36 Public Finance : Introductory Issues

Kamal Singh

Introduction

One of the basic premises of classical economist is the policy of Laissez fair which denotes the idea of non-interference by the government or restricting the role of government. Traditionally Government was assigned the role of providing the suitable environment for smooth conduct of market e.g. maintain law and order, providing safety to traders and etc. In lieu of these activities the government collected the taxes and other fees, which provides substantial part of government revenue. But due to growth of an economy and economic activities, the scope of government activities expanded and it started exhorting its influence in the working of the economy. For example in case of depression , individual and foreign investors might not be interested in investment or they doesn’t have enough resources for investment so to pull the economy from the doldrums of depression, the government can provide assistance in form of public Investment . Similarly government role was emphasized in curbing the income and wealth inequalities via the tools of taxation and subsidies. In this entire process government collect money or revenue and undertake expenditure. The study of government revenue and expenditure form the integral part of public finance.

Definition of public finance

According to Prof Dalton ‘Public Finance is concerned with the income and expenditure of public authorities and with the adjustment of one to another’

According to Harold Grover, ‘A field of enquiry that treats on income and outgo of governments (Federal, State and local). In modern times this includes four major divisions: public revenue, public expenditure, public debt and certain problems of fiscal system as a whole such as fiscal administration and fiscal policy.

According to Prof. Taylor, “Public Finance deals with government Finance and government finance is concerned with raising government revenue and making expenditures.

So public finance is the study of public revenue and public expenditure and other issues involving these aspects of the government.

Subject matter of Public Finance are:

• Public Revenue: Public revenue refers how the revenue is collected and generated in the most efficient way. The different types of taxes, tax rates and tax base, incidences and shifting of direct and Indirect taxes. The effect of various taxes and their analysis.
• Public Expenditure: Once the revenue has been generated the next big issues is to spend this revenue. Though the functions of the government are umpteen, but resources are less, so public expenditure relates to principles and problems of allocating the resources under different heads. There are various canons and principles governing the optimum allocation of revenue. The expenditure should be done in a way as to minimise the wastage and optimising the welfare.
• Public debt: Most of the time public expenditure exceeds public revenue, so to bridge the deficit and for other different needs government restores to the policy of public debt. It refers to loan which the government (centre or state) raises to meet the deficiency or contingency from different sources.
• Financial administration: Financial administration is related with the methods of administration, control and problems relating to preparation of budget, its various types process, etc. In other words how the financial function of the government will be carried is the matter of financial administration.

Main functions of the State

There are three important functions which the state performs. These functions are a) allocative b) distributive and c) stabilisation.

Allocative function: The resources which are at the disposal of the government are limited and the function of the state or the duties which the government has to perform are numerous. This give rise to problem of scarcity and choice .The allocative function of the state, decides to allocate the scarce resources in different areas, for example making provision for private and public goods. How much resources should be diverted for providing private goods and public goods.

Distributive function: Distributive function of the state emerges from the contention that in the free market the distribution of income and wealth is unfair. Market cares for only those who can pay price for the good and the others are excluded. This principle leads to inequalities in the distribution of income and wealth. Under the distributive function, the government interfere the market by the process of taxes and subsides and try to bridge these gaps.

Stabilisation function: For the economic growth and prosperity it is quite important that key economic variables should be stable. The government intervenes in the market to ensure steady growth and low inflation (leading to lower unemployment). The government attempts to achieve this role through monetary policy and fiscal policy. The aim is to get stable prices, stable growth and full employment.

Major aspects in Public Finance

Public expenditure

Public expenditure refers to the expenditure which is undertaken by the government on the various activities which are directed towards the welfare of the people and for the economic growth. Public expenditure is necessary for promotion of trade and commerce, building infrastructure , development of agriculture and industry , regional growth , for providing gainful employment , etc.

Principles governing public expenditure

While undertaking public expenditure numerous considerations are to be kept in mind. Governments should have the objective that there is minimum wastage in the process of expenditure. There are numerous wants/needs/ aspiration of the people from the government , but the resources at the disposal of the government to fulfil them are relatively scarce , so while undertaking the public expenditure governments should be extra careful. There are different principles/canons which the governments should follow while undertaking public expenditure. These principles/ canon are:

1) Principle of maximum social advantage: The theory of maximum social advantage is given by Prof. Hugh Dalton. According to Prof Dalton, “ The best system of public finance is that which secures the maximum social advantage from the operations which it conducts”. It simply discuss that when the government undertake certain activity there is some sacrifice which people have to bear which is called marginal social sacrifice . Similarly there is certain benefits which the society receive which is called marginal social benefit. According to Dalton the economy achieves maximum social advantage when the marginal social sacrifice is equal to marginal social benefit. In nut shell it describe that the expenditure done by the government should have minimum burden on the people and people should get maximum benefit.

2) The Principle of Economy: According to principle of the economy, the government should spend the money in such a way that the wasteful expenditure should be avoided.

3) The Principle of Sanction: According to the principle of sanction, all the public expenditure which is incurred should have the sanction of the competent authority. The sanction is necessary because it helps in avoiding waste, extravagance, and overlapping of public money.

4) The Principle of balanced Budgets: The government should strive for maintaining balanced budget. The budget should neither be surplus nor deficit. It simply refers that the government should neither overspend nor underspend.

5) The Principle of Elasticity: According to this principle the public expenditure should have built in flexibility. It means that it should not be rigid, as and when need arises it should have flexibility to change. For example in case of recession or slow down, it should be possible for the government to increase the expenditure so that economy can be lifted from the grip of recession.

6) No unhealthy effect on Production and Distribution: The public expenditure should be such that it should not have adverse effect on production or distribution of wealth. Public expenditure should rather provide impetus for production. It should strive for reducing the inequalities rather than concentrating wealth or income into the hands of few.

Public goods and merit goods

There are different categories of goods which are studied in economics like Normal goods, Superior goods, Inferior goods etc. but the special types of goods public goods and merit goods occupies an important place in public finance

Public goods in general sense means goods which are provided to the public by the government at subsided price. But in economics jargon not every good provided by government is public good, it should have some characteristics. The important feature of public goods is:

1) Non-rival in consumption: Public good is non-rival in consumption which means once the public goods are available they are available to everyone in equal amount and the consumption of public good by one person doesn’t diminishes the amount of the good available to other consumers. This feature of non-rival in consumption extends to the fact that the marginal cost of providing the good is zero for additional consumer. Because of this principle it is inefficient to exclude consumer from consuming the public good or exclusion principle is not advisable

2) Non-excludable: This principle propounds that once the public good is produced the individuals who do not pay the price cannot be excluded from the benefits of the good or service. Example street light, once street light is installed on a road, everyone will enjoy the benefit of light and there is no way to exclude a person from receiving the benefit of street light.

Pure and impure public goods: Public goods can be further classified as pure and impure public good. A good which has both the principle of Non rivalry and non-excludability is pure public good example lighthouses, street light, national defence etc. on the other hand some public goods can be partially rival or partially excludable. Example cable television, the consumption by one consumer doesn’t diminishes the amount available to other consumer but the cable service provider can charge the fee for providing the connection or the consumer who doesn’t pay for cable connection will be excluded from its benefits.

MERIT GOODS

The concept of a merit good is given by Richard Musgrave. These are those goods which are not distributed by the means of price system or market system or the demand supply basis. As in case of merit goods, it is believed that they will be under consumed by people because of lack of knowledge or otherwise. Similarly the market forces will under supply the quantity if left to market. So government mostly produce them and provide to the people. These are those good which are provided on merit. Unlike the nature of public good which is non-rival and non-excludability and zero marginal cost to additional user? Merits good are partially rival and excludable and exhibit positive marginal cost for additional user. Example are free or subsided education, inoculation etc. Subsided education is given to few may be on basis of merit. All people who wish for free education cannot be given subsided education so it is excludable and rival in consumption. They are given on certain merits. If one more student is to be given free or subsided education, government has to incur extra expenditure.

2. Public Revenue

Public revenue refers to source of income to the government from the entire sources. The main sources of public revenue are:

Taxes

Taxes are the compulsory payments which are made by citizens of the country to the government.

Taxes can be divided into categories 1) Direct tax and 2) Indirect Tax.

Direct tax is a tax whose incidence and impact fall of the same person. Impact means the initial burden of the tax. It means who bear the burden of the tax in the first instance. Incidence of the tax refers to the final burden of the tax, or who ultimately pays the tax. In direct taxes the burden of the tax cannot be shifted. Example, income tax, corporation tax, etc.

Indirect tax is the tax whose incidence and impact is on different person. The burden of the tax can be shifted on to another person. Example sales tax , in the case of sales tax, impact is on the seller of the product but the seller shifts the burden to the consumer and it is the consumer who ultimately pays the tax or who bears the burden.

Progressive, Proportional and Regressive Taxes

Taxes can also be classified as progressive, proportional and regressive according to the relationship between tax rate structure and tax revenue

Progressive tax: A tax is called progressive tax in which the tax rate increases as the taxable amount increases or tax rate increases with tax base increase. Income tax is one of the famous progressive taxes.

Regressive tax: A regressive tax is tax in which tax rate decreases as tax base increases. For example, if there is tax of Re1 on one packet of X commodity and if a person has income of Rs 10 then this Re 1 will represents 10% of the person’s income. However, if the other person income is Rs 20 then this Re1 will represents 5% of that person’s income. So this tax is regressive.

Proportional tax: Proportional tax is a tax under which the tax rate is the same at each level of tax base. The tax rate remains same but the tax amount increases as the person’s income increases. For example if the tax rate is 10 % and person income is Rs 50,000, the tax amount will be Rs 5,000 and if the individual income is Rs 1 Lakh, he will pay Rs 10,000.

Budget

The government needs large amount of revenue to perform number of activities, example provision of law and order, public goods, safety and security of its citizens etc. Similarly government undertake large amount of expenditure called public expenditure. In performing these functions, it is necessary to keep the estimate of the revenue and expenditure, so the concept of budget comes to forefront. Government budget is statement of the estimated receipts and expenditure of the government during a fiscal year. It provides an idea that how much of the revenue will be collected by the government and how much expenditure will be incurred in the following fiscal year. There are number of objectives which the government tries to achieve through the medium of government budget like reallocation of the resources, reducing the inequalities in income and wealth, achieving the economic stability, to achieve economic growth and economic development and many more similar objectives.

Government Budget can be divided into two parts 1) Revenue Budget and 2) Capital Budget.

Revenue budget is further classified into two categories revenue receipts and revenue expenditure.

Similarly capital budget has two parts, capital receipts and capital expenditure.

Revenue Receipts and Revenue expenditure

Revenue receipts are those receipts which cannot be reclaimed from the government. These receipts neither create any liability to government nor leads to loss of capital of the government. Revenue receipts are further of two types 1) Tax receipts and Non tax receipts. Tax receipts accrue through various direct and indirect taxes which have been discussed in above paragraph. Non tax receipts are like interest receipts on account of loans by the central government, dividends and profits on investments made by the government, fees and other receipts for services rendered by the government etc. Revenue expenditure are current or consumption expenditures incurred on civil administration, defence forces, public health and education, maintenance of government machinery. This type of expenditure is of recurring type which is incurred year after year.

Capital Receipts and Capital Expenditure

Capital receipts are those receipts of the government which leads to creation of certain liability or reduction in its assets. Examples of capital receipts are loan raised by government from public, loan raised via borrowing from Reserve Bank of India, loans received from various international organisation or foreign countries.

Capital Expenditure is the expenditure which is incurred by the government which lead to creation of physical or financial assets or reduction in financial liabilities. Example of capital expenditure is expenditure on Infrastructure, investment in shares etc. Both Revenue and capital expenditure can further be classified into planed and non-planned categories.

Balance and Unbalanced Budget

Government Budget can further be classified as 1) Balanced Budget and 2) Unbalanced Budget.

Balance Budget is that budget in which government revenue is equal to government expenditure.

Balanced Budget:  Budget Revenue = Budget expenditure

Unbalance Budget is that budget in which government revenue is not equal to government expenditure.

There can be two categories under unbalance budget a) Surplus budget and b) deficit budget.

Surplus budget: Budget Revenue > Budget expenditure

Deficit Budget: Budget Revenue < Budget expenditure

Different types of Deficits

There are few important types of deficits which are discussed in public finance.They are budget deficit, revenue deficit, fiscal deficit and primary deficit. The brief explanation about these deficits is as follow

1) Budget deficit: Budget deficit can be defined as the excess of government expenditure over its receipts. It simply tells us that the expenditure of the government is more than the revenue of the government.

Budget Deficit: Budget Revenue < Budget expenditure

2) Revenue deficit: The revenue deficit refers to the excess of government’s revenue expenditure over revenue receipts.

Revenue deficit = Revenue expenditure – Revenue receipts

Revenue deficit indicates that government revenue expenditure that is expenditure on administration, salaries etc. is more than the revenue receipts which it collects via tax and non-tax sources.

3) Fiscal deficit : Fiscal deficit is the difference between the government’s total expenditure and its total receipts excluding borrowing

Gross fiscal deficit = Total expenditure – (Revenue receipts + Non-debt creating capital receipts)

Non-debt creating capital receipts are those receipts which are not borrowings and, therefore, do not give rise to debt. Fiscal deficit can also be defined as budgetary deficit plus government’s market borrowings and liabilities. Fiscal deficit is an indicator of the indebtedness of the government. High fiscal deficit is considered bad for fiscal health for the country as well it harms the credit worthiness of the country.

Primary Deficit:- Primary deficit is defined as fiscal deficit minus interest payment.

Primary deficit = Fiscal deficit – interest payment.

Public Debt

Public debt refers to the loans raised by the government from within the country or outside country. Public debt is source of public finance and it carries obligation of repayment to the individuals/institution, along with interest.

Need of Public debt

Public debt is needed on number of occasion like financing economic development, in the time of natural calamities, wars, to cver budget deficits, financing five year or annual plans, for pulling the economy out of recession or depression, to control inflation etc.

Source of public debt

There are primarily two main sources of public debt. They are internal and external.

Internal debt is the loan taken by government within the political boundaries of the country. The main sources of internal borrowing are: i) Individuals ii) Banking & non-banking institutions, iii) Central Bank.

External Debt: It refers to the loans which are raised by government from foreign/external sources. The main sources are: i) Foreign governments, 2) Foreign monetary institutions like World Bank, International monetary fund, MF, International Finance Corporation, international development association etc.

Sources for Further Reading on Indifference curve analysis.

• Musgrave and Musgrave, (1989) Public Finance in Theory and Practice, Mc Graw- Hill International Edition.
• Jha R.(1998) Modern Public Economics, Routledge London
• Cullis, J. G. and Jones, P.R. 1998. Public Finance and Public Choice. Oxford: Oxford University Press.
• Harvey S. Rosen and Ted Gayer (2007), Public Finance, Eighth Edition, Mc Graw Hill ,New York.
• Dalton, H , Principles of Public Finace , London , Routledge Kegan Paul Paul , Ltd.
• Gupta, Janak Raj , Public Economics in India Theory and Practice, Atlantic Publisher , New Delhi