Chapter 4: PUBLIC EXPENDITURE

Introduction

Dear learner! In previous unit you have learnt different aspects of public revenue, including
the sources, principles, and effects of public revenue in an economy. In this unit we will
discuss different aspects of public expenditure. Public expenditure is incurred by public
authorities-central and local governments-either for the satisfaction of collective needs of the
citizens or for promoting their economic and social welfare.

Thus, in this unit we will discuss different aspects of public expenditure, including meaning
and nature of public expenditure, classification of public expenditure, canons of public
expenditure, theories on why public expenditure increases over time, and effects of public
expenditure.

Objectives:

Upon completing your study in the unit you should be able to:

 explain the meaning and nature of public expenditure;

 give reasons why public expenditure is increasing over time;
 differentiate different classification of public expenditure;
 discuss different theories on state activities;
 explain different canons of public expenditure;
 discuss different theories of public expenditure; and
 explain different impacts of public expenditure in an economy.
Section 1: Analysis of Public Expenditure

Overview

The public sector incurs different costs in fulfilling its objectives. Every government has to
maintain law and order, provide social services such as education; health care services etc., and
provide the low income section of the society with low-cost housing, and so on. All these
multifarious activities which are increasing every year require huge funds. Public expenditure,
thus occupies the same important place in the study of public finance as public revenue.
4.1: Meaning and nature of Public Expenditure

Section-1: In this section the meaning and reasons for public expenditure will be discussed.

 What does public expenditure means? Why and for what purposes governments spend
societal scarce resources?
Public expenditure refers to the expense which a government incurs for:

 its own maintenance;

 the society and the economy; and
 helping other countries
With expanding state activities, it is becoming increasingly difficult to separate the portion of
public expenditure meant for the maintenance of the government itself from the total.

A number of reasons can be enumerated for inherent long-term tendency recorded in history in
increasing public expenditure. Some of the reasons are:

A. Expansion in the traditional functions of the state:

 Defense became increasingly expensive and expansive over time. That is with
advancement of defense technologies, every nation has to prepare itself for a
strong defense.
 Administrative set kept increasing both in coverage and intensity.
B. The state activities were increasing in their coverage: The tendency of increasing
public expenditure is related to a growing role of the state, in ever increasing socio-
economic complexities of modern society.
C. Many societies are experiencing a growing population: Population growth is a
major contributing factor in the growth of public expenditure.
D. Most countries have registered increasing urbanization: Urbanization implies a
much larger per capita expenditure on civic amenities.
E. Prices have a secular tendency to go up: This also adds to public expenditure even
if the scale of state services remains unchanged.
F. Modern governments have shown a tendency to run into debt: Public debt is one
of the factors which leads to a subsequent increase in public expenditure in the form
of increasing of debt servicing and repayment of the loans. These and other factors
 have contributed to the ever increasing tendency of public expenditure. The details of
why government activities have increased over time will be discussed in the later part
of the unit.
4.2: Classification of public Expenditure

Classification of public expenditure refers to the systematic arrangement of different items of

states expenditure on some scientific and economic basis from which one is able to distinguish
between the nature and effects of different types of public spending. The government in any
nation performs many functions, which involve expenditure of different type according to the
classified activities of the government. These expenditures will have different economic, social
and political effect on the state. Thus systematic classification is necessary for a clear
understanding of the nature and effects of various branches of public expenditure. Broadly we
have two classifications- Accounting and Economic classifications. The Economic classification
is further classified into Productive and Unproductive and Transfer and Non-transfer
Expenditures.

4.2.1 Accounting Classification:

This approach classifies public expenditures into two categories; namely, Current and Capital
Expenditure.

i. Current Expenditure: Includes all sorts of administrative and defense

expenditure and debt services. They are also referred to as non- developmental
expenditure. They are intended for continuing the existing flow of goods and services and
maintain the capital of the country intact. On the other hand, capital expenditures
contribute to increase productive capacity of the nation and therefore, are known as
development expenditure. Expenditures on constructions of dams, public works, state
enterprises, agricultural and industrial development, etc., are some of the components of
capital expenditure.
4.2.2 Economic Classification: The Economic Classification also classifies the public
expenditure into two broad classes.
A. Productive and Unproductive Expenditures: This distinction emphasizes that while
some expenditures are in the nature of consumption; others are in the nature of
investment and help the economy in improving its productive capacity. Expenditures on
 administration, defense, justice, law and order and maintenance of the State are
unproductive.
Expenditures which add to the tangible assets in the economy and enable it to produce
more in the future are said to be Productive Expenditures. Expenditures on Power
Stations, Dams, Irrigations, Water-works, etc., are in this category.
B. Transfer and Non-transfer Expenditure: A Transfer Expenditure is a payment without
corresponding receipt of goods or services by the state. Examples are interest payments
old-age pensions and unemployment benefits. In this case the government is simply
transferring the right or claim to use the goods or services to certain sections of the
society.
Non-transfer Expenditure is that by which the state pays for its purchases or use of
goods and services. While in the case of transfer expenditure, the beneficiaries are to
decide about the use of real resources, in the case of non-transfer expenditure, it is the
state which uses the resources straightaway. Such a use of resources by the stat, of
course, may be for health care and such like things are all of non-transfer or real
expenditures are type as are the investment expenditures.
4.3 Canons of Public Expenditure
Like canons of taxation, there are propounded canons of public expenditure which
should govern the public expenditure decisions. They reflect the philosophy of a
judicious use of public funds with associated legal propriety. These canons or
principles help the economy and the society in achieving their diverse objectives.
Thus, in this section different canons of public expenditure will be discussed,
including Canon of Economy, Canon of Sanction, Canon of Benefit, and Canon of
Surplus.
A. Canon of Economy: The resources of the economy are always scarce compared with its
needs. No wastage should, therefore, be permitted. This canon implies that the process of
public expenditure should not involve the use of resources more than what are just
necessary. That is, utmost care must be taken to avoid wasteful usage of public funds.
B. Canon of Sanction: This canon asserts that no public funds should be used without proper
authorization and further that funds must be used only for which they have been sanctioned.
In a democratic form of government, it is the legislature which sanctions the expenditure on
 demand by the executive authorities. The idea is that such a restriction would avoid
unwanted expenditure and will also be a check against misappropriation of funds. Given the
authority by the legislature, detailed authorizations are worked out and at each stage the
spending unit has to have the sanction and approval of the appropriate authorities.
C. Canon of Benefit: Canon of benefit says that the public expenditure should be incurred only
if it is beneficial to the society. This implies that the authorities should try to choose that
combination of items for public expenditure which collectively maximize the social benefit.
D. Canon of Surplus: This canon is to mean that government should avoid deficit budgeting, at
least a persistent one. It should always try to be prudent and should aim at meeting its
current expenditure needs out of its current revenue. It should not over-spend and run into a
debt. However, since it may not possible to avoid some deficits, it would be better if the
general effort is directed at achieving a moderate surplus. Most economists are not in favor
of this canon because it limits the role that the public sector should play in an economy. For
instance a government may get into huge deficit in its effort of economic growth or if the
nation is in state of war. In both cases a large deficit has to be incurred.
4.4: Theories of Growth of Public Expenditure:

 Why do you think public sector has shown an increasing tendency?

(You can use the space left below to write your response.)

Different Economists gave different reasons why the public sector has shown an increasing
tendency over time and as a consequence the public expenditure increases. According to Prof.
A.C. Pigou, government sector would grow with increasing levels of national income. That is,
with increasing wealth the optimum amount of public good is likely to rise. R.A. Musgrave also
presented similar thought. He argued that if the consumption of the public goods is non-rival, the
per capita cost of any given total supply will be less, the larger the number of consumers. Thus,
the relative price of the goods, i.e. the tax price confronting the individual taxpayer can be
expected to fall as the size of the population sharing the goods rises. Then, if the fall in the prices
of these goods stimulates a relatively large percentage increase in the demand for them (i.e. e p >
1), the result will be an increasing share of total expenditure directed at such goods. In general
the following are among the factors which contributed to the increase of public expenditure:

 heavy costs of war;

  rise in prices involving higher payment of wages and salaries;
 heavy technological risks in Research and Development programs like atomic
energy or space exploration;
 need for social progress arising from democratic forces; and
 Increasing the revenue and income of the sates, and so on.
There are various theories developed by different economists concerning the trends of public
expenditure, which includes:

 Wagner’s Hypothesis,
 Wiseman-Peacock Hypothesis, and
 Critical Limit Hypothesis.
4.4.1: Wagner’s Law of Increasing State Activities

 Do you have any concept about Wagner’s Law of State activities?

Adolph Wagner, the German Political economist (1835 – 1917) believed that a functional
“cause-and-effect” relationship exists between the growth of the economy and the relative
growth of the public sector. He based his hypothesis on historical facts. According to him there
are inherent tendencies for different activities of the government – central and state – to increase
both intensively and extensively. There was a functional relationship between the growth of the
economy and the growth of the government activities. However the government activities grow
faster than the economy.

Wagner believed that social progress was the basic cause of the relative rise of government in
industrializing economies. According to him, social progress leads to a growth in government
function/role, which, in turn, leads to the absolute and relative growth of governmental economic
activity. In nutshell, he emphasized on certain expenditures presented as below:

A. The traditional functions of the state (like defense, administration, justice, etc) were
expanding. Defense, administration, and justice were all getting expensive and expansive
as society progress.
B. The state activities were also increasing in coverage; that is, traditionally state activities
were limited to justice, law and order, maintenance of social order and defense. But with
the development of society and the growth of the state responsibilities government was
 expanding its activities in the field of welfare sector including enrichment of the cultural
life of the society, and strengthening the social security systems, subsidies and direct
provision of merit goods.
C. The expansion of the sphere public goods; that is, the shifting of composition of national
produce in favor of public goods has been the trend for every progressive government
and recognized as the necessary line of action to increase the happiness of the largest
society. There is a continuous rise in public expenditure with respect to national income
(GNP) irrespective of ideological issues.
D. Population growth, urbanization, etc provide additional causes for public expenditure to
increase overtime.
This law is applicable to modern progressive sector only, in wich the state is interested in
expanding public sector of the economy. Wagner emphasize on long term forces rather than
short term change in public expenditure. He also more concerned with mechanism of increase in
public expenditure. It is consistent with the fact that in the future state expenditure will increase
at a rate lower than national income, though in the past it has increased at a faster rate.

The constant proportion line may be used as reference. This line

PG2 represents the situation where the public sector maintains a
constant proportion of the total economy production (GNP) of the
goods
public
t of society overtime. Along line PG2 (public good -2), however, the
outpu proportion of resources devoted to the production of output of
capita
PG1 public good is expanding overtime, i.e. the real per capita output of
public goods is increasing more rapidly than the real per-capita
per
Real
income. But this will be reversed in the long-term.
0 Real per capita income

That is, in the figure the real capita output of public goods is measured on the vertical axis and
real per capita income on the horizontal axis. Time is an important third dimension implicit to
the graph. Line PG1 represents a circumstance in which the public sector maintains a constant
proportion of the total economic production of the society over time. In other words, as real per
capita increases due to the economic development of the society, the real per capita output of the
public goods remains at the same proportion of total economic activity. This PG 1 may be used as
a reference point to the graphical presentation of the Wagner hypothesis depicted by line PG 2.
Along PG2, the proportion of resources devoted to the output of public goods is expanding over
time.

This implies that when the real capita output of public goods remains at the same proportion of
total economic activity, i.e. PG1, the equation is:

PGa/Ya = PG0/Y0, where the subscript a refers to the latter and 0 an earlier point of time.

But the proportion of resources devoted to the output of public goods is expanding over time, i.e.
PG2, the equation is:

PGa/Ya > PG0/Y0

In other words, the income elasticity of expenditure for public goods (Ye) is elastic.

The Wagner hypothesis implies that the proportion of real per capita of public goods to real per
capita income will tend to decline in the pre-industrialization and post-industrialization stages of
society’s economic evolution, but increases when society enters an industrialization stage. In the
pre-industrial stage, the goods which are mostly wanted are private goods like food, clothing,
shelter, etc, which are divisible goods and supplied by the private sector through market-type
arrangement. Hence, the real per capita output of private goods may well become a larger
proportion of real per capita income during the pre-industrial stage.

As real per capita income continues to increase, investment in social capital items such as
communications, transportation an education must take place as part of economic development
process. Since these goods tend to possess heavy fixed costs of production and collective
consumption characteristics, they are provided by the government. Thus, when the economy
enters an industrialization stage, the real per capita output of public goods becomes a greater
proportion of real per capita income over an extended period of time. This stage represents
Wagner hypothesis. And in the postindustrial stage sufficient public goods are provided. Need
for public goods become less urgent. Hence, the real per capita output of private goods may well
become a larger proportion of real per capita income during the post-industrial stage.

According to A.Wagner, in the initial stages of economic growth, the state finds that it has to
expand its activities quite as fast in several fields like education, health, civic amenities,
transport, communications, and so on. But when the initial deficiency is removed, then the
increase in state activities may be slowed down.

4.4.2: The Displacement, Inspection, and Concentration Effects

 Do you have any idea about the Displacement, Inspection, and Concentration Effects?
The theory was forwarded by Alan T. Peacock & Jack Wiseman in their work published in 1961
“The Growth of Public Expenditure in the UK”. They stressed the time pattern of public
expenditure using British data for period of 1890 to 1955. According to them, public
expenditure does not increase in smooth and continuous manner, but it increases in “step-like
fashion”. At times, some social or other disturbances take place, creating a need for increased
public expenditure which the existing public revenue cannot meet. While earlier, due to an
insufficient pressure for public expenditure, the revenue constraint was dominating and
restraining an expansion in public expenditure, now under changed requirements such a restraint
gives way. The public expenditure increases and makes the inadequacy of the present revenue
quite clear to everyone. Thus, now government moves from the older level of revenue and
expenditure plateau to new revenue and expenditure plateau due to the social disturbances. Their
analysis involves three related elements:

A. Major social disturbances like war and depression cause a steep increase in public
expenditure. That is, a previous lower level of tax and public expenditure are now replaced or
displaced by
 NP)
%G
(as a higher one. This is known as a Displacement
ture Effect. These disturbances create a displacement
effect by which the previous (lower) tax and
endi
New fiscal
exp
expenditure levels are replaced by new and
plateau
and
nue higher budgetary levels. After the social
reve Increase due to disturbance has ended, the new (higher) level of
ic social disturbance tax is tolerated and society thinks that it can bear
Publ the higher tax burden in order to support a
higher level public expenditure.
0 Time (years)

B. After the removal of the cause of the displacement effect (i.e. end of the war), a new level of
“tax-tolerance” is reached and maintained. This supports or sustains the higher plateau of
public expenditure. In this way the public expenditure get stabilized at a new level till
another disturbance occurs to cause the displacement effect. Moreover, war or other social
disturbances frequently forces people and their government to seek solution to important
long-standing and pending problems previously neglected which is refer to as Inspectional
Effects. Some of the new expenditures include, for instance, veterans’ benefits, debt
payments, rehabilitation activities, etc.
C. Finally, in addition to displacement and inspection effects Peacock and Wiseman also
describe the “concentration effect”. The concentration effect refers to the apparent
tendency for central government economy activity to become an increasing proportion of
total public sector economic activity, while a society is experiencing economic growth. In
other words, it refers to the apparent tendency of the central government economic
activity’s to grow faster than that of state and local level governments. This is inevitable
because the Central Government has to take a number of measures to sustain higher
economic activity.
This theory emphasize that the reoccurrence of abnormal situation cause sizable jumps of public
expenditure and revenue. It also emphasized that the public expenditure increases because of
displacement effect and concentration effect, which leads a pressure on tax structure of the
economy. The theory also established that public expenditure is increased because of economic
growth, civic awareness and state responsibilities to provide civic amenities and to get equal
distribution of wealth.
In general Peacock and Wiseman conclude that:

 The relative growth of the public sector tends to occur on step-like basis
(displacement effect);
 An inspection process occurs whereby existing problems are more clearly
defined with potential solutions more carefully studied during a major
disturbance; and
 A concentration process exists whereby the central government becomes a
larger proportion of the aggregate public sector.
4.4.3: Colin Clark (Critical Limit) Hypothesis (CLH)

 Can you guess what Critical Limit Hypothesis is all about?

Another hypothesis concerned with the tolerance level of taxation has been advanced by
Colin Clark (the CLH). The proposition of the hypothesis is associated with the British
economist Colin Clark, “Public Finance and Changes in the Value of Money,” Economic
Journal, December 1947. His theory focuses on the effects of increasing public expenditure
rather than its causes.

Based on the data from several Western Economies Clark concluded that inflation
necessarily occurs when the government sector, measured in terms of taxes and other
receipts, exceeds 25% of aggregate economic activity (even under the balanced budget). The
hypothesis is based on two institutional factors:

A. When taxes collected by the government reach the critical limit of 25% ratio of the
aggregate economic activity reflected in the gross national product, community
behavioral patterns change and people become less productive. This is because
income earners are affected by reduced incentives since increasing proportions of
additional income must be paid in taxes under a progressive tax system. In other
words, because of heavy burden of taxation, the incentive to produce is adversely
affected leading to a curtailed supply. This is supply side effect (since it reduces
supply).
 B. On the other hand, demand effects of the government financing become quite strong even
if the budget remains balanced. People become less restraint to various inflationary
means of financing government expenditure.
The loss of incentives thus tends to reduce aggregate supply while the increased purchasing
power resulting from inflationary financing techniques tends to expand aggregate demand,
leading to inflationary situation in the economy.

Clark emphasized that the share of the government sector should not increase in most of the
countries. But due to political and economic reasons, the share of government sector is
increasing more than 25%, which is causing deficit budget, and thus deficit financing results
inflation in the economy.

In fact, a number of independent variables can be suggested to explain the positive theory
regarding theories of public expenditure growth, including:

 the process of industrialization itself (Wagner);

 increasing tolerance level of taxation following periods of national crisis (Peacock-
Wiseman);
 increased vested interests in public expenditure by bureaucrats and elected
representatives;
 strong preferences by society for public and quasi-public goods to cause an income-elastic
demand for these goods;
 growth population and growing concentration of people in towns;
 macroeconomic stabilization and economic growth policies;
 increasing importance of welfare functions and distributional problems;
 rise in prices and national income and less resistance to taxation as society becomes more
affluent; and
 Environmental and other resource-related policies of government.
All these variables don’t lead to a uniform theory of public expenditure which is applicable to
different types of countries. There is no certainty that the independent variables of one nation
will be similar with another.
4.5: Economic Effects of Public Expenditure

 Can you list different effects of public spending in an economy?

(You can use the space left below to write your response.)

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In a socialist country, the public sector directly produces most of the goods and services and
increases production and employment as stipulated in planed programs of the country. Further
inequality of income arising from property rights doesn’t arise since individual property rights
are abolished. But in mixed economy, where the private sector plays an important part, the public
sector influences production and employment mostly by indirect methods. This is particularly so
in developed countries where the private sector is sufficiently strong to maintain economic
efficiency. In underdeveloped countries, however, direct intervention by the government
becomes inevitable to transform the economy, though the private sectors play an important role
in the process of production. The scope of public expenditure in mixed economies can be stated
as follows:

A. The public sector produces some important public goods which the private sector can’t
produce since the benefits of these goods accrue collectively to the society.
B. The government may subsidize the private production of certain partial social goods for
increasing their output. In such cases, the external benefits are recognizable and
appropriable and the market can allocate these goods efficiently if certain subsidies are
given by the government so that their prices reflect marginal social cost.
C. In under developed countries, the public sector may have to produce certain private goods
which are considered important from the point of view of economic development which
the private sector is unable to produce due to lack of adequate resources, lack of
enterprise or technical know-how or lack of experience. The public sector may also
produce these goods to have strategic control over the economy.
 D. Public expenditure may be used as a balancing factor or contra-cyclical measure to attain
full employment and maintain stability.
E. Public expenditure may bring about equitable distribution of income between different
sections of the community.
4.5.1: Impact of Public Expenditure on Production and Employment

 Can you discuss the impact of public expenditure on production and employment?
(You can use the space left below to write your response.)
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If public expenditure is used as an indirect method for influencing production and employment,
it can:

 increase the ability and willingness of the people to work, save and invest; and
 help to divert economic resources between different uses and localities.
If public expenditure can increase the efficiency of a person to work, it will promote production
and national income. For example, public expenditure on education, medical services, cheap
housing facilities, etc., can increase the efficiency of persons to work. Again, all public
expenditure will increase the beneficiary’s ability to save in so far as it gives him any additional
margin of this kind. Ability to invest will also be increased if public expenditure places investible
funds in the hands of any agency whose business is to undertake capital expenditure. The effects
of public expenditure o the willingness to work, save and invest depend considerably on the
expectation of future benefits. In some cases, these benefits reduce the willingness to work, save
and invest. For instance, war pensions and interest on war loans will rarely increase the desire to
work and save. Particularly, fixed, periodical and unconditional grant will become disincentives.
But when the grant increases with an increase in effort, the desire to work and save will go up.

Public expenditure can have far-reaching effects on the utilization of resources. The government
can divert resources from one field and increase production in another. For example, the
government can reduce the production of currently consumable goods ad increase the
expenditure on defense. Alternatively public expenditure may bring about a better allocation of
economic resources between the present and the future. Unlike the private individuals, the
government makes investments in railways, irrigation projects, afforestation, etc., which don’t
yield immediate returns, but can provide social and economic benefits to the future generation.
The government also allocates resources among different regions to bring about balanced
regional development. This can be done through Central grants and regional planning. Further,
public expenditure can also modify the allocation of resources among various sectors and hence
influence the composition of GNP. For instance, an increase in public investment in highway
construction may stimulate automobile and allied industries, and this expansion in turn may
retard highway expansion.

The effect of public expenditure on the production of private goods and services depends on the
state of employment. With unemployment, government activities may not decrease the
production of private good and services. On the other hand, if there is full employment, the
output of the private sector of the economy may be reduced with the increase in that of the public
sector.

4.5.2: Public Expenditure and Economic Growth

 In what way public expenditure influences economic growth?

(You can use the space left below to write your response.)
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In under developed countries, where the government directly intervenes in the economy to
accelerate the process of growth, public expenditure is converted into public investment. This is
because there is no a change in the economic base of the country without additional government
investment. In fact, public expenditure determines both the scale and pattern of investment. The
more the public investment, the greater is the magnitude of saving and investment in the country
and so also the change in the rate of growth of income. However, the magnitude of investment is
limited by the availability of resources. The size of investment will, therefore, depend on the
resources that the government can raise for this purpose.
But once investment resources are known, the government can determine the pattern of
investment. Here the government has to make a choice between long-term growth or structural
change of the economy and short-term growth or providing immediate employment opportunities
and meeting the present needs of the community. Clearly, there is a clash between the
maximization of present output and consumption, and growth and output in future. The more
labor-intensive techniques are used the more output in the short-run maximized; but more
capital-intensive techniques provide a greater surplus for reinvestment for the future growth. But
in under developed countries, it is inevitable that public expenditures should have the dual role of
preparing the economy for structural change and at the same time of fulfilling the immediate
needs by proper allocation of existing resources.

4.5.3: Public Expenditure and Economic Stabilization

 Based on Keynesian Theory, can you explain how public expenditure is used for economic
stabilization?
(You can use the space left below to write your response.)
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The importance of public expenditure as an ‘economic stabilizer’ has its origin to the “General
Theory” of Maynard Keynes. Keynes could effectively prove that public expenditure can be used
as a balancing factor. If there was an imbalance between investments and savings thereby
causing recession or depression in a country, the government could control such a situation by
increasing expenditure on public works or transferring income from the rich to the poor whose
marginal propensity to consume is higher than that of the former.

In Keynes’ view, the peculiar characteristics of a developed monetary economy account for
unemployment. Even if the wage rates were perfectly flexible (which is not possible due to the
fact that trade unions and welfare legislations are now an integral part of modern democratic
countries), and commodity prices perfectly competitive, unemployment could still exist. Keynes,
therefore, sought a means to prosperity through monetary expansion, public investment and other
forms of government action, which is represented a complete departure from the traditional
policy of laissez faire (classical view). Due to this analysis, public expenditure assumed
tremendous importance as a contra-cyclical or compensatory device to maintain stability and
promote increased employment opportunities.

The importance of public expenditure in Keynesian economics could be seen in three lines of
thought:

 prevention of periodic tendencies to depression in a capitalist economy;

 regulation of the tendency towards secular stagnation in matured
economies; and
 improvement in the distribution of income so as to increase aggregate
consumption.
i. Keynes’ analysis of periodic tendencies to depression in capitalist economies is based
upon the assumption that when national income rises, the volume of saving tends to
grow; i.e. the marginal propensity to consume (MPC) declines as income goes up. The
decrease in the MPC due to the increase in income creates a deficiency in aggregate
demand which leads to unemployment. Therefore, there is a need to increase real
expenditure (through rise in public expenditure) to fill up the gap between income and
consumption demand out of that income.
ii. In Keynesian terms, the MPC is less than unity – a small increase in income will
be accompanied by a smaller one in consumption. This idea is an important feature of
‘cyclical Keynesianism’. The secular upward shift in consumption function in the long-run
is a result of the secular rise in income. In short, the role of expenditure as a compensatory
fiscal policy will play an important part to avoid large-scale cyclical unemployment and
excess capacity.
iii. Cyclical Keynesianism has a further premise, i.e. it leads to stagnation which
implies that in advanced industrial economies, the long-term prospects of investment are
likely to lag behind full employment savings. When the economy reaches a high state of
development and thus “matures”, a point is eventually reached at which full employment
cannot be maintained in the absence of government action, because at the full employment
 level of national income, the volume of investment is inadequate to absorb the amounts of
savings which are made at this income level. The stagnation thesis implies that
government expenditure would have to be permanently expanded in order to eliminate the
gap between investment and savings at full-employment levels.
iv. Basing his analysis on the proposition that the MPC of the poor is greater than
that of the rich, Keynes suggests that if there is a less unequal distribution of income,
total consumption will increase, which will, due to the multiplier effect, facilitate
greater increase in national income and employment opportunities.
4.5.4: Public Expenditure and Redistribution of Income

Keynes advocated improvement in the distribution of income in favor of the poor for increasing
aggregate consumption since the MPC of the poor is assumed to be greater than that of the rich.
But he didn’t consider the question of equity in the distribution of income.

The optimal theory of distribution of income indicates that the ultimate allocation of income
among factors depends upon:

 relative factor supplies;

 the nature of productive processes;
 the relative demands for the various goods and services, and
 Factor returns, which is determined by relative factor endowments.
But the argument that the optimal return should be based on the existing factor endowments is
hardly correct as these are not fixed for all time to come. The doctrine of factor endowment is
more useful in explaining where a factor has been than in indicating where it might go.

Inequality in capitalist society arises mainly due to two reasons:

 differences in the amount of income-property held by various individuals; and

 differences among individuals in the value of personal talents or skills which
each possesses.
Since in capitalist state private property is recognized, the government may change the pattern of
resource ownership by levying death and inheritance taxes or by placing limits upon the amount
of income-producing property which the individual may own. Secondly, the government may
also alter the pattern of resource price, by establishing minimum wages or minimum prices for
certain products. This method is more popular in underdeveloped countries than in develop ones.
Third, the government may alter personal incomes independently of resource ownership or
resource prices by the creation of purchasing power on the one hand and by public expenditure
on the other.

To sum up, the purpose of an economic policy should be to contribute towards achieving the
maximum social benefits. A shift towards equality may be achieved through various forms of
public expenditure, specifically those which are meant to help the poorer section of the society.

A number of welfare measures like, free education, health, potable water and other facilities can
be provided through government spending. In addition, numerous social security schemes can be
adopted whereby people are entitled to old-age pensions, unemployment relief, sickness
allowances and so on.
Unit-5: Government Budgeting

Dear Learner, it is well known that no government can afford to take taxation, borrowings,
expenditure and other fiscal decisions at random. On account of their inter-connection, all
decisions and polices must form a part of its over-all set of objectives. The whole approach has
to be quite systematic if chaos and wastage are to be avoided. Therefore, the government
describes its intentions and policies which it would take to pursue during forthcoming period
(usually a year) and draws up a financial plan corresponding to this scheme of things. Such a
financial plan contains the details of estimated receipts as also proposed expenditures and other
disbursements under various heads. Therefore, a budget enables the authorities to decide about
each individual item of revenue and expenditure in the over-all context of its policies. Thus, in
this unit we will discuss government budget in general and, more specifically, what a budget is,
classification of government budget, effects of public budget in an economy.

Unit Objectives:

After studding this chapter you should be able to:

 Define what government budget is

 Explain the different theories of government budgeting
 State the various classification of budget
 Explain the role the government budget can play as instrument of economic
policy.
5.1: Meaning and purpose of government budget

Section-1: The budget is much more than a statement of income and expenditure of public
authorities. It is a reflection of not only taxation and public expenditure policy, but also of a plan
for future course of action. From the study of the budget, one can make an assessment as to the
extent to which it is designed to secure the normative ideals of allocation, distribution,
stabilization and growth. Thus in this section we will discuss the meaning and purposes of
government budget.

Objectives of the section:

Upon completing this section you should be able to:

 Define government budget

 Explain purposes of public budget
 Explain processes of government budget
 What does government budget means?
A budget is a financial plan by government to pursue its objectives in a year.

In general, a budget shows financial accounts of the previous year, the budget and revised
estimates of the current year, and the budget estimates for the forthcoming year. In addition, the
estimates for the forthcoming years are split up into two parts-those based upon the assumption
that existing taxes and their rates would continue, and those based upon the proposed changes
therein. A budget, in this sense, becomes both a description of the fiscal policies of the
government and the financial plans corresponding to them.

Though budget is a program for future action and is generally framed for a year, it presents a
picture of the details of expenditure, taxation and borrowings for three consecutive years, i.e., the
actual receipts and disbursements of the previous year, the budget and revised estimates of the
current year and the estimated receipts and expenditures of the coming fiscal year Though
budget estimates for the coming fiscal year contain proposals of taxation, borrowing and public
expenditure, the government in course of implementation of the budget programs might face
shortage of funds due to some important additions of activities and, hence, might be in the
necessity of fresh proposal of revenue receipts and expenditure which are made in what is called
a “Supplementary Budget”. In this way, the action plan of the original budget gets revised.
Budgeting process requires three ingredient elements:

 Determination of variety of policy objectives the government intends to perform, such as

defense, education. Health care, etc.
 Estimating the cost of providing or fulfilling these objectives, and
 An assessment of willingness and ability of the public to pay and other revenue sources.
A good budget is one which is able to satisfy certain conditions and is formulated according to
certain well drawn principles. One such principle is the budget should be accompanied by an
account of the performance of the fiscal policies and programmes of the government during the
previous year. This provides a necessary basis for deciding as to what is to be done, what has
been accomplished and what more should be aimed at and in what directions.

The budget proposals should also be accompanied by an analytical description of the current
economic situation of the country as also the position of the Treasury. The budget proposals
become far more meaningful in the light of the above mentioned accounts and descriptions. And,
they enable the legislature and the public to see the relevance or otherwise of the budget
proposals and help the legislature in taking a more objective and rational stand in this
connection. Furthermore, the proposals themselves should be as clear as possible. They should
be clearly comprehensible so that correct judgment can be formed as to the way in which the
budget is expected to function in the coming year. Accordingly, detailed budget proposals must
accompany the proposals under major heads of receipts and expenditure. There should also be
various statements which highlight the particular aspects of the budget.

2.1.1: The Purpose of Budgeting: The purpose of government budget is varied. There are a
number of objectives which the budget seeks to attain simultaneously. The overall purpose is to
use the budget as instrument of government economic policy. The following are the chief
purpose of the budget.

 To serve as instruments of adjusting the economy by affecting aggregate demand and

aggregate supply
 To serve as instrument of economic growth by increasing government saving and
investment
 To reduce the income gap or inequality between or among individuals, families and
regions.
Taking together, government budget is a policy instrument to direct and administer the
economy of the country.

To achieve any purpose, a planning is necessary. The government needs to achieve many goals
all of which cannot be attained at a time. A proper plan of action is, therefore, necessary. A
budget is such a plan which explicitly mentions the programs that are to be taken up in the course
of the fiscal year. Secondly, implementation of a program requires availability of necessary
funds. The extent of availability depends upon the budgetary sources of revenue. Hence, that
program-structure has to be built which can be supported by the funds. This is the most
important purpose of the government budget. Thirdly, to achieve efficiency in public
expenditure, physical targets of achievement are specified in the budget. In fixing the physical
targets, careful considerations is given to the factors of efficiency in course of implementation of
the programmes so that nearer the actual achievement at the close of fiscal year, the higher is the
efficiency of level of expenditure agencies. Fourthly, most of the countries, particularly in
developing world, today have taken up their task of their economic development in the phased
manner of five year plans and long-drawn perspective plans. In order that the planned targets are
achieved at the end of the plan period, resources have to be found. The annual government
budgets are framed with an eye to the provision of necessary funds for the purpose. Lastly, the
government budget serves the purpose of public accountability of funds to a considerable extent.
The first control is imposed at the budgeting framing level itself when the government asks
different departments to submit their own budgets. Because the departments know that their
programmes of expenditure will be scrutinized by the government level, they become careful to
observe economy in the budget. The next stage of control is imposed by the legislature which is
the ultimate authority to decide the size and extent of the budget. At the end of the financial year,
again, the government and its various departments are responsible to the legislature for their
action and budgetary performance. Hence, budget serves as a powerful weapon of financial
control in respect of both collection of revenues and disbursement of them.

5.2 Theories of government budgeting

Section-2: There are two theories of government budgeting, in this section we will discuss these
two theories.

Section Objectives:

Upon completing this section you should be able to:

 Explain the classical theory of balanced budget

 Discuss the modern budget theory
 Compare and contrast the two theories
., (1) the classical theory of balanced budget and (2) the modern theory of ‘Managed Budget’.
The classical theory of balanced budget is based on the assumption of full employment on one
hand and the ‘laissez-faire’ doctrine on the other. Since the economy operates at full
employment level, the problem of economy in the classical system is not attainment of growth.
The economy functions with maximum efficiency. Moreover, with the philosophy of ‘laissez-
faire’ followed, the functions of government are limited to the minimum and, hence, most of the
economic activities are performed by the private sector. Under such a situation, the size of the
budget is always small and the budget should always be balanced. If there is budget deficit and
it is financed by public borrowing, it will withdraw funds from private sector where they are
more productively employed. Such diversion of resources will bring down over all economic
efficiency.

Another justification of the balanced budget is that since deficit financing through borrowing is
easy, the practice of unbalanced budget will encourage expansion of government activities as
against the classical notion of small budgets. This will reduce the capacity of government to
spend for more important purposes because interest charges on borrowed funds have to be paid
in addition to repayment of the principal amount. Thus, public borrowings are expensive; they
require double payment in the form of debt charges as well as repayment.

There are two views regarding the balanced budget theory. According to one view, the
balancing of budget is brought about by equating current revenues with current expenditure.
There is no role of borrowing in the budget. Since total revenues are equal total expenditures,
the budget is balanced. In the other view of balanced budget, governmental receipts include
public debt also. The budget has, however, two parts – current budget and capital budget, both of
which are balanced. Thus, current expenditures are financed by current revenues while capital
expenditures are financed by public borrowing. Thus, the overall budget is balanced.

Modern Theory: As against the above, the modern theory of Managed Budget does not agree
with the classical assumption of full employment. The celebrated Keynesian theory of
underemployment equilibrium shows that full employment is only a limiting case and is not
automatically attained. It follows that the normal situation is one of less than full employment in
an economy. Hence, in order to ensure employment of unutilized and idle resources, a flexible
budgetary policy is needed.
Thus, when widespread unemployment exists, the classical system of balanced budget becomes
helpless. The modern economists like Keynes, Hansen, Dalton and others advocate that the
objective of budget policy should be to attain and maintain full employment. The modern
approach to flexible budget policy is essentially a counter measure against economic fluctuations
of business cycle to which advanced countries are subjected. When depression and
unemployment occurs in the economy due to deficiency of effective demand, the need is to inject
additional purchasing power into the economy so that effective demand, hence employment of
production factors are enhanced. This objective can be realized through a deficit budget policy;
because such a budget will put additional purchasing power into circulation and the aggregate
consumption expenditure will increase. This will raise prices and profit prospects of the business
community which will employ available unutilized production factors to increase production and
meet the increased demand. When the economy, on the other hand, suffers from inflation due to
excess purchasing power over and above the amount necessary to deal with the transaction of
available goods and services at prevailing prices, the necessity is to pump out the excess amount
from the economy. This can be done by surplus budget which will raise more revenues like
taxes and borrowings and lower down government expenditures. The process will cure the ills of
inflation and bring about economic stabilization. When there is neither inflation nor
unemployment, the budget should be balanced. Thus, there should be flexibility in the budget
policy according to the modern economists. Whether the budget should be balanced or a deficit
or a surplus should be decided by the prevailing economic circumstances. Hence, the modern
theory is called the principle of managed budget.

The main difference between classicists and modem economists in so far as the principle of
government budgeting is concerned lies with their views on savings and investment. To the
classical economists, saving is always equal to investment because the former is automatically
converted into the latter. In such a system, there is no unemployment. To the modem economists,
however, savings and investment need not be equal. They are determined by different factors
and, more normally, they are different. When savings become more than investment, deficiency
of effective demand develops and unemployment occurs due to fall in production. The economy
is then faced with depression. On the other hand, when investment becomes more than saving,
the aggregate purchasing power in the economy increases and the available output cannot absorb
it at the prevailing price level. Thus, there becomes inflation. It is only when savings are equal to
investment, the stabilization function of the economy remains undisturbed and the society suffers
neither form unemployment nor from inflation.

Under such circumstances, the modem theory argues, the budget policy of government should be
flexible, allowing for balanced budget when there is neither inflation nor unemployment i.e.,
when savings and investment are equal and for unbalanced budget when the economy suffers
from either inflation or unemployment, i.e., when savings and investment are unequal.

Learning Activities

1. Explain the classical theory of balanced budget

2. Discuss the modern budget theory
3. Compare and contrast the two theories
5.3: Classification of Government Budget

Section-3: In old days, a budget was more or less only a statement of the financial plans of the
government. But now the importance of the government activities is fully recognized.
Government’s financial activities contribute a major portion to the flow of funds in the economy
and the government’s fiscal policy together with the financial flows has a wide impact on the
working of the economy. The actual role of the government transactions in the life and working
of the economy cannot be underestimated because of the immense impact which they have.
Accordingly, now various facets of budget estimates are presented to indicate the manner in
which the budget would be affecting the economy. Thus, in this section we will discuss different
classification of the government budget and the rationale for each of these classifications.

Objectives of the section:

Upon completing of this section you should be able to:

 Explain different classification of govern budget

 Distinguish between current and capital account
 Explain economic and functional classifications
 Describe Performance and Program Budgeting
 Discuss Zero base budgeting
 Explain Planning and Programming Budget system
 5.3.1: Current and Capital Budgets
 What do capital and current accounts mean?
In many countries, the budget is divided into revenue (current) and capital
accounts. Revenue account covers those items which are of recurring nature;
while capital account covers those items which are in nature of acquiring and
disposing of capital assets. It is argued that every economic unit must distinguish
between current expenses and those incurred for acquiring of capital assets.
Current expenses are equivalent to consumption; while acquiring of capital assets
are not. It is only when these capital assets depreciate that real expenditure takes
place in the sense of consumption. This is the rationale because of which private
commercial units do not count the amounts spent on the acquisition of capital
assets as part of current expenses for the year. It is only the depreciation part that
is so counted. It is argued that the government should also follow the same
practice.
The main sources of government revenue are taxes and borrowings from internal
sources on one hand and loans and grants from other governments and
international agencies on the other. In the revenue budget, the current expenditure
is met out of domestic taxation, while the expenditure on capital account is made
out of domestic and foreign borrowings. Government obligations for some extra-
ordinary expenditure particularly in the initial stages of development arise on
account of economic overheads like roads and railways, electricity generation,
schools and hospital buildings and facilities and other investment projects which
require special revenues and are generally financed by borrowing. Such
expenditures and receipts are shown in the capital budget.

Table 5.1 Revenue and Capital Budget

Revenue Budget Capital Budget

Items of receipts items of items of receipts items of
Expenditure Expenditure
a.Taxes on income a. Administrative a. Loans and a. Public works
and general services recoveries
b. Taxes on b. Social services b. Market loans b. Construction of
property power generation
plant.
c. Custom duties c. economic services c. Small savings c. construction of
roads and railways
d. Union excise d. community d. External loans d. Flood control
duties services works
e. Non-tax e. Maintenance of e. Other receipts e. Irrigation canals
revenue road and railways. etc.
etc.
f. Other revenues. f. Total revenue f. Total capital f. Total capital
Total revenue expenditure receipts expenditure
receipts
Since capital projects are very important as they will form the sources of regular flow of
productive services in future, the long drawn financial plan and its consequence on the economy
over years ahead can be read from the capital budget. Such a separation of the budgets secures
expenditure discipline and, hence, the lenders can form a clear idea about the solvency or
otherwise of the country. It is, therefore, very important for developing countries to frame such a
type of budget. The above table will give an idea of the structure of revenue and capital budgets.

5.3.2: Incremental and Zero-base Budgets

 What does Zero-Base Budget means?

It is a budgeting technique which calls for a total review of the entire budget each year,
with emphasis on a ranking of alternative projects rather than a detailed item-by-item
analysis. In this case, first setting the expenditure total and then allocating it among all
possible projects are appraised and judged on their merits, with the budget total the end
result of this micro process.

On the other hand, when past levels of expenditures are taken as given and only new additions to
or reductions from the past outlay are examined it is known as 'incremental budgeting' which
should not be allowed to be in vogue since it cannot ensure proper allocation of economic
resources. ‘Such a focus on increases and reductions can well lead to hardening of the
bureaucratic arteries, maintain old programmes that go unexamined simply because no
substantial changes are called for in the budget’. This deficiency of incremental budgeting is
done away with by ‘Zero-base budgeting’.

Since every outlay in the budget has some attainment objective, either short-run or long-run, it is
necessary to regularly examine the expenditure components in the light of anticipated results. In
the case of budgeted expenditure having been associated with long term objective, the time-
bound expected result-component should be examined occasionally. This is what is done by
Zero-base budgeting. It is not necessary, however, that each and every programme be reviewed
afresh or restructured anew every year under the zero-base budgeting, though such necessity
might arise in case of some of the programmes. But it does require that programmes should not
go unscrutinized in any case for a long period. Such budgeting is a new technique of bringing the
spending agencies under a regular scrutiny and accountability. Zero-base budget, therefore, acts
as a constant reminder of the necessity of utmost efficiency in public expenditure and in resource
allocation programmes.

5.3.3: Economic and Functional Classification

There are many governmental functions on which expenditure is planned in the budget. To get a
fuller picture of the various implications of budget frame, a proper analysis is necessary. Modem
budgeting recognizes this need and attempts to classify the budget from different analytical
angles. The Economic Commission for Asia and Far East explains this necessity in the
following words. The systems of classification provide information on the working of budgetary
process. Since such a process has a multitude of functions and objectives, different types of
classification are needed, either singly or in combination, to serve the purpose of appropriation,
programme management and review, evaluation of plan implementation, and financial and
economic analysis. The various ways in which the public sector transactions can be classified
are (a) by organization, (b) by object, (c) by function, (d) by their economic character, (e) by
programme and (f) by origin of the purchases affected by the government.

Accordingly, from different analytical view points, we may classify the budget in the following
ways.

i. Functional Classification. A better idea of government expenditure is obtained from

functional classification since it goes by purpose of expenditure rather than by
 departments of government. It classifies public expenditure by specific governmental
function such as defense, health, education, promotion of agriculture, etc.
Since the resources of government are limited and since the functions of government are
many, the latter are essentially competing objectives. Therefore, it is important to
determine the extent of budgetary resources that can be earmarked for each of these
purposes of public expenditure. This is what the functional classification does.

ii. Economic Classification. Economic classification seeks to categorize the government

receipts and expenditures into different classes of economic significance so that the
pattern of resource allocation and its impact on the rest of the economy can be readily
grasped. This classification shows how expenditure for a particular purpose, say, health,
is divided between such classes of economic significance as current expenditure on
goods and services, capital formation, current transfers, capital transfers and loans. It
also shows how expenditure belonging to a particular category, say, capital formation, is
designed to serve different purposes. Obviously, such classification provides important
macro-economic information that are essential for construction of national accounting
data.
Economic classification broadly categorizes public expenditure into two classes, viz.,
current expenditure and capital expenditure. Current expenditure is divided into three
classes each of which, again, is sub divided into four classes, as shown in the following
table.

Table 5.2 Current and Capital Budget

1. Current Expenditure 1. Capital Expenditure

a. Consumption expenditure a. Gross capital formation
b. transfer payment b. Capital transfers
c. Total current expenditure c. Investment in shares
(a + b) d. Loans and advances
a. Consumption Expenditure e. Repayment of public debt
i. Salaries and wages Total capital expenditure
ii. Goods and services = (a + b + c + d + e)
iii. Less outside sales a. Gross capital formation
iv. Net consumption i. Buildings and other
expenditure construction
= (i) + (ii) – (iii) ii. Machinery and equipments
 b. Transfer payment iii. net increase in stock
i. Interest payment Total G.C.F = (i) + (ii) + (iii)
ii. Grants to local bodies b. Capital transfers
iii. Subsidies i. Grants for capital formation to
iv. Income account of household total bodies
Total transfer payment = ii. Other capital transfers
(i + ii + iii + iv) Total cap. Transfers = (i) + (ii)
c. Loans and advances
i. Capital formation
ii. Current consumption
Total = (i) + (ii)

Similarly, capital expenditure is divided into five classes. viz., gross capital formation,
capital transfers, investment in shares, loans and advances and repayment of public debt.
Again gross capital formation, capital transfers and loans and advances are also sub-
divided into more significant categories as shown in the table.

5.3.4: Performance and Program Budgeting System (PPBS)

Spending a particular set of resource for particular purpose (which may be called a project) is
known as Program Budgeting. Here it requires- first programming or a stage- wise sequence of
steps for executing it. Second, it requires tests for assessing the actual performance. When
budgeting covers these two aspects it is called Program and Performance Budgeting System
(PPBS). It is based upon activities, functions and projects of government.

Technically, the performance and program budgeting are similar but not identical with each
other. Program budgeting consists of three stages:

 Defining the objectives of various fiscal measures and polices, and identifying the
programs out of which a selection is to be made.
 Use of cost-benefit approach for assessing the comparative ranking of the identifying
programs and, subject to the availability of resources, selecting the best.
 The third stage is ‘projective’, that is, in it current programs and policies are related to
their future benefits, problems, costs and other developments. Program budgets, by their
nature are forward looking. They belong to what is essentially a long-term planning
 system under which budget is an allocative process between competing claims, and the
budget itself is a statement of policy for the appropriate planning period. Accordingly, an
effective implementation of a program budget should have a time schedule for financial
flows and other activities together with achievements of targets. A performance budget,
on the other hand, is to assess accomplishments and failures of a program budget.
Obviously, programming and performance budgets are interlinked and neither has any
useful meaning without the other.
The program approach stresses the end product, such as elimination of poverty in rural areas or
providing basic education, etc., relative to the goals of governmental activity, rather than the
inputs of various types of materials and manpower. The approach is designed to consider the
pursuit of policy objectives of government in light of all economic costs of the program.

Second, program budgeting stresses the relationship between various outputs or programs and
the inputs necessary to produce them. The work of each department is classified into programs,
which are broken into subcategories. Programs include all work seeking to attain the same
objective.

Under this classification, the budget would frame a program structure to attain a particular
objective and specify spending to attain it. We may think of all those expenditures allocated to
the set of programs under a particular objective as belonging to a total spending agency which is
responsible for attainment of the objective. If, for example, the objective is poverty removal,
these expenditures would constitute the poverty removal program. It is important to note that
since these expenditure agencies are inter-related, some programs expenditure would draw
support from a number of agencies. To explain the anatomy of program budgeting, let us take the
following example.

Table 5.3 General Objective: Poverty Removal

1. Current Expenditure 1. Capital Expenditure

 Specific objective No.1 Increase of earning capacity
programs a. Elementary and secondary education
program
b. Enrollment incentive program
c. Teachers training program
d. Adult literacy program
e. Vocational education program
f. Labour mobility program
g. Skill formation program
h. Job placement program
Specific objective No. 2 Income maintenance
Programs a. Employment insurance program
b. Social security programs like retirement and
disablement benefits
c. Consumption subsidy program
d. Public distribution program
e. Price support program etc.
Specific objective No. 3 Community Improvement program
Programs a. Low income housing program
b. Area development program
c. flood control program
d. consumers’ co-operative program
e. market improvement program
Specific objective No. 4 Agriculture Improvement Program
Programs a. Input supply program
b. Irrigation improvement program
c. Flood control program
d. Land reforms program
e. Agriculture wage restructuring program, etc

In this way, there may be as many specific objectives as would be helpful in securing the general
objective of purpose. A more detailed program budgeting will break down each of these program
into what are known as program elements. For example, 'Enrolment Incentive Program may be
broken down into such program elements as (a) supply of school uniform, (b) free tuition and
free supply of books, (c) scholarship scheme and (d) mid-day meal scheme. Such a program
element is considered as the smallest unit of analysis. A fully developed system of program
budgeting requires expenditure to be allocated against each of these program elements.

The primary advantage of the program budget structure is that it provides a more useful basis for
evaluation purpose.
Learning Activities:

1. Explain different classification of govern budget

2. Distinguish between current and capital account
3. Explain economic and functional classifications
4. Describe Performance and Program Budgeting
5. Discuss Zero base budgeting
5.4: Effects of Government Budget in an Economy

Section-5: Budgetary or fiscal policy consists of steps and measures which the
government takes, both on the revenue and expenditure sides of its budget. Fiscal
policy means the use of taxation, public borrowing, and public expenditure for
purposes of stabilization and economic development. The detail analysis of fiscal
policy will be presented in another unit of this module, but in this section only the
effect of government budget in an economy will be discussed

Government budget is an important instrument of economic policy in both

developed and developing countries. In the developed countries, the economy often
faces cyclical fluctuations and hence requires government adjustments. In the
underdeveloped countries, the economy operates at less than full employment level
and, hence, the main problem is how to attain economic growth. In these poor
countries, growth process is faced with a number of problems. They are allocation,
distributional and stabilization. Budget serves as an important device to achieve
economic development in these countries also. The following are the important
ways in which the government budget can influence the economy of a country.

Objectives of the section:

After completing this section you should be able to:

  Explain effects of government budget on economic growth
 Discuss the effect of government budget on economic stabilization
 Discuss how government budget is used in resource allocation
 Explain how government budget can be used to improve regional
imbalances.
(1) Revenue Raising Device. The government requires enough revenue to discharge its fiscal
responsibility. Modern countries have increasingly become welfare states with larger and larger
state activities coming under the fold of public sector. Hence, resources have to be found in
sufficient quantity. Budget secures this purpose through a financial plan. The receipts side of the
budget clearly mentions the sources and the extent of funds for the purpose of financing state
activities.

(2) Provision of Infrastructure: One of the problems of the poor countries is absence of proper
economic infrastructure. Without proper transport and communication system, large scale
generation of electric power, establishment of basic and key industries and proper training
facilities for workers and entrepreneurs, industrial development is not possible. Similarly,
agricultural production and productivity cannot improve in the absence of proper irrigation
facilities, flood control measures, technological improvement with research and development
activities, etc. These facilities must be provided by the government. The cost of supplying these
services is heavy and cannot be raised directly from the beneficiaries. Therefore, these facilities
are supplied free of direct charges through the budgetary provisions. Thus, budget has a
tremendous influence on the industrial and agricultural development.

(3) Proper Allocation of Resources. Most efficient allocation of resources is given by the
equality between marginal cost and price which is possible only under perfect market
conditions. Underdeveloped countries seriously suffer from misallocation of resources. The
general market conditions in private sectors are set by existence of monopoly, monopolistic
competition and oligopoly. To correct this misallocation, the government has to interfere either
in the form of production subsidy or supply of goods and services by public authorities so that
the gap between average revenue (i.e. price) and the marginal cost is reduced as far as possible.
This is the reason why the heavy investment public welfare industries which are subjected to
decreasing cost conditions are increasingly coming under the fold of public sector.
(4) Balanced Economic growth. Underdeveloped countries suffer from regional imbalance in
economic development. If everything is Left to the private sector, which is motivated by profit
maximization, the industries will be located in the urban and already-developed areas. The
government can correct this geographical imbalance by setting up public sector industries in
backward areas. Moreover, the development of agriculture and small scale and village industries
can be secured through government patronage in the form of supply of infrastructure facilities
and various incentive or subsidy measures. This will develop the economy of rural areas.

(5) Income and Employment. Since underdeveloped countries are low income economics,
people live in poverty and, hence, saving and investment is very low. Income of the people can
be increased only through increased productivity and production. Budgetary provisions can go a
long way to achieve this. When agricultural technology is improved through budgetary
programmes, the income of the people engaged in agriculture rises. People get gainful
employment in the sector. Improvement in small scale industries in the rural areas and setting up
of public sector industries in the backward regions will increase employment opportunities in
these industries. The budgetary provisions of employment-related tax concessions can influence
creation of employment opportunity in the private sector also.

(7) Saving and Investment. In underdeveloped countries, the level of saving and investment is
very low. Moreover, without increased saving and investment, economic growth cannot be
achieved. Due to low level of income, marginal propensity to consume is very high and, hence,
the mass people cannot save. Public saving is, therefore, necessary. Taxation of various types
serves this purpose. The saving and investment of private individuals are also influenced by the
savings-investment-related tax concessions and other budgetary subsidy programmes. Capacity
and willingness to work, save and invest of the people is increased through various human
capital formation measures and creation of employment opportunities. These are all done
through budgetary expenditures.

(8) Full Employment and Price Stability. An important function of the budget is to secure the
objective of full employment and price level stability. We have seen how this should be done in
the case of depression and inflation. When the economy, on the other hand, suffers from neither
inflation nor deflation, the budget is to maintain full employment and prevailing prices through
judicious programmes of public expenditure and taxation. In this case, a balanced budget is
helpful in developed countries. In the underdeveloped economies where resources are not fully
employed public expenditure programmes and tax incentive measures are put into operation to
secure full employment.

Chapter 6: PUBLIC DEBT

 Government expenditure may be financed either by tax or non-tax revenues of the
government or by borrowing (public debt). If there is a persistent need for additional
expenditures either due to war or recession and balanced budget is not adequate to meet the
situation, deficits have to be covered by public debt. In addition, there is a time-lag between
receipt of income and the spending of it and also between the spending and its reappearance
as income; that is the consumers who receive additional income due to increase in investment
are not likely re-spending it immediately. Thus, borrowing is necessitated to fill the time-lag
of the investment demands.
On the other hand, when government expenditures have exceeded tax and other revenue
collections, we have a deficit budget. This forces government to enter into deficit financing
either by drawing down the cash balances of the government or by borrowing. Thus, in this
unit we will discuss these two basic issues, public debt and deficit financing. In this unit we
will cover issues such as: Nature and kinds of public debt, Effects of public debt,
Redemption of public debt, Public debt in a developing economy, nature and meaning of
deficit financing, effects of deficit financing in an economy and measures to be taken to
check adverse effects of deficit financing.
Unit objectives:
After studying this chapter, you should be able to
 Explain the nature and kinds of public debt
 Explain the burden of public debt
 Discuss effects of public debt on present and future generations
 Describe debt management and different methods of debt redemption
 Explain what deficit financing is and different sources of deficit financing
 Discuss adverse effects of deficit financing in an economy
 Explain measures to be taken to minimize the adverse effects of deficit financing

6.1 NATURE AND KINDS OF PUBLIC DEBT

Section-1: Public debt is of recent event and was unheard of prior to the 18 th century. In modern
times, however, borrowing by the States has become a normal method of government finance
along with other sources such as taxes, non-tax revenues, etc. Thus, in this section we will
discuss the meaning and sources of public borrowings.

Section objectives:

Upon completing this section you should be able to:

 Define public debt

 Explain different sources of public borrowings
 Discuss possible factors which forces government to borrow
 What does Public Debt means?
Public borrowing or public debt is a debt or a loan as taken by the government from its
own people or from foreign countries or both. Borrowing may be short-term or long term.
The government may borrow from banks, business organizations, individuals and foreign
countries.
Government needs to borrow when current revenue falls short of public expenditure since
current public revenue is usually insufficient to meet the current and development
expenditures of the modern governments.
 Why Public Debt?
The reasons on account of which a government might raise public debt are:
 A government like any other economic unit collects revenue and spends it.
And, it is also a fact that its revenue and expenditure flows may not match
each other during any given time interval. Thus, government might be
forced to fill the gap through borrowing whenever its expenditures exceed
its receipts.
 There may be a sudden spurt in government expenditure. There may be
wars, or natural calamities in which case the government would be forced
to incur much larger expenditure and may run into a debt.
 Modern governments do not subscribe to the philosophy of avoiding a
surplus or a deficit budget for its own sake. Rather they are ready to use
them as a matter of policy. This approach is sometimes referred to as that
 of functional finance-in which the government is ready to have repeated
surplus or deficit budgets of achieving a variety of objectives including
those of economic growth and stabilization.
The instruments of public borrowings are in the form various types of government bonds
and securities. A government bond or a government security paper is a form of a written
promise to pay, made by the government to the lender of the capital. The proceeds from
public borrowings constitute the revenue of a capital nature, while the provision for their
repayment, and servicing should be regarded as an expenditure of a capital nature in any
budget. The payment of interest on loans borrowed is, however, a charge on the revenue
account of the budget.
Learning Activities:
1. Define public debt
2. Explain different sources of public borrowings
3. What are the possible factors which forces government to borrow?
6.2: Classification of Public Debt
Section-2: Based on the source of borrowing, the use of public loans in the economy, and
the terms of payments, there are various categories of public debts. Hence in this section
we will discuss the major forms of public debts.
Section objectives:
Upon completing this section you should be able to:
 Explain internal and external debt
 Distinguish between productive and unproductive debt
 Differentiate compulsory and voluntary debt
 Explain funded and unfunded debt
 Discuss marketable and non-marketable debt

1. Internal and External Debt

 If funds are raised from the public and banks in the domestic country to finance deficit, it
is said to be internal debt. But deficit financing by borrowing from external and friendly
countries is termed as external debt.
The main sources of internal loans are:
i. Borrowing from individuals. Public debt borrowed from individuals is in
the form of bonds, debentures or loan. The carry fixed rate of interest and
are repayable on due dates by the government to the individuals from
whom it borrows.
ii. Borrowing from Commercial Banks. Public debts are also raised by the
government from commercial banks in the form of loans. Commercial
banks can subscribe to government loans through creation of credit.
iii. Borrowing from Non-Banking Financial Institutions. Public debt is also
raised by the government from non- banking financial institutions, such as
insurance companies, trust, mutual saving banks, pension funds, etc. in the
form of government bonds.
iv. Borrowing from Central (National) Bank. The Central (National) Bank of
a nation is also an important subscriber to the government loans. Central
Bank purchases bonds of both the central government as well as sub-
national state governments.
The External Sources- include foreign individuals and foreign banks,
international institutions and foreign governments. International financial
institutions which lend money are International Monetary Fund (IMF),
World Bank, Agricultural Development Bank, African Development
Bank, etc.
2. Marketable and Non-Marketable Debt
The debt can be divided into marketable and non-marketable debt. Marketable issues are
traded and are available to all buyers. They include bill, notes and bonds. The major
difference between them is one of maturity. Bills are issued mostly with maximum
maturities of twelve months, but the maturity periods can also be as short as three months.
This treasury bills represents short-term borrowing intended to meet only the current
government expenditure. Notes can run from one to ten years maturity period. Bonds can
 prolong for longer periods (i.e. more than 10 years). Notes and bonds carry an annual coupon
payment and are redeemable at par at the date of maturity. They are issued to finance long-
run capital projects. Example, the Bond issued by Ethiopian Government for Renascence
Dam on Abay River. But bills are sold at a discount and pay no interest, with the appreciation
in value to the maturity representing the investor’s return. Non-marketable issues are
offered to various groups of investors and can be held only by the initial buyer. It is held by
individuals in the form of saving bonds. This is also called small savings. For mobilizing
small savings, various types of saving certificates are issued like: National Savings
Certificates, National Development Certificates, Rural Development Bonds, Compulsory
Deposits, etc.
3. Productive or Non-productive Debt.

Public borrowing that generates additional productive capacity leads to economic growth and
hence they are productive. For instance, the funds raised by public borrowing for building up
economic infrastructure for the economy through schemes for the development of irrigation,
transport, power and communication are productive. Public borrowings for defense, war
financing, current consumption, etc are not directly productive. This, public debt raised from
consumption activities are called deadweight (non-productive) debt.

4. Compulsory and Voluntary Debt

When the government borrows from public by using forceful methods, that is, by virtue
of its sovereign powers, we may call it compulsory debt. For instance, the loans raised
during an emergency such as war or national disaster. On the other hand, when the
government borrows from the public by issuing securities like bonds, it is called
voluntary debt.
5. Funded and Unfunded debt
Funded debt is a long-term debt, exceeding the duration of at least a year. Funded debt
may be for a specified period of time, to be paid at the will of the government. These are
permanent debts in the sense that new securities are issued every time the debt matures.
Thus the permanent debt covers loans raised in the open market by sale of securities or
otherwise.
 On the contrary, unfunded or floating debt is relatively short-period debt, meant to meet
current need. They are generally redeemable within a year. Small savings of the people,
provident fund deposits etc. fall under this category.
Learning Activities
1. Explain internal and external debt
2. What are the differences between productive and unproductive debt?
3. Differentiate compulsory and voluntary debt
4. Explain funded and unfunded debt
5. Discuss marketable and non-marketable debt

6.3: EFFECTS OF PUBLIC DEBT

We should clearly distinguish economic effects of public borrowing from economic effects of
public debt. Borrowing refers to the method of securing funds, and it is one of the four
alternatives available to the government-the other sources being taxation, profits from State
enterprises and money creation. The effects of borrowing, therefore, relate to government expen-
diture financed through borrowing as different from the effects of a similar programmed
financed by taxation. On the other hand, the effects of public debt refer to the effects on the
economy which are caused by the existence of public debt, after it had been incurred.

Public borrowing from individuals and firms has effects on all aspects of economic life. In this
section different effects of public debt in an economy shall be discussed.

Objectives of the section:

After completing this section you should be able to:

 Explain the effects of public debt on consumption

 Discuss the effects of public debt on production and investment
 Explain the effects of public debt on income distribution
 Describe the effects of public debt national income
 Discuss the effects of public debt on resource allocation
 What are the different effects of public debt in an economy?
They may be considered as follows:

1. Effects on consumption. The effect of public debt on consumption depends upon how it
is financed by individuals. If they lend to the government out of their idle savings,
consumption is not affected. If they buy out of past savings it has only a limited impact
on present expenditure. But if they lend by cutting present savings, it may make them feel
less secure and so they may reduce consumption. But if the people feel that they have
invested in government securities which are considered safe investment, they may
actually increase their consumption.
2. Effects on Production and Investment. The effect of public debt on production depends
upon whether it affects private investment or not. If people buy government bonds by
selling their shares or debentures in private individual firms, there is an adverse effect on
private investment. But if the money borrowed by the government is for productive
purpose, overall production is not affected. But if it is used for wasteful or non-
productive purpose, total investment is affected negatively.
If people buy government bonds by taking away their bank deposits, bank’s lending
capacity is reduced and this again affects private investment. Private investment is not
affected only when it is financed by people out of their idle funds.

If the government uses the funds for productive purpose, it can repay it out of income
generated by these projects. But if public debt is used for unproductive purposes, it can
be repaid only by through additional taxation in future which affects future consumption
as well as production by reducing future disposable incomes. However, if public debt is
used for welfare schemes, it may increase people’s efficiency to work and thus improve
productive capacity.
3. Effects on Distribution. Public debt is bound to have effects on distribution of income
because it involves transfer of purchasing power from one sector to another. Usually
government bonds are purchased by the richer section. But the burden of tax to repay the
debt falls on all sections including the poor. To that extent the inequality of income will
increase. If the bondholder and taxpayers is the same people, theoretically there will be
no effect on redistribution of income. Hence redistribution of income effects of public
 debt depends upon whether the taxpayers and the bond holders are the same people or
not.
However if the public debt is used for public welfare programmes especially the poor,
inequalities of income deceases. But if public borrowing creates inflation, the beneficial
effects of redistribution will be neutralized as prices rise.
4. Effects on National Income. Public debt has an adverse effect on national income only
if private investment is adversely affected. However if government expenditure is
incurred on capital goods, it gives incentive to greater production and this again increases
the income. Government investment financed by public debt will have a multiple effect
on national income. If public debt is financed by commercial banks and national banks,
the credit creation and the public expenditure from that will have a very large
expansionary effect on national income.
5. Effects on Resource Allocation. Unlike tax finance, public debt has little effect on
resource allocation. Public borrowing curtails business investment activities but the
decline of business investment varies from one industry to another. Allocation of
resources is not affected much.
6. Effects on Liquidity. Effect of public debt on liquidity is favorable because the
governments bonds are liquid assets which can be sold in the market whenever the bond
holders need money. So public debt increases the volume of liquid assets in the country.
Secondly the larger quantity of such liquid government bonds can result the failure of
monetary policy. For example, when national bank tries to control inflation through
monetary policy tools like bank rate, the commercial banks can increase their cash
reserves by selling government bonds.
7. Effects on Money Market. The government has to compete with the private sector for
fund. Usually if the rate of interest paid by private sector on borrowing is high, the
government also will have to raise its interest rate to attract public funds. On the other
hand if the state tries to borrow from commercial banks and national banks, more than
what is available at current rate of interest it results in currency expansion.
Learning Activities:

1. What are the effects of public debt on consumption?

2. Discuss the effects of public debt on production and investment
 3. Give brief explanation of the effects of public debt on income distribution
4. What are the effects of public debt on national income?
5. Briefly explain the effects of public debt on resource allocation
6. What are the effects of public debt on resource allocation?
7. What are the effects of public debt on money market?

6.4: BURDEN OF PUBLIC DEBT

Section-4: A lot of discussion has taken place on this question in economic literature. The
classical philosophy of laissez faire equated a sound budgetary policy with that of private
budgeting. Just as a private economic unit cannot and should not run into a persistent deficit,
similarly, the government should avoid repeated deficits. In line with this philosophy, public debt
was often divided into productive and dead-weight categories. The general idea was that the
government should not raise loans for consumption activities; at the most, it may do so for the
investment activities only. The question is what if government runs into debt? In this section we
will discuss the burden of public debt in an economy.

Section objectives:

After completing this section you should be able to:

 Explain the burden of internal and external debt in a society

 Compare and contrast debt burden on present and future generations
 Discuss conditions in which future generation will be worse off due to
public debt.
 What are the impacts of public debt on present and future generations?
A. Burden of Internal Debt

The following arguments can be cited with regard to the burden of internal debt:

a. According to Learner, the internal debt may not have any direct money burden on the
community as a whole, since the payment of interest and increased taxation to meet the
burden of debt involve simply a transfer of purchasing power from one group of person to
another, i.e. to the extent that bond holders(creditors) and taxpayers are the same, public
debt has no direct money burden. But to the extent the creditors (bond-holders) and
 taxpayers belong to different income groups, the change is the distribution of income
among different sections of the community.
b. According to Domar, if interest on debt as a proportion of national income rises, the burden
of public dept increases since a larger portion of national income will have to be taxed to
pay the interest. This burden depends on two factors: First, it depends upon the wastage of
resources that take place in terms of administrative costs of administering tax collection
and interest payments). Second, it depends on the distributive effects that such a process
generates. If, for example, through this taxation and interest payment, the income
inequalities increases, public debt may be claimed to have added to the burden of the debt.
Increase in public debt may necessitate imposition of additional tax on enterprise which
may adversely affects the power as well as the willingness of individuals to work and save.
B. Burden of External Debt

In one sense, the burden of a foreign debt is similar to that of domestic debt. That is, the
government will have to pay it through additional taxation. But, while in domestic debt, interest
payments and the repayment of loans are available to local nationals; in the case of foreign debt
they are available to foreigners. In another sense, the total money burden of an external debt is
more because there is the additional transfer problem. That is, the government will have to find
necessary monetary resources to pay off the external debt and besides will have to secure foreign
currencies too (after all, foreigners will have to be paid in their currencies). The transfer problem,
therefore, requires that during the term of the loan, the balance of trade must become favorable.
In other words, a regular payment of interest and principal to foreign countries will be possible
only if the export value exceeds the import value by at least the obligations arising from the loan.

But external debt can mean a certain impoverishment of the economy. The payment of interest
and debt redemption to foreign Countries means a corresponding exhaustion of national income
and makes greater demand on the gold and foreign exchange resources of the country. This is
what has been referred to as the transfer problem in the previous paragraph. But properly
speaking, there is no impoverishment involved. What actually happens is this: originally, when
foreign loans were made, they entered the debtor country in the form of machinery, raw
materials and other essential goods, for which no corresponding exports were made at that time.
After the lapse of a certain time, the debtor country manages to secure excess of exports over
imports to pay for the external loan. In this case, there is no actual impoverishment of the
economy involved but goods are paid for goods. But if the external debt would really deprive the
citizens of a debtor country of a certain amount of, goods and services, this would be a net direct
real burden of an external loan.

However, there is one sense in which an external loan can be a source of trouble to a debtor
country. The transfer problem necessitating the creation of an export surplus means “an
exhaustion of the country’s future capacity to import,” which is of vital importance for
development. But if the foreign loans are floated only when it is absolutely essential and when
internal resources are utilized as far as possible, and if the foreign loans are used to increase the
total national product, including goods specially meant for export, there is no reason why the
debtor country should suffer in the future.

An underdeveloped country which borrows abroad for the development of social and economic
overheads and basic industries will find that the benefits outweigh the burden of repayment of
the loan. Thus, an external loan for development purposes is not a burden but a profitable
venture. This is exactly like an internal loan meant for development purposes.

C. Debt Burden and Future Generations

Taxes impose a direct burden on present generation but the government borrowing doesn’t
impose such a burden. In the case of debt financing of public expenditure the burden of
public expenditure will occur to the present generation, but burden of taxation to pay for
the interest and repayment of principal debt will fall upon the future generation. In the
classical system where investment adjusts automatically with savings at full-employment
level of income, any transfer of resources from the private sector to the public uses leaves
the private sector with few resources. In this narrow sense, the burden of today’s public
expenditure must be borne by today’s generation. But the resource withdrawn from the
private sector to the public uses leaves the private sector with few resources.
In this narrow sense, the burden of today’s public expenditure must be borne by today’s
generation. But the resource withdraws from the consumption, the welfare of the present
generation will be affected and the income of future generation remains untouched. If,
however, it is withdrawn from capital formation, welfare of the present generation is
 untouched while the future generation will inherit a small capital stock and will get lower
level of income. In this case, therefore, the future generation is burdened.
There is no direct money burden of the public debt on the future generation. This is
because the burden of taxation to pay for the public debt is cancelled out by the receipt of
interest from the government by bond-holders. While the question of shifting the burden to
the future generation is actually confusing. It is, however, possible to argue that under tax
financing the present generation will have to curtail its consumption. But under financing
consumption is not likely to fall, since owners of public debt have bonds and securities in
lieu of funds transferred to government. If there is a reduction in saving and capital
formation by the current generation, debt financing can impose a heavy indirect burden on
future generation.
To sum up, public debt will put a burden on future generation if two conditions are
satisfied:
 The current generation reduces its savings and increase current consumption, and
 The debt financing of the government does not add to capital stock and productive
capacity of the nation.

Learning Activities:

1. What are the burdens of internal and external debt in a society?

2. Compare and contrast debt burden on present and future generations
3. Briefly discuss conditions in which future generation will be worse off
due to public debt.

6.5: Debt Redemption and Debt management

Section-5: The public debt has a direct effect on people apart from higher rate of taxation.
Public debt mostly consists of unproductive debt. Anyway, the sooner it is paid off the
better for both the government and the people. Thus, in this section we will discuss
different method of debt redemptions and proper debt management from the government
side.
Section objectives:
Upon completing this section you should be able to:
  Explain what debt redemption means
 Discuss different methods of debt redemptions
 Explain what debt management means
 Describe different conditions that the government should follow in its debt
management.
6.5.1: Debt Redemption
 What does debt redemption means?
Redemption refers to methods of repayment of loan.
There are varies methods available to the government to pay off debt:
1. Repudiation of debt! One simple way of ending the debt obligations is to repudiate
the debt. This refers to refusal by the government to pay the interest as well as the
principal debt. Normally government doesn’t repudiate its debt because it will shake
the confidence of the general public. However, in the extreme circumstances a
government may be forced to repudiate its internal or external debt of obligation. So
repudiation is the most extreme method of redemption.
2. Conversion of a loan! An old loan can be converted into a new loan, i.e. the
governments don’t pay loan but it simply substituted old by new one.
3. Serial Bond redemption! The government made the serial to pay earlier a certain
portion of the bond issued previously. This system enables a portion of the debt
being paid off every year:
4. Buying up loan! The government may redeem its debt from buying up its bond
whenever it has got a surplus income. This method is good if the government get
sufficient amount of surpluses, though it is not systematic.
5. Sinking fund! This is the most systematic method of redemption of debt. It refers to
the aggregation and gradual accumulation of funds which will be sufficient to pay off
the public debt. For instance, the government may float a loan for a construction of
road. The government also imposes taxes (or toll) for real payment of this loan. The
tax proceed which create funds for repayment of this loans is known as sinking funds.

6. Capital levying! This refers to a very heavy tax on property and wealth. It is another
method of debt redemption which is generally adopted for unproductive debt. This
 method is generally adopted at the end of war or any natural calamities. It is a once-
for-all tax imposed on the capital assets to repay the unproductive war debt.

6.5.2: Public Debt management

The term debt management refers to the formulation and implementation of a debt policy
designed to achieve certain objectives. According to the traditional philosophy, debt
management consists of keeping its interest cost to the minimum possible, and paying it off as
early as possible. However, a modern welfare states use debt management as a policy tool for
achieving various socio-economic objectives.

Therefore, debt management aims at proper timing and issuing of government bonds, stabilizing
their prices (the prices of bonds) and minimizing the cost of servicing debt. It is argued that
government should follow the policy of “low interest costs” in order to:

 Strength and stabilize the market for government bonds

 Raise the price of government bonds
 Make the government bond more attractive
 Minimize the cost of serving the national debt
 Encourage funding of debt by private firms
Thus, the basic function of debt management policy is to create the demand for bonds and
securities. Debt management policy has to run in harmony with the monetary
management of the country. They both influence stabilization and economic growth.
Open market operations are usually conducted by sale/purchase of government securities.
Through general and selective credit controls, monetary policy tries to influence the
volume and flows of funds and thereby the working of the entire economy.
Learning Activities:
1. What does debt redemption means?
2. What are the different methods used in debt redemptions?
3. What does debt management means?
4. Briefly discuss different conditions that the government should follow in its
debt management.
5.
 Chapter 7: Deficit Financing
Section-6: In the previous discussions we have seen that government borrows from
different sources when ever its expenditure is in excess of its revenue. But government
may finance its budget deficiency by utilizing the cash balances with the central
(national) bank or creating fresh currency. Thus, in this section we will discuss the issue
of brining fresh currency or borrowing from the central bank by government to fill
budgetary gap.
Section objectives:
After completing this section you should be able to:
 Define deficit financing
 Explain objectives of deficit financing
 Discuss the effects of deficit financing
 Explain measures to be taken to minimize adverse effects of deficit financing
7.1: Meaning of Deficit Financing
 What does deficit financing means?
The term ‘deficit financing’ is generally used to mean any government expenditure which
is in excess of its current revenue it receives by way of taxes, fees, foreign grants and
loans.
Deficit financing is said to have been practiced whenever the government expenditure
exceeds the government receipts from taxes, fees, surpluses from public undertakings,
borrowings from the public, etc. Such an excess of expenditure is financed either by
drawing down the cash balance of the government (in Central Bank or in state treasuries)
or by borrowing from the Central Bank. In both cases, the money supply with the public
increases. Thus, deficit finance refers to the creation of additional purchasing power in
the form of currency notes. Thus, deficit financing means the creation of new currency.
A deficit budget resulting from reduced tax revenue and /or higher government spending, or
both, tends to be expansionary, and a surplus budget resulting from higher tax revenue and/
or reduced government spending, or both tends to be contractionary. In Keynesian terms, the
expansionary and contractionary results involve the multiplier effect that the public sector
purchasing power through a deficit budget, or a net decrement in private sector purchasing
power through a surplus budget. However, the financing of a deficit or disposing of a surplus
exerts secondary economic effects: economic development, inflation, and alike.
7.2: Objectives of Deficit Financing
The main purposes or objectives of deficit financing are as follows:
1. Deficit Financing and War: When the financial resources raised by the government
through taxation and public borrowings etc., prove to be insufficient to meet cost of war,
the government is left with no other choice except to resort to deficit financing to raise
the necessary financial resources for the success of war.
2. Deficit Financing and Employment: During the period of recession or depression the
problem is that of lack of demand and unemployment. For increasing demand and the
level of employment, government should resort to deficit financing to finance public
work projects.
3. Deficit Financing & Economic Development
The developing countries are keen to promote rapid economic growth. But, the resources
required for the development far exceeds the amount which can be raised by normal means
of resource mobilization, viz., taxation, borrowing, surpluses from public enterprises, etc.
The uncovered gap is made by deficit financing. Rapid economic development can be
achieved only by stepping up the rate of investment. In a country where the majority of the
people are living at a subsistence level, voluntary savings are severely limited and resources
raised by additional taxes may cause political and economic problems. Therefore, to raise
additional resources for the development efforts, the governments are compelled to resort to
deficit financing.
7.3: Adverse Effects of Deficit Financing
The following may be the ill effects of deficit financing in an economy
1. Deficit Financing and Inflation
Deficit financing results in a sharp rise in general price level of the country. New money
created results in an increase in aggregate monetary demand for the existing supply of goods
and services. But if the supply of output, especially that of the consumer goods, is increasing
when deficit financing is being done, there is no danger of inflation. In the absence of elastic
supply of consumer goods, deficit financing carries with it a great inflationary bias.
In the early stages of development, inflationary danger is very real indeed. This is because of
the urgent need to invest large sums in long-term projects such as buildings of big dams, steel
plants machines, as well as in the development of transportation and communication system.
Such investment doesn’t add to the supply of consumer goods in the short-run. Thus, prices
shoot up under the pressure of excessive demand for consumer goods. In the long-run,
productive investment made under the plans will increase the productive capacity and will
therefore bear fruit in the form of greater supply of consumer goods. Thus, inflation created
by productive investment of economic development if a right dose of it is used for financing
those schemes or projects which yield quick results.
2. Inequalities of Income and Wealth
Deficit financing adversely affects the equitable distribution of income and wealth. As
deficit financing results in inflation, therefore, in such a situation rich become richer and
poor become poorer. In other words, during inflation industrialists and businessmen earn
huge profits and laborers and fixed income group suffer on account of sharp reduction in
the purchasing power of the people. Thus disparity of income increases as rich become
richer and poor become poorer.
3. Adverse Effects on Savings and Investment
The household savings which contribute substantially to domestic earnings are directly
related to the price level. Increase in prices resulting from deficit financing ultimately
results in the reduction in savings. Deficit financing also negatively affects investment.
This is due to its negative effects on savings on one hand and it also diverts resources
from investing in capital goods to consumer goods, which are not desirable for a
developing economy.

7.4: Measures to Check Adverse Effects of Deficit Financing

The following measures may curb inflationary effects of deficit financing

1. Restriction on credit
When a careful watch over prices is kept and prices are not allowed to rise beyond
what are considered reasonable limits, deficit financing may be considered as safe.
Therefore, to curb inflationary situation, restriction on bank credit is essential.
2. Control over prices
 Prices of consumer goods and essential raw materials have to be effectively
controlled. To check diversion of scarce capital towards consumption goods sector,
the government should impose taxes on industrialists to encourage the diversion of
resources towards production goods sector which plays a pivotal role in industrial
development of the country.
3. Increase in Production of Public Sector
To check inflationary trend, the government should make its utmost efforts to
increase the production of public enterprises owned by it and provide incentives to
increase production in private sector. Emphasis should be laid to increase the
production of food grains, raw materials and consumer goods. This will increase the
supply of goods and will ultimately check inflation.