Public Fin CH-1

CHAPTER ONE
1. BASICS OF PUBLIC FINANCE
Overview of Public Finance
Financing of government is a matter of universal concern. Government all over the world have
started a number of public projects, such as social security, protection and other services of
public utilities like electricity, water supply, railways, heavy electrical, atomic energy, etc. To
provide social amenities in the form of education, health and sanitation facilities and public
utilities, the government requires adequate revenue. The total expenditures and revenues of the
government are much larger than the revenues and expenditures of a single man with in the
country.
Public Finance, therefore, deals with the income and expenditure of public authorities. It deals
with the financial operations or finances of the government-central, state and local government
raises revenues from various tax sources and non-tax sources, such as revenue from general,
administrative and economic services, borrowings from individuals, corporations and friendly
foreign countries. The government raises revenue from internal as well as external sources to
incur huge expenditure on varies functions the government has to perform.
In fact Public Finance deals with how and through what different sources the government gets
income, how it spends it and how it controls and administers its incomes and expenditures.
These two activates, i.e. raising of revenue through taxation and other sources and spending it on
various services plus borrowing from internal as wee as external sources, together constitute
‚Public Finance‛. We, therefore, can say that Public Finance includes Public revenue, Public
expenditure and public debt as well.
1.1. Meaning of Public Finance
Public finance is made up of two terms: ‘Public’ and ‘Finance’, which need to be understood
individually, before we understand the meaning of ‘public finance’.
Public refers to a group of individuals, like individuals of a country, city, etc. Finance refers to
monetary resources. Therefore, public finance refers to the monetary resources of the public,
which are managed by public bodies like the federal government, state government etc.
Public Finance & Taxation Chapter 1 1 Basics of Public Finance
The government, which is a public body, provides goods and services (like education, transport
services, infrastructure, health care, etc. that individuals cannot provide) to the public at large.
The government pays for the production and distribution of the goods and services by collecting
taxes (from the public) and borrowing from the financial markets (if taxes are not sufficient).
Therefore, public finance is the study that deals with the income and the expenditure of the
government. Raising of necessary funds for incurring expenditure constitutes the subject matter
of public finance. Public finance also deals with the problems of adjustments of income and
expenditure of the government.
1.2. Scope of Public Finance:
Public finance deals with the income and expenditure pattern of the Government. Hence the
substances concerned with these activities become its subject matter. The subject matter of the
public finance is classifies under five broad categories.
1) Public Expenditure
2) Public Revenue
3) Public Debt
4) Financial administration and control
5) Economic stability and growth
1) Public Expenditure
Expenditure is the end and aim of the collection of revenues. In public expenditure, we are
concerned with the principles and problems relating to the expenditure of public funds. We
study the fundamental doctrine that governs the distribution of the expenditure among various
heads. We also study various effects of public expenditure 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.
Public expenditure is done under two broad heads viz., developmental expenditure and non-
developmental expenditure. The former includes social and community services, economic

services, and grants in aid. The latter mainly consists of interest payments, administrative
services, and defense expenses.
2) Public Revenue
Revenue includes all incomes irrespective of the source they are obtained from. Thus, in the
wider sense, we can include taxes as well as borrowings under public revenue. Public revenue is
the means for public expenditure. Increasing activities of the government are the cause of
increasing public expenditure. Methods of public revenue and their volumes have significant
impact on production and distribution of wealth and income in the country. It has effects on the
nature and the volume of economic activities and on employment.
3) Public Debt
A public authority can obtain income through loans and public borrowings. The study of public
debt includes: methods and objectives of public borrowings; management of public debt; and
burden of public debt-internal and external.
4) Financial Administration and control
Under financial administration, we are concerned with the machinery of the government that is
in charge of performing various financial functions of the state.
Thus financial administration and control include the following:
(1) Study of budgets and their procedure
(2) Budget as an instrument of securing certain objectives, such as promotion of employment,
economic growth with stability, welfare of the weaker sections, infrastructural
development of promoting private investments, etc.
(3) Financial and physical controls through different fiscal tools for controlling private
expenditure in the economy to avoid the effects in inflation, deflation, recession etc.
5) 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.
1.3. Functions of Modern Government and Fiscal Operations

Government of a modern state generally undertakes the following functions:
1) Allocation Function
The government operations basically involve the efficient provision of government funds in
maximizing the welfare of the community. The government taxes the public and uses the amount
in providing certain facilities and services considered essential by the by the people and the
community. These facilities are such that they could not be provided by the people themselves
such as defense, or they could be provided but only at a high cost such as education and
Medicare. Fiscal operations of taxation and public expenditure have the effect of transferring
resources form the public which would have been used for consuming private goods to produce
public goods which would satisfy collective wants. The objective of fiscal operations is to provide
for the proper allocation of resources between private and public goods so as to maximize social
welfare.
2) Distribution function:
In a free enterprise economy, distribution of income and wealth is unequal and many times it is
grossly unequal resulting in exploitation of the lower income gropes. Inequality of income and
concentration of economic power in the hands of a few are responsible for distorting production
in favor of the rich and for reducing the social welfare of the community. Fiscal operations have
been used to reduce the incomes and wealth of the rich (through progressive taxation) and using
the money collected to raise the income and standard of living of the lower income group
(through public expenditure}. The use of fiscal policy to reduce inequality of incomes and wealth
has been quite common in many countries.
3) Stabilization Function
Modern economies are subject to fluctuations, viz., business boom and inflations on one side and
business recessions and depressions on the other. Such fluctuations are not in the interest of the
country. Fiscal operations have been used to moderate these fluctuations and if possible to
eliminate them altogether. For instance, business booms and inflations are sought to be
controlled through heavier taxation while business recession is sought to be checked through
public expenditure.

Functions of modern governments are broadening due to socio-political reasons. Therefore, to
discharge these increasing functions, the government has to increase its expenditure. To meet
out the enormous amount of expenditure it has to mobilize funds with the help of public finance
policy. Hence public finance has developed into an important branch of economics.
1.4. Similarities and difference between Public Finance and Private Finance
In order to understand public finance better, we need to understand how it is different from
private finance. Public finance and private finance are based on the same fundamental principles
and share certain similarities, such as satisfaction of human wants, aiming for optimum use of
limited resources, and etc. However, they are also different in many respects. Some of the
similarities and differences are discussed here below:
Similarities
1. Satisfaction of human wants
Both the public and private finance have the same objective, viz, 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 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 good of the
people by incurring expenditure on the society.
3. Borrowings
Another similarity between the public and private finance is that many times both have to be
obtained from the market in the form of borrowings whenever the expenditure of either the
government or any individual or firm exceeds their income/revenue
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 these respects, therefore, both the public and private
finance are quiet similar to each other.

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
Another similarity between public and private finance is that 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 devises ways and means
to raise the requisite revenue to meet its expenses.
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. But the
government (public finance) can use forceful methods to collect revenues. 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 government gives utmost publicity to its budget by publishing
it in newspapers and by showing it on television. Whereas private finance is a secret affair. An

individual tries to keep his accounts secret as he does not want his competitors to know his real
financial position.
6. Long/Short-term Considerations
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, multipurpose hydro-electric
projects etc.
7. Elasticity of Finance
Public finance is elastic in nature as compared to private finance. Public fiancé 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 no much scope for changes in private finance.
8. Deliberation in Expenditure
The pattern of expenditure of an individual is governed by habits, customs, status, personal
needs, etc. On the contrary, the pattern of public expenditure is governed and controlled by
deliberate 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 rights.
1.5. Economic and Social Significance of Public Finance
I) Economic Significance
Public Finance occupies great significance in developing countries. According to R.J Chelliah,
‚Public Finance has a positive and significant role in the context of economic development.‛ The
importance of public finance in developing country may be summarized as under:-
Capital Formation
Since the economic development of a country depends on the rate of capital formation, the first
and the foremost aim of Public Finance is to promote capital formation. In a developing country,
the government’s economic policy should concentrate on production and fiscal policy should act

as a tool of capital formation. For rapid capital formation, the government should incur
expenditure on the establishment of basic and heavy industries, infrastructural development,
such as power projects, transport sector, means of communication etc.
Economic Stabilization
Economic Stabilization is yet another economically significant responsibility of the government.
The problem arises whenever there is economic instability such as inflation, deflation and
recession. Public Finance (revenue and expenditure process of the government) may be,
therefore, used to secure economic stability or to remove economic fluctuations in the country.
Full Employment
Public Finance also plays an important role in increasing employment. In a developing country,
major problem faced by the people is the problem of unemployment. This problem leads to low
standard of living, poverty, backwardness, ignorance, and above all starvation. It is the function
of public finance to provide employment opportunities. Therefore, expenditure should be
incurred by the government for increasing employment opportunity and for achieving full
employment. To generate employment, public Expenditure should be incurred on setting up new
industries, encouraging small-scale and cottage industries through financial subsidies,
expenditure on training-schemes, etc.
Balanced Regional Development
For the economic development of the country, balanced regional development is very essential.
Balanced regional development is possible by setting up private industries in backward areas
instead of in urban areas. To encourage this diversion, the government should provide fiscal or
tax concessions, communication facilities should also be provided. If the private industries fail to
divert to backward regions, should be taxed heavily.
Reduction in Economic Inequalities
One of the major problems of developing countries is unequal distribution of income and wealth.
There is a gap between the rich and the poor. Public finance has an important role to play in this
context. To bring about equitable distribution of income and wealth, the government should
follow the system of progressive taxation. In other words, government should impose heavy
taxes on the richer section of the society, and the amount realized from the rich should then be

spent on the poor by way of providing them social amenities such as free education, medical
facilities, and public utilities like road, water supply, recreation facilities, etc.
Mobilization of Resources
The government can mobilize or raise resources by imposing taxes on the people and industries,
by encouraging savings through various saving schemes, surplus of public enterprises, and
borrowings and making them available for investment for the rapid economic development of
the developing country.
Optimum Utilization of Resources
Optimum utilization of scarce resources is very essential for the economic development of the
developing country. In a developing country, we find that there is non-utilization or destruction
of scarce resources. The solution of this problem lies on the optimum utilization of available
resources by means of adopting planned monetary and public finance policies. The state can
direct the flow of consumption, production and distribution in the right direction by adopting
balanced budgetary policy.
II) Social Significance
The government has the following responsibilities or social significances in its public finance
operation:
Just and Equitable Distribution of Income and Wealth
Social justice or equitable distribution of income and wealth is another responsibility of the
government in its public finance operations. As already been discussed, there is unequal
distribution of income and wealth in developing countries. There is a wide gap between the rich
and the poor sections of the society, and this gap can be bridged by adopting a rational fiscal
policy, such as taxation and public expenditure. In other words luxury items purchased mainly
by the rich should be subjected to higher rates of taxation, and necessary items should be
exempted from taxation. Social justice also requires investment expenditure on the establishment
of enterprises in the public sector. By doing so, the government would be able to produce goods
of mass consumption to make available cheap good to the people.
Satisfaction of Social wants and Merit wants

Another significant point of public finance is the satisfaction of social or collective wants and
merit wants.
Wants are divided under three heads:
A) Private wants
B) Social or collective wants, and
C) Merit wants
A) Private wants
Private wants are those wants which are satisfied by individuals according to their personal
incomes. Degree of satisfaction depends upon their respective incomes. Wants for houses, food,
clothes, entertainment or recreation, etc.., are satisfied according to individual preferences.
B) Social Wants or Collective Wants
Social or collective wants require public goods which are demanded by all members of society
equally whether the people have the capacity to pay or not. Wants like defense, education, public
health, flood control provisions, weather forecasting bureaus, research centers, police protection,
social overhead capital like roads, bridges, etc are collective wants which must be available to all
the people, irrespective of whether they are rich or poor, whether they can afford to have them or
not. In other words, consumer is supreme. Public expenditure on these heads is necessary to
satisfy social or collective wants. Since nobody is ready to pay for them, therefore, taxes are
imposed on the people to meet public expenditure for the satisfaction of these wants. Social and
collective wants are ascertained by a democratic process, through discussion and voting in the
assembly of elected representatives and the decisions arrived at are binding of all.
C) Merit Wants
Merit wants are essential private wants such as food, clothing, housing, etc., which are satisfied
by the government at low prices for the poor due to their low level of income. Merit wants are,
thus, provided by the government for the benefit of the poor. These wants are satisfied by the
government for the upliftment and progress of the poor. Such wants are food, clothing, low cost
housing, free nutritious means to school children, free education to the children of the poor, low
priced milk to the poor, old age pensions and social security measures, maternity benefits, etc.

Satisfaction of these wants for the poor increases their productive efficiency and thereby their
income.
Fiscal policy to Curb or Prevent Undesirable Wants
Another important aspect of public finance is that the government not only satisfies social wants
and merit wants, but also discourages and curbs undesirable wants of the people from the social
point of view. Undesirable wants are cigarette-smoking, liquor drinking, chewing tobacco, etc.
Such harmful wants are discouraged and curbed by imposing heavy taxes and spending a large
amount on publicity, health measures for the affected people, etc.
I. PUBLIC EXPENDITURE
Government or public expenditure can be defined as the spending by public authorities like
federal, state and local authorities on various activities for achieving social and economic
objectives. It also includes amounts spent for protecting citizens and amounts incurred to satisfy
the general common needs of the public at large. Thus, it brings about social as well as economic
development of the state.
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, of
the people etc. 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.
Objectives of Public Expenditure
Dr. Dalton divided the aims of public expenditure in to two parts:
(i) Security of life against the external aggression and internal disorder and injustice.
(ii) Development or up gradation of social life in the community
The public authority works in many ways for the benefit of the people. The government
organizes the generalized services like public health and education. The whole society is
benefited by these functions of the state.

Secondly, through public expenditure, the government influences directly or indirectly, the
industrial and commercial system of nation there by helps towards the economic and social
development of the society.
Thirdly, in modern times, the responsibilities of the government are increasing every year.
For the economic development of the country, the government has started, on its own
accord, industries and commercial business. This sector of the economy which is under the
direct control of the state has come to known as public sector. Expenditure in this sector is
increasing rapidly every year. In an underdeveloped economy, this aim of public
expenditure has attained great significance.
Fourthly, Dalton points out that the public expenditure should be carried on up to that limit
where the marginal benefits arising from different branches of expenditure are equal.
Public spending should be designed to optimize the level of investment in such a way as to
maintain full employment with growth.
Public spending may be incurred at an increasing rate in the back ward region to uplift their
economy.
Reasons for Growing Public Expenditure
A multitude of factors have caused the rising trend of public expenditure in modern times. We
may enlist a few of them below:
1) Welfare state: - the modern state is a welfare state. It aims at promoting the economic,
political, and social well-being of citizens. It has to spend increasing amounts on such items as
social insurance, unemployment relief, free medical aid, free education, child welfare, women
welfare, labor welfare, concessional rates of water supply, food stuff, electricity, etc. to improve
the economic and social welfare of the country. As a result the public expenditure is bound to
increase.
2) Defense: - due to the invention of nuclear weapons, there is always a danger of foreign
aggression. International political situation is uncertain and insecure. Modern states are already
facing a cold war. As such, every nation has to prepare itself for a strong defense. The defense
expenditure in the form of expenditure on war materials, maintenance, and growth of armed
forces, pension to retired war personnel, etc. are perpetually rising.

3) Population growth: - it is an admitted fact that the population is increasing rapidly. As a
result, the government has to incur greater expenditure to meet the requirements of the
increasing population. Rising population also possess problems in poor countries. The states
have added responsibility by solving such problems as food, unemployment, housing and
sanitation. The states have to spend more and more on family planning campaigns every year.
4) Transport and Communication: - With the expansion of trade and commerce, the state has to
provide and maintain a quick and efficient transport system. Transport being a public utility
the state has to provide it cheaply also. The government has to spend a lot on constructing new
railway lines, new roads, highways, bridges, and even canals to connect different areas with a
smooth transport system as a precondition of growth.
5) Urbanization Effect: - the spread of urbanization is an important factor leading to relative
growth of public expenditure in modern times. Urbanization is responsible for the increase in
expenditure on water supply, electricity, construction, and maintenance of hospitals, roads,
schools and colleges, provision of transport, parks, libraries, sanitation, community halls, street
lights, play grounds, etc.
6) Growth of Democracy: - growth of democracy and socialism has been responsible for the
increasing tendency of public expenditure to a great extent. In a democracy, to achieve the good
will of the public, the ruling party has to incur heavy expenditure on providing variety of
services and facilities to the public. Expenditure on elections and by-elections is increasing
every year. Number of ministries and executive officers has also been increased. As a result of
this, the public expenditure increases rapidly.
7) Rising Trend of Prices: - public expenditure is also increasing in every country due to
increasing trend of prices. The reason is that the government has to buy goods and services
from the market at higher prices. The government has also to increase the salaries, allowance,
etc. of government employees leading to a rapid increase in government expenditure.
8) Increase in Activities of the State:- In recent years, activities of the state, particularly in the
social and economic fields, such as education, public health, public recreation, public works,
commerce and industry, etc. have increased tremendously.

9) The Planning Effects: - In a less developed economy, the government adopts economic
planning for the development of the country. In a planned economy, thus, when the public
sector is expanding its role, the public expenditure shows an increasing trend. Huge sums are
also spent by the government on formulating and implementing plans.
10) The Rural Development Effect: - In an underdeveloped country, the government has also to
spend more and more for rural development. It has to undertake schemes like community
development projects and social measures. The government also incurs expenditure on
imparting training to personnel for implementing rural development programs.
11) General Expenditure and internal Security: - Internal situation of a country is becoming
uncertain and insecure day by day. Government has been constantly facing communal and
political riots. Hence, to check and control these troubles, the government has to spend more on
the maintenance of law and order. Moreover, the government is bound to spend a huge
amount, as in a free country it is essential that the just demands of the public are duly
considered.
CANONS OF PUBLIC EXPENDITURE
In economic literature, the expression ‚Canons of public expenditure‛ used for the fundamental
rules or principles governing the spending policy of the government. The following canons of
public expenditure have been laid down by prof. Findlay Shirras:
1. Canon of Benefit: This canon suggests that every public spending must ultimately be used
for the cause of social benefit i.e, for the general well-being of the common people. In other
words, the state spending should confer benefits on the entire community at large than on an
individual group or section. It means public funds should be spent in such directions which
pursue common interest and promote general welfare.
2. Canon of Economy: - It implies that public expenditure should be incurred carefully and
economically. Economy here means wasteful and extravagant expenditure should be avoided
at all levels. Public expenditure must be productive and efficient. Hence, it must be incurred
only on very essential items of common benefit-without duplication in a way that involves
minimum cost. An efficient system of financial administration is therefore, every essential in
any country.
3. Canon of Sanction: - This canon suggests that no public spending should be made without
the approval of proper authority. Only obtaining prior sanction is not sufficient. It must be
properly inspected and examined whether the sanctioned amount of money is being spent
properly on the sanctioned items or not. As a rule, therefore, money has to be spent on the
purpose for which it is sanctioned by the proper authority and accounts properly audited.
4. Canon of Surplus: - This canon 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. In other words, public authorities should aim at surplus of income
over expenditure and they should avoid deficits. Frequent and huge deficits lead to
uncontrollable financial situation with dire 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 changes in requirements
and circumstances. In other words, there should be scope for changes in public expenditure to
the requirements of the country.
6. Canon of Productivity: - This canon or principle implies that the expenditure policy of the
government should be such that would encourage production in a country. That means a
large part of public expenditure must be allocated for development purposes.
7. Canon of Equity: - One of the foremost aims of public expenditure is also to insure the just
and equitable distribution of income by conferring on the poorer section of the countries
where the gap between the highest income and the lowest income group is very wide.
Underdeveloped countries have given this aim a significant and particular importance in the
economic activities of the state and in their fiscal policies.
Classification of public expenditure
There is no fixed basis for classifying public expenditure. In fact, public expenditure has been
classified by applying different criteria / bases, as advocated by various economists. Some of the
bases of classification are explained below:
A) Current and Capital Expenditure
Technically in the structure of a budget most governments classify public expenditure in to two:
i. Current expenditure
ii. Capital expenditure
All sorts of administrative and defense and debt services are called current expenditure. They are
also referred to as non-developmental expenditure. They are intended for continuing the excising
flow of goods and services and maintaining the capital of the country intact.
On the other hand, capital expenditure contributes to increased productive capacity of the nation
and therefore is known as development expenditure. Expenditures on construction of dams,
public works, state enterprises, agricultural and industrial development, etc are instances of
capital expenditure.
B) Classification on the basis of Benefits
Since the expenditure of the state is aimed at conferring benefits on people, it can be classified on
the basis of quantity of benefits into four classes:
i) Public expenditure benefiting the entire society
General administration, Legislators, defense, education, transport, etc. are such services which
benefit entire society in general. Therefore, the expenditure incurred on the above matters can be
classified under this group.
ii) Expenditure Benefiting particular person or group and the whole community in general.
Police, justice, etc.. are such items which provide security to the life and property of the entire
community but their advantage is to those people who have taken the course of law. Thus, these
services affect the entire society in general and some groups or persons in particular.
iii) Expenditure directly benefiting group or person and indirectly the entire society
Social security, public welfare, unemployment relief, etc. are such expenditures which are
administered with the aim of directly helping the particular section but their indirect effect falls
upon the entire society.
iv) Expenditure benefiting particular group aims
Public expenditure is incurred for the benefit of a particular group of society. The entire society is
not benefited by such expenditure. Subsidy to particular industries is one of such type

C) Classification on the basis of Functions (Fundamental Classification)
Prof. Adam Smith classified public expenditure on the basis of functions of government in the
following main groups:
i) Protection functions: - The group includes public expenditure on the security of citizens i.
e expenditure on police, on armed forces, and other paramilitary forces to counteract
external invasion and internal disorder. Expenditure is also incurred on jails to provide
justice to the people.
ii) Commercial functions: - This group includes public expenditure on the development of
trade and commerce E.g. On development of the means of transport and
communications, public enterprises, etc.
iii) Development functions: - This group includes public expenditure for the development of
citizens and the country. E.g education, public recreation etc. It also includes expenditure
on public utilities.
D) Classification on the basis of Revenue
Prof. F.S Nicholson classified public expenditure on the basis of amount of revenue obtained by
the state in return for the services rendered. He divides expenditure in to four heads:
1. Expenditure without direct return
Expenditure without direct return of revenue, e.g poor relief or in some cases direct
loss i.e. expenditure on wars etc.
2. Expenditure without direct return, but with indirect benefit
Expenditure without direct return, but with indirect benefit of revenue, e.g Education.
It is usually assumed that educated people are better tax payers or less expensive than
criminals or poor
3. Expenditure producing partial return
Expenditure with partial direct return, e.g Education for which fees are charged,
subsidized railway services, which pay part of their running expenses.
4. Expenditure producing full return
Expenditure with full return or even profit, e.g. the post office, gas service, and
generally public enterprises.

E) Classification on the basis of Importance/Optional and obligatory Expenditure
J.S Mill classified public expenditure in to optional and obligatory/necessary. G. Findlay Shirras,
almost on the same basis has classified public expenditure in to the following two groups:
1. Primary or Obligatory Expenditure
It includes all expenditure which must be incurred by every state, e.g Defense,
maintenance of law and order, judiciary, civil administration, payment of debts, etc
2. Secondary or Optional Expenditure
It includes public expenditure on the remaining items, e.g. Social expenditure, education,
health, poor relief, unemployment dole, maternity benefits. In the modern times,
expenditure, which once was regarded as optional may now be obligatory and necessary
for the state, i.e education, public health, and poor relief.
F) Classification on the basis of necessary, useful, and superfluous expenditure
Prof. Rocher classified expenditure in to the following three groups:
1. Necessary public expenditure: - It includes public expenditure which cannot be postponed by
the state such as expenditure on defense, maintenance of law and order etc.
2. Useful public expenditure: - It is that public expenditure which is desirable but can be
postponed for some time (like construction of an additional bridge over a river).
3. Superfluous public expenditure: - It is that public expenditure which the state may or may
not incur.
This division of expenditure in to three general groups does not really solve the fundamental
problem as the above classification is based on arbitrary lines. The merits and demerits of public
expenditure are changing with the change in the activities and responsibility of the state. The
expenditure which once was regarded as superfluous may now is regarded as necessary and
useful for the state, i.e., poor relief. The expenditure which is necessary is also useful, and the
expenditure which is not useful is also not necessary.
G) Classification on the basis of grants and purchase price
Dalton classified public expenditure in to two categories:
1. Grants: - It is that public expenditure which the government incurs but does not get any
commodity or service in return, e.g. each old age social insurance, poor relief, etc are grants.

2. Purchase price: - Payments made by public authority to any of its employees by way of salaries
and wedges or two contractors whom it employs are purchase prices. In other words, when
the state incurs expenditure and gets in return some services or commodity the expenditure is
collected a purchases price, e.g the salaries of government employees and the price paid for
purchasing furniture etc.
H) Classification on the basis of transferability
Prof. Piguo also classified public expenditure into following groups:
1. Transferable Public Expenditure
Transferable Public Expenditure is that expenditure which is incurred by the state in the form
of payment of money to people either gratuitously or public expenditure on existing property
rights to private persons, e.g., payment of interest of government, debt, pensions, sickness
benefit, etc.., and also subsidies on the production of particular kinds of commodities such as
sugar, milk, meat or house, etc.
2. Non –transferable public expenditure
Non-transferable public expenditure is incurred to purchase current services or productive
resources of the nation, e.g., expenditure on army, air force, navy, civil administration,
education, judiciary, etc.
I) Classification on the basis of constant and variable expenditure
Prof. J.k.Mehta classified public expenditure into the following two categories:
1. Constant Expenditure
The constant expenditure is that amount which does not depend upon the services that
financed by it. The expenditure on defense is a clear example of this class. Such expenditure is
incurred irrespective of the number of people using the services and hence the people have no
influence upon the amount that the government decides to spend.
2. Variable Expenditure
Variable expenditure likewise, is that which increases with every increase in the use of public
service by the people for whose benefit is incurred. Expenditure on postal service is an
example of variable expenditure.
J) Classification on the basis of revenue and capital account

This classification is based on the fact that whether public expenditure confers benefits in the
present period or in the future period. Public income and expenditure of each head is divided in
to two classes:
1. Revenue account: - Expenditure which provides present benefits is classified as expenditure
on revenue account.
2. Capital account: - Expenditure which confers benefits in the future is classified as
expenditure on capital account.
Revenue expenditure of the government includes current expenditure on administration
including defense, public, commercial undertakings, such as railways, posts, telegraph, and
grant-in-aid to the state.
Capital expenditure includes expenditure on capital assets such as construction of buildings, long
term projects, construction of hospitals, loans to various institutions, etc.
Effects of Public Expenditure
Public expenditure, in modern government finance, is regarded as a means of securing social
ends rather than just being a mere financial mechanism. Public expenditure is significant in a
modern economy because it produces many direct and indirect socio economic effects. A brief
account of these effects may be given as under:
I. Effects of Public Expenditure on Production
While analyzing the effects of public expenditure, Dalton very correctly said that just as taxation,
other things being equal should reduce production as little as possible. So, the public expenditure
should increase it as much as possible. He further added that the level of production and
employment in any country depends upon the following three factors.
(i) Effects upon ability to work, save and invest
Ability to work, save and invest depends upon the health and efficiency possessed by the
persons. Health and efficiency depends upon the level of consumption and level of consumption
depends up on the public expenditure incurred by the government. Public expenditure on
education, medical services, cheap housing facilities, means of transport and communication,
etc., will increase the efficiency of persons to work. Some of the expenditure, like expenditure on
free education, unemployment benefit, and free medical facilities, etc., are helpful in increasing
the purchasing power of the people especially of the low income groups and hence it helps to
protect and promote the efficiency of the people and their ability to work and save. Public
expenditure on increasing the salaries and wages of the people and the supply of goods and
articles at cheap rates to them will increase their purchasing power, standard of living, health,
efficiency and hence their ability to work and save may increase. Likewise, public expenditure on
the maintenance of law and order, creates confidence in the minds of the people and hence it
encourages them to make investment in productive activities. As production increases, income of
the people also increases; hence their ability to work, save and invest also goes up. Thus it is
evident that public expenditure can promote production and employment.
(ii) Effects upon willingness to work, save and invest
Public expenditure also affects the willingness of the people to work, save and invest. Pension,
provident fund, interest free loan, free medical and unemployment allowances and other
government payments provide security to a person and, therefore, reduces the willingness of
persons to work and save, when a person knows that the will be looked after by the government
when he in not in a position to earn any income. In the absence of any saving, the question of
investment does not arise at all.
On the contrary, expectation of larger amenities and higher standard of living would stimulate
people to work hard. It is this encouragement which would encourage them to save more and to
invest their savings for production purposes. Expenditure on benefits such as sickness benefits
would certainly increase the desire of the people to work more, since they are assured of relief if
they fall sick due to hard work.
(iii) Effects on diversion of resources
Public expenditure also affects the diversion of resources. Government incurs public expenditure
in the form of giving financial assistance to productive sector. In the same way, if the government
wishes to attract productive resources to a particular area or region, it will start giving a variety
of incentives in the form of tax holidays and other allowances or concessions etc. to the
industrialists.
II. Effects of Public Expenditure on distribution

Public expenditure also helps the government in bringing about equitable distribution of income
and wealth. Not only taxation policy but public expenditure policy can also remove inequalities
in the distribution of income and wealth. To bring about equitable distribution of income and
wealth, the government should impose higher taxes on the richer section of the society and the
amount realized from them should impose higher taxes on the richer section of the society and
the amount realized from them should then be spent on the poorer section of the society by way
of providing social amenities, and subsidies to them. Public expenditure has, thus, an important
role in reducing economic inequalities in the society.
Effects of Progressive, Proportional and Regressive Expenditure
Public expenditure by its nature may be progressive, proportional or regressive.
1. Progressive Expenditure: - public expenditure is progressive if smaller the recipient’s income
the larger the proportionate addition made by the expenditure. Progressive public
expenditure thus reduces inequalities of income distribution. Progressive public expenditure
provides greater benefits to the poor. Old age pension, free education to economically weaker
sections, subsidies on essential goods of mass consumption. etc., are progressive
expenditures.
Limitations of progressive Expenditure
We have seen that progressive public expenditure reduces inequalities in the distribution of
income and wealth to a great extent. But it suffers from certain limitations also. These are:
1. Discourage savings of poor: - The progressive public expenditure the will and the ability of
the people to work and save. As we have seen that low income people have greater
tendency to consume, any increase in their incomes owing to public expenditure, tends to
increase their consumption, and thus reduces savings which may adversely affect capital
formation. On the other hand, the rich has lower propensity to consume and a greater
tendency to save. This factor plays an important role in promoting savings and
investments.
2. Steeply graduated taxation: - a heavy and steeply graduated taxation imposed for sharply
progressive public expenditure may discourage the desire of tax payers to work hard and

save more. Dalton puts it, ‚ if the prospect of grant causes a person to work and save less
than he would otherwise have done, the effect of the grant in increasing his income will be
diminished, in the opposite cases its effects will be increased.‛ Thus, the progressive
public expenditure and the progression in taxation should not affect the efforts of the
people to work, save and invest though it is the duty of the state to fulfill every need of
their life.
2. Proportional Expenditure: - public expenditure is proportional if whatever the size of the
recipient’s income, the proportionate addition is the same. In other words, public expenditure
is proportional if its benefits reach everybody in equal proportion. In proportional
expenditure benefits increases with an increase in income.
3. Regressive Expenditure: - public expenditure is regressive, if the smaller the recipient’s
income, the smaller the proportionate addition made by the expenditure. A regressive
expenditure confers larger benefits to the richer sections, e.g., subsidies on luxury goods, etc.,
tends to widen the gap of inequalities, In other words, in regressive expenditure, the benefits
increases at a faster rate as the income increases. Such expenditure increases the inequality in
the distribution of income and wealth
Hence the objective of public expenditure in distribution should be to reduce inequalities of
income and provide maximum advantage to the society. As Dalton puts, ‚That system of public
expenditure is best which has the strongest tendency to reduce inequalities of income.‛
Therefore, a government which wants to reduce income inequalities should resort to progressive
taxation.
III. Effects of Public Expenditure on Employment
Public expenditure affects employment as well as employment opportunities. It can increase
employment in the country. The following expenditures of the government increase employment
opportunities:
i) Heavy expenditure in public sector
For the economic development of the country, the government should make investment in public
sector such as heavy engineering, iron and steel coal etc. production goods sector provides direct
employment to the people by creating millions of jobs. Thus it clearly becomes the responsibility

of the state to prevent a situation of unemployment. The object of state should be to achieve full
employment. Full employment does not mean that everyone has a job. By full employment,
Kenynes implied, a state of affairs in which there should always be ‚more vacant jobs than
unemployed men and that the normal lag between losing one job and finding another will be
very short.‛
ii) Expenditure on public utilities: Public expenditure incurred by the government on
public utilities, such as supply of water, electricity, telephone services, etc., create a
large volume of employment.
iii) Public expenditure to encourage small-scale industries
To promote employment in small-scale industries, the government should provide tax incentives
and allowances to such industries. The government should incur public expenditure on small-
scale sector in the form of cheap credit, supply of raw material at concessional rates, free
technological assistance, helping these industries in the marketing of goods, etc., In this way,
large employment is created in the small-scale sector.
iv) Public expenditure during the period of depression
Public expenditure plays an important role during the period of depression and recession,
Depression is a period of falling prices, falling demand and rising cost of incomes. Recession is a
period of rising prices, falling demand and rising cost of production. It is the responsibility of the
government to check these situations by incurring public expenditure on public works,
programmes and producers by way of providing tax incentives and reducing the rates of sales
tax, excise duties, custom duties etc. Such expenditure creates employment and income in the
country and consequently, effective demand starts rising.
v) Public expenditure to create employment
To create employment opportunities in backward regions, the government should promote
industries in the public sector and private sector in backward area. To encourage industries in the
public as well as private sectors, the government should grant deductions and concessions to
such industries. If public expenditure is directed towards the promotion of industries in the
public and private sectors in backward areas, not only will additional jobs created, but the
markets will also be widened and there will be all round economic development of the country.

IV. Effects of Public Expenditure on Economic Stability
Economic stability is judged by the behavior of prices. Price stability is related to the manner in
which price behaves in an economy. There should be a normal rise in price because normal rise
in price is considered as a sign of healthy economy. Problem arises whenever there are price
fluctuations. Price fluctuations may be known as abnormal economic situations.
There are three states of abnormal price behavior:
1. Inflation
2. Deflation or depression, and
3. Recession.
1. Effects of public expenditure on inflation
Inflation is a state of rising money supply, rising demand but stable supply, public expenditure
may be useful in controlling inflation. In this situation the aim of the government should be to
spend less than its revenue. Inflation may be averted by reducing public expenditure on civil
services, defense, interest payments etc. Thus funds acquired by means of a surplus budget may
be used to provide capital to those sectors which experience shortage of capital so that the total
productive capacity of the economy may increase. Therefore, public expenditure should be
incurred on a minor irrigation projects, better quality of seeds, manure etc., in the field of
agriculture. In the field of industries, public expenditure may be incurred on providing facilities
for the establishments of new industries and for the expansion of the existing ones.
2. Effects of public expenditure in deflation/depression
Depression is a state of falling price, falling money supply, and falling demand. Falling prices
cause losses among business-men and manufactures and this leads them to curtail production
and employment. Thus, a large number of workers are thrown out of employment. In such
situation, the government should employ workers on public works projects. The employed
workers receive wages from the government and can thus increase the demand for various
commodities. The increased demand leads to increase in production. Thus, the objective of public
expenditure during depression should be to create effective demand for consumer goods, which
would create employment and thus, would help to maintain economic stability.

3. Effect of public expenditure in recession
In a state of recession prices continue to rise in spite of continuously falling demand. Recession or
in other words, prices should be kept under control through proper public expenditure policy.
To sustain demand, it becomes essential to bring down prices. This is only possible if cost of
production is kept under control, fiscal support may be extended to the producers in the form of
reduction in the rates of sales tax, excise duties and custom duties. This would create demand for
the products which would incur expenditure in the form of higher wages to the workers.
V. Effects of public Expenditure on Economic Development
Economic development depends on the rate at which the per capita income increases. It also
refers to the structural changes in the economy. Economic development also refers to the
problems of underdeveloped countries; the problems are concerned with unused resources even
though their uses are well-known, while those of advanced countries are related to growth, most
of the resources, being already known and developed. However, the problem of underdeveloped
countries is to make rapid and accelerated economic development.
Tools of Public Expenditure Management
One of the important functions of the government is to collect resources from the economy and
use them for implementing policies relating to achievement of social and economic objectives.
The economic objectives can be met only if the resources are used efficiently and effectively.
Management of public expenditure is very critical for any economy. Public expenditure is the
means through which public policies are implemented.
Misallocation or misuse of public funds can pose serious problems to the society. Tax payers are
concerned about the amount they pay to the government in the form of taxes and the benefits
that they receive from the government in return.
Efficient management of public expenditure is necessary in order to ensure credibility of the
government. Economists / analysts working on fiscal policies need to understand thoroughly
how the expenditure side of public finance is managed. Public expenditure management is
concerned primarily with the budgeting total revenue and expenditure, allocation of resources
among various sectors and efficiency of execution of budgets.

Budgets should take into account all the expected expenditures which are to be met as per the
decisions made by the government at the stage of planning itself, and should focus on priority
areas.
Efficient public expenditure management can be achieved with the help of the following tools:
1. Accuracy in budget preparation
Budget planning and preparation is very critical to good public expenditure management. While
formulating a budget, it is necessary to obtain consistent and reliable data on past public
expenditures in order to budget for the current period. Past experience should be taken into
account so that past errors may be rectified.
A number of other factors need to be taken into account to ensure a sound budget:
(a) Completeness of coverage of all expected expenditure
(b) Usage of realistic and reasonable assumptions
(c) Usage of realistic projections for expected revenue
(d) Inclusion of provision for change in costs
(e) Inclusion of provision to meet unexpected expenditures
It is necessary to ensure proper control over total expenditure and minimize the cost of budget
management.
Productive efficiency and efficient allocation of resources also helps in public expenditure
management.
Disclosure of all relevant public revenue and expenditure information is important for
accountability of government and to reduce corruption.
Public participation in the budget process for a pre-defined part will also help in better
accountability and transparency. Priority areas need to be identified at the time of budget
preparation itself so that funds are not spent excessively on non- priority areas. It is also
necessary that proper classification is made between implementing agency (administrative
function), purpose of expenditure (functional classification) and use of expenditure (economic
classification).

2. Budget execution
Once the budget is approved at the federal government level, the responsibility of execution
generally lies with the ministries and other appointed agencies. The ministries should ensure that
they adhere to the spending limits laid down by the federal government and regularly report to
the government. Monitoring is generally done at the central level on an aggregate basis and
appropriate responsibility should be placed for the monitoring. It is necessary for the Ministry of
Finance to ensure that it obtains reliable data on expenditure from the executing agencies at
regular intervals and analyze it effectively. This will help in overall control of expenditure.
Factors that are important in budget execution are whether the targets are likely to be met and
whether the expenditure is likely to exceed budgets. It is important that the monitoring process is
such that expenditure incurred will be within the budgeted amount and appropriate measures, if
required, are taken to control expenditure.
3. Cash planning
Adequate cash planning is necessary to so that the government is able to meet budgeted
expenses and unexpected expenditures without resorting to additional borrowings. It also helps
in ensuring that the budget targets are met and the economic policies are implemented smoothly.
Even though the budget has been prepared well and with adequate planning, liquidity problems
may arise as the timing of cash inflows and outflows may vary. In order to ensure timely
availability of cash for meeting expenditure, the government needs to prepare an annual cash
flow forecast (bifurcated month-wise) at the beginning of each year.
It can take into account the past experience and future projections while preparing the cash flow
forecast. If a shortfall of cash is expected in a particular month, the government can either
postpone the expenditure or make arrangement for collecting additional revenue. The monthly
projected cash flow should be updated with actual figures on a regular basis so that it helps in
achieving budgeted targets. Quick updating of information is possible only with a well-
established reporting system.

4. Well-defined expenditure policies
Policies that are well defined need to be framed along with projections of estimated expenditure
to be incurred in relation to those policies.
5. Information on public revenue
It is necessary to inform the citizens about the sources and amounts of public revenue and how
these are managed by the government since the quantum of revenue determines the amount
available for public expenditure. This will help citizens to monitor how public funds are being
used and managed.
6. Public expenditure tracking
The tracking of public funds will ensure that funds are used for the purpose for which they were
allocated and were intended to be used. This tracking must be quantitative as well as qualitative.
Quantitative tracking is in the form of verifying records whereas qualitative tracking may be in
the form of assessing from beneficiaries their opinion on the quality of services, technical reviews
etc.
7. Accounting
The accounting categories and classification for budgeting as well as actual accounting should be
common at the Federal government level so that accurate analysis is feasible. Accounting needs
to be done on a timely basis and should be reliable. Appropriate processes for analysis of the
accounts should be established.
8. Audit
An independent authority should be responsible for undertaking the audit of the entire process
of public expenditure management.
II. PUBLIC REVENUE
Government needs funds to perform various functions to achieve economic and social objectives.
These funds are referred to as public revenue. Government receives revenue from various
sources like taxes, fees, grants etc.; tax revenue is the major source of revenue for any
government. Revenue obtained by Government from sources other than tax is called Non- Tax
revenue.

Public revenue, like public expenditure, is very necessary for the government to perform its
various functions for the welfare of the society. The necessary of raising the public revenue
follows from the necessity of incurring public expenditure. As the modern government has to
perform several functions for the welfare of the people and such functions require huge amount
of expenditure, it can be financed only though public revenue. The important sources of public
revenue include taxes, income from currency, market borrowings, and sale of public assets,
income from public undertakings, fees, fines, gifts and donations.
Prof. Dalton has defined ‚public Revenue: in a broad and a narrow sense. In the wider sense, it
includes all the income and receipts which the government happens to get during any period of
time. Public income/Revenue includes income from taxes, prices of goods and services supplied
by public enterprises, revenue from administrative activities such as fees and fines, etc and gifts
and grants, while public receipts include all the incomes of the government which it may have
received during a given period of time. In the narrower sense, it includes only those sources of
income of the government, which are described as ‚revenue resources‛
Income in every society is generated from three important sectors. These are:
(1) Primary sector or Agriculture sector
(2) Secondary or industrial sector and
(3) Tertiary sector or service sector.
In order to optimize income from these sectors, the government plays a vital role in removing the
problems faced by the people in each of these sectors by providing financial and other types of
support.
Revenue Receipts and Capital Receipts
It is normal practice with a government to divide its receipts into revenue and capital categories.
Broadly speaking, revenue receipts include ‚routine‛ and ‚earned‛ ones. For this reason, they
do not include borrowings and recovery of loans from other parties, but they do include tax
receipts, donations, grants, fees and fines etc.
Capital receipts, on the other hand, cover those items which are basically of non-repetitive and
non-routine variety and change government’s financial liabilities/ assets.

Revenue receipts:
These receipts are divided into tax-revenue and non tax revenue.
i. Tax revenue is divided into three sections:
a) Taxes on income: This section covers all those taxes which are levied on receipts of
income. The Government imposes two types of taxes on income. They are: Tax on
personal income, and Tax on corporation profits.
The personal income tax is levied on the net income of individuals, firms and other
association of persons. The tax on the net profits of the joint stock companies is known as
corporation tax.
b) Taxes on property and capital transactions: This section covers taxes on specific forms of
wealth and its transfers such as, wealth tax, gift tax, rental income tax, land use tax, etc.
c) Taxes on commodities and services: This section includes taxes on production, sale,
purchase, transport, storage and consumption of goods and services.
The important taxes levied by the Government on commodities are: Custom duty, Excise
tax, Value added tax and Turnover tax.
 Customs Duty includes both import and export duties. These duties are levied
when the goods cross the boundaries of the country.
 Excise duties are levied on the commodities produced in the country.
 Value Added Tax is levied by the Government on the commodities sold at a
specified percentage on the value of sales.
 Turnover Tax is levied by the Government on the sales which are not covered
under VAT.
ii. Non- tax revenue of the government is divided into three sections:
a) Currency, coinage and mint: This category covers the receipts of currency note printing
and of the mints. Profit from creation of currency by the government is excess of face
value of currency over its cost of creation is included here.
b) Interest receipts, dividends and profits: This section comprises, apart from interest
receipts on loans by the government to other parties, dividends and profits from public

sector undertaking run by or as government departments including other income
generating departments. Examples are contributions from railways, posts,
telecommunications and surplus profits of central bank transferred to the Government.
c) Other Non-tax revenue: This section covers revenue from various government activities
and services such as from administrative services, various departments, police, jails,
agriculture and allied services, industry minerals, water and power development services,
transport and communications, supplies and disposal, public works, education, housing,
information and publicity, broadcasting, grants- in aid, and contributions etc.
Administrative Revenue includes the following:
(1) Fees: It is the compulsory payment made by the individuals who obtain a definite service in
return. Fees are charged by the Government to bear the cost of administrative services
rendered by it. These services are rendered for the benefit of general public. It includes court
fee, registration fee, etc.
(2) Licenses: A license fee is collected not for any service rendered, but for giving permission or a
privilege to those who want to do a special or specified work. It is charged on the grounds of
control of certain activities.
(3) Fines and Penalties: Fines and penalties are imposed as a form of punishment for the
mistakes committed such as violation of the provisions of law, etc. The basic aim behind them
is to prevent the people from making mistakes. A fine is also compulsory like a tax, but it is
imposed more as a deterrent than as a source of revenue.
(4) Forfeitures: Forfeiture means the penalty imposed by the courts on the persons who have not
complied with the notice served by it or for the breach of contract or has failed to pay the
dues in time, etc.
(5) Escheats: The property of a person having no legal heirs and dying intestate, will be taken
possession of by the government. That is, the Government can take over the property of a
person who dies without having any legal heirs or without keeping a will. But, it cannot be
considered as a main source of revenue to the Government.
(6) Special Assessment: According to Prof. Seligman, special assessment means ‚a compulsory
contribution levied in proportion to the special benefit derived to defray the cost of the

specific improvement to property undertaken in the public interest‛. Thus, it is a compulsory
payment or contribution. It is levied in proportion to the special benefits derived to bear the
cost of specific improvement to property. Whenever the Government has made certain
improvements, somebody will get benefited. For example, irrigation facility, road and
drainage facility, etc.
Because of this, the value of the property in the neighborhood will rise. This rise in the value
will provide an unearned increment. Hence, the Government has a right to appropriate a part
of this unearned increase. This appropriation is called as special assessment.
(7) Gifts and Grants: Gifts are voluntary contributions from Non-Government donors to the
Government for various purposes like drought relief, defense, national relief, promotion of
family planning, etc. Grants are usually given by one Government to another. For example, in
a federal set up, the Union Government provides grants to the State Governments to carry out
their functions and fulfillment of obligations. Moreover, the Government of one country may
receive grants from other country.
(8) Royalties: Royalty is received by the government when it allows private enterprises to use
government/ public assets or intellectual property. Royalty is generally charged as a
percentage of revenue derived from the use of the asset or a percentage of the unit price of the
product sold. Example: Private sector enterprise has to pay royalty to the government to
extract natural resources like petrol/ crude oil from government owned lands.
III. PUBLIC DEBT
In this section we will cover: 1) Nature and kinds of public debt. 2) Effects of public debt. 3)
Burden of public debt. 4) Redemption of public debt.
Nature and Kinds of Public Debt
Public debt is of recent growth and was unheard of prior to the 18 th century. In modern times,
however, borrowing by the States has become a normal method of government finance along
with other sources such as taxes, fees, etc. The government may borrow from banks, business
houses, other organizations and individuals. Besides, it can borrow within the country or from
outside. The government loan is generally in the form of bonds (or treasury bills if the loan is
required for short periods) which are promises of the government to pay to the holders of these
bills the principal sum along with interest at the stated rate. Borrowing is resorted to in order to
provide funds for financing a current deficit. This definition very clearly explains the three
features of public debt.
1. Public debt arises in the form of borrowings by the treasury or by the state exchequer.
2. The government borrows a certain amount now but promises to pay in the future not only
the principal amount but the interest also.
3. The government borrows when there is a budget deficit i.e. public expenditure is more than
revenue.
Classification of Public Debt
Public debt can be classified in different ways according to various factors like sources of
borrowing, purpose of loan, the term duration of loan provision for repayment, nature of
contribution, marketability.
1. Source of Borrowing (internal debt and external debt).
There are two sources of public debt, internal and external. Internal debt refers to public loans
floated within the country, while external debt refers to the obligations of a country to foreign
governments, or foreign nationals or international institutions. Though external debt is
becoming very common these days, there has been general prejudice against foreign debt, based
on ignorance and faulty economics.
2. Purpose of the loan (Productive and unproductive debt)
Public debt is said to be productive if the investment yields an income which will not only meet
the yearly interest payments of the debt but also help repay the principal over the long run. All
public debt can be said to be productive in another sense too. The government may undertake
certain projects through loans which may not be productive in the sense given above but which
may be really useful to the community – for example, a railway line connecting a backward
region, an irrigation work to prevent famine conditions in an area, and so on. In this sense all
public debt is productive. But in many cases, public debt may be contracted during war-time to

finance war. Such debt is unproductive because it does not create an asset; it is a dead-weight
debt or a useless burden on the community.
3. Funded debt and unfunded or floating debt.
Broadly speaking, funded debt is a long-term debt, undertaken for creating a permanent asset
and the government normally makes arrangements about the mode and the time of repayment.
Unfunded and floating debt is a relatively short-period debt meant to meet current needs. The
government undertakes to pay off the unfunded debt in a very short period, say, within six
months. Treasury bills are examples of unfunded debt. The rate of interest on unfunded debt is
lower.
4. Time Duration of loan (short, medium, and long term loan).
According to time duration of the loan, public debt can be classified into short term, medium
term, and long term loans. Short term loan is usually incurred for a period varying from three
months to one year. Usually government gets such loans from the central (national) banks by
using treasury bills. These loans are also called ‘ways and means advances’. Such loans are
obtained to overcome temporary deficits in payment to be made by the government in the course
of one year to pay salaries etc.Medium term loans are those which are obtained for more than
one year but less than ten years. Usually the governments borrow only long term loans for more
than ten years. The maturity period is long so that the rate of interest tends to be higher on the
long term loan than short term loan. Long term loans are incurred to finance development
schemes.
Why Public Debt is incurred? (Causes of public debt)
Public loans in modern times are necessary to meet difficult situations. In the first place, modern
governments do not have any large accumulated balance or treasure to meet a budget deficit.
Normally, the annual expenditure of the government should be and is met by annual income.
But because of many circumstances the yield from taxation and other sources may not be equal to
the actual expenditure. Similarly, there may be unplanned and unexpected emergency situations
like major fires, floods and famines. It may not be possible to secure funds through taxation.
Short-term borrowing in anticipation of tax collections in subsequent years is ordinarily used in
the above two circumstances.

Secondly, a factor which necessitates public loans is war. Modern warfare is so costly that the
normal income through taxation falls short of the actual war expenditure. A public loan is a
better and easier method of collecting revenue than taxation. Governments, therefore, have to
borrow extensively from individuals and institutions towards war financing. In fact, the
enormous increase in public debt in most countries is due mainly to the First and Second World
Wars.
Thirdly, public borrowing is considered very useful to remedy a depression. Business depression
and unemployment are generally due to deficiency of demand for goods and services. Keynes
advocated increased public expenditure financed through borrowing and not through taxation.
For, while taxation will reduce the incomes of the public and their demand still further,
borrowing will have no such effect. Besides, loans enable the government to make use of idle and
unutilized funds of the public.
Finally, public loans are resorted to for development purposes. Underdeveloped countries
interested in the development of their natural resources to the optimum level find public
borrowing a very useful device to finance the various development projects. In countries like
Ethiopia, public debt has been increasing in recent years because of this factor.
Sources of Public Borrowing
Every government has two major sources of borrowing-internal and external. Internally, the
government can borrow from individuals, financial institutions, commercial banks and the
central bank. Externally, the government generally borrows from individuals and banks,
international institutions and other governments.
Government may borrow from other countries to finance war expenditure or to pay for
development projects or to payoff adverse balance of payments. Two important sources have
become prominent. They are: (a) international financial institutions, viz., the IMF and World
Bank, which give loans for short term to payoff temporary balance of payments difficulties and
for long term for development purposes; and (b) government assistance generally to assist in
development projects. For developing countries like Ethiopia, external sources of borrowing are
becoming considerably important in recent years.

Effects of Public Debt
The effects of public debt refer to the effects on the economy which are caused by the existence of
public debt, after it had been incurred. Public borrowing from individuals and firms has effects
on all aspects of economic life. They may be considered as follows:
1. Effects on consumption. The effect of public debt on consumption depends upon how it is
financed by individuals. If they lend to the government out of their idle savings, consumption
is not affected. If they buy out of past savings it has only a limited impact on present
expenditure. But if they lend by cutting present savings, it may make them feel less secure
and so they may reduce consumption. But if the people feel that they have invested in
government securities which are considered safe investment, they may actually increase their
consumption.
2. Effects on Production and Investment. The effect of public debt on production depends upon
whether it affects private investment or not. If people buy government bonds by selling their
shares or debentures in private individual firms, there is an adverse effect on private
investment. But if the money borrowed by the government is for productive purpose, over all
production is not affected. But if it is used for wasteful or non-productive purpose, total
investment is affected negatively.
If people buy government bonds by taking away their bank deposits, bank’s lending capacity
is reduced and this again affects private investment. Private investment is not affected only
when it is financed by people out of their idle funds.
If the government uses the funds for productive purpose, it can repay it out of income
generated by these projects. But if public debt is used for unproductive purposes, it can be
repaid only by through additional taxation in future which affects future consumption as well
as production by reducing future disposable incomes. However, if public debt is used for
welfare schemes, it may increase people’s efficiency to work and thus improve productive
capacity.
3. Effects on Distribution. Public debt is bound to have effects on distribution of income
because it involves transfer of purchasing power from one sector to another. Usually
government bonds are purchased by the richer section. But the burden of tax to repay the

debt falls on all sections including the poor. To that extent the inequality of income will
increase. If the bondholder and taxpayers is the same people, theoretically there will be no
effect on redistribution of income. Hence redistribution of income effects of public debt
depends upon whether the taxpayers and the bond holders are the same people or not.
However if the public debt is used for public welfare programmes especially the poor,
inequalities of income deceases. But if public borrowing creates inflation, the beneficial effects
of redistribution will be neutralized as prices rise.
4. Effects on National Income. Public debt has an adverse effect on national income only if
private investment is adversely affected. However if government expenditure is incurred on
capital goods, it gives incentive to greater production and this again increases the income.
Government investment financed by public debt will have a multiple effect on national
income. If public debt is financed by commercial banks and national banks, the credit creation
and the public expenditure from that will have a very large expansionary effect on national
income.
5. Effects on Resource Allocation. Unlike tax finance, public debt has little effect on resource
allocation. Public borrowing curtails business investment activities but the decline of business
investment varies from one industry to another. Allocation of resources is not affected much.
Burden of Public Debt
Four types of burdens of public debt:
(a) Direct money burden,
(b) Direct real burden,
(c) Indirect money burden, and
(d) Indirect real burden.
(a) Direct Money Burden. Public debt involves payment of interest and repayment of the
principal by the government, who will have to raise the necessary amount by way of taxes. The
direct money burden of public debt consists of the tax burden imposed on the public and it is
equal to the sum of money payments for interest and repayment of principal. Actually, in the
case of an internal debt, there can be no direct money burden because all the money payments
(taxes) and receipts (interest) cancel out.

Suppose the government of Ethiopia collects taxes to the extent of Birr 1000 million a year from
the general public towards its debt services. This amount is transferred from the public to the
government. But the latter distributes this amount to the general public by way of interest on its
loans. Thus servicing of internally held public debt is reduced to a series of transfers of wealth
between parties – total receipts will necessarily be equal to total payment. There would,
therefore, be not net direct money burden in internal debt. On the other hand in the case of an
external debt, money payments by the debtor nation (say Ethiopia) are to external creditors (say,
Americans); these constitute clear direct money burden of public debt on the debtor nation.
(b) Direct Real Burden. When we refer to monetary transfers between taxpayers and creditors
we are speaking about the direct money burden. But when we refer to the distribution of taxes
and public securities among the public, we are referring to the real burden of public debt. We
know that people hold public securities (and get interest from the Government) but they also pay
taxes towards the cost of the debt service. If the proportion of taxation paid by the rich towards
the cost of the debt service is smaller than the proportion of public securities held by them, while
on the other, if the proportion of taxation paid by the poor and middle income groups towards
the cost of the debt service is greater than the proportion of public securities held by them, there
is a direct real burden from public debt. In this case, public debt has been responsible for
worsening inequality of incomes.
Suppose, on the other hand, government bonds and securities are held by the working classes
and the middle income group (and, therefore, they receive the interest) while the taxation
towards the cost of debt service is paid by the rich (by way of income tax and the other highly
progressive direct taxes) then public debt actually tends to decrease the inequality of incomes in
the country. In this case there is actually no direct real burden but there is a direct real burden to
the community. Thus whether internally held public debt imposes a direct real burden or
provides a, direct real benefit will depend upon the distribution of taxation on the one hand and
ownership of public securities on the other, among different sections of the community.
We may now refer to the direct real burden of external debt. In the case of external debt, there is a
transfer of payment from the debtor country to the creditor country. The direct real burden refers
to the loss of economic welfare which these money transfers involve. In case the money
payments for servicing external debt are made by the richer classes, the direct real burden will be
less; if, on the other hand, they are contributed by the poorer sections of the country, the direct
real burden will be much more.
(c) Indirect money and real burdens. Heavier taxation to meet debt charges may reduce
taxpayers’ ability and desire to work and save and thus check production. Heavy debt charges
may also force the government to economies on public expenditure as might promote
production. In case these adverse effects of taxation could be neutralized by some favorable
effects of public expenditure, the indirect burden of public debt can be cancelled out. In practice,
however, this may not be possible. In the case of external debt, indirect money and real burden
arise from checks to production because of additional taxation (to pay for debt charges) and to
possible economies which government may effect in desirable social expenditure.
Burden of External Debt
In one sense, the burden of a foreign debt is similar to that of domestic debt. That is, the
government will have to pay it through additional taxation. But, while in domestic debt, interest
payments and the repayment of loans are available to local nationals; in the case of foreign debt
they are available to foreigners. In another sense, the total money burden of an external debt is
more because there is the additional transfer problem. That is, the government will have to find
necessary monetary resources to pay off the external debt and besides will have to secure foreign
currencies too (after all, foreigners will have to be paid in their currencies). The transfer problem,
therefore, requires that during the term of the loan, the balance of trade must become favorable.
In other words, a regular payment of interest and principal to foreign countries will be possible
only if the export value exceeds the import value by at least the obligations arising from the loan.
But external debt can mean a certain impoverishment of the economy. The payment of interest
and debt redemption to foreign Countries means a corresponding exhaustion of national income
and makes greater demand on the gold and foreign exchange resources of the country. This is
what has been referred to as the transfer problem in the previous paragraph. What actually
happens is when foreign loans were made, they entered the debtor country in the form of

machinery, raw materials and other essential goods, for which no corresponding exports were
made at that time. After the lapse of a certain time, the debtor country manages to secure excess
of exports over imports to pay for the external loan. In this case, there is no actual
impoverishment of the economy involved but goods are paid for goods. But if the external debt
would really deprive the citizens of a debtor country of a certain amount of, goods and services,
this would be a net direct real burden of an external loan.
However, there is one sense in which an external loan can be a source of trouble to a debtor
country. The transfer problem necessitating the creation of an export surplus means ‚an
exhaustion of the country’s future capacity to import,‛ which is of vital importance for
development. But if the foreign loans are floated only when it is absolutely essential and when
internal resources are utilized as far as possible, and if the foreign loans are used to increase the
total national product, including goods specially meant for export, there is no reason why the
debtor country should suffer in the future.
An underdeveloped country which borrows abroad for the development of social and economic
overheads and basic industries will find that the benefits outweigh the burden of repayment of
the loan. Thus, an external loan for development purposes is not a burden but a profitable
venture. This is exactly like an internal loan meant for development purposes.
Can the Future Generation be made to bear the burden of Public Debt?
It is often contended that the burden of public debt can be shifted ‚to make posterity pay‛ the
debt of the present generation. The argument assumes that taxation imposes a direct burden on
the present generation while government borrowing does not impose such a burden. Suppose
public expenditure is financed out of taxes, the benefit of public expenditure as well as the
burden of taxation will fall upon the present generation.
On the other hand, in the case of debt financing of public expenditure, the benefit of public
expenditure will accrue to the present generation but the burden of taxation to pay for the
interest and repayment of principal will fall upon the future generations. Financing of investment
projects such as construction of irrigation works, rail and road construction, etc., though
borrowing is sought to be justified on the ground that (a) the benefit of public debt accrues to
future generations, and (b) the burden of servicing and repaying public debt would, therefore, be
borne by the future generations. This line of thinking is obviously wrong and cannot be
maintained.
In the first place, real resources required by the government for war, economic development or
any other purpose have to be obtained now and at the immediate cost of the present generation,
whether they are derived from taxation or borrowing. Borrowing is only an alternative to
taxation for diverting real resources from private sector to the government. The present
generation will have to transfer these resources to the government either through taxes or
through loans and will, therefore, have to suffer a loss of resources. In other words, the present
generation will have to bear the burden of public debt and the question of shifting it to the future
generations does not arise.
Secondly, there is no direct money burden of public debts on the future generations. As we have
seen earlier, the burden of taxation to pay for public debt is cancelled out by the receipt of
interest from the government. While some groups in the future pay taxes some others will
receive interest. The question of shifting the burden to the future generations is actually
confusing.
It is, however, possible to argue that under tax financing, the present generation will have to
curtail its consumption, but in the case of debt financing there will be no such reduction of
consumption. The assumption here is that those who are paying taxes do so out of their current
income and, therefore, reduce their consumption expenditure but those who are subscribing to
public debt do so out of their savings. Debt financing leaves in the hands of public debt owners
bonds and other securities which they consider as part of their wealth. While tax financing
makes the general public poorer and, accordingly, reduce their consumption, debt financing does
not have such a result since the owners of public debt do not feel that they are poorer. In fact,
they have bonds and securities in lieu of funds transferred to the government. Under debt
financing, therefore, consumption is not likely to fall. In this sense, tax financing imposes a real
burden on the present generation, while debt financing does not impose such a burden on the
future.

Suppose, the present generation reduces its savings to subscribe to public debt, and suppose
further that as a result of reducing saving and capital formation, the capital stock of future
generation is reduced. In such a case debt financing can impose a heavy indirect burden on the
future generation. On the other hand, if the present generation reduced its consumption, to
subscribe to public debt, saving and capital formation would not be affected and the future
generation would not be burdened through inheritance of reduced capital stock. The above
analysis is defective since the expenditure side of the government is ignored. If the government
resorts to debt financing for planned economic growth and accumulation of capital stock, the
benefits will be available to the future generations and there will be no real burden from such
debt – for the loss of welfare through taxation will be more than made good by benefits from
government investment.
Only in the case of external debt the burden of public debt can be passed on to the future
generations. When a country raises resources in foreign countries for war, the present generation
receives additional resources and, therefore, need not curtail its consumption or saving. The
future generations will have to pay the interest and also repay the principal, and hence the
burden of external debt is on them. But in case the country has borrowed in a foreign country for
development purposes (as in the case of India), the future generations may not feel the burden on
account of increased productivity which external borrowing has made possible.
Generally, therefore, the burden of public debt cannot be shifted from one generation to another.
We cannot ‚make posterity pay‛. Nor is it normally correct to make the future pay for policies
taken now for which the future has no control or influence.
Redemption of Public Debt
It is fact that mounting public debt has a demoralizing effect of the people apart from the fact
that the public is subjected to higher rates of taxation. Besides, public debt consists mostly of
unproductive or dead-weight debt – war debt is a good example of such debt – the sooner it is
paid off, the better both for the government as well as for the public. The various methods
available to the government to pay off its debt are:

(i) Repudiation of Debt
Repudiation of debt means simply that the government refuses to pay the interest as well as the
principal. Repudiation is not paying off a loan but destroying it. Normally, a government does
not repudiate its debt, for this will shake the confidence of the general public in the government.
However, in extreme circumstances, a government may be forced to repudiate its internal or
external debt obligations. For instance, internally the country may be facing financial ruin and
bankruptcy and externally, it may be faced with shortage of foreign exchange.
Generally, a government may not repudiate its internal debt lest it should lead to internal
rebellion: those who have lent to the government would obviously rise against the government.
However, the temptation of a government to repudiate its external debt obligation may be strong
at certain times. Of all the methods of redeeming debt, repudiation is the most extreme.
(ii) Conversion of Loans
Another method of redemption of public debt is known as conversion of loans, that is, an old
loan is converted in to a new loan (in a broad way, conversion is the same as refunding debt; i.e.,
repayment of a debt through a new loan). Conversion may be resorted to when at the time of
redemption of a loan; the government has not the necessary funds. Conversion of a loan is,
always done through the floating of a new loan. Hence, the volume of public debt is not reduced.
Really speaking, therefore, conversion of debt is not redemption of debt.
(iii) Serial Bond Redemption
The government may decide to repay every year a certain portion of the bonds issued previously.
Therefore, a provision may be made so that a certain portion of public debt may mature every
year and decision may also be made in the beginning about the serial number of bonds which are
to mature each year. This system enables a portion of the debt being paid off every year. A
variant of this type of bond redemption is to determine the serial number of bonds to mature
every year through lottery. While under-the first variant, the bond-holders know when the
different sets of bonds would mature and could take up the bonds according to their
convenience, under the second variant, the bond-holders are uncertain about the time of
repayment and they may get back their money at the most inconvenient time.

(iv) Buying up Loans
The government may redeem its debt through buying up loans from the market. Whenever the
government has surplus income, it may spend the amount to pay off government loan bonds
from the market where they are bought and sold. It is a good system, provided the government
can secure budget surpluses. The only defect of this method of canceling debts is that it is not
systematic.
(v) Sinking Fund
Sinking fund is probably the most systematic and, therefore, the best method of redeeming
public debt. It refers to the creation and the gradual accumulation of a fund which will be
sufficient to pay off public debt. Suppose the government floats a loan of Birr10 billions,
redeemable in say, 10 years, for the purpose of road construction. At the time the government is
floating the loan, it may levy a tax on petrol, the proceeds of which would be credited to a fund
known as the sinking fund. Year after year, the tax proceeds as well as interest on investments
will make the fund grow till after 10 years it becomes equivalent to the original amount
borrowed; at that time, that debt will be paid off. One danger of the sinking fund methods is that
a government, in need of money, may not have the patience to wait till the end of the period of
maturity but may utilize the fund for purposes other than the one for which originally the
sinking fund was instituted.
(vi) Capital Levy
Public debt may be redeemed through a capital levy which, as we have seen earlier, may be
levied once in a way with the special objective of redeeming public debt. It is generally advocated
immediately after a war for the following reasons:
Heavy public debt is incurred during a war to prosecute it and hence is quite heavy
immediately after war.
War debt is unproductive and is a dead weight on the community necessitating heavy
taxation year after year. It will be better to wipe it out once and for all by a special levy.
Due to war-time inflation, businessmen, producers and speculators would have amassed
large fortunes and hence it is easier for them to contribute to a capital levy and, in a sense, it

is just they bear a part of the war burden.
Redemption of public debt through capital levy will leave the higher income groups almost
in the same old position, since they will be receiving back from the government what they
had paid by way of a special levy.
Redemption through a special levy is said to be superior to the method of the sinking fund, as it
is levied only once, while for purposes of the sinking fund, taxes have to be imposed year after
year. The greatest merit of capital levy is that it will reduce heavy tax burden which will
otherwise be necessary to redeem public debt. But the danger of a capital levy is that the
government may be tempted to resort to it too often.
(vii) Redemption of External Debt
The redemption of external debt can be made only through accumulating the necessary foreign
exchange to pay for it. This can be done by creating export surpluses. Towards this end, foreign
loans should be carefully invested in those industries which have high productive potentialities
and which will promote exports directly. At the same time, the exportable surplus should consist
of goods which can be really taken by foreigners. Temporarily, of course, redemption of an old
debt can be made through the floating of new loans.
From the various methods available to a government to pay off its debt, the most common and-
sensible method is to redeem part of the public debt every year, so that the debt may not go on
mounting.
Public Debt management
Public debt management refers to important policy decisions to be made with regard to public
debt. This is an important aspect of modern public finance as it is now accepted that public debt
is an active fiscal tool just like taxation and public expenditure, all of which have varied effects
on the economy. Hence the floating and repayment of debt should be carefully planned. The
forms of public debt, the terms of loan with regard to interest and duration, the ownership
pattern are all crucial issues in management of public debt. In short public debt management is
concerned with the policy decisions on the structural characteristics of public debt.

Objective of Public Debt Management
Public debt management can help the government to achieve several goals. Important objectives
of public debt management in this respect are:
It should not have any adverse effect on the economy, especially on willingness and ability
to work and save
During inflation public debt management should aim at curtailing aggregate demand
During depression it should help to raise aggregate demand in order to improve
employment.
Public debt management can help to secure funds during War.
It should go hand in hand with monetary policy to strengthen the money market.
IV. Fiscal policy
Fiscal policy is also called as budgetary policy. In broad terms, fiscal policy refers to that
segment of national economic policy, which is primarily concerned with the receipts, and
expenditures of these receipts and expenditures. It follows that fiscal policy relate to those
activities of the state that are concerned with raising financial resources and spending them.
Resources are obtained through taxation and borrowing both within the country and from
abroad. Spending is done mainly on defense development and administration. Financial
accounts of the income and expenditure position are shown in budgetary statement. Budget can
act as an important tool of economic policy. The state by its policy of taxation-regulated
expenditure can influence the economic activities and development.
Private outlay is insufficient to produce maximum national income. An increase in state outlay
beyond its revenue can increase national income. Keynes emphasized the effects of government
revenue and expenditure upon the economy as a whole and argued that they should be used
deliberately and consciously to secure economic stabilization. This underscores the importance
of budget in economic development.
Fiscal policy relates to the government’s decision making with respect to taxation, government
spending, government borrowing and management of government debt. The policy relates to
government decisions, which influence the degree and manner in which funds are withdrawn

from private economy. Basically fiscal policy in these different facets deal with the flow of funds
out of the private spending and saving stream into the hands of government and the recycle
funds from government into the private economy.
It is thus obvious that fiscal policy deals quite directly with matters, which immediately influence
consumption and investment expenditure. Therefore, it influences the income, output and
employment in the economy. Fiscal policy is primarily concerned with the aggregate effects of
public expenditure and taxation on income output and employment. In developed economies the
propensity to consume leads to stability. Excess saving by the community leads to lowering of
demand for goods and services resulting in sub optimal employment level. Fiscal policy should
balance the economy by sustaining the consumption in the economy.
In under developed and developing countries main objectives are rapid economic development
and an equitable distribution of the income. Fiscal policy can be an important instrument for
attaining these objectives. Fiscal policy influences the economy by the amount of public income
that is received and on the other by the amount and direction of public expenditure. The
important fiscal means by which resources can be raised for the public exchequer are taxation,
borrowing from public and credit creation. These means must be used in harmonious
combination so as to produce the best overall effects on the economic life of the people in terms
of economic progress and social welfare.
Role of Fiscal Policy in Economic Development:
In under developed and developing countries development is the main concern. The primary
task of fiscal policy in an under developed and developing countries is to allocate more
resources for investment and to restrain consumption.
The fiscal policy should reduce the economic inequalities of income and wealth. This can be
achieved by taxation and public distribution measures. Poverty and unity cannot co exist.
Therefore fiscal policy should attempt economic development of the socially unfortunate to
bring about national unity. Private section is not interested in investing in social and economic
overheads. Investments in social and economic overheads like education, medical facilities,
infrastructure, dams etc. are very essential to accelerate the rate of economic growth.

In under developed and developing countries the requirement of growth demands that fiscal
policy has to be used progressively for raising the level of investments and savings rather than
keeping the consumption level. In under developed and developing countries fiscal policy has
to be used as an instrument of resource mobilization. In order to attain growth with stability
the goal of fiscal policy should be promotion of highest possible rate of capital formation and
should reduce the actual and potential consumption. Further fiscal policy should encourage
private investment and attract foreign funds for development projects.
The existing pattern of investment may differ from the optimum pattern of investment. Thus
it becomes a responsibility of government to undertake investments in such a way that it is
most beneficial for the people of the country.
Fiscal policy should control inflation within tolerable levels since inflation mostly affects the
poor.
In under developed and developing countries there exist regional imbalances in addition to
social inequalities. Fiscal policy should aim at reducing both regional and social imbalances by
directing investments to less developed regions.
Fiscal policy should direct available resources for providing basic physical, infrastructural needs
like irrigation, roads, basic industries, railways, ports, telecommunications etc. Therefore
government of a country through its fiscal policy is able to increase rate of investment and also
alter the pattern of investment. It follows that the main role of fiscal policy in an under developed
and developing countries is to expand productive capacity by raising the level of real capital
including skills as well as plants and equipment and to check the demand generating effect of
expanding investment. In developed countries its role is to expand both production capacity as
well as the level of aggregate monetary demand in relation to their economic growth. In under
developed countries the better approach is to transfer resources to capital formation without
inflation. Fiscal policy through its different measures such as taxation policy budgetary policy,
public debt policy and a co-ordination with monetary policy can direct the economic destiny of a
nation. Fiscal policy can be used to mitigate the effects of trade cycles such as inflation and
depression.

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CHAPTER ONE

1. BASICS OF PUBLIC FINANCE

Overview of Public Finance

incur huge expenditure on varies functions the government has to perform.

expenditure and public debt as well.

1.1. Meaning of Public Finance

individually, before we understand the meaning of ‘public finance’.

expenditure of the government.

1.2. Scope of Public Finance:

public finance is classifies under five broad categories.

4) Financial administration and control

5) Economic stability and growth

welfare, growth, stabilization and other policies, by the government.

Public Finance & Taxation Chapter 1 2 Basics of Public Finance

services, and defense expenses.

nature and the volume of economic activities and on employment.

burden of public debt-internal and external.

4) Financial Administration and control

in charge of performing various financial functions of the state.

Thus financial administration and control include the following:

(1) Study of budgets and their procedure

(2) Budget as an instrument of securing certain objectives, such as promotion of employment,

economic growth with stability, welfare of the weaker sections, infrastructural

development of promoting private investments, etc.

5) Economic Stability and Growth

of economy, welfare of the people, etc.

1.3. Functions of Modern Government and Fiscal Operations

Public Finance & Taxation Chapter 1 3 Basics of Public Finance

has been quite common in many countries.

Public Finance & Taxation Chapter 1 4 Basics of Public Finance

similarities and differences are discussed here below:

1. Satisfaction of human wants

private finance is concerned with the satisfaction of personal or individual wants.

people by incurring expenditure on the society.

government or any individual or firm exceeds their income/revenue

4. Engagement in Similar Activities

finance are quiet similar to each other.

Public Finance & Taxation Chapter 1 5 Basics of Public Finance

unlimited objectives whereas the resources are limited.

6. Problem of Adjustment of Income and Expenditure

sectors face the problem of adjustment of income and expenditure.

is social benefit or public welfare.

2. Adjustment Approach of Income and Expenditure

to raise the requisite revenue to meet its expenses.

capacity to pay. Private individuals or bodies have no such powers.

it in newspapers and by showing it on television. Whereas private finance is a secret affair. An

Public Finance & Taxation Chapter 1 6 Basics of Public Finance

in view short-term considerations. On the contrary, government incurs expenditure keeping in

view the long-term considerations such as construction of dams, multipurpose hydro-electric

The pattern of expenditure of an individual is governed by habits, customs, status, personal

deliberate economic policy of the government.

9. Right to Print Currency

not enjoy such rights.

1.5. Economic and Social Significance of Public Finance

importance of public finance in developing country may be summarized as under:-

Public Finance & Taxation Chapter 1 7 Basics of Public Finance

expenditure on the establishment of basic and heavy industries, infrastructural development,

such as power projects, transport sector, means of communication etc.

Economic Stabilization is yet another economically significant responsibility of the government.

of public finance to provide employment opportunities. Therefore, expenditure should be

employment. To generate employment, public Expenditure should be incurred on setting up new

industries, encouraging small-scale and cottage industries through financial subsidies,

expenditure on training-schemes, etc.