Chapter 2

Public Economics

Public Finance
The term public means government and finance means science of management of
money. So literally public finance means the study of allocation of economic re- sources
for achieving the goals of public affairs. Thus, public finance is the study of allocation
and management of resources and technology for achieving the goals of public
organization.

Public Revenue
The income of the government through all sources is called public income or public
revenue. In a modern welfare state, public revenue is of two types, tax revenue and
non-tax revenue.

Tax Revenue

A fund raised through the various taxes is referred to as tax revenue. Taxes are
compulsory contributions imposed by the government on its citizens to meet its general
expenses incurred for the common good, without any corresponding benefits to the tax
payer.

Non-Tax Revenue

Public income received through the administration, commercial enterprises, gifts

and grants are the source of non-tax revenues of the government.

• Administrative Revenues:Under public administration, public authorities can raise

some funds in the form of fees, fines and penalties, and special assess- ments.

17
18 CHAPTER 2. PUBLIC ECONOMICS

• Profits of State Enterprise: Profits of state undertakings also are an important

source of revenue.

• Gifts and Grants: These form generally a very small part of public revenue.
Quite often, patriotic people or institutions may make gifts to the state.

Public Expenditure
Expenses incurred by the public authorities—central, state and local self- govern-
ments—are called public expenditure. Such expenditures are made for the mainte-
nance of the governments as well as for the benefit of the society as whole. As a modern
state is termed a ‘welfare state’, the horizon of activities of the government has
expanded in length and breadth.
Causes of Increase in Public Expenditure:

1. Size of the Country and Population

2. Defence Expenditure

3. Welfare State

4. Economic Development

5. Inflation

Tax
A tax is a mandatory fee or financial charge levied by any government on an in-
dividual or an organization to collect revenue for public works providing the best
facilities and infrastructure. India has a well developed taxation structure. The tax
system in India is mainly a three tier system which is based between the Central,
State Governments and the local government organizations. In most cases, these
local bodies include the local councils and the municipalities.

Direct Taxes

A Direct tax is a kind of charge, which is imposed directly on the taxpayer and paid
directly to the government by the persons (juristic or natural) on whom it is imposed. A
direct tax is one that cannot be shifted by the taxpayer to someone else. The some
important direct taxes imposed in India are as under:

1. Income Tax: Income Tax Act, 1961 imposes tax on the income of the individ-
uals or Hindu undivided families or firms or co-operative societies and trusts
or every artificial juridical person.
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2. Corporation Tax: The companies and business organizations in India are taxed
on the income from their worldwide transactions under the provision of Income
Tax Act, 1961.

3. Property Tax: Property tax or ‘house tax’ is a local tax on buildings, along with
appurtenant land, and imposed on owners. The tax power is vested in the states
and it is delegated by law to the local bodies, specifying the valuation method,
rate band, and collection procedures.

4. Inheritance (Estate) Tax: An inheritance tax, also known as an estate tax or death
duty, is a tax which arises on the death of an individual. It is a tax on the
estate, or total value of the money and property, of a person who has died. India
enforced estate duty from 1953 to 1985.

5. Gift Tax: Gift tax in India is regulated by the Gift Tax Act which was consti-
tuted on 1st April, 1958. According to it, the gifts received by any individual in
excess of Rs. 50,000 in a year would be taxable.

Indirect Taxes

An indirect tax is a tax collected by an intermediary (such as a retail store) from the
person who bears the ultimate economic burden of the tax (such as the customer).
An indirect tax is one that can be shifted by the taxpayer to someone else.

1. Customs Duty: The Customs Act was formulated in 1962 to prevent illegal imports
and exports of goods. Besides, all imports are sought to be subject to a duty
with a view to affording protection to indigenous industries as well as to keep
the imports to the minimum in the interests of securing the exchange rate of
Indian currency.

2. Central Excise Duty: The Central Government levies excise duty under the Central
Excise Act, 1944 and the Central Excise Tariff Act, 1985. Central ex- cise duty
is tax which is charged on such excisable goods that are manufactured in India
and are meant for domestic consumption.

3. Service Tax: The service providers in India except those in the state of Jammu and
Kashmir are required to pay a Service Tax under the provisions of the Finance Act
of 1994. Service Tax is levied on the gross or aggregate amount charged by the
service provider on the receiver.

4. Sales Tax: Sales Tax in India is a form of tax that is imposed by the Govern-
ment on the sale or purchase of a particular commodity within the country.
20 CHAPTER 2. PUBLIC ECONOMICS

5. Value Added Tax (VAT): The practice of VAT executed by State Governments
is applied on each stage of sale, with a particular apparatus of credit for the
input VAT paid.

6. Securities Transaction Tax (STT): STT is a tax being levied on all transactions
done on the stock exchanges.

Goods and Services Tax

GST is known as the Goods and Services Tax. It is an indirect tax which has replaced
many indirect taxes in India such as the excise duty, VAT, services tax, etc. The
Goods and Service Tax Act was passed in the Parliament on 29th March 2017 and
came into effect on 1st July 2017. Goods and Service Tax (GST) is levied on the supply
of goods and services. It is a comprehensive, multi-stage, destination- based tax that
is levied on every value addition. GST is a single domestic indirect tax law for the
entire country.
There are three taxes applicable under this system: CGST, SGST IGST.

1. CGST: It is the tax collected by the Central Government on an intra-state sale.

2. SGST: It is the tax collected by the state government on an intra-state sale.

3. IGST: It is a tax collected by the Central Government for an inter-state sale

Budget
A budget is an estimate of income and expenditure for a future period as opposed
to an account which records financial transaction. Budget is an essential element in the
planning and control of the financial affairs of a nation and is made necessarily because
income and expenditure do not occur simultaneously
A government budget is an annual financial statement which outlines the esti-
mated government expenditure and expected government receipts or revenues for
the forthcoming fiscal year. Depending on the feasibility of these estimates, budgets
are of three types – balanced budget, surplus budget and deficit budget. Mentioned
below are brief explanations of these three types of budgets:

Balanced Budget

A government budget is said to be a balanced budget if the estimated government

expenditure is equal to expected government receipts in a particular financial year.
Advocated by many classical economists, this type of budget is based on the principle
 21

of “living within means.” They believed the government’s expenditure should not
exceed their revenue. Though an ideal approach to achieve a balanced economy
and maintain fiscal discipline, a balanced budget does not ensure financial stability
at times of economic depression or deflation. Theoretically, it’s easy to balance the
estimated expenditure and anticipated revenues but when it comes to practical
implementation, such balance is hard to achieve.

Surplus Budget

A government budget is said to be a surplus budget if the expected government

revenues exceed the estimated government expenditure in a particular financial year.
This means that the government’s earnings from taxes levied are greater than the
amount the government spends on public welfare. A surplus budget denotes the
financial affluence of a country. Such a budget can be implemented at times of inflation
to reduce aggregate demand.

Deficit Budget

A government budget is said to be a deficit budget if the estimated government

expenditure exceeds the expected government revenue in a particular financial year.
This type of budget is best suited for developing economies, such as India. Espe-
cially helpful at times of recession, a deficit budget helps generate additional demand
and boost the rate of economic growth. Here, the government incurs the excessive
expenditure to improve the employment rate. This results in an increase in demand for
goods and services which helps in reviving the economy. The government cov- ers
this amount through public borrowings (by issuing government bonds) or by
withdrawing from its accumulated reserve surplus.

Deficit
Deficit is the amount by which the spending done in a budget surpass the earnings. A
government deficit is the amount of money in the budget by which the spending done
by the government surpasses the revenue earned by it. This deficit presents a picture
of the financial health of the economy. To minimise the deficit or the gap between
the expenses and the income, the government may reduce a few expenditures and also
increase revenue-initiating pursuits.
There are several measures that apprehend a government deficit, and they have
their own inferences for the economy, such as:

1. Revenue deficit

2. Fiscal deficit
22 CHAPTER 2. PUBLIC ECONOMICS

3. Primary deficit

Revenue Deficit

A revenue deficit refers to the surplus of the government’s revenue expenditure over
the revenue receipts.
Revenue deficit = Revenue expenditure – Revenue receipts
This deficit only incorporates current income and current expenses. A high
degree of deficit symbolises that the government should reduce its expenses. The
government may raise its revenue receipts by raising income tax. Disinvestment and
selling off assets is another corrective measure to minimise a revenue deficit.

Fiscal Deficit

A fiscal deficit is the distinction between the government’s total expenditure and its
total receipts, which excludes borrowing.
Gross fiscal deficit = Total expenditure – (Revenue receipts + Non-debt creating
capital receipts)
A fiscal deficit has to be financed by borrowing. Hence, it includes the total
borrowing necessities of the government from all the possible sources.

Public Debt
Public debt or public borrowing is considered to be an important source of income
to the government. If revenue collected through taxes and other sources is not
adequate to cover government expenditure, government may resort to borrowing.
Public debt may be raised internally or externally. Internal debt refers to public
loans floated within the country, while external debt refers loans floated outside the
country. Loans taken by the government may be from individuals, banks, financial
institutions like the International Monetary Fund, World Bank etc. The instruments
of public debt take the form of government bonds or securities of various kinds

Trade Cycles
Trade cycle or business cycle is an inherent part of the economy. It implies a wave-
like fluctuations in the level of economic activity, particularly in national income,
employment and output. It is mostly present in a capitalist economy.
According to Keynes, “A trade cycle is composed of periods of good trade char-
acterised by rising prices and low unemployment percentages, altering with periods
of bad trade characterised by falling prices and high unemployment percentages.”
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Features of cyclical fluctuations

All fluctuations in the economy are not cyclical. Cyclical fluctuations have the
following prominent features:

1. Wave-like movements; Cyclical fluctuations are wave-like movements and are

recurrent in nature.

2. Synchronic; The entire business of an economy acts like an organism. Any

happening on the economic front affects the entire economy.

3. Cumulative; The process of expansion and contraction is of a cumulative and self-

reinforcing nature.

4. Self-generating forces; A trade cycle can terminate the period of prosperity

and start depression. Hence, there cannot be indefinite depression or eternal
prosperity.

5. Not identical; Although they recur with great regularity, trade cycles are not
identical.

6. Not symmetrical; The movement from upward to downward is more sudden

and violent than that from downward to upward.

Classification of business cycles

The following are the main classification of business cycles:

1. The short Kitchin cycle; Named after the British economist Joseph Kitchin, it
denotes a minor cycle. The duration of the cycle is approximately 40 months.

2. The long Jugler cycle. Named after French economist Clement Jugler, it is
a major cycle. It is defined as the fluctuation of business activity between
successive crises. The duration of this cycle is on the average of nine and a half
years.

3. The very long Kondratieff cycle; Russian economist N D Kondratieff has put
forth that there are longer waves of cycles of more than 50 years duration,
made of six Jugler cycles.

4. Building cycles; This relates to the construction of building which is of fairly regular
duration. It varies between fifteen to twenty years.

5. Kuznets cycle; Simon Kuznet propounded a new type of cycle, the secular
swing of 16-22 years.
24 CHAPTER 2. PUBLIC ECONOMICS

Phases of a business cycle

Normally, a business cycle can be divided into four phases. They are:

1. Expansion or prosperity or the upswing.

2. Recession or upper-turning point.

3. Contraction or depression or downswing.

4. Revival or recovery or lower turning point.

A business cycle starts from the trough or low point, passes through a recovery and
prosperity phase, rises to a peak, declines through a recession and depression phases
and again reaches a trough. This is given in figure ??.

Y
Economic activity

O Time X
Figure 2.1: Phases of Business Cycle

Recovery

The phase of depression does not continue for long. During depression, the busi-
nessmen postpone replacement of their equipment and the consumers defer their
spending on the purchase of durable goods. The process of recovery once started takes
the economy to the peak of prosperity and the cycle is completed repeating itself at
frequent intervals.

Prosperity

In this period, there is all round prosperity. Business outlook is extremely optimistic. The
economy operates at its full capacity. The level of employment is high, volume
 25

of output is large, the price level is tend to be rising, interest rates tend to increase,
speculative activities are at a high pitch, investment spending is at a high level, total
income of the country increases and credit expansion is at its peak.

Recession

The prosperity finally culminates into recession. Prosperity has the seeds of self-
destruction. Over optimism will turn into acute pessimism. Once recession starts, it
goes on gathering momentum and finally, assumes the shape of depression.

Depression

The period of recession is rather short and depression sweeps the economy very
soon. It merges into depression when there is a general decline in economic activity.
Depression is characterised by mass unemployment and general fall in prices, profits,
wages, interest rate, consumption, expenditure, investment, bank deposits and loans.

Macro-Economic Policies
Economic theory attempts explain why problems arise in the economy, and how
these problems can be dealt with. Macroeconomic policy can be defined as a pro-
gramme of action undertaken to control, regulate and manipulate macroeconomic
variables to achieve the macroeconomic goals of the society. The two instruments of
macroeconomic policies are fiscal policy and monetary policy. The relative effective-
ness of fiscal and monetary policies are measured in terms of their relative powers
to change the equilibrium level of income and interest.

Goals of Macroeconomic Policy

Macroeconomic policies can play a useful role in raising the rate of saving and
investment and therefore ensure rapid economic growth. Thus three important goals
or objectives of macroeconomic policy are:

1. Economic stability at a high level of output and employment.

2. Price stability.

3. Economic growth.

Monetary Policy
Monetary policy may be defined as the deliberate and conscious management of supply
of money for the purpose of attaining the desired objectives.
26 CHAPTER 2. PUBLIC ECONOMICS

Monetary policy is an important instrument to achieve the objectives of macroe-

conomic policy. It is formulated and implemented by the Central Bank of a country.
In some countries such as India the Central Bank (the Reserve Bank is the Cen- tral
Bank of India) works on behalf of the Government and acts according to its directions
and broad guidelines of the government. However, in some countries such as the
USA the Central Bank (i.e., Federal Reserve Bank System) enjoys an independent status
and pursues its independent policy.
Monetary policy is concerned with changing the supply of money stock and rate
of interest for the purpose of stabilizing the economy at full-employment or potential
output level by influencing the level of aggregate demand.In times of recession, mon-
etary policy involves the adoption of some monetary tools which tend the increase the
money supply and lower interest rates so as to stimulate aggregate demand in the
economy. On the other hand, at times of inflation, monetary policy seeks to contract
the aggregate spending by tightening the money supply or raising the rate of interest.

Instruments of Monetary Policy

There are four major tools or instruments of monetary policy which can be used to
achieve economic and price stability by influencing aggregate demand or spending
in the economy. They are:

1. Open market operations;

2. Changing the bank rate;

3. Changing the cash reserve ratio; and

4. Undertaking selective credit controls

In times of recession or depression, expansionary monetary policy (easy money

policy) is adopted which raises aggregate demand and thus stimulates the economy.
On the other hand, in times of inflation and excessive expansion, contractionary
monetary policy (tight money policy) is adopted to control inflation and achieve
price stability through reducing aggregate demand in the economy.

Monetary Policy to Control Depression (Recession)

When the economy is experiencing recession, which is due to a fall in aggregate demand,
the central bank intervenes to cure such a situation. Central bank will ex- pand the
money supply in the economy to lower the rate of interest with a view to increase the
aggregate demand to stimulate the economy. The following three mon- etary policy
measures are adopted as a part of an expansionary monetary policy to
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cure recession and to establish the equilibrium of national income at full employment
level of output.

1. The central bank undertakes open market operations and buys securities in
the open market.

2. The Central Bank may lower the bank rate (Discount rate), which is the rate
of interest charged by the central bank of a country on its loans to commercial
banks.

3. The central bank may reduce the Cash Reserve Ratio (CRR) to be kept by
the commercial banks.

4. Similar to the Cash Reserve Ratio (CRR), in India there is another monetary
instrument, namely, Statutory Liquidity Ratio (SLR) used by the Reserve
Bank to change the lending capacity and therefore credit availability in the
economy

Monetary Policy to Control Inflation (Boom)

To control inflation or boom, a contractionary monetary policy is to be adopted.

Contractionary monetary policy is one which reduces the availability of credit and
raises the rate of interest. A tight monetary policy to control inflation involves the
following measures.

1. The Central Bank (monetary authority) sells the securities to commercial banks
and public through open market operations.

2. The Central Bank will raise the bank rate which in turn increases the lending
rate of commercial banks.

3. The Central Bank will raise Cash Reserve Ratio (CRR) and Statutory Liquid-
ity Ratio (SLR) which results sin the contraction of credit in the economy.

4. Central Bank will use the qualitative credit control by which the Central Bank will
ask commercial banks to raise the minimum margins for obtaining loans from
banks against the stocks of commodities.

Fiscal Policy for Economic Stabilisation

Fisc means treasury and hence fiscal policy is the use of taxation, public expenditure and
public borrowing either for economic development or for economic stability. In the
words of Arthur Smithies, “fiscal policy is a policy under which the government uses its
expenditure and revenue programmes to produce desirable effects and to avoid
undesirable effects on the national income, production and employment.”
28 CHAPTER 2. PUBLIC ECONOMICS

Instruments of Fiscal Policy

The major instruments of Fiscal policy are Taxation, Public Expenditure and Public
borrowing. The government uses these instruments for economic stability or for
economic development. Some times, the term budgetary policy is also used to represent
fiscal policy.

Fiscal Policy for Stabilisation

Fiscal policy is an important instrument to stabilize the economy, that is, to over- come
recession and control inflation in the economy. Fiscal policy is mainly a policy of
demand management. It should be further noted that when the government adopts
expansionary fiscal policy to cure recession, it raises its expenditure without raising taxes
or cuts down taxes without changing expenditure or increases expen- diture and cuts
down taxes as well. With the adoption of expansionary fiscal policy, Government will
have deficit in its budget. Thus, expansionary fiscal policy to cure recession and
unemployment will involve a deficit budget. On the other hand, to control inflation,
Government reduces its expenditure and increases taxes and will have a surplus
budget. Thus, policy of budget surplus is adopted to remedy infla- tion. We will
briefly discuss the fiscal policy to cure recession (boom) and to control inflation (boom).

Fiscal Policy during Recession (Depression)

During recession, the economy experiences a decrease in aggregate demand due to

a fall in private investment. Private investment may fall when businessmen become
highly pessimistic about making profits in future, resulting in decline in marginal
efficiency of investment. As a result of fall in private investment expenditure, ag-
gregate demand curve shifts down creating deflationary (recessionary) gap. It is the task
of the government (fiscal policy) to close this gap by increasing government expenditure
or by reducing taxes. Thus there are two fiscal methods to get the economy out of
recession and they are an Increase in Government Expenditure and a Reduction of
Taxes.

Fiscal Policy during Inflation

When there are large increases in consumption demand by the households or invest-
ment expenditure by the entrepreneurs or an increase in Government expenditure, the
aggregate demand increases beyond full employment level results in inflationary
pressures (boom) in the economy. This inflationary situation can also arise if too
large an increase in money supply in the economy occurs. In these circumstances
inflationary gap occurs which tend to bring about rise in prices. An alternative way
 29

of looking at inflation is to view it from the angle of business cycles. After recovery from
recession, when during upswing an economy finds itself in conditions of boom and
prices start rising rapidly. Under such circumstances anti-cyclical fiscal policy calls for
reduction in aggregate demand. Thus, fiscal policy measures to control inflation are (1)
reducing Government expenditure and (2) increasing taxes.

Inflation
Inflation means persistent rise in general level of prices. Hawtrey defines inflation
as “the issue of too much currency.” According to Ackley, “inflation is a persistent
and appreciable rise in the general level of prices.”

Types of Inflation
On the basis of speed of inflation it is classified into:

1. Creeping inflation; When the rise in prices is very slow like that of a snail or
creeper, it is called creeping inflation. This is the rise in prices to the extent of
10 percent per decade, or one percent per annum.

2. Walking or trotting inflation; When price rise moderately and the annual inflation
rate is a single digit, ie., less than 10 percent per annum.

3. Running inflation; When prices rise at rate of speed of 10 to 20 percent per

annum.

4. Galloping inflation; when the price rise is more than 20 percent per annum it
is called galloping inflation.

5. Hyperinflation; it is an inflation rate when the rate of inflation is more than 50

percent per month.

Causes of inflation

Causes of inflation can be analysed from two angels:

1. Increase in demand for goods and services.

2. Decrease in supply of goods and services.

30 CHAPTER 2. PUBLIC ECONOMICS

Factors causing increase in demand

Following are the factors which cause an increase in the size of demand.

• Increase in public expenditure

• Increase in private expenditure

• Increase in money supply.

• Rise in disposable income.

• Increase in consumer spending.

• Cheap money policy.

• Deficit financing.

• Black money.

• Increase in exports.

• Repayment of public debt.

Factors causing a decrease in supply

Following are the factors resulting in a reduction in the supply of goods and services:

• Shortage of supplies of factors of production.

• Industrial disputes.

• Natural calamities.

• Hoarding by traders.

• Hoarding by consumers.

• Increase in exports.

• Lop-sided production.

• Law of diminishing returns.

• International factors.
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Effects of Inflation.
A moderate rise in prices is good, as it stimulates the economy. However, a contin-
uous rise in prices affects different sections of the economy differently.

1. On redistribution of income and wealth: Inflation affects the poor and middle
classes very badly as their wages and salaries are fixed but prices of commodi- ties
tend to rise. They become more impoverished. Whereas, businessmen,
industrialists, traders, real estate holders, speculators and others with flexible
incomes become richer by raising the prices.

2. On different groups of the society: Debters generally benefit by inflation wihle the
losses are inflicted upon the creditors. Inflation affects the salaried class. Wage
earners generally suffer during inflation. The fixed income groups are the hardest
hit as their income is fixed the cost of living increases. Entrepreneurs and
investors usually benefit from inflation. Government as a debtor also gains from
inflation.

3. Efect on production: Inflation generally positively affects the production pro- cess.
It boosts teh economy as the profit margin increases it creates optimistic situation
in the economy.

4. Other effects: Inflation badly affects the balance of payments. It leads to

depreciation of the currency. It could also lead to the collapse of the monetary
system. Socially, it widens the gap between the rich and poor. This could also lead
to political unrest.

Measures to control inflation

The various measures that are adopted to control inflation are:

1. Monetary measures.

2. Fiscal measures, and

3. Other measures.