CHAPTER ONE

1. BASICS OF PUBLIC FINANCE

Governments from all over the world have started number of public projects: such as social amenities in the
form of education, health and sanitation facilities; social security and protection; public utilities: like electricity,
water supply, railways, heavy electricity, atomic energy; developmental projects: such as mega dams, mega
structures, etc. To provide such and such public goods governments the government requires adequate revenue.
1.1 Definition Public Finance
Public finance is a study of the financial aspects of government. The term has been variously defined.
According to Dalton, “public finance is one of those subjects which lie on the borderline between economics
and politics. It is concerned with the income and expenditure authorities and with the adjustment of the one to
the other.” Harold Groves, an authority on the subject, defines public finance as: “A field of inquiry that treats
of the income and outgo of governments (federal, state and local). In modern times this includes four major
divisions: public revenue, public expenditure, public debt, and certain problems of the fiscal system as a whole,
such as fiscal administration and fiscal policy.
Generally public finance is a study of income and expenditure of the central, state, and local governments.
Government performs many functions which the individual cannot or do not perform. Therefore, rising of
funds for the expenditure and their disbursement constitutes the subject of Public finance.
1.2 Scope of Public Finance
The subject matter (scope) of public finance consists of the following five categories of financial activities of
government:
1. Public income: this part includes the study of raising public revenues and the principles of
taxation.
2. Public expenditure: this consists of the study of the principles and the effects of public
expenditure.
3. Public debt: this part studies the causes and the methods of public borrowing as well as public
debt management.
4. Financial Administration (Fiscal Policy): this part studies the use of fiscal policy to bring about
economic stability in the country.
5. Economic Stability and Growth: It should be emphasized here that the above parts are not
distinct and separate from one another but are intimately related to one another.

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1.3 The Roles of Government in the Economy
Public expenditure is determined by political will of the leading forces in the state: their priorities, their
desired state model, and their interpretation of current economic and political phase. Past choices have
relevant impact on public expenditure because of inertia and instrumentalism. Bureaucracy may play an
important decision role for the actual expenditure. Sometimes considered as a completely exogenous
variable, the public expenditure would thus be fully in the hand of political decision-makers without
dependency from the economic context. With its prioritized structure and its peculiar decision-making
processes, public expenditure substantiates the prevailing kind of State. In democracy, public expenditure
is an expression of people's will, managed through political parties and institutions. At the same time, public
expenditure is characterized by a high degree of inertia and law-dependency, which tempers the will of the
current majority. In particular, as a much sketched framework, one may distinguish at least three general
models of state to which public expenditure corresponds: There are:
1. Minimal state: where only justice, public order, foreign policy and some other basic functions
should be carried out by the state, relying on private initiative for the others.
2. Welfare state: where the State cares about the people's well-being directly, also through
expenditure in schooling, health, support for the poor, the old, the disadvantaged.
3. Developmental state: where the State takes the responsibility of fostering economic development,
also through expenditure in infrastructure, support for firms, export and production in general.
Both the welfare and developmental state include the items of the minimal state. Military expenditure and
special policies are common traits of the three models, maybe in different proportions. Comparing function
shares in public expenditure, one can get insights in the kind of state under analysis. Needless to say, the
State does not exert its influence on economy and society through public expenditure only, but also for
example through laws.
1.4 Public Expenditure
Expenditure is the end and aim of the collection of revenues. It includes the principles and the effects of
public expenditure. As public expenditure is an important component of public finance, it has various effects
on total employment, total income, aggregate investment, output, distribution and general price level etc.
Through public expenditure, the government contributes to the financial flows of the economy and
conditions the demand and supply patterns. Public expenditure is also used as a tool for implementing
welfare, growth, stabilization and other policies by the government.

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1.5 Public Revenue
Revenue includes all incomes irrespective of the source they are obtained from. Thus, we can include taxes as
well as borrowings under public revenue.
1.6 Public Debt
A public authority can obtain income through loans. The loans raised in a particular year constitute receipts
for that year. It is an income of a capital nature, while the provision for repayment of the capital sum for the
year constitutes expenditure of a capital nature. Public debt also includes:
 Methods and objectives of public borrowings;
 Management of public debt; and
 Burden of public-internal and external
Methods of public debt are an important instruments of not only raising funds but also for meeting increasing
government expenditure, for securing economic stability, increasing public borrowings during the periods of
inflation and liquidation of public debt during the period of depression (i.e. the bond holder can sale or transfer
to others when there is a need of money before the maturity date of the bond), borrowings from the people
during inflation and borrowings from banks during depression and so on. Debt raised for productive purpose
will not be a burden on the economy
1.7 Financial Administration and Control

This category includes the preparation of financial budget, the control and administrations of the budget
relevant problems like through auditing etc. The term budget includes ‘Annual Financial Statements’ which
incorporates all the annual statements of receipts and expenditures of the government.
1.8 Economic Stability and Growth

The study of public finance includes fiscal policy of the government in dealing with inflationary and
deflationary situations, instability of the price level, promotion of full employment, growth of economy,
welfare of the people, etc. Economic stabilization is of recent origin. It has a wide scope to play especially in
the less developed countries. The main task of this section is to frame and look after the implementation of
various policies required for economic stabilization and growth.

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1.9 Fiscal Federalism
Decentralization is a broad term employed to signify distribution or allocation of power compared to
centralization. It is not only the phenomenon of federal states but also unitary states. If power and
functions are decentralized to several tiers of governments, in federal arrangements or to sub regions in
unitary states (which do not qualify the principle of federalism), there is a need for fiscal decentralization
in order to carry out their responsibilities. For instance, China, a unitary state, has a fiscal system divided
in to five levels of administrations: (1) Central (2) Provincial; (3) Prefecture; (4) County, and (5)
Township. In addition, Britain has two types of internal administrative arrangements from the center:
administrative regions and autonomous regions.
The autonomous regions (sometimes termed as quasi-federalism) have more decentralized powers than
the administrative regions. Hence, high degree of fiscal decentralization is also scored thereof. In some
cases of unitary sates, the trend of decentralization advances than federal states do formally. The question
that follows is not only about the degree to which power is distributed or devolved, but also in whose
prerogative power is such devolution undertaken. In unitary states, whatever power is decentralized, the
center can restructure and recentralize the power as it deems necessary at any time. However,
decentralization in federalism is non-centralization, not subject to the will and whim of federating units.
Each level of government is supreme in its power including financial matters formally granted by the
federal constitution.
Therefore, fiscal decentralization is a general concept that encompasses decentralization of financial
resources and power of spending in both unitary and federal form of states. On the other hand, the fiscal
decentralization of federal states assigned by federal constitution is termed as „fiscal federalism‟.
Accordingly, fiscal federalism encompasses principles of fiscal relations between federal and state
governments, which are the command over resources by various level of governments and the direction
and size of intergovernmental fiscal flows. This includes the division of tax power and the means through
which resources are adjusted to match expenditure responsibilities for the federal and state governments.
The major issues of fiscal federalism are summarized as:
 allocation of expenditure responsibilities, which deals with the issue of which item of power of
spending should be carried by which level of government;
 allocation of revenue raising power; which deals with the issue of which types of taxes should
be levied and non-tax revenues should be assumed in which jurisdiction by which level of
governments;
 the fiscal imbalance between the tires of government and disparities between them in executing
their respective responsibilities; vertical and horizontal imbalances; and

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  The intergovernmental financial transfer; which deals with the issue of financial flows between
the federal and the states and among the states; vertical transfer and horizontal transfer in order
to adjust the imbalance and keep a viable federal system.
Generally, the study of fiscal federalism focuses on allocation of expenditure responsibilities, the
revenue raising power and adjusting vertical and horizontal imbalances between the federal and the states
and among the states respectively through intergovernmental fiscal transfer.
? Discuss the four major subject matters of fiscal federalism
1.10 Public Finance and Private Finance
Finance in general means public as well as private finance. Public finance relates to the money- raising
and income-expenditure functions of the government. Private finance refers to the income-expenditure
phenomenon of an individual or private business firm. By private finance we mean the financial
problems and policies of an individual economic unit. It is a convention to look into similarities and
dissimilarities between the two so as to provide an analytical foundation for the decision making aspects
of public finance.
Similarities
(1) Satisfaction of Human Wants
Both the public and private finance have the same objective, i.e., the satisfaction of human wants. Public
finance is concerned with the satisfaction of social or collective wants, whereas private finance is
concerned with the satisfaction of personal or individual wants.
(2) Maximum Advantage
Both the public finance and private finance try to secure maximum advantage or maximum benefit. An
individual or a corporation or a private business firm tries to obtain maximum advantage from his
expenditure. Similarly, the government also tries to obtain maximum good of the people by incurring
expenditure on the society.
(3) Borrowings
As and when the current incomes become insufficient to meet the current expenditure, they individuals
and Governments rely upon borrowings. Both of them are having loan repayment plans.
(4) Engagement in Similar Activities
Both the private and public sectors are engaged in activities that involve lots of purchases, sales and
other transactions. Similarly, they are engaged in production, exchange, saving capital accumulation,
investment, and so on. In order to finance these operations, the government, creates money, raises loans
and makes payments etc. Similarly, a private economic unit lends, borrows, receives payments, and
makes payments and so on. In these respects, therefore, both the public and private finance are quite
similar to each other.

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(5) Scarcity of Resources
The scarcity of resources is also an important factor which is common to both. They have unlimited
objectives, whereas the resources are limited.
(6) Problem of Adjustment of Income and Expenditure
Both the public as well as private sectors face the problem of adjustment of income and expenditure.
Dissimilarities
(1) Motive- The motive of private finance is personal interest or benefit, whereas the motive of public
finance is social benefit or public welfare.
(2) Adjustment Approach of Income and Expenditure
Dissimilarity between the individual’s private finance and the government’s public finance is that every
individual tries as far as possible to adjust his expenditure to his income because his expenditure depends
on his income. Conversely, the government first prepares its budget. In other words, the government first
determines its expenditure and then creates ways and means to raise the requisite revenue to meet its
expenditure.
(3) Nature of Resources
The resources (private finance) of an individual are more or less limited, whereas the resources of the
government (public finance) are enormous. Government can raise resources from tax sources as well as
non-tax sources. The government can borrow from internal as well as external sources.
(4) Coercive Methods
An individual (private finance) cannot use coercive methods to raise his income, whereas the government
(public finance) can use forceful methods to collect revenue. In other words, to collect revenue, the
government imposes taxes at a high rate on the people irrespective of their capacity to pay. Private
individuals or bodies have no such powers.
(5) Secrecy of Budget
Public finance is an open affair as the government gives utmost publicity to its budget by publishing it
in newspapers and by showing it on television. For example, the Ethiopian government tells to the public
the yearly approved budget by parliament, whereas private finance is a secret affair. An individual try to
keep his accounts secret as he does not want his competitors to know his real financial position.
(6) Long/Short-term Consideration
Another point of difference between private and public finance is that the private individuals incur
expenditure in those areas of business which give quick returns. They, as individuals keep in view short-
term considerations. On the contrary, government incurs expenditure keeping in view the long-term
considerations, such as construction of dams, multi-purpose hydro-electric projects, etc.
(7) Elasticity of Finance

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Public finance is elastic in nature-as compared to private finance. Public finance can be increased by
imposing various taxes as public finance is open to drastic changes. Private finance on the other hand,
cannot be increased as there is not much scope for changes in private finance.
(8) Deliberation in Expenditure
The expenditure pattern of private finance is influenced/governed by various factors such as customs,
habits, culture, religion, business conditions etc. But the pattern of expenditure of public finance is
influenced/governed by the economic policy of the Government.
(9) Right to Print Currency
The government has a right to print currency which is legal, whereas private individual does not enjoy
such a right.

1.11 Meaning and Importance of Public Expenditure

Public expenditure is incurred by public authorities --Central, State and local Governments either for the
satisfaction of collective needs of the citizens or for promoting their economic and social welfare. Public
expenditure is not only the most important but also the central part of the study of public finance. It is
incurred by the government for the attainment of public good. Every government has to maintain law and
order, armed forces for providing protection, public parks, schools, health of the people. Government has
to perform certain other welfare measures like maternity protection, arranging for cheap food, cloth and
low-cost housing for the poor and so on. All these multifarious activities which are increasing every year
require huge funds. Therefore, public expenditure, deals with the expenditure which a government incur
for its own maintenance, the society and the economy and helping other countries.
Current and Capital Expenditure
Technically, in the structure of a budget, most governments classify public expenditure in two:
i. Current Expenditure and
ii. Capital Expenditure
All sorts of administrative and defense expenditure and debt services are called current expenditure. They
are also referred to as non-developmental expenditure. They are intended for continuing the existing flow
of goods and services and maintaining the capital of the country intact. On the other hand, capital
expenditures contribute to increased productive capacity of the nation and therefore, are known as
development expenditure. Expenditures on construction of dams, public works, state enterprises,
agricultural and industrial development etc., are instances of capital expenditure.

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 1.12. Canons of Public Expenditure
The expression “canons of public expenditure” is used explain the fundamental rules or principles
governing the spending policy of the government. The following canons of public expenditure
have been laid down by Prof. Findley Shirras:
1. Canon of Benefit: This cannon suggest that every public spending must ultimately be used for the
cause of social benefit i.e. for the general wellbeing of the common people.
2. Canon of Economy: it implies that public expenditure should be incurred carefully and
economically. Economy here means that wasteful and extravagant expenditure should be avoided
at all levels. Public expenditure must be productive and efficient. Hence, an efficient system of
financial administration is therefore, very essential in any country.
3. Canon of sanction: These cannon suggest that no public spending should be made without the
approval of proper authority. As a rule, therefore, money must be spent on the purpose for which
it is sanctioned by the highest authority and accounts properly audited.
4. Canon of Surplus: These cannon suggests that saving is a virtue even for the government, so an
ideal budget is one which contains an element of surplus by keeping public expenditure below
public revenue. Frequent and huge deficits lead to uncontrollable financial situation with direct
consequences of inflation. Therefore, every government should attempt to balance its income and
expenditure.
5. Canon of Elasticity: this canon requires that the expenditure policy of the state should be such that
changes must be possible in the expenses according to the change in requirements and
circumstances. In other words, there should be scope for changes in public expenditure according
to the requirements of the country.
6. Canon of Productivity: This principle implies that expenditure policy of the Governments should
encourage production in a country. That means a large part of public expenditure must be allocated
for development purpose.
7. Canon of Equity: One of the foremost aims of public expenditure is also to ensure the just and
equitable distribution of income. Thus, it is more significant to narrow the gap for the countries
where the gap between the highest income and the lowest income groups is very wide. services