CHAPTER - II

THEORIES OF PUBLIC EXPENDITURE AND

ECONOMIC REFORMS IN INDIA

Public Finance impacts the economy in many ways. The impact is both direct

and indirect and it is felt both in the short run and in the long run. “Attempts to do

anything through Government entail public expenditure. Public outlays have been

powerful tools for shaping societies in the past and these will have much to do with the

kind of world that will confront the individuals in the future”1. Explaining the growth

of public expenditure has always been a wide field in the science of public finance.

This chapter is divided into two parts. Part I deals with Theories of Public

Expenditure and Part II deals with Economic Reforms in India.

PART-I

THEORIES OF PUBLIC EXPENDITURE

INTRODUCTION

Public expenditure was restricted only to a small extent till 19th century due to

laissez faire policy followed by the government, as classical then believed money left in

private hands could bring better returns. Consequently, the governmental expenditure

used to be very low. So, “the classical economist did not devote much attention to the

discussion of public expenditure”2

It was only in 20th century when John Maynard Keynes pointed out the

important role of public expenditure in determining the level of income and distribution

1
Sibani Datta, (1985) “Public Expenditure and Economic Development”, Ashish Publishing House,
New Delhi, p.1.
2
Quoted by Atul Sarma & V.B.Tulsasidhar, (1984), Economic Impact of Government Expenditure,
Concept Publishing Company, New Delhi, p.7

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in the economy. Since then the governments not only perform such primary functions

as the civil administration and defence of the country, but also take considerable

interest in promoting the economic development of their respective countries.

Consequently, the expenditure of modern governments has increased so much during

recent years. Therefore, now-a-days an important place has been given to public

expenditure by the modern economists.

There are various theories of public expenditure propounded by different

economists at different times. The aim of these theories is not only to explain the

growth of public expenditure but also to find solutions to distribute the public

expenditures more efficiently and to derive the optimal size of government. Some of

the important theories of public expenditure are enumerated below.

PURE THEORY

The pure theory of public expenditure was first expounded in a consistent form

in the 1950s in three articles by Professor Samuelson. In the subsequent period the pure

theory of public expenditure gained wide renown in Western economic and financial

literature; it is part and parcel of courses on the theory of public finance.

The “pure theory of public expenditure" fully preserves the category of

governmental services but emphasizes the specific forms of the consumption of these

services. For this a special theoretical construction is introduced, the concept of the

“public good”. The main feature, distinguishing a public good from a private one, is

that consumption of a public good by a member of society does not entail any harm for

other persons, the scale of their consumption remaining unchanged. Then a more

general question arises, namely, the criteria for the choice between public and private

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goods, and, together with this, the distribution of private goods among members of

society. It can be demonstrated that there is a set of solutions which satisfy the criterion

of optimality usually employed in microeconomic models (the Pareto criterion).

To choose from this abundance of alternative decisions the best one, it is necessary to

introduce into the model a macroeconomic choice function or, following the

terminology accepted in Western economic literature, the “social welfare function”.

Principle of Maximum Social Advantage

Taxation (government revenue) and government expenditure are the two tools.

Neither of excess is good for the society, it has to be balanced to achieve maximum

social benefit. Dalton called this principle as “Maximum Social Advantage”. Economic

welfare is achieved when Benefits from Marginal Utility of Expenditure = Marginal

disutility due to imposition of taxation.

Principle of Maximum Aggregate Benefit

Maximum satisfaction should be yielded by striking a balance between

public revenue and expenditure by the government and Pigou termed it as “Maximum

Aggregate Welfare”. He explains it with respect to “Net Social Benefit” (NSB) which

is the difference between Maximum Social Benefit (MSB) and Maximum Social

Sacrifice (MSS).

Bowens model

Considering the case of only Public goods, Bowen states that if goods are

consumed by people then they themselves should provide the cost of those goods.

Satisfaction that a person gets from the same commodity will differ from person to

person. Hence, the contribution that a person will make to its cost will depend on their

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satisfaction. The more the number of times they use the good, the more will be the cost

paid by them.

MUA + MUB = MCZ

Voluntary Exchange Theory for the determination of public Expenditure

It was introduced by Swedish Economist Erik Lindhal in 1919. According to his

theory, determination of public expenditure and taxation will happen on the basis of

public preferences which they will reveal themselves. Cost of supplying a good will be

taken up by the people. The tax that they will pay will be revealed by them according to

their capacities.

WAGNER’S LAW OF INCREASING STATE ACTIVITIES

A German economist, Adolph Wagner, in his classic book, formulated a law of

expanding state activity. He asserted that there is a long run propensity for the scope of

government to increase with higher levels of economic development. Wagner’s law

states that increased public expenditure is due to the pressure of social progres.3

In brief, the law states that for growing economies, the share of all major government

expenditure increases. Wagner based this generalization on two considerations4:

a) The income elasticity of demand for services provided by the government is greater

than unity.

b) During the course of economic development, the public sector constantly

encroaches upon the private sector.

3
Quoted by S.K. Singh, Op. cit., p.33.
4
Quoted by Frederic L. Pryor (1965), “East and West German Governmental Expenditures”, Public
Finance, Vol. XX, No. 3-4, p.303

17
 In trying to demonstrate the first consideration Wagner divided government

expenditure into two types: i) those dealing with justice and power functions (internal

and external security) and ii) those dealing with cultural and welfare functions

(socio-cultural and economic expenditures)5.

Considering the justice and power functions Wagner argued that higher levels

of economic development increase the strains of living and induce higher criminality;

thus increasingly larger public expenditures are needed to control such crime.

Furthermore, higher levels of economic development being increasingly complicated

trade and legal relations, which in turn, requires increasing arbitration on the part of the

state. On an international level, military forces cast off their former aggressive aspects

and assume a preventive role, which requires larger standing armies.

Concerning the cultural and welfare functions, Wagner stated that increasingly

larger expenditures on education and public health are needed with higher per capita

national products. Consumption of cultural services grows faster than the GNP as the

basic housing nourishment and clothing needs of population are increasingly met.

Expenditure on governmental administration rise faster than the GNP with the

increasing extensions of the functions of government and with the increasing

bureaucratization of the state.

About the second consideration namely, public sector encroaching upon the

private sector, Wagner argued that the encroachment of public sector upon private

sector is i) due to consolidation of state powers and ii) due to break down in the market

5
Ibid, p.303

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mechanism in producing certain goods and services which brings about the state

intervention.6

Wagner suggested that the inevitable changes in technology and the increasing

scale of investment required in many activities would create an increasing number of

large private monopolies whose effects would have to be offset, or the monopolies

taken over by the state in the interest of the economic efficiency.

WISEMAN-PEACOCK HYPOTHESIS

Wiseman-Peacock (1961) based their hypothesis on the analysis of public

expenditure in U.K for a period of 65 years from 1890 to 1955. They postulated that

“Public expenditure tends to increase by sharp jerks in a step-wise manner rather than

continuously and smoothly”.7 When revenue constraints dominate, the growth of

expenditure is restrained. The public expenditure increases and makes the inadequacy

of the present revenue quite clear to everyone. The movement from the older level of

expenditure and taxation to a new and high level is the “Displacement Effect”.

The inadequacy of the revenue as compared with the required public expenditure

creates an “Inspection Effect”. The government and the people review the revenue

position and the need to find a solution of the important problems that have come up

and agreed to the required adjustments to finance the increased expenditure. They attain

a new level of ‘tax tolerance’. They are now ready to tolerate a great burden of taxation

and as a result the general level of expenditure and revenue goes up. In this way, the

public expenditure and revenue get stabilized at new level till another disturbance

occurs to cause a ‘Displacement Effect’

6
Frederic L. Pryor., Op.Cit., p.304
7
Jack Wiseman and Allan T. Peacock(1961), “The Growth of Public Expenditure in the United
Kingdom,” National Bureau of Economic Research, Princeton University Press, p.14

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 In addition to the displacement and inspection effects, Peacock and Wiseman

also describe a ‘concentration effect’. Each major disturbance leads to the government

assuming a large proportion of the total national economic activity, the net result is the

‘concentration effect’. The concentration effect also refers to the apparent tendency for

central government economic activity to grow faster than that of the state and local

level governments. Thus Peacock-Wiseman approach to government spending trends is

much more modest in what it purports to explain than in Wagner’s hypothesis.

COLIN CLARK HYPOTHESIS

Colin Clark in his “Public Finance and Changes in the Value of Money” puts

forth what he calls the ‘Critical Limit Hypothesis’ regarding tax tolerance. Colin Clark

based this hypothesis on the inter-war data of several western countries. The hypothesis

is that when the share of the government sector exceeds 25 per cent of the total

economic activity of the country, inflation occurs even under balanced budget.8

To support his contention, he argues that when the government share of the

aggregate economic activity reaches the critical limit of 25 per cent, the income earners

are so affected by reduced incentives (due to high tax incidence) that their productivity

suffers. They produce much less than what they are capable of, leading to a curtailed

supply. On the other hand, demand effects of the government financing become quite

even if the budget remains balanced. All told, inflation results from this maladjustment

between demand and supply. The basic defect of Clark’s hypothesis is its reliance on

the institutional frame work of the economy, and the choice of a definite figure (25%)

as the critical limit.9

8
Colin Clark (1945), “Public Finance and Changes in the Value of Money”, Economic Journal,
December, pp.371-389
9
Quoted by H.L. Bhatia (1980), Public Finance, Vikas Publishing House Pvt. Ltd., New Delhi,
pp. 217-218

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 It would have been more acceptable to assert that in a market economy,

increasing state activity leads to mounting inflationary pressures. Moreover, whether or

not government’s budgetary activities would lead to inflation also depends upon the

manner in which public expenditure is incurred.

WAGNER SQUARED HYPOTHESIS

Buchanan and Tullock (1977) examined Wagner’s thesis with U.S data. But

they related public expenditure to the output of public goods alone. They observed

discrepancies between the growth of expenditure and the growth of output, which they

designed as ‘Wagner Squared Hypothesis’. They base their argument on two facts.

Firstly, more rapid growth of expenditure on administration than that on the output of

state activities; Secondly, increasing proportion of population covered by social

security and other transfer payments.

But limitations of these twin hypotheses stem from the general difficulty of

measuring the output of public administration. Output of public and merit goods is

often measured by cost which itself depends on expenditure on particular items.10

Alan Tait Peacock does not argue with this explanation of Buchanan and

Tullock. He says that a typical individual does not relate his tax payments with the

receipts of government services. He considers his tax liabilities as they are and strives

for additional opportunities for making government services and not for reducing taxes.

The politicians, to win their votes, try to expand government services and therefore

impose more taxes. The government expenditure keeps on increasing without any

reference to productivity cost of government services.

10
Shri Prakash and Sumitha Chowdhury, Op.cit., pp.32-33.

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THEORY OF PUBLIC CHOICE

Public Choice11 is based on the new classic contributions by writers such as

Kenneth J. Arrow, Anthony Downs, James Buchanan, Gordon Tullock, Mancur Olson

and William Niskanen with Joseph Schumpeter as an important forerunner. Application

of public choice theory covers almost all areas in economics, especially public finance

as epitomized in the ‘calculus of consent’ developed by James Buchanan.

Public Choice approach seeks to analyze political processes and the interaction

between the economy and the polity by using the tools of modern neo-classical

analysis. It provides an explicit study of the working of the political institutions and the

behavior of governments, parties, voters, interest groups and bureaucracies. Public

choice is part of an endeavour to apply the ‘rational behaviour’ approach to areas

beyond the bounds of traditional economics.

Public Choice theory is characterized by two main features. Most basically, the

individual is taken as the unit of analysis. He is assumed to be ‘rational’ in the limited

sense of responding in a systematic and hence predictable, way to incentives; he

chooses courses of action that yield the highest net benefits according to his own

evaluation (utility function)

The second feature of public choice approach is that the behavior of an

individual is explained by concentrating on changes in the constraints to which he is

exposed. Changes in behavior are not attributed to (unexplained) shifts in preferences.

Individuals are assumed to be capable of comparing alternatives, seeking substitution

possibilities and making marginal adjustments without losing sight of the maximization

principle.

11
Quoted by David N. Hyman, Op.cit., p.157

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 The government may be assumed to pursue certain ideological goals but it is

subject to a variety of constraints. The extent to which these constraints restrict the

government depends on the structure of the economy and the prevailing economic

conditions. Public expenditure needs to be financed by tax revenue. If public

expenditure is increased on social welfare programmes it releases two diametrically

opposite reactions in the electorate: the beneficiaries extol the government which has

increased their welfare; the tax payers who have to foot the bill have reservation about

returning the party in charge of the government to power. The government has perforce

to weigh the intensity of the two reactions and accordingly keeping self-interest always

in view without unduly sacrificing the interest of the state.12

POSITIVE THEORY OF PUBLIC EXPENDITURE

The positive theory or behavioural theory of public expenditure is “that body of

economic and political analysis which attempts to understand and explain the observed

pattern and level of government expenditures and the changes in those expenditures

over time”13

In short, positive theory explains the things as it is. The concern of this positive

theory is thus very different from that of the extensive recent literature dealing with

cost-benefit analysis and other techniques related to the efficiency with which

government expenditure programmed are executed. Like the theory of public goods, the

cost-benefit and program-budgeting discussion is really concerned with how

government should do things rather than with why government does and what it does.

12
Quoted by D.T. Nanje Gowda (1988), Public Expenditure Under Planning - A Case Study of
Karnataka, Indus Publishing Company, New Delhi, pp.vi-vii.
13
Richard M.Bird (1970), The Growth of Government Spending in Canada, Canadian Tax
Foundation, Toranto, p.6

23
 Positive economics is objective and fact based. Positive statements must be able

to be tested and proved or disproved by examining the actual data prevailed in the

country.

NORMATIVE THEORY OF PUBLIC EXPENDITURE

The modern theory of public good as conventionally formulated is basically

concerned with three separate problems. (1) The requirements for the optimal provision

of a public good .(2) The demonstration that the private market will fail to provide the

optimal amount of such goods and (3) The problem of whether a political mechanism,

which will perform this task properly, can be devised. Most of the recent literature on

the subject has been concerned with the first two of these problems. Public goods

theory therefore is essentially normative in nature.

The normative theory of public expenditure is concerned primarily with

establishing the requirements for achieving the optimal provision of certain goods and

services. Writers in this field have therefore not usually been concerned with explaining

what governments in fact do rather with what they should do, under certain

assumptions if they want to allocate economic resources efficiently, so as to make it

possible to maximize ‘social welfare’.

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 PART-II

ECONOMIC REFORMS IN INDIA

INTRODUCTION

India is a Federal State, the Union-State financial relations are based on the

principle of federal finance. In a federation, there is constitutional division of powers,

functions and resources between the Central and the State governments. The two sets of

governments are independent so far as their own functions and resources are concerned.

But, being a part of the federal system, central government policies have influenced, to

an extent, states’ finances. In early 1990, a major economic crisis surfaced in India.

Almost all states in India have also witnessed a secular deterioration in their fiscal

balances. In the reform period, beginning from mid-1991, Central Government’s

several reform measures have also adversely impacted States’ budgets.

ECONOMIC CRISIS IN INDIA

The economic crisis of Indian economy did not develop suddenly. “The origin

of the crisis is directly attributable to the cavalier macro management of the economy

during the 1980s which led to large and persistent macro economic imbalances”.14

The Gulf Crisis in the late 1990 sharply accentuated macro economic problems in

India. The rate of inflation also climbed which was certainly a cause for concern.

The gross fiscal deficit of India which was 5.1 per cent of GDP in 1981-82, rose to 7.8

per cent in 1990-91. Since this fiscal deficit had to be met by borrowings, the internal

debt of the Central government increased rapidly, rising from 33.3 per cent of GDP at

the end of 1980-81 to 49.7 per cent of GDP at the end of 1990-91. How alarming this

fiscal situation was can be realized from the fact that in 1990-91 interest payments had

14
V.K Puri, and S.K Misra (2016), “Indian Economy - Its Developing Experience” Himalaya
Publishing House Pvt. Ltd., Mumbai, p.745.

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eaten up 39.1 per cent of the total revenue collections of the Central Government.

According to Deepak Nayyar, “The internal imbalance in the fiscal situation and the

external imbalance in the payments situation were closely related, through the absence

of prudence in the macro management of the economy”.15

FISCAL CRISIS OF STATE GOVERNMENTS

In a liberalised economic environment, state governments will have to play a

relatively more important role than in the past. While the expenditure commitments of

the state governments are likely to increase, they are faced with a relatively hard budget

constraint. They do not have independent borrowing powers; the volume of their

borrowing is determined by the Union Ministry of Finance and the Planning

Commission in consultation with the Reserve Bank of India. One subset of fiscal

deficits is revenue deficit which takes into account only the revenue expenditures and

revenue receipts. Fiscal deficits are being driven more and more by deficits on revenue

account. That is, the principal cause of states’ budgetary problems has been the high

and accelerating growth of current expenditures. Since Central Government itself is

faced with a difficult fiscal situation, the prospect of obtaining a larger share of central

revenues than in the past by way of transfers does not appear to be bright either.

ECONOMIC REFORMS IN INDIA

To tackle the problems emanating from the crisis, the government of India

introduced reforms. In the words of Seema Joshi, “The Indian economy grew at a

comparatively low rate of growth of 3.5 per cent from 1950 to 1980. The plethora of

procedures, permits, bureaucratic controls and protectionist policies created under

Import Substitution Strategy (ISS) along with other factors landed us into the economic

15
Deepak Nayyar (1993), “Indian Economy at the Crossroads – Illusions and Realities”, Economic
and Political Weekly, Vol. 28, No.15 April 10, p.639.

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crisis of 1991 which was reflected in macro economic mismanagement of the economy

judged from such parameters as high fiscal deficit, high balance of payment deficit,

double digit inflation, low forex reserves, etc. An attempt was made to resolve this

crisis through programme (SAP) / economic reforms.”16

“The term economic reforms is used to describe significant changes in a

sizeable number of economic policies as part of a package of policy changes”.17

“We have used the term economic reforms to indicate all the measure falling under the

stabilisation programme as well as the structural adjustment programme”.18

Structural Adjustment Policies are economic policies which countries must

follow in order to qualify for new World Bank and International Monetary Fund (IMF)

loans and help them make debt repayments on the older debts owed to commercial

banks, governments and the World Bank. Although economic reforms are designed for

individual countries but have common guiding principles and features which include

export-led growth; privatisation and liberalisation; and the efficiency of the free market.

Economic reforms generally require countries to devalue their currencies against the

dollar; lift import and export restrictions; balance their budgets and not overspend; and

remove price controls and state subsidies.

The reform process has necessarily to express itself as changes in specific

policy areas affecting the economic system. The policy areas are: Fiscal Policy,

Monetary Policy, Capital Market Policy, Trade Policy, Exchange Rate Policy,

Industrial Policy and Foreign Investment Policy, and Public Sector Policy. Of these

16
Seema Joshi (2006), “Impact of Economic Reforms on Social Sector Expenditure in India”,
Economic and Political Weekly, Vol.41, No.4, January 28, p.358.
17
R.H. Bates, and Anne O. Krueger, (1993), “Political and Economic Interactions in Economic
Policy Reform”, Oxord, Blackwell Publications, p.5.
18
K Seeta Prabu, (2001). “Economic Reform and Social Sector Development: A Study of Two
Indian States”, Sage Publications, New Delhi, p.31.

27
Fiscal Reforms are the integral and perhaps the most critical part of the overall

economic reforms program.

“In the financial sector, there is a need to bring down the fiscal deficit and also

the rate of inflation and interest rates. The fiscal deficit has to be brought down both by

augmenting revenues and also by curtailing government expenditure through measures

like reducing subsidies and downsizing of bureaucracy. The financial crisis affecting

the state governments is more severe than that affecting the centre. But the basic

reforms that are required are similar in both cases – resource mobilization efforts and

austerity.”19

“The fiscal deficit of the Central government could be easily cut by pursuing a

discreet taxation policy. But the overall economic reform policy did not permit the

government to follow this route. The burden of the fiscal deficit correction fell on

public expenditure management.”20

The World Bank and the IMF argue that economic reforms are necessary to

bring a developing country from crisis to economic recovery and growth. The resulting

national wealth will eventually "trickle down" or spread throughout the economy and

eventually to the poor.

Over the last 25 years, these economic reforms have generated an intense debate

and considerable popular resistance. The desirability of the reforms and their effects

remain contentious issues, and opinions continue to be divided. Kirit Parikh opines

“…The reforms have put the Indian economy on a higher growth path……..with more

sensible policies, we have an opportunity to accelerate our growth further and take off

19
K.P.L Mathur (2001), “India: Fiscal Reforms and Public Expenditure Management”, JBIC Research
Paper No.11, Sep, pp.71.
20
V.K. Puri and Misra, Op. cit., p.637.

28
into a high growth trajectory”21. Whereas Arun Ghosh believes “…. In no sector or

manner has the new economic policy succeeded”.22

CONCLUSION

The literature on Indian Economy is flooded with reviews of its economic

reforms particularly during the nineties. An important area of concern expressed in

most of the studies focusing on social welfare in India has been the cut in public

expenditure, particularly social sector expenditure and capital expenditure.

The objective of the present paper is to analyse the impact of economic reforms on

expenditure pattern of southern states with special reference to Tamil Nadu. Generally

‘before’ and ‘after’ approaches are used for analysing the impact of economic reforms.

In order to examine the impact, the study look at the trends in some indicators like

compound annual growth rate, volume of state activity and income elasticity in pre and

post reform periods.

21
Parikh, Kirit (1997), “India’s Economy: Poised for Take-Off”, Economic and Political Weekly,
Vol.32, Nos.20-21, May 23-30, p.1151.
22
Ghosh, Arun (1997), “Budget 1997-98: Underlining NEP”, Economic and Political Weekly, Vol.32,
Nos.20-21, May 23-30, p.1139.

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