Public Finance

Public Finance

“ The task of economic stabilization requires

keeping the economy from straying too far
above or below the path of steady high
employment. One way lies inflation, and the
other lies recession.
Flexible and vigilant fiscal and monetary
policy will allow us to hold the narrow middle
course.” (US president John F. Kennedy 1962)
 The Concept Of Public Finance

• Public finance is a study of income and

expenditure of the government at the central,
state, and local levels.
• Government has to perform certain functions in a
country such as to supply certain public or
collective goods which individuals cannot or do
not singly perform. And this is the responsibility of
the government to provide those goods for which it
needs revenue.
 The Concept Of Public Finance

• In the narrow sense, public finance is defined only

as the study of income and expenditure of the
government.
• But the broader view is that public finance does
not deal only with the income and expenditure of
the government but also the sources of income and
the way of expenditure of various government
corporations, public companies, and quasi
governmental ventures.
The Concept Of Public Finance
 The Concept Of Public Finance
Public finance is composed of the following
constituents:
1. Public Expenditure: wages and salaries; subsidies
and transfers; expenditure on goods and services
such as infrastructures like road, electricity,
telecom, and human capital accumulation like
health and education; interest expenditure etc.
2. Public Revenue: Different sources of government
revenue with major focus on tax revenue.
3. Public Debt: Often public revenue falls short of
expenditure and government has to borrow from
internal and external sources.
Public Expenditure
Public Revenue
Public Debt
 The Concept Of Public Finance
Public finance is composed of following
the constituents:
4. Public financial administration: As Walter
Bagehot remarks money cannot manage itself,
an efficient, energetic and scientific
management is required to look after the public
expenditure, public revenue and public debt.
What are the authorities, institutions, agencies to
look after the management, control, and
scrutinizing work created by government? How do
they keep check on the use and misuse of fund?
Answer to all these questions relate public financial
administration.
Public Financial Administration
 The Concept Of Public Finance
Public finance is composed of the following
constituents:
5. Economic stabilization and economic growth:
Maintaining stability and promoting
balanced sustainable growth through the
functions mentioned above is another
constituent of public policy.
Economic Stabilization And Economic
Growth
 Role of The Government
Role Of The Government
• Promotion of human capital accumulation
• Provision of essential public goods
• Decentralization
• Facilitating and regulating the private sector for
promoting industries, financial institutions, and
building infrastructures.
• Protections of individual liberties
• Private rights to land and capital
• Good courts and legal systems
• Representative political systems
In the absence of the government intervention, high
rates of unemployment can persist for long periods

Price level
Aggregate Supply

Aggregate Demand
Output (GDP)
Y YF
Markets may tolerate equilibrium output (Y)
less than full employment output (YF)
 How Does Government Work?
With policy:
• Macroeconomic policy
• Fiscal policy
• Monetary policy
• Infrastructure investment
• Microeconomic policy
• Social investment and labour policy
• Industrial policy
• Competition policy
 Government Budgeting
• Derived from Latin word „Bague‟ and French
word „Bougette‟. „Bougette‟ means small leather
bag.
• Budget provision initially introduced in the UK.
In 1733, the then Chancellor of Exchequer
Walpole came with the leather bag in the
parliament to present the annual statement of
income and expenditure, and when he opened bag
people used the term he is opening the budget.
Thus, the term budget became popular.
Government Budgeting
 Government Budgeting

• Budget is a financial statement of the

government comprising expenditures and
revenues for a year. It is both economic as
well as political document. It is a mirror to
look into development activities undertaken
by the government, which sets a framework
for policy formulation and implementation.
Budget document is a good source of public
information on past activities, current
decisions, and future prospects.
Government Budgeting
 Government Budgeting
• A good budget document contains:
• (a) overall development policy,
• (b) size and composition of revenue and
expenditure, and policy,
• (c) size and composition of external and
internal borrowings, and policy,
• (d) whether budget is deficit or surplus and how
is deficit covered and surplus disposed of ?
• (e) actual of the previous year, revised estimates
of the current year and estimates for the next
fiscal year.
 Government Budgeting
• The main components of budget are government
expenditures and government revenues. The
expenditures are classified into:
• (a) object classification,
• (b) functional classification
• (c) economic classification.
• The object classification includes expenditure on
personal compensation and benefits; travel and
transportation of persons and things;
communication, utilities and rent; printing and
reproduction; supplies, and materials; equipment;
grant subsidies and contributions; insurance claims
and indemnities, and reimbursable etc.
Government Budgeting
 Government Budgeting
 Functional classification is comprised of
expenditures on general public services and
economic services. The general public services
include: expenditure on defense, education, health,
social security and welfare, housing and community
amenities, and other community and social services.
Likewise, economic services consist of expenditures
on agriculture, mining, manufacturing, electricity
roads, water transport, railways, communications,
interest on the public debt and so on.
 Government Budgeting
 Economic classification consists of:
 (a ) current expenditures,
 (b) capital expenditure, and
 (c) principal repayment.
The current expenditures include expenditures
on goods and services such as wages and
salaries, other purchases of goods, interest
payments, subsidies and other current transfers.
Capital expenditures include acquisition of new
and existing fixed assets, purchase of stocks
(inventories), purchase of land and intangible
assets, and capital transfers.
 Government Budgeting
Revenues are classified into: tax and non-tax
revenues.
 Tax revenues constitute both direct and indirect
taxes. The premier direct taxes are on net income,
property, and capital gains. Major indirect taxes
include taxes on goods and services (VAT, excise etc),
taxes on international trade and transactions (export
and import duties).
 Non tax revenues constitute income from public
enterprises, sales of government property,
administrative fees, fines, penalties and royalties
etc.
Elements Of Budget
 Government Budgeting
• Elements Of Budget:
• Close to reality: despite being an estimate, it should be
based on reality primarily on the basis of the
experience of the previous year.
• Simple and obvious: Since this is a public document,
all who are interested should easily get the required
information after looking on it.
• Flexibility: Not only income and expenditure estimates
are there but also the policies and programs of the
government. Thus, should have the quality of
flexibility.
 Government Budgeting
• Elements of budget:
• Single fund: A single fund of the government
should be established there for all revenues and
expenditures.
• Extensive: Should be in detail about each
•item of revenue and expenditure.
• Publicity: it is made public and all the
stakeholders are free to comment on this.
• Annularity: Prepared for one fiscal year.
 Government Budgeting
•Principles of budget:
• Balanced budget principle: Classical
economists opine that government budget
should be balanced that means
expenditure (G) should be equal to revenue
(T). If not followed, either government has
to borrow internally or externally or has to
increase the tax. Supporters of balanced
budget argue that unbalanced budget
creates disturbances in economy.
Principles of Budget
 Government Budgeting
•Principles of budget:
• Principle Of Unbalanced Budget: A budget
deficit is incurred when expenditures exceed
taxes and other revenues for a year. And a
budget surplus occurs when all taxes and other
revenues exceed expenditures for a year. Though
unbalanced means both surplus or deficit budget, a
number of economists refer to deficit budget as
unbalanced budget. Keynes has supported this
principle arguing that along with the higher
government expenditure, there will be multiplier
effect in the economy.
 Government Budgeting

Estimate Enactment or legislation

Budget
cycle
Evaluation Execution

Auditing Accounting
 Components Of Budget

• Revenue Receipts
• Capital receipts
• Revenue expenditure
• Capital expenditure
Thus A Budget Has Two Main Components
[A] Receipts ,
[B] Expenditure.
 Receipts
•A. Revenue Receipts
• 1. Tax Revenue
• 2. Non –Tax Revenue
•B. Capital Receipts
• 3.Recovery Loans
• 4.Other Receipts
• 5.Borrowing & Other Liabilities
• Total Receipts = A+B
Receipt Items Of The Budget
Receipts
Revenue Receipts
 Tax Revenue
Tax Revenue Includes All The Revenues Earned
Through Various Kinds Of Taxes. Taxes Are
Broadly Divided Into Direct & Indirect Taxes.
 Taxation
Tax Revenue: Taxes are the most important source of
government income. Taxes can be defined as "a
compulsory contribution imposed by a public authority,
irrespective of the exact amount of service rendered to
the taxpayer in return."
According to Professor Seligman, a tax is "a compulsory
contribution from a person to the government to defray
the expenses incurred in the common interest of all,
without reference to special benefits conferred."
 Direct Taxes
1. Corporation Tax
2. Income Tax
3. Interest Tax
4. Wealth Tax
5. Gift Tax
6. Expenditure Tax
 Indirect Tax
1. Custom Duties
2. Excise Duties
3. Sales Tax
4. Service Tax
 Non Tax Revenue
It Includes The Revenue Accruing To The Government
From Sources Other Than Tax. These Are ;
1. Interest Receipts
2. Dividends
3. Grants
4. Fines
 Capital Receipts
These Include Borrowing Of The Government.
Since These Receipts Have To Be Repaid By
The Government ,The Capital Receipts Are
Liabilities. Capital Receipts Include Public
Borrowing , Recivery Of Loans And Resale Of
Shares And Bonds Held By The Government.
Expenditure Items
Expenditure Items
 Revenue Expenditure

It Is The Expenditure Incurred For The Day-to-

day Functioning Of The Government
Departments And Various Services Offered To
The People, Payment Of Interest On Borrowings,
subsidies Etc.
Revenue Expenditure Will Not Result In The
Creation Of Assets
 Capital Expenditure
Capital Expenditure Is The Expenditure Incurred
On Creating Permanent Assets. Such
Expenditure Is Incurred On Items Like
Construction Of Buildings, roads, bridges,
canals, Power Plants, capital Equipments
 Deficit Financing
Budget deficit is the annual difference between
government outlays and receipts (G-T).
The government budget constraint identifies financing
options open to the government:
G= T+∆B +∆MB
Where,
G=Total government expenditure.
T=Total government revenue from taxes, charges, and
sales.
∆B=Change in public debt
∆BM= Change in monetary base (Reserve money)
 Deficit Financing
G-T= ∆B +∆MB
• The idea is that if the government spends more than the
revenue either it should borrow or create base money or do
both. If the government is in surplus, it will either retire debt
or contract the monetary expansion.
• Borrowing from the domestic sector can have also
crowding out, the idea that increase in government purchases
ultimately cause reductions in private consumption or
investment.
• Monetary expansion to finance the government deficit can
have inflationary implications.
Deficit Financing
 Deficit Financing
Government borrowing can be made raising
through internal debt or external debt.
•Budget deficit financing identity:
•Budget deficit=Domestic borrowing+ foreign
borrowing+ printing money + +arrears
 Deficit Financing
In other words, government deficit can be financed
through following sources:
1. Withdrawal of past accumulated cash balances by the
government.
2. Borrowing from public
3. Borrowing from central bank and other banks
4. Issuing new currency
5. External loan
6. Forced savings
 Deficit Financing
(Role of deficit financing):
• To augment rate of net investment (particularly in
developing countries, private sector is not proactive to take
investment initiative because of the various constraints, thus
there is the large role of the government and has to )
• Development of economic and social overheads
• To control economic depression
• Reconstruction of the economy
• Augment community savings
• Incentive to private investment
•Utilization of the natural resources
• War financing
Role Of Deficit Financing
 Effects Of Deficit Financing
•Inflation: expansion of money supply and expansion of credit
leads to inflation.
•Crowding out of the private investment: Excessive reliance on
public borrowing creates distortion on investment of the private
sector and may also cause high interest, additional disincentive
for investment.
•Balance of payments difficulties: As monetary income of the
people rise, and also because of the rise in government
expenditure, imports may rise causing an adverse effect on
balance of payments.
•Increases debt servicing: Causing high government expenditure
and pushes country towards vicious circle of debt and deficit.
And also challenges long term debt sustainability.
 Effects Of Deficit Financing
Arrears: Past accumulated debt if can not be
repaid because of the increased deficit, it causes
inefficiency and loss of creditability.
Rises tax burden to finance debt service, which
creates distortions in the behavior of economic
agents.
Effects Of Deficit Financing
 Fiscal Policy
• Fiscal policy means setting of the taxes and
public expenditures to help dampen the
swings of business cycle and contribute to the
maintenance of a growing, high employment
economy, free from high or
volatile inflation. Fiscal policy operates
through changes in government
expenditures, taxation, and public
borrowings.
Fiscal Policy
 Objectives Of Fiscal Policy
• Optimum allocation of resources: economic
resources such as man, material, money should be
used wisely and productively. Should avoid
wastage of resources and ensure maximum
productive employment of economic resources.
• Price stability: Falling prices (deflation) lead to
decline in economic activity, while steeply rising
prices (inflation) hit hard the fixed income groups.
Fiscal policies should aim at securing price stability
by fighting against inflationary or deflationary
tendencies in the economy.
Objectives Of Fiscal Policy
 Objectives Of Fiscal Policy
 Equitable distribution of income and wealth: The
fiscal policies should be designed in such a manner that
inequalities between rich and poor should be minimum.
It should serve to secure equitable distribution of
income and wealth among various sections of the
society and geographical regions.
 Full Employment: This is possible if the economy
attains its economic growth in commensurate with the
growth rate of population. The fiscal policy be
designed in such a manner that the rate of increase in
income, and hence the rate of increase in employment
opportunities is much higher than the growth rate of
population.
Equitable Distribution Of
Income And Wealth
Full Employment
 Objectives Of Fiscal Policy
• Economic Growth: Less developed
countries are caught in the vicious cycle of
poverty because of the low economic
growth primarily caused by low capital
formation, low human capital accumulation,
and lack of technology. Thus, the fiscal policy
should be oriented towards attaining higher
sustainable growth.
Economic Growth
 Instruments Of Fiscal Policy
• Fiscal policy seeks to achieve national economic
objectives through changes in taxes, or changes in
government expenditure, or a combination of
• (a) taxes,
• (b) government expenditure, and
• (c) public debt.
• These instruments are used to influence national
income, output, employment, and prices.
• Taxes, besides bringing revenue to the government,
can be used to encourage or restrict private
expenditures on consumption and investment.
Instruments Of Fiscal Policy
 Instruments Of Fiscal Policy
 Government expenditure, may take different forms
such as recurrent expenditure, capital expenditure
etc. These expenditures have income creating effect.
Increased government spending raises income directly,
and so indirectly through multiplier process.
 Management of public debt influences aggregate
spending through changes in the liquid asset
position of the public. Public borrowing leads to
tighter credit by reducing loanable funds otherwise
available, and may have crowding out effect. But
the expenditure of these borrowed funds by the
government eliminates the tightening effect.
 Types Of Fiscal Policy
• Usually classified as: expansionary vs. Contractionary,
and discretionary vs. automatic (built in stabilizers).
• Expansionary fiscal policy: This increases AD either
by increasing government expenditure (G) or reducing
tax. Thus, the impact is either the budget deficit is
increased or surplus budget is reduced. During the
periods of recession or depression, government follows
expansionary policy to boost income, output and
employment.
• Contractionary fiscal policy: Government reduces
expenditure or increases tax particularly to offset the
effect of inflationary gap.
Expansionary Fiscal Policy
 Types Of Fiscal Policy
Discretionary fiscal policy: Discretionary fiscal policy is the
deliberate and conscious attempt by the government to
promote full employment and price stability by contracyclical change in
public expenditure or taxes or both. Discretionary fiscal policy change
requires specific legislation.
During depression, the effective discretionary policy may take four
alternative forms: (a) reducing tax rates and leaving
government expenditures unchanged, (b) increasing
government expenditures and leaving tax rates unchanged, (c)
simultaneously increasing government expenditures and reducing taxes,
and (d) Increasing taxes and government expenditures both.
During inflation, reverse of the above measures are suggested.
 Types Of Fiscal Policy
• Automatic fiscal policy or built-in stabilizers: This
policy operates through the built-in stabilizers to
contract fluctuations in economic activity. Built-in
stabilizers are those factors which automatically cause
government expenditure to rise and tax receipts to fall
during economic contraction and cause government
expenditure to fall and tax receipts to rise during
economic expansion. The important built in stabilizers
are: progressive income tax, and unemployment
compensation.
• During expansion, people pay high income tax and
vice versa. Similarly, during contraction more
people join the queue for unemployment benefit and
vice versa.
Automatic Fiscal Policy Or
Built-in Stabilizers
 References
•Engineering Economic Analysis –NPTEL
http://nptel.ac.in/courses/112107209/
•Engineering Economics
http://www.inzeko.ktu.lt/index.php/EE
•Fundamentals of Economics and Management
Institutes of Cost Accountants of India
www.icmai.in
•Modern Economics : Dr. H. L. Ahuja
•Principles for Macro-economics- C Rangarajan
Public Finance…