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.”

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.
In the narrow sense, public finance is defined only  as
the study of income and expenditure of the  interest expenditure etc.
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 and the
way of expenditure of various government
corporations, public companies,  and quasi-
governmental ventures.
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;
2. 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.
3. Public Revenue: Different sources of government 
revenue with major focus on tax revenue.

Public Debt: Often public revenue falls short of 

expenditure and government has to borrow from 
internal and external sources.
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

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
5. Economic stabilization and institutions, and building infrastructures.
economic growth:  Maintaining stability  Protections of individual liberties
and promoting balanced sustainable  Private rights to land and capital 
growth  Good courts and legal systems
 Representative political systems
Economic Stabilization And Economic  Growth
Slide 17

How Does Government Work?

Macroeconomic policy
  Fiscal policy The object classification includes expenditure on 
 Monetary policy personal compensation and benefits; travel and  
 Infrastructure investment transportation of persons and things;  communication,
utilities and rent; printing and  reproduction; supplies,
Microeconomic policy and materials; equipment;  grant subsidies and
contributions; insurance claims  and indemnities, and
 Social investment and labour policy
reimbursable etc.
 Industrial policy
 Competition policy GOVERNMENT BUDGETING

Government Budgeting  Functional classification is comprised of  

Derived from Latin word Bague and French  word
Bougette.
Bougette means small leather  bag.
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  expenditures on agriculture, mining
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.
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  transfers.
of the current year and estimates for the next  
fiscal year.
The main components of budget are government 
expenditures and government revenues. The 
expenditures are classified into:
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
manufacturing, electricity roads, water
transport, railways, communications, interest
on the public debt and so on.
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
Capital expenditures include acquisition of new
and existing fixed assets, purchase of
stocks (inventories), purchase of
land and intangible assets, and
capital transfers.

a) Object classification,
b) functional classification  Revenues are classified into:
c) economic classification. tax and non-tax revenues.
  Tax revenues constitute both direct and Annularity: Prepared for one fiscal year.
indirect  taxes. The premier direct taxes are on
Principles of budget:
net income,  property, and capital gains. Major
indirect taxes  include taxes on goods and  Balanced budget principle: Classical 
services (VAT, excise etc),  taxes on economists opine that government budget 
international trade and transactions (export  should be balanced that means  expenditure (G)
and import duties). should be equal to revenue  (T).
 If not followed, either government has to
 Non tax revenues constitute income from borrow internally or externally or has to
public  enterprises, sales of government increase the tax. Supporters of balanced budget
property,  administrative fees, fines, penalties argue that unbalanced budget creates
and royalties  etc. disturbances in economy.

Principles of budget:

Elements Of Budget: Principle Of Unbalanced Budget: A budget  deficit is

incurred when expenditures exceed  taxes and other
Close to reality: despite being an estimate, it should be  revenues for a year. And a  budget surplus occurs when
based on reality primarily on the basis of the  all taxes and other  revenues exceed expenditures for a
experience of the previous year. year.

Simple and obvious: Since this is a public document,  all Though  unbalanced means both surplus or deficit
who are interested should easily get the required  budget, a number of economists refer to deficit budget
information after looking on it. as unbalanced budget. Keynes has supported his
principle arguing that along with the higher government
Flexibility: Not only income and expenditure estimates 
expenditure, there will be multiplier effect in the
are there but also the policies and programs of the 
economy.
government. Thus, should have the quality of  flexibility.
Components Of Budget
Single fund: A single fund of the government  should be
established there for all revenues and  expenditures.  Revenue Receipts
 Capital receipts
Extensive: Should be in detail about each item of
 Revenue expenditure
revenue and expenditure.
 Capital expenditure
Publicity: it is made public and all the  stakeholders are
Thus A Budget Has Two Main Components
free to comment on this.
Receipts

Expenditure.

Receipts

Revenue Receipts

Tax Revenue
Deficit Financing
Tax Revenue Includes All The Revenues Earned  Through
Various Kinds Of Taxes. Taxes Are  Broadly Divided Into Budget deficit is the annual difference
Direct & Indirect Taxes. between  government outlays and receipts (G-T).

Taxation The government budget constraint identifies financing 

options open to the government:
 Tax Revenue: Taxes are the most important
source of  government income. Taxes can be G= T+∆B +∆MB
defined as "a  compulsory contribution imposed
Where, G = Total government expenditure.
by a public authority,  irrespective of the exact
amount of service rendered to  the taxpayer in T = Total government revenue from taxes, charges, and 
return." sales.
 According to Professor Seligman, a tax is "a
compulsory  contribution from a person to the ∆B = Change in public debt
government to defray  the expenses incurred in
∆MB =  Change in monetary base (Reserve money)
the common interest of all,  without reference
to special benefits conferred." G-T= ∆B +∆MB

Expenditure Items  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.

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
Effects Of Deficit Financing
In other words, government deficit can be
Inflation: expansion of money supply and expansion of
financed  through following sources:
credit leads to inflation.
1. Withdrawal of past accumulated cash
Crowding out of the private investment: Excessive
balances by the  government.
reliance on  public borrowing creates distortion on
2. Borrowing from public
investment of the private  sector and may also cause
3. Borrowing from central bank and other banks
high interest, additional disincentive  for investment.
4. Issuing new currency
5. External loan Balance of payments difficulties: As monetary income
6. Forced savings of the  people rise, and also because of the rise in
government  expenditure, imports may rise causing an
Role of deficit financing
adverse effect on  balance of payments.
 To augment rate of net investment
Increases debt servicing: Causing high government
 Development of economic and social overheads
expenditure  and pushes country towards vicious circle
 To control economic depression of debt and deficit.  And also challenges long term debt
 Reconstruction of the economy sustainability.
 Augment community savings
 Incentive to private investment Effects Of Deficit Financing
 Utilization of the natural resources
Arrears: Past accumulated debt if can not be  repaid
 War financing
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.
 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.

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.

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.

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 
Full Employment
Objectives Of Fiscal Policy borrowed funds by the  government eliminates the
tightening effect.
Economic Growth

Less developed countries are caught in the vicious cycle

of poverty because of the low economic growth Types Of Fiscal Policy
primarily caused by low capital formation, low human
Usually classified as: expansionary vs. Contractionary, 
capital accumulation and lack of technology.
and discretionary vs. automatic (built in stabilizers).
Thus, the fiscal policy should be oriented towards
Expansionary fiscal policy: This increases AD either  by
attaining higher sustainable growth.
increasing government expenditure (G) or reducing  tax.
Instruments Of Fiscal Policy Thus, the impact is either the budget deficit is 
increased or surplus budget is reduced. During the 
Fiscal policy seeks to achieve national economic  periods of recession or depression, government follows
objectives through changes in taxes, or changes in  expansionary policy to boost income, output and
government expenditure, or a combination of taxes, employment.
government expenditure, and public debt.
Contractionary fiscal policy: Government reduces 
These instruments are used to influence national  expenditure or increases tax particularly to offset the 
income, output, employment, and prices. effect of inflationary gap.
Taxes, besides bringing revenue to the government,  Expansionary Fiscal Policy
can be used to encourage or restrict private 
expenditures on consumption and investment.

Types 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  contracyclical change in public expenditure or
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
Discretionary fiscal policy:
 Discretionary fiscal policy is the deliberate and
conscious attempt by the government to
promote full employment and price stability by
taxes or both.
 Discretionary fiscal policy change requires
specific legislation.
 During depression, the effective discretionary
policy may take four alternative forms:
  reducing tax rates and leaving government
expenditures unchanged;
 Increasing government expenditures and
leaving tax rates unchanged;
 Simultaneously increasing government
expenditures and reducing taxes;  and
 Increasing taxes and government expenditures
both.

During inflation, reverse of the above measures are

suggested.

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.