PUBLIC FINANCE & TAXATION

Prepared By Lakiyaw M.

Blue-Nile College (2011)

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 Chapter One: Public Finance

Introduction:
Governments have a solemn and constitutional duty to
safeguard and protect the life and liberty of its citizens.
Governments are also responsible to provide such
goods and services to its citizens, like roads, ports,
airports, health services, etc.
In order to provide the these, Governments need to
incur expenditure on internal administration, internal
security, internal law and order, a sound judicial system,
external defence of the country and on creating
infrastructure of roads etc.
Governments meet this expenditure partly by levying
taxes on its citizens and partly by raising loans.
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 Meaning of Public Finance:

 The financial operations of the Governments with

regard to raising and disbursement of finances are
called Public Finance.
 Public Finance is the study of the income and
expenditure of the State.
 It deals only with the finances of the Government.
Scope of Public Finance may be divided into following
five parts:
(1) Public expenditure,
(2) Public Revenue,
(3) Public Debt, and
(4) Public Financial Administration.
(5) Economic Stabilization
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 1. Public Expenditure
Public Expenditure is the end and aim of the
collection of State revenues.
The term ‘Public Expenditure’ refers to the
expenses incurred by the Government for its
own maintenance and also for the preservation
and welfare of society and economy as a
whole.
It refers to the expenses of the public
authorities, Central, State and Local
Governments, for protecting the citizens and
for promoting their economic and social
welfare.
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 Public Expenditure Classifications
 Based on benefit accrued, public expenditure may
be classified as:
a) Expenditure which confers common benefit on all:
e.g defence, education, transport,
b) Expenditure which confers special benefit on
some people: e.g police protection, justice, etc.
c) Expenditure which directly confers benefit on
certain persons and indirectly on the entire
society: e.g. Social security, public welfare, unemployment relief,
old age pension, etc.
d) Expenditure which confers special benefit on some
individuals: e.g. Subsidy given to particular industries or
individuals’ subsidized low cost housing provided to the poor.
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 Canons/principles/ of Public Expenditure
1)Canon of Benefit:
Expenditure should bring increased
production, preservation of social whole
against external aggression and internal
disorder, and as far as possible reduction in
income inequalities.
Public funds must be spent in those
directions which are most conducive to
public interest.
Public expenditure must result in the
achievement of maximum social advantage.
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2. Canon of Economy:

wasteful extravagant expenditure should be

avoided.
The public authorities should not waste the
limited resources at their disposal.
 It is, therefore, necessary that Government
should incurs expenditure with greatest care and
prudence.
It should aim at maximum benefit.
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3. Canon of Sanction:
 The canon requires that there should be in place a proper
procedure for authority to incur expenditure out of public
funds and that accountability for expenditure should be
inbuilt in the scheme of sanction and incurring of
expenditure.
 The spending authority should obtain proper sanction from
the authority vested with the power of sanction.
 The canon also sees that there should be adequate control
and audit of public expenditure to ensure that
 expenditure is as per sanction and likelihood of avoidable
and unscrupulous expenditure and misappropriation of
funds is avoided.
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4. Canon of Surplus: This canon enjoins that
public expenditure should be, as far as
possible, met from current public
revenues, without resorting to deficits or
borrowings.
5. Canon of Elasticity: According to this
canon, expenditure policy of the
Government should be such that it may be
possible to change the size and direction
of public expenditure according to
requirements of different circumstances.
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6. Canon of Productivity:
This canon implies that public
expenditure should be such that would
encourage production and productive
efficiency in the country.
7. Canon of Equitable Distribution:
This canon is particularly important for
the countries where obvious
inequalities of income and wealth are
present.
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 Focus of Public Expenditure

 Public expenditure is primarily aimed to

provide governance (Administration), security
(Defence and Policing) and justice (Courts) to
citizens.
Public expenditure is also incurred to provide
citizens with certain goods and services /public
goods/which an individual cannot acquire
because of cost factor or which an individual
does not solely need for his individual need.
Such goods and services are called ‘Public
Goods’.
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 Public Goods VS Private Goods

Private Goods:
 Refer to all those goods and services, which are consumed by
people to satisfy their personal and private wants or needs.
 Priced in the market on the basis of their cost of production
on the one side and the nature of demand on the other.
 There is no compulsion that every one will have to buy them.
 The distribution of these goods is based on effective
demand and market price.
 Private goods are divisible in the sense that price mechanism
divides people in to two groups: who want to consume them
and those do not.
 Private goods are subject to the principle of exclusion; in the
sense that price mechanism excludes the group of people who
are not willing to consume a particular good.
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 Public Goods:
 Collective wants are those which are demanded by all
members of the community in equal or more or less equal
measures.
 Defense, education, public health, infrastructure facilities like power,
transportation and communication, etc., are examples.
 Public goods are Goods and services produced to satisfy collective
wants.
 These goods are supplied by the country to all its citizens.
 But the degree of benefit a person derives will depend upon the use
he can put it to.
 unlike private goods, public goods are not divisible but have to be
collectively consumed.
 produced and supplied by the public authorities to meet collective
wants.
 The price mechanism does not apply and these goods can not carry a
price tag, As everyone is a beneficiary
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 Effects of Public Expenditure
Effects on Production and Employment
 The beneficial effect of public expenditure is in the form
of greater production of output and more equitable
distribution of wealth and income in the society.
 Public expenditure on generalized social services like
health, education, public health, etc. tends to raise the
efficiency of the nation.
 Consequently such expenditure tends to increase the
productivity of the nation leading to greater prosperity
of individuals.
 Public expenditure on infrastructure like roads, ports,
railways, etc. create tremendous employment avenues
for the citizens, raising their income.
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Increased income higher consumption
increased demand increased employment
and more avenues of increased income for the
citizens. increase in savings by citizens
which is likely to be channeled in new
production facilities through investment.
Government has to choose the particular
region or area and industry for incurring
public expenditure so that it maximizes
national production and follows it with
maximum community welfare.
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Effects on Distribution
 Public expenditure is also most powerful fiscal
instrument available to the Government to bring
about an equitable distribution of income and
wealth in the country.
 While formulating its expenditure policies,
government takes into account as to which of the
socio-economic group in the country are being
specially benefited by it.
 Part of public expenditure will help bring about a
more equal distribution of income and wealth and
the consequential removal of existing disparities
in people’s living standards in the society.
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Effects on Economic Stability
Major Nation state economies are affected by
business cycles whereby a cycle of growth is
generally followed by a cycle of stagnation
or even negative growth.

Increased public expenditure during the

stages or cycles of stagnation or negative
growth reinvigorates the economy and
lessens some of the pain of stagnation.

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Effect on Economic Growth
Public expenditure has a tremendous impact on
economic growth.
Public expenditure on infrastructure like roads,
ports, railways, electricity, shipping, etc. results
in opening up of more and more areas of the
country, industrialization of backward areas
and Philip to both industrial and agricultural
production.
This type of expenditure makes it easier to move
surplus production to deficit areas of the
country and even for export of surplus
production.
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 2. Public Revenues

In a broad sense, ‘Public Revenues’ includes

all the income and receipts, irrespective of
their source and nature, which the
Government obtains during any given
period of time.
It will include even the loans
raised by the Government.
In a narrow sense, it will include only those
sources of income of Government which are
described as revenue resources.
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1. Taxes:
The most common method of financing
Government expenditure is by taking resort to
taxation.
In every country, largest part of the public
revenue is raised through taxes.
Taxes may be imposed on persons income or
wealth or on both, they may be direct or indirect,
and they may be of different rates and nature.
Tax is a compulsory contribution imposed by a
public authority, irrespective of the exact amount
of service rendered to the taxpayer in return, and
not imposed as a fine for any legal offence.
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2. Fees:
The other important source of public revenue
is the fees charged for rendering certain
services by the State.
Fee is the revenue which is paid to the
Government for the special service rendered by it.
3. Price: -
The third important source of public revenue
is the price.
The Government sells some services and goods
and receives price in payment for them.
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4. Fines and Penalties:
Fines and penalties are payments made by
citizens for contravention of the laws of land.
This is a major source of revenue of modern
nation states.
5. Gifts:
 A small portion of public revenue is
generated through gifts made by individuals,
corporate and foreign Governments or
agencies.
Its significance as a source of public revenue
has been declining over the years.
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6. Borrowings:
It is a major source of public revenue to finance large
projects or programes requiring large investments.
Borrowings, besides being an important source for
financing public expenditure, also help Governments
to regulate money supply in the economy.
7. Printing of Paper Money:
The Governments, through their Central Banks, may
resort to printing of paper money to meet public
expenditure.
Governments have the ability to create money and
assign it legal tender qualities.
Modern Governments, however, avoid now using this
source for financing public expenditure.
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 3. Public Debt

Public debt is the loans raised by Governments and

is a source of public finance which carries with it
the obligation of repayment to the individuals,
along with interest, from whom the debt was
raised.
Importance of Public Debt
 1. Financing Economic Development
 2. Unpopularity of Taxation
 3. Facing Natural Calamities
4. Waging Wars for Defending the Nation
5. Covering Temporary Budget Deficit
6. Fighting Depression
7. Controlling Inflation
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 Sources of Public Debt
1. Borrowings from individuals;

2. Borrowings from Commercial Banks;

3. Borrowings from Non-Banking

Financial Institutions;
4. Borrowings from Central Bank;

5. Borrowings from External Sources.

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 4. Financial Administration
This category includes the preparation
of financial budget, the control and
administrations of the budget relevant
problems auditing etc.
The term budget includes ‘Annual
Financial Statements’ which
incorporates all the annual statements
of receipts and expenditures of the
government.

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 5. Economic Stabilization

Under developed countries have Z ff. features.

1. Predominantly agriculture based economy
2. Low capital formation
3. Inferior technical know how
4. Low per capital income
5. Over population and poor health and educational facilities.
6. High propensity to consume leading to low capital formation.
This category analyses the use of public finance to bring
the economic stability in the country.
It studies the use of financial policies of the Government
from the view of economic development
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 Functions of Modern Government
Government of a modern state generally undertakes the
following functions:
1. Security - Both external and internal involving outlay for
military, police and other protective services.
2. Justice or settlement of disputes
3. The regulation and control of economy – including the
services such as coinage,
a) weights and measures, the business practices , operation of
public sector
b) undertakings

4. Of social and cultural welfare through education, social relief,

social insurance, health and other activities.
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5. Conservation of natural resources.
6. Promotion of the unity of the state by control of
transportation and communication.
7. Administration and financial system, government
revenue expenditure and fiscal control.
8. Education and employment.
9. Housing.
10.Public health.
11.Up-liftment of weaker sections of the society.
12.Restore social justice in the society.
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 Fiscal Policy
Fiscal policy is also called as budgetary policy.
Fiscal policy refers to a national economic policy primarily
concerned with the receipts, and expenditures of these
receipts and expenditures.
Fiscal policy relate to those activities of the state that are
concerned with raising financial resources and spending
them.
Resources are obtained through taxation and
borrowing both within the country and from abroad.
Spending is done mainly on defense development and
administration.
It is concerned with the aggregate effects of public
expenditure and taxation on income, output and
employment.
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Fiscal policy relates to the government’s
decision making with respect to the following:
1.Taxation
2.Government spending
3.Government borrowing and
4.Management of government debt.
Fiscal policy deals quite directly with matters,
which immediately influence consumption
and investment expenditure.
Therefore, it influences the income, output
and employment in the economy.
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Role of Fiscal Policy in the Developing Economy
Allocate more resources for investment
and to restrain consumption.
Reduce the economic inequalities of
income and wealth.
Raising the level of investments and
savings.
Undertake investments in such a way
that it is most beneficial for the people of
the country.
Control inflation within tolerable levels.
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