Chapter One

Public Finance and Public Sector

General concepts
What is public finance?
 It is the field of economics that studies government activities and the alternative means
of financing government expenditures.
 It is the study of state.
 It is the study of income and the expenditure of the government. Eg. Rising of necessary funds
 It is an instrument for bringing about desired social and economic changes.
 It is a science that deals with the nature and principles of the income & expenditure of the gov’t.
Why we study public finance?
 To learn about the economic basis for government activities.
 To understand the impact of:
o Government expenditures,
o Regulations,
o Taxes, and borrowing on incentives to work, invest, and spend income.
 To understand the role of gov’t in the economy and its impact on resource use and the well-
being of citizens.
What PF deals with?
 It deals with the income and expenditure of the public authorities.
o The term Public means the Government that is Central, state and local authorities.
 It deals with the problems income adjustments and expenditure of the government.
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 public finance is classified under five broad categories. They are,
1. Public revenue
2. Public Expenditure
3. Public debt
4. Financial administration
5. Economic stabilization

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We shall now explain them briefly.
1. Public Revenue:
 It includes & dealt with:
 The sources of the public revenue,
 Principles of taxation,
 Effects of taxes on the economy,
 Methods of raising revenue
 It is the means for public expenditure.
o Increasing activities of the government are the cause of increasing public expenditure.

 The sources of public revenue are:

a. Tax revenue, and
b. Non-tax revenue
1.2 CATEGORIES OF REVENUES OF GOVERNMENT:
The revenues on the basis of nature can be classified as in the following manner.
Tax Revenue:
The revenue from tax includes the following:
A. Tax on Income:
They includes:
a) Tax on personal income, and
b) Tax on corporation profits.
c) Taxes on Rental income
d) Other income taxes
The personal income tax is levied on the net income of individuals, firms and other
association of persons. The tax on the net profits of the joint stock companies is known as
corporation tax.
B. Taxes on Property:
It is the tax revenue from properties including rental income tax land use tax etc.
C. Taxes on Commodities:
The important taxes levied by the Government on commodities are:
a) Excise Duty,
b) Value Added Tax
c) Turnover Tax
 Excise duties are levied on the commodities produced in the
country. Excise duties now constitute the single largest source of
revenue to the Union Government.
 Value Added Tax is levied by the Government on the commodities
sold at specified percentage on the value of sales.
 Turnover Tax is levied by the Government on the sales which are
not covered under Vat.
b) Non-tax revenue: This includes: .
The following categories of revenue are included under non-tax revenue.

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Administrative Revenue: It includes the following:
(1) Fees: It is the compulsory payment made by the individuals who obtain a definite
service in return. Fees are charged by the Government to bear the cost of
administrative services rendered by it. These services are rendered for the
benefit of general public. It includes court fee, registration fee, etc.
(2) Licenses: A license fee is collected not for any service rendered, but for giving
permission or a privilege to those who want to do a special or specified work. It
is charged on the grounds of control of certain activities.
(3) Fines and Penalties: Fines and penalties are imposed as a form of punishment for the
mistakes committed such as violation of the provisions of law, etc. The basic aim
behind them is to prevent the people from making mistakes. A fine is also
compulsory like a tax, but it is imposed more as a deterent than as a source of
revenue.
(5) Escheats: The property of a person having no legal heirs and dying in testate will be
taken possession of by the Government. That is, the Government can take over
the property of a person who dies without having any legal heirs or without
keeping a will. But, it cannot be considered as a main source of revenue to the
Government.
(6) Special Assessment: According to Prof. Seligman, special assessment means “a
compulsory contribution levied in proportion to the special benefit derived to
defray the cost of the specific improvement to property undertaken in the
public interest”. Thus, it is a compulsory payment or contribution. It is levied in
proportion to the special benefits derived to bear the cost of specific
improvement to property. Whenever the Government has made certain
improvements, somebody will get benefited. For example, irrigation facility,
road and drainage facility, etc.
Because of this, the value of the property in the neighborhood will rise. This
rise in the value will provide an unearned increment. Hence, the Government has a
right to appropriate a part of this unearned increase. This appropriation is called as
special assessment.
(7) Gifts and Grants: Gifts are voluntary contributions from Non-Government

donors to the Government for various purposes like drought relief, defense, national

relief, promotion of family planning, etc. One Government to another usually gives grants.

For example, in a federal set up, the Union Government provides grants to the State

Governments to carry out their functions and fulfillment of obligations. Moreover, the

Government of one country may receive grants from other country.

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2. Public expenditure
1.1 Meaning and Importance of Public Expenditure
Public expenditure is incurred by public authorities --Central, State and local Governments either
for the satisfaction of collective needs of the citizens or for promoting their economic and social
welfare. Public expenditure is not only the most important but also the central part of the study of
public finance. It is incurred by the government for the attainment of public good. Every
government has to maintain law and order, armed forces for providing protection, public parks,
schools, health of the people. Government has to perform certain other welfare measures like
maternity protection, arranging for cheap food, cloth and low-cost housing for the poor and so
on. All these multifarious activities which are increasing every year require huge funds.
Therefore public expenditure, deals with the expenditure which a government incur for its own
maintenance, the society and the economy and helping other countries.

3. Public debt
A public authority can obtain income through loans. 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.
 It deals with the causes, methods, problems of public borrowings & its mgt.
o Advantages of Debt.
 Transfer of funds from public to government is voluntary.
 Loans do not reduce the wealth of the lenders.
 Debt raised for productive purpose will not be a burden on the economy.
 This includes both internal debt and external debt.
a. Internal debt:
 Needs of gov’t for funds can’t be fully met by taxation alone due to its limited scope
 Government therefore has to resort to alternate sources. Eg. Rising of debt.

b. External Debt:
 Internal sources of finance are limited.
 Countries therefore go for external debt.
 The transfer of capital at international level may take the form of:
i) Financial aid through grants and loans
ii) Commodity aid
iii) Technical assistance

 External debt is an immediate source of funds for development.

 However, such debt has the following drawbacks.

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 i) Political subordination
ii) Other obligation
iii) Excess supply of goods and services in debtor’s country

 However, such external inflows help to achieve faster growth.

4. Financial Administration
This category includes the preparation of financial budget, the control and administrations of the
budget relevant problems like through auditing etc. The term budget includes ‘Annual Financial
Statements’ which incorporates all the annual statements of receipts and expenditures of the
government.
(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.

1.2. Public finance 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. It is a convention to
look into similarities and dissimilarities between the two so as to provide an analytical
foundation for the decision making aspects of public finance

There are both similarities and differences between public finance and private finance.

a. Similarities
1. Satisfaction of Human Wants:
 Individual is 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, viz, the satisfaction of
human wants.

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2. Maximum Satisfaction:
 Both aim at maximum satisfaction.
3. Borrowing a Common Feature:
As and when the current incomes become insufficient to meet the current expenditure, the
individuals and Governments rely upon borrowings. Both of them are having loan repayment
plans.
4. 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.

B. Differences
1. Adjustment of Income and Expenditure:
 In private finance, the individual first considers his income and then decides about his
expenditure.
 But 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.
2. Nature of Benefit:
 The private finance aims at individual benefit ie the benefit of individual household.
 But the public finance aims at collective benefit, i.e. the benefit of the nation as a whole.
3. Postponement of Expenditure:
 In private finance, the individual can postpone or even avoid certain expenditure, as he
likes.
 But in the case of public finance, the Government cannot avoid certain commitments like
social welfare measures and thus cannot postpone the certain expenses like relief
measures, defense, etc.

4. Allocation of Resources:

 In private finance the individual can allocate or distribute his income to various
expenditure to get the maximum satisfaction.

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  But it is not possible in the case of public finance; Government cannot aim at maximum
satisfaction on the expenditures made.
5. Motive of expenditure:
 In private finance, the individual expects return in benefit from the expenditure made.
 But the government cannot expect return in benefit from various expenditures made.
 Profit or benefit is the motive of private finance
 Social welfare and economic development is the motive of public finance.
6. Influence on expenditure:
 The expenditure pattern of private finance is influenced by various factors such as :
 Customs,
 Habits,
 Culture,
 religion,
 Business conditions etc.
 But the pattern of expenditure of public finance is influenced and controlled by the
economic policy of the Government.
7. Nature of Budget:
 In private finance, individuals prefer surplus budget as a virtue and a deficit budget is
undesirable to them.
 Government does not prefer a surplus budget since it creates negative opinion on the
Gove’t.
 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.
8. source of resources:
 In private finance,
o The individuals have limited resources.
o They cannot raise the income, as they like.
o They do not have the power to issue paper currencies.
 But, in the case of public finance:
o The Government has enormous of resources.
o It can collect revenues, can get grants-in-aid and borrow from other countries.
o The government can also print currency notes to increase its revenue.

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9. Coercion(Complusation):
 Under private finance:
o The individuals and business units cannot use force to get their income.
 In public finance:
o The government can use force in the form of imposing taxes to get income/high rate
o Government can undertake any of the existing private business by way of
nationalization, which is not possible in the hands of individuals.
11. Publicity:
 In private finance
 Individuals do not like to disclose their financial transactions to others.
 They want to keep them secret.
 In public finance
 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.
12. Audit:
 Private finance, Auditing of the financial transactions of the individuals is not always
necessary.
 But the accounts of the public authorities are subject to audit and inspection.

1.4 Economic and Social Significance of Public Finance

(1) Economic Stabilization
Economic stabilization is yet another economically significant responsibility of the government.
The problem arises whenever there is economic instability such as inflation and deflation. Public
finance (revenue and expenditure process of the government) may be, therefore, used to secure
economic stability or to remove economic fluctuations in the economy.
(2) Full Employment
Public finance also plays an important role in increasing employment. In an
underdeveloped/developing country, major problem faced by the people is the problem of
unemployment. This problem leads to low standard of living, poverty, backwardness, ignorance

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and above all starvation. It is the function of public finance to provide employment opportunities.
Therefore, expenditure should be incurred by the government for increasing employment and for
achieving full employment. To generate employment, public expenditure should be incurred on
setting up new industries, encouraging small-scale and cottage industries through financial
subsidies, expenditure on training schemes etc.
(3) Balanced Regional Development
For the economic development of a country, balanced regional development is very essential.
Balanced regional development is possible by setting up private industries in backward areas
instead of in urban areas. To encourage this diversion, the government should provide fiscal or
tax concessions in the form of 5 year tax holiday, communication facilities should also be
provided. If the private industries fail to divert to backward regions, should be taxed heavily.
(4) Reduction in Economic Inequalities (Distribution function)
One of the major problems of underdeveloped countries is the unequal distribution of income
and wealth. There is a gap between the rich and the poor. Public finance has an important role to
play in this context. To bring about equitable distribution of income and wealth, the government
should follow the system of progressive taxation. In other words, the government should impose
heavy taxes on the richer section of society, and the amount realized from the rich should then be
spent on the poor by way of providing them social amenities such as free education, medical
facilities, public utilities like road, water facility, recreation facilities etc.
(5) Mobilization of Resources (Allocation function)
Mobilization of resources is another important role of public finance. The government can
mobilize or raise resources by imposing taxes on the people and industries, by encouraging
savings through various saving schemes, surplus of public enterprises and borrowings and
making them available for investment for the rapid economic development of the
underdeveloped country.
6. Fiscal Policy to Curb or Prevent Undesirable Wants
Another important aspect of public finance is that the government not only satisfies social wants
and merit wants, but also discourages and curbs certain undesirable wants of the people from the
social point of view. Undesirable wants are cigarette-smoking, liquor drinking, chewing of
opium and tobacco etc. Such harmful wants are discouraged and curbed by imposing heavy taxes
and spending large amount on publicity, health measures for the affected people, etc.

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Private goods vs. public goods
1. Private Goods:
Private goods refer 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,
transportation, communication etc. These goods are priced in the market on the basis of their cost
of production on the one side 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 every one will have to buy them. Thus distribution of these
goods is based on effective demand and market price. As a result, only those who do demand the
private goods will pay for their cost of production on a voluntary basis. Thus, private goods are
divisible in the sense that price mechanism divides people in to two groups, those who want to
consume them and those do not; and private goods are subject to the principle of exclusion; in
the sense that price mechanism excludes the group of people who are not willing to consume a
particular good.
2. Public Goods
Public goods are normally supplied by public agencies due to their natures of non-rivalry and
non-excludability. The nature of consumption of public goods is such that consumption by one
does not reduce consumption for others. Such public goods like roads, power, municipal
services, and other public infrastructures have favorable results on many families, business
enterprises, industries and the general public. Besides, consumption of public goods by an agent
does not exclude others from doing same. Such nature of public goods therefore makes them
impossible for private suppliers to avail them at market prices like other commodities.

a. Private Goods
 Refer to goods/services consumed by people to satisfy their personal & private wants/needs.
o Eg. Food, clothing, shelter, recreation, transportation, communication etc.
 Are priced in the market on the basis of cost of production and demand
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.

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  There is no pressure that everyone will have to buy them.
 Distributed based on effective demand and market price.
 Are divisible
 Price mechanism divides people in to two groups, (who want to consume and who do not;)

 Are excludable;
 Price mechanism excludes the group of people who are not willing to consume a particular good.

Public Goods
Trogen (2003) identified two definitions for public goods.
a. Casual Definition of Public Goods
 PGs are those goods and services provided through the public sector.
 This definition, while usually correct, is not entirely accurate.
 Gov’t may also supply some private goods to individuals like public housing.
 Pure Public goods are goods/ services that are:
 non-rival in consumption and
 non-excludable
As per of this definition,
 A good is “rival” in consumption when the act of one person consuming it precludes another
person from enjoying the same good.
 Many people, on the other hand, can enjoy “Non-rival” goods, simultaneously.
 A good is “excludable” when it is feasible to exclude individuals from enjoying a good unless
they pay for it (Stiglitz, 2000).
 A good is “non excludable” when it is not feasible to exclude those who do not pay (Trogen,
2003).

Common goods:
 Are rival in consumption but are not excludable.
 Are sometimes called common pool resources.
 Eg. Fish in the sea, common pastures, clean air, clean water
 Common goods are different from public goods, because they are rival in consumption.
Toll goods:
 Are those goods that are non-rival in consumption but still excludable
 Toll road, cable TV, movie theater, college course

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Pure public goods
 Are non-rival in consumption for an entire population of consumers, and their benefits
having the characteristic of non-exclusion?
 consumed by all members of a community
 Are a rare anomaly in a world
 Are completely non-rival and completely non-excludable.
o Eg. National defense, , radio waves

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