‘new economics’ which is primarily a new concept of public finance. They assume that a capitalist economy by itself cannot function and thereby the government will have to come to the rescue of the economy at certain times. They emphasize compensatory action through fiscal policy to stabilize and regulate the economic system of a country. The Keynesian concept of public finance has been called functional finance by Abba P. Lerner. Functional finance is the system of judging fiscal measures by the way they function in the economy. Functional finance reduces fiscal operation of taxation, public expenditure and the public debt to operations of policy so as to reduce the volume of money and the aggregate demand in the country. For example, according to functional finance, the main function of taxation is not to secure funds for the state but to be an effective weapon in the hands of the state so as to reduce the purchasing power of the people. In the same way, the main function of public expenditure is to influence the volume of aggregate demand to equal aggregate supply.
Thus, the old precepts vanished, economists began to visualize the instrument of fiscal policy as a means of promoting a healing to their economy. Public finance became Functional Finance signifying a study of the fiscal functions of the government that could eliminate unwanted distortions and fluctuations in the economic activity.
3)      Taxation and Equitable Distribution: The use of taxation as a powerful instrument for transferring income from the rich to the poor was not favoured by classical economists. However, in the modern concept of public finance, taxation is considered as an important means of reducing economic inequalities of income and thereby promoting social justice. Further classical economists favoured taxing the poor than the rich, i.e., they favoured indirect taxation. But modern economists believed in taxing those who are able to save rather than those who are anxious to consume, i.e. taxing the rich rather than the poor. Moreover, contrary to the classical economists, modern economists favoured progressive and direct taxation as an instrument of collecting public revenues and to make equitable distribution of income in the country. Now unearned income is considered socially undesirable and, therefore, an attempt is also made to confiscate a portion of unearned income through direct taxes, such as gift tax, wealth tax, death duty etc. Modern economists do not recommend taxing every item of expenditure but only those items which do not adversely affect the general welfare of the masses. Hence, indirect taxes are recommended on those commodities which are generally consumed by the rich and not by the poor.
According to Prof. Musgrave, public finance deals with the economics of public sector including not only its financing but its entire bearing on the level of and allocation of resources as well as on the distribution of income among consumers. And the importance of the public sector lies in the fact that the market mechanism alone cannot perform all economic functions. Thereby, public policy is needed to guide, correct and supplement it (i.e. market mechanism) in certain respects. Prof. Musgrave assigned three important responsibilities to the public policy; (i) securing adjustments in the allocation of resources, (ii) securing economic stabilization growth.

The modern concept of public finance gives importance to the distribution branch of economics. The function of the distribution branch is to determine as to what steps are needed to bring about the desired or equitable state of distribution in the economy.