INTRODUCTION

What does Public Finance mean?

 Earlier writers viewed public finance as a subject which discusses only the financial operations of the fisc.
According to Adam Smith’s laissez fair concept the invisible hand of the market can give the solutions to all
the problems the economy encounters. In other words, private sector can adequately tackle the problem of
capital formation and growth. Government should govern least and limit its own activities to the barest
minimum necessary. State activities were to be tolerated only as a necessary evil.
 Their definition may be stated as follows: public finance is the description of the way in which the operation
of the treasury will interfere with the working of the private sector and the way in which it can keep such
interference to the minimum.
 With the passage of time the idea of welfare state has gained currency. A modern government is now expected
to check trade cycles, reduce unemployment, bring about distributive justice, help in capital accumulation &
economic growth, remove regional disparities, provide merit goods, maintain healthy balance of payment and
keep exchange rate stable.
 Public Finance is the subject which deals with not only the way in which the public treasury operates, it also
deals with the repercussions of the different policies which the treasury might adopt and accordingly deals
with question of choice of this policies and operations.

Branches of public finance

 There are two main branches of public finance: theory of public revenue and theory of public expenditure.
 Theory of public revenue deals with
 Sources of revenue
 Forms of revenue
 Principles which should govern choice between them
 Theory of public expenditure deals with regulation of demand/supply through expenditure
 Public debt is studied separately due to its overriding importance

Comparison between public finance and private finance

Similarities
 Both are engaged in activities that involve lots of purchases, sales and other transactions.
 Both are engaged in production, exchange, savings, capital accumulation, investment and so on.
 Both lend and borrow.
 Both have limited resources at their disposal and are trying to make their best by taking decisions such that the
“most important” wants are satisfied first.
 A private individual tends to distribute his expenditure on various commodities and services so as to equalize
marginal utilities of all these expenditures. Public sector does the same.
 The adjustment of income & expenditure of both public and private finance need not be exact in any given
year.
Dissimilarities
 Individual income determines his expenditure whereas public expenditure determines necessary income. If
need (private- marriage, public- war, calamities) be adjustment may be made in opposite direction by both
private and public authority.

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  Private economic unit may resort to deficit financing only for a short period and up to a limit. The state can
resort to a policy of permanent deficit financing.
 Without repaying its earlier loans, a private economic unit loses its credit standing but the government does
not.
 On account of high creditworthiness the state can borrow at rates much lower than the private economic units
are generally able to.
 A private economic unit cannot raise non-repayable loan, but the state may do.
 A public authority may raise either an internal or an external loan. But an individual cannot raise an internal
loan.
 A public authority has the power to create currency. But an individual is not legally allowed to do that.
 Private finance follows ‘the market principle’; but public finance follows ‘the budget principle’.
 In private finance, the view taken would be a short term one. But it is not so with the state.

Major Functions/Objectives/Goals of Public Finance

 The allocation function
 The distribution function
 The stabilization function

The allocation function

 In pure public goods cases market fails entirely while in quasi-public goods cases it can function only in an
inefficient way.
 Market is a giant auction where consumers bid for products and producers sell to the highest bidders. Thus
market furnishes a signaling system whereby producers are guided by consumers’ demands. This market
principle does not apply in the public goods cases.
 In the cases of public goods and quasi-public goods exclusion principle is ineffective
 Exclusion is frequently impossible or prohibitively expensive (example-street light, air-cleaning).
 Even if exclusion is feasible it would be inefficient to exclude as MCi=0.
 It is impossible for a private producer to collect price in exchange of such goods due to the fact that
consumers will not voluntarily offer payment. Thus the linkage between producers and consumers breaks
down and government must step in to provide for such goods.
 Government has to decide
 how much of such goods is to be provided and what is the composition
 how the cost will be allocated
 How much a particular consumer should be asked to pay?
 One should pay for the benefit received. But how are these benefits valued by the recipients?
 Recipients do not want to reveal how highly they value the public services.
 “Free riders” problem gives rise to lack of finance.
 A different technique i.e. political process enters the picture as a substitute for the market mechanism to
determine the supply of social goods and the cost allocation thereof. This process involves ballot voting
instead of dollar voting

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The distribution function
 Income distribution depends on the distribution of factor endowments. The resulting pattern of distribution
involves substantial degree of inequality and thus might not be acceptable.
 Views on distributive justice differ but most would agree that some adjustments are required. Preferred
distribution depends on social philosophy and value judgment
 Egalitarianism: Everyone should be equal. There is controversy regarding the meaning of equality.
Milton Friedman supported equality of opportunity, while John Maynard Keynes supported more
equal outcomes.
 Utilitarianism (Jeremy Bentham, 1789): The welfare of the greatest number should be maximized.
This ignores the position of minority groups.
 Mini-max principle (John Rawls, 1971): The welfare of the least well-off in society should be
maximized.
 Persons have the right to the fruits derived from their endowment
 The choice among these criteria is not simple, nor is it easy to translate any criterion into corresponding
“correct” pattern of distribution.
 Fiscal instruments of distribution policy
 Income tax-transfer scheme
 Income tax used to finance public services
 Taxes on goods purchased largely by high-income consumers with subsidies to other goods, which are
used chiefly by low-income consumers.
 In choosing among alternative policy instruments, allowance must be made for resulting “dead-weight loss”.

The different functions of government are not independent. This is particularly true of allocation and distribution
functions. There is trade-off between allocative efficiency and distributional equity. In order to improve fairness in
distribution, government may have to give up some allocative efficiency. For example, taxes used to redistribute
income from the rich to the poor can distort prices and hence resource allocation, thereby reducing economic
efficiency. Where a government chooses to locate on the equity-efficiency trade-off depends upon its underlying
social preference and values. Some government will emphasize efficiency while others will have strong preference for
equity.

The stabilization function

 The economy may suffer from sustained periods of unemployment or inflation or stagflation. Unemployment
has obvious implications for social welfare. Inflation too has a number of undesirable consequences such as a
balance of payments problem, adverse changes in the exchange rate, and rising money wages. Full
employment and price stability do not come about automatically in a market economy. Stabilization, thus,
requires public policy guidance.
 Level of employment and prices depends on the level of aggregate demand relative to potential or capacity
output valued at prevailing price. Level of demand is a function of spending decisions of consumers, investors
and government. These decisions in turn depend upon many factors such as past and present income, wealth
position, credit availability, and expectations.
 Insufficient spending leads to a situation characterized by unemployment and recession. Expansionary
measures have to be taken in this situation. Excess spending, on the other hand, brings about inflationary
pressure. Policy of contraction is needed to combat this situation.
 Instruments for implementing stabilization policy are
 tax
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  government expenditure
 built-in-stabilizer

 The outcome of macroeconomic policy is highly uncertain, especially in a highly interdependent global
setting. In addition, demand management through fiscal policy results in changes in the size of the
government’s debt. These changes in the government debt have significant implications for monetary policy.
The complex interaction between the two sets of policy instruments means that they have to be considered
together.

Constraints faced by government sector

Government sector has several limitations in actively participating in economic activities.
 In many cases, the state cannot afford to provide all the goods which cannot be satisfactorily provided by
market. For example, we need to develop, on a large scale, roads, communications and other infrastructure,
education and health services, and so on. But Bangladesh government does not have enough resources to
undertake the supply of these goods and services to a satisfactory extent.
 The administrative machineries of the state are historically less efficient due to the lack of skill, statistical
information, and so on. This limitation is even more severe in the case of underdeveloped/developing
countries.
 Because of the absence of personal profit motive, there is a lack of initiative and proper system of incentives
in the public sector.
 The boundaries of government activities are subject to political atmosphere, and social traditions and attitudes.
State activities cannot run counter to these factors.

Role of public sector in different economic systems

The role of public sector in the economy is based upon relevant economic and socio-political objectives and within the
constraints of the country’s institutional framework.
In a capitalist economy, the main task of providing goods and services is assigned to the private sector in which
individual economic units are motivated by economic rationality and guided by the market mechanism in their
decision making. The owners of factors of production are guided by the income which they can earn in alternative
employments; the investors are guided by the profitability of alternative investments; the consumers try to maximize
their consumer surplus, and so on. In this arrangement, the government has only a limited role to play.
A socialist economy, on the other hand, is dominated by the state sector. In this case, economic activities and
decisions of the state are expected to be guided not by commercial profitability but by the objective of social welfare
maximization. Market mechanism is assigned, if at all, a very marginal role.
In a mixed economy, both private and public sectors play significant role in economic activities. It is argued that an
unregulated market mechanism is not a panacea. Sometimes it may provide undesirable outcomes such as
misallocation of resources, income inequality, and instability. This is the ground on which active state participation is
supported.
Islamic economy is a kind of mixed economy in which every economic decision must be based on the principles of
Islamic sharia. Interest based banking system will be replaced by a banking system based on profit and loss sharing.
Zakat will be given utmost priority. Such economy allows a substantial role of the state in economic activities.