Public Finance

Chapter: 1

Public finance is the approach to managing the public funds in the country’s economy that
plays the most important role in the development and growth of the nation, both domestically
and internationally.
Prof. Dalton, in his book Principles of Public Finance, states that “Public Finance is concerned with
income and expenditure of public authorities and with the adjustment of one to the other”

The scope of Public Finance

The scope of public finance is not limited to managing the finance. Prof. Dalton classifies the
scope of public finance into four areas as follows –

Public Income
As the name suggests, public income refers to the income of the government. The government
earns income in two ways – tax income and non-tax income. Tax income is easy to recognize; it’s
the tax paid by people of the country in the form of income tax, sales tax, duties, etc. On the
other hand, non-tax income includes interest income from lending money to other countries,
rent & income from government properties, donations from world organizations, etc. This area
studies methods of taxation, revenue classification, methods of increasing government revenue
and its impact on the economy as a whole, etc.

Public Expenditure
Public expenditure is the money spent by government entities. Logically, the government will
spend money on infrastructure, defense, education, healthcare, etc., for the growth and welfare
of the country. This area studies the objectives and classification of public expenditure, effects of
expenditure in different areas, and effects of public expenditure on various factors such as
employment, production, growth, etc.

Public Debt
When public expenditure exceeds public income, the gap is filled by borrowing money from the
public or from other countries or world organizations such as The World Bank. These borrowed
funds are public debt. This area of public finance explains the burden of public debt, why it is
necessary, and its effect on the economy. It also suggests methods to manage public debt.

Financial Administration
As the name suggests, this area of public finance is all about the administration of all public
finance, i.e., public income, public expenditure, and public debt. Financial administration includes
preparing, passing, and implementing government budgets and various government policies. It
also studies the policy impact on the social-economic environment, inter-governmental
relationships, foreign relationships, etc.

Functions of Public Finance

There are three main functions of public finance as follows –

The Allocation Function

There are two types of goods in an economy – private goods and public goods. Private goods
have a kind of exclusivity to themselves. Only those who pay for these goods can get the benefit
of such goods, for example – a car. In contrast, public goods are non-exclusive. Regardless of
paying or not, everyone can benefit from public goods, for example, a road. The allocation
function deals with the allocation of such public goods. The government has to perform various
functions such as maintaining law and order, defense against foreign attacks, providing
healthcare and education, building infrastructure, etc. The list is endless. The performance of
these functions requires large-scale expenditure, and it is important to allocate the expenditure
efficiently. The allocation function studies how to allocate public expenditure most efficiently to
reap maximum benefits with the available public wealth.

The Distribution Function

There are large disparities in income and wealth in every country in the world. These income
inequalities plague society and increase the crime rate of the country. The distribution function
of public finance is to lessen these inequalities as much as possible through the redistribution of
income and wealth. In public finance, primarily three measures are outlined to achieve this
target–

• A tax-transfer scheme or using progressive taxing, i.e., in simpler words charging higher
tax from the rich and giving subsidies to the low-income
• Progressive taxes can be used to finance public services such as affordable housing, health
care, etc.
• A higher tax can be applied to luxury goods or goods that are purchased by the high-
income group, for example, higher taxes on luxury cars.

The Stabilization Function

Every economy goes through periods of booms and depression. It’s the most normal and
common business cycle that leads to this scenario. However, these periods cause instability in
the economy. The objective of the stabilization function is to eliminate or at least reduce these
business fluctuations and their impact on the economy. Policies such as deficit budgeting during
the time of depression and surplus budgeting during the time of boom helps achieve the required
economic stability.
Importance of Public Finance
The major importance of public finance are listed below as:

Steady State Economic Growth

Public finance is important to achieve a sustainable high economic growth rate. The government
uses fiscal tools in order to bring an increase in both aggregate demand and aggregate supply.
The tools are taxes, public debt, and public expenditure, and so on.

Price Stability
The government uses public finance in order to overcome form inflation and deflation. During
inflation, it reduces the indirect taxes and general expenditures but increases direct taxes and
capital expenditure. It collects internal public debt and mobilizes for investment. In case of
deflation, the policy is just reversed.

Economic Stability
The government uses fiscal tools to stabilize the economy. During prosperity, the government
imposes more taxes and raises the internal public debt. The amount is used to repay foreign debt
and invention. The internal expenditures are reduced. During the recession, the case is just
reversed.

Equitable Distribution
The government uses the revenues and expenditures of itself in order to reduce inequality. If
there is high disparity, it imposes more taxes on income, profit, and properties of rich people and
on the goods they consume. The money collected is used for the benefit of poor people through
subsidies, allowance, and other types of direct and indirect benefits to them.
Proper Allocation of Resources
Government finance is important for the proper utilization of natural, manmade, and human
resources. For it, on the production and sales of less desirable goods, the government imposes
more taxes and provides subsidies or imposes taxes lightly on more desirable goods.

Balanced Development
The government uses the revenues and expenditures in order to erase the gap between urban
and rural and agricultural and industrial sectors. For it, the government allocates the budget for
infrastructural development in rural areas and direct economic benefits to the rural people.

Promotion of Export
The government promotes the export by imposing less tax or exempting from the taxes or
providing subsidies to the export-oriented goods. It may supply the inputs at subsidized prices. It
imposes more taxes on imports and so on.

Infrastructural Development
The government collects revenues and spends for the construction of infrastructures. It has to
keep the peace, justice, and security too. It has to bring socio-economic reformation too. For all
these things it uses the revenues and expenditures as fiscal tools.

Difference between Public and Private Finance

The following are the main points of difference between public and private finance:

Adjustment between Income and Expenditure

An individual determines his expenditure on the basis of his income. He prepares his family
budget on his expected income during the month. On the other hand, the government first
estimates its expenditure and then finds out means to raise the necessary income. As pointed
out by Bastable, ‘The individual says, I can spend so much, the Finance Minister says, ‘I have to
raise so much’.
Elasticity of Finance
Public Finance is more elastic than private finance. There is not much scope for changes in private
finance while drastic changes can be made in government finance. For example, a private
individual cannot affect any special increase in his income. As against this, the government can
increase its income by imposing fresh taxes on the people.

Differences in Objectives
There is a fundamental difference in the objective of private and public finance. The motive of
private expenditure is personal benefit whereas the objective of public expenditure is a social
benefit. An individual always tries to save and a firm to earn profit. But there are no such
considerations on the part of the government, except the public welfare. However, there are
some public enterprises that are run on profits that are utilized for public welfare.

Nature of Expenditure
There are differences in the nature of expenditure between the two”. An Individual’s expenditure
is governed by his habits, customs, fashions, etc. On the other hand, The government expenditure
depends on its economic and social policies, like removing unemployment and poverty, reducing
income inequalities, providing’ infrastructure facilities, etc.

Compulsion
There is compulsion in public finance. People have to pay taxes. If they do not pay, they are
punished by fine and imprisonment. But an individual or firm cannot force anybody to pay him
money. The same is the case with loans. The government can force the people to lend it during
war or emergency. But an individual cannot compel any person to lend him money.

Law of Equi-marginal Utility

The private individual spends his money on various items in such a manner as to secure equal
marginal utilities from them. It is only by equalizing the various marginal utilities that he can
secure maximum utility out of his expenditure. The government, on the contrary, does not give
as much importance to this law as a private individual does. Modern governments sometimes
incur certain types of expenditure from which they do not derive any advantage, but they incur
this expenditure to satisfy certain sections of the community.

Present Vs Future
An individual is more concerned with his present needs and tries to satisfy them. Life being
uncertain and short, he has his immediate gain or profit in view. On the other hand, the
government is a permanent organization. It is concerned not only with the welfare of the present
generation but also with future generations. It, therefore, undertakes and spends on those
activities which also benefit future generations.

Nature of the Budget

A surplus budget is always good for a private individual. Bun a surplus budget may not be good
for the government. It implies two things:

• The government is levying more taxes on the people than is necessary.

• The government is not spending as much on the welfare of the public as it should.
Keynes supported a deficit budget to meet the situation created by the depression. Further, the
government budget is passed by the parliament. But the budget of an individual or firm is a
private affair without any controlling authority.

Nature of Borrowing
In the case of an individual, there can be no internal borrowing. An individual cannot borrow
from himself. He can borrow only from an external agency. The State, however, can borrow both
from internal as well as external sources. It borrows not only from its own citizens but also from
foreigners.