611: Public Finance and

Taxation

Dr. Mohammed Jamal Uddin FCMA

MBA, Evening,
Fall 2021
Introduction to Public Finance
Contents

▪ Concept and constituents of public finance,

▪ Theories of public finance-
• Classical theory,
• Keynesian theory, and
• Musgrave theory.
▪ Allocation and distribution- Pareto and social
optimality, Pareto optimality and the
competitive solution: Efficiency in consumption,
Efficiency in production,
▪ Good governance- Accountability and
Transparency.
 Concept & Subject Matter

▪ Public finance is the field of economics that studies

government activities and the alternative means of financing
government expenditures.
▪ Modern Public finance emphasizes the relationships between
citizens and governments.
▪ It is a subject which deals with the various kinds of income of
the government and the various policies and objectives for
whose achievement this income (revenue) is used (i.e; public
expenditure).
 Objectives and Functions

▪ The basic objective of studying public finance is to

understand the impact of government expenditures,
regulations, taxes and borrowing on incentives to work,
invest; and spend income.
▪ This public finance develops principles for
understanding the role of government in the economy
and its impact on resource use and the well-being of
citizens.
 Constituents of Public Finance

These are Public Expenditure, Public Revenue, Public Debt, &

Public (Financial) Administration.

▪ Public Expenditure:
Public Expenditure deals with the principles and problems
relating to the allocation of public spending:
➢ Different channels,
➢ Classification and justification of public expenditure,
➢ Expenditure policies of the government and,
➢ The measures adopted for general welfare.
 Constituents of Public Finance

▪ Public Revenue:
Public revenue deals with the method of raising funds and the
principles of taxation:
➢ the classification of public revenue,
➢ cannons and justification of taxation,
➢ the problem of incidence and shifting of taxes,
➢ effects of taxation, etc.
 Constituents of Public Finance

▪ Public Debt:
Public debt deals with the study of the causes and
methods of public loans as well as public debt
management:
➢ the various modes and policies which are adopted
to collect money from the public,
➢ the various factors responsible for the public
borrowings.
 Constituents of Public Finance

▪ Public (Financial) Administration:

Financial administration deals with the problem of how
the financial machinery is organized and administered:
➢ authorities, institutions, agencies to look after
the management, control and scrutinizing work
created by the government.
 Public Finance vs Private Finance

▪ Individual determines his expenditure based on income, but

government determines its income based on expenditure.
▪ Government: income source is more flexible than private’s source.
▪ Usually, private expenditure is based on the law of equal marginal
utility, but it is difficult for the governments.
▪ Private finance is narrow & short-lived comparing with public
finance.
▪ Public finance is subject to public censor but not the private
finance.
 Public Finance vs Private Finance…

▪ Predetermined policies behind public expenditure but no so for

private expenditure.
▪ Budgeting process of the public finance differs from private
finance’s budgeting.
▪ Government accounts are audited by constitutional authorities,
but private finance has its own arrangement.
▪ A private individual can face the problem of being bankrupt, but
no government can be bankrupt.
 Public Finance vs Private Finance…

▪ Similarities between Public Finance and Private Finance:

➢ Both face the problem of scarcity,
➢ Both require efficient administration,
➢ Both are based on rationality of thought.
 Theories of Public Finance

Theories are Classical Theory, Keynesian Theory, Musgrave

Theory:

▪ Classical Theory:
➢ The view of the whole classical school of thought: “Supply
creates its own demand”, and thus overruled any possibility of
unemployment or over production.
➢ Assumption: there may come a position of full-employment,
and no resource in the economy can remain unutilized.
➢ The full employment implies the complete utilization of all the
factors of production including labor and capital.
➢ Argument: if labor is mobile and there is flexibility in the system
of wage payment, the whole labor force can be employed till
the economy reaches its level of full-employment.
 Theories of Public Finance

▪ Classical Theory…
➢ Unemployment is caused due to immobility of labor, and
rigidity in the wage system.
➢ There cannot be reduction in any one’s income if an individual
reduces his expenditure. This is so because the additional
amount of money saved by reducing the expenditure is
invested on the capital goods. Hence the level of “effective
demand” has no reason to fall. The effective demand keeps an
economy at full employment level. This is all done by the
private enterprises which is solely guided by the market price
and motivated to earn maximum profit.
 Theories of Public Finance

▪ Classical Theory…
• Effect of Taxation and the Role of Government:
➢ The classical economists believed that since the whole
productive work is done by the private enterprise, the
government has no powerful media to raise the economic
level of the country.
➢ The private enterprise ensures full employment and the
government has no chance to deal with the economic
activities of the private enterprise.
➢ If the government imposes taxation, the private enterprises
will substitute it by curtailing expenditure.
➢ If the government increase its expenditure through
borrowing, it will create a chance for inflationary trend and
rising prices.
 Theories of Public Finance

▪ Classical Theory…

➢ Classical economists believed in “balanced budget”. Taxes

always impose restriction on the private savings, resulting
low level of saving potential; and low level of private
investments. In this way taxes have an adverse effect on
the capital formation. That is why, they believed in small
budget.
➢ A deficit budget leads to inflationary trend. If the
government’s deficit is substituted by the long-term bonds
issued by the government, such bonds may simply
substitute the private share certificates and securities, and
thus may not help in creating an atmosphere of inflation.
 Theories of Public Finance

Keynesian Theory:
Keynes in his article “The General Theory” asserts that one’s
expenditure is another man’s income. If all are spending whole
of their income the result would be a constancy in the flow of
income and expenditures. Keynes argued that a part of income
is kept reserved and not spent by an individual and if this
reduction is not compensated by an increase in investment
expenditure, the result would be fall in the income of others,
consequently leading to low production, decreasing level of
employment and national income. Thus, Keynes totally rejects
the idea that equilibrium always at the full employment which
is the core of the classical view. Keynes also disagrees with the
classical economists that supply creates its own demand.
 Theories of Public Finance
Keynesian Theory is Based on Following Essential Elements:

a) Inflation, Deflation and Balanced Budget:

Classical economists desired a balanced budget. This idea is based on the assumption
that there is full employment in the economy which is very different, and thus it is
unrealistic to think of a balanced budget all the time. Budget is considered to be tool
in the hand of the state to fulfill following aims:

i) Economic: like full employment, check inflationary as well as deflationary

tendencies;

ii) Social: like removing economic inequality and providing minimum requirements to
the poor section of the community, and

iii) Political: like fulfilling the promises made by the government at the elections.

According to Keynes, if there is inflation; a Surplus budget may be of help and in case
if there is deflation; a deficit budget may work as an efficient tool. If investments
exceed savings; there is increasing prices; and if the savings exceeds investment;
there is deflationary tendency in the economy.
 Theories of Public Finance
b) Increase in Employment Income and Their Effects:
With the increase in employment, income increases and the propensity to save also
increases; but consumption does not increase at the equal rate, and the result is fall in
the level of effective demand which causes unemployment. Now, here, the techniques
of public finance are of valuable help. The state should increase its public expenditure
by investing on the public works, like construction of dams, roads, railways etc. The
money for investing on such public works may be borrowed from the people who have
accumulated savings. The state may further use the technique of deficit financing in
order to compensate the fall in the gross expenditure. This is more realistic than the
classical economists who disfavored the techniques of deficit financing.

c) National Debt:
Classical economists considered the concept of national debt in the sense of un availed
opportunity. For them it is harmful for an economy to create national debt. Modern
version of national debt is quite contrary to the classical approach. Now-a-days,
national debt is treated as an important tool of public finance; such debts are of great
help in the event of certain emergencies like floods and famines. It is also helpful in
meeting the requirements of a deficit budget. In the underdeveloped countries,
borrowings from the public helps in developing the national resources.
 Theories of Public Finance

d) Taxation and Equitable Distribution:

The classical economists disfavored application of taxation technique for
transferring wealth from rich to poor people.
In the modern times, taxation is used as one of so many techniques to remove
the inequalities of income in the society. Social justice is the goal of the
modern states, and taxation is looked as one of the best techniques in
accomplishing this goal. But taxing the rich more, the gaps can be reduced.
Taxes and duties are raised on those commodities which are used by the rich;
this leads to better social conditions and promotes the equality of income.

e) Economic Growth and Welfare of the People:

Classical economists argued that imposition of taxes will lead to reduction in
national income and production incentives. But modern view considers that
the welfare of the people lies in the maximum total production. If the
economy starts growing up, it will certainly raise the per capita income and
living standard of the people.
 Theories of Public Finance

Musgrave Theory:
Musgrave gave the theory of public finance by dividing into two approaches:
a) Normative or optimal Theory of public Finance, b) Theory of Budget policy.

a) Normative or optimal Theory:

Musgrave suggested that the state must initiate some principles and rules to
achieve the goal of highest degree of public economy. In other words, he held
that the state should prepare an optimal budget plan, based on the set
programs decided at the very initial stage, and must find out the ways to
achieve such pre-determined programs. This was called by Musgrave as the
“Normative or optimal” Theory of public finance.
 Theories of Public Finance

b) Theory of Budget Policy:

The state should develop a theory or set of principles so that everyone can
come to know the causes behind each step taken by the state in accomplishing
the objectives. This will enable to ensure the best way, or the best principles
and one can predict the future steps to be taken by the state.
Musgrave suggested that legislative actions should be taken in order to
implement these two approaches. While studying the first-theory, the attitude
of the market is to be recorded towards various types of taxes, and the best of
them should be suggested for the future to get maximum possible returns. For
the implementation of second approach, we should know and study the
manner in which the market is behaving to various types of taxes.
 Theories of Public Finance

Musgrave laid emphasis on the first approach; and in this regard he said,
“our task will be to examine how the objective can be determined in an
optimal fashion and how they can be implemented accordingly”.
Musgrave imagines a state in which he underlines three responsibilities.
Fiscal Department of such a state, namely-
a) the use of fiscal instruments in the distribution of income and wealth;
b) to secure adjustments in the distribution of income and wealth; and
c) to try its best maintain economic stabilization.
 Allocation and Distribution

▪ Pareto Optimality
The concept of Pareto optimality is named after Vilfrado Pareto (1848-1923)
Italian engineer and economist, who used the concept in his studies of
economic efficiency and income distribution..
Pareto efficiency or Pareto Optimality is a state of allocation of resources
from which it is impossible to reallocate so as to make any one individual or
preference criterion better off without making at least one individual or
preference criterion worse off.
▪ Conditions of Pareto Optimality:
There are two main conditions of Pareto Optimality: i) Efficiency in Exchange,
& ii) Efficiency in Production.
 Allocation and Distribution

i) Efficiency in Exchange:
The first condition for Pareto Optimality relates to efficiency in exchange. The
required condition is that the marginal rate of substitution between any two
products must be same for every individual who consumes both.
It means that the marginal rate of substitution (MRS) between two consumer
goods must be equal to the ratio of their prices.
Suppose there are two consumers A and B who buy two goods X and Y, and
each faces the price ratio of Px/Py. Thus, A will choose X and Y such that his
MRSxy(A)= Px/Py. Similarly, B will choose X and Y such that his MRSxy(B)= Px/Py
Therefore, the condition for efficiency in exchange is:
MRSxy(A) = MRSxy(B) = Px/Py.

ii) Efficiency in Production:

The second condition for Pareto optimality relates to efficiency in production.
There are three allocation rules for demonstrating efficiency in production
under perfect competition.
 Allocation and Distribution

• R1 relates to the optimum allocation of factors. It requires that the marginal

rate of technical substitution (MRTS) between any two factors to produce the
same product.
Suppose there are two firms A and B that use two factors: Labor (L) and capital (K)
and produce one product. Thus, the condition of equilibrium for firm A is MRTSLK
(A) =PL/PK, and that of firm B is MRTSLK (B) = PL/PK.
Therefore, rule one for efficiency condition is MRTSLK(A) = MRTSLK(B) = PL/PK.

• R2 states that the marginal rate of transformation between any factor and any
product must be the same for any pair of firms using the factor and producing
the product. It means that the marginal productivity of any factor in producing a
particular product must be the same for all firms. Thus-
MRPXL(A) = MRPXL(B) = PL/Px

• R3 for efficiency in production requires that the marginal rate of transformation

(MRT) between any two products must the same for any two firms that produce
both. This condition requires that if there are two firms A and B, and both
produce two products X and Y, then MRTXY(A) = MRTXY(B).
 Allocation and Distribution

Efficiency in Exchange and Production:

Pareto optimality under perfect competition also requires that the marginal
rate of substitution (MRS) between two products must equal the marginal rate
of transformation (MRT) between them. It means simultaneous efficiency in
consumption and production.
Symbolically,
MRS(xy) = Px / Py & MRT(xy) = Px / Py
Therefore, MRS(xy) = MRT(xy)

Pareto optimality conditions will be achieved if :

1. Second order conditions are satisfied for each consumer and producer,
2. No consumer is satiated,
3. There are no external effects either in consumption or production,
4. There are no indivisibilities,
5. There are no imperfections in factor and product markets.
 Good Governance

Governance means the process of decision-making and the process by which

decisions are implemented (or not implemented).
Since governance is the process of decision-making and the process by which
decisions are implemented, an analysis of governance focuses on the formal
and informal factors involved in the decision making and implementing the
decisions made and the formal and informal structures that have been set in
place to arrive at and implement the decision.
Good governance is about the processes for making and implementing
decisions. It is not about making “correct” decisions but about the best
possible process for making those decisions.
 Good Governance

Consensus
Accountability
oriented

Participatory Transparency

Good Governance
Follows the
Responsiveness
rule of law

Effective & Equity &

Efficient Inclusiveness

Figure : Characteristics of Good Governance

 Good Governance

1. Consensus Orientate:
There are several getters and as many view points in a given society.
Good governance requires mediation of the different interests in
society to reach a broad consensus in society on what is in the best
interest of the whole community and how this can be achieved. It also
requires broad and long-term perspective on what is needed for
sustainable human development and how to achieve the goals of such
development.
2. Participation:
Participation by both men and women is a key cornerstone of good
governance, participation could be either direct or through legitimate
intermediate institutions or representatives. Participation needs to be
informed and organized.
 Good Governance

3. Rule of law:
Good governance requires fair legal frameworks that are enforced
impartially. It also requires full protection of human rights, particularly
those of minorities. Impartial enforcement of laws requires an independent
judiciary and an impartial and incorruptible police force.
4. Effectiveness and Efficiency:
Good governance means that processes and institutions produce results
that meet the needs of society while making the best use resources at their
disposal. The concept of efficiency in the context of good governance also
covers the sustainable use of natural resources and the protection of the
environment.
 Good Governance

5. Accountability:
Accountability is a key requirement of good governance. Not only
governmental institutions but also the private sector and civil society
organizations must be accountable to the public and to their
institutional stakeholders. Who is accountable to whom varies
depending on whether decisions or actions taken internal or external
to an organization or institution.
6. Transparency:
Transparency is the basis of good governance and the first step in
fighting corruption. It provides a universal rationale for the provision
of good records management systems, archives, and financial
regulatory and monitoring systems. It doesn’t create a business
environment in which only the corrupt flourish.
 Good Governance

7. Responsiveness:
Good governance requires that institutions and processes tray to
serve all stakeholders within a reasonable timeframe.

8. Equity and Inclusiveness:

A society’s well being depends on ensuring that all its members feel
that they have a stake in it and do not feel excluded from the
mainstream of society. This requires all groups, but particularly the
most vulnerable, have opportunities to improve or maintain their well
being.
 Good Governance

Why is Good Governance Important?

Good governance is a set of fundamental principles which, if implemented, have
real world benefits. Good governance.
1. Leads to better policy outcomes:
A decision-making process that incorporates good governance attributes will, on
balance, produce better policy outcomes.
2. Promotes ethical decision-making:
Good governance helps to create an environment in which public officials ask
themselves whether something is the right thing to do when making decisions.
3. Promotes confidence in Government:
Good governance entrances the confidence of citizens in their government, both
in terms of how it conducts business and the outcomes of the decision-making
process.
 Good Governance

Why is Good Governance Important? …

4. Encourages Elected and Appointed Government official to feel confident
about their role in government :
Good governance improves the confidence of public officials in their
involvement in government, the decision-making process and the quality of the
outcomes that process produces.
5. Helps Government meet its conduction in an open, transparent and
accountable fashion, and in accord with other good governance act, public
officials are more likely to conduct their business in compliance with, and thus
meet, their constitutional and statutory responsibilities.