UNIT – 1 –BASICS OF PUBLIC FINANCE

INTRODUCTION

The 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
 Cont,d
 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.

 Cont’d
• 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. The important ones being
maintenance of law and order, defense, socio-economic
development, etc.
 Cont’d
 Public finance is thus concerned with the use and accomplishment of
essential monetary resources of the government. In fact Public Finance
deals with how and through what different sources the government gets
income, how it spends and how it controls and administers its incomes
and expenditures.

 These two activates, i.e. raising of revenue through taxation and other
sources plus borrowing from internal as well as external sources and
spending it on various services, together constitute “Public Finance”.
We, therefore, can say that Public Finance includes Public revenue,
Public expenditure and public debt.
 Definitions of Public Finance

• Public Finance is a very old science and different

economists have defined it in their own ways. Some of the
important definitions of Public Finance is as follow:
Public Finance is concerned with the income and
expenditure of public authorities and with the adjustment of
one to the other.” By Huge Dalton.
“Public Finance deals with the provision, custody and
disbursement of resources needed for conduct of public or
government functions.” By Professor Lutz.
 Cont’d
“Public Finance is a science which deals with the activity of
the statement in obtaining and applying the material means
necessary for fulfilling the proper function of the state.” By
Carl Penn.
“Public Finance is the study of the principles underlying the
spending and raising of funds by public authorities.” By
professor Findlay Shirras.
THE ROLE OF GOVERNMENT IN THE ECONOMY AND FISCAL OPERATIONS:

 We should know the role of the government to enable us to

appreciate the importance of government sector.
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 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.
 Cont’d

• Fiscal operations of taxation and public expenditure have

the effect of transferring resources from 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 groupes.
 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
 Cont’d
• 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}.
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.
 Cont’d
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.
 Scope of Public Finance

• As a student you have to answer the following questions:

what is that we study in public finance? What are the
various branches of the study of public finance?

• The contents of the science of public finance are divided

into five categories of financial activities of the government:
 Cont’d
1. Public revenue,
2. Public expenditure
3. Public debt,
4. Financial administration and control;
4. Economic stability and growth
 Public revenue

• In a broad sense, ‘Public Revenues’ includes all the income

and receipts, irrespective of their source and nature, which
the Government obtains during any given period of time. It
will include even the loans raised by the Government.
• In a narrow sense, it will include only those sources of
income of Government which are described as revenue
resources.
 Sources of Public Revenue
• Taxes: The most common method of financing Government
expenditure is by taking resort to taxation. In every country,
largest part of the public revenue is raised through taxes.
• Taxes may be imposed on persons income or wealth or on both,
they may be direct or indirect, and they may be of different rates
and nature.
• Tax is a compulsory contribution imposed by a public authority,
irrespective of the exact amount of service rendered to the
taxpayer in return, and not imposed as a fine for any legal
offence.
 Cont’d
• Fees: The other important source of public revenue is the
fees charged for rendering certain services by the State. Fee
is that revenue which is paid to the Government for the
special service rendered by it.
 Cont’d
• Fines and Penalties: Fines and penalties are payments made
by citizens for contravention of the laws of land. This is a
major source of revenue of modern nation states.
• Gifts: A small portion of public revenue is generated
through gifts made by individuals, corporate and foreign
Governments or agencies. Its significance as a source of
public revenue has been declining over the years.
 Cont’d
• Borrowings: It is a major source of public revenue to finance large
projects or programmes requiring large investments. Borrowings,
besides being an important source for financing public expenditure,
also help Governments to regulate money supply in the economy.

• Printing of Paper Money: The Governments, through their Central

Banks, may choice to printing of paper money to meet public

expenditure. Governments have the ability to create money and

assign it legal tender qualities. Modern Governments, however,

avoid now using this source for financing public expenditure.

 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.
• public expenditure is an important component of public
finance, therefore we also study various effects of public
expenditure on total employment, total income, aggregate
investment, output, distribution and general price level etc.
 Cont’d

• 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.
 Canons of Public Expenditure

• Following are the important canons of public expenditure:

Canon of Benefit: This canon suggests that every public
spending must ultimately be used for the cause of social
benfit 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.
 Cont’d

• 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.

• 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.

 Cont’d

• 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.
 Cont’d
• 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.
 Cont’d
• 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.
 EEFECTS OF PUBLIC EXPENDITURE
• 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:
1. 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.
• He further added that the level of production and employment
in any country depends upon the following factors.
 Cont’d
• (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.
 Cont’d

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
 Cont’d
• 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.
2. Effects of Public Expenditure on distribution
Effects of Progressive, Proportional and Regressive Expenditure

• Public expenditure by its nature may be progressive, proportional or

regressive.
• 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.
 Proportional Expenditure

• public expenditure is proportional if whatever the size of the

recipient’s income, the proportionate addition is the same.

• 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
 3. Effects of Public Expenditure on Employment

• Heavy expenditure in public sector

• Expenditure on public utilities

• Public expenditure to encourage small-scale
industries
• Public expenditure during the period of depression

• Public expenditure to create employment

 4. Effects of Public Expenditure on Economic Stability

There are three states of abnormal price behavior:

1. Inflation
2. Deflation or depression, and recession
 Public Debt

• Meaning of Public Debt

• Public debt is the debt which state owes to its subjects or to the
nations of other countries. Public debt arises due to borrowings by the
government.
• The government may borrow from banks, business organizations, and
individuals.
• The borrowings of the government may be within the country or from
outside the country or both. The public debt is generally in the form of
bonds or treasury bills.
 Sources of Public debt

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
banks, international institutions and other
governments.
 Objectives and importance of public debt

1) To cover budget deficits:

2) Rapid expansion in the state’s function

3) In times of depression:
4) To curb inflation:
5) To finance development plan:

6) To finance public enterprises:

7) Creation of social overhead capital:

8) To have better allocation of resources

9) Expansion of health services:
10)To finance war:
 Classification of Public Debt

• Government loans differ from one another in many ways

• The differences are due to the market, in which the loans are floated, the term
and duration of loan repayment provision, the conditions of repayment or the
purpose for which they are used and its nature of contribution.

The different forms/kinds of public debt are given below:

1) Internal and external debts

2) Productive and unproductive debts

3) Redeemable and irredeemable debts

4) Funded and unfunded debts

5) Voluntary and compulsory debts

 1. Internal and external debts
• Internal debt refers to the public loans floated within the
country,
• External debts refer to the obligations of country to
foreign governments or foreign nationals or international
institutions.
• The payment of interest on foreign debt reduces the net
income of the debtor country by transferring a part of its
income abroad; the payment of interest on internal debt
has no such effect.
 Cont’d

• Mean that:
o the interest on internal debt is taken away from tax-
payers as taxes and paid out as interest on internal
loan.
o It is round about way of taking money out of one’s
pocket and putting it in to another or the same tax-
payer.
 2) Productive and unproductive debts
Productive loans are those which are used for those projects which
yield an income to the government.
• For instance, the loans used :
 for the construction of railways, irrigation and power projects
 for the establishment of heavy industries such as iron and steel,
cement and fertilizers.
 the principal and the interest both can be repaid out of the income
derived from these projects
 the productive loans should not be considered as a burden upon
the Government and the tax-payers
 Cont’d

unproductive loans are those which are incurred

on those projects which do not yield any income.
For instance loans taken for financing war and
for giving relief in times of flood and drought .
The special character of unproductive debts is
that they have no existing assets and they are
considered as dead weight upon the government.
3. Redeemable and irredeemable debts:
Redeemable loans, are also know as terminable
debts, are those loans for which the government
promises to pay off at some future date.
 When a loan is redeemable :
• the government has to make some arrangement for
its repayment. If it is decided to pay it off from tax
money.
• the government has to pay the interest and the
capital both on some future date
Those loans, for which no such promise is made, are
called irredeemable loans.
 cont’d
• in case of irredeemable loans the government may
have to pay only interest regularly.

• 4. Funded and unfunded debts:

• Funded debts are long term debts. The payment of

those may be made at least after a year or may not
be made at all.
• unfunded debts are those that are paid off within a
year.
 5. Voluntary and compulsory debts
Generally, government debt is of a voluntary
nature, the individuals and the institutions are
invited to purchase government bonds.
However, compulsory loans are not common in
modern times. But the government has to exercise
its pressure for getting loans during an emergency
such as war, and during an inflationary period so
that the volume of purchasing power in the hands
of people may be reduced and the rising prices may
be checked.
 Cont’d
• In most of the cases, the loans floated by the
government are over – subscribed, because the
government has a much better credit than a private
individual or a company, and that is why the rate of
interest on the government securities is very low.
• If the rate of interest on government securities is
very low than it may be difficult to get loans
voluntarily from the public and it has to exercise the
influence.