Chapter One

Basics of Public
Finance
1
 Introduction
The participation of the government in the

economic activities is essential to accomplish

the goals of any welfare state.
Depending on the level of development of

each country the roles of government sector

differ.
 The governments of advanced countries are

committed to stability and full employment.

 In case of under developed countries the

government aims at accelerated economic

 Govt sector can play a decisive role in

shaping and charting the path of any

economy.
However, in all cases the aim is to attain:

 full employment and

 economic development through the devt
of:
 agriculture,
 industry and
 service sector.
 1.2 Private and Public Goods
a. Private goods
 It refers to all those goods and services,
which are consumed by people to satisfy
their personal and private wants or needs.
 They relate to articles of food, clothing,

shelter, recreation, etc.

 These goods are priced in the market on

the basis of their cost of production and the

nature of demand on the other.
 All those who want them and are willing to pay the market

price will buy them.

 Those who do not want them or who are not in a position

to pay for them will be excluded from the consumption of

these goods.
 In other words there is no compulsion that everyone will

have to buy them.

 Thus, private goods are divisible or subject to the principle

of exclusion.
 In the sense that, price mechanism divides people in to two

groups, those who want to consume them and those do not.

 Hence, price mechanism excludes the group of people

who are not willing to consume a particular good.

b. Public goods
It refers to G & S produced to satisfy collective wants.

 Collective wants are those which are demanded by all

members of the community in equal or more or less

equal measures.
Example:
 Defense,
 education,
 public health,
 infrastructure facilities like power, transportation and
communication, etc.

These goods are supplied by the country to all its

citizens.
 Features of public goods
 they cannot be divided and their benefits cannot be

shared b/n the people on the basis of each

individual’s requirements.
 Unlike private goods, public goods are not divisible
but have to be collectively consumed.
 the principle of exclusion is not applicable since they

are consumed collectively.

 Since the public goods are supplied to all the people

irrespective of their ability and willingness to pay for

them, the pricing system is useless and
 Therefore, a method of compulsory payment will have

to be designed to finance their cost of production.

 1.3. Merit Wants

 There are certain wants which almost all

members of the society should be able to
satisfy.
 Examples of such wants include educational
and health needs of the society.
 On account of their overriding importance,
such goods are called ‘Merit Wants’.
 Provision of such goods help the economy in
attaining a high level of efficiency and contributes
in achieving of the basic objectives of the society.

 Such goods, if left in the private sector, many

sections of society may be deprived of
educational and health needs to lead a better life.
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1.4 Function of modern Gvt and fiscal operation
Gvt. of a modern state undertakes the ff.
functions:
1. Allocation Function:
The gvt taxes the public and uses the amount in
providing certain facilities and services
considered essential by the people and the
community.
These facilities are provided at a high cost such
as education and Medicare.
Fiscal operations of taxation and public
expenditure have the effect of transferring
resources from private goods to produce public
goods which:
 would satisfy collective wants.
The objective of fiscal operations is to maximize
social welfare.
2. Distribution function:
In a free enterprise economy:
 distribution of income and wealth is unequal and

 many times it is grossly unequal resulting in

exploitation of the lower income groups.
Inequality of income and concentration of
economic power in the hands of a few are
responsible for:

distorting production in favor of the rich
and
 reducing the social welfare of the
community.
Fiscal operations have been used to:

 reduce the incomes and wealth of the

rich through progressive taxation and
 raise the income and standard of living
of the lower income group through
public expenditure.
The use of fiscal policy to reduce inequality of

incomes and wealth has been quite common in

many countries.
3. Stabilization Function:
Modern economies are subject to
fluctuations:
 business boom and inflations on one side and
 business recessions and depressions on the
other.
 Such fluctuations are not in the interest
of the country.
Fiscal operations have been used to
moderate these fluctuations and if possible
to eliminate them altogether.
For example:
 Business booms and inflations can be controlled
through heavier taxation.
 Business recession can be checked through
public expenditure.
 1.5. Public Finance and its Scope

• Public Finance is a very old science and different

economists have defined it in their own ways.
• Some of the important definitions of public
finance are as follows:
• According to Hugh Dalton’s, “Public finance is
concerned with income and expenditure of public
authorities and with the adjustment of one to the
other.”
• In the words of Prof. Lutz, “Public finance deals
with the provision, custody and disbursement of
resources needed for conduct of public or
government functions.”
• In the words of Prof. Findlay Shirras, “public
13
finance is the study of the principles underlying
 Cont’d
• According to Prof. Buchanan, “The
government, considered as a unit, public finance
studies the economic activity of government as a
unit.”
• In the words of Bastable, “public finance deals
with expenditure and income of public
authorities of the state and their mutual relation
as also with the financial administration and
control.”
• All of them say that it is a study of income and
expenditure of the central, state, and local
governments.
• Government performs many functions which the
individual cannot or do not perform. 14
 Scope of Public Finance

• The contents of the science of PF are divided into

five categories of financial activities of the
government:
1. Public Revenue, 2. Public Expenditure, 3. Public Debt,
4. Financial Admin & Control, and 5. Economic Stability and
Growth.
(1) Public Revenue
• Revenue includes all incomes irrespective of the
source they are obtained from.
• Thus, in the wider sense, we can include taxes as
well as borrowings under public revenue.
• But in the interest of the clarity, we study such
incomes separately.
• Hence, in public revenue, we include only those
incomes which do not carry with them the obligation
of repayment for the state. Thus, public revenue15
 Cont’d
(2) Public Expenditure
• Expenditure is the end and aim of the
collection of revenues.
• In public expenditure, we are concerned with the
principles and problems relating to the
expenditure of public funds.
• We study the fundamental doctrine that governs
the distribution of the expenditure among
various heads.
• As public expenditure is an important component
of public finance, therefore we also study various
effects of public expenditure on total
employment, total income, aggregate
investment, output, distribution and general
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price level etc.
 Cont’d
• Through public expenditure, the government
contributes to the financial flows of the economy
and conditions the demand and supply patterns.
• Public expenditure is also used as a tool for
implementing welfare, growth, stabilization and
other policies, by the government.
(3) Public Debt
• A public authority can obtain income through
loans and public borrowings.
• The loans raised in a particular year constitute
receipts for that year. It is an income of a
capital nature, while the provision for
repayment of the capital sum for the year
constitutes expenditure of a capital nature.
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 Cont’d
The study public debt also includes:
1) Methods and objectives of public borrowings;
2) Management of public debt; and
3) Burden of public debt-internal and external
• Methods of public debt are an important
instruments of not only raising funds but also for
meeting increasing government expenditure, for
securing economic stability, increasing public
borrowings during the periods of inflation
and liquidation of public debt during the period
of depression.
• Borrowings from the people during inflation and
borrowings from banks during depression and so
on.
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 Cont’d
(4) Financial Administration and Control
• The scope of public finance is not confined only
to public revenue, public expenditure and public
debt.
• We have to examine the mechanism by which
the above processes are carried on.
• Without a study of relevant dimensions of
financial administration the subject of public
finance remains incomplete.

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 Cont’d
• Thus, financial administration and control include
the following:
1) Study of budgets and their procedure.
2) Budget as an instrument of securing
certain objectives, such as promotion of
employment, economic growth with
stability, welfare of the weaker sections,
infrastructural development for promoting
private investments, etc.
3) Financial and physical controls through
different fiscal tools for controlling private
expenditure in the economy to avoid the
effects of inflation, deflation, recession etc.

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 Cont’d
(5) Economic Stability and Growth
• The study of public finance includes fiscal policy
of the government in dealing with inflationary
and deflationary situations, instability of the
price level, promotion of full employment, growth
of economy, welfare of the people, etc.
• Economic stabilization is of recent origin.
• It has a wide scope to play especially in the less
developed countries.
• The main task of this section is to frame and look
after the implementation of various policies
required for economic stabilization and growth.

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 1.6. Fiscal Policy

• Fiscal policy is a government policy related to

taxation and public expending.
• Fiscal policy and monetary policy, which is
concerned with money supply, are the two
most important components of a
government’s overall economic policy, and
governments use them in an attempt to
maintain economic growth, high employment
and low inflation.

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Role of Fiscal Policy in the Developing
Economy
Allocate more resources for investment
and to restrain consumption.
Reduce the economic inequalities of
income and wealth.
Raising the level of investments and
savings.
Undertake investments in such a way
that it is most beneficial for the people of
the country.
Control inflation within tolerable levels.

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 1.7. Public Vs Private Finance

• Finance in general means public as well as

private finance.
• Public finance relates to the money raising
and income-expenditure functions of the
government.
• Private finance refers to the income-
expenditure phenomenon of an individual or
private business firm.
• By private finance we mean the financial
problems and policies of an individual
economic unit.
• There are both similarities and differences
between public finance and private finance.24
 Similarities

(1) Satisfaction of Human Wants

• Both have the same objective, i.e., the
satisfaction of human wants.
• Public finance is concerned with the
satisfaction of social or collective wants, whereas
private finance is concerned with the
satisfaction of personal or individual wants.
(2) Maximum Advantage
• Both try to secure maximum advantage/benefit.
• An individual or a corporation or a private firm
tries to obtain maximum advantage from his
expenditure.
• Similarly, the government also tries to obtain
maximum good of the people by incurring 25
 … Similarities

(3) Borrowings
• Many times both have to be obtained from
the market in the form of borrowings
whenever the expenditure of either the
government or any individual or firm exceeds
their income/revenue.
(4) Engagement in Similar Activities
• Both the private and public sectors are
engaged in activities that involve lots of
purchases, sales and other transactions.
• Similarly, they are engaged in production,
exchange, saving, capital accumulation,
investment, and so on. 26
 … Similarities

(5) Scarcity of Resources

• The scarcity of resources is also an important
factor which is common to both.
• They have unlimited objectives, whereas
the resources are limited.
(6) Problem of Adjustment of Income and
Expenditure
• Another similarity between public and
private finance is that both the public as
well as private sectors face the problem of
adjustment of income and expenditure.

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 Dissimilarities

(1) Motive
• The motive of private finance is personal
interest or benefit, whereas the motive of
public finance is social benefit or public
welfare.
(2) Adjustment Approach of Income and
Expenditure
• Every individual tries as far as possible to
adjust his expenditure to his income because
his expenditure depends on his income.
• Conversely, the government first prepares its
budget.
• In other words, the government first
determines its expenditure and then devises
28
 …Dissimilarities

(3) Nature of Resources

• The resources of an individual are more or less
limited, whereas the resources of the
government are enormous.
• Government can raise resources from tax
sources as well as non-tax sources. It can borrow
from internal as well as external sources.
(4) Coercive Methods
• An individual cannot use coercive methods to
raise his income, whereas the government can
use forceful methods to collect revenue.
• In other words, the government imposes taxes at
a high rate on the people irrespective of their
capacity to pay. 29
 …Dissimilarities

(5) Secrecy of Budget

• Public finance is an open affair as the
government gives utmost publicity to its
budget by publishing it in newspapers and
by showing it on television.
• For example, the Ethiopian government tells
to the public the yearly approved budget by
parliament, whereas private finance is a
secret affair.
• An individual tries to keep his accounts secret
as he does not want his competitors to know
his real financial position.
30
 …Dissimilarities

(6) Long/Short-term Consideration

• Private individuals incur expenditure in those
areas of business which give quick returns.
• They, as individuals keep in view short-term
considerations.
• On the contrary, government incurs
expenditure keeping in view the long-term
considerations, such as construction of dams,
multipurpose hydro-electric projects, etc.

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 …Dissimilarities

(7) Elasticity of Finance

• Public finance is elastic in nature than private
finance.
• It can be increased by imposing various taxes
as public finance is open to drastic changes.
• Private finance on the other hand, can’t be
increased as there is no much scope for
changes in it.
(8) Deliberation in Expenditure
• The pattern of expenditure of an individual is
governed by habits, customs, status, personal
needs etc.
• On the contrary, the pattern of public
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expenditure is governed and controlled by
 …Dissimilarities

(9) Right to Print Currency

• The government has a right to print
currency which is legal, whereas private
individual does not enjoy such a right.

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 Federal Finance
Where the gvt's functions are divided b/n two

sets of authorities i.e. the Central Gvt, and the

State gvts, it is called a federal system.
Federal finance refers to the system of
assigning the source of revenue to the
Central as well as State Gvts for the efficient
discharge of their respective functions i.e.
 clear-cut division is made regarding the
allocation of resources of revenue b/n the
central and state authorities.
 Principles of Federal Finance
The ff. main principles must be applied:
1. Principle of Independence:
 Under the system of federal finance:

Gvt should be autonomous and free
about the internal financial matters
concerned.
 Each Government should have:
 separate sources of revenue,
 authority to levy taxes,
 to borrow money and
 to meet the expenditure.
 Gvt should normally enjoy autonomy in
fiscal matters.
 2. Principle of Equity:
From the point of view of equity:
 resources should be distributed among the d/t

states
 so that each state receives a fair share of
revenue.
 The allocation of resources should be made

to give:
 equitable treatment to the individuals and
business firms in d/t places.
 3. Principle of Uniformity:
In a federal system, each state should pay

equal tax payments for federal finance.

But this principle cannot be followed in

practice b/c the taxable capacity of each

unit is not of the same.
 4. Principle of Adequacy of
Resources:
The resources of each Gvt i.e. Central and

State:
 should be adequate to carry out its
functions effectively.
Adequacy must be decided with reference

to both current as well as future needs.

The resources should be elastic to:
 meet the growing needs and
 unforeseen expenditure like war, floods
 5. Principle of Fiscal Access:
In a federal system:
 there should be possibility for the Central
and State Gvts to:
 develop new source of revenue within
their prescribed fields to meet the
growing financial needs.
Resources should grow with the increase in

the responsibilities of the Government.

 6. Principle of Integration and Co-
ordination:
The whole financial system of a federation

should be well integrated.

There should be a perfect co-ordination

among d/t layers of the financial system of

the country.
This should be done in such a way to:
 promote the overall economic development of the
country.
 7. Principle of Efficiency:
The financial system should be well
organized and efficiently administered.
There should be no scope for evasion and

fraud.
No one should be taxed more than once in a

year.
Double taxation should be avoided.
 8. Principle of Administrative
Economy:
 The cost of collection should be at the

minimum level and

 the major portion of revenue should be

made available for the other expenditure

outlays of the gvts.
9. Principle of Accountability:
Each Gvt should be accountable to its own

legislature for its financial decisions

The End of Chapter
1
Thank You!!!