Public Finance

By Lageru .Z.

Chapter One=Basics of Public Finance

1.1.Meaning of Public Finance

The word public refers to general people and the word finance means resources. So public
finance means resources of the masses, how they are collected and utilized. In other word, the
word finance signifies money matters and their management. Public finance in its modern sense
pre-supposes the existence of money economy. The discipline of public finance describes and
analyses government services, subsidies and welfare payments, and the methods by which the
expenditures to these ends are covered through taxation, borrowing, foreign aid and the creation
of money.

1.2.Definitions of Public Finance

According to Hugh Dalton, “Public finance is one of those subjects which lie on the border lines
between economics and police. It is concerned with the income and expenditure of public
authorities and with the adjustment of the one to the other.” Governments plan their revenue and
expenditure each fiscal year by preparing a budget. They may plan to match their expenditure
with their revenue, aiming for a balanced budget. On the other hand, they may plan to spend less
than they rise in taxation, running a budget surplus and using this surplus to repay former public
debts. On the other hand, they may plan to spend more than they rise in taxation, running a
budget deficit that has to be financed by borrowing.

According to M .Maria John Kennedy, “Public finance deals with finance of the public as an
organized group under the institution of government. It thus deals only with finances of
government including the raising and disbursement of government funds. ”
According to Philip E .Taylor, “Public finance is science that deals with the financial operations
and polices of finance sector (FISC) of state treasury.
According to Harold M. Grooves “Public finance is the fiscal science, its policies are fiscal
police and their problems are fiscal problem.”
According to Findlay Shirras, “Public finance is the study of principles underlying the spending
by public funds authorities”.
According to H.L Lutz, “Public finance deals with the provision, custody and disbursement
resource needed for conduct of public or government function.”
According to Jonathan Gruber, Public Finance is the study of the role of the government in the
economy.
In the words of Adam Smith, the investigation into the nature and principles of state expenditure
and revenue is called public finance.
Public Finance is the collection of taxes from those who benefit from the provision of public
goods by the government, and the use of those tax funds toward production and distribution of
the public goods. (Business Dictionary)
In the words of B.G. Boldyrev, Public Finance is the aggregate of economic relationships arising
from the creation and use of centralized and decentralized monetary resources.
In the words of J. Smith Public Finance is a branch of economics, which deals with the revenue
and expenditure patterns of the government and their various effects on the economy.
In the words of Professor Bastable, Public Finance is a branch of economics, which deals with
income and expenditure of public authorities or the state and their mutual relation, as well as the
financial control of national wealth which help in carrying on the administration of the state.
In modern civilized communities, the income and expenditure of public communities consist of
money receipt and money payments.
Public Finance is often synonymous to public financial management, public fiscal
administration, public economics, fiscal management or public sector management.

Public finance is closely connected on the issues of income distribution and social equity.
Governments can reallocate income through transfer payments or by designing tax systems that
treat high-income and low-income households differently.

The purview of public finance is considered threefold: governmental effects on efficient

allocation of resources, distribution of income, and macroeconomic stabilization.

1.3. Scope of Public Finance

Scope of public finance is subject matter of public finance. The subject matter of public finance
deals with the way in which the public treasury operates. It also deals with the effect of different
policies, which the treasury might adopt.

Since a modern government often operates at several levels such as federal, provincial and state
or local levels, therefore the subject matter of public finance, look into the financial problems
and policies of the government at different levels and studies the inter-governmental financial
relations. Thus, the scope of public finance is both broad and deep and the solution of fiscal
problems requires coordination of the efforts of many specialists. The scope of public finance
includes the following four types of activities-
PUBLIC FINANCE

PUBLIC PUBLIC PUBLIC FINANACIAL

1. Public Revenues, It deals with the method of raising revenue.
REVENUE It covers the area of canons
ADMINISTRATIO
EXPENDITURE DEBT
and classification of taxation, type of taxes, effect of taxation, incidence
N of taxes, shifting taxes
RE
Fig 1 framework of scope of public finance
and other related problems. In this part of public finance, we study the various sources from
which the Government collects revenues. Tax is the main source of revenue hence all principles
of taxation and incidence of taxation are the subject matter of this part of public finance.

2. Public Expenditure, It deals with the principle and classification of public expenditure, effect
of public expenditure and the related problems. In order to perform the various functions, the
Government incurs expenditure out of the revenues collected by the state authorities from
different sources. In this part of public expenditure, we study the main principles of public
expenditure. Along with that, we study the effects of expenditure on various sectors and the ways
and means through which the Government keeps a check on its expenditure.

Public expenditure is the expenditure made for the government operations, income distribution,
employment insurance, health Care and Public financing of campaigns (defenses) etc.

Government operations are those activities involved in the running/administration of a state or

a functional equivalent of a state (for example, revolutionary movements) for the purpose of
producing value for the citizens. Government operations have the power to make, and the
authority to enforce rules and laws within a civil, corporate, religious, academic, or other
organization or group.

Income distribution some forms of government expenditure are specifically intended to transfer
income from some groups to others. For example, governments sometimes transfer income to
people that have suffered a loss due to natural disaster. Likewise, public pension programs
transfer wealth from the young to the old. Other forms of government expenditure, which
represent purchases of goods and services, also have the effect of changing the income
distribution. For example, engaging in a war may transfer wealth to certain sectors of society.
Public education transfers wealth to families with children in these schools. Public road
construction transfers wealth from people that do not use the roads to those people that do (and
to those that build the roads).

Economists classify government expenditures into three main types.

I. Government consumption is government purchases of goods and services for current use
are classified as government consumption.
II. Government investment is government purchases of goods and services intended to
create future benefits such as infrastructure investment or research spending etc.
III. Transfer payments is government expenditures that are not purchases of goods and
services, and instead just represent transfers of money such as social security payments,
transfer income to people that have suffered a loss due to natural disaster, unemployment
compensation, public pension programs transfer wealth from the young to the old age or
disability, student grants etc. It is means of income redistributing by giving out money
 under social welfare program. However it not include subside given to farmers, exporters
and manufacturers.
1.4.Financing of government expenditures

Government expenditures are financed primarily in three ways:

 Government revenue
o Taxes- revenue refers to those revenues that are obtained from taxation
o Non-tax revenue is the revenue derived from sources other than taxation. example
revenue from government-owned corporations, sovereign wealth funds, sales of
assets, or seigniorage etc
 Government borrowing
 Money creation

Seigniorage; - is the net revenue derived from the issuing of currency. It arises from the
difference between the face value of a coin or bank note and the cost of producing, distributing
and eventually retiring it from circulation. Seignior age is an important source of revenue for
some national banks, although it provides a very small proportion of revenue for advanced
industrial countries.

1.5.Public finance through state enterprise

Public finance in centrally planned economies has differed in fundamental ways from that in
market economies. Some state-owned enterprises generated profits that helped finance
government activities. The government entities that operate for profit are usually manufacturing
and financial institutions, services such as nationalized healthcare do not operate for a profit to
keep costs low for consumers. Example, Ethiopian commercial bank, etc

3. Public Debt deals with the course and method of public borrowing and the burden and
management of public debt. Like individuals, the Government also borrows funds from the
public to meet its obligations and certain abnormal situations like war, famine, floods or natural
calamities. The reason is that the Government expenditure exceeds its income in abnormal times.
The government meets the deficit in the budget by borrowing the funds from the public. Now,
the government borrows funds in normal situations for its promotional function i.e. for the
economic development of the country. This part of public finance deals with the borrowing
activities of the government.

Government debt also known as public interest, national debt and sovereign debt is the debt
owed by a central government. In federal states, "government debt" may also refer to the debt of
a state or provincial, municipal or local government. By contrast, the annual "government
deficit" refers to the difference between government receipts and spending in a single year.

Public debt refers to borrowing by a government from within the country or from abroad, from
private individuals or association of individuals or from banking and non-banking financial
institutions. Public debt or public borrowing is considered to be an important source of income to
the government. If revenue collected through taxes & other sources is not adequate to cover
government expenditure government may resort to borrowing. Such borrowings become
necessary more in times of financial crises & emergencies like war, droughts, etc.

A broader definition of government debt may consider all government liabilities, including
future pension payments and payments for goods and services the government has contracted but
not yet paid.

1.6.Major Forms/types/classifications of Public Debt

Major forms of public debt are:

1. Internal and External Debt:

2. Productive and Unproductive Debt:
3. Compulsory and Voluntary Debt:
4. Short-term, Medium-term and Long-term loans:
5. Funded and Unfunded Debt:

1. Internal and External:

i. Internal debt: - it refers to the funds borrowed by the government from various sources within
the country. In other word, the Public loans floated within the country are called internal debt.
The various internal sources from which the government borrows include individuals, banks,
business firms, and others. The various instruments of internal debt include market loans, bonds,
treasury bills, ways and means advances, etc.

Internal debt is repayable only in domestic currency. It implies a redistribution of income and
wealth within the country & therefore it has no direct money burden.

ii. External debt:-it represents a claim of foreigners against the real income (GNP) of the
country, when it borrows from other countries and has to repay at the time of maturity. External
loans are raised from foreign countries or international institutions. These loans are repayable in
foreign currencies. External debt is owed to foreigners or foreign governments or institutions. An
external loan involves, initially a transfer of resources from foreign countries to the domestic
country but when interest and principal amount are being repaid a transfer of resources takes
place in the reverse direction. It enables the country to consume more than it produces.

The following points of distinction between internal and external debts are noteworthy:

A. An internal loan may be voluntary or compulsory/obligatory, but an external loan is

normally voluntary in nature. Only in the case of a colony, an external loan can be raised
by compulsion.
B. An internal loan is controllable, can be estimated before hand with certainty, while
external loans are always uncertain, and cannot be estimated so confidently. Its
realization is very much conditioned by international politics and foreign policies of the
lending government.
C. Internal loan is in terms of the domestic currency, while external loans are in terms of
foreign currencies.
An important feature of external debt is, that usually foreign exchange resources of the
borrowing country increase when the loans are received in terms of foreign currencies. But,
when there is repayment of such loans, i. e., debt servicing charges, foreign exchange reserve is
depleted to that extent.

Sometimes, however, external loans are repayable in the borrowing country’s domestic currency,
so that foreign exchange resources are least affected.

Since under internal debts, borrowing takes place within the country, the availability of total
resources does not arise. Simply the resources transferred from the bondholders’ individuals and
institutions to the public treasury, and the government can spend, these for public purposes.

Similarly, payment of interest for repayment of principal of internal loans would transfer
resources from taxpayers to bond-holders. An internally- held public debt, thus, represents only a
commitment to effect a certain transfer of purchasing power among the people within the
country. It has, therefore, no direct net money burden as such. It amounts to only a redistribution
of income in the community from one section to the other.

External debt, on the other hand, leads to a transfer of wealth from the lender nation to the
borrower nation. When the loan is made through the means of external loans the resources
available to the borrowing nation increase.

However, when a foreign loan is repaid or interest is paid on such loans, there would be a
transfer of resources from the debtor to the creditor countries, causing a decline in total resources
of the debtor country.

To cover the interest and repayment of the principal of an external loan, the debtor government
has to limit its expenditure in the future or reduce private spending by increasing taxation, thus
cutting the use of resources at home.

2. Productive and Unproductive Debt:

I. Productive debt:-Public debt is said to be productive when it is raised for productive purposes
and is used to add to the productive capacity of the economy.

Public debt is said to be productive or reproductive, when government loans are invested in
productive assets or enterprises such as railways, irrigation, and multipurpose projects etc.,
which yield a sufficient income to the public authority to pay out annual interest on the debt as
well as help in repaying the principal in the long-run.

The productive debt is expected to create assets, which will yield income sufficient to pay the
principal and interest on the loan. In other words, they are expected to pay their way; they are
self-liquidating.

Productive loans are self-liquidating. Generally, such loans should be repaid within the lifetime
of property. Thus, such loan does not cause any net burden on the community.
ii. Unproductive debt:-

Unproductive debts are those which do not add to the productive capacity of the economy. On
the other hand, a debt, which does not add to the productive assets of a country, is Unproductive
debts. When the government borrows for unproductive purposes like financing a war, or for
abundant/lavish expenditure on public administration, etc., such public loans are regarded as
unproductive. E.g., Public debt used for war, famine relief, social services, etc. is considered as
unproductive debt.

Unproductive debts are not necessarily self-liquidating. The interest and the principal amount
may have to be paid from other sources of revenue, generally from taxation, and therefore, such
debts are a burden on the community.

3. Compulsory and Voluntary Debt:

I. Voluntary debt: - the members of the public on voluntary basis provide these loans. Most of
the loans obtained by the government are voluntary in nature or usually, public borrowings are
voluntary in nature.

The Government makes an announcement in the media to obtain such loans. The rate of interest
is normally higher than that of compulsory debt, in order to induce the people to provide loans to
the government. . i.e., sales to the public of government bonds (long-term loans) and treasury
bills (short- term loans) in the capital market

ii. Compulsory debt:-When government borrows from people by using coercive (forced)
methods, loans so raised are referred to as compulsory public debt. A compulsory debt is a rare
phenomenon in modern public finance unless there are some special circumstances like war or
crisis. The rate of interest on such loans may be low. Compulsory borrowing is a compromise
between taxation and borrowing. Like a tax, it is a compulsory contribution to the government
but the only difference is that loans are rapid but tax is not. An important example of forced
loans familiar in India is that of Compulsory Deposit Scheme (CDS).

4. Redeemable and Irredeemable Debts:

On the criterion of maturity, public debts may be classified as redeemable or irredeemable.

i. Redeemable debt:-The debts that the government promises to pay off at some future date are
called redeemable debts. Most of the debt is redeemable in nature. There is certain maturity
period of the debt. For redeemable debts, the government has to make some arrangement to
repay the principal & the interest on the due date. They are, therefore, terminable loans.

ii. Irredeemable debt:-Such debt has no maturity period. Their maturity period is not fixed. The
loans for which no promise is made by the government regarding the exact date of maturity, and
all that the government does is to agree to pay interest regularly for the bonds issued, are called
irredeemable debts. In this case, the government may pay the interest regularly, but the
repayment date of the principal amount is not fixed. They are generally of a long duration.
Irredeemable debt is also called as perpetual debt. Normally, the government does not resort to
such borrowings.

Under such loans, society is burdened with a perpetual debt, as tax-payers would have to pay
heavily in the end. Therefore, redeemable debts are preferred on grounds of sound finance and
convenience.

5. Short-term, Medium-term and Long-term loans:

According to their duration, redeemable loans may further be classified as short-term, medium-
term or long-term debts.

i. Short-Term debt:-Short-term loans are repayable after short interval of time. They are
intended to bridge the gap temporarily between current revenue and current expenditure. It is
called floating debt. Short-term debts mature within a short period say, of 3 to 9 months.
Generally, interest rates on such loans are low. E.g., the treasury bills advance from the Central
Bank., which usually have a maturity period of 90 days (three months), are the best examples of
short term loans.

ii. Long-Term debt:-Long-term debts, on the other hand, are those repayable after a long period.
Long-term debt has a maturity period of ten years or more. Long-term loans usually bear a high
rate of interest. Such loans are raised for developmental programs and to meet other long-term
needs of public authorities. They are also called funded debt.

iii. Medium-Term debt: - The Government may borrow funds for medium term needs. These
funds can be used for development and non-development activities. The period of medium term
debt is normally for a period above one year and up to 5 years. One of the main forms of medium
term debt is by way of market loans.

Similarly, the government, bearing intermediate interest rates, floats loans of medium-term (in
between short-term and long-term). For war finance, or to meet expenditure on education, health,
relief work, etc., such loans are generally preferred.

6. Funded and Unfunded Debt:

i. Funded debt: - Funded debt is, in fact, a long-term debt, exceeding the duration of at least a
year. It is repayable after a long period. The period may be 30 years or more. Funded debt has an
obligation to pay fixed sum of interest subject to an option to the government to repay the
principal. The government may repay it even before the maturity if market conditions are
favorable. Funded debt is undertaken for meeting more permanent needs, say building up
economic & industrial infrastructure. The government usually establishes a separate fund to
repay this debt. The government credit money into this fund & debt is repaid on maturity out of
this fund.

It comprises securities, which are marketable on the stock exchange. Funded debt in its proper
sense is, however, an obligation to pay a fixed sum of interest, subject to the option of the
government to repay the principal. In such debts, the creditor bondholder has no right to anything
but the interest.

ii. Unfunded debt:-Unfunded debts incurred to meet temporary needs/ to meet current needs of
the governments. It incurred always in anticipation of public revenue, a temporary measure. It
has comparatively short duration. They are generally redeemable within a year. The rate of
interest on unfunded debt is very low. Unfunded debt has an obligation to pay at due date with
interest.

Purposes of Public Debt:

The following are the principal purposes for raising public loans:

I. Public Debt to Meet Budget Deficit:

This means bridging Gap between Revenues and Expenditure. It is not always proper to effect a
change in the tax system whenever the public expenditure exceeds the public revenue. It is to be
seen whether the transaction is casual or regular. It often happens that towards the end of the
financial year, government experiences shortage of funds. If the budget deficit is casual, then it is
proper to raise loans to meet the deficit. To cover this gap between revenue and expenditure, the
government raises temporary loans or gets ‘ways and means, advance from the Central Bank.
Example government issues what are called ‘Treasury Bills’ which are repayable after three
months.

However, if the deficit happens to be a regular feature every year, then the proper course for the
State would be to raise further revenue by taxation or reduce its expenditure.

ii. Financing Public Works Programs:

During depression, the government has to launch public works program to provide
employment. In this way, money is injected into the economy to lift the depression. For this
purpose, it becomes necessary to raise public loans to ensure economic stability.

iii. Curbing Inflation:

When inflation is rampant and it is desired to bring down the prices, the government issues
public loans. In this way, money or purchasing power is drawn from the public. Reduction in
money supply will bring down prices.

iv. Public Debt for Financing Economic Development Purposes:

The underdeveloped countries are now very keen on speedy economic development, which
involves huge investment. They are unable to raise adequate finances through taxation. Hence
resort to public borrowing becomes necessary. Example Public Debt to construct railways,
irrigation projects and other works
v. Financing the Public Sector:

Economic system, which is becoming increasingly popular, is that of mixed economy. For
several reasons, economic, political and social, there has to be a rapidly expanding public sector.
The financing of this sector is not possible without resort to public borrowing.

vi. Public Debt to Meet Emergencies like War:

A modern war is a very costly affair. To prosecute a modern war by taxation is simply out of the
question. Public borrowing becomes essential. In many countries, the existing public debt is, to a
great extent, on account of war expenses. Especially after World War II, this type of public debt
had considerably increased. A large portion of public debt in India has been incurred to defray
the expenses of the last war.

Thus, public borrowing is necessitated by the requirements of filling the gap between revenue
and expenditure, public programs, economic development and war finance.

Methods of Debt Redemption:

Modern governments make it a point of honor to repay their debts. Debt repayment maintains
and strengthens the national credit. If a national emergency arises later, it will be easy to raise
funds. Repayment of loans also releases funds for trade and industry.

The following are some of the methods adopted:

i. Utilization of Surplus Revenue:

This is an old method and badly out of tune/adjust with the modern conditions. Budget surplus is
not a common phenomenon. Even when there is a surplus, it is so insignificant that it cannot be
used for making any substantial reduction in the public debt.

ii. Purchase of Government Bonds:

The government may buy its own stock in the market, thus wiping off its obligation to that
extent. This may be done by the application of surplus revenues or by borrowing at low rates, if
the conditions are favorable.

iii. Terminable Annuities:

When it is intended completely to wipe off a permanent debt, it may be arranged to pay the
creditors a certain fixed amount for a number of years. These annual payments are called
annuities. It will appear that, during the time these annuities are being paid, there will be much
greater strain on the government finances than when only interest has to be paid.

iv. Conversion:
This is a method for reducing the burden of the debt. A government may have borrowed when
the rate of interest was high. Now, if the rate of interest falls, it can convert a high-rated loan into
a low-rated one.

The government gives notice to the creditors that either they should agree to reduce the interest
rate for future payments or it will exercise the option of repaying the loan, in case the
bondholders do not accept the lower rate. Then, the government will raise a new loan at lower
rate of interest and, with the proceeds, pay off the old debt. The effect is to convert a high-rated
loan into a low-rated one. The financial burden is consequently reduced.

v. Sinking Fund:

This is the most important method. A fund is created for the repayment of every loan by setting
aside a certain amount every year out of the current revenue. The sum to be set aside is so
calculated that over a certain period, the total sum accumulated, together with the interest
thereon, is enough to pay off the loan.

4. Financial Administration, It concerned with the machinery of the government which is in

charge of performing fiscal function of the state. The various aspects of a public budget such as
preparation, sanction, implementation and auditing fall within the purview of financial
administration. In this branch of public finance; we study how the Government controls its
financial operations or in other words, we study the problem of financial management. It covers
matters like preparation of budget and its approval from the legislature, the audit of Government
accounts etc. and other related matters.

5. Fiscal Federalism

This lesson will explain what fiscal federalism is, its theory, its advantages, how it works….

Definitions of Fiscal federalism

Fiscal federalism is financial relations between units of governments in a federal government

system. Fiscal federalism is part of broader public finance discipline. This term was introduced
by the German-born American economist, Richard Musgrave in 1959. Fiscal federalism deals
with the division of governmental functions and financial relations among levels of government.

Fiscal federalism attempts to define the division of governmental functions, and the financial
relationship between, different levels of government (usually how federal or central governments
fund state and local governments).

As a subfield of public economics, fiscal federalism is concerned with "understanding which

functions and instruments are best centralized and which is best placed in the sphere of
decentralized levels of government". In other words, it is the study of how expenditure side and
revenue side are allocated across different (vertical) layers of the administration. An important
part of its subject matter is the system of transfer payments or grants by which a central
government shares its revenues with lower levels of government.
Fiscal federalism operates through the various federal taxes, grants, and transfers that occur in
addition to states and localities. The federal government regulates, subsidizes taxes, provides
goods and services, and redistributes income.

The theory of fiscal federalism

The theory of fiscal federalism Was originally developed by German-born American economist
Richard Musgrave in 1959. Musgrave argued that federal government systems have the ability to
solve many of the issues local governments face by providing the balance and stability needed to
overcome disruptive issues like uneven distribution of wealth and lack of widely available
resources. Musgrave further theorized that federal governments should manage a nation's money
from the top and give it to states, who can distribute it locally as needed

The theory of fiscal federalism assumes that a federal system of government can be efficient and
effective at solving problems governments face today, such as just distribution of income,
efficient and effective allocation of resources, and economic stability. Economic stability and
just distribution of income can be done by federal government because of its flexibility in
dealing with these problems. Because states and localities are not equal in their income, federal
government intervention is needed. Allocation of resources can do effectively by states and local
governments. Musgrave argued that the federal or central government should be responsible for
the economic stabilization and income redistribution but the allocation of resources should be the
responsibility of state and local governments.

Main concepts

The concepts of fiscal federalism are related to vertical and horizontal fiscal relations. The
notions related to horizontal fiscal relations are related to regional imbalances and horizontal
competition. Similarly, the notions related to fiscal relations are related to vertical fiscal
imbalance between the two senior levels of government, which is the centre and the
states/provinces. While the concept of horizontal fiscal imbalance is relatively non-controversial
(as explained above), the concept of vertical fiscal imbalance is quite controversial/hot.

The following are benefits of fiscal decentralization:

 regional and local differences can be taken into account;

 lower planning and administrative costs;
 competition among local governments favors organizational and political innovations;
and
 More efficient politics as citizens have more influence

There are several disadvantages of fiscal federalism as well:

 the lack of accountability of state and local governments to constituents;

 the lack of availability of qualified staff;
 the possibility for people to choose where to reside;
 a certain degree of independence of the local governments from the national government;
 Unavailability of infrastructure of public expenditure at the local level
Nature of Public Finance

Nature of public finance implies whether it is a science, art, or both. Public finance is a science
as well as an art.

1.7.Public finance as Science

Science is the systematic study of any subject, which studies the relationship between facts.
Public finance has been held as science, which deals with the income and expenditure of the
governments finance. It studies the relationship between facts relating to revenue and
expenditure of the government. It is a science because we study in it the various principles,
problems and policies underlying the spending and raising of funds by the public authorities. It
teaches how to collect taxes in the best way, how to maintain them economically, and how to
spend them properly.

Arguments in support of Public Finance as Science

 Public finance is systematic study of the facts and principles relating to government
expenditure and revenue.
 Public finance is studied by the use of scientific/systematic methods.
 Principles of Public finance are empirical/experimental/practical.
 Public finance is concerned with definite and limited field of human knowledge

Public finance as Art

Art is application of knowledge/understanding/familiarity for achieving definite objectives.

Fiscal Policy, which is an important instrument of public finance, makes use of the knowledge
of government’s revenue and expenditure to achieve the objectives of full employment,
economic development, equality, Price stability etc. To achieve the goal of economic equality
taxes are levied which are likely to be opposed. Therefore, it is important to plan their timing and
volume. The process of levying tax is therefore an art. Study of Public finance is helpful in
solving many practical problems. Public finance is therefore an art also.
As an art, public finance enables the concerned personnel to adopt the principles and policies in
solving the financial problems of the Government in the best possible way to the maximum
benefit of the society. The way to be adopted should be logical, suitable and proper according to
the time. Application of various principles and policies depends much on the ability of the
personnel in the Government how best he can extract from it in the public interest.

From the above discussion, it can be concluded that public finance is both science and art. It is
positive science as well as normative science.

It is a positive science, as by the study of public finance information about the problems of
government’s revenue and expenditure can be known. It also offers suggestions in this respect.

It is also normative science as study of public finance presents norms or standards of the
government’s financial operations. It reveals what should be the quantum of taxes, kind of taxes
and on what items less of public expenditure can be incurred.
Key Features of Public Sector
The public sector is so large a part of most economies that it influences virtually every aspect of
economic life, either through its own expenditure on goods and service provided by the private
sector, its wage payments to public-sector employees, or its social security payments (pensions,
sickness and unemployment benefits). similarly, the financing of these expenditures by means of
various taxes (income tax, value-added tax, corporation tax, etc.) affects the size and pattern of
spending by individuals and businesses.
1. The public sector is broad: - It encompasses all organizations that receive their funding from
public sources such as taxes, fees or licenses. Therefore, it will embrace not just government
departments, but also government enterprises.
2. The public sector has multiple goals: - Rather than having a single bottom‐line, the public
sector has several, which are being pursued at once.
3. The public sector uses various tools to reach it goals: - There are a series of instruments used
to achieve the goals of government.
4. The public sector often uses the private sector to deliver public goods:-
Modern governments frequently use contracts with private corporations as a means of acquiring
needed expertise, outsourcing work, or extending their workforces while seeming to contain the
growth of the public service. This contracted work does not mean that the regular public service
is relieved of its accountability for public funds. Governments devote considerable energy to
administering contracts, especially during a period of increased scrutiny by the public and by the
contracting community in particular.
5. The public sector is a democratic institution: - Governments own none of the resources they
spend. Taxpayers do. In a democratic society, the ways in which governments spend resources
must be transparent and readily open to questioning. Accounting for public sector funds and their
proper expenditure is not only part of good management; it is essential to good government and
good governance of the public enterprise. It is also, where governments are most heavily
scrutinized and where they can get into a great deal of trouble. Such scrutiny is one of the bases
of a government’s legitimacy.

Key Features of Public Finance (PF)

1. PF involves the collection of money: - The public sector makes most of its money through
taxation, transfers, fees, and the sale of goods.

2. PF involves allocating resources: - The income of the public sector is not tied to any one
specific goal. Rather, public sector funds are consolidated into a consolidated revenue fund
(CRF) and subjected to a democratic decision‐making process that distributes them across a
range of activities. This process is known as the budgetary process. There are exceptions to this
rule in which specific taxes or fees are directed to specific programs. A Budget tells the public as
well as serving as the instrument of government planning of its own economic and social
commitments, the budget plays an integral role in the application of fiscal policy, specifically the
operation of demand management policies to reduce unemployment and inflation.
 1.8. The Role of Government in the Economy
The government provides the legal framework and services needed for the effective operation of
a market economy. In the context of economic development, that mission has five primary parts:
Providing a legal and social framework for economic activity; providing public goods; regulating
economic activity; reallocating resources; and stabilizing the economy. We will deal with each in
turn.
a. Setting the Legal and Social Framework for Economic Activity

By creating a sound legal framework, the government establishes the legal status of business
enterprises and ensures the right and protection of private ownership, a key factor in encouraging
entrepreneurship within a country’s borders. By establishing the legal rules of the game, the
government directs the relationships between businesses, resource suppliers, and consumers,
thus improving resource allocation, which in turn supports efforts to alleviate poverty.

Government protects individuals’ rights to the goods and services they exchange in a market
system through three basic institutions, such as police forces, national defense forces, and the
courts and criminal justice system. This allows individuals to interact with each other through
voluntary agreement, reserving for the government the legitimate use of force.

The protection of rights and enforcement of contracts are necessary for a functioning economy,
and they make up a sizable fraction of the public budget.

b. Providing Public Goods and Ensuring Positive Externalities

Public goods are those that can be enjoyed by an unlimited number of people without prejudice
to one another and without exclusion of others. Some examples include lighthouses, national
defenses, the legal system, and parks. They cannot ordinarily be sold to individual buyers.
Government produce goods and services to satisfy households' needs (e.g. state health care) or to
collectively meet the needs of the whole community (e.g. defence, public order and safety).
Externalities, or spillovers, occur when some of the costs or benefits of an economic activity
are passed on (or spill over) to parties other than the immediate seller or buyer.
Externalities, which have a beneficial effect on others, are referred to as positive externalities.
Example investment in research and development, training, and education
Externalities, which have a detrimental effect, are referred to as negative externalities. Example
Pollution
c. Regulating Economic Activity
Regulation is called for where the private sector allocates resources inefficiently and where the
imposition of rules can provide incentives for more efficient provisions of goods and services.
The market does not regulate property rights, financial markets. It does not provide a judicial
system for the enforcement of contracts. It does not enact or enforce standards to promote
human health, ensure public safety, or protect the environment.
The state must provide these services directly or regulate their providers. State controls market
participant by regulating prices, by setting service standards, or by providing the good or service
in question.
d. Reallocating Resources
To redirect the flows of money, goods and services among corporations and households the
government uses reallocation systems. The purpose is for social justice, increased efficiency or
other aims legitimized by the citizens. Examples redistribution of national income and wealth,
the corporate income tax paid by companies to finance unemployment benefits, the social
contributions paid by employees to finance the pension systems;
There are a few closely related reasons why a government may engage in some redistribution of
income. One is to improve the well-being of those members of society who are least fortunate,
providing a safety net for people who have fallen on hard times (perhaps in the course of change
in the economy) and ensuring that everyone has access to a minimal standard of living.
Another is to provide greater equality, where it is desired as a social goal. At the extreme, the
goal of equality could be achieved by take away the wealth of above- average wealth holders and
giving it to those below the average wealth. This destroys the incentive to be productive, and
create a very poor society for everyone. Example, Higher taxes on upper-income individuals.
e. Stabilizing the Economy
Stabilization policies are designed to address severe fluctuations in economic activity that may
be caused by demand shocks (such as an unexpected drop in demand for the country’s exports)
or supply-side shocks.
Some stabilizers are automatic. The example is unemployment compensation: if the economy
falls into recession.
Other stabilizers require a conscious policy choice. So-called active stabilization policies were
very popular in the period immediately following World War II. Example, government attempted
to use monetary or fiscal policy to stabilize inflation and, a balance-of-payments deficit (as
imports increased).

By LAGERU Z.