PUBLIC FINANCE

SECOND SEMESTER – MODULE –

1 INTRODUCTION TO PUBLIC FINANCE

Q.1 Examine the scope and functions of public finance.

Public finance is that branch of general economics which 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 centers on the revenue-expenditure process of Government is referred
to traditionally as public finance.” According to Taylor, public finance studies the manner in
which the state through its organ, the government, raises and spends the resources required.
Public Finance is thus concerned with the operation and policies of the fiscal public treasury. The
definition of Public Finance by U.K. Hicks in Public Finance highlights the satisfaction of
collective wants which in turn leads to the need to secure necessary resources carry out their
purposes.

SCOPE OF PUBLIC FINANCE

Prof. Dalton categories the scope of public finance into four areas which includes 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 relatives 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 publicexpenditure (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, inter
governmental 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 public finance narrow 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 defense, 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, to mobilise resources, to 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 orderto 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) (b) (c) (d)
(a) Allocation of resources The most important objectives 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 affect
the distribution of national income and resource Taxation
and public expenditure policies are used by the government
to reduce inequalities. Progressive direct taxation impose
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 absence of sharp cyclical
movements in the form of booms and depressions. To bring
about such stability, counter cyclical 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 capitalformation and investments through
public expenditure and tax incentives to private sectors.

Q.2 Examine the similarities and dissimilarities between public finance and private finance. OR
Distinguish between public finance and private finance.
Public finance deals with study of income, Expenditure, borrowing and financial administration
of the government.
Private finance is the study of income, expenditure, borrowing and financial administration of
individual or private companies. Both public and private finance are fundamentally similar in
nature but different from each other on various operational aspects The similarities and
differences between public and private finance have been explained below.
SIMILARITIES:

1. Objective Satisfaction of human wants is the main objective of both public and private
finance. The main aim of public finance is to satisfy social wants and that of private
finance to satisfy individual wants.
2. Principles The principle of maximum social benefits is the guiding principle followed by
the government while spending its income. Individuals also follow the principle of
maximum satisfaction when spending out his given income.
3. Income, Expenditure and borrowing The resources or the income for both government
and the individuals are limited In case of shortage, borrowing can be done for both and
both are under obligation to repay the borrowed money.
 4. Policies Both the private and public finances adopt policies for maximizing welfare. In
Private finances as well as in public finance only sound policies will enable maximization
of welfare and benefits.
5. Administration The effectiveness and success of measures adopted by private and public
sector depends on the administrative machinery. If the administrative machinery is
inefficient and corrupt it will lead to losses and wastages.

Dissimilarities: (Distinction Between Public And Private Finance)

1. Magnitude: The most significant difference between the two types of finances is in
terms of size and magnitude. Households and businesses have relatively smaller
amount of resources available to them and hence their budgets are smaller in size as
compared to those of governments.
2. Public Scrutiny: Personal budgets of households are a private affair and not made
public. In case of businessfinance, the budget is made known to the stakeholders and
General public for information and scrutiny. In case of public finance, every
budgetary decision has to be made known to the people of the nation.
3. Source of revenue: Private economic units earn their income by using assets owned
by them. Their sources of income are salaries, wages, interest, rent and profits which
arise out of transactions. In case of governments, the source of income are taxes and
non tax revenues. In case of taxes, fees, fines, fines there in an element of compulsion
4. Sources of borrowing: Private economic units may borrow from informal sources like
friends, Relatives,moneylenders as well as from formal sources like banks and
financial institution. Public bodies can borrow almost on a continuous basis from
internal and external sources. They can borrow from the people, the central bank,
Commercial banks and other financial institutions as well from external sources.
5. Motives Incase of public finance, the decisions are reached through political and
administrative procedure and based on common social objectives. Private finances is
governed by profit motive for businesses or satisfaction of wants of individuals and
households.
6. Time dimension: Both private and public financial activities try to balance between
the immediate objectives and future goals. But private economic units, especially
households, are primarily focused on fulfillment of present and immediate wants. In
case of public authorities, the focus is on both present and future
7. Income Expenditure adjustment Generally, while a private economic unit adjust its
expenditure to income, public bodies adjust income to expenditure. Private finance
will try and adjust expenditure according to income and in order to do so may even
forego fulfillment of certain wants. On the other hand, Government are guided by
welfare and growth consideration for which expenditure have to be predetermined.
Since they have the power to raise fund through taxation, borrowing, deficit
 financing, they try to adjust their revenues to the predetermined expenditure
requirements.
8. Assessment of outcomes: It is much easier to measure and evaluate the outcome of
private financial activities than the outcome of public financial activities. In case of
private economic units, the outcome may be measured by profits of business,
fulfillments of wants of households. In case of public finance, the outcome has to
measured and evaluated in terms of multiple parameters. These are social welfare,
economic growth, security, Productivity and efficiency.
9. Nature of the budget: Private economic units aim at surplus budget. Having a surplus
is considered economically prudent. This is not the case with government budgets. In
countries that need to grow and develop rapidly, deficit budgets need to be followed.
A long term surplus budget indicates that the government may not be fulfilling some
of its obligation.

THE PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE

Q.3 Explain the Principle of maximum social advantage OR Examine the Daltons version of
Principle of Maximum Social Advantage.

Critically examine Daltons Principle of Maximum Social Advantage. OR The ‘Principle of

maximum social Advantage’ was introduced by British economist Hugh Daton. According to
Hugh Dalton, “Public Finance” is concerned with income & expenditure of public authorities
and with the adjustment of one with the other. Budgetary activities of the government results in
transfer of purchasing power from some individuals to others.

Taxation causes transfer of purchasing power from tax payers 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
1. Marginal social Sacrifice
2. Marginal Social Benefits This principle is however based on the following assumptions:
 All taxes result in sacrifice and all public expenditures lead to benefits.
  Public revenue consist of only taxes and no other sources of income to the government.
 The government has no surplus or deficit budget but only balanced budget.
 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 public due to the
imposition of an additional unit of tax Every unit of tax imposed by the government taxes
result 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 greater
amount of impact and greater amount of sacrifice on the society. That is why the marginal
social sacrifice goes on increasing.

MODERN TRENDS IN PUBLIC FINANCE

Q.6 What is sound finance? Discuss the features of sound finance.
Classical economists believed that the less the government interfered in the economy the better it
is. This belief, along with private ownership of factors of production, was the foundation of
Laissez faire capitalism, which is a system where economic transactions are largely between
private owners of factors of production and such transactions are free from government
restrictions, taxation and subsidies. Laissez faire policy advocates market mechanism should be
left tee of any government interference. In such a system, the role of the government was
expected to be restricted to traditional areas like defence, law and order, justice, provision of
civic amenities and therefore most government spending was expected to be restricted to these
areas. The role of the budget and fiscal policy did not extend beyond raising funds through
taxation and spending on traditional functions. The primary belief was that the size of the

Government’s budget should be small and the budget should balance. These beliefs form the
basis of the principle of sound finance. The following are some of the features of sound finance:
1. Say’s Law: Like many others classical principles, the principle of sound finance is also
based on Say’s Law, that is, “Supply creates its own demand.” Since one man’s
expenditure is another man’s income, aggregate demand will always be equal to
aggregate supply. This belief forms the base of the argument on which classical
economists argued in favour of sound finance.
2. Full employment: The classical economists argued that since ADAS, there cannot be
over-production and under consumption. In other words, the economy cannot suffer from
fluctuations like unemployment and inflation. Driven by profit motive, the private sector
 will ensure optimum use of resources. Therefore, there will be full employment in the
economy. Only voluntary and frictional unemployment may exist.
3. Invisible hand: Private owners of factors of production will always achieve maximum
level of efficiency in their use of resources, as they are driven by self-interest and profit
motive. The concept of Adam Smith’s ‘invisible hand’ is used to explain how private self
interest will result in collective social good.
4. Taxations According to the classical school of thoughts, taxes are harmful because they
adversely affect willingness and ability to work, save and invest. Taxation was expected
to be kept at a minimal limit. High progressive taxation will lead to slow economic
progress. Redistributive effects of taxation were ignored.
5. Public expenditures Government spending was expected to be in the traditional areas like
defence, law and order, justice, provision of civic amenities. Since government budget
was not expected to be large in size, government spending was not large relative to total
spending in the economy. Therefore, it was believed that government spending would not
have any significant impact on the economy.
6. Balanced Budget: In laissez faire capitalism, since all factors of production are normally
owned and used by private individuals, the government can make use of such factors only
by depriving the private sector. Therefore, there is no justification for the government to
expand its expenditure beyond revenue and incur deficit budget. Budget should always
balance except during wartime when government will have to expand expenditure to fight
war. The state should not take up business activities because the private sector
iconsidered to be most efficient.
7. Market efficiency: The market mechanism is assumed to achieve maximum level of
efficiency. Market failures are only temporary and the market is fully capable of
correcting itself. Therefore there is no justification of any government regulation and
restrictions on the market. The use of the budget to correct market failures was not
considered.
8. Ricardian Equivalence Theorem: Budget deficits are uneconomical, harmful and socially
undesirable. They lead to inflation and harm economic progress. This belief was based on
Ricardian Equivalence Theorem. Deficits will have to be later met by raising taxes. This
is known to the people and they will increase their savings to pay higher taxes later. As
their savings increase, they will not increase consumption and therefore, increased public
expenditure will not be able to boost demand, production and stimulate growth.
9. Political View: Sound finance is compatible with a political system that supports private
ownership and minimizes government’s role. Generally, ideologically the conservative
parties believe in the principle of sound finance while the more liberal parties support
functional finance. However, in practice most governments have been observed to follow
functional finance.

Q. 7 Explain functional finance and discuss its features.

In the 1920s in Europe, and the 1930s in the United States, major economies experienced
depression. During this period many economists started questioning sound finance principles.
Low profit expectations during depression kept4 investment spending low, causing
unemployment to rise. Given such a collapse of economic expectations, the economists favored,
at least temporarily, giving up the sound finance principles and using government spending to
stimulate the economy Increased government spending during depression would mean running a
deficit budget. But this was considered necessary as private investment was not forthcoming.
Increased government expenditure in infrastructure building, job creation and paying social
security would increase income. This would encourage spending and aggregate demand would
rise and ultimately would help pull the economy out of the depression or recession. This view
that fiscal policy can be used to offset undesirable cyclical fluctuations in output was later termed
as ‘functional finance’ by Abba P. Lerner.

The concept of functional finance has the following features:

1. Market failures: Market failures can have severe economic consequences in the form of
depression and hyper inflation. The Great depression of 1930s brought the powerful US
economy down. In more recent times, the financial crisis of 2007-08 in the USA showed
that due to excessive de-regulation, financial markets can fail and become the cause of a
severe and long standing recession. Also, due to globalization, this recession has affected
the economic prospects of almost every country in the world.
2. Importance of fiscal policy: Taxation, public expenditure and public debt must be adopted
according to the needs of the time. While classical economists believed that the main aim
of public finance is to raise revenue, modem economists believe that the main objective
of public finance is to correct imbalances in the economy. In periods of inflation a policy
of surplus budget must be adopted and during depression, deficit budget must be adopted.
3. Aggregate demand Aggregate demand consists of consumption demand, investment
demand, government expenditure and net foreign income. Modern economists believed
that it is aggregate demand that determines level of national income and employment.
Deficiency in aggregate demand results in unemployment. Government expenditure
needs to be increased
During such times to boost aggregate demand and to bring the economy out of
depression.
4. Budget: Modern economists believe that the government, through public expenditure,
taxation, or deficit financing, can maintain full employment. During recession and
depression, public expenditure should be increased and the budget should be expanded to
increase aggregate demand. A deficit budget is perfectly justifiable to pull the economy
out of recession. On the other hand, during inflation, the government may have a surplus
budget by raising taxes to control consumption.
 5. Income redistribution According to modem economists, the distribution of national
income is as important as its size. A more even distribution of income would increase the
average propensity to consume (APC) and would increase the level of investment and
employment. Imposing high taxes on the rich and redistributing them to the poor through
pension, welfare schemes and allowances. This will improve APC and increase aggregate
demand, boosting investment, employment, production and profits.
6. Welfare capitalism: Keynes advocated fiscal measures for controlling capitalism an
Preventing its collapse. Keynes gave importance to compensatory actions through fiscal
measures for improving and maintaining the level of effective demand and thus the level
of economic activity in the country. The concept of functional finance forms the basis of
welfare capitalism that now exists in most of the advanced economies
7. Social objectives: Public finance has to function in the interest of the entire society and
not for the benefit of a select few. Every taxation, expenditure, borrowing policy and
ownership and operation of public utilities must be measured on the basis of their effects
on the entire society. Objective of taxation should be to redistribute income in the most
socially just manner Expenditure on social security, poverty eradication, medical care and
education will always be justifies as they bring in distributive justice. Public expenditure
and taxation should follow the objective of equalising marginal social cost and marginal
social benefit.

Q.8. Explain the concepts of Redistributive Taxation and Anti Inflationary Taxation.
In reality taxes are used for variety of purposes. They are not only a major source of
revenue for the government but they provide incentives or disincentives and correct
market failures. Taxes also help in income distribution and reduce income inequalities
Direct taxes can also be used as an instrument to control inflation and bring stability in
the economy.

A) REDISTRIBUTIVE TAXATION
Classical economists considered taxation as a means for raising revenue. But modern economists
consider taxation as a tool for redistributing incomes among the various sections of society.
Modem economists believe that taxation can be used for transferring income from the rich to the
poor. This is referred to as redistributive taxation. Redistributive taxation are aimed at reduce
savings of the rich and using the resources raised to increase the consumption of the poor Income
inequality harms the economy in many ways. Widening gap between the rich and the poor is not
only socially undesirable, but is also harmful for the economy’s growth. High degree of income
inequality reduces average propensity to consume and may lead to depression and
unemployment. Therefore, modem economists have recommended the use of taxation to
redistribute income in a more socially desirable manner. Most economies use progressive
taxation to redistribute income.
Progressive taxes are generally imposed on income and wealth. They impose a heavier burden on
the rich than the poor A redistributive fiscal policy includes progressive direct taxation and
public expenditure on social security, job creation and promotion of social equity. Such
expenditure are in the form of old age pensions, unemployment allowances, free and subsidized
housing, education, health care and food distribution. All these are aimed at reducing people’s
cost of living, increasing their capacity to consume and provide social justice Redistributive
taxation also increases people’s average propensity to consume. When income distribution
improves due to transfer of income from the rich to the poor, larger number of people can
increase their consumption levels. This increases aggregate demand and leads to increased
investment and employment. However, highly progressive direct taxes have certain limitations.
They result in tax evasion, giving rise to a black economy. At the same time, such taxes can
adversely affect people’s willingness and ability to work, save and invest. This can harm
economic progress Another limitation of redistributive taxation is that often government use the
redistributive fiscal policy to fulfil their political agenda of winning elections by providing
subsidies and transfers to a very large extent. This can result in excessive consumption, causing
inflation and lowering the value of money. Besides, such a fiscal policy may result in large
deficit and public borrowing, pushing interest rates upward. High interest and high inflation will
harm growth prospects.

B) ANTI-INFLATIONARY TAXATION.
In modem welfare states, the government has to incur huge expenditure to meet the growing
social and economic needs of the people. In such a situation, taxation becomes an important
source of funding such expenditure. Taxation plays a very important role in such economies.
Through taxation, the government control private consumption in order to make resources
available for meeting collective needs of the people. At the same time taxation is used to
redistribute income. In most growing economies with large public expenditure, there is always
the possibility of inflation due to excessive consumption. In such situations, anti-inflationary
taxation is used to reduce propensity to consume. Anti-inflationary taxation may be in the form
of higher rates of direct and indirect taxes. Anti-inflationary taxation that reduces consumption is
justified if the resources released from private consumption are used by the government for
increasing welfare of the society. While redistributive taxation like progressive direct taxes is
designed to reduce savings, anti inflationary taxes are designed to reduce consumption. When the
government uses taxation to reduce savings (redistributive taxation), the funds raised from such
taxes are funds which might have been left idle by the people. But when anti inflationary
taxation is used to reduce consumption, the resources raised by the government are funds that
people would otherwise have used for consumption. Therefore funds raised through anti-
inflationary taxation should be used productively.
The general classical View is the all taxes are anti-inflationary and all public expenditures are
inflationary. Modern economists believe that neither all taxes are anti-inflationary nor
expenditures are inflationary. The effects of taxation and public expenditure depend on the state
of the economy. During normal situations, any tax that reduces consumption and promote
investment may be anti- inflationary.