CHAPTER ONE

BASICS OF PUBLIC FINANCE

1
The Field of Public Finance
 Public finance is field of study in economics that is
concerned with the financial activities of the public
sector—that part of the economy controlled by
governments
 Richard Musgrave definition: The complex of
problems that center around the revenue-expenditure
process of government is referred to traditionally as
public finance

2
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
 What is Public Finance?
• Public finance is the study of how spending and tax
policies influence our economic lives.
In examining how governments influence our lives,
public finance addresses one fundamental issue: why
do we want the public sector to exert such powerful
influences over our lives & public finance, a sub
discipline of economics ( also known as public sector
economics or just public economics), provides us
with a framework for understanding changing and
improving the ways in which the public sector
influences our lives

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
The Field of Public Finance
• We want to know:
– Which activities it is sensible for governments to
perform
– The right quantities of public goods and services
that should be provided
– And the best method of paying for those services

4
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
Musgrave’s Economic Roles of Government

• Allocation
• Distribution
• Stabilization

5
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
 Scope of Public Finance:
• The Subject matter of the public finance is
classifies under five broad categories. They are:
1. Public revenue
2. Public Expenditure
3. Public debt
4. Financial administration
5. Economic stabilization

6
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
 Public Revenue Source
• Public revenue is the means for public
expenditure. Various sources of public revenue
are:
a. Tax revenue
b. Non-tax revenue

7
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
 Public Revenue Source…
A)Tax revenue: - Taxes are compulsory payments to
government without expectation of direct return or benefit
to tax payers.
It imposes a personal obligation on the taxpayer.
Taxes received from the taxpayers, may not be incurred for
their benefit alone.
Taxation is the powerful instrument in the hands of the
government for transferring purchasing power from
individuals to government.
The objectives of taxation are to reduce inequalities of income
and wealth; to provide incentives for capital formation in
the private sector, and to restrain consumption so as to
keep in check domestic inflationary pressures.
8
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
 Public Revenue Source…
B)Non-tax revenue:- This includes the revenue
from government or public undertakings,
revenue from social services like education and
hospitals, and revenue from loans or debt service.

To sum up, non-tax revenue consists of:

Interest receipts
Dividends and profits
Fiscal services and others.

9
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
 Public Expenditure theories
• Government of a country has to use its
expenditure and revenue programs to produce
desirable effects on national income, production,
and employment.
• The role of public expenditure in the
determination and distribution of national income
was emphasized by Keynes.
• Public expenditure plays the dual role of
administration and economic achievement of a
nation.
10
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
 Public Expenditure theories…
• Hence planned expenditure and accurate foresight of
earnings are the important aspects of sound
government finance.
• Public expenditure is done under two broad heads
viz., developmental expenditure and non-
developmental expenditure.
• developmental expenditure includes social and
community services, economic services, and grants
in aid.
• non-developmental expenditure mainly consists of
interest payments, administrative services, and
defense expenses.
• Expenditure can also be classified into revenue and
capital expenditure.
11
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
 Public Debt/ Deficit Financing
• This category deals with the causes, methods and
problems of public borrowings and its
management.
• This includes both internal debt and external debt.
• Debt raised for productive purpose will not be a
burden on the economy.
• There are many objectives of creation of public
debt. Debt may be raised to meet the normal
current expenditure, exigencies like war, finance
productive government enterprise, finance public
social welfare and economic development.
12
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
 Public Debt/ Deficit Financing
• Measures of debts and deficits are widely used to
estimate the risks of fiscal crises.
• They also enter into assessments of the
sustainability of the government’s tax and spending
policies and thus judgments about intergenerational
equity.
• Deficits are used to estimate whether the
government’s fiscal policy is stimulating or
constraining the rest of the economy.
• Debt must be measured to determine whether high
levels inhibit economic growth. And estimates of
spending and revenue must be made to assess the
impact of the size of government on economic
growth and other variables.
13
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
 Public Financial Management
• Public financial management entails the
development of laws, organizations and systems to
enable sustainable, efficient, effective and
transparent management of public finance.
• Public financial management (PFM) is an essential
part of the development process.
• Sound PFM supports aggregate control,
prioritization, accountability and efficiency in the
management of public resources and delivery of
services, which are critical to the achievement of
public policy objectives, including achievement of the
Millennium Development Goals (MDGs).
14
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
 Public Financial Management

• In addition, sound public financial

management systems are fundamental
to the appropriate use and
effectiveness of donor assistance since
aid is increasingly provided through
modalities that rely on well-functioning
systems for budget development,
execution and control.

15
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
Public Goods and the Need for Government

• A game theoretic motivation for government

• Market failure and potential roles for
government
• Constitutional definition of scope and
limitations of government
• State and local governments and their powers

16
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
Market Failure and Potential Roles for
Government
• Public goods
• Externalities
• Lack of competition
• Imperfect information
• Distribution of income

17
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.