PUBLIC FINANCE - CHAPTER 1

SYLLABUS

UNIT 1- ROLE OF GOVT (Musgrave and Lekhi)

● The nature, scope and significance of public economics

● Public vs. Private Finance
● Principle of Maximum Social advantage: Approaches and Limitations-
● Functions of Government - Economic functions -allocation, distribution and stabilization;
● Regulatory functions of the Government and its economic significance.

UNIT 2- PUBLIC GOODS AND PUBLIC SECTOR (Hyman)

● Concept and characteristic of public goods,

● national vs. local public goods;
● determination of provision of public good;
● Externality concept of social versus private costs and benefits, merit goods, club goods;
● Provision versus production of public goods - Market failure and public Provision

UNIT 3- PUBLIC EXPENDITURE (Lekhi)

● Structure and growth of public expenditure;

● Wagners Law of increasing state activities;
● Wiseman-Peacock hypothesis;
● Pure theory of public expenditure
● Trends of Public expenditure
● Subsidies in India
 UNIT 1

● Public finance is that branch of general economics that deals with financial activities of
the state or government at national, state and local levels.
● It is a study of income and expenditure of central, state and local government and the
principles underlying them.
● According to Dalton “Public Finance is concerned with the income and expenditure of
public authorities and with the adjustment of the one to the other.
● The economics of public finance is fundamentally concerned with the process of rising
and Disbursement of funds collection of revenue and its spending for the functioning of
the government.

Professor Richard Musgrave defined Public Finance as, “The complex of problems that centres
on the revenue-expenditure process of Government is referred to traditionally as public finance.”

SCOPE OF PUBLIC FINANCE

Prof. Dalton categorises the scope of public finance into four areas which include public income,
Public expenditure, public debt and financial administration.

(a) Public revenue

The study of various sources of government’s income, the principles guiding the raising of
income (e.g. canons of taxation), their relative merits and demerits and their effects on the
economy (e.g. impact and incidence of taxation).

(b) Public expenditure

The study of the manner in which public expenditure is classified, the principles guiding public
expenditure (canons of public expenditure), causes of growth and effects of public expenditure.

(c) Public debts

The study of public debt forms a very important part of public finance in modern times as
governments are increasingly resorting to debt to meet the growing needs of the people. Public
finance studies the sources, burden and impact of public debt.

(d) Financial administration

This includes the study of the preparation, passing and implementation Of the budget, budgetary
policies and their socio-economic impact, intergovernmental financial relations, fiscal
management and fiscal responsibility.

FUNCTIONS OF PUBLIC FINANCE.

● The functions of public finance all activities with regard to collection of revenue and
expenditure on various activities. Earlier theories of public finance narrow the definition
of the functions to be carried out by public authorities. It is clear that the area of state
activity has enlarged over the past two decades which increased the functions and scope
of public finance.

1) Economic activities of the state

The scope of public finance was confined to the traditional functions of the state, that is,
provision of defence, law and order, justice and civic amenities. But with the emergence of
welfare states the scope of public finance was broadened. Public finance now includes the use of
the budget as a tool to correct distortion in the economy, mobilise resources, maintain price
stability, create employment, prevent market failure, achieve growth equity and maximize social
welfare.

2) Functional Finance
The government should maintain a reasonable level of aggregate demand at all times by using
the budget. Most developed economies followed functional finance policies in order to control
trade cycles. Developing countries followed such policies to promote economic growth.

3) Fiscal Operations
The scope of public finance includes fiscal operations and their objectives. Fiscal operations
refer to raising public revenue, spending to achieve certain goals and financial administration.
For such operations, the government uses fiscal tools like taxation, public expenditure and public
debt. The following are the objectives of fiscal operations;
(a) Allocation of resources
The most important objective of fiscal operations is to determine how the Country’s resources
will be allocated to different sectors of the economy in order to achieve predetermined goals. The
national budget determines how funds are allocated to different heads of expenses. The policy of
public expenditure is used by the government to directly undertake resource allocation for
different sectors. On the other hand, the government can use taxation and subsidies to indirectly
influence resource allocation.

(b) Distribution
Fiscal operations can be effectively used to affect the distribution of national income and
resources Taxation and public expenditure policies are used by the government to reduce
inequalities. Progressive direct taxation imposes a heavier burden on the rich than the poor.
Public expenditure on social infrastructure and subsidies on food housing, health and education
help reduce income inequality.

(c) Stabilisation
Developed economies experience business cycles. Economic stability implies an absence of
sharp cyclical movements in the form of booms and depressions. To bring about such stability,
countercyclical fiscal operations are adopted. To counter depression and recession, government
expenditure is increased to generate employment and taxes are reduced to encourage
consumption and investment. During inflation, public expenditure is reduced and taxes are
raised.

(d) Economic growth

In developing and underdeveloped economies, the objectives of fiscal operations are more
promotional in nature. The basic focus of fiscal operations in such economies is the use of
budgetary operations to achieve growth and development. This is done by encouraging capital
formation and investments through public expenditure and tax incentives to private sectors.

Allocation Function
Social Goods and Market Failure
 ● The basic reason for market failure in the provision of social goods is not that the
need for such goods is felt collectively whereas that for private goods is felt individually.
● The market mechanism is well suited for the provision of private goods.
● It is based on exchange, and exchange can occur only where there is an exclusive title
to the property which is to be exchanged.
● In fact, the market system may be viewed as a giant auction where consumers bid for
products and producers sell to the highest bidders
● Application of the exclusion principle tends to be an efficient solution.

➢ Such is not the case with respect to social goods. Here it would be inefficient
to exclude any one consumer from partaking in the benefits, since such participation
does not reduce consumption by anyone else.
➢ The application of exclusion would thus be undesirable even if it were readily feasible.
➢ Given such conditions, the benefits from social goods are not vested in the property rights
of particular individuals, and the market cannot function
➢ With benefits available to all, consumers will not voluntarily offer payments to the
suppliers of such goods.
➢ Hence, no voluntary payment is made, especially where many consumers are involved.
➢ The linkage between producer and consumer is broken and the government must step in
to provide for such goods.

● A need for public provision may arise even in situations where consumption is
rival, so that exclusion would be appropriate.
● Such is the case because exclusion may be impossible or prohibitively expensive

Public Provision versus Public Production

● Private goods may be produced and sold to private buyers either by private firms, as is
normally done, or by public enterprises, such as public power and transportation
authorities or the nationalized British coal industry.
 ● Social goods, such as spaceships or military hardware, similarly may be produced by
private firms and sold to the government; or they may be produced directly under public
management, as are services rendered by civil servants or municipal enterprises.
● If we say that social goods are provided publicly, we mean that they are financed through
the budget and made available free of direct charge.
● How they are produced does not matter. When looking at the public sector in the national
accounts, we will see that the cost of such provision is divided about equally between
compensation paid to public employees (whose output may be viewed as public
production) and outputs purchased from private firms.
● Public production of private goods which are then sold in the market plays only a very
limited role in the U.S. system

THE DISTRIBUTION FUNCTION

● The allocation function, concerned with the provision of social goods, inevitably departs
from the market process but nevertheless poses the type of problem with which economic
analysis has traditionally been concerned, i.e., the efficient use of resources given a
prevailing distribution of income and pattern of consumer preferences.
● The issue of distribution is more difficult to handle. Yet, distribution issues are a major
(frequently the major) point of controversy in the budget debate.
● In particular, they play a key role in determining tax and transfer policies

Determinants of Distribution

● In the absence of policy adjustments, the distribution of income and wealth

depends first of all on the distribution of factor endowments, including personal
earnings abilities and the ownership of accumulated and inherited wealth.
● The distribution of income, based on this distribution of factor endowments, is
then determined by the process of factor pricing, which in a competitive market
sets factor returns equal to the value of the marginal product.
● The distribution of income among individuals thus depends on their factor
endowments and the prices which they fetch in the market.
● This distribution of income may or may not be in line with what society considers
fair or just.
● A distinction must be drawn between ( l) the principle that efficient factor use
requires factor inputs to be valued in line with competitive factor pricing and (2)
the proposition that the distribution of income among families should be fixed by
the market process.
● Principle l is an economic rule that must be observed if there is to be an efficient
use of resources, whether in a market economy or in a planned economy.
● Proposition 2 is a different matter. For one thing, factor prices as determined in the
market may not correspond with the competitive norm.
● But even if all factor prices, including wages and other returns to personal
services, were determined competitively, the resulting pattern of distribution might
not be acceptable.
● It typically involves a substantial degree of inequality, especially in the
distribution of capital income; and though views on distributive justice differ, most
would agree that some adjustments are required, if only to provide an adequate
floor is at the bottom of the scale.
● Such adjustments, however, may involve efficiency costs, and the costs must be
allowed for in designing distribution policies
How Income Should Be Distributed

➔ Economics helps to determine what constitutes an efficient use of resources, based

on a given pattern of distribution and effective demand.
➔ But there is the further question of what constitutes a fair or just state of
distribution.
➔ Modem economic analysis has steered shy of this problem.
➔ The essence of modem welfare economics has been to define economic efficiency
in terms that exclude distributional considerations.
➔ A change in economic conditions is said to be efficient (i.e., to improve welfare) if
and only if the position of some person, say A, is improved without that of anyone
else, including B and C, being worsened.
➔ This criterion, which may be qualified and amended in various ways, cannot be
applied to a redistribution measure which by definition improves A's position at
the expense of B's and C's.
➔ While the "someone gains, no one loses" rule has served well in assessing the
efficiency of markets and of certain aspects of public policy, it contributes little to
solving the basic social issues of fair distribution
➔ The answer to the question of fair distribution involves considerations of social
philosophy and value judgment.
➔ Philosophers have come up with a variety of answers, including the view that
persons have the right to the fruits derived from their particular endowments, that
distribution should be arranged so as to maximize total happiness or satisfaction,
and that distribution should meet certain standards of equity, which, in a limiting
case, maybe egalitarian

Fiscal Instruments of Distribution Policy

❖ Among various fiscal devices, redistribution is implemented most directly by

 ➢ (1) a tax-transfer scheme, combining progressive taxation of high-income
with a subsidy to low-income households. Alternatively, redistribution may
be implemented by
➢ (2) progressive taxes are used to finance public services, especially those
such as public housing, which particularly benefit low-income households.
Finally, redistribution may be achieved by
(3) a combination of taxes on goods purchased largely by high-income
consumers with subsidies to other goods which are used chiefly by
low-income consumers.

➔ In choosing among alternative policy instruments, allowance must be made for

resulting deadweight losses or efficiency costs, i.e., costs that arise as consumer or
producer choices are interfered with.
➔ Redistribution via an income tax-transfer mechanism has the advantage that it does
not interfere with particular consumption or production choices.
➔ However, even this mechanism is not without its "efficiency cost," since the
choice between income and leisure will be distorted.
➔ As we will see later, an optimal solution might call for a complex mix of taxes and
subsidies.
➔ However, we will disregard this for the time being and think of the function of the
distribution branch as being met by a set of direct income taxes and transfers.
➔ While redistribution inevitably involves an efficiency cost, this consequence by
itself establishes no conclusive case against such policies. It merely tells us that
➔ ( 1) any given distributional change should be accomplished at the least efficiency
➔ cost and (2) a need exists for balancing conflicting equity and efficiency
objectives.
➔ An optimally conducted policy must allow for both concerns.
THE STABILIZATION FUNCTION

Having dealt with the role of budget policy in matters of allocation and
distribution, we must now note its bearing on the macro performance of the
economy, i.e., on targets such as high employment, a reasonable degree of price
level stability, the soundness of foreign accounts, and an acceptable rate of
economic growth

Need for Stabilization Policy

★ Achievement of these targets does not come about automatically but requires
policy guidance.
★ Without it, the economy tends to be subject to substantial fluctuations and may
suffer from sustained periods of unemployment or inflation.
★ To make matters worse, unemployment and inflation-as we have painfully learned
in the 1970s-may exist at the same time.
★ With growing international interdependence, forces of instability may be
transmitted from one country to another, which further complicates the problem
★ For various reasons, including the fact that wages and prices tend to be
downward rigid, there is no ready mechanism by which such employment will
restore itself automatically.
❖ Expansionary measures to raise aggregate demand are then needed.
❖ At other times, expenditures may exceed the available output under conditions
of high employment and thus may cause inflation.
❖ In such situations, restrictive measures are needed to reduce demand.
❖ Furthermore, just as deficient demand may generate further deficiency, so may an
increase in prices generate a further price rise, leading to renewed inflation.
❖ In neither case is there an automatic adjustment process that ensures that the
economy is promptly returned to high employment and stability.
 ★ Changing expectations introduce a dynamic force that may prove a source of
growth as well as system instability and decline.

Instruments of Stabilization Policy

Policy instruments available to deal with these problems involve both monetary and
fiscal measures and their interaction is of great importance

Monetary Instruments
● While the market mechanism, if it functions well, may be relied upon to determine
the allocation of resources among private goods, it cannot by itself regulate the
proper money supply.
● As Walter Bagehot pointed out a century ago, "Money does not control itself."
● If left to its own devices, the banking system will not generate precisely that
money supply that is compatible with economic stability, but the will-in respond to
the credit demands of the market-accentuate prevailing tendencies to fluctuation.
● Therefore, the money supply must be controlled by the central banking system and
be adjusted to the needs of the economy in terms of both short-run stability and
longer-run growth.
● Monetary policy-including the devices of reserve requirements, discount rates, and
open market policy-is thus an indispensable component of stabilization policy.
● Expanding the money supply will tend to increase liquidity, reduce interest rates,
and thereby increase the level of demand, with monetary restrictions working in
the opposite direction.

Fiscal Instruments
● Fiscal policy as well as a direct bearing on the level of demand.
● Raising public expenditures will be expansionary as demand is increased, initially
in the public sector and then transmitted to the private market.
 ● Tax reduction, similarly, may be expansionary as taxpayers are left with a higher
level of income and may be expected to spend more.
● Changes in the level of deficit thus play an important role.
● At the same time, much will depend on how the deficit is financed.
● If accompanied by an easy monetary policy, the expansionary effects of deficit
finance will be greater as the deficit can be met by increased credit.
● If matched by tight money, placing the additional debt will call for an increase in
the rate of interest and thus have a restrictive effect on market transactions.
● Moreover, effects upon international capital flows, as the American economy has
seen in the 1980s, are again of major importance.

COORDINATION OF BUDGET FUNCTIONS

1. The budget policy involves a number of distinct objectives, but these overlap in
practice, thereby complicating an efficient policy design, i.e., a design which does
justice to its diverse goals

Public Finance and Private Finance

 ● Public Finance is the study of the financial operations of the government.
● Government is also an economic unit like a firm or household.
● Hence, there are bound to be similarities between the financial operations of firms and
households on one hand and that of the government on the other.

Similarities

1. Satisfaction of human wants is the common objective of private as well as public

finance.
● The only point is that the individual uses his resources to satisfy his private wants
● The state is concerned with the use of its resources to satisfy social wants.
2. Both kinds of finance are based on the principle of rationality.
● A rational individual tries to maximise his personal benefits through his expenditure.
● A rational government tries to maximise social benefits through public expenditure.
3. Both private and public finance have income and expenditure. The ultimate aim of
both is to balance their income and expenditure.
4. When expenditure is greater than income, both try to borrow to meet the gap. Bot
individuals and governments have to plan to return these loans.
5. Both are concerned with the problem of economic choice i.e., they try to satisfy
unlimited ends with limited sources.

Dissimilarities

1. The final objectives are different.

● i.e., the government tries to fulfil objectives that are different from that of firms and
households.
● The motive of public finance is a social benefit. Thus tax policy can be used to reduce
conspicuous consumption or the production of harmful goods.
● The government spends money for public welfare, without expecting any return.
● But an individual will spend only if it is beneficial or profitable to him.
 ● Thus while an individual sets an objective standard of the utility of his expenditure, like
social justice and full employment.

2. The process of adjustment of income and expenditure in private finance and public
finance are diametrically opposite.
● An individual tries to adjust his expenditure to his income.
● The government however decides what it wishes to spend and then plans to get the
required resources.
3. Resources of an individual are relatively limited while the state‘s resources are wider.
● An individual cannot borrow from world monetary institutions like IMF or the World
Bank.
● In short public revenues are more elastic than individual incomes.

4. Individual plans according to the time duration over which he earns his income. But in
public finance, the budget is prepared for one year.
5. Individuals always seek quick returns. They save only a small amount for future and
spent more to satisfy their current needs.
● The state spends huge sums of money on hydroelectric projects, afforestation etc. which
may yield benefit after a generation or two.
6. In the case of private finance a rational consumer seeks to maximise his total
satisfaction by allocating his income as per the law of equity-marginal utility.
● He tries to spend his income in such a way that the last unit of money, spent on each
good, yields the same satisfaction.
● The government on the other hand seeks to get maximum social advantage.
● The fiscal policy of the modern government aims to achieve an equitable distribution of
income in the society and to promote economic growth.
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 policy.
8. The pattern of expenditure in the case of private finance is often influenced by
customs, habits, social status tec.
 ● The pattern of the government expenditure is guided by the general economic policy
followed by the government.
9. Private finance is always a secret affair.
● Individuals need not reveal their financial transactions to anyone except for filing tax
returns. But public finance is an open affair.
10. Individuals can plan to postpone their private expenditure.
● But the state cannot afford to postpone vital expenditures like defence, famine relief etc.
11. An individual has to earn his income by working. He cannot force one to get his
income.
● But the government can use force or coercive power to raise revenue especially taxation.

THE PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE

★ The ‘Principle of maximum social Advantage’ was introduced by British economist

Hugh Daton.
★ According to Hugh Dalton, “Public Finance” is concerned with the income &
expenditure of public authorities and with the adjustment of one with the other.
★ Budgetary activities of the government result in the transfer of purchasing power from
some individuals to others.
★ Taxation causes transfer of purchasing power from taxpayers to the public authorities,
★ While public expenditure results in transfers back from the public authorities to some
individuals, therefore financial operations of the government cause ‘Sacrifice or
Disutility’ on one hand and ‘Benefits or Utility’ on the other.
★ The principle of Maximum social Advantage states that public finance leads to economic
welfare when public expenditure & taxation are carried out up to that point where the
benefits derived from the Marginal Utility of expenditure is equal to the Marginal
Disutility or the sacrifice imposed by taxation.
★ Hugh Dalton explains the principle of maximum social advantage with reference to:-

A. Marginal social Sacrifice B. Marginal Social Benefits

This principle is however based on the following assumptions:
(i) All taxes result in sacrifice and all public expenditures lead to benefits.
(ii) Public revenue consists of only taxes and no other sources of income to the government.
(iii) The government has no surplus or deficit budget but only a balanced budget.
(iv) Public expenditure is subject to diminishing marginal social benefit and taxes are
subject to increasing marginal social sacrifice.

Marginal Social Sacrifice (MSS)

Marginal social Sacrifice (MSS) refers to that amount of social sacrifice undergone by the public
due to the imposition of an additional unit of tax

❖ Every unit of tax imposed by the government taxes results in loss of utility.
❖ Dalton says that the additional burden (marginal sacrifice) resulting from additional units
of taxation goes on increasing i.e. the total social sacrifice increases at an increasing rate.
❖ This is because, when taxes are imposed, the stock of money with the community
diminishes.
❖ Every additional unit of taxation creates a greater amount of impact and a greater amount
of sacrifice on society. That is why the marginal social sacrifice goes on increasing.

The above diagram indicates that the Marginal Social Sacrifice (MSS) curve rises upwards from
left to right. This indicates that with each additional unit of taxation, the level of sacrifice also
increases. When the unit of taxation was OM1, the marginal social sacrifice was OS1, and with
the increase in taxation at OM2, the marginal social sacrifice rises to OS2.

Marginal social benefit (MSB)

● While the imposition of tax puts the burden on the people, public expenditure confers
benefits.
● The benefit conferred on the society, by an additional unit of public expenditure is known
as Marginal social benefit (MSB).
● Just as the marginal utility from a commodity to a consumer declines as more and more
units of the commodity is made available to him, the social benefit from each additional
unit of public expenditure declines as more and more units of public expenditure is spent.
● In the beginning, the units of public expenditure are spent on the most essential social
activities. subsequent doses of public expenditures is spent on less and less important
social activities.
● As a result, the curve of marginal social benefits slopes downward from left to right as
shown in the figure below.

In the above diagram, the marginal social benefit (MSB) curve slopes downward from left to
right. This indicates that the social benefit derived out of public expenditure is reducing at a
diminishing rate. When the public expenditure was OM1, the marginal social benefit was OB1,
and when the public expenditure is OM2, the marginal social benefit is reduced at OB2.
The Point of Maximum Social Advantage
The social advantage is maximized at the point where marginal social sacrifice cuts the marginal
social benefits curve. i.e. MSS and MSB are equal.

● At point P social advantage is maximum. Now consider Point P1. at this point marginal
social benefit is P1Q1.
● This is greater than marginal social sacrifice S1Q1. Since the marginal social sacrifice is
lower than the marginal social benefit, it makes more sense to increase the level of
taxation and public expenditure.
● This is due to the reason that additional units of revenue were raised. And spending by
the government leads to an increase in the net social advantage.
● This situation of increasing taxation and public expenditure continues, as long as the
levels of taxation and expenditure are towards the left of point P.

❖ At point P, the level of taxation and public expenditure moves up to OQ. At this point, the
marginal utility or social benefit becomes equal to marginal disutility or social sacrifice.
Therefore at this point, the maximum social advantage is achieved.
 ● At point P2, the marginal social sacrifice S2Q2 is greater than the marginal social benefit
P2Q2.
● Therefore, beyond point P, any further increase in the level of taxation and public
expenditure may bring down the social advantage.
● This is because; each subsequent unit of additional taxation will increase the marginal
disutility or social sacrifice, which will be more than marginal utility or social benefit.
● This shows that maximum social advantage is attained only at point P & this is the point
where the marginal social benefit of public expenditure is equal to the marginal social
sacrifice of taxation

A brief note about Limitations of Maximum Social Advantage

The principle of maximum social advantage has been criticized on various

grounds. The main practical difficulties in following the principle of maximum
social advantage are discussed in the article.

i) Difficulties in Measuring Social Benefits:

The principle of maximum social advantage is theoretically explained with the help of the
marginal utility analysis. The Marginal benefits of public expenditure and the marginal disutility
on the sacrifice of public revenue are concepts, the objective measurement of which is extremely
difficult.

ii) Unrealistic Assumptions:

It is unrealistic to assume that government expenditure is always beneficial and that every tax is
a burden to society. For example, taxes on cigarettes or alcohol can provide benefit to society,
expenditure on social overheads like health care will give rise to social benefits whereas an
unnecessary increase in expenditure on defence may divert resources from productive activities
causing loss of welfare to the society.

iii) Neglect of 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. Dalton fails to take into
account all such other sources.

iv) 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 it is not
possible practically.

v) Large Budget Size:

The financial operations of the government involve the collection of large sums of money from
taxation and other sources and the disbursement of large amounts by way of public expenditure.
The effects of small additional amounts of these on the community are difficult to measure.
Therefore, in practice, the public authorities are not in a position to estimates the marginal
benefits and the marginal sacrifices.

vi) Change in 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. For example, in times of war government expenditure and revenue must
increase, and the increase is to the advantage of the community. What is optimum at one level of
national income may not be so at a higher level. Therefore, it is difficult to determine the point
of maximum social advantage.

vii) Different Periods:

The impact of many public projects is felt over a long period by both the present and the future
generations. In order to determine maximum social advantage, it becomes necessary to calculate
social benefits from public expenditure in a short period and in a long period.

Role of Government in Organized Society

 The basic functions of the government are listed in the Constitution. They are: 'To
form a more perfect Union; 'To establish Justice'; 'To insure domestic Tranquillity; 'To
provide for the common defence'; 'To promote the general Welfare'; and 'To secure the
Blessings of Liberty.'

Social security: Modern society is an epitome of unequal development resulting in

the creation of the poor and the rich. It is an unfortunate situation that existed long back
when the concept of government was not in existence. In modern times, it is the duty of the
government to ensure that the poor people are protected from the incessant rise of
inflationary prices. Different schemes are carried out to ensure the availability of food and
housing to the weaker strata of the society.

Defence of the country: It is a well-known fact that a government is by the people, for the
people, and from the people. In addition, the defence of the country is the responsibility of
the government. The combination of armed, navy and air force is created to defend the land,
water, and sky of the nation. They play an important role in protecting the countries from
invaders and attacks from terrorist organizations. In the medieval period, the kingdoms rarely
had an organized army, therefore the chances of conflict were always high.

Tax collection: In order to maintain the government machinery, money is required which can
only be obtained by taxing the citizens. According to the experts, the taxes that have to be
levied should be kept to a minimum so that people are able to pay them in full. High taxation
leads to instances of evasion with people refusing to comply with the rules.

A separate tax collection department is created to accomplish the task without any hassles.
Swift and lower taxation ensure that the required financial option is available for the
seamless running of the government.

Fundamental Rights: A Democratic form of government in recent times has led to the
election of representatives by popular mandate. It plays an important role in ensuring the
fundamental rights of the minority and majority in the country. One of the most important
aspects of the right is that it provides equal opportunities to men and women to develop their
professional and personal lives. The society becomes more open and the laws to be
implemented are discussed by the elected representatives in detail.
Education: It is the ardent duty of the government to educate the people and make them
more informative. In addition, numerous vocational programs are also conducted to enhance
the skill sets of the people so that they can be gainfully employed across different sectors of
the economy. Employment to the youth is the fundamental duty of any government and
would go a long way in enhancing the gross domestic production of the country by many
notches. Unemployment is the biggest curse of any nation because it gives rise to an army of
people who are disgruntled with the government and can create havoc by destroying the
public property and lives.

Role of Government in Economic Development

In modern times, State participation in economic activity can hardly be a matter of

disagreement. The free play of economic forces, even in highly developed capitalist
countries, has often meant large unemployment and instability of the economic system.
In the advanced countries, State intervention has been invoked to ensure economic
stability and full employment of resources. State action is all the more inevitable in
under-developed economies which are struggling hard to get rid of poverty and to attain
higher living standards.
Accordingly, Governments are playing a vital role in the development of under-developed
economies.
Their role is all the more remarkable in the following respects:

(i) Comprehensive Planning

In an under-developed economy, there is a circular constellation of forces tending to

act and react upon one another in such a way as to keep a poor country in a stationary
state of under-development equilibrium. The vicious circle of under-developed equilibrium
can be broken only by a comprehensive government planning of the process of economic
development. Planning Commissions have been set up and institutional framework built up.
(ii) Institution of Controls

A high rate of investment and growth of output cannot be attained, in an under-developed

country, simply as a result of the functioning of the market forces. The operation of these
forces is hindered by the existence of economic rigidities and structural disequilibria.
Economic development is not a spontaneous or automatic affair.
On the contrary, it is evident that there are automatic forces within the system tending to
keep it moored to a low level. Thus, if an underdeveloped country does not wish to remain
caught up in a vicious circle, the Government must interfere with the market forces to break
that circle. That is why various controls have been instituted, e.g., price control, exchange
control, control of capital issues, industrial licensing.
(iii) Social and Economic Overheads

In the initial phase, the process of development, in an under-developed country, is

held up primarily by the lack of basic social and economic overheads such as schools,
technical institutions and research institutes, hospitals and railways, roads, ports, harbours
and bridges, etc. To provide them requires very large investments.
Such investments will lead to the creation of external economies, which in their turn will
provide incentives to the development of private enterprise in the field of industry as well as
of agriculture. The Governments, therefore, go all out inbuilding up the infrastructure of the
economy for initiating the process of economic growth.
Private enterprise will not undertake investments in social overheads. The reason is
that the returns from them in the form of an increase in the supply of technical skills and
higher standards of education and health can be realised only over a long period. Besides,
these returns will accrue to the whole society rather than to those entrepreneurs who incur
the necessary large expenditure on the creation of such costly social over-heads. Therefore,
investment in them is not profitable from the standpoint of the private entrepreneurs,
howsoever productive it may be from the broader interest of the society. This indicates the
need for direct participation of the government by way of investment in social overheads, so
that the rate of development is quickened.
Investments in economic overheads require huge outlays of capital which are usually
beyond the capacity of private enterprise. Besides, the returns from such investments are
quite uncertain and take very long to accrue. Private enterprise is generally interested in
quick returns and will be seldom prepared to wait so long.
Nor can private enterprise easily mobilize resources for building up all these
overheads. The State is in a far better position to find the necessary resources through
taxation borrowing and deficit-financing sources not open to private enterprise. Hence,
private enterprise lacks the capacity to undertake large-scale and comprehensive
development. Not only that, it also lacks the necessary approach to development.
Hence, it becomes the duty of the government to build up the necessary infrastructure.
(iv) Institutional and Organisational Reforms
It is felt that outmoded social institutions and defective organisation stand in the way
of economic progress. The Government, therefore, sets out to introduce institutional and
organisational reforms. We may mention here abolition of zamindari, imposition of ceiling
on land holdings, tenancy reforms, introduction of co-operative farming, nationalisation of
insurance and banks reform of managing agency system and other reforms introduced in
India since planning was started.
(v) Setting up Financial Institutions

In order to cope with the growing requirements for finance, special institutions are set
up for providing agricultural, industrial and export finance. For instance, Industrial Finance
Corporation, Industrial Development Bank and Agricultural Refinance and Development
Corporation have been set up in India in recent years to provide the necessary financial-
resources.
(vi) Public Undertakings

In order to fill up important gaps in the industrial structure of the country and to start
industries of strategic importance, Government actively enters business and launches big
enterprises, e.g., huge steel plants, machine-making plants, heavy electrical work and heavy
engineering works have been set up in India.
 (vii) Economic Planning

The role of government in development is further highlighted by the fact that under
developed countries suffer from a serious deficiency of all types of resources and skills,
while the need for them is so great. Under such circumstances, what is needed is a wise and
efficient allocation of limited resources. This can only be done by the State. It can be done
through central planning according to a scheme of priorities well suited to the country‘s
conditions and need.

CHAPTER 4- PUBLIC GOODS

Concept:

Goods like national defense cannot be sold as easily as candy bars in markets for the exclusive
benefit of individual consumers. Similarly environmental protection, roads, public safety etc.
have benefits that must be shared by large groups of individuals.

The production of these goods for sale in the marketplace would be accompanied by positive
externalities because any item purchased for individual use would provide external benefits to a
large number of third parties.

Goods with benefits that cannot be withheld from those who don’t pay and are shared by large
groups of consumers are public goods.

In most cases, government provision of public goods implies that the goods are freely available
to all rather than being sold in markets. The costs of making the good available are usually
financed by taxes.

CHARACTERISTICS OF PUBLIC GOODS

Public goods are nonrival in consumption

A given quantity of a public good can be enjoyed by more than one consumer without decreasing
the amounts enjoyed by rival consumers. For eg- tv/ radio transmissions are nonrival in
consumption- the channels can be enjoyed by many consumers. Another eg- benefits of national
defense services are nonrival. When the nation’s population increases, no citizen suffers a
reduction in the quantity of national defense because more people are being defended.

Goods that are rival in consumption are called private goods. A given quantity of fish available
on a dock is said to be rival in consumption because, as the number of fish made available to any
one consumer increases, the quantity available for rival consumers decreases. Except when
externalities are present, prices can efficiently allocate goods that are rival in consumption.

Pricing a good that is nonrival in consumption serves no useful purpose and is inefficient,
because an additional consumer of a nonrival good does not reduce the benefit to others who
wish to consume it; the marginal cost of allowing additional people to consume a given amount
of a good with nonrival benefits is zero.

In most cases, it is also unfeasible to price units of a public good. This characteristic of public
goods, called nonexclusion, implies that it is too costly to develop a means of excluding those
who refuse to pay from enjoying the benefits of a given quantity of a public good. For example,
it is unfeasible to exclude those who refuse to pay for cleaner air from enjoying the benefits of a
given amount of air quality improvement, once it has been supplied for the benefit of other
people. Air quality improvement has the property of nonexclusion.

Non rival goods need not necessarily be nonexcludable. TV broadcasting services are nonrival,
but it is feasible to exclude those who refuse to pay from the benefits of transmissions through
cable provision of the broadcasts or use of signal coding for satellite transmission.

Similarly, the benefits of roads are often nonrival. However, it is feasible to use tolls to exclude
those who refuse to pay. The characteristics of nonrival consumption and nonexclusion vary in
degree but much can be learned from investigation of problems involved in making available
efficient amounts of a good that is both nonrival in consumption and has nonexclusive benefits.

Pure Public Goods and Pure Private Goods

A pure public good is nonrival in consumption for an entire population of consumers, and its
benefits have the characteristic of non exclusion. A given quantity of a pure public good is
consumed by all members of a community as soon as it is produced for, or by, any one member.

In contrast, a pure private good is one that, after producers receive compensation for the full
opportunity costs of production, provides benefits only to the person who acquires the good, and
not to anyone else. A pure private good is a rival in consumption, and its benefits are easily
excluded from those who choose not to pay its market price.

Market exchange for pure private goods results in neither positive nor negative externalities. A
pure public good results in widely consumed external benefits to all people, even if made
available only for one person.

Goods are ranked according to their degree of publicness or privateness in terms of the range and
extent to which their production or consumption generates externalities.

Pure public “bads” can also exist. These activities result in external costs affecting a wide range
of the population. Air pollution, for eg., is a pure public bad if pollutants diffuse in the
atmosphere, affecting all individuals. At the other extreme, national defense can be considered a
pure public good. It is impossible to protect any one individual against harm from a foreign
invasion without protecting all individuals in the nation.
The marginal cost of distributing a pure public good to an additional consumer is zero for a given
amount of the public good because of its nonrival characteristics. The marginal cost of allowing
additional people to consume certain amounts of a pure public good falls to zero after the good
has been made available for any one person.

Don’t confuse distribution cost with production cost. The marginal costs of accommodating an
additional consumer will be zero for a given quantity of a pure public good. However, the
marginal cost of producing additional units of the public good will be positive, because
increasing the quantity of a pure public good requires additional resources.

We assume that the AC of a pure public good is constant. 2 units of the public good cost twice as
much as one unit. So, if the AC of the public good is $200 per unit, the MC will also be $200.

A pure public good is not divisible into units that can be apportioned among consumers. A given
quantity of a pure public good can only be shared rather than enjoyed individually.

Its benefits are collectively consumed by the entire population. A unit of a pure private good can
be enjoyed only by a single consumer. The more units of a given amount available to be
consumed by one person, the less is available to rival consumers.

Eg: Bread versus Heat- Suppose a certain number of people are confined to a room. Decisions
made in that room affect only those in the room and no one else. Each day, residents of the room
receive a fixed quantity of bread and a certain amount of fuel to heat the room. The bread is a
pure private good in the sense that it is possible to slice it and divide it among the individuals.
The total amount of bread available each day equals the sum of the amounts consumed by the
people in the room. If more bread is allocated to any one person, less will remain for others.
Bread is easily sold in a market where price is established each day by DD and SS. Given the
daily price of bread, the people in the room could adjust their consumption of bread according to
their preferences and economic circumstances.

But, it is impossible to divide the room’s heat among the people. All individuals in the room at
any point in time experience the same temperature level. Additional people can be
accommodated in the room at a given temperature without using more or less fuel. It is
impossible for one person to consume more heat that it reduces the amount available to others; it
is impossible for different people in the room to consume different quantities of heat; Individual
consumers of heat will lack the ability to adjust the amount of heat they consume in accordance
with their own tastes and economic circumstances. The level of heat in the room will have all the
characteristics of a pure public good for those who occupy the room.

Some public goods, like world peace, provide collectively consumed benefits to everyone, no
matter where they are. Some goods are collectively consumed within nations, although others
produce collectively consumed benefits that are locally consumed. The geographic range of
benefits influences desirability of having public goods supplied by various levels of government.

PROVISION OF PRIVATE AND PUBLIC GOODS: MARKETS AND GOVERNMENT

The ss and distribution of goods and services among individuals reflect collectively agreed-upon
institutional arrangements in a community. It is difficult to decide the most appropriate means for
making goods and services available.

Private goods that are individually consumed are sometimes supplied through markets by the
government, eg- bus services, electricity, and other public utility services; whereas many non
rival consumption goods with characteristics of public goods, are privately produced and
supplied through markets. Eg- recreational services sold through private clubs, tv and other
communication services, private police protection. In many cases, goods and services are
supplied both through markets under private production and by governments through political
institutions. For example, both private and public schools are available.

Recreational services and facilities, such as parks, tennis courts, and golf courses, are supplied by
both the government and the private sector. At the extreme, pure private goods can be supplied
through the government and financed through taxation. For example, citizens could agree
collectively to supply clothing through the government and allow every person one identical suit
of clothes per year at no direct charge, financing production and distribution through taxation.

Similarly, it is possible to envision goods that have the characteristics of public goods being
produced privately and sold through markets when the costs of exclusion are not very high. Eg-
cable tv services in which programming that is nonrival in consumption is produced by
profit-maximizing firms that sell monthly subscriptions; The fee is an exclusion device, making
the service available only to those who sign a contract and agree to pay.

It is not possible to draw a neat line between pure private goods and pure public goods. Many
intermediate cases exist in which external benefits or costs accrue only to some people and the
transaction costs associated with trading goods with collectively consumed benefits are not
prohibitive. In those cases, both private supply and government supply are feasible, and it is
often difficult to determine which supply method is appropriate.

Congestible Public Goods and Private Goods with Externalities

Government ss through political institutions and private ss through markets are two alternatives
that can be evaluated according to the extent to which externalities are associated with either the
production or consumption of the good and the extent to which it is possible to develop a means
of selling rights to use the good or service.
Congestible public goods are those for which crowding or congestion reduces the benefits to
existing consumers when more consumers are accommodated. The MC of accommodating an
additional consumer is not zero after the congestion point. For eg, an additional user of a
congested road decreases benefits to existing users by slowing down traffic and increasing the
risk of an accident.

After N* users of a road have been accommodated per hour, the marginal cost of allowing
another user on that road becomes positive.

Price-excludable public goods are those with benefits that can be priced. Eg- Private clubs that
share facilities like tennis courts, pools, and diners areas for small groups. Membership rights,
which are sold in the market, are negotiable and can be sold by their holders to others. By joining
clubs and paying dues, members share the cost of facilities and services that they otherwise can’t
afford.

The dues ration the facilities of the club to avoid the effects of congestion. Other
price-excludable public goods include such public facilities as schools and hospitals. These
goods can be priced, but their provision results in positive externalities.

Goods and services have been divided into four categories:

 1. Pure private goods
2. Price-excludable public goods
3. Congestible public goods
4. Pure public goods

Pure private goods- individually consumed goods- subject to low-cost exclusion from benefits
for those who don’t pay for the right to receive such benefits. The production of these goods
usually doesn’t generate an externality, but there are external benefits for others consuming these
goods; sold in markets by private firms or the government. When sold in markets, their costs of
production are financed by the revenue obtained from sales ; they may be produced by the
government or purchased by the government from private firms, distributed free of direct charge
to eligible recipients, and financed by taxes. Such is the case for public welfare programs that
give medical services, food, housing etc. to low-income citizens who are eligible. These services
also could be sold at subsidized prices, with losses made up from tax-financed subsidies.

Price-excludable public goods- individually consumed- subject to exclusion, but their

production or consumption is likely to generate externalities. Such goods can be distributed
through markets when produced either by private firms/ government. The production/
consumption of these goods can be subsidized to account for their positive externalities. The
good would be financed by both the revenue from sales and the taxes used to finance the subsidy.
Eg- private and public hospitals, mass transit facilities, and schooling. These goods also can be
produced by the government and distributed with no direct charge. However, the quantity and
quality of the service would be determined collectively through political institutions, and costs
would be financed through taxation. Eg- public schooling, public sanitation service, and
government-supplied inoculations that are available at public health facilities.

Congestible public goods- nonrival in consumption- only up to a certain point. After the number
of consumers exceeds a certain amount, the goods become at least partially rival in consumption.
An increase in the use of the good by one consumer decreases the benefits from a given amount
of the good that can be enjoyed by others. Exclusion from benefits is possible through fees. In
some cases, they’re also price-excludable- often in the form of services flowing from shared
facilities that can be distributed in markets by government or firms through admissions,
memberships, or fees; these might receive public subsidies. Privately supplied examples include
clubs for sharing recreational facilities, amusement parks, theaters, sporting events.
Government-supplied goods of this type might be partially or fully financed by taxes. Eg- Public
parks, civic centers, auditoriums, roads, bridges, and similar public facilities.

Pure public goods- collectively consumed benefits that are not subject to crowding and are
subject to high-cost exclusion. It’s difficult to sell use rights to the benefits of these goods, and
markets are unlikely to provide a convenient mechanism for distributing them. They could be
produced privately through voluntary contributions, with the quantity and quality depending on
the revenue collected. Eg- Private charity. However, goods resembling pure public goods are
most likely to be distributed free of direct charge by governments, with the quantity and quality
of the service determined through political institutions and financed by taxes. Eg- national
defense, environmental protection.

Semi Public goods exist in a continuum ranging from pure private goods to pure public goods.
Goods could be categorized according to degree of rivalry in consumption and excludability. The
horizontal axis of the graph plots the extent to which the benefits of the good are rival on a scale
of zero to one.

A pure private good with benefits that are fully rival in consumption would rate one on the
horizontal axis while a pure public good with benefits that are completely nonrival in
consumption would rate a zero on the horizontal axis. A congestible public good with benefits
that are only partially nonrival would be assigned a number from between zero and one on the
horizontal axis depending on the degree of its congestibility.
The vertical axis measures the excludability of the good on a scale of zero to one. A pure private
good, which is perfectly excludable because its benefits can be fully withheld from someone who
does not pay, would be a one on the vertical axis. Similarly, a pure public good that is not price
excludable would be a zero. Goods, such as highways for which tolls can be charged and other
price-excludable goods, would be assigned a number between zero and one depending on the
ease with which the benefits of the product can be priced.

A pure private good corresponds to point A on the graph where there is full excludability and full
rivalry for the benefits of the good. A pure public good corresponds to point B where the benefits
are fully nonrival and price excludability is impossible. Some goods like cable TV transmissions,
would correspond to a point on the vertical axis like C because the benefits are nonrival, but
price exclusion is relatively easy because signals can be scrambled and those who decline to pay
can be denied the benefits. A highway subject to congestion would correspond to a point like H,
where there is a degree of rivalry and price exclusion is possible through tolls.

Education as a Public Good

Education has some characteristics of a public good and a private good. Education is commonly
believed to result in widely ranging external benefits when it is provided at least at some minimal
level to all children in a society. However, at the same time, the exclusion principle can easily be
applied to educational services so that it can be withheld from those who do not pay for it.
Education is a clear example of a partially public good. Decisions must be made, therefore, about
how to supply it. Education can be made available through the marketplace like any private
good. Education can also be supplied by governments and given out free of charge in equal
amounts to all children in a society.

THE DEMAND FOR A PURE PUBLIC GOOD

The demand for a pure public good is different from that of a pure private good. The market DD
curve for a pure private good gives the sum of the quantities demanded by all consumers at each
possible price per unit of the good. For any given price, a point on the market DD curve for a
pure private good is found by adding the quantity that each individual would purchase at that
price. The individual demand curves are added laterally over the horizontal axis to obtain the
market demand curve.
In Figure 4.4- there are only 3 consumers of the private good. At a price of $3 per loaf, the
person whose demand curve is DA purchases 1 loaf per week. That is the quantity for which the
price equals his marginal benefit per week (MBA= $3).

The person whose demand curve is represented by DB purchases 2 loaves per week at $3 per
loaf. At that amount of weekly purchase of bread, MBB= $3. Finally, the person with demand
curve DC purchases 3 loaves per week at a price of $3 per loaf because MBC $3 at that amount
of weekly consumption. The total market quantity demanded by these three consumers is six
loaves per week at a price of $3 per loaf. This is represented by point E on the market demand
curve. Until the price falls below $4 per loaf, the only individual purchasing the good will be the
one whose demand curve is represented by DC. At lower prices, the other individuals whose
demands are represented by DB and DA progressively enter the market, and the quantities that
they demand as prices are lowered are added to that of the consumer whose demand is DC. The
market demand curve for the private good is labeled D equals summation QD.

For a pure public good, all consumers must consume the same quantity of the good. Purchasers
of a pure public good would not be able to adjust their consumption so that one person had one
unit per week, while another person enjoyed two units per week, and still another had three units
per week. If consumer A had three units per week, all other people would consume three units
per week. For a pure public good, consumers cannot adjust the amounts purchased until the price
of the good equals their marginal benefit from the good per week. In fact, a pure public good
cannot be priced because of its nonexclusion property.

For a pure public good, all consumers must consume the same quantity of the good. Purchasers
of a pure public good would not be able to adjust their consumption so that one person had one
unit per week, while another person enjoyed two units per week, and still another had three units
per week. If consumer A had three units per week, all other people would consume three units
per week. For a pure public good, consumers cannot adjust the amounts purchased until the price
of the good equals their marginal benefit from the good per week. In fact, a pure public good
cannot be priced because of its nonexclusion property.
The demand for a private good is obtained by adding the quantities demanded by each consumer
at each possible price. The efficient output is six units per week, which corresponds to point E.
At a price of $3 per loaf, MBA MBB MBC MC.

How then can a demand curve for a pure public good be derived? The variables on the vertical
axes are not market prices. Instead, they are the maximum amounts that people would pay per
unit of the pure public good as a function of the amount of the good actually available. For
example, suppose the three consumers live together in a small community and desire to provide
themselves with security protection. The quantity of security protection can be measured by the
number of security guards hired per week to patrol their community. Security guards represent a
pure public good for these three consumers. No way exists for any one person in this community
of three to hire a security guard for his own benefit without benefiting his neighbors.

Figure 4.5 shows each person’s demand curve for security guards. A point on any of the
individual demand curves represents the maximum amount that the consumer would pay to get
each unit of the corresponding quantity of the public good. This maximum amount is the
marginal benefit of security protection at each quantity. Each individual’s demand curve shows
how the marginal benefit of security guards declines as more are made available.

The total amount that would be given up per security guard hired per week is the sum of the
annual weekly marginal benefits of each of the three consumers. Points on the aggregate demand
curve for a pure public good could be obtained by adding each person’s marginal benefit at each
possible quantity.

The demand curve for a pure public good is obtained by summing the individual demand curves
vertically. The marginal benefit, or demand price, that each person would pay per unit of the
public good is summed at each quantity of the good, because all people must consume the same
quantity.

For example, the person with the demand curve DA would pay a maximum of $300 per security
guard if only one guard were provided per week. Similarly, the maximum amounts the people
with demand curves DB and DC would give up per security guard if only one were provided per
week would be $250 and$200, respectively. A point on the market demand curve therefore is
obtained

by adding these maximum amounts. Because the maximum amounts reflect the

marginal benefit of security protection, the point on the market demand curve

represented by point Z1 corresponds to the sum of the marginal benefits of all

three consumers. This equals $750 per year when only one security guard is

provided.

The marginal benefit of additional units of a pure public good declines in the

same fashion as do those of pure private goods. The amount per security guard

that could be collected if two guards were made available per week is less than

that which could be collected per guard when only one is provided per week.

This too is shown in Figure 4.5. The maximum amount per guard that each of

the three consumers would give up when two guards are made available per

week is $250 for A, $200 for B, and $150 for C. Therefore, the sum of the marginal

benefits when two security guards per week are provided is $600, as represented

by point Z2 in Figure 4.5. Adding the marginal benefit received by each

consumer from any number of security guards in this way gives points on the

demand curve for the pure public good. This curve is labeled D= summation MBi
 CHAPTER 3 - THEORY OF PUBLIC EXPENDITURE

● The concept of public expenditure plays a very prominent role in public finance.
● In the nineteenth century, the economists paid very little attention to public expenditure
as there was no sound classification of the expenditure by Central Government, State
Government and Local government.
● There were no principles for these public expenditures.
● Basically, the functions of the government were restricted to justice, police and arms.
There was also the confirmed belief that government expenditures are totally wasteful
and money can be best utilised by the private persons rather than government in the
ancient times.
● With the passage of time, the situation has altogether changed and economic activities
have become complex which have forced the economists to pay a great attention to public
expenditure.
● Thus, in modern times, the subject of public expenditure has earned great significance.
● Public expenditure is the expenditure incurred by public authorities i.e. Central
GOvernment, State Government and Local bodies for the satisfaction of collective needs
ot the citizens or for promotion of economic and social welfare.
● The development functions include education, public health, social security, irrigation,
canal, drainage, roads, buildings etc. These functions of social welfare have increased
public expenditure to a greater extent.

In short, it has gained a significant place in the study of publicfinance as the place of
consumption in economics due to two major reasons -
 1. The economic activities of the state has increased manifold
2. Nature and volume of public expenditure has greatly affected the economic life of the
country in a different manner i.e. it has affected production and distribution and general
level of economic activities.

THEORIES OF PUBLIC EXPENDITURE

❖ In ancient times, classical theorists did not pay much attention to frame any theory
regarding the increase of public expenditure.
❖ They simply regarded it as an administrative institution which is only concerned with
performing certain protective functions.
❖ In 20th century the concept of the government has changed altogether.
❖ The modern state is termed a welfare state in which the Government has enormous
functions to perform.
❖ For the first time, Adolph Wagner, a fiscal theorist propounded an empirical theory to
effect that Govt. inequitably grows larger.

Therefore, the various theories regarding increasing public expenditure can be theorized
propounded by an empirical theory to effect that Govt. inequitably grows larger.

(a) Pure theories of public expenditure (b) General theories of public expenditure.

A. PURE THEORIES OF PUBLIC EXPENDITURE

The pure theories regarding increasing public expenditure can be further classified into four parts

(1) Pigou's Ability to Pay (3) Samuelson Theory (2) Benefit Analysis (4) Johansen Theory

1. PIGOU'S ABILITY TO PAY THEORY

Prof. Pigou gave the most comprehensive treatment to the ability to pay theory in the
determination of optimum level of public expenditure.
GENERAL THEORIES OF PUBLIC EXPENDITURE

There are three important theories of increasing public expenditure given by

- Adolph Wagner,
- Wiseman
- Peacock and Colin Clark.

1. ADOLPH WAGNER HYPOTHESIS

★ Adolph Wagner, a famous German fiscal theorist believed that there is a functional cause
and effect relationship between the growth of an economy and the relative growth of the
public sector. Presenting his famous 'Law of the increase of state activities', Adoph
Wagner opines ;

★ "Comprehensive comparisons of different countries and different times show that among
progressive people, with which alone we are concerned, an increase regularly takes place
in the activity of both the central and local governments. This increase is both extensive
and intensive; the central and local governments constantly undertake new functions,
while they perform both old and new functions more efficiently and completely." Adolph
Wagner

● According to Wagner, relative growth of the government sector was an inherent

characteristic of industrialising economics.
● Wagner's hypothesis of increasing state activity holds that as per capita income and
output increase in the industrial nations, the public sector of these nations necessarily
grows as a proportion to total economic activity.
● Wagner has divided public expenditure into two parts: (a) expenditure for internal and
external security, (b) culture and welfare which implies health, transport, education,
banking and the like.
 ● Expenditure for external security would increase in a growing economy as the nature of
use of force by the state from simple aggression to prevention of attack and use of force
by the state from simple aggression to prevention of attack and use of sophisticated
weapons.
● Similarly, the expenditure for internal security would rise due to greater friction between
economic units and urban people

Wagner's Hypothesis with the help of Diagram

This has been shown in Fig. 7.6. The real per capita income has been shown on the X-axis and
the real per capita output of public goods has been shown on the Y-axis.

● Line A¹, represents a situation in which the

public sector maintains a constant proportion of the
total economic production of society over time.
● In other words, while the real per capita
income increases due to the economic development
of the country, the real per capita output of public
goods remains at the constant proportion of total
economic activity. T
● the constant proportion line may now be
used as a reference point to the graphical representation of Wagner's law as shown by the
line A2, again along with the line A², the proportion of the total resources devoted to the
output of public goods, expanding over time.

Factors Responsible for Persistent increase in Public Expenditure

● Wagner's hypothesis was supported by the famous economist F.S. Nitti.

● He concluded with the subject of empirical evidence that this law was applicable not only
to Germany but also to various governments which differed widely from one another.
● According to the Wagner hypothesis, there are many factors which are responsible for
persistent increase in public expenditure.

They are as under :

1. Continuous Extension of Social Activity. Wagner admitted that continuous extension

of social activities was the basic reason for the relative growth of public expenditures.

● In the past, governments restricted themselves to the problems of external defence

and maintenance of law and order within the country.
● But in the modern and dynamic world, old-fashioned concepts have changed
altogether and new governments are assigned with the objective of promoting
economic, political and social well being of its citizens.
● Besides, they perform their functions in the removal of all business fluctuations
maintaining full employment in a country.
● Thus, growth of these government functions lead to absolute and relative growth
of economic activity.

2. War and Preparation for War. In the present century, the most important single factor in
pushing public expenditure upward is war.

● Expenditure for national defence accounts for half of the total expenditure.
● Wars and rumours of war between countries forced them to remain ready for it all
the time.
● Therefore, progress in the art of military goods has been so rapid that war goods
have been an extremely costly affair in recent times.

3. Growth of Population and Urbanisation. The growth of population and urbanisation is

another factor responsible for the rise of public expenditure, in turn, governmental
activities.
 ● Thus, the process of urbanisation seeks an expansion in such expenditures as
those of protection of life and property.
● This imposes additional responsibilities upon the government.
● The functions they perform are inspection of food distribution of essential
commodities, promotion of public health, construction and maintenance of
hospitals, education and other amenities of life.
● Furthermore, modern societies are becoming more complex which need huge
amount of expenditure to meet their demands.

4. World Depression. The great world depression of 1929-33 is another major factor responsible
for the extension of public expenditures.

● This depression demonstrated the need for government intervention which is responsible
for the growth of government activities in various fields.
● So investment activities of modem governments constitute another factor for increased
public expenditure

5. Rise in Prices. The sky rocketing rise in prices has equally contributed to the rise in public
expenditure since independence.

● The rise in prices has two effects. One, the government has to pay a higher price for all
goods and services which it has to buy.
● Two, it has to find larger financial resources to meet its growing expenditure.
● In this way, the increased government expenditure is itself one of the contributory factors
responsible for the secular rise in prices.

6. Democratic Institutions. Democratic institutions are not the direct factor responsible for
pushing public expenditures.

● But it makes indirect influence upon it.

● A modern democratic state has to maintain the ceremonial head of the state and it incurs
expenditure on legislature at the central, state and even local levels.
● Above all, they have to maintain diplomatic and consular relations with the rest of the
 world.
● It will not be out of place to note the increasing concern for underdeveloped nations telt
by the advanced countries which have started diverting part of their resources for
economic development of these backward nations.
● It is, therefore, whatsoever the real cause, these activities constitute very important factor
for the increased public expenditure in the 20th centur

7. Role of Economic Planning. In almost all countries, the state government adopted the planning
in any form to accelerate the pace of economic growth. This has substantially increased the
expenditures

8. Modern Complexities of Life. The fast growing complexities of modern life compelled the
government to take in hand qualitative and quantitative functions for the betterment of common
lots. These welfare schemes of the government naturally involve massive public expenditure.

9. Role of the Public Sector.

"Increased efficiency of the public sector is also the factor to stimulate public expenditure
relative to that of private organisations. It is a well known fact that individual private
organisations always look for maximum profit whereas the public sector exclusively works for
the social advantage of the country." Prof. Dalton

Criticism of the Theory

Wagner's hypothesis was widely criticised by noted economists such as Allan Peacock and Jack
Wiseman on the following grounds

1. It lacks Interdisciplinary Relationships. No doubt, it deals with inter-disciplinary phenomena

but basically it lacks an interdisciplinary relationship in its analytical framework. Other sciences
like political science, economics and sociology must be evolved in any theory of public
expenditure.

2 Not Comprehensive Analysis. Although Wagner's hypothesis possesses the accumulating and
explaining of the crucial historical facts, it lacks a comprehensive analytic framework.

3. Not Acceptable to Western Countries. Wagner's version is based on an organic

self-determining theory of the state which is not, however, at least accepted in most western
countries.

4. It Ignores the Influences of War. Wagner's hypothesis ignores the influence of war on
government's spending activities which play a vital role in public expenditure in modern times.

2. PEACOCK-WISEMAN HYPOTHESIS

● This hypothesis of the growth of public expenditure was advanced by Peacock and Jack
Wiseman in the study of public expenditure in Great Britain during the period 1896 1955.
● It stresses the time pattern of public spending trends and highlights the fact that the
increase in public expenditure does not follow any smooth and continuous trend but the
increase in public expenditure occurred in step-like manner or in jerks.
● During the phase, some social or other disturbance takes place which shows the need for
increased expenditure as the existing public revenue could not meet the situation.

However, the approach of the hypothesis is made of three separate concepts:

1. Displacement effect

2. Inspection effect

3. Concentration effect

● Peacock and Wiseman observed that the relative growth of the public sector in Great
Britain followed a discrete step-like pattern rather than a continuous growth pattern
● The government's fiscal activities have risen step by step to successive new higher levels
during the span of seven decades.
● Most of the upward steps in taxing and spending have taken place during periods of
major social disturbances.
 ● This has created a 'displacement effect by which the previous lower tax and expenditure
are replaced by new and higher budgetary levels.
● After the social disturbance has ended, the newly emerged level of tolerance makes the
society willing to support a higher level of public expenditures in the society realises that
they are capable of carrying a heavier tax burden than it previously was.
● In this way, the public expenditure and revenue get stabilised at a new level and still
another disturbance occurs to cause à displacement effect
● Thus, the social disturbance ends that no strong motivation exists which may compel the
society to return to the lower level of taxation.
● The higher government revenues are used, instead, to support a permanently higher level
of public sector allocation.

This displacement effect does not require the new higher growth of expenditure to continue
with the same expenditure pattern that was created by the social disturbance this way, the
increased expenditures are partly a direct result of disturbance while other expenditures
frequently involve the expansion of government into new areas of econo activity. For instance,
war and other social disturbances frequently force people and their government to find solutions
to problems which previously had been neglected. This is known as 'inspection effect

Thirdly, Peacock and Wiseman also described a concentration effect which the apparent tendency
for central government economic activity to grow faster than that of state and local govts when a
society is experiencing economic growth.

GROWTH OF PE

● Public expenditure has increased manifold in the recent past and it continues to be
exhibiting an increasing trend in almost all countries of the world.
● The end of the 'Laissez faire policy' has contributed much to this fact in the recent period.
● "Public expenditure grows because, and as, public activities increase. This increase is
both extensive and intensive.
The reasons responsible for inducing increased volume of expenditure

1. Welfare States. In modern times, states are the welfare states.

● They have the aim of promoting the economic, political and social life of the people.
● It is the moral duty of the state to improve the living standard of the general public.
● To achieve this aim, the state has to undertake so many welfare functions like education,
public health etc.
● This is true in all types of governments either capitalist or communist government.
● State intervention is increasing through legislative and administrative measures to
enhance production and improve the distribution system.
● The new functions are social insurance, unemployment relics, cheap medical facilities,
old age pensions, housing facilities etc. The state has come to reduce the social
inequalities in the society. Especially in underdeveloped countries such as India, the state.
expenditure is rising very fast.
● The welfare aspect of government activity is described as the pressure for social progress
by Wagner. According to Wagner's hypothesis, the pressure of social reform may be
regarded as the root cause of the relative growth of public expenditure today. In short.
These functions have necessitated the adoption of the strategy of planned economic
development which involves huge amounts of expenditure.

2. To meet the Defence Needs.

● Due to rapid growth of the science and technology in the sphere of nuclear weapons,
there is a grave threat of foreign attacks.
● The political situation all over the world is uncertain and insecure. If one country
strengthens its defence forces, the other countries are forced to take similar steps in their
self-defence in anticipation.
● The manufacture of modern nuclear weapons, training and planning of the army is a very
costly affair.
● The technique of war is a changing phenomenon and with the change of technique of
 war, new weapons have to be purchased for the army.
● It increases the burden of public expenditure.
● In India, the defence expenditure has increased manifold since Chinese aggression in
1962 and wars with Pakistan in 1965 and 1971 respectively.
● Furthermore, the defence expenditure also includes the maintenance of army, air force,
navy, development of military art and practice. Obviously, this has led to a huge increase
in public expenditure.

3. Development of Agriculture. In developing countries like India, the development of

agriculture is the key factor of the progress of the economy.

● The government has come to know the effect of agriculture or the industry sector.
● The inter-relationship between agriculture and non-agriculture sector causes the
development of both the sectors
● The expansion of the agricultural sector provides a stimulus to industrialisation.
● On the other hand, the industrial sector also helps to supply modern tools and implements
to which in turn are responsible for the rise in agricultural productivity.

4. Urbanisation. The spread of urbanisation is another factor for the relative growth of public
expenditure in the modern times.

● There has been an increased tendency of expenditure on civil administration with the rise
of population in these areas.
● Expenses on water supply, electricity, transport, maintenance of roads, educational
institutions, traffic controls, and public health have increased tremendously in these days.
● Hence, increase in expenditure on civic amenities has led to an upward increase in public
expenditure:

5. Democratic and Socialistic Structure of the Government.

● The growth of democracy and socialism everywhere in the world has been responsible
for the increase of public expenditure to a greater extent.
● A democratic form of government is more expensive than the other forms of government.
 For instance, democracy in India has become a costly affair.
● Expenditure on election, bye-election and administrative set up is increasing.
● The ruling party has to persuade the public opinion in their favour by making excessive
expenditures on new policies.
● Furthermore, they have to fulfill their promises made in the manifesto at the time of
election.
● Similarly, there is a gradual shift of thinking from capitalism to socialism with the result
that state governments have to shoulder larger responsibilities to perform social activities.
● Public sector and nationalisation are equally responsible to push the public expenses to a
larger extent.

6. Rural Development Schemes.

● The government has to spend huge amounts for the development of rural folk in
developing countries like India where the majority of population. lives in villages.
● It has to undertake schemes like community development projects and other social
measures.
● In India, many such schemes have been introduced to eradicate poverty. They are IDRP,
DPAP, NREP, TRYSEM, CSRE, DDP, SFDA/MFALA etc.
● Undoubtedly, they have raised the expenditure of the government manifold.

7. Industrial Development. After the world depression, the government took active participation
to promote industrial development.

● Actually, it brought a happier life, higher standard of living, increased the efficiency and
raised the production of all commodities to a sufficient level.
● In addition to it, the government also took measures to control monopolies and to provide
consumer goods and services at reduced cost.
● This led naturally to a greater share for public expenditures.
8. Rising Population.

● The growth of population is also responsible for increase in the public expenditure as the
government needs money to perform various functions efficiently.
● In fact, rising population is a grave threat to the development of poor countries like India.
● The state bears additional responsibility for solving problems such as food,
unemployment, housing and sanitation etc.
● So it has to spend a huge amount on the family planning programme every year to
persuade people to have a small family.

9. Growth of Transport and Communication.

● The growth of transport and its expansion, the state has to spend to maintain a quick and
efficient transport system.
● Government is supposed to run these services even at a no profit no loss basis.

10. Increasing Price Level.

● Another factor which has contributed to rise in public expenditure, is the rise of price
levels all over the world since the Second World War.
● Rise in the price level has two important effects on the government: (1) the government
has to pay higher prices for all goods and services which it has to buy ; and (i) it has to
find larger financial resources to meet its growing expenditure

CANONS OF PUBLIC EXPENDITURE

● The canons or principles of public expenditure are the fundamental rules which should
govern the expenditure policy of the state authority,
● Some economists like Prof A.G. Bucher attempted to lay down certain guidelines for
public expenditure to be followed by the concerned government.
● Therefore such rules have to help insight into the problem in case of any pit-tall it must
 easily be choked at the early stage followed,

In this regard, under-mentioned guidelines should be

(1) It should promote the welfare of the society

(2) should stimulate the social welfare

(3) An eye should be kept whether the funds are properly utilised for conducting social welfares

In fact, the principles of public expenditure determine the efficiency and propriety of the
expenditure itself. Prof. Shirras has made the unique contribution in suggesting the canons of
public expenditure. These canons are broadly described below

1. Canon of Benefit. Other things being equal, expenditure should bring with it important social
advantages such as increased production, the preservation of the social whole against external
attack and internal disorder and as far as possible a reduction in the inequalities of Income. In
short, public funds must be spent in those directions most conducive to the public interest i.e.
maximum utility is to be attained in public expenditure -Prof. Shirras

Therefore, this law states that the public expenditure should be planned in such a way that it
results in the achievement of maximum social advantage. Public money should not be utilised for
the benefit of an individual or particular group rather it should equitably conder benefits on the
entire society. Thus this canon is synonymous with the principle of maximum aggregate benefit

"Public Expenditure in every direction must be carried just so far that the advantage to the
community of a further small increase in any direction is just disadvantage of a corresponding
small increase in taxation and in reced by the from any other source of public income. This gives
the ideal of public expenditure and public income? - Hugh Dalton

This principle of social benefit in the theory of public finance is similar to the equi marginal
utility in the theory of consumer behaviour. Thus, public authorities should distribute its
resources in such a manner that marginal utility from all uses should be equal. The canon of
benefit has no substitute or alternative. However, it is difficult to measure the benefit from some
items of public expenditure. In short, the canon of benefit aims at the improvement of production
and distribution system in the country

2 Canon of Economy. The canon of economy means the state should be economical in spending
money. In other words, the wasteful and extravagant expenditure should be avoided. Public
expenditure must be productive and efficient. So the state should not spend more than necessary
on the expenditure.

"Economy means protecting the interests of tax-payers not merely in affecting economies in
expenditure, but in developing revenue - Prof Shirrias

So, the expenditure incurred by the state should help to expand its revenue.

3. Canon of Sanction. They cannot sanctions refers to the proper procedure of stimulating the
pill separation and act arbitrariness and influence tantes intensis in the matter of the expenditure.
It requires that the spending authorities should abu sanit from a higher authority established for
the purpow. In other work this wins assets that no public expenditure should be incurred without
This does not imply that every government body has no liberty of speeding expenditure to a
certain limit, but every expenditure beyond that limit should be incurred after obtaining the
sanction of proper authority. The main object of this canon and the possibility of unwise
spendings. The canon of sanction also includes the the spending authority should spend the
amount of money for which it has been sanctioned and assure that the sanctioned money is
properly utilised. Public accounts should always is audited at the end of financial year. This also
helps to control unwise and arbitrant spending of public money.
4. Canon of Surplus. The canon of surplus means that governments should avoid deficits. It
should aim at surpluses in the budget. They should not spend more than what they earn just as an
individual does. Thus, everybody should live within one's means

"Public authorities must earn their living and pay their way like ordinary citizens. Balanced
budgets must, as in the private expenditure, be the order of the day. Annual expenditure must be
balanced without the creation of fresh credits unrepresented by the new assets." - Prof. Shirras

This canon seems to be sound and secure. It is like cutting one's coat according to one's cloth
Thus, public authorities must have sufficient revenues not to meet their current expenditure but
must have surplus for an unforeseen future. It does not mean that the state should not borrow
money but it should have enough revenue to pay interest and have capability to repay the loans
and debts

In the modern time the balanced budget is not always considered good. It depends upon the
condition of the economy. Balanced budget is desirable when there is full employment price
stability. In inflationary conditions, a surplus budget is desirable because it will reduce the
excessive purchasing power in the hands of the public. On the other hand, a deficit budget is
desirable in times of depression because it will increase the purchasing power of the people and
will increase the effective aggregate demand and bring squilibriury between demand and the
current output. But the canon surplus has lost the importante in present times.

Other canons.

Besides, the above noted canons of public expenditures, there are others as well - they are canons
of of elasticity, productivity and equitable distribution
These canons are detailed below

1. Canon of Elasticity. The canon of classiche expenditure policy of government should be

flexible ze should be possible to meet and the direction.