Chapter one

Meaning and Scope of Public Finance

1
• The Meaning and Scope of Public Finance
• Public finance deals with how governments raise money, how
that money is spent, and the effects of these activities on the
economy and on society.
• Public finance studies how governments at all levels – national,
state and local – provide the public with desired services and
how they secure the financial resources to pay for these services.
• Public finance is one of those subjects, which lie on the
borderline between Economics and Politics.

2
• Public finance is the study of income and the expenditure of the
government.
– Hence, it can be defined as the science that deals with the
nature and principles of the income and expenditure of the
government.
• The term ‘public’ means the government that is central, state and
local authorities.
• Rising of necessary funds for incurring expenditure constitutes
the subject matter of public finance.
• It also deals with the problems of adjustments of income and
expenditure of the government. It is also known as fiscal
operations of the treasury. Thus, fiscal operations and fiscal
policies are integral parts of public finance.

3
• The need to study public finance arises as
governments provide public goods including government
financed items and services such as roads, military forces,
lighthouses, and streetlights.
• Private citizens would not voluntarily pay for these services, and
therefore businesses have no incentive to produce them. It also
enables governments to correct or offset undesirable side effects
of a market economy. These side effects are called spillovers or
externalities.
• For example, households and industries may generate pollution
and release it into the environment without considering the
adverse effect pollution has on others. If it costs less to pollute
than not to, people and businesses have a financial incentive to
continue polluting. Pollution is a spillover because it affects
people who are not responsible for it. To correct a spillover,
governments can encourage or restrict certain activities.
4
• Public finance provides government programs that moderate the
incomes of the wealthy and the poor. These programs include
social security, welfare, and other social programs.
• For example, some elderly people or people with disabilities
require financial assistance because they cannot work.
Governments redistribute income by collecting taxes from their
wealthier citizens to provide resources for their needy ones. The
taxes fund programs that help support people with low incomes.

5
• THE SCOPE OF PUBLIC FINANCE
• Public finance deals with the income and expenditure
pattern of the government.
– Hence, the substances concerned with these
activities become its subject matter.
• The subject matter of the public finance is classified
under five broad categories: public revenue, public
expenditure, public debt, financial administration and
economic stabilization. We shall now explain them
briefly.

6
• A. Public Revenue
• Governments undertake various activities and they must have
funds, or revenue, to pay for these activities.
• Public revenue is, therefore, represents the means for public
expenditure.
• Accordingly, most governments generate revenue from taxes,
such as income taxes, capital taxes, and sales and excise taxes.
• This category involves sources of the public revenue, principles of
taxation, effects of taxes on the economy, methods of raising
revenue and the like are dealt with.
• Various sources of public revenue are categorized in to tax
revenue and non-tax revenue.

7
• Tax Revenue
• Taxes are compulsory payments to government without
expectation of direct return or benefit to tax payers.
• It imposes a personal obligation on the taxpayer.
• Taxes received from the taxpayers, may not be incurred for their
benefit alone.
• The objectives of taxation are to reduce inequalities of income
and wealth; to provide incentives for capital formation in the
private sector, and to restrain consumption to keep in check
domestic inflationary pressures etc.

8
• The various types of taxes can be grouped under three heads.
– First type can be titled taxes on income and expenditure
which include income tax, corporate tax etc.
– The second is taxes on property and capital transactions and
includes estate duty, tax on wealth, gift tax etc.
– The third head, called taxes on commodities and services,
covers excise duties, customs duties, sales tax, service tax etc.
• These three types can be reclassified into direct and indirect
taxes.
• The first two types belong to the category of direct taxes and the
third type comes under indirect taxes.

9
• Non-Tax Revenue
• This includes the revenue from government or public
undertakings, revenue from social services like education and
hospitals, and revenue from loans or debt service.
• To sum up, non-tax revenue consists of interest receipts,
dividends and profits, and fiscal services and others.

10
• B. Public Spending
• This category deals with the principles of public expenditure and
its effect on the economy.
• The term ‘public expenditure’ is used to designate the
expenditure of government bodies.
• It differs from private expenditure in that governments need not
pay for themselves or yield a financial profit.
• The budget determines which public goods to produce, which
spillovers to correct and how much assistance to provide to
financially disadvantaged people.
• The chief administrators of the government propose the budget
and the legislature finally pass the budget.

11
• Government spending may take two forms: exhaustive spending
and transfer spending.
– Exhaustive spending refers to purchases made by a
government for the production of public goods.
• For example, to construct a new harbor the government
buys and uses resources from the economy, such as labor
and raw materials.
– In transfer spending the government transfers income to
people to help them support themselves.

12
• Transfers can be one of two kinds: cash or in-kind.
– Cash transfers are cash payments, such as social security
checks and welfare payments.
– In-kind transfers involve no cash payments but instead
transfer goods or services to recipients.
• Examples of in-kind transfers include food stamp coupons
and Medicare.

13
• Public expenditure can also be done under two broad heads of
developmental expenditure and non-developmental expenditure.
– The former includes social and community services, economic
services, and grants-in-aid.
– The latter mainly consists of interest payments, administrative
services and defense expenses.
• Expenditure can also be classified into revenue and capital
expenditure.

14
• C. Public Debt
• This category deals with the causes, methods and problems of
public borrowings and its management.
• This includes both internal debt and external debt.

15
• Internal Debt
• Increasing need of government for funds cannot be fully
met by taxation alone in under developed and developing
countries due to limited scope of taxation.
• Government therefore has to resort to alternate sources.
Rising of debt is one such source.
• Debt, though involves withdrawal of resources by limiting
private consumption, has certain advantages.
• Loans do not reduce the wealth of the lenders.
• Debt raised for productive purpose will not be a burden on
the economy.

16
• External Debt
• In under developed and developing countries, internal sources
are limited.
• Under developed and developing countries, therefore go for
external debt.
• The transfer of capital at international level may take the form of
financial aid through grants and loans, commodity aid and
technical assistance.
• External debt is an immediate source of funds for development.
• However, such debt has drawbacks including political
subordination and other obligation and excess supply of goods
and services in debtor country.
• However, such external inflows help to achieve faster growth.

17
• D. Financial Administration
• This category includes the preparation of financial budget, the
control and administrations of the budget and relevant problems
including auditing.
• In other words, all financial activities involve issues of financial
including public budget, its passing, implementation, auditing
and other similar matters.
• The term budget includes ‘Annual Financial Statements’ which
incorporates all the annual statements of receipts and
expenditures of the government.

18
• E. Economic Stabilization
• This category studies the use of financial policies of the
government from the viewpoint of economic development.
• Accordingly, it analyses the use of public finance to bring the
economic stability, growth and distributive justice in the country.
• These aspects of the economic policy of the government have
assumed such a great significance that they are often given a
separate treatment in the discussion of public finance theories.

19
• Features of Public and Private Finances
• There are both similarities and differences between public finance and
private finance. Let us discuss the similarities first.
• Both private and public finances aim at obtaining maximum
satisfaction.
– As such, individuals are concerned with the personal wants, while
the government is concerned with the social wants. Thus, both the
private and public finance have the same objective, vis-à-vis
satisfaction of human wants.
• On the other hand, both individuals and governments face the
problem of economic choice. That is their sources of revenue are
limited, comparing with their expenditure. Hence, they have to satisfy
the unlimited ends with limited means.
• Closely related to this aspect, borrowing is a common feature of both
private and public finances.
– When the current income becomes insufficient to meet the current
expenditure, the individuals and governments rely upon borrowings
and accordingly they have loan repayment plans. 20
• Dissimilarities between Public Finance and Private
Finance
• Even though the private and public finances look alike, there are
certain fundamental differences between them.
• Adjustment of income and expenditure: In private finance, the
individual first considers his income and then decides about his
expenditure. Nevertheless, the case of public finance, the
government first estimates the volume of expenditure and then
tries to find out the methods of raising the necessary income.
That is the private finance tries to adjust its income to
expenditure, whereas the public finance tries to meet the
expenditure by raising income.
• Nature of benefit: The private finance aims at individual benefit
that is the benefit of individual household. However, the public
finance aims at collective benefit, i.e. the benefit of the nation as
a whole.
21
• Postponement of expenditure: In private finance, the individual can
postpone or even avoid certain expenditure, as s/he likes. However,
in the case of public finance, the Government cannot avoid certain
commitments like social welfare measures and thus cannot
postpone certain expenses like relief measures, defense, etc.
• Allocation of resources: In private finance, the individual can
allocate or distribute his income in various ways to obtain
maximum satisfaction. Nevertheless, it is not possible in the case of
public finance; government cannot aim at maximum satisfaction on
the expenditures made.

• Motive of expenditure: In the case of private finance, the individual

expects return in benefit from the expenditure made. However, the
government cannot expect return in benefit from various
expenditures made. That is profit or benefit is the motive of private
finance whereas the social welfare and economic development is
the motive of public finance.
22
• Influence on expenditure: The expenditure pattern of private finance is
influenced by various factors such as customs, habits culture religion, business
conditions etc. Nevertheless, the pattern of expenditure of public finance is
influenced and controlled by the economic policy of the government.

• Nature of perspective: In private finance, the individual strives for immediate

and quick return. Since his life span is definite and limited, he gives importance
to the present or current needs and allots only a little portion of income for the
future. However, the government is a permanent organization and is the
caretaker of the present and the future as well. Thus, the government allots a
considerable amount of its income for the promotion of future interests. That
is private finance has a short-term perspective whereas the public finance has
a ling term perspective.

• Nature of budget: In private finance, individuals prefer surplus budget as virtue

and a deficit budget is undesirable to them. However, the government does
not prefer a surplus budget. If the government bring surplus budget, it will
create negative opinion on the government. This is because surplus budget is
the result of high level of taxation or low level of public expenditure both of
which may affect the government adversely. 23
• Nature of resources: In private finance, the individuals have limited resources. They
cannot raise the income, as they like. Thy do not have the power to issue paper
currencies while in the case of public finance the government has enormous kinds of
resources. Besides the administrative and commercial revenues, the government can get
grants-in-aid and borrow from other countries. The government can print currency
notes to increase its revenue.

• Coercion: Under private finance, the individuals and business units cannot use force to
get their income. Nevertheless, in public finance the governments can use force in the
form of imposing taxes to get income i.e. taxes are compulsory in nature. It is an
obligation on the part of the taxpayer. No one can refuse to pay taxes if he is liable to
pay them. Besides the above, the government can undertake any of the existing private
business by way of nationalization, which is not possible in the hands of individuals.

• Publicity: Individuals do not like to disclose their financial transactions to others. They
want to keep them secret. Nevertheless, the government gives the greatest publicity to
its budget proposals and the allocation of resources to different heads. It is widely
discussed. Publicity strengthens the confidence of the people in the government.

• Audit: In the case of private finance, auditing of the financial transactions of the
individuals is not always necessary. On the other hand, the accounts of the public
authorities are subject to audit and inspection.
24
• CLASSIFICATION OF GOODS
• In classifying goods and services produced in an economy, we
should consider two basic criteria of categorizations.

• Criterion I: The Nature of Consumption

• This criterion attempts to categorize goods based on whether
there is rivalry in consumption of a particular good.
• Accordingly, some goods and services are individually
consumable.
– In such instances, consumption is said to be rival because
there is competition between those who are willing and able
to consume the same type of good of service.
In other words, there is rivalry between consumers
themselves.

25
• In contrast, many goods cannot be consumed alone.
• There are also many goods and services, though, may be
consumed individually, whose utility increases when they are
consumed jointly.
For instance, you cannot consume telephone service alone.
Neither will you enjoy peace delivered to you alone and
denied to the rest; nor would you like to live in a city where
you are the only healthy person.
• In such cases, consumption is said to be non-rival. In these and
other similar cases, the nature of consumption tends to be non-
rival.

26
• Criterion II: The Feasibility of Product Divisibility
• There are certain goods the availability of which to users decided
in discriminatory manner where only those who pay the stipulated
market price of good may be allowed the use of it.
– That is such a good may be priced and the principle of exclusion
can be applied to its users.
– Exclusion, in essence, refers to the ability of the suppliers to
exclude those who want to consume a commodity or service
but do not want and/or not able to pay the market price.

• For some commodities and services, exclusion is quite easy while

for some types of goods services it is quite difficult.
– Even there are cases where exclusion is very impossible. Peace
is very expensive but once produced everybody is free to
consume and enjoy it.
– It is impossible to prevent one from consuming peace because
s/he is not willing or able to pay the price. 27
• Table 1.1 Types of Goods and Services

Criteria Exclusion

Easy to Difficult to
Feasible Impossible

Individual Private Goods Common – Pool

Consumption

(Rival) Goods

Joint (Non-Rival) Collective Public Goods

(Club) Goods

28
• A. Private Goods
• Private goods are goods that can be consumed individually and
for whom exclusion is easy.
– Due to this, there is competition (rivalry) among buyers in
consumption of such goods.
• The same holds true among the sellers since each seller can
effectively exclude free riders – those who want to consume the
product but need to avoid the respective pay.
• Grocery commodities, bazaar items like clothes, shoes, pencils,
etc. are examples of private goods.

29
• B. Common Pool Goods
• Common pool goods are goods and services that can be
consumed individually but excluding those who are not willing
and/or able to pay is difficult.
– In such cases, there is rivalry (competition) between
consumers.
– However, it is difficult (or even it may be impossible) to
exclude those who are not willing and/or able to pay the
necessary price.

30
• An example of this type may be fishing in an open sea. You can
individually consume the fishes you cached. The more the other
fishers fish the less successful you will be. Thus, there is rivalry
between you and the other fishers and between the other fisher
themselves. However, there is no market mechanism that will
prohibit you or the other fisher from fishing. Thus, you will over
fish and they will over fish and eventually all of you will be worse
off.

• A common pasture (grazing land) is another example. This

phenomenon is sometimes known as the tragedy of commons.
The tragedy arises from collective ownership of resources and/or
ill-defined ownership.

31
• C. Collective Goods
• These are goods and services that can be consumed jointly only
but exclusion is easy.
• Because of the joint nature of consumption, there is no rivalry
between consumers (although their might be weak temporary
competition on queue).
• A good example is telephone service. You cannot consume
telephone service alone.
• On the other hand excluding those who are not willing and/or
able to pay is quite easy for collective goods.
• If you do not pay, telecom can easily cut you off.
• Watching a game in stadium is also a collective good.
• The other name for collective goods is club goods because they
require subscription. If there is any competition between
consumers, it is in order of subscription not in consumption.
32
• D. Public Goods
• These are goods and services that can be consumed jointly only
and also excluding those who are not willing and/or able to pay is
either very difficult or very impossible.
• Thus once a public good is produced, everybody is free to
consume it.
• There is no market mechanism that will force people pay for their
consumption of public goods.
• A good example is radio program – once produced it is in the air.
• Most public goods are not divisible and therefore we do not
know how much of the total public good produced is consumed
by a single person.
• It is unlikely that you can calculate the percentage of the total
peace produced by the nation consumed by you alone.

33
• Seriously speaking, there is no clear-cut distinction between the
private, common-pool, collective and public goods. Many of the
goods and services produced in economy might posses all of the
characteristics we discussed above.
• Implications
• The major implication of the above discussion is perfectly
competitive market is effective and efficient in producing and
distributing the private goods only. Most of the microeconomic
theories about the efficiency of market apply for the private
goods only. Market does not work well in production and
distribution of common-pool goods, collective goods and public
goods due to absence of competition between sellers and/or
buyers. Public goods, for instance, are essential for the proper
functioning of the society as whole and the economy in particular.

34
• Externalities in consumption of goods
• Production and/or consumption and/or transaction of some
goods and services may affect the well-being of those who has
not involved (also known as third party) in the production
and/or consumption and/or transaction.
– Such effects are known as externalities which also known as
neighborhood effects or spillover effects.
• The production/consumption of some goods may have a
favorable effect on third party. Conversely, the
production/consumption of some goods may result in
unfavorable effects to those who are not involved in it.
• Accordingly, one shall discriminate between two types of
externalities: positive and negative externalities.

35
• Positive Externality
• To conceptualize positive externality, let us assume that you
have a garden in which you grow vegetables and flowers. You
are toiling on your garden for your purpose but your
neighbors are enjoying your garden even one of them has
started an apiculture (beekeeping) business. Her bees are
feeding on the nectars of your flowers and she is even selling
honey and wax. Quite obviously, your neighbor is obtaining
some advantages from the activity you are engaged in.
• Do you think that you have any right to claim payment for
your nectars? What if she refuses to pay? Can you prevent
the bees from flying into your garden and collect the nectars?
• In economic terms, your garden has produced a positive
externality to your neighbors. They get the pleasure without
paying the price for the utility they consume.
36
• Negative Externality
• Unlike the positive externality, negative externality is associated
with negatively affecting the welfare of the third party.
• Assume that you have industrialist neighbor who manufactures
furniture and other metal works. Because of the high demand
for the products, commonly she has arranged a night shift
working until the midnight. You have no problem with both the
person and the business except that the extreme noise
nuisance created by the machines all day long and even in the
night that makes you restless.
• Can you demand compensation? What if he asks compensation
from you to move his factory away from your home? There is no
easy solution! In this example, the factory produces negative
externality to its neighbors.
• Undoubtedly, such externality will cause an economic loss to
other economic units. 37
• FRAMEWORK OF MUSGRAVE’S THREE FUNCTIONS OF THE
STATE
• According to Musgrave, for conceptual purposes, the functions of
government should be separated into three functions or
branches, macroeconomic stabilization, income redistribution,
and resource allocation.

38
• Stabilization function:
• The government has the responsibility to maintain high
employment, a reasonable degree of price level stability, and an
appropriate rate of economic growth.
• It uses both fiscal and monetary policies to stabilize the
economy.
• Fiscal policy tools are tax and government spending. Monetary
policy tools are money supply and interest rate.
• is ordinarily assigned to the central government because:
– First, sub-national governments commonly cannot much
affect macroeconomic conditions within their boundaries.
– The second problem with sub-national macroeconomic policy
is the limited power to borrow and the lack of the power to
print money

39
• Distribution function:
 The government has the responsibility to adjust the
distribution of income and wealth to assure conformance with
what society considers a "fair" or "just" state of distribution.
 This is done by progressive taxation of income, which taxes
low incomes proportionately less than high incomes, and by
transfer payment programs that provide support for the poor.
 The distribution function is also commonly assigned primarily
to the central level of government.

40
• Allocation function:
• The allocation branch is to see that resources are used efficiently.
• With respect to resource allocation function, Musgrave argues
that policies of sub-national branches of governments should be
permitted to differ in order to reflect the preferences of their
residents.
• Decentralization of taxing and spending power allows sub-
national governments to tailor schemes that match the demand
of their constituency that will increase efficiency ultimately
because local governments have better information about their
residents' needs than the central government.

41