MODULE 1 – PUBLIC FINANCE CHAPTER 1 – CONCEPT OF PUBLIC FINANCE.

MODULE 1 – PUBLIC FINANCE

CHAPTER 1 – CONCEPT OF PUBLIC FINANCE

ORIGINPublic finance is one of the oldest branches of the economic theory. In fact, public finance was born when the concept of state (government) was born.

Public finance came into existence mainly to satisfy social want.

Human Wants

Individual Wants(Food, clothing, shelter, etc.)

Social Wants(protection of society against external enemies & anti social elements, basic infrastructure

etc. )

DEFINITION1 Sir Hugh Dalton Public Finance is concerned with the income and

expenditure of public authorities and with the adjustment of one to the other

2 Prof. R. R. Musgrave The complex of problems that centre around the revenue expenditure process of the government is referred to as public finance

3 Prof. P. E. Taylor Public finance deals with the finances of the public in an organized group under the institutions of government.

SCOPE OF PUBLIC FINANCE

1. Public Revenue The public revenue refers to the

income of the government. Broadly the income of the

government can be divided into tax revenue and non-tax revenue.

This part explains the types of taxes, the effect on taxes on the economy & the people, the advantages & disadvantage of taxes etc.

It also includes the study of the sources of non-tax revenue of the government.


2. Public Expenditure

This part of public finance explains the objectives of public expenditure, the classification of public expenditure, causes of increase in public expenditure, effects of spending money in different ways, etc.

This part also explains how the government can influence the production of goods and services, through the instruments of public expenditure.


3. Public Debt This part explains the

classification of public debt, burden of public debt and the causes responsible for growth of public debt in modern economies.

It also explains why the government requires loans, debt management and the methods used by the government for debt redemption.


4. Financial administration

This is a more practical part of public finance.

It studies the procedure to be followed by the government in imposing taxes, collecting the taxes, spending the collected money and getting the government income & expenditure audited by the competent authority.

It also explains how the government adjusts the two sides of public finance to each other.


5. Economic stability & growth

This part of public finance takes us to the objectives of public finance namely, to maintain internal and external economic stability and to expedite the rate of economic growth.

The government has to maintain the balance between stability and economic growth.

FUNCTIONS OF PUBLIC FINANCE

Public Finance is defined as a study of income and expenditure of the government. Naturally the functions of public finance are similar to functions of the government. the functions of public finance have also grown, multiplied and diversified over a long period. They can be presented as follows:1. Defence

2. Maintenance of law and order

3. Economic growth

4. Reducing inequalities

5. Reducing regional inequalities


1.Defence The first and foremost

responsibility of the state (government) has been to provide protection to the people against the aggression of other countries or extremists or other groups of people.

Even today the ministry of defence is the one of the most important and high profile ministries of any government.

A very large part of the budget is earmarked for the defence of the country.


2. Maintenance of law and order

Any community is characterised by the presence of the some anti-social elements.

They use other means like committing thefts, smuggling, contract killing etc. and earn their income.

Hence it is the responsibility of the government to protect the community against such anti-social elements.


3. Economic growth The responsibility of a modern

state is not only to preserve the social order but to improve it in all ways.

In less developed economies, the economic growth of the country is given top priority after defence.

Public finance has to provide adequate resources for investing in different sectors and bringing about economic growth.


4. Reducing inequalities Extreme inequalities are bad. They give rise to social unrest,

revolutions and bloodshed. Hence one of the functions of

public finance is to reduce inequalities.

This can be done by charging higher taxes to people with high income and providing aid to people with lower incomes in the form of free or subsidized food, free houses, medical aid, education etc.


5. Reducing regional inequality

In a vast country like India, some parts are more developed and some parts are less developed.

Regional inequalities give rise to several problems such as large scale migrations from less developed parts to more development parts.

This problem is very evident in the city of Mumbai where lakhs of people migrate from various parts of the country.

Public finance helps to reduce regional inequalities by collecting more taxes from developed states and spending it on less developed states.

PUNJAB

RAJASTHAN

SIMILARITY BETWEEN PUBLIC AND PRIVATE FINANCE

1. The Economic Problem Both, an individual and a community face the economic problem. Both, the society as well as an individual have to arrange the

wants in an order of importance and satisfy them. An individual would first pay attention to acquiring food, clothing

and shelter. The society, under the leadership of the government has to pay

attention first to defence of the country, maintenance of law and order and then go to satisfy the other wants in order of importance.


2. The aim The aim of the government is to

get maximum satisfaction to the community.

Similarly the aim of an individual in earning the income and spending it, is to get maximum satisfaction for himself and his family members.


3. The procedure to achieve the aim With the objective of getting maximum satisfaction from the

limited resources available, the government distributes its income on different items of expenditure in such a way that the marginal utility of money spent on different items to the community is equal.

An individual also follows the same procedure in distribution of his income.

Thus, the law of equi-marginal utility enables both the government and the individual to obtain maximum satisfaction from the total amount of money spent.


4. Balancing income & expenditure

The income and expenditure of an individual need not balance every month.

Similarly, the income and expenditure of the government need not balance every year.

DIFFERENCES BETWEEN PUBLIC AND PRIVATE FINANCE

1. Sources of income The government can depend

upon taxation, borrowings and creation of new money as sources of its income.

An individual depends upon salary, rent, interest, profit which are sources of his income. He can also take a loan.

The government can print paper currency against certain assets and use that currency as its income. This source is not open to an individual.


2. Source and size of borrowing The government can take an internal loan i.e. loan from its

own citizens or an external loan i.e. loan from some other state or citizens of some other states.

An individual can take a loan from some other individuals.

Further, the capacity of the government to borrow is much larger than the capacity of any individual to borrow.

Also, the government can get loans more easily and on easy terms and conditions as compared to an individual.


3. Balancing income and expenditure

Government – Adjusts income as per the expenditure

Individual – Adjusts expenditure as per the income


4. Budget principle and market principle

The government does not enquire about getting a proper price for its services. Whether the cost of service is covered or not covered, the government goes on rendering the services to the citizens if they are necessary.

An individual is guided by the market principle. He would produce a commodity or a service and render it to someone else only if the price received covers the cost of production.


5. Perspective A society has a very long life,

it is almost eternal. Therefore the government can take a very long term view of its finances. It may incur some expenditure at present even though, the returns may be reaped after a considerably long time.

The vision of an individual is limited. A person can look to at the most the next generation but not beyond that.


6. Motive The government works for

social welfare. It takes up a particular project without consideration of profit or loss to itself.

An individual looks at the profit motive. A person produces a commodity or a service and sells it only if the price earned covers the cost of production and leaves something for the producer of the service.

RECAP OF SIMILARITY AND DIFFERENCES BETWEEN PUBLIC

AND PRIVATE FINANCESr No Similarity Differences

1 The economic problem Sources of income

2 The aim Source and size of borrowing

3 The procedure to achieve aim Balancing income and expenditure

4 Balancing income and expenditure Budget principle and market principle

5 Perspective

6 Motive

SOUND FINANCE The concept of sound finance was based upon the belief that in

economic activities, the private sector is always more efficient and careful than the public sector.

The private sector is careful about keeping the cost of production at the lowest level.

The private sector uses resources most efficiently and effectively.

The private sector can earn a profit only if the commodity is produced at the lowest cost and is sold at the lowest price.

Hence, it was maintained that government should not interfere in the working of the economy which was called the market economy.

SOUND FINANCEThis belief gave rise to following principles: The government should undertake only two functions namely the

defence of the country and maintenance of law & order.

Government should keep its expenditure at its lowest level.

The government budget should always be balanced.

A deficit budget should be avoided at any cost.

The only objective of public finance is to satisfy the wants of the state.

FUNCTIONAL FINANCE

The concept of sound finance was strongly challenged by the Great Depression, 1929. The principles of sound finance failed to provide a solution to the problems associated with the Great Depression.

Economists like J. M. Keynes and A. P. Learner tried to find out some new principles which would help the countries caught in the Great Depression.

Principles evolved out of thinking of these people during the Great Depression is together called as functional finance.

FUNCTIONAL FINANCE

Functional finance gave rise to following principles: During inflation, a surplus budget is recommended.

Deficit budget is recommended during depression.

Public finance has to discharge several responsibilities like developing infrastructure, setting up basic and heavy industries etc.

Public finance can also be used for social purposes such as removal of poverty, reducing inequality and reducing regional imbalance.

REDISTRIBUTIVE TAXATION

Inequality exists in every society

To a certain level inequalities are necessary because then it acts as an incentive for people to work harder. To a certain level inequalities are necessary because then it acts as an incentive for people to work harder.

However, extreme inequalities are bad.

They give rise to social unrest, revolutions and bloodshed.

Hence, it is the responsibility of the government to reduce inequalities by re-distributing income in favour of the poor.

One of the method to reduce inequality is by way of taxation.

TAXATION AS A TOOL OF REDUCING INEQUALITY

The direct taxes are more useful in reducing inequalities in income & wealth and re-distribute income in favour of the poor.

The Indirect taxes are taxes on goods. The poor people spend a larger part of their incomes on consumption and save a smaller part. Therefore the taxes on goods fall more heavily on the poorer section of the community.

TAXATION AS A TOOL OF REDUCING INEQUALITY

For re-distributing incomes and wealth, the direct taxes are imposed at progressive rates.

In Indirect taxes like the excise duty and the customs duty, the necessaries of life like foodgrains, cheaper clothing, cheaper footwear are exempted from the indirect taxes. The costly durable consumer goods like automobiles, expensive TV, watches, cameras etc. are subject to heavy taxes.

TAXATION AS ANTI-INFLATIONARY MEASURE

MeaningInflation is defined as a fall in the value of money i.e. a rise in the price level. In simple words, commodities which were available at Rs. x are now available at Rs. 1.5x or Rs. 2x.

How inflation takes placeInflation takes place when people have more purchasing power in their hands. They show a tendency to spend more. As a result, there is an increase in demand. So when the expenditure rises, the demand also rises. If the rising demand is not balanced by a rise in supply, the price level shows a tendency to rise.

Rs. 5 – 13 grams

Rs. 5 – 10.5 grams

Earlier Now


Taxation as a tool of controlling inflation During inflation, the government increases the rates of the

direct taxes like the income tax wealth tax etc. When the income is reduced, the expenditure is reduced. When expenditure is reduced, the demand is reduced. A cut in demand is helpful in preventing a rise in prices and

bringing the price level down to a lower level.

Tax RateIncome in hand

Expenditure Demand Inflation


Taxation as a tool of controlling inflation For controlling inflation the government reduces the taxes on

raw materials and on intermediate goods.

Government imposes heavy taxes on exports. The demand for exported goods falls in the foreign countries and thus the exports fall. This leads to an increase in internal supply and as a result the price level comes down

Prices of raw material &

intermediate goods

Prices of final goods

Inflation

Prices of export goods

Export sales

Internal supply of

goodsInflation

CONCEPT OF MAXIMUM SOCIAL ADVANTAGE

INTRODUCTION The concept of sound finance maintained that government

expenditure should be kept at the lowest level. However, this concept was criticized by various economists. It was maintained that the effect of public expenditure is more

important and not its size. The aim of all government activities is to increase the welfare of

the community. Public finance is an instrument which can help the government

in increasing the welfare of the community. So that public finance which creates “Maximum Social

Advantage” is good.


THE PROCESS Public finance has two sides namely taxation (i.e. public

revenue) and public expenditure. A tax is a compulsory payment to be made by an individual to

the government and for which the tax-payer does not get any direct and proportionate return.

The money taken away by the government is spent by it on satisfying collective wants such as defence of the country, maintenance of law and order, economic development and social welfare etc.

This expenditure creates some satisfaction or utility on the part of the community.


BALANCE BETWEEN SATISFACTION AND DIS-SATISFACTION

Satisfaction and Dis-satisfaction can be compared to each other and can be balanced with each other.

The dis-utility created by taxation can be balanced against utility created by public expenditure.

TAXATION – SATISFACTION

PUBLIC EXPENDITURE - SATISFACTION


MARGINAL PRINCIPLE A comparison between sacrifice and satisfaction can be made

by using the marginal principle. We can take the sacrifice and benefit separately.

MARGINAL SOCIAL SACRIFICE As a person or the community pays more and more units of

money (rupees) in the form of taxes, every additional rupee paid imposes more and more sacrifice on the community.

This is derived from the principle of Diminishing Marginal Utility. When a person pays more and more rupees, the marginal dis-

uitility imposed upon him is higher and higher.Tax paid Marginal Social Sacrifice (MSS)

First unit 19Second unit 20Third unit 21Fourth unit 22Fifth unit 23


MARGINAL SOCIAL BENEFIT As the government spends more and more units of money (rupees), the utility

derived by the community from every additional rupee spent by the government is less and less.

It is subject to the principle of Diminishing Marginal Utility.

Tax paid Marginal Social Sacrifice (MSS)

First unit 25Second unit 24Third unit 23Fourth unit 22Fifth unit 21


BALANCE BETWEEN MARGINAL SOCIAL BENEFIT AND MARGINAL SOCIAL SACRIFICE The government has to balance the effects of taxation and public

expenditure at every rupee collected and spent. At a particular rupee collected and spent, the MSB becomes equal to

MSS. This is the point where the net social benefit (Social Benefit - Social

Sacrifice) is the maximum.

Tax / Public Expenditure

MSB MSS NSB Total NSB

First unit 25 19 6 6Second unit

24 20 4 10

Third unit 23 21 2 12Fourth unit 22 22 0 12Fifth unit 21 23 -2 10


GRAPH OF MAXIMUM SOCIAL ADVANTAGE

PUBLIC EXPENDITURE AND LAW OF SUBSTITUTION

The government distributes its income on different items in such a way that the community gets maximum benefit.

Similarly the government imposes different taxes in such a way that the social sacrifice suffered by the community should be the minimum.

MARGINAL PRINCIPLE The government uses the marginal principle for ensuring that the total

benefit derived by the community from different items of public expenditure should be maximum.

This is possible when the marginal social benefit derived from different items of public expenditure is equal.

1 2 3Expenditure Item A Item B1 20 182 19 163 18 144 17 12

TAXATION AND LAW OF SUBSTITUTION

The government has to collect a certain amount of money through taxes.

The government can use different taxes. The total amount is collected through different taxes in such a

way that the marginal sacrifice imposed by different taxes on community is equal.

• If the government wants to collect a total amount of ` 4/- through taxes, it will collect ` 3/- through Tax ‘A’ and 1 through Tax ‘B’.

Tax MSS of Tax A

MSS of Tax B

1 16 182 17 203 18 224 19 24

RULES FOR IMPLEMENTING MSA

1. The total amount of taxation and public expenditure are arranged in such a way that the Marginal Social Benefit of public expenditure is equal to Marginal Social Sacrifice of taxation.

MSB = MSS

2. The total amount of public expenditure is distributed over different items in such a way that the marginal social benefit derived from all of them should be equal.

3. The different taxes should be arranged in such a way that the Marginal Social Sacrifice of all of them should be equal.

EVALUATION OF PRINCIPLE OF MSA

1. Not measurableThe principle of Maximum Social Benefit is developed on the assumption that the Marginal Social Sacrifice of taxation and Marginal Social Benefit of public expenditure are measurable in quantity. In practice, they are not measurable.

EVALUATION OF PRINCIPLE OF MSA

2. Inevitable expenseEvery time the government imposes a tax or spends public money, it is not possible to compare sacrifice imposed on the community and benefit derived by the community. Certain expenses like expenses on defence, maintenance of law and order have to be incurred without social benefit.

3. Small unitsThe application of marginal principle assumes that taxation and public expenditure can be increased by small units. In practice, it is not possible to increase them by small units. They are imposed and increased in lumpy amounts.

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MODULE 1 – PUBLIC FINANCE CHAPTER 1 – CONCEPT OF PUBLIC FINANCE.

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