Principles Of Public Finance

(Notes for Final Exams by Muhammad Ali)

Meaning of Public Finance

Public finance is the branch of economics. It is made of two words as public and
finance. The term public means government and finance means science of
management of money. So literally public finance means the study of allocation of
economic resources for achieving the goals of public affairs. Thus, public finance
is the study of allocation and management of resources and technology for
achieving the goals of public organization.

What is Public Finance?

Public finance is the management of a country’s revenue, expenditures, and debt

load through various government and quasi-government institutions.
A country’s financial position can be evaluated in much the same way as a
business’ financial statements.
 Definition Of Public Finance

Public Finance is the way of managing the public funds in the economy of the
country which plays the most important role in the development and growth of the
nation both domestically as well as internationally and it also affects every
stakeholder of the country whether that stakeholder is a citizen or not.

Components of Public Finance

The main components of public finance include activities related to

collecting revenue, making expenditures to support society, and implementing a
financing strategy (such as issuing government debt). The main components
include:

Tax collection

Tax collection is the main revenue source for governments. Examples of taxes
collected by governments include sales tax, income tax (a type of progressive tax),
estate tax, and property tax. Other types of revenue in this category include duties
and tariffs on imports and revenue from any type of public services that are not
free.

Budget

The budget is a plan of what the government intends to have as expenditures in a

fiscal year. In the U.S., for example, the president submits to Congress a budget
request, the House and Senate create bills for specific aspects of the budget, and
then the President signs them into law.

Expenditures
Expenditures are everything that a government actually spends money on, such as
social programs, education, and infrastructure. Much of the government’s spending
is a form of income or wealth redistribution, which is aimed at benefiting society as a
whole. The actual expenditures may be greater than or less than the budget.
 Deficit/Surplus

If the government spends more then it collects in revenue there is a deficit in that
year. If the government has less expenditures than it collects in taxes, there is a
surplus.

National Debt

If the government has a deficit (spending is greater than revenue), it will fund the
difference by borrowing money and issuing national debt.

Managing Public Finance

Let’s take a closer look at how taxes, expenditures, and the deficit work. Below is
a diagram of how the three are connected, and how the government determines
how much financing it needs in a given fiscal year.

Total government revenue or tax collection is represented by the blue bar. This is
a source of cash for the government.

Expenditures are a use of cash, and to the extent that they are greater than
revenue, there is a deficit.

The difference between revenue and expenditures is the deficit (or surplus) that
is funded with national debt.
 Objectives of Public Finance

Managing Public Needs

The basic objective is managing the basic needs of the public like food, shelter,
health, infrastructure, and education. All this is the responsibility of the
government so that the basic public needs and be fulfilled and public and
contribute to the development of the economy.

Economic Development

Proper management leads to economic development, which leads to the growth of

the nation.
 Removes Inequality

It also aims at removing the inequality by proper allocation of resources i.e.,

providing the relief to the poor by collecting the taxes from the rich class people.

Maintaining Price Stability

It helps in controlling the inflation by various packages and means for the
development of the nation at large.

Other objectives

1. Fulfilling the basic needs of the nation.

2. Generating employment.
3. Maintaining the currency value in the international market.

The scope of Public Finance

Prof. Dalton classifies the scope of public finance into four areas as follows –

Public Income
As the name suggests, public income refers to the income of the government. The
government earns income in two ways – tax income and non-tax income. Tax
income is easy to recognize, it’s the tax paid by people of the country in the form
of income tax, sales tax, duties, etc. On the other hand, non-tax income includes
interest income from lending money to other countries, rent & income from
government properties, donations from world organizations, etc.

This area studies methods of taxation, revenue classification, methods of

increasing government revenue and its impact on the economy as a whole, etc.

Public Expenditure
Public expenditure is the money spent by government entities. Logically, the
government is going to spend money on infrastructure, defense, education,
healthcare, etc. for the growth and welfare of the country.
 This area studies the objectives and classification of public expenditure, effects of
expenditure in different areas, effects of public expenditure on various factors such
as employment, production, growth, etc.

Public Debt

When public expenditure exceeds public income, the gap is filled by borrowing
money from the public, or from other countries or world organizations such as The
World Bank. These borrowed funds are public debt.

This area of public finance explains the burden of public debt, why it is necessary
and its effect on the economy. It also suggests methods to manage public debt.

Financial Administration
As the name suggests this area of public finance is all about the administration of
all public finance i.e., public income, public expenditure, and public debt.
Financial administration includes preparation, passing, and implementation of
government budget and various government policies. It also studies the policy
impact on the social-economic environment, inter-governmental relationships,
foreign relationships, etc.
 Functions of Public Finance
There are three main functions of public finance as follows:

The Allocation Function

There are two types of goods in an economy – private goods and public goods.
Private goods have a kind of exclusivity to themselves. Only those who pay for
these goods can get the benefit of such goods, for example – a car. In contrast,
public goods are non-exclusive. Everyone, regardless of paying or not, can benefit
from public goods, for example – a road.

The allocation function deals with the allocation of such public goods. The
government has to perform various functions such as maintaining law and order,
defense against foreign attacks, providing healthcare and education, building
infrastructure, etc. The list is endless. The performance of these functions requires
large scale expenditure, and it is important to allocate the expenditure efficiently.
The allocation function studies how to allocate public expenditure most efficiently
to reap maximum benefits with the available public wealth.

The Distribution Function

There are large disparities of income and wealth in every country in the world.
These income inequalities plague society and increase the crime rate of the
country. The distribution function of public finance is to lessen these inequalities
as much as possible through redistribution of income and wealth.

In public finance, primarily three measures are outlined to achieve this target –

• A tax-transfer scheme or using progressive taxing, i.e. in simpler

words charging higher tax from the rich and giving subsidies to the
low-income
• Progressive taxes can be used to finance public services such as
affordable housing, health care, etc.
• A higher tax can be applied to luxury goods or goods that are
purchased by the high-income group, for example, higher taxes on
luxury cars.
 The Stabilization Function
Every economy goes through periods of booms and depression. It’s the most
normal and common business cycles that lead to this scenario. However, these
periods cause instability in the economy. The objective of the stabilization function
is to eliminate or at least reduce these business fluctuations and its impact on the
economy. Policies such as deficit budgeting during the time of depression and
surplus budgeting during the time of boom helps achieve the required economic
stability.

Following are the other functions:

Management of income and expenditure by optimum utilization of the

resources.
Managing the growth and price stability in the economy.
Providing the necessary needs and infrastructure to the public.
Take initiatives for the development of the public, which can contribute to
the development of the nation.
Maintaining the transparency of the policies and the records of income and
expenditures.
Compare the actual position with the budgets and accordingly alter the
policies and manage the economy.
Monitor the functioning and effectiveness of the financial policy.
Preparing the financial policies for the development of the nation and the
economy at large.

Objectives of Public Finance

Public finance strives to achieve societal benefits like higher growth, wealth
creation and sharing, factors controlling stability of income, property and economy
etc. The objectives of public finance are achieved by managing and drafting
policies pertaining to key areas such as taxation, management of public revenue
and expenditure, raising and servicing public debt, fiscal administration at various
levels.

Public finance is required at all social levels considering different levels of

government, management and analysis with an eye on key focus areas:
 Financial Management

Collection of revenues from public and arranging the required finance together
with allocation and use of public funds in an efficient and effective manner is
the essence of public Finance Management.

Revenue Management

Government revenues are from both tax and non-tax sources. Effective
measures to increase revenue base and improvising revenue collection is
important for effective management of public finance.

Expenditure Management

Appropriating and usage of all the expenditures in a proper manner reflects the
effectiveness of proper development and maintenance of the project as well as
society. Misappropriation of funds by means of inflating bills, unnecessary
expensing, allocating funds for discretionary expenses are common while
spending public commingled funds.

Fiscal Policy Amendments

Government finances are mostly burdened by budget deficits and continuous

leverage slows down current as well as future growth. Therefore, amendments
to fiscal policies are necessary to rationalize and prioritize Government
operations for a sustainable economic growth.

Regulatory Changes

Continuous scrutiny and changes to underlying regulations is required to

achieve and check targeted development.
 Public Policy

Implementing and laying down sound policies is important for development of

public as well as private sectors.

Public Debt Management

All debts either raid raised by the Government or for public projects has direct
costs associated inform of interest as well has associated opportunity costs,
which burdens the expenses. Effective management of public debt through
restructuring and rationalization is required to control financing costs.

Process Improvement

A systematic approach is required to help Governments and public bodies to

carry the operations and processes swiftly to achieve maximum societal
benefits.

Management of Information System

Powerful IT system is required in today’s world as correct information supports

effective and corrective decision making.

Capacity Creation

Adequate capacity to serve requirements in times of stress and considering

future needs is required at institutional as well as individual level.

Interdepartmental Synchronization

To run a society efficiently and ensuring maximum benefits requires

synchronization and alignment of working various departments all together.
 Types of Public Finance

Public Revenue

Public revenue is the collection of money from the public by way of direct and
indirect taxes, penalties, fines, fees, maintenance, etc.
 Public Expenditure

Public expenditure is the expenditure for the public like infrastructural facilities,
basic health facilities, medical and educational facilities, etc.

Public Debt

When the expenditure exceeds the revenue, the government will take the help of
debt to fulfill the needs of the country and to run the economy.

Financial Administration

Financial Administration is managing the public finance as well as managing the

needs of the government like salaries to the public electives, expenditure on
maintenance of public heritage, etc.

Importance/Significance of Public Finance

It carries the utmost importance in the following ways:

✓ The proper management of public finance ensures the growth of the

nation.

✓ It encourages investment through various policies and packages.

✓ Preparation, implementation, and change with change in the technology
the policies framed by the government for the development of the
economy at large.
✓ It helps to maintain price stability, reduce inflation and unemployment.
✓ It is also important in terms of allocating natural as well as human
resources.
 Difference Between Private and Public Finance

Comparison Chart

BASIS FOR
PRIVATE FINANCE PUBLIC FINANCE
COMPARISON

Meaning Private finance is the Public finance is concerned

study of income and with the revenue/incomes
expenditure, borrowings, and expenditure, borrowings,
etc. of individuals, etc. of the economy or
households and government.
business firms.

Adjustments Individuals adjust their Government adjust the

spending as per their income, according to the size
income. of expenditure on different
segments.

Objective To maximize profit. To promote social welfare.

Nature of Budget An individual attempts to The government prefers a

maintain a surplus deficit budget.
budget.

Financial Transactions are kept Transactions are open and

Transaction secret. known to all.

Time Horizon No fixed period One year

Elasticity Less Comparatively more

The difference between private and public finance can be discussed in the points
below:

1. Public Finance refers to that branch of finance which studies government

financial dealings, including government spending, borrowing, deficits and
taxation. On the flip side, by Private Finance, we mean the study and
analysis of the income, expenditure, and debt of private individuals, firms
and household.

2. In public finance, the government ascertains the total expenditure to be made

on different sectors first and then identifies the sources from which the
revenue can be generated to meet those expenses. On the contrary, in the
case of private finance, any individual, household, or business enterprise
decides the quantum of expenditure to be made, on the basis of his/her
income.

3. The main objective of private finance is to manage the finances in such a

way which helps in earning maximum profit. As against, the primary
objective of public finance is the welfare of the general public.

4. In private finance, the individual seeks to maintain a surplus budget by

spending only a certain portion of his income. On the contrary, in public
finance, the government usually frames a deficit budget, during the phase of
economic development, war or depression.

5. In private finance, the individual’s income and his/her expenditure is his /her
own affair, and so it can be kept secret. Conversely, in public finance, the
government uses public money, for providing public utility services, that is
why it cannot be kept secret.
 6. Public finance is related to the yearly budget of the government, which is
fixed, but private finance is related to daily, weekly or monthly budget of an
individual or household.

7. Public finance is relatively more elastic than private finance because an

individual cannot make sudden and huge changes in his income, but the
same is possible in case of public finance.

Difference Between Fiscal Policy and Monetary Policy

There are two types of fiscal policy:

Expansionary Fiscal Policy: The policy in which the government minimizes

taxes and increase public spending.

Contractionary Fiscal Policy: The policy in which the government

increases taxes and reduce public expenditure.

There are two types of monetary policies:

Expansionary Monetary Policy: The policy in which the money supply

is increased along with minimization of interest rates.
 Contractionary Monetary Policy: The policy in which there is a
decrease in money supply and rise in interest rates.

Comparison Chart

BASIS FOR
FISCAL POLICY MONETARY POLICY
COMPARISON

Meaning The tool used by the The tool used by the

government in which it uses central bank to regulate
its tax revenue and the money supply in the
expenditure policies to affect economy is known as
the economy is known as Monetary Policy.
Fiscal Policy.

Administered by Ministry of Finance Central Bank

Nature The fiscal policy changes The change in monetary

every year. policy depends on the
economic status of the
nation.

Related to Government Revenue & Banks & Credit Control

Expenditure

Focuses on Economic Growth Economic Stability

Policy Tax rates and government Interest rates and credit

instruments spending ratios

Political Yes No
influence
The following are the major differences between fiscal policy and monetary policy:

1. The policy of the government in which it utilizes its tax revenue and
expenditure policy to influence the aggregate demand and supply for
products and services the economy is known as Fiscal Policy. The policy
through which the central bank controls and regulates the supply of money
in the economy is known as Monetary Policy.

2. Fiscal Policy is carried out by the Ministry of Finance whereas the Monetary
Policy is administered by the Central Bank of the country.

3. Fiscal Policy is made for a short duration, normally one year, while the
Monetary Policy lasts longer.

4. Fiscal Policy gives direction to the economy. On the other hand, Monetary
Policy brings price stability.

5. Fiscal Policy is concerned with government revenue and expenditure, but

Monetary Policy is concerned with borrowing and financial arrangement.
6. The major instrument of fiscal policy is tax rates and government spending.
Conversely, interest rates and credit ratios are the tools of Monetary Policy.

7. Political influence is there in fiscal policy. However, this is not in the case of
monetary policy.
 Difference Between Public Goods and Private Goods
Difference and Comparison

BASIS PUBLIC GOODS PRIVATE GOODS

Meaning Public goods are the ones Private goods are the ones

which are provided by the which are manufactured and

nature or the government sold by the private companies

for free use by the public. to satisfy the consumer needs

and wants.

Provider Nature or government Manufacturers i.e.,

entrepreneurs

Consumer Rich and poor are treated Preference to rich consumers

equality equally

Availability Readily available to all Reduces with each

consumption

Quality Remains constant Varies with ability to buy

BASIS PUBLIC GOODS PRIVATE GOODS

Decision Social choice Consumer's decision

Objective Overall growth and Profit earning

development

Traded in No Yes

Free Market

Opportunity No Yes

Cost

Free riders’ Yes No

problem

Rivalry Non-rival Rival

Excludability Non-excludable Excludable

BASIS PUBLIC GOODS PRIVATE GOODS

Demand Horizontal Vertical

Curve

Examples Police service, fire Clothes, cosmetics, footwear,

brigade, national defense, cars, electronic products and

public transport, roads, food

dams and river

Private Goods
The products which are rival and excludable at the same time as clothes,
cosmetics and electronics are termed as private goods.

Private goods are the products or services which are manufactured or produced by
the companies owned by entrepreneurs who aim at meeting customer’s
requirement to earn profits through the trading of such goods in the free market.

Characteristics of Private Goods

Private goods serve the personal needs of consumers. Following are the
various characteristics of these goods:
 • Rival: The private products involve rivalry or competition
among the consumers for its usage since the consumption by
one person will restrict its use by another.
• Excludable: These goods involve cost, and therefore the non-
payers are excluded from the consumption.
• Rejectable: Private goods can be unaccepted or rejected by
the consumers since they have multiple alternatives and the
right to select the product according to their preference.
• Traded in Free Market: Such goods can be freely bought
and sold in the market at a given price.
• Opportunity Cost: These goods have an opportunity, i.e., the
consumer has to let go of the benefit from a similar product
while selecting a particular private commodity.

Advantages of Private Goods

These goods have a mutual benefit for the manufacturers and the consumers; both
serve their purpose through the selling and buying of such products respectively.
Private goods are essential to carry on trade activities for economic development.
Such goods restrict the consumption by the people who do not have buying
capacity, thus limiting its usage by the rich in other words it discourages the free-
riders.

Public Goods
The goods which are non-rival and non-excludable at the same time, for
instance, road, bridge and dams are called public goods.

Public goods are the commodities or services provided by the nature of the
government of a country, free of cost or by taxing the few people to offer
mass benefit to the public in general.

Characteristics of Public Goods

These commodities or services develop the infrastructure and living standard of a
country. To know more about public goods, let us go through its following
features:
 o Non-Rival: The public goods are non-competitive, i.e. it can serve
many people at the same time without hindering the usage of one
another.
o Non-Excludable: These goods are usually free of cost and can be
used by anyone without any restriction.
o Non-Rejectable: The consumption of such goods cannot be
dismissed or unaccepted by the public since it is available collectively
to all the people.
o Free-Riding: The goods categorized under public goods benefit even
those who have not paid for it. Such people are termed as free-riders.

Advantages of Public Goods

Public goods carry the mass benefit for the people. They have a broader
perspective. These goods can be used by many people or the public simultaneously.
These are usually free of cost and can be utilized by the rich and poor equally.
The primary objective of such goods is to provide essential amenities to the public
in general, along with promoting social welfare and development of the nation as a
whole.

Purpose Of Taxation

Taxation is a form of financing of government activities in almost every country.

The International Centre for Tax and Development (ICTD) estimates that 80% of
overall government funding in half of the countries around the world is accounted
for by tax revenues. Governing authorities are able to increase taxation levels by
changing taxation rules and expanding tax bases.

Primarily, the revenue collected is utilized for the welfare of taxpayers; this means
that the specific benefit received is independent of the individual payment.
However, there are some exceptions, such as payroll taxes, where the taxpayer will
directly benefit from medical coverage and retirement benefits.

Taxation patterns differ greatly among developing and developed countries. Higher
tax revenues are collected in developed countries than in developing countries due
to efficient taxation compliance mechanisms and effective tax collection methods.

However, both of these factors are directly affected by the competency of the
political system. Generally, developed countries rely more on income taxation to
realize most of their national output, more so than developing countries who rely
heavily on consumption and trade taxes.

Types of Taxation

The following are the different types of levies imposed on residents by the
government:
 1. Income Taxes

Income taxes are levies imposed on the total financial income of an individual,
such as wages, investments, and salaries. Most income taxes increase with the rise
in the taxpayer’s earnings. This means that higher-income earners pay more taxes
than low-earners. This is also referred to as progressive taxation.

2. Corporate Taxes

Corporate income tax is levied on business income. The burden of corporate tax is
shared between the business, its consumers, and the employees through setting
higher prices and paying low wages. To encourage business growth, most
governments levy businesses a corporate tax rate of below 30%.

3. Payroll Taxes

Payroll taxes are levies imposed on employees’ income to finance social security
funds. Normally, the payroll tax amount is automatically deducted from the income
and paid by the employer on behalf of the employee.

For example, in the United States, the highest payroll taxes are 12.4% tax to
finance Social Security and 2.9% tax to pay Medicare, accounting for a 15.3% total
tax rate. In this case, the employer remits 7.65% of the tax rate, which amounts to
half of the payroll taxes. The other half is automatically deducted from the
employee’s income.

4. Capital Gain Taxes

Capital gains taxes are levied on capital assets, which include personal properties
and investments like stocks, homes, bonds, cars, or jewelry. When an asset
increases in value, such as rising stock prices, it is referred to as capital gain.

Therefore, when an individual benefits from a capital gain, tax is paid on the profit
earned.
 5. Property Taxes

Property taxes are generally imposed on physical property, such as land and
buildings. They are the primary revenue source for local state governments.
Property levies account for over 70% of local tax revenues. Property taxes finance
key public services, such as fire departments, schools, roads, security, and rapid
medical services.

Classes of Taxes

Taxes are classified into different criteria ranging from the mode of payment, the
subject bearing the tax burden, and the extent of shifting the burden.

1. Direct Taxes

Direct taxes are levies subjected to individuals based on the taxpayer’s net wealth,
expenditure, or personal net income. Levies on net worth are based on the
taxpayer’s assets value minus total liabilities, while expenditure taxes are paid on
income that is not directed to savings.

2. Indirect Taxes

Indirect taxes are taxes imposed on transactions such as imports and exports and
the production and consumption of goods and services. Examples include value-
added taxes, legal transaction taxes, manufacturing taxes, and custom taxes on
import duties.
 Non-Excludable Goods

Non-excludable goods refer to public goods that cannot exclude a certain person
or group of persons from using such goods. As a result, restricting access to the
consumption of non-excludable goods is nearly impossible.
For example, a public road allows practically everyone to use it regardless of the
type of motor vehicle they are using, or even if they are just walking.

Non-Excludable Goods Vs Excludable Goods

Non-excludable goods and excludable goods are opposites. The former means
every single person can access a certain public good and consume it, while the
latter refers to goods that restrict some people from using them. Excludable goods
are private goods, while non-excludable goods are public goods.

For example, while everyone can use a public road, not everyone can go to a
cinema as they please. To enter one, a person needs to purchase a ticket, and their
purchase of a ticket excludes someone else because seating is limited.

Non-Rivalrous Goods
Non-rivalrous goods are those goods that can be consumed by the
people and the community without affecting the availability of the same
goods to others.

For example, when a concert or government office decides to put on a

fireworks display, everybody can watch it, making the good non-rivalrous
because everyone who sees it can enjoy exactly the same fireworks
display. Besides its being non-rivalrous, it is also non-excludable. Most
public goods are non-rivalrous.

Rivalrous Goods

Rivalrous goods are private goods wherein people may compete for their
consumption of it. For example, a person who buys a car can only use it for
himself and restrict others from using it.