PUBLIC FINANCE AND TAXATION

Sir. Prof. Dr. Bidhan Chandra Mazumder

23rd EV Section A

1. CONCEPT

Individual Food, clothing, shelter, health, education, etc.

Wants
Human
Wants
Social protection of society against external enemies
Wants and anti-social elements, basic infrastructure, etc.

Public finance is one of the oldest branches of the economics1. In fact, public finance was
born when the concept of state (government) was born. Public finance came into existence
mainly to satisfy social wants.

So, public finance is said to be the field of economics that studies government activities and
the alternative means of financing government expenditures. That is, public finance is related
to the financing of government activities, and can be narrowly defined as a subject, which
discusses financial operations of the fisc2 (or public treasury).

Public finance is concerned with how a government raises money, how that money is spent
and the effects of these activities on the economy and society. It studies how governments at
all levels—national, state and local—provide the public with desired services and how they
secure the financial resources to pay for these services.

Some important definitions of public finance given by famous economists from time to time
are:

Sir Hugh Dalton (1887-1962; a British economist and politician): Public Finance is
concerned with the income and expenditure of public authorities and with the adjustment of
one to the other.

Prof. Richard. A. Musgrave (1910-2007; an American-German economist): The complex of

problems that center around the revenue and expenditure process of the government is
referred to as public finance.

Prof. Philip. E. Taylor (1908-1975; an American economist): Public finance deals with the
finances of the public in an organized group under the institutions of government.

Modern Public finance emphasizes the relationships between citizens and governments. It
deals with the finances of public bodies – national, state or local – for the performance of
their functions relating to providing public goods and services like social securities, health,
education, judicial, old age allowance, protection against foreign invaders and environmental
disasters, etc. The performance of these functions leads to expenditure. The expenditure is
met by public revenue raised through taxes, fees, sale of goods and services and loans.
Public finance studies the manner in which revenue is raised; the expenditure is incurred
upon different items, etc.

Therefore, it can be concluded that public finance deals with the income and expenditure of
public authorities and principles, problems and policies relating to these matters.

[Note: 1. An economy encompasses all activities related to production, consumption, and

trade of goods and services in an area. The economy of particular region or country is
governed by its culture, laws, history, and geography, among other factors, and it evolves
due to the choices and actions of the participants. The economic result of a country is
usually measured by GDP, and per capita (income). Among others, inflation, labor market,
cash rate (bank rate, interest rate), exchange rate, consumer price index (CPI),
personal/household consumption expenditure index (PCEI), industrial & services activities,
balance of trade, business investment are also in use. The economy is divided into two parts
in general, public sector economy and private sector economy.

Public sector economy is the part of national economy providing basic goods and services
that either are not or cannot be provided by the private sector. It consists of national/central
and local governments, their agencies and their chartered bodies. It is one of the largest
sectors of any economy in the US, for example, it accounts for about 20% of the entire
economy. In Bangladesh, public enterprise activities are around 6% of GDP and their fixed
assets represent 25% of gross fixed capital formation. The net worth of public enterprises is
app. 14% of GDP.

Private sector economy, on the other hand, is the part of national economy made up of
private enterprises. It includes the personal sector (household) and corporate sector
(companies), and is responsible for allocating most of the resources within an economy.

But economics is a social science concerned with the production, distribution, and
consumption of goods and services. It studies how individuals, businesses, governments, and
nations make choices about how to allocate resources. So economics is a subject of social
science where both public sector and private sector economies are the parts.

2. The term ‘fisc’ or fiscal is derived from an old Greek word which means ‘basket’, it
symbolizes the public purse. In Renaissance Italian, the word fisc meant the treasury.]
2. OBJECTIVE OF STUDYING PUBLIC FINANCE

The basic objective of studying public finance is to understand the impact of government
expenditures, taxes, borrowing and their regulations on incentives to work, to invest; and to
spend income.

The broad objective of public finance is to develop principles for understanding the role of
government in the economy in order to achieve overall fiscal discipline, allocation of
resources to priority needs, and efficient and effective allocation of public services so that
the well-being of citizens is ensured as well as the economic development of a country is
made.

[Note: Objectives in a chronological order: Managing price stability – Removing inequality

– Economic development – Managing public needs.]

3. IMPORTANCE OF PUBLIC FINANCE

i. Provision of Public Goods: For providing public goods like roads, military services and
street lights, etc., public finance is needed. Business firms will have no incentive to produce
such goods, as they get no payment from private individuals.

ii. Tackle Market Economy: Public finance enables governments to tackle or offset
undesirable side effects of a market economy. The side effects are called spill overs or
externalities. For example, pollution. The governments can introduce recycling programs to
lessen pollution or they can make laws to restrict pollution or impose pollution charges or
taxes on activities that bring about pollution.

iii. Steady State Economic Growth: Government finance is important to achieve

sustainable high economic growth rate. The government uses the fiscal tools in order to bring
increase in both aggregate demand and aggregate supply. The tools are taxes, public debt,
and public expenditure and so on.

iv. Price Stability: The government uses the 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.

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

vii. Proper Allocation of Resources: The government finance is important for proper
utilization of natural and human resources. For it, on the production and sales of less
desirable goods, the government imposes more taxes and provides subsidies or imposes less
taxes or in some cases no taxes on more desirable goods.

viii. 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.

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

x. Infrastructural Development: The government collects revenues and spends for the
construction of infrastructures. It has to keep 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.

Moreover, with the acceptance of the principle of welfare state, the role of public finance has
been increasing. Modern governments are no more police states as the classical economists
viewed.

As the scope of state participation in the economic activity is widening, the scope of public
finance has also been increasing. Generation of employment opportunities, control of
economic fluctuations like boom and depression, maintaining economic stability etc. are
some of the thrust areas of the governments through fiscal operations.

4. SUBJECT MATTER/CONSTITUENTS/SCOPE OF PUBLIC FINANCE

The subject matters of Public Finance can be broadly classified in to six categories –a)
Public revenue b) Public expenditure c) Public debt d) Public (Financial) administration e)
Economic stabilization and f) Local Government Finance.

a) Public Revenue

The income of the state/government is referred to as Public Revenue. Broadly the income of
the government can be divided into tax revenue and non-tax revenue. That is, this part
explains the various ways of raising revenue by the government that includes a detailed
explanation of
 i) the types of taxes,
ii) the principles and effects of taxes on the economy and the people, and how the
burden of taxation is shared among the various classes of society,
iii) the advantages and disadvantage of taxes,
iv) the sources of non-tax revenue,
v) ‘tax expenditures’ or ‘tax preferences’ (that is, tax revenue forgone on account of
various tax concessions, rebates, exemptions, and the like) as important segments
of revenue policy of the government, etc.

b) Public Expenditure

This part of public finance explains:

I) the objectives of public expenditure,

II) the policies of public expenditure,
III) the principles and problems relating to the allocation of public expenditure,
IV) the classification and justification of public expenditure,
V) the causes of increase in public expenditure,
VI) effects of spending public money, for example, government expenditure provides
various kinds of social and economic facilities stimulating the capacity to work of
the people. Increased capacity implies increased efficiency and greater
employment. Level of income and saving tends to rise facilitating greater
investment and adding to the pace of growth, etc.

This part also explains how the government can influence the production of goods and
services through the instruments of public expenditure. Examples of public expenditure
instruments/elements are wages, goods and services, pensions, subsidies, other transfers,
capital expenditures like purchase of fixed assets, construction of infrastructures, etc.

c) Public Debt

Public debt means government borrowings. The governments borrow when its revenue falls
short of its expenditure.

This part of public finance explains:

i) various principles and methods of raising public debts and their economic effects,
ii) the classification of public debt,
iii) burden of public debt, and
iv) 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.
d) Public (Financial) Administration

It deals with the most important and practical part of public finance, i.e. -

i) budget,
ii) budgetary planning,
iii) types of budgets,
iv) methods of budget preparation,
v) war finance,
vi) development finance, etc.

Thus, public (financial) administration refers to the mechanism by which the financial
functions are carried on. In other words, public (financial) administration studies the
organizing and disbursing of the finances of the state/government.

It explains the procedure to be followed by the government in -

i) imposing taxes,
ii) collecting the taxes,
iii) spending the collected money and
iv) getting the government income and expenditure audited by the competent
authority.

It also explains how the government adjusts the two sides of public finance (i.e. revenues and
expenditure) to each other.

e) Economic Stabilization and Growth

The government has to maintain the balance between stability and economic growth. This
part of public finance takes us to the objectives of public finance namely, to maintain
economic stability and to expedite the rate of economic growth.

The use of Public revenue and Public expenditure to secure stability in levels of prices by
controlling inflationary as well as deflationary pressures is studied in this part of public
finance. Similarly, the income and expenditure policies adopted by the government so as to
attain full employment, optimum use of resources, equitable distribution of income, etc. are
also studied.

Local Government Finance

Some of the government activities for public well-beings are governed and executed by the
local governments like union councils, municipalities, and city corporations. These parts of
government also require fund to procure and spend. This part of public finance explains the
principles and policies governing the distribution of functions and funds among the public
authorities in a local government set up.
5. 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: defense; maintenance of law and order; economic growth; and reducing
inequalities.

Defense

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 defense 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 defense of
the country.

Maintenance of Law and Order

Any community is characterized 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.

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

Reducing Inequalities

Inequalities refer to the differences of income and wealth between the members of the
society, i.e. poor and rich. Extreme inequalities are bad. They give rise to social unrest,
revolutions and bloodshed.

In a third world country like Bangladesh (though currently, in the line of emerging as a
developing country), there is a big gap of income and various facilities between the people
living in rural and urban areas, which gives rise to several problems, such as large scale
migrations from rural areas to urban areas.

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.
[Inequalities are measured generally by Gini-coefficient. The coefficient ranges from 0 (or
0%) to 1 (or 100%), with 0 representing perfect equality and 1 representing perfect
inequality. Values over 1 are theoretically possible due to negative income or wealth.]

6. DISTINCTION BETWEEN PUBLIC FINANCE AND PRIVATE FINANCE

By private finance we mean the financial problems and policies of an individual economic
unit (which does not form a part of state organs) like individual, firm or community as
compared with those of the public authorities. It is a convention to look into similarities and
dissimilarities between the two so as to provide an analytical foundation for the decision-
making aspects of public finance.

SIMILARITIES

The areas in which both private and public sectors are similar are described below
highlighting the economic problems, economic activities, aims and procedure to achieve the
aims, and balancing income and expenditure.

The Economic Problem

Both, an individual and a community/society face the economic problem. Both of them have
to arrange the wants in an order of importance and satisfy them by sharing economic
activities between each other.

Both have limited resources at their disposal and try to ensure that the ‘most important’
wants are satisfied first. 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
defense of the country, maintenance of law and order and then go to satisfy the other wants
in order of importance.

In that sense the problems and decisions of both private sector and public sector are similar.

The Economic Activities

Modern economies are monetized. That is, most of the economic activities have financial
counterparts involving creation and use of financial claims.

Both private and public sectors are engaged in activities that involve purchase, sales and
other transactions. Likewise, they are engaged in production, exchange, savings, capital
accumulation, investment, and so on. In order to finance these operations, the government,
amongst other things, creates money (which is also a financial assets), raises loans, and
makes payments, etc. Similarly, a private economic unit lends, borrows, receives and makes
payments, and so on.

In these respects, therefore, both the public and private finances are quite similar to each
other.
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. In this respect, both the public and private finances are
quite similar to each other.

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.

[Marginal utility: Utility/satisfaction of income arising from one additional unit of

dollar/taka spent.

Equi-marginal Utility: Equal marginal utility. That is to obtain maximum satisfaction in the
society, the marginal utility of income of all members of the society (tax payers) is said to be
the same.]

Balancing Income and Expenditure

Although, the income and expenditure of both an individual and the government need not
balance every month, they take necessary steps to know the differences between their
income and expenditure for a certain period of time.

But the similarities mentioned above between the two types of finances almost end here. In
contrast, the differences between the two are quite sharp.

DISSIMILARITIES

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.

Issuance of Currency

The government or a competent authority on its behalf can create legal lender currency (that
is, money the creditors cannot refuse to accept in discharge of their claims upon their
debtors) against certain assets and use that currency as its income. This source is not open to
a private economic unit. Its obligations can never become legal tender.

A private economic unit is always expected to pay back its obligations. In contrast,
obligations of public authorities via issue of currency need not be redeemed at all.
Source and Size of Borrowing and Its Repayment

The capacity of the government to borrow is much larger than the capacity of any individual
to borrow. The deficit budgeting (that is, spending more than the income) of a private
economic unit can be only for a limited period and only up to a limit. Given its economic
standing, it can accumulate outstanding debt liabilities up to a limit and no more. But this
constraint hardly applies to the state/government. It can plan to add to its outstanding debt
with every budget, and may also succeed in doing so. However, the distinction between
private and public borrowings does not end with only amounts of possible borrowings, but
extends to their forms, rates of interest and other terms and conditions.

A private firm cannot raise non-repayable loans, but the government may and sometimes
does. Furthermore, high creditworthiness of the state/government enables it to borrow at
rates much lower than the private economic units have to pay. It has the support of the
central bank of the country as an agent and as an underwriter when its loans are floated in the
market. In some cases, it may adopt indirect coercive methods to borrow at lower rates.

The government can take an internal loan i.e. loan from its own citizens within the country
or an external loan i.e. loan from some other countries or citizens of some other countries.
But a private economic unit (such as individual/firms) cannot raise an internal loan, rather
can take a loan from some other units (individuals/firms).

Further, the government can get loans more easily and on easy terms and conditions as
compared to an individual/firm, simply due to its high creditworthiness.

[Note: When a government borrows money from its own citizens by selling bonds or long-
term credit instruments, an internal debt is created. It is owed by a nation to its own citizens.
Internal debt comprises treasury bills, market stabilization schemes, ways and means of
advances, and securities against small savings, etc.]

Balancing Income and Expenditure

Government – Adjusts income as per the expenditure

Individual – Adjusts expenditure as per the income

That is, while a private economic unit proceeds by first ascertaining its income and then
determining its expenditure, the government usually first decides about its expenditure and
then goes round to seek revenue for it.
‘Budget Principle’ and ‘Market Principle’

A private finance follows the market principle, or principle of economic rationality. It means
that private economic units are guided by market signals and of market mechanism and their
own economic interest. An individual would produce a commodity or a service and render it
to someone else only if the price received covers the cost of production.

In contrast, the public finance follows the budget 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.
That is, the essence of the budget principle is that the services in this sphere are determined
not by profit expectations and the willingness of the individuals to spend their money for the
purchase of such services, but by decisions reached through political and administrative
procedures and based on common social objectives. The state does not go by the principle of
‘quid pro quo’.

[‘Quid pro quo’ is a Latin phrase. It means roughly ‘this for that’. In other words, the phrase
describes the context when something is given in return for something else.]

Long-term and Short-term Perspective

The vision of an individual is limited. A person can look to at the most next generation but
not beyond that. That is, in private finance, the view taken is a short term one.

In contrast, a society has a very long life, it is almost eternal. Therefore, the government can
take a very long term view of the interests of the economy as a whole and be ready to suffer
commercial losses for that purpose both in the short and long run. It may incur some
expenditure at present even though, the returns may be reaped after a considerably long time.
For example, an investment is made by the government in education to remove illiteracy,
vis-a-vis to expect development of an unprivileged society.

Working Motive/Objectives

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.
 PUBLIC FINANCE AND TAXATION
Sir. Prof. Dr. Bidhan Chandra Mazumder
23rd EV Section A

Theories of Public Finance:

1. Classical Theory
2. Keynesian Theory
3. Musgrave Theory

1. Classical Theory:

Classical economic theory or classical political theory is school of thought in economies that
flourished, primarily in Britain, in the late 18 th and early-to-mid 19th century. Its main
thinkers are held to be Adam Smith (1723-1790; Scottish economist, called father of
economics), Jean Baptiste Say (1767-1832; French economist and businessman),
David Richardo (1772-1823; British Political Economist), Thomas Robert Malthus (1766-
1834; English cleric, scholar and influential economist in the fields of political economy and
demography), and John Stuart Mill (1806-1873; British philosopher and political
economist).
J. B. Say, famous classical economist said that “Supply creates its own demand”, and thus
overruled any possibility of unemployment or over production. This is the view of the whole
classical school of thought. According to them, there may come a position of full-
employment, and no resource in the economy can remain unutilized. The full employment
implies the complete utilization of all the factors of production including land, labor and
capital.

The classical economist argued that, if labor is mobile and there is flexibility in the system of
wage payment, the whole labor force can be employed till the economy reaches its level of
full-employment. Unemployment is caused due to immobility of labor, and rigidity in the
wage system.

Classical economists believed that there cannot be reduction in any one’s income if an
individual reduces his expenditure. This is so because the additional amount of money saved
by reducing the expenditure is invested on the capital goods. Hence the level of “effective
demand” has no reason to fall down. The effective demand keeps an economy at full
employment level. This is all done by the private enterprises which is solely guided by the
market price and motivated to earn maximum profit.
Effect of Taxation and the Role of Government:

The classical economists believed that since the whole productive work is done by the
private enterprise, the government has no powerful media to raise the economic level of the
country. The private enterprise ensures full employment and the government has no chance
to deal with the economic activities of the private enterprise. If the government imposes
taxation, the private enterprises will substitute it by curtailing expenditure. If the government
increases its expenditure through borrowing, it will create a chance for inflationary trend and
rising prices. From this point of view, a “Laissez-faire (LF)” economic concept was
developed by Adam Smith. LF is French phrase used to mean “to pass” or “let do”. In other
words, let the market do its own thing. If left alone, the laws of supply and demand will
efficiently direct the production of goods and services within the framework of market
mechanism, i.e. rational market structure where there is an “invisible hand” – that is the
market system allows individuals to exchange goods and services voluntarily, based on
price, without knowing each other. Here people will take their decision to buy or sell on the
basis of their buying capacity and benefits. The only role of government in a LF economy is
to prevent any coercion/persecution/repression/harassment/forcing against individuals; to
prevent rational market forces in operating from theft, fraud, and monopolies. LF policies
need three components to work: capitalism, the free market economy, and rational market
theory. Thus, LF is called one of the guiding principles of capitalism.

Classical economists believed in “balanced budget”. Taxes always impose restriction on the
private savings, resulting low level of saving potential; and low level of private investments.
In this way taxes have an adverse effect on the capital formation. That is why, they believed
in small budget.

A deficit budget leads to inflationary trend. If the government’s deficit is substituted by the
long-term bonds issued by the government, such bonds may simply substitute the private
share certificates and securities, and thus may not help in creating an atmosphere of capital.

2. Keynesian Theory:

Keynesian economic theory is a school of thought in economics, developed by the British

economist John Maynard Keynes during the 1930s in an attempt to understand the Great
Depression. Keynes advocated for increased government expenditures and lower taxes to
stimulate demand and pull the global economy out of the depression.

Keynes in his article “General Theory of Employment, Interest and Money” asserts that one’s
expenditure is another man’s income. If all are spending whole of their income the result
would be constancy in the flow of income and expenditures. Keynes argued that a part of
income is kept reserved and not spent by an individual and if this reduction is not
compensated by an increase in investment expenditure, the result would be fall in the income
of others, consequently leading to low production, decreasing level of employment and
national income.
Keynes totally rejects the idea that equilibrium always at the full employment which is the
core of the classical view. Keynes also disagrees with the classical economists that supply
creates its own demand.

Keynes in his eminent work “General Theory of Employment, Interest and Money” not only
criticized the classical Say’s law but also propounded a new theory of income and
employment.

Keynes tried to prove that full-employment is not the normal feature of an advanced
capitalistic economy and that underemployment equilibrium is its normal feature.

It is important to note that Keynesian theory of income and employment is a short-run theory
because Keynes assumes that the amount of capital, the size of population and labor force,
technology, efficiency of laborers, etc. do not change. That is why in Keynesian theory the
amount of employment depends on the level of national income and production. This is
because, given the amount of capital, technology and labor efficiency, increase in income
and output can be obtained by employment of more labor. Therefore, in Keynesian short-run,
the higher the level of national income, the greater the amount of employment; and lower the
level of national income, the lower the amount of employment.

Keynesian Theory is Based on Following Essential Elements:

a) Inflation, Deflation and Balanced Budget:

Classical economists desired a balanced budget. This idea is based on the assumption that
there is full employment in the economy which is very different, and thus it is unrealistic to
think of a balanced budget all the time. Budget is considered to be tool in the hand of the
state to fulfill following aims:

i) economic; like full employment, check inflationary as well as deflationary tendencies;

ii) Social: like removing economic inequality and providing minimum requirements to the
poor section of the community, and

iii) Political: like fulfilling the promises made by the government at the elections.

According to Keynes, if there is inflation; a Surplus budget may be of help and in case if
there is deflation; a deficit budget may work as an efficient tool. If investments exceed
savings; there is increasing prices; and if the savings exceeds investment; there is
deflationary tendency in the economy.

b) Increase in Employment Income and Their Effects:

With the increase in employment; income increases and the propensity to save also
increases; but consumption does not increase at the equal rate, and the result is fall in the
level of effective demand which causes unemployment. Now, here, the techniques of public
finance are of valuable help. The state should increase its public expenditure by investing on
the public works, like construction of dams, roads, rail-ways etc. The money for investing on
such public works may be borrowed from the people who have accumulated savings. The
state may further use the technique of deficit financing in order to compensate the fall in the
gross expenditure. This is more realistic than the classical economists who disfavored the
techniques of deficit financing.

c) National Debt:

For Classical economists it is harmful for an economy to create national debt. Modern
version of national debt is quite contrary to the classical approach. Now-a-days, national debt
is treated as an important tool of public finance; such debts are of great help in the event of
certain emergencies like floods and famines. It is also helpful in meeting the requirements of
a deficit budget. In the underdeveloped countries, borrowings from the public help in
developing the national resources.

d) Taxation and Equitable Distribution:

The classical economists disfavored application of taxation technique for transferring wealth
from rich to poor people.

In the modern times, taxation is used as one of so many techniques to remove the inequalities
of income in the society. Social justice is the goal of the modern states, and taxation is
looked as one of the best techniques in accomplishing this goal. By taxing the rich more, the
gaps can be reduced. Taxes and duties are raised on those commodities which are used by
the rich; this leads to better social conditions and promotes the equality of income.

e) Economic Growth and Welfare of the People:

Classical economists argued that imposition of taxes will lead to reduction in national
income and production incentives. But modern view considers that the welfare of the people
lies on the maximum total production. If the economy starts growing up, it will certainly
raise the per capita income and living standard of the people.
3. Musgrave Theory:
Richard Musgrave transformed economies in the 1950s and 1960s from a descriptive and
institutional subject to one that used the tools of microeconomics and Keynesians macroeconomics
to understand the effect of taxes. Musgrave took about 20 years to conceive, write and publish the
1959 work for which he is best known for “The Theory of Public Finance”, an analysis of how
governments allocate resources and respond to social needs. “It still stands unchallenged” the
economic historian Mark Blang wrote decades ago. A German origin American economist, R.
Musgrave is called the father of modern public finance.

Musgrave gave the theory of public finance by dividing into two approaches:

a) Normative or optimal Theory of public Finance

b) Theory of Budget policy.

a) Normative or optimal Theory:

Musgrave suggested that the state must initiate some principles and rules to achieve the goal of
highest degree of public economy. In other words, he held that the state should prepare an optimal
budget plan, based on the set programs decided at the very initial stage, and must find out the ways
to achieve such pre-determined programs. This was called by Musgrave as the “Normative or
optimal” Theory of public finance.

b) Theory of Budget Policy:

The state should develop a theory or set of principles so that everyone can come to know the causes
behind each step taken by the state in accomplishing the objectives. This will enable to ensure the
best way or the best principles and one can predict the future steps to be taken by the state.

Musgrave suggested that legislative actions should be taken in order to implement these two
approaches. While studying the first-theory, the attitude of the market is to be recorded towards
various types of taxes, and the best of them should be suggested for the future to get maximum
possible returns. For the implementation of second approach, we should know and study the manner
in which the market in behaving to various types of taxes.

Musgrave laid emphasis on the first approach; and in this regard he said, “Our task will be to
examine how the objective can be determined in an optimal fashion and how they can be
implemented accordingly”.

Musgrave imagines a state in which he underlines three responsibilities. Fiscal Department of such a
state, namely-

a) the use of fiscal instruments in the distribution of income and wealth;

b) to secure adjustments in the distribution of income and wealth; and

c) to try its best, maintain economic stabilization.

 PUBLIC FINANCE AND TAXATION
Sir. Prof. Dr. Bidhan Chandra Mazumder
23rd EV Section A

Allocation and Distribution:

Richard Musgrave in his “The Theory of Public Finance” book proposes that the main
economic functions of government could be divided among three branches, the Allocation,
the Distribution, and the Stabilization Branches of government. But here we consider the
relation between the Allocation Branch and the Distribution Branch.

Allocation is the division of the resource flow among alternative product uses, and thus the
job of the Allocation Branch is to “secure adjustments in the allocation of resources”.
Distribution, on the other hand, is the division of the resource flow, embodied in products,
among different people, and thus the job of the Distribution Branch is to “secure adjustments
in the distribution of income and wealth”.

Musgrave suggests that we think of each branch as run by a “manager” who is instructed to
“plan his job on the assumption that the other two branches will perform their functions
properly.” Thus, the Allocation Branch proceeds on the “assumption of full employment of
resources and that the proper distribution of income has been secured.” The distribution
branch assumes that “a full-employment of income is available for distribution and that the
satisfaction of public wants is taken care of.”

Alike a quasi-linear utility, the Allocation Branch can get its job done while paying almost
no attention to the actions of the Distribution Branch. Now, if there is quasi-linear utility,
then as long as the Allocation Branch knows that the Distribution Branch is not going to be
so cold-hearted as to leave some consumers with zero private goods, there is a unique Pareto
optimal amount of public goods. All the Allocation Branch needs to do is to solve for the
Pareto optimal quantity of public goods and provide it.

But in general, the Allocation Branch will not be able to determine the right amount of
public goods to supply unless it knows what the Distribution Branch is doing. This makes
life more complicated, but does not necessarily mean that we must abandon Musgrave’s
program of divisional separation. Recall that Musgrave’s suggestion was not that each
branch should ignore the actions of the others, but rather than each branch should assume
that the other branches “will perform their functions properly”.
Pareto Optimality/Efficiency:
The concept of Pareto optimality is named after Vilfrado Pareto (1848-1923), Italian
engineer and economist, who used the concept in his studies of economic efficiency and
income distribution.

The efficiency criterion is satisfied when resources are used over any given period of time in
such a way so that making it impossible to increase any one person’s well-being without
reducing any other person’s well-being.

So, Pareto efficiency or Pareto Optimality is a state of allocation of resources in an economic

situation in which it is impossible to make one party better off without making another party
worse off.

In neo-classical economics, a Pareto efficient outcome is an action that harms no one and
helps at least one person.

Understanding Pareto Efficiency:

To clearly understand the concept of Pareto Efficiency, it is important to introduce the

concept of Pareto Improvement.

A resource allocation is Pareto improved if there exists another allocation in which one
person is better off, and no person is worse off. And a resource allocation is Pareto efficient
if no Pareto improvement is possible.

Therefore, Pareto Efficiency indicates that resources can no longer be allocated in a way that
makes one party better off without harming other parties. In Pareto Efficiency, resources are
allocated in the most efficient way possible.

Pareto Efficiency and the Production Possibility Frontier:

The concept of Pareto efficiency can be applied to the Production Possibility Frontier/Curve
(PPF/PPC). That is the PPF/PPC can be used to illustrate the concept of Pareto efficiency
and Pareto improvements in welfare.

 Pareto efficiency will occur on points that lie on a production possibility

frontier/curve.
 When an economy is operating on a PPF, it is not possible to increase output of one
goods/service without reducing output of another goods/service.
 When an economy lies well within the PPF boundary (i.e. under the PPF line), there is
an inefficient use of resources or under-utilization of resources

Here it becomes possible for output of two goods or services to increase at the same time.
Points that lie within the PPF show an inefficient or under-utilization of resources – this is
Pareto inefficient.
In the above graph, points A and B are Pareto efficient because there is no Pareto
improvement possible and here increasing the output of one good would decrease the output
of the other good. Points, D and C are Pareto inefficient because there is a possibility of
increasing output of both goods’ wheat and beef. D and C can be Pareto improved until they
reach to the PPF meaning that output of both products, what and beef, can increase as we
move from within the PPF to points on the PPF boundary. Therefore, it would be a Pareto
improvement as the total output in the economy increases.

So, any resource allocation is Pareto efficient if no Pareto improvement is possible.

Therefore, every point on the PPF frontier is Pareto efficient.

Simple Example of Pareto Efficiency:

Consider the following background information for an allocation problem:

• Two types of goods: Apples and Oranges

• Two individuals: Chowhan and Julia

Consider the preferences for each individual:

• Chowhan does not have a preference for apples or oranges

• Julia has a preference for apples over oranges

Consider the following allocation:

• Apples are all allocated to Chowhan

• Oranges are all allocated to Julia

Is the allocation above Pareto efficient?

To determine whether an allocation is Pareto efficiency, it is important to determine if a

Pareto improvement is possible. As in, is there a way to make an individual better off
without making someone else worse off?

In the example above, a Pareto improvement is possible. If the allocation of oranges went to
Julia and the allocation of apples went to Chowhan, both individuals would be better off
while no one would be worse off. Julia has a preference for apples while Chowhan does not
have a preference for apples or oranges.

Therefore, the current allocation of apples to Chowhan and oranges to Julia is Pareto
inefficient. For the allocation to be Pareto efficient apples should be allocated to Julia and
oranges should be allocated to Chowhan.

Social Optimality/Efficiency and the Competitive Solution:

You may immediately recognize that this is the socially optimal outcome achieved by a
perfectly competitive market referred to above. Social optimality/efficiency is the optimal
distribution of resources in society, taking into account all external costs and benefits as well
as the internal (private) costs and benefits. Social efficiency occurs at an output where
Marginal Social Benefit (MSB) = Marginal Social Cost (MSC).

It can be shown that an economy will be Pareto Optimal when the economy is perfectly
competitive and in a state of static general equilibrium. The intuitive case for this is based on
the fact that prices reflect economic values in a competitive market. If a unit of goods or
services could produce more or bring greater satisfaction in some activity other than its
present use, someone would have been willing to bid up its price, and it would have been
attracted to the new use.

When this price system is in equilibrium, the marginal revenue of product, the opportunity
cost, and the price of a resource or asset will all be equal. Each unit of every good and
service is in its most productive use or best consumption use. No transfer of resources could
result in greater output or satisfaction.
This can be examined more formally in terms of three criteria that have to be met for market
equilibrium to result in Pareto Optimality. These are that there should be: exchange
efficiency, production efficiency and output efficiency.

Exchange efficiency or Efficiency in Consumption:

Exchange efficiency occurs when, for any given bundle of goods, it is not possible to
redistribute them such that the utility (welfare) of one consumer is raised without reducing
the utility (welfare) of another consumer.

A simple example of this is where there are two individuals, one with a loaf of bread, the
other with a block of cheese. Both can be made better off by exchanging bread for cheese.
An efficient exchange system will allow exchange of bread and cheese to take place until
neither party can be made better off without one of them becoming worse off.

Exchange efficiency concerns the distribution of goods. Given a particular set of available
goods, exchange efficiency provides that those goods are distributed so no one can be made
better off without someone else being made worse off. Exchange efficiency thus requires
that there is no scope for trades, or exchanges that make both parties better off.

The amount of one commodity which an individual is willing to give up in exchange for a
unit of another commodity is called the marginal rate of substitute (MRS). Exchange
efficiency requires that all individuals have the same MRS.

The first condition for Pareto Optimality relates to efficiency in exchange. The required
condition is that the MRS between any two products must be same for every individual who
consumes both.

It means that the MRS between two consumer goods must be equal to the ratio of their
prices.

Suppose there are two consumers A and B who buy two goods X and Y, and each faces the
price ratio of Px/Py. Thus A will choose X and Y such that his MRS xy (A)= Px/Py. Similarly,
B will choose X and Y such that his MRSxy (B) = Px/Py

Therefore, the condition for efficiency in exchange is:

MRSxy(A) = MRSxy(B) = Px/Py

In a multi-product, multi-consumer economy, exchange is far more complex and involves

the use of money to facilitate exchange. However, the principle is the same. So long as
products can be reallocated to make one person better off without making another worse off,
the economy is operating sub-optimally from the point of view of exchange efficiency. In a
perfectly competitive market, exchange will occur until this criterion is met.
Exchange efficiency alone does not necessarily result in Pareto Optimality. This is because it
relates only to a specific bundle of goods. It may be possible to make one or more
individuals even better off - without making any one else worse off - by altering the bundle
of goods produced in the economy. This could involve raising the total volume of goods
produced, as well as altering the combination of goods produced.

Production efficiency:

Production efficiency occurs when the available factors of production are allocated between
products in such a way that it is not possible to reallocate the production factors so as to raise
the output of one product without reducing the output of another product.

This is analogous to technical or production efficiency at the level of the firm. What is being
said here is that there are many situations in which it is possible to raise the total output in an
economy by simply reallocating factors of production at no additional cost. This is because
factors of production are more productive in some uses than they are in others. In a
competitive economy, producers bid for factors of production until they are reallocated to
their most productive use.

For example, if there is a lot of unproductive, low-wage labor employed in the agricultural
sector and labor shortages in the industrial sector where labor productivity is potentially
high, factory owners will bid up the price of labor and draw labor from the agricultural sector
into the industrial sector. This could significantly raise output in the industrial sector without
having a negative impact on output in the agricultural sector. So long as factors of
production can be redistributed in a way that increases the output of one product without
reducing the output of others, the economy is operating sub-optimally in terms of production
efficiency.

If an economy is not productively efficient, it can produce more of one goods without
reducing production of other goods. Because of the production possibility Frontier (PPF), the
economy cannot produce more of one good without giving up some of another good, given a
fixed set of resources.

There are three allocation rules for demonstrating efficiency in production under perfect
competition.

a) Rule, one relates to the optimum allocation of factors. It requires that the marginal rate of
technical substitution (MRTS) between any two factors to produce the same product is equal.

Suppose there are two firms A and B that use two factors: Labor (L) and capital (K) and
produce one product. Thus, the condition of equilibrium for firm A is MRTS LK(A) =PL/PK,
and that of firm B is MRTSLK(B) = PL/PK.

Therefore, rule one for efficiency condition is MRTSLK(A) = MRTSLK(B) = PL/PK.

b) Rule two states that the marginal rate of productivity (MRP) between any factor and any
product must be the same for any pair of firms using the factor and producing the product. It
means that the marginal productivity of any factor in producing a particular product must be
the same for all firms. Thus-

MRPXL(A) = MRPXL(B) = PL/PX

c) Rule three for efficiency in production requires that the marginal rate of transformation
(MRT) between any two products must be the same for any two firms that produce both.
This condition requires that if there are two firms A and B, and both produce two products X
and Y, then MRTXY(A) = MRTXY(B) = Px / Py.

Output Efficiency (Holding both Exchange and Production efficiencies Together):

Output efficiency occurs where the combination of products actually produced is such that
there is no alternative combination of products that would raise the welfare of one consumer
without reducing the welfare of another.

Both the exchange efficiency and the production efficiency criteria must hold in order for
this criterion to be met. The combination of outputs produced according to this criterion is
distributed between consumers according to the exchange efficiency criterion, and the
economy is operating with production efficiency.

Pareto Optimality is the result of rational economic behavior on the part of producers,
consumers and owners of factors of production in a perfectly competitive economy.
Although we don't have the scope to examine the underlying theory here it can be shown that
Pareto Optimality will be achieved if all markets are perfectly competitive and in
equilibrium.

Pareto optimality under perfect competition also requires that the marginal rate of
substitution (MRS) between two products must equal the marginal rate of transformation
(MRT) between them. It means simultaneous efficiency in consumption and production.

Symbolically,

MRSxy = Px / Py & MRTxy = Px / Py

Therefore,

MRSxy = MRTxy

It is important to realize that, whilst Pareto Optimality is the outcome in an economy that
meets each of the three efficiency criteria listed earlier, this does not mean that there is only
one 'optimal' allocation of resources. A Pareto efficient economy results in the maximization
of aggregate economic welfare for a given distribution of income and a specific set of
consumer preferences. A shift in income distribution changes the incomes of individual
consumers. As their incomes change, so too will their preferences, as their demand curves
for various products shift to the left or right. This will result in a different equilibrium point
in the various markets that make up the economy. Every alternative distribution of income or
set of preferences is characterized by a different Pareto Optimum. Thus, since there is an
infinite number of different ways in which income can be distributed, there is also an infinite
number of different Pareto Optimal equilibriums.

Obviously, in practice, no economy can be expected to attain the Pareto Optimum position.
Moreover, the Pareto principle is of little practical use as a policy tool since it is rarely
possible to devise a policy that makes someone better off without making someone else worse
off. Nevertheless, it is an important concept in the neo-classical tradition of economics and
integrates much of the theory. It is also a standard against which economists can explore the
real world, where making one person better off almost invariably means making someone
else worse off.

Basic Condition for Pareto Efficiency:

1. Exchange Efficiency: Marginal rate of substitution between any two goods must be the
same for all individuals.

2. Production Efficiency: Marginal rate of technical substitution between any two inputs
must be the same for all firms.

3. Product mix efficiency: Marginal rate of transformation must equal marginal rate of
substitution.

Competitive economies satisfy all three conditions.

Pareto optimality Assumptions (conditions will be achieved if):

1. Second order conditions are satisfied for each consumer and producer. i.e. MRS, or
MRTS, or MRP, or MRT must be equal to zero.

2. No consumer is satiated

3. There are no external effects either in consumption or production.

4. There are no indivisibilities (i.e. no physical inability, or economic inappropriateness, of

running a machine or some other piece of equipment at below its optimal operational
capacity).

5. There are no imperfections in factor and product markets.

[Note: 1. Utility function: In economics, utility function is an important concept that
measures preferences over a set of goods and services. Utility represents the satisfaction that
consumers receive for choosing and consuming a product or service.

2. Quasi: a combining form meaning “resembling,” “having some, but not all of the features
of,” used in the formation of compound words: quasi-definition; quasi-monopoly; quasi-
official; quasi-scientific.

3. Quasi-linear utility function: A utility function with the property that the marginal rate of
substitution (MRS) between x1 and x2 depends only on x1 is: U(x1, x2)=v(x1) + x2, where v is
an increasing function: v′(x1)>0 because someone prefers more free time to less. This is
called a quasi-linear function because utility is linear in x2 and some function of x1.

Demand with quasi-linear preference

4. Marginal rate of substitution (MRS): In economics, the marginal rate of substitution
(MRS) is the amount of a good that a consumer is willing to consume in relation to another
good, as long as the comparable good is equally satisfying. In other words, the marginal
rate of substitution is the rate at which a consumer can give up some amount of one good in
exchange for another good while maintaining the same level of utility. At equilibrium
consumption levels, marginal rates of substitution are identical. That is the MRSs are
graphed along an indifference curve which is usually downward sloping and convex.

5. Efficiency means producing a desired result with a minimum of effort or expense.

Synonymous with this is the minimization of wasted effort that creates no harms or puts
adverse impact to the useful results.

6. Neoclassical economics is a broad theory that focuses on supply and demand as the
driving forces behind the production, pricing, and consumption of goods and services. It
emerged in around 1900 to compete with the earlier theories of classical economics.

Alfred Marshall was an English economist (1842-1924), and the true founder of the
neoclassical school of economics, which combined the study of wealth distribution of the
classical school with the marginalism of the Austrian School and the Lausanne School.

7. Social Efficiency/Optimality: This is the optimal distribution of resources in society,

taking into account all external costs and benefits as well as the internal (private) costs and
benefits. Social efficiency occurs at an output where Marginal Social Benefit (MSB) =
Marginal Social Cost (MSC).

Social efficiency is closely related to the concept of Pareto efficiency – A point where it is
impossible to make anyone better off without making someone worse off

8. Social Benefits are the total benefits received by individuals/households, firms and
communities arising from the production of goods and services in the society. Social benefit
= private benefit + external benefit.

9. Social Cost is the total cost paid for by the society due to the activities of an
individual/households, firm or community. Social cost = private cost + external cost.
10. Private Benefits are the benefit received by an individual, firm or community as a result
of an economic transaction which they are directly involved in. Examples: (i) The revenue
from selling a Corona Virus vaccine for the producer. (ii) The satisfaction of eating a
chocolate ice cream.

11. External Benefits are the benefit received by an individual, firm or community as a result
of an economic transaction which they are not directly involved in. External benefits are also
called spillover benefits of goods and services. The external benefits of i) education include
lower government health, welfare, and prison costs; strengthened democracy, human rights,
political stability, and social capital; less crime and poverty; environmental benefits; better
international competitiveness; new ideas and diffusion of technology; ii) pollution free
environment include healthy life, lower government and private health cost, etc.

12. Private Cost is the cost borne by an individual or firm directly involved in a transaction,
i.e. production and consumption. For example, consumption expenses paid by individuals;
raw materials purchased, labor/wages paid, overheads such as rent, transportation,
commission, salary, advertising, package, etc. paid by firm.

13. External Costs (also known as Externalities) are the costs incurred by an individual, firm
or community as a result of an economic transaction which they are not directly involved in.
External costs are also called spillover costs or third-party costs, can arise from both
production and consumption of goods and services. For example, when people buy fuel for a
car, they pay for the production of that fuel (an internal cost), but not for the costs of
burning that fuel, such as air pollution.

14. Marginal Social Benefits (MSB): Marginal social benefit is the change in benefits
associated with the consumption of an additional unit of a good or service. It is measured by
the amount people are willing to pay for the additional unit of a good or service. These
benefits are experienced by the individual consumers of a particular good along with (plus
or minus) any social or environmental benefits. MSB can be greater than marginal private
benefit (MPB) if there are positive externalities of consumption (e.g. education) (i.e. MSB =
MPB + MEB) or less than MPB if there are negative externalities of consumption (e.g.
smoking) (i.e. MSB = MPB – MEC).

15. Marginal Private Benefits (MPB): The benefits enjoyed by the individual consumers from
one unit of additional consumption of a particular good. MPB does not take into account any
external benefits or costs arising from a goods consumption.
16. Marginal External Benefits (MEB): The additional benefit imposed on (received by)
third parties by the consumption of an extra unit of a good or service. The benefit, a
consumption externality, may be negative or positive.
Below is a diagram to highlight the external benefit that is present in a market with a
positive consumption externality. This measures the size of the external benefit that will be
realized from third-parties if the amount of goods consumed rises to the socially optimal
amount i.e. it is the opposite of a dead weight loss triangle. In this instance the marginal
external benefit exists because there is a divergence between the marginal private benefit
and the marginal social benefit curves.

17. Marginal Social Costs (MSC): Marginal social cost (MSC) is the change in society's
total cost brought about by the production of an additional unit of a good or service. It
includes both marginal private cost and marginal external cost. For example, suppose it
costs a producer $50 to produce an additional unit of a good. Suppose that when the
additional unit is produced pollution is emitted which causes $25 worth of damage to the
paint on your car. The marginal social cost of production is the producer's cost plus the
external cost, or $75.

18. Marginal Private Cost (MPC) is the change in the producer's total cost brought about by
the production of an additional unit of a good or service. It is also known as marginal cost of
production. For example, if production costs rise from$1,000 to $1,050 as one more unit of a
good is produced the marginal private cost is $50.

19. Marginal External Cost (MEC) is the change in the cost to parties other than the
producer or buyer of a good or service due to the production of an additional unit of the
good or service. For example, suppose it costs the producer $50 to produce another unit of a
good. Suppose this production results in pollution which causes $60 worth of damage to
another company's plant. The marginal external cost is $60.20. Marginal Rate of Technical
Substitute (MRTS) is the amount by which the quantity of one input has to be reduced when
one extra unit of another input is used so that output remains constant.
21. Marginal rate of transformation can be defined as how many units of good x have to be
stopped being produced in order to produce an extra unit of good y, while keeping constant
the use of production factors and the technology being used.

Marginal productivity- under perfect competition, the price of a factor of production is equal
to its marginal productivity.]
 PUBLIC FINANCE AND TAXATION
Sir. Prof. Dr. Bidhan Chandra Mazumder
23rd EV Section A
Good Governance:
Governance means the process of decision making and the process by which decisions are
implemented (or not implemented).

Since governance is the process of decision making and the process by which decisions are
implemented, an analysis of governance focuses on the formal and informal factors involved
in the decision making and implementing the decisions made and the formal and informal
structures that have been set in place to arrive at and implement the decision.

Good governance is about the processes for making and implementing decisions. It is not
about making “correct” decisions but about the best possible process for making those
decisions.

Characteristics of Good Governance:

1. Accountability
2. Transparency
3. Responsiveness
4. Equity and Inclusiveness
5. Consensus Oriented
6. Participatory
7. Follows the Rule of Law
8. Effective and Efficient

1. Accountability (responsibility, answerability, liability etc.):

Accountability is a key requirement of good governance. Not only governmental institutions

but also the private sector and civil society organizations must be accountable to the public
and to their institutional stakeholders. Who is accountable to whom, varies depending on
whether decisions or actions taken internal or external to an organization or institution.

2. Transparency (Operating in such a way that it is easy for others to see what actions
are performed):

Transparency is the basis of good governance and the first step in fighting corruption. It
provides a universal rationale for the provision of good records management systems,
archives, and financial regulatory and monitoring systems. It doesn’t create a business
environment in which only the corrupt thrive.
3. Responsiveness:

Good governance requires that institutions and processes try to serve all stakeholders within
a reasonable timeframe.

4. Equity and Inclusiveness:

A society’s well-being depends on ensuring that all its members feel that they have a stake in
it and do not feel excluded from the mainstream of society. This requires all groups, but
particularly the most vulnerable, have opportunities to improve or maintain their well-being.

5. Consensus Orientate:

There are many view-points in a given society. Good governance requires mediation of the
different interests in society to reach a broad consensus in society on what is in the best
interest of the whole community and how this can be achieved. It also requires broad and
long-term perspective on what is needed for sustainable human development and how to
achieve the goals of such development.

6. Participation:

Participation by both men and women is a key cornerstone of good governance; participation
could be either direct or through legitimate intermediate institutions or representatives.
Participation needs to be informed and organized.

7. Rule of Law:

Good governance requires fair legal frameworks that are enforced impartially. It also
requires full protection of human rights, particularly those of minorities. Impartial
enforcement of laws requires an independent judiciary and an impartial and incorruptible
police force.

8. Effectiveness and Efficiency:

Good governance means that processes and institutions produce results that meet the needs
of society while making the best use of resources at their disposal. The concept of efficiency
in the context of good governance also covers the sustainable use of natural resources and
the protection of the environment.
Why is Good Governance Important?

Good governance is a set of fundamental principles which, if implemented, have real world
benefits.

1. Leads to better policy outcomes:

A decision-making process that incorporates good governance attributes will, on balance,

produce better policy outcomes.

2. Promotes ethical decision making:

Good governance helps to create an environment in which public officials ask themselves
whether something is the right thing to do when making decisions.

3. Promotes confidence in Government:

Good governance entrances the confidence of citizens in their government, both in terms of
how it conducts business and the outcomes of the decision-making process.

4. Encourages elected and appointed Government officials to feel confident about their
role in government:

Good governance improves the confidence of public officials in their involvement in

government, the decision-making process and the quality of the outcomes that process
produces.

And then it helps Government officials to conduct their activities in an open, transparent and
accountable fashion. In accordance with other good governance act, public officials are more
likely to conduct their business in compliance with, and thus meet their constitutional and
statutory responsibilities.