CHAPTER - 01

PUBLIC FINANCE
 MEANING :
The complex problems that centre around the income expenditure process of government are
studied in "Public Finance ". Public Finance according to Dalton, "is concerned with the income and
expenditure of public authorities and with the adjustment of one to the other, adjustment not necessarily
to equality, but to whatever arithmetical relationship, in given conditions, is best. In the traditional sense
thus, public finance is a study of the nature and principles of state expenditure and state revenue. In short,
public finance is a fiscal science.
Modern public finance analyses the fundamental problems of government's fiscal activity such as ;
1. To what extent the state should intervene in the economic field ?
2. What should be the size of public revenue ?
3. What should be the size of public expenditure ?
4. In what way should taxes be raised? What should be characteristics of the tax system ?
5. How should the tax burden be distributed? How should equity be realized ?
6. What should be the formal and effective incidence of taxation on production, consumption,
distribution and welfare ?
7. In what ways public expenditure should be incurred? How can it improve community welfare ?
8. What would be the criterion for a budget and how it should be balanced ?
9. What should be the nature of the burden of public debt ? How it should be managed?
It is concerned with the income and expenditure of public authorities, and with the adjustment of the
one with the other. Public finance, in fact, is "an inquiry into the facts, techniques, principles, theories,
rules and policies shaping, directing, influencing and governing the use of scarce resources of
government.
SCOPE OF PUBLIC FINANCE
OR
SUBJECT MATTER OF PUBLIC FINANCE
The scope or subject-matter of public finance includes the following.\
(1) Public Revenue. Under this section, we study all the sources from which the Government - Central,
Provincial or Local- derives its revenue. -An extensive study of the principles of taxation is an
integral part of this section. Within the purview of public revenue, we take up the classification of
public revenue, canons and justification of taxation, the problem of incidence and shifting of taxes,
effects of taxation etc.
(2) Public Expenditure. Public expenditure is the end and aim of the collections of revenues. Therefore,
in public expenditure we are concerned with the principles and problems relating to the expenditure
of public funds. Here we study the fundamental principles governing the flow of funds into different
channels, classification and justification of public expenditure, expenditure policies of the
government and the measures adopted for keeping check on public expenditure.
(3) Public Debt. Like a private individual, the government also requires loans to meet certain situations
created by war, famine, floods or other calamities. As a matter of fact, government expenditure
usually exceeds its income. To meet the deficit in the budget, the government borrows money from
the public by way of loans which are to be repaid on due dates. Modern governments also borrow
from the public to promote rapid economic development of the country. As a matter of fact,
governments are forced to borrow from the people as well as from the international institutions like
the World Bank and' the foreign governments.
Dr. Rahul More, Head, Dept of Economics, Abeda Inamdar Senior College, Pune. Page 1
(4) Financial Administration. The scope of public finance is not confined only to public revenue, public
expenditure and public debt. We have to examine the mechanism by which the above processes are
carried on. No financial treatise can be regarded as complete unless it considers the problem of
financial administration. No financial treatise can be complete unless it considers the problems of the
'Budget' and financial. Therefore, under fiscal or financial administration, we are concerned with the
machinery of the government that is in charge of performing financial functions of the state.
Preparation of budgets and its final acceptance by the legislature, as a check on its expenditure
through auditing of accounts etc. constitutes an important part thereof.
(5) Economic Stabilisation. This section is of recent origin. Under this section the use of fiscal policy is
studied so as to bring economic stability in the country. Fiscal policy occupies important place in the
economic system of a country. Through this policy under economic system balance is maintained in
the public sector in such away as to achieve the target of public welfare. It has a wide scope to play
especially in the less developed countries like India, Pakistan etc. The main task of this section is to
frame and look after the implementation of various policies required for economic stabilization and
growth.
Though the scope of public finance consists of the above five sections, not all of them have been
given equal importance by writers on the subject. For instance, the last section - economic stabilization is
of the recent developments arising out of the peculiar economic conditions through which the world is
passing. It should be remembered that the above five sections comprising the scope of public finance are
not distinct arid separate from one another but are intimately related to one another.
We must also keep in mind the fact that the scope and subject matter of public finance is not
static but dynamic in the sense that it is continuously widening with the change in the concept of state,
functions of the state and the changing problems of _economics. The techniques of raising public
income, public expenditure, and public borrowing are swiftly changing, economic and social
responsibilities of the state are increasing quite rapidly, new problems of defence and public
administration etc. are growing. Besides these major (actors, other factors too .are responsible for
widening the scope and subject matter of public finance.

 IMPORTANCE OF PUBLIC FINANCE :

Public Finance had little importance in the 19th century, the reason was that the government in
those days did not intervene in economic affairs. Adam Smith, Ricardo etc. were the ardent supporters of
Laissez-faire Poiicy and believed in the minimum possible state interference in the affairs of the public.
To look after the security of the life and property against foreign aggression was perhaps the only duty of
the state in earlier times. During the 20th century, public finance has come into the forefront on account
of the new concept of 'Welfare State'. Modern Governments do not confine themselves to maintenance of
law and order only. On the contrary, they actively intervene in economic matters. According to James
Weison, "Finance is not mere arithmetic, 'without sound finance no sound government is possible and
without sound government no sound fmance is possible." Hence, the importance of public finance has
vastly increased in recent years. It has assumed the responsibility of being one of the most effective
instruments of state control on economy. The increasing importance of public fmance is evident from the
following:
(1) Expansion of State Activities. From the time the state came into being as an organised
institution, the importance of public finance is constantly increasing day by day. The reasons for such an
increase are two-fold. Firstly, the activities of the state are not confined to looking after the security of
life and property against foreign aggression only. This process of expansion of State activities has
continued all through the past several centuries. All the Governments of the world have a vast number of
duties to discharge. Secondly, there are political reasons for the increasing importance of public finance.
There has been the gradual drift of public sentiment from capital economy to socialist economy. Even
the countries having primary capitalist economy are now shifting to socialist economy. With the growth

Dr. Rahul More, Head, Dept of Economics, Abeda Inamdar Senior College, Pune. Page 2
of the duties and functions of the state, the study of public finance has naturally attained particular
significance and importance of public finance is constantly increasing in modern times.
(2) Growing Use of Money. Another reason for the increasing importance of public finance has
been the growing use of money and particularly of credit in modern times. With the increasing use of
money in all the spheres of life, all functions of the state came to be performed through this medium. All
the activities of the state assumed a financial aspect. With the widening of state activities, separate
department of public finance came into being.
(3) Emergence of Generallsed Services. The importance of public finance has also increased due
to emergence of generalised services which can. be performed more conveniently, efficiently, and also at
the minimum cost as against individual. Such services are education, health, social security and
protection from certain uncertainties. The need for such generalised services is increasing day by day
and with them is increasing the importance of public finance. .
(4) Reduction in Economic Inequalities. Public finance can play a vital role in reducing economic
inequalities which is the source of dissatisfaction, class-struggles, poverty etc. The state can levy heavy
taxes on richer sections of the society and thereby spend the income so received on providing food,
cheap housing, free medical aid etc. for the poorer sections of the society. Similarly, heavy taxes can be
imposed on the use of harmful commodities, such as harmful drugs, wine, opium, hashish etc.
(5) Increases Employment. Public finance can play vital role in increasing employment which is
the burning problem of almost all the countries of the world. The Governments these days establish, give
grants, subsidies, grant exemption from excise duty, sales tax etc. to employment-oriented cottage and
small-scale industries. Unbalanced budget is also an indispensable measure of increasing volume of
employment during depression.
(6) New Line of Thinking. The new line of thinking which had occurred and developed in
political, social and economic conditions of the different countries of the world has also given
importance to public finance. For instance, the public treasury which was the purse of the king or the
autocratic ruler, became now the funds of the welfare state which are collected for the financing of the
activities of general welfare of the society. More recently, it did not remain merely a means of increasing
funds of public treasury and their disbursement in the public interests but it has also assumed the
responsibility of being one of the most effective instruments of state control on economy.
(7) Importance in Underdeveloped Economies. Public finance has also assumed great
importance in underdeveloped economies of the world. Today, there is the majority of nations which are
backward or underdeveloped. The vicious circle of poverty has encircled the economies of these nations
in the form of low capital income, low standard of living, low savings, low investment and capital
formation, all-round poverty, mass unemployment and consequently, slow rate of economic growth.
Public finance can play vital role in increasing capital formation, savings, incomes, standard of living,
national and per capita income, employment, planned economic development, prosperity and rapid
reduction in poverty.
(8) Importance in Developed Countries. It is now generally accepted that the main problem of
industrial or high income economies, ie. developed countries, is stability in business conditions with all-
round rapid progress in the economy of the country. Fiscal policy has come to assume significance as an
effective means of stabilisation in advanced economy of developed countries. They have no other
alternative except the adoption of correct fiscal policy.
(9) Importance in Developing Countries. The basic problem of a developing country is rise in
capital formation and rapid economic growth. According to Raja Chelliah, "Fiscal policy has a great and
positive role in the context of rise in capital formation and rapid economic growth in a developing
country like India." Fiscal policy is generally regarded as the most powerful and the least undesirable
weapon of control which the state can wield. Capital accumulation can be done by adopting a positive
taxation policy.

Dr. Rahul More, Head, Dept of Economics, Abeda Inamdar Senior College, Pune. Page 3
 (10) Importance in Social Field : Public finance is called to play an active and important role in
organising and directing social welfare programmes, uplifting of backward classes, controlling
consumption of harmful commodities, removing social inequalities etc.

 DIFFERENCE BETWEEN PUBLIC & PRIVATE FINANCE :

1. Private: It deals with revenue and expenditure of private sector.
2. Public: It deals with revenue and expenditure of the government sector (public sector)
3. Time Period : Public finance is related to one year time period whereas private finance
is concerned with daily, weekly and monthly budget, etc.
4. Income vs Expenditure : In public, revenue follows expenditure. On the other hand, in
private finance expenditure follows revenue.
5. Deficit Financing : In the case of the deficit budget, Govt. can issue new notes. On the
other hand, the private sector has no authority to issue new notes.
6. Nature of Budget : In the public sector, the deficit budget is appreciable. In the private
sector, the surplus budget is appreciable.
7. Compulsory Loans : The government can take compulsory loans from different
financial institutions to meet its expenditure whereas the private sector cannot do it.
8. Secrecy : A government budget is no more secret, rather Govt. publicizes its budget
through T.V, Radio, etc. On the other hand, the private budget is tried to be kept secret.
9. Nature of Projects : In public finance, Government has to complete long term projects.
On the other hand, the private sector has a short terms project to complete.
10. Nature of changes : Public finance is concerned with remarkable changes whereas the
private sector is concerned with minor changes.
11. Written Document : Public budget is a written document whereas the private budget is
not a written document.
12. Audit System : Govt. revenue and expenditure is regularly checked by an audit system.
On the other hand, there is no audit system in private finance.
13. Foreign Assistance : The Government can depend upon foreign assistance but in private
finance, there is no chance of any foreign aid.
14. Direct or Indirect Source of Income : In public finance, the source of income is
indirect i.e., various taxes whereas in private finance source of income is direct.
15. Prior Sanction : Govt. takes prior sanction from its cabinet, national assembly, senate,
etc whereas, no prior sanction is required from any authority.
16. Future Planning : There is long term planning while in private finance short term
planning is the motive.
17. Use of Financial Resources : In public, the main objective is the social welfare of the
people whereas, in private resources are used just for maximum personal satisfaction.
18. Record of Finance : The private may or may not keep the record of its finance whereas
Govt. keeps the permanent record of its finance.
19. Finally : We can conclude that the finance of both the private and public sectors is
concerned with revenue and expenditures. Anyhow, we can differentiate private and
public finance on the basis of certain grounds.

Dr. Rahul More, Head, Dept of Economics, Abeda Inamdar Senior College, Pune. Page 4
 PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE (MSA)

Introduction
The 'Principle of Maximum Social Advantage' was introduced by British
economist Hugh Dalton. According to Hugh Dalton, "Public Finance" is concerned with income
& expenditure of public authorities and with the adjustment of one with the other Budgetary
activities of the government results in transfer of purchasing power from some individuals to
others. Taxation causes transfer of purchasing power from tax payers to the public authorities,
while public expenditure results in transfers back from the public authorities to some
individuals, therefore financial operations of the government cause 'Sacrifice or Disutility' on
one hand and 'Benefits or Utility' on the other. This results in changes in pattern of production,
consumption & distribution of income and wealth. So it is important to know whether those
changes are socially advantageous or not.
If they are socially advantageous, then the financial operations are justified otherwise not.
According to Hugh Dalton, "The best system of public finance is that which secures the
maximum social advantage from the operations which it conducts.
The 'Principle of Maximum Social Advantage (MSA)' is the fundamental principle
of Public Finance. It states that public finance leads to economic welfare when pubic
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 consist 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 :-

Dr. Rahul More, Head, Dept of Economics, Abeda Inamdar Senior College, Pune. Page 5
 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 maximised 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.

Dr. Rahul More, Head, Dept of Economics, Abeda Inamdar Senior College, Pune. Page 6
 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

CONCLUSION :
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.

Dr. Rahul More, Head, Dept of Economics, Abeda Inamdar Senior College, Pune. Page 7