PUBLIC FINANCE

At the end of the lecture the students will be able to :

  • Understand the concept of Public Finance,
  • The various components of Public Finance and
  • The difference between Private and Public Finance

Background

In the previous lectures distinction was between public and private sector by explaining that public goods are non excludable (i.e. the use by one person cannot exclude other person) whereas private goods are excludable. Similarly public goods are non-divisible (the use cannot be divided) and private goods are divisible. e.g. parks and roads are non excludable and non divisible. Whereas the use of motorbike is excludable and non divisible.

In the production of goods finance is required. For example if parks are to be made available then in developing parks, finance or money is required. Similarly if motor bike is to be produced money is required by the producer. The distinction between production of public and private goods makes us think that how finances are raised by public sector. This leads us to understand public finance.

Public finance is related to the financing of government activities i.e. how government raises money to produce goods and services. It a subject discusses financial operation of the fisc or public treasury. Public finance is a subject and is taught as a semester course. But since than this is introductory course. We will only touch upon this subject in few lectures.

Public finance has undergone repeated revision in line with development in state and government activities. At one time, it was said that the role of the government was not to interfere with the market forces but to limit its activities to the barest minimum, therefore, it should perform its conventional functions of law and order, defence and collect taxes and to create infrastructural facilities like roads, bridges etc.

Concept & Definition

‘Public finance deals with the finance of the government. The finances of the government include the raising and disbursement of government fund’ or public fund.

Carl Plehm says that the term public finance has come to be confined to the study of funds raised by government to meet the cost of the government activities and responsibilities. The subject matter of public finance deals with not only the way in which public treasury operates, it also deals with the repercussions of policies adopted.

Musgrave calls the government sector as ‘public household’. The objective of this household are:

1.  Allocation of resources: It means that government will tax rich people and spend money in areas where private sector will not invest. For example private sector will not develop parks and road.

2.  Distribution of income and wealth: Government redistributes income by taxing rich and spending on welfare programme for the poor. It will reduce income inequalities in society by subsidising food items.

3.  Stabilization of prices and employment: Government will stabilize prices by controlling the prices of food items and will invest so that people are employed.

Components of Public Finance

The government operates at three levels, i.e., Federal, provincial and Local. The subject of public finance looks into financial problems and policies of government at these three levels and studies inter governmental financial relation. The area of public finance also sees that how the 3 government raise and share resources.

Following are the main components of public finance:

(1)Public revenue: sources of government income are:

a.Taxation and its effect on economy

b.Non-tax revenues such as fee, fines, grants, interest receipt etc.

c.Public debt problems: public debt is a source of income

(2)Public Expenditure: through public expenditure government participates and contributes to the financial flows of the economy. It is also a tool for implementing welfare and other policies. The expenditure that government makes affects the economics because government expenditure is inflow to the economy.

(3)Financial Administration: It involves issues of financial administration including public budget, its approval, financial implementation, control systems and audit. Without the study of financial administration the subject of public finance remains incomplete.

(4)Federal finance: It studies the multilayer (the 3 levels of government) system of government which necessitates a division of function and resources between the layers of government and inter-governmental relations. We will deal with each of these areas separately.

Similarities & Dissimilarities between Public and Private Finance

Private finance means the financial problems of individual economic unit, i.e., a household, a shop, a firm etc. Private finance does not form part of government. We will look at the similarities and dissimilarities to develop analytical framework for public finance.

Similarities

Modern economies are monetized, that is goods and services are exchanged through a medium of money. In other words both public & private sector create and use financial claims. Both are engaged in activities that involves purchase, sales and other transactions. Both are thus engaged in production of goods and service, exchange goods & services, save capital and invest capital to further create money.

In order, to finance its operations and invest in projects government creates money (which is a financial asset), raises loans, makes payment, etc. Similarly, private economic unit lends, borrows, receive payments, make payments, etc. In this respect both are quite similar. So both sectors are engaged in satisfying wants of society. Both have limited resources at their disposal and try to maximize decisions. But the similarities are few.

Dissimilarities

The dissimilarities are many and are discussed one by one in the following paragraph:-

  1. Private economic unit has to live within its means and its borrowing capacity is less then government. Its deficit budgeting can be only for limited time period. It can accumulate outstanding debt liabilities up to a certain amount. But the government can add to its outstanding debt with every budget by borrowing from the banking sector or by floating bonds and bills. A number of governments resort to instrument like bond and treasury bills to raise money.
  2. It is not only the amount of borrowings over which government has control but also the forms, interest paid on loans and other terms that government dictate. Government can borrow both internally and externally i.e., from domestic banking sector and from international banking & financial sector. The high creditworthiness of government enables it to borrow at lower rates because it has the support of the Central Bank which serves as an agent and underwriter when loans are floated in the market.
  3. The government can create legal tender currency. That is it has the power to add to currency supply. Governments have control over Central Bank & mints, therefore, the government decides how much money has to be supplied to economy. Although there are formal technical restriction to the supply of money, that is how much currency supply should be added, but restriction can be waived if the government so wants.
  4. The private finance follows the ‘market principle’ or the principle of economic rationality but the public finance follows the ‘budget principle’. The market principle is that private sector will invest where there are profits. On the other hand budget principle means that investment will be made not on the basis of profit but on the basis of redistribution of resources.
  5. The government is expected to take the long term and short term view of the economy, because society is perpetual entity and for its welfare many activities are needed which have no immediate economic return. For example education does not have short term returns.
  6. The government has complete power to raise money through taxes, confiscation, borrowing and printing notes; it has to use this power carefully because over borrowing by the government from the banking sector can banking sector leave little money for the private sector. This is called ‘crowding out’. Similarly excessive taxation can discourage savings and investment.
  7. What can be said about public finance is that there are some fundamental differences between public and private finance. But it is essential to remember that public sector is part of the total economy. The activities of public and private sector affect each other because there is mutual transferring of resources.

The Economic System and Public Finance

The public sector is the important sector and it can be operated in an effective way to improve the performance of economy.

The classical economist believed that private sector was always efficient because it responded to the market signals. And that market directs where to invest money. The market directs investment where there is profit and that is the most efficient way to make decision. Classical economists were therefore, against too much interference of government. They believed that if government would start spending money in various sectors of the economy then government will have to borrow from banking sector. This would lead to budget deficit. Budget deficit in their view was not good and government should try to balance the budget.

On the other hand there is Keynsian view that government will have to invest to increase employment and wages. Government investment will also correct market failures.

The borrowing by the government will lead to budget deficit and interfere with economy. It was said that government should balance the budget.

Concepts

  • Public finance: that branch of finance that deals with raising of taxes and expenditure by government.
  • Public debt: government borrowings accumulated over a long period of time.
  • Public deficit: the excess of expenditure over income in one budget period of government i.e. one year.
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