Public Finance (Econ 4122)

Chapter 4
PUBLIC EXPENDITURE
 PUBLIC EXPENDITURE
• Public expenditure refers to the expenses which the
government incurs for its own maintenance, for the
society, for help other countries and the economy as a
whole.
• Historically, public expenditure has recorded a continuous
uptrend over time in almost every country.
• However, traditional thinking and philosophy did not favor
the growth of public expenditure. Instead, it considered
market mechanism as a better guide in working of the
economy and allocation of its resources.
• It was argued that each economic unit was the judge of its
own economic interests and the government was certainly
not able to decide on behalf of others.
Causes of Growth in Public
Expenditure
 Population growth
 Increasing urbanization
 Provision of economic overheads(Transportation
and communication)
 Maintenance of law and order
 Welfare activities
 Provision of public goods and utility services
 Servicing of public debt
 International obligation
 Public expenditure: Canons,
Theories and Accountability
Canons of public expenditure
I. Canon of Benefit.
 PE should be so planned and implemented as to bring
about the greatest possible benefit to society. It means that
all such expenditures which do not bring benefit to society
should be avoided.
 Benefit from PE may be identified with achievement of proper
allocation of economic resources, proper distribution of
income and wealth in society and stability of price level and
growth of economy.
 This canon also points to the need of undertaking a cost-
benefit analysis of the competing schemes of public
expenditure before the final selection of investment project is
made.
 Canons of Public Expenditure
ii. Canon of economy
 Public expenditure should be incurred carefully so that there is no wastage
of funds. Since resources are limited in the society, they have to be most
properly utilized.
 Economical use means most proper utilization.
 Most important reasons of wasteful expenditures are poor planning,
execution, corrupt practice and delay due to time lag between plan and
execution and, hence, escalation of prices.
 These types of wastage have to be avoided at any cost
iii. Canon of surplus
 This canon requires that expenditure of public authorities should be kept
within the limits of current revenues.
 If possible, the expenditure should be less than the earnings of government
so that it can be used when there is deficit.
 Surplus can be generated either by controlling expenditure or by
increasing current revenues.
 Canons of Public Expenditure

iv. Canon of sanction

 This canon requires that the public authorities should not
be allowed to spend funds without having a previous
sanction from appropriate authority for the purpose.
 It also requires that funds sanctioned for a particular
expenditure should not be diverted to a different purpose
and spent thereon. In a democracy, such sanctioning
authority is vested on the legislature.
 Since there are different agencies in the governmental set
up for executing public expenditure programs, detailed
authorizations are worked out for different spending
agencies so that misuse and wastage of expenditure can
be avoided.
 Canons of Public Expenditure

v. Canon of Elasticity
 Canon of elasticity requires that the rules of public
expenditure should not be too rigid to achieve the real
purpose and that it should be allowed to vary
according to the needs and circumstances.
 For example, if the economy suffers from
unemployment and deficiency of demand, there should
not be a rigidity that the budget should be balanced.
 Under such situation, the government should go for a
deficit budget and inject additional purchasing power
into the economy so that effective demand is increased
and factors of production are employed on larger scale.
 Canons of Public Expenditure

vi. Canon of certainty.

• This canon requires that public authorities should
clearly know the purpose and extent of public
expenditure.
• The spending unit should be certain as to the
amount and objective of public expenditure.
• This requires a proper expenditure plan well
thought out beforehand.
• The canon of certainty is followed through the
preparation of budget.
 Theories of Public Expenditure
Classical Theory of Minimum Expenditure
• According to classical theory, public expenditure must be
limited to the bare minimum and must not exceed public
revenues.
• This theory is based on the assumption of full – employment
and laissez-faire doctrine.
 Since the economy operates at full employment level, the problem of
economy in the classical system is not attainment of growth.
 The economy functions with maximum efficiency.
 Moreover, with the philosophy of ‘laissez-faire’ followed, most of the
economic activities are performed by the private sector. Hence, the
size of PE is always small and the budget should always be balanced.
 If public expenditure becomes more and is financed by public
borrowing, there will be withdrawal of funds from private sector
where they are more productively employed. Such diversion of
resources will cause a decline in overall economic efficiency.
 Principle of Maximum Social
Advantage
• The funds paid by tax payers come to the public treasury.
These funds go back to the people through public expenditure
programs.
• The principle of maximum social advantage lays down that
public expenditure should be so planned and, hence, revenue
resources so raised so as to bring about benefit larger than
sacrifice and that the surplus of aggregate satisfaction in the
society is maximum.
• Large investment of expenditure means large sacrifice of tax
payers. Even then if it is a capital investment, the ultimate
benefit may be much larger than the communities’ sacrifice.
• On the contrary, unremunerative public expenditure, even
when amount is small, will not achieve the principle.
 Principle of Maximum Social
Advantage
• Secondly, the method of taxing to raise resources
for expenditure has to be judicious. The same
amount may be raised from a number of
alternative taxes. That method should be
employed which will result in least sacrifice.
• Thirdly, tax-expenditure programme should be so
structured as to result in increased productive capacity
of community and, hence, enhanced national income.
• The principle of maximum social advantage is
derived from the principle of equi-marginal
returns as applied to an individual.
 Principle of Maximum Social
Advantage
• Thus, if it is found that marginal utility from
public expenditure on medical and public health
measures is greater than the marginal utility
derived from the same amount spent on provision
of public parks, then the government should
transfer the public funds from the latter to the
former account. This will maximize social
advantage.
 Principle of Maximum Social
Advantage

Figure 4.1 Public expenditure on public parks Figure 4.2 Public expenditure on
medical and public health
 Principle of Maximum Social
Advantage
• As shown in figures 4.1 and 4.2, the limited amount of public
expenditure totals OA and the amount O1B spent respectively
on public parks and medical and public health.
• Expenditure is measured along horizontal axis and marginal
utility along vertical axis.
• As clear from the figures, the allocation of expenditure at OA
results in lower marginal utility than at O1B.
• Hence, transfer of expenditure of the amount AK (=BL) from
public parks to the provision of medical and public health will
raise aggregate utility because the increase of utility area
BLMD is larger than reduction of utility area KACN.
• This is how equality in marginal utility from public
expenditure in all directions will maximize social advantage.
 Principle of Maximum Social
Advantage
• The main defect of the theory is that it is not
possible to measure precisely the difference in
benefits from different directions of public
expenditure.
• Secondly, the requirement of the principle that
expenditure should not be specially made for a
particular section of society is not followed in
many underdeveloped countries where special
attention is paid to the benefits of backward
sections of society in preference to other
communities
 Principle of Maximum Aggregate
Benefit
• Pigou also argues that expenditure should be made in
such a way that it leads to maximum welfare of the
maximum number.
• In his words, “expenditure should be pushed in all
directions up to the point, at which satisfactions
obtained from the last shilling/Birr expended is equal
to the satisfaction lost in respect of the last shilling/Birr
called upon government service.” MSB = MSS
 Principle of Maximum Aggregate
Benefit
• Pigou's theory requires the application of two rules, viz.,
 the principle of equi-marginal returns whereby
individuals maximize satisfaction by spending their
income on different goods in such a way that marginal
utility from each type of expenditure is equal and
 the principle of equality between marginal social sacrifice
and marginal social benefit.
• This is illustrated in figure 4.3 where the size of the
budget i.e. the amount of public expenditure or, for that
matter, taxation is measured horizontally and marginal
utility, i.e. benefit from public expenditure or marginal
disutility, i.e. sacrifice from taxation is measured
vertically.
Principle of Maximum Aggregate
Benefit
 Principle of Maximum Aggregate
Benefit
• Marginal social benefit and marginal social sacrifice are
shown by the curves EEl and TTl respectively. The net
benefit is shown by NN1 curve.
• Thus, when the amount of public expenditure or taxation
increases from OC to OL, marginal social benefit from
expenditure is reduced from AC to KL, while marginal
social sacrifice of taxation increases from CD to LM.
• At OL amount of expenditure, MSB (Marginal Social
Benefit) and MSC (Marginal Social Cost) are equal
because KL = LM.
• It is here that optimum size of budget is determined and
maximum aggregate benefit is secured to the society.
 Principle of Maximum Aggregate
Benefit
• The theory, though excellent in outlook, is not
practically applicable.
• There is neither a scientific measure for MSB
and MSC nor a convincing method of
constructing utility graphs without assuming the
impracticable inter-personal utility comparison.
• However, the theory has enough materials to
guide the public authority in the direction of
achieving greatest good of the greatest number.
 Bowen's Model of Public Expenditure

 Since social goods, by definition, are those goods and

services which are consumed equally by all, the cost of
supplying them have to be contributed by all beneficiaries.
 How much amount of social goods is to be supplied by the
public authority will be determined at that level where
marginal cost of supplying the social goods becomes equal
to the sum of marginal utilities received by the
beneficiaries.
 Assuming that there are only two individuals in society,
viz., A and B and only one type of public goods, called X,
the following condition will hold for the determination of
public expenditure or, what it means the same thing, the
amount of social goods to be supplied by the government
 Bowen's Model of Public Expenditure

MUA + MUB= MCx

Or Px­A + Px­B = MCx, Hence, TCx = QPx­A + QPx­B,

• where MU stands for marginal utility derived from

social goods, MC stands for marginal cost of supplying
social goods, A and B are consumers, X stands for the
social good supplied, P stands for price to be paid by
the consumer, Q indicates quantity of social goods and
TC stands for total cost of supplying the quantity.
 Bowen's Model of Public Expenditure

• The demand schedules for social goods of A and B

are shown by the lines aa and bb respectively. The
line tt shows the aggregate demand schedule of
both A and B.
• Let SS be the supply schedule of social goods
which are assumed to be produced under conditions
of increasing cost.
• Since the same amount of social good will be
consumed by both A and B, the aggregate demand
schedule, tt is made up of vertical addition of aa
and bb.
Bowen's Model of Public Expenditure
 Bowen's Model of Public Expenditure

• The equilibrium output will be determined at OQ

because it is at this level of production that the aggregate
demand schedule and aggregate supply schedule intersect
at point P, where the equilibrium price will be PQ.
• This is the combined unit price which will be
contributed by both A and B. Of the unit price PQ, A
contributes QN and B contributes QR, their respective
demand prices.
 Bowen's Model of Public Expenditure

• If the output is less than this, say, OC, the

demand price or the combined contribution will
be much larger (CG) than the supply price (CE).
• Since the combined offer price exceeds the unit
cost, this will lead to increase in supply of social
goods.
• If, on the other hand, supply is more than OQ,
say, OD, the unit cost (DK) exceeds the
combined offer price (DL). This will lead to
reduction in supply of social goods. In this way,
equilibrium output is established at OQ.
 Bowen's Model of Public Expenditure

• At OQ level of output, the marginal cost of supplying

social goods is PQ which is equal to the sum of QN
and QR, the marginal utility to B and A respectively.
The total cost of supplying OQ amount of social
good equals OQPU which is covered by A's
contribution OQRV plus B's contribution OQNW
since OQRV + OQNW = OQPU.
 Lindahl’s Model of Voluntary
Exchange
• The voluntary exchange model of public expenditure theory
is concerned with what Erik Lindahl calls 'purely fiscal'
problem of providing for the satisfaction of public wants.
• It does not concern itself with the problem of just
distribution of income. This is taken as given.
• The determination of public expenditure and taxation is to
be made on the basis of individual preferences.
• For this purpose, says Lindahl, three sets of decision are
necessary, i.e. the determination of total amount of public
expenditure and taxes, allocation of total public expenditure
among various social wants, and allocation of total taxes
among various individuals. All these have to be done
simultaneously.
 Lindahl’s Model of Voluntary
Exchange
• if 'A', the purchaser of his benefit share, is willing
to contribute x percent of the total joint cost, B will
be called upon to contribute the rest, i.e. (1-x)
percent for purchasing his own benefit share.
• Thus, one will have to pay more if the other
contributes less so that the joint contribution of both
A and B covers total cost of supplying the social
good.
• It follows that A's offer to contribute certain
percentage of total cost may be looked upon as B's
supply schedule of social goods; and B's offer may
be similarly interpreted from the view point of A.
 Lindahl’s Model of Voluntary
Exchange
• We measure quantity of social goods along horizontal
axis, percentage of total cost contributed by 'A' along
left vertical axis and percentage of total cost
contributed by 'B' along right vertical axis.
• The total unit cost of supplying social goods is OV.
The curve aa is the demand schedule of individual 'A'.
• The demand schedule of individual 'B' is given by the
curve bb, calculated by inverted scale on the right axis.
• The demand schedule of 'A' may be viewed as supply
schedule of 'B' and the vice versa
 Lindahl’s Model of Voluntary
Exchange

• A' will be willing to contribute 100 percent of cost

for output OD, which will be available free to 'B'.
• At the output level OG, individual 'A' is willing to
contribute 75 percent of the cost (GS) and, hence,
the output is available to 'B' at 25 percent of cost
(RS) since the vertical distance between upper
horizontal axis and B's supply schedule at this level
of output is RS percent.
• However, B will be willing to contribute 50 per cent,
i.e. RT because T is the point on his demand
schedule.
 Lindahl’s Model of Voluntary
Exchange
• Thus, the total contribution of both A and B will
exceed the cost of supplying the social good by ST
percent (25 percent).
• This is an indication of their preference for larger
scale of social goods.
• The optimum level of social goods is given by' OE at
which' A' contributes EQ percent and B contributes
PQ percent of cost and, hence, the combined
contribution is exactly equal to the total cost of
supplying this level of output.
Lindahl’s Model of Voluntary
Exchange
 Lindahl’s Model of Voluntary
Exchange
• If, now, 'A' contributes KC Percent and 'B' contributes NC
percent so that OK amount can be supplied, both will be
paying larger than what they are willing to pay.
• Hence both 'A' and 'B' will vote for smaller amount of social
goods. In the same way it can be shown that both the
individuals will vote for larger amount of social goods at the
-level of supply lesser that the optimum scale of OE output.
• We assumed in the beginning a single type of social goods
and two tax payers only in order to simplify the solution. If
we now relax these assumptions and allow for a number of
social goods and many tax payers, the theoretical validity of
the model will not be affected though some complexity will
arise.
 Samuelson's Benefit theory of
Public Expenditure
• Application of market principle to the pricing of
social goods to determine optimum allocation of
resources becomes the starting point of
Samuelson's theory.
• In the case of a private good, marginal utility and
marginal cost are equal for all consumers.
• Since utility schedules of individuals are
different, such equality and, hence, efficient level
of output will be attained with different
consumers consuming different amounts of
output at the same price.
 Samuelson's Benefit theory of Public
Expenditure
• It follows that the aggregate demand schedule will be the
horizontal summation of individual demand schedules.
• However, in the case of public goods which are, by definition,
consumed equally by all, different individuals will pay
different prices for the same quantity of output.
• Here the sum of marginal utilities to consumers will be equal
to the marginal cost.
• It follows that the individual demand schedules will be
vertically added in this case. Thus, under such circumstances,
“even if all preferences are revealed, there is no single best
solution analogous to the pareto optimum in the satisfaction of
purely private wants. Instead, we are confronted with large
number of solutions, all of which are optimal in the Pareto
sense.”
Musgrave's Optimum Budget Theory
• The Optimum Budget theory of Musgrave seeking to
determine the optimum amount of public expenditure
is a normative approach to budget policy.
• Musgrave built up an ideal theory according to which
a budget should realize three objectives, viz, proper
allocation of resources, proper distribution of
income, and price level stability with full
employment.
• For each of three objectives, Musgrave would
consider a sub-budget. When these three sub-budgets
are prepared according to their objectives, they will
be consolidated into a single whole budget plan.
Musgrave's Optimum Budget Theory
• The optimum budget theory seeks to achieve the purpose of
allocation branch of the budget.
• Musgrave's theory of determination of optimum public
expenditure in the allocation branch of the budget is based on
benefit approach.
• The people have a choice pattern or preference schedule
between public goods, private goods and leisure. Leisure is a
component of welfare because leisure can be transformed
into production of goods and services of earnings of income.
• Optimum budget theory seeks to allocate public expenditure
or provide for public goods in such a manner and, to that
extent, whereby the community, as a whole, is able to derive
the greatest attainable satisfaction.
Musgrave's Optimum Budget Theory

• This is possible when allocation of public expenditure in

different lines of state activity is so determined in the budget
that the community is able to reach the highest possible
indifference surface as between public goods, private goods
and leisure.
• Practical difficulty, however, lies in the fact that the people
cannot be made to reveal their preference pattern and that it
is difficult, if not impossible, to construct community
indifference surface from individual indifference patterns.
 Control and Accountability of Public
Expenditure
• “It means that expenditures are justified in terms of
the whole welfare of society and in terms of the
financial means at the disposal of government.
• Control implies that expenditures are economic by
which we mean that resources not unlimited in
quantity are devoted to their most productive uses.”
• Control of public expenditure is sought to be
ensured multi-dimensionally at a number of stages.
The most important means of control are budgetary
control, legislative control, executive control, audit
control, and parliamentary control.
 Control and Accountability of Public
Expenditure
a) Budgetary Control. Budget preparation is the most
primary stage of expenditure control. Budget is a well-
thought-out plan of governmental activities during the
coming year and speaks of much more than a mere
statement of income and expenditure of public authorities.
• It specifies the functions and objects of public
expenditure.
• How much of the public funds is to be spent for which
particular purpose, and which particular department,
• what should be attainment of physical targets against the
specific expenditure amount and
• what should be the allocation of funds for the use of a
particular department are all specified in the budget frame.
 Control and Accountability of Public
Expenditure
b) Legislative Control. After the budget plan is prepared, it
has to be presented in the legislature for its approval.
There occurs debate in the legislature where the members
seek clarification and justification of expenditure
programmes.
(c) Administrative Control. The rules and regulations
ensure that no amount is spent without proper sanction or
diverted to some other purpose for which it is not
sanctioned. There is elaborate body of rules to fix
responsibility on specific executive personnel for the
funds spent. The rules ensure that there is no fraud or
misuse or misappropriation or any other kind of leakage
during the execution of public expenditure programmes.
 Control and Accountability of Public
Expenditure

• (d) Audit Control. The next stage is scrutiny

of accounts and audit control. There is the
system of both internal and external audit.
Every department has its accounts section
which scrutinizes all accounts of expenditure
and ensures that public funds are spent
according to rules of propriety, economy and
efficient utilization.
 Control and Accountability of Public
Expenditure

(e) Parliamentary Control. The last of these stages of

expenditure control is the parliamentary right to enquire into
any particular item of expenditure deal.
• There are two committees constituted by the parliament to
go into such scrutiny. They are (i) Public Accounts
Committee and (ii) the Estimates Committee.
• Public accounts committee is entrusted with the
responsibility of examining audit reports and appropriation
accounts. They also examine profit and loss accounts of
government undertakings and autonomous bodies. They
follow up cases of impropriety, unauthorized and illegal
expenditure, misuse and misappropriation and go into further
investigation if necessary.
 Control and Accountability of Public
Expenditure

• Estimates committee locks into the financial operation

of the executive and suggests measures to achieve
maximum economy of expenditure consistent with
maximum efficiency.
• The parliamentary committees pinpoint the erring
officials, examine them and suggest follow-up
measures for suitable punishment to them.
 Effects of public expenditure on production
and distribution

Effects on Production and Employment

• The level of production and the level of
employment in any country depends upon
three factors:
 Ability of the people to work, save and invest,
 Willingness to work, save and invest, and
 Diversion of economic resources as between
different uses and localities
 Effects on Production and
Employment
• Ability to Work, Save and Invest.
• If public expenditure can increase the efficiency of a person
to work, it will promote production and national income.
Public expenditure on education, medical services, cheap
housing facilities and recreational facilities will increase the
efficiency of persons to work.
• At the same time, public expenditure can promote income of
the people.
• Finally, public expenditure, particularly repayment of public
debt, will place additional funds at the disposal of those who
can invest. Thus, it will be seen that public expenditure can
promote ability to work, save and invest and thus promote
production and employment.
 Effects on Production and
Employment
• Willingness to Work, Save and Invest. The effects of
public expenditure on the willingness-as different from
ability to work and save and invest on production are
not clear enough.
• Pensions, interest on loans, provident fund and other
government payments provide security and safety to a
person, and therefore, reduce the willingness of persons
to work and save;
• why should a person work hard and save when he
knows well that he will be looked after by the
government when he is not in a position to earn an
income?
 Effects on Production and
Employment

• Diversion of Economic Resources. Public expenditure has far-

reaching effects on the utilization of economic resources as
between alternative uses.
• Public expenditure can bring about a better allocation of
economic resources as between the present and the future.
• In a free capitalist society very, little provision is made for the
future. This is because people prefer the present rather than the
future and, therefore, they do not make adequate provision for
the future.
 Effects on Production and
Employment

• The State on the other hand, is the custodian of the

interests of the future generations also and, therefore,
has to see that adequate provision is made for the
future.
• Public expenditure on transport, irrigation and other
projects which yield both immediate return as well as
social and economic benefits for generations to come,
are some examples.
 Effects on Production and
Employment
• Secondly, the government spends money in the
conservation of economic resources which are very
essential for the future.
• Thirdly, the government spends money for
encouragement of research and invention, promotes
education and training, looks after public health and
sanitation and also takes the responsibility of social
security measures.
• It is necessary to emphasize that the diversion of
economic resources in all these ways will greatly
increase production.
 Effect of public expenditure on
distribution of income
• Public expenditure (as part of fiscal policy)
can be used by the government to achieve this
aim.
• While taxes, particularly progressive direct
taxes, have the effect of reducing the incomes
and wealth of the higher income groups,
public expenditure has the effect of raising the
incomes of the lower income groups.
 Effect of public expenditure on
distribution of income

• Government's expenditure on education, public health

and medicine, housing, etc., is directed to help the poor
and the lower income classes (who make use of
government schools and hospitals).
• At the same time, social security schemes are run by the
government for the benefit of the working classes so
that they may be protected from unemployment,
accidents, sickness and old age.
 Public Expenditure and Control of
inflation

• The most serious type of inflation has always been due to enormous
government expenditure. This type of situation may be due to war
when large sums are spent for military purposes or due to
preparations for war during peace time.
• However, the government can suitably change and adjust its
expenditure during an inflationary period so that the inflationary
pressure may be reduced.
• For instance, all those schemes which may be justified during a
period of depression and low level of employment may be omitted
during an inflation.
 Public Expenditure and Control of
inflation

• At the same time, the government can postpone the

construction of social capital such as post offices,
schools, etc., which will increase the size of income of
people but will not contribute to the increase of goods.
• Secondly, the government can give subsidies to those
industries which are producing inflation-sensitive
goods so as to accelerate their production or to enable
producers to sell them at lower prices.
Content of Development Expenditure

• Development expenditure of the government should aim at

stimulating and supplementing private initiative and
enterprise.
• It is possible-and some governments of developing countries
have attempted to do so-to eliminate the private sector
altogether and plan for the entire economy as a whole. There is
some advantage in that. But many may not like a communist
pattern of economic development which is rapid, of course,
but may prove to be nevertheless ruthless and inhuman
Content of Development Expenditure

• In a democratic setup, with parliamentary

institutions, emphasis will have to be not on the
elimination of the private sector but the setting up
of a mixed system in which private enterprise will
be given active encouragement and, at the same
time, the government will become an interested
and active participant in development activities.
Content of Development Expenditure

a. Stimulating private initiative. Development

expenditure of the government will take the form
of stimulating private initiative and enterprise.
 Direct stimulation is done by the Government
helping the private sector through loans, subsidies,
tax concessions and exemptions and providing
market and other information and research facilities.
Content of Development Expenditure

b. Provision of social and economic overheads.

• Indirect stimulation of the private sector may be done
by the government through the provisions of social and
economic overheads -education and public health will
come under the first head, and provision of power,
transportation, communication, etc., will come under
the second head.
• The private sector industries would reap enormous
benefits of economies of production from these
facilities provided by the government. Social and
economic overheads are neces­sary and essential
prerequisites for economic growth.
Content of Development Expenditure

c. Public enterprises. The government will have to

start and run such undertakings which the private
sector may be unwilling to undertake, either because
profit margins are low or almost nothing, or because
they require huge capital investment and a long time
to yield returns.
 These enterprises may not be appealing to the
private sector from the commercial point of view
but may be of great significance from the point of
view of economic welfare of the community as
well as that of economic progress.
Content of Development Expenditure

• In this group will come all the key and basic

industries, development of irrigation resour­ces,
electric power, etc. In fact, any industry which is
necessary for the country and which will help in the
growth of the economy can be taken up by the
government. The idea, however, is not to compete
with the private sector but really to supplement and
complement it.
ANY QUESTIONS?