ECN 312

INTRODUCTION TO PUBLIC FINANCE

Introduction

In public finance we study the finances of the Government. Thus, public finance deals with
the question how the Government raises its resources to meet its ever-rising expenditure.
As Dalton puts it, public finance is ―concerned with the income and expenditure of public
authorities and with the adjustment of one to the other.

Accordingly, effects of taxation, Government expenditure, public borrowing and deficit

Further, it also deals with fiscal policies which ought to be adopted to achieve certain
objectives such as price stability, economic growth, more equal distribution of income.

Economic thinking about the role that public finance is expected to play has changed from
time to time according to the changes in economic situation.

Before the Great Depression that gripped the Western industrialized countries during the
thirties, the role of public finance was considered to be raising sufficient resources for
carrying out the Government functions of civil administration and defense from foreign
countries. During this period, the classical economists considered it prudent to keep
expenditure to the minimum so that taxing of the people is avoided as far as possible.

Further, it was thought that Government budget must be balanced. Public borrowing was
recommended mainly for production purposes. During a war, of course, public borrowing
was considered legitimate but it was thought that the Government should repay or reduce
the debt as soon as possible

Meaning and Scope of Public Finance

The distinctions between public and private goods and the concept of the public sector lead
us to look into the subject matter of public finance.

Public finance is related to the financing of state activities, and can be narrowly discussed
as a subject, which discusses financial operations of the fiscal (public treasury). Earlier
writers on the subject needed to define public finance in such a narrow manner, though this
is no longer the case now.

Boundaries of the subject of public finance have undergone repeated revisions in line with
developments in state activities and corresponding economic philosophy.

According, with the passage of time, the definition of public finance has expanded to cover
ever-widening areas. In early days of capitalism, it was widely believed that private sector
was always more efficient than the public one. By implication almost all-economic
decision were to be guided by the invisible hand of the role of the government was not to
interfere with the working of the market forces but to limit its own activities to the barest
minimum necessary.

Firstly, it was to protect the society against internal disruption, and to ensure that effective
law and order situation prevailed. With this, the state was to maintain itself and was to
create the needed administrative, judicial and policy set-ups.

Secondly, the society was to be protected against any foreign aggression that might take
place. The state was to maintain armed forces to meet these objectives.

Thirdly, where private sector found itself unable to create and run social overheads or
infrastructural facilities for reasons of their commercial non-viability but they were
otherwise essential for efficient working of the economy, the state was to step forth and
assume the responsibility of creation and maintenance of such social overheads. The
argument for stepping in of the state was not that the public sector was more efficient than
the private one.

The basic argument was that in the absence of public sector, essential social overheads
would not come into existence. However, the social marginal benefit usually far exceeds
its social marginal cost. It therefore, pays the society to expand social overheads. The
private marginal benefit, however, is much less compared with the private marginal cost,
and as a result the private sector is not ready to develop them. The state is accordingly
expected to finance social overheads out of public funds and run them, if need be, at a
commercial loss.

It must be noted that the state, according to the laissez-faire philosophy, was considered as
something extraneous to the economy, which was more or less equated with its private
sector only. It was, therefore, considered best that the public sector should help and
supplement private sector but never replace it. It was not thought desirable to have a
planned economy even for taking the problems of capital formation and economic growth.

Since activities of the state were to be tolerated only as a necessary evil and were to be
reduced to the minimum possible scale, the real question was not to decide the basic
allocation of economic activities between public and private sectors and to deal with the
associated financial and allied problems, but rather to analyze the way the state should
operate. With this philosophy in background the theory of public finance was obviously
assigned a united field.

It was a mainly considered a deception of the way in which operations of the treasury
therefore with the working of the private sector of the economy and the way in which it
could keep such an interference to the minimum.
It deals only with the finances of the government. The finances of the government include
the raising and disbursement of government funds. Public finance is concerned with the
operations of the fiscal or public treasury. Hence, to the degree that it is a science, it is the
fiscal science, policies and, its problems are fiscal problems.

Self-Assessment Exercise

Define Public revenue

The Concept of Functional Finance

But under the impact of the Great Depression of thirties and the Keynesian explanation of
it, the thinking about and role of public finance underwent a sea change. The classical view
of public finance could not meet the requirements of the then prevailing situation.

In order to increase aggregate effective demand and thereby raise the level of income and
employment in the country, public finance was called upon to play an active role. During
the Second World War and after, the Western economies suffered from serious inflationary
pressures which were attributed to the excessive aggregate demand.

So, in such inflationary conditions, the public finance was expected to check prices through
reducing aggregate demand. Thus the budget which was previously meant to raise
resources for limited activities of the Government assumed a functional role to serve as an
instrument of economic regulation.

It came to be realized that government’s taxing and spending policies could go a long way
in mitigating economic fluctuations. Balanced budgets are no longer considered sacrosanct
and the governments can spend beyond their resources without offending canons of sound
finance to restore the health of the economy.

Public borrowing and consequent increase in public debt at the time of depression raises
aggregate demand and thereby helps in raising the level of income and employment.
Therefore, deficit budget and increase in public debt at such times is a thing to be
welcomed.
It was further demonstrated by Keynes that deficit financing by the Government could
activate a depressed economy by creating income and employment much more than the
original amount of deficit financing through the process of multiplier

Thus, after Keynesian revolution public finance assumed a functional role of maintaining
economic stability at full employment level. Therefore, the present view of public finance
is not one of mere resource-raising for the Government but one of serving as an instrument
for maintaining stability through management of demand. Therefore, this present view of
public finance has been described by A.P. Lerner as one of ―Functional Finance‖.

In developing countries, public finance has to fulfill another important role. Whereas in the
developed industrialized countries, the basic problem in the short run is to ensure stability
at full employment level and in the long run to ensure steady rate of economic growth, that
is, growth without fluctuations, the developing countries confront a more difficult problem
of how to generate a higher rate of economic growth so as to tackle the problems of poverty
and unemployment.

Therefore, public finance has to play a special role of promoting economic growth in the
developing countries besides maintaining price stability. Further, for developing countries
mere economic growth is not enough; the composition of growing output and distribution
of additional incomes ought to be such as will ensure removal of poverty and
unemployment in the developing countries.

Therefore, public finance has not only to augment resources for development and to
achieve optimum allocation of resources, but also to promote fair distribution of income
and expansion in employment opportunities. This is the functional view of public finance
in the context of the developing countries.

Self-Assessment Exercise

What are the concept of functional finance?

1. Economic Efficiency

Economic efficiency is the standard that economists use to evaluate a variety of resources.
Typically, efficiency can be determined by a general formula of ratios and their generated
outcomes. The difference between technical efficiency and economic efficiency is the relationship
of values people place on things. Values in technical efficiency may be subjective from one person
to another. Economic efficiency focuses on eliminating waste to provide as much value as
possible. Technical efficiency looks to maximize value, while sacrificing as much as is needed to
create the best initiative.

2. Distribution of Income

Distribution of income is the calculation of the wealth and income of a nation once it is divided by
its total population. The overall distribution can be evaluated through a series of statistical studies.
Wealth and income are two separate entities. Wealth is the overall value of a population’s physical
possessions and financial assets. Income is the exact monetary value of a population’s net intake
over a selected period of time. The information gathered from a country’s wealth and income can
be a valuable resource to help answer a variety of political, social and economic questions.

3. Macroeconomic Stabilization

Macroeconomic stabilization is a process by which the stabilization and growth of the economy is
monitored through the development of fiscal and monetary policies, laws and regulations.
Stabilization of the economy acts as the foundation to economic growth. Without stabilization, the
economy is doomed to collapse. To achieve a stabilized macroeconomic environment, a balance
is required between the government budgeting, domestic commerce, banking operations,
international trade and governing institutions. In order to maintain ongoing macroeconomic
stabilization and an optimal level of economic efficiency, the market must be managed to ensure
interest rates, business cycles and demand within the economy remains steady.
Self-Assessment Exercise

Discuss the component of Public revenue

Importance of Public Finance

1. Steady state economic growth:

Government finance is important to achieve sustainable high economic growth rate. The
government uses the fiscal tools in order to bring increase in both aggregate demand and
aggregate supply. The tools are taxes, public debt, and public expenditure and so on.

2. Price stability:

The government uses the public finance in order to overcome form inflation and deflation.
During inflation it reduces the indirect taxes and genera expenditures but increases direct taxes
and capital expenditure. It collects internal public debt and mobilizes for investment. In case of
deflation, the policy is just reversed.

3. Economic stability:

The government uses the fiscal tools to stabilize the economy. During prosperity, the
government imposes more tax and raises the internal public debt. The amount is used to repay
foreign debt and invention. The internal expenditures are reduced. During recession, the case is
just reversed.

4. Equitable distribution:

The government uses the revenues and expenditures of itself in order to reduce inequality. If
there is high disparity it imposes more taxes on income, profit and properties of rich people and
on the goods they consume. The money collected is used for the benefit of poor people through
subsidies, allowance, and other types of direct and indirect benefits to them.

5. Proper allocation of resources:

The government finance is important for proper utilization of natural, manmade and human
resources. For it, on the production and sales of less desirable goods, the government imposes
more taxes and provides subsidies or imposes taxes lightly on more desirable goods.

6. Balanced development:

The government uses the revenues and expenditures in order to erase the gap between urban and
rural and agricultural and industrial sectors. For it, the government allocates the budget for
infrastructural development in rural areas and direct economic benefits to the rural people.

7. Promotion of export:

The government promotes the export imposing less tax or exempting form the taxes or providing
subsidies to the export oriented goods. It may supply the inputs at the subsidized prices. It
imposes more taxes on imports and so on.

8. Infrastructural development:

The government collects revenues and spends for the construction of infrastructures. It has to
keep peace, justice and security too. It has to bring socio-economic reformation too. For all these
things it uses the revenues and expenditures as fiscal tools.

Self-Assessment Exercise

Discuss the importance of Public revenue

In this unit we conclude that public finance is the study of the role of the government in the
economy. It is the branch of economics which assesses the government revenue and
government expenditure of the public authorities and the adjustment of one or the other to
achieve desirable effects and avoid undesirable ones.

Tutor-Marked Assignment

1. Discuss the concept functional finance

2. define the term Public Finance.

Basic Principles of Public Finance

Introduction
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, however, the basic
principles of public finance are the taxes and revenue

Principles of Public Finance

Two questions basic to the study of public finance at a level of government are:
1. What should the level of government spending be?
2. How should the government obtain its revenue?
These two questions can be answered only within the framework of the broad economic
and social objectives of society. The objectives in turn are the result of psychological
factors and physical environment which will vary both from one community to another and
from one generation to another.

Each new generation must make itself aware of the requirements of the society and the
economy and build upon and change the objectives of the past generation. Because our
society is dynamic, there is a need for continual re-evaluation of objectives and the means
of attaining those objectives.

Attitudes toward government spending in the United State today differ widely. One
extreme attitude, derived from European feudalism before 1800, is expressed by: One state
may be good because of great expenditures and another bad because of small expenditure.
On the other extreme, derived from 19th Century industrialism and the private enterprise
creed, is: The very best of all plans of public finance is to spend very little. Out of this latter
era have come three beliefs with regard to government finance.

The first is that government pending is a necessary evil and that the lowest level of spending
is the best possible objective. The problem presented by this belief is in determining what
the lowest level should be. Different group in society have varying opinions of what the
minimum services of government should be. The balanced budget concept is the second
major belief. The problems of applying this concept to government services which are not
primarily concerned with dollars and cents profit are many. Even business has revised its
approach to the balanced budget in modern time by borrowing large sums for expansion
during inflationary periods and accumulating savings during tight money periods.

To stabilize the economy, some public finance experts propose that government attempt to
offset this business practice by spending during depressions to put money into the economy
and accumulating reserves or repaying debts during inflation to decrease the amount of
money in the economy. Or, they say, the government should cut taxes during depression to
leave more money for consumer spending and investment and raise taxes during an
inflationary period. With permissive legislation, changing the tax rates would be easier
than changing the level of government spending for short periods of time. The third belief,
which started in the period of early capitalism, is that of economic neutrality, which means
that government should tax in such a manner as to affect existing economic relationships
as little as possible. This concept would discourage any attempt by the government to curb
the effects of the business cycle or to control consumption of certain items by means of a
high tax (cigarettes, liquor, drugs, imports, etc.).

Although it is difficult to define the ethical values of a society at a particular time, three
basic objectives of our society are generally accepted.
These are:
I. Maximum individual freedom of choice.
2. Best possible standards of living, in terms of available resource, and consumer and
resource owner preferences.
3. Distribution of income in conformity with currently accepted standards of fairness.
These goals are quite general, but they provide a framework for use in considering
government activities.
Generally, the major conflicts occur over methods of reaching these goals rather than over
the goal themselves.