Nature and Scope of Public Finance

Public Finance-Meaning:

According to Findley Shirras, “Public finance is the study of the

principle underlying the spending and raising of funds by public
authorities”.

Carl Plehn regards Public finance as, “The science which deals with the
activity of the statesman in obtaining and applying the material means
necessary for fulfilling the proper functions to the state”.

According to Hugh Dalton, “public finance is concerned with the

income and expenditure of public authorities, and with the adjustment of
the one to the other”.

It is a branch of economics which deals with income and expenditure of

government of a country. The function of public authorities are simply
revenue raising and revenue spending for covering the cost of
administration and defense in the days of early economists. But modern
states have to perform various functions to promote the welfare of the
people. Therefore, the public finance includes the study of financial
administration as well as of financial control.

According to Professor Bastable, "public finance is a branch of

economics which deals with income and expenditure of public
authorities or the state and their mutual relation as also with the financial
administration and control."

Scope of Public finance:

The scope of public finance covers a full discussion of the influence of
government’s fiscal operations at the level of overall activity,
employment, prices and growth process of the economic system as a
whole.

Prof. Taylor states, “Public finance deals only with the finances of
government include the raising and disbursement of government funds.

According to Musgrave, “the scope of public finance embraces the

following three functions of the government’s budgetary policy confined
to the fiscal department:
i).The allocation branch
ii).The distribution branch
iii).The stabilization branch

These refer to three objectives of the budgetary policy, i.e. the use of
fiscal instruments.

i) To secure adjustments in the allocation of resources.

ii) To secure adjustments in the distribution of income and wealth, and
iii) To secure economic stability.

The scope of public finance may be divided into following four parts:
1) Public Revenue
2) Public Expenditure
3) Public Debt
4) Financial Administration

Distinction between private and public finance:

Public finance is used for the benefit of the people of an economy while
the private finance is used for the benefit of an individual or his family.
Public finance and the private finance are differentiated as under:

1. Adjustment of income and expenditure: a government first prepares

an estimate of expenditure and then means to raise that sum and the
individual must adjust his expenditure to his income.
2. Budgeting: the unit for the public budget is one year but an individual
needs not balance his budget during a given period.

3. Deficit financing: deficit financing is a peculiar privilege of

government but an individual cannot do it, unless he is prepared to go
behind the bars.

4. Different objectives: an individual tries to maximize his satisfaction or

profit from a given amount of resources but the objective of government
expenditure is to maximize social benefit.

5. Publicity of finance: budgets are published and the widest publicity is

given to them. On the other hand, the secrecy surrounds individual
finance.
6. Coercion: a government has to pass a law and compel the citizen to
pay a tax while an individual lacks the coercive authority.

Public goods vs. private goods:

The characteristics of pure public goods are:

• Non-excludability: The benefits derived from the provision of pure

public goods cannot be confined to only those who have actually
paid for it. In this sense, non-payers can enjoy the benefits of
consumption at no financial cost to themselves – this is known as
the “free-rider” problem and it means that people have a
temptation to consume without paying.
• Non-rival consumption: Consumption of a public good by one
person does not reduce the availability of a good to everyone else –
therefore we all consume the same amount of public goods even
though our tastes and preferences for these goods (and therefore
our valuation of the benefit we derive from them) might differ

Examples of Public Goods:

There are relatively few examples of pure public goods. Examples of
public goods include flood control systems, some of the broadcasting
services provided by the BBC, public water supplies, street lighting for
roads and motorways, lighthouse protection for ships and also national
defense services.

A private good or service has three main characteristics:

1. Excludability: Consumers of private goods can be excluded from

consuming the product by the seller if they are not willing or able
to pay for it. For example a ticket to the theatre or a meal in a
restaurant is clearly a private good. Another example is the
increasing use of “pay-per-view” as a means of extracting payment
from people wanting to watch exclusive coverage of sporting
events on television or the payment required to travel on a toll-road
or toll-bridge. Another example of a private good is the use of
subscription-based services on the internet. Excludability gives the
service provider (the seller) the chance to make a profit from
producing and selling the product. As we shall see, with public
goods, such excludability does not exist. When goods are
excludable, the owners can exercise property rights.
2. Rivalry: With a private good, one person's consumption of a
product reduces the amount left for others to consume and benefit
from - because scarce resources are used up in producing and
supplying the good or service. If you order and then enjoy a pizza
from Pizza Hut, that pizza is no longer available to someone else.
Likewise driving your car on a road uses up road space that is no
longer available at that time to another motorist. The greater the
volume of traffic on the roads, the higher the likelihood of traffic
congestion which has the effect of reducing the average speed and
increasing the average journey time for each road user.
3. Rejectability: Private goods and services can be rejected - if you
don't like the soup on the college or school menu, you can use your
money to buy something else, or you can choose not to buy a
season ticket for your local soccer club and instead use the money
 to finance a subscription to a local health club. All private goods
and services can be rejected by the final consumer should their
tastes and preferences change.

Public goods and market failure:

Why is there market failure with public goods? The main reason is that
private sector producers will not supply public goods to people because
they cannot be sure of making an economic profit. This is due to the
characteristics of public goods outlined earlier. Consumers can take a
free ride without having to pay for the good or service. The obvious
solution is that these goods are provided collectively by the government,
and then financed through taxation of individual households and
businesses.

The Principle of maximum social advantage:

The 'Principle of Maximum Social Advantage (MSA)' is the

fundamental principle of Public Finance. 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 MU (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:-

1. All taxes result in sacrifice and all public expenditures lead to

benefits.
 2. Public revenue consists of only taxes and no other sources of
income to the government.
3. The government has no surplus or deficit budget but only balanced
budget.
4. 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. As a result of diminishing stock of money, the marginal
utility of money goes on increasing. Eventually 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.

The Marginal social sacrifice is illustrated in the following diagram:-

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 imposition of tax puts 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 are made available to him, the
social benefit from each additional unit of public expenditure declines as
more and more units of public expenditure are spent. In the beginning,
the units of public expenditure are spent on the most essential social
activities. Subsequent doses of public expenditure are 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 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:

Social advantage is maximized at the point where marginal social

sacrifice cuts the marginal social benefits curve.

This is at the point P. At this point, the marginal disutility or social

sacrifice is equal to the marginal utility or social benefit. Beyond this
point, the marginal disutility or social sacrifice will be higher, and the
marginal utility or social benefit will be lower.
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
unit of revenue raised and spent by the government leads to 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 the 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 marginal
social benefit P2Q2. Therefore, beyond the 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 marginal social benefit of public expenditure is equal to the
marginal social sacrifice of taxation.

Maximum Social Advantage is achieved at the point where the marginal

social benefit of public expenditure and the marginal social sacrifice of
taxation are equated, i.e. where MSB = MSS.

This shows that to obtain maximum social advantage, the public

expenditure should be carried up to the point where the marginal social
benefit of the last rupee or dollar spent becomes equal to the marginal
social sacrifice of the last unit of rupee or dollar taxed.

Market failure:

An economic term that encompasses a situation where, in any given

market, the quantity of a product demanded by consumers does not
equate to the quantity supplied by suppliers. This is a direct result of a
lack of certain economically ideal factors, which prevent equilibrium.

A market is an exchange institution that serves society by organizing

economic activity. Market use prices to communicate the wants and
limits of a diffuse and diverse society so as to bring about coordinated
economic decisions in the most efficient manner. Market work well
when prices reflect all values. ‘Market Failure’ occurs when some costs
and/or benefits are not fully reflected in market price. For environmental
assets, market can fail if prices do not communicate society’s desire and
constrains accurately. Price often understate the full range of services
provided by an asset, or do not exist to send a signal to the market place
about the value of asset. Market failure occurs when private decisions
based on these prices or lack of them; do not generate an efficient
allocation of recourses. Efficiency is defined as Pareto optimality – the
impossibility of reallocating resources to make one persons better off
without making anyone else worse off.
The market system fails to function properly for many kinds of
environmental goods because such resources including the services they
provide are often not traded in market. Market failure can occur due to
any or all of the following:

Lack of or weak property rights.

Public goods and/ or common property characteristics.

Externalities and

Asymmetric information

Weakness of the free market economy:

The very basic problem with a free market economy is that it is based on
Greed and not Need.

"Free-trade agreements”:-

They are usually far, far from that: the bigger country gets open access
and often even more market-share without the smaller country getting
commensurate treatment and markets in the bigger country.

"Level-playing field":-

There is no such thing: in a free market economy the stronger economy

tilts the playing field in its favour and ensures that the weaker is playing
up a slope or kicking into the wind, together with an umpire biased
against it.

Role of the government:

Stabilization and Growth: Perhaps most importantly, the government

guides the overall pace of economic activity, attempting to maintain
steady growth, high levels of employment, and price stability. By
adjusting spending and tax rates (fiscal policy) or managing the money
supply and controlling the use of credit (monetary policy), it can slow
down or speed up the economy's rate of growth -- in the process,
affecting the level of prices and employment.
For many years following the Great Depression of the 1930s, recessions
-periods of slow economic growth and high unemployment-were viewed
as the greatest of economic threats. When the danger of recession
appeared most serious, government sought to strengthen the economy by
spending heavily itself or cutting taxes so that consumers would spend
more, and by fostering rapid growth in the money supply, which also
encouraged more spending. In the 1970s, major price increases,
particularly for energy, created a strong fear of inflation -- increases in
the overall level of prices. As a result, government leaders came to
concentrate more on controlling inflation than on combating recession
by limiting spending, resisting tax cuts, and reining in growth in the
money supply.

Ideas about the best tools for stabilizing the economy changed
substantially between the 1960s and the 1990s. A period of high
inflation, high unemployment, and huge government deficits weakened
confidence in fiscal policy as a tool for regulating the overall pace of
economic activity. Instead, monetary policy -- controlling the nation's
money supply through such devices as interest rates -- assumed growing
prominence. Monetary policy is directed by the nation's central bank,
known as the Reserve Bank of India, with considerable independence to
evolve its policy frame from time to time.

Summary:

Public finance is concerned with the income and expenditure of public

authorities, and with the adjustment of the one to the other. It is a branch
of economics which deals with income and expenditure of government
of a country. The scope of public finance embraces the following three
functions of the government’s budgetary policy confined to the fiscal
department; the allocation, the distribution and the stabilization. The
scope of public finance may be divided into following four parts:
1).Public Revenue, 2).Public Expenditure, 3).Public Debt and
4).Financial Administration. Public finance is used for the benefit of the
people of an economy while the private finance is used for the benefit of
an individual or his family. The characteristics of pure public goods are
(1).Non-excludability (2). Non-rival consumption. The private good or
service has three main characteristics: Excludability, Rivalry and
Rejectability. The main reason is that private sector producers will not
supply public goods to people because they cannot be sure of making an
economic profit.

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 MU
(Marginal Utility) of expenditure is equal to the Marginal Disutility or
the sacrifice imposed by taxation. 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.
The benefit conferred on the society, by an additional unit of public
expenditure is known as Marginal Social Benefit. Maximum Social
Advantage is achieved at the point where the marginal social benefit of
public expenditure and the marginal social sacrifice of taxation are
equated, i.e. where MSB = MSS.

‘Market Failure’ occurs when some costs and/or benefits are not fully
reflected in market price. Market failure occurs when private decisions
based on these prices or lack of them; do not generate an efficient
allocation of recourses. Market failure can occur due to any or all of the
following: lack of or weak property rights, public goods and/ or common
property characteristics, externalities, asymmetric information and
Weakness of the free market economy.

Modern governments by adjusting spending and tax rates (fiscal policy)

or managing the money supply and controlling the use of credit
(monetary policy), it can slow down or speed up the economy's rate of
growth in the process, affecting the level of prices and employment.

I. FAQs
1. Define ‘public finance’.

2. Bring out the scope of public finance.

3. Distinguish between public finance and private finance.

4. What are the characteristics of public goods?

5. What are the characteristics of a private good?

6. Bring out the role of government in stabilizing the economic growth.

7. What is ‘Market failure’? Why it occurs?

8. Explain the ‘principle of Maximum Social Advantage (MSA).
9. Where exactly (at which point) MSA is achieved?
10. On what assumptions the principle of MSA depends?

II. Quiz

1. Non-rival in consumption is a characteristic of ---------- goods.

A) private goods b) public goods
c) consumer goods d) producer good

2. Excludability in consumption is a characteristic of -------- goods.

a) durable good b) consumer good
c) private good d) public good
3. The additional burden (marginal sacrifice) resulting from an additional
unit of taxation goes on --------------.

a) decreasing b) increasing

c) evaded d) avoided

4. ‘Market Failure’ occurs when some costs and/or benefits are not fully
reflected in ------------.

a) Market price b) Profit

c) Investment d) Sacrifice

5. ------------- is achieved at the point where MSB=MSS.

a) Marginal Social Loss b) Maximum Social Advantage

c) Maximum Social Sacrifice d) Maximum social disadvantage

Answers:

1. Public goods
2. Private goods
3. increasing
4. market price
5. Maximum Social Advantage

Reference:

B.P. Tyagi, “Public Finance”.

Hugh Dalton, “Public Finance”

Ackley, G. (1978), Macroeconomics : Theory and Policy, Macmillan Publishing
Co., New York.
Bhargava, R.N. (1971), The Theory and Working of Union Finance in India,
Chaitanya

Publishing House, Allahbad.

Gupta, S.B. (1994), Monetary Economics, S. Chand & Company, New Delhi.

Houghton, E.W. (Ed.) (1988), Public Finance, Penguin, Baltimore.

Jha, R. (1998), Modern Public Economics, Routledge, London.

Mithani, D.M. (1981), Macroeconomic Analysis and Policy, Oxford & IBH, New
Delhi.

Mithani, D.M. (1998), Modern Public Finance, Himalaya Publishing House,

Mumbai.

Musgrave, R.A. and P.B. Musgrave (1976), Public Finance in Theory and Practice,
McGraw

Hill, Kogakusha, Tokyo.

Shapiro, E. (1996), Macroeconomic Analysis, Galgotia Publications, New Delhi