Public Finance An Overview : Importance of Public Finance, Principle of Maximum Social Advantage, Public Goods, Revenue and Its Sources And Merits of Progressive Taxation

 Meaning Of  Public Finance

Public finance is a study of income and expenditure or receipt and payment of government. It deals the income raised through revenue and expenditure spend on the activities of the community and the terms ‘finance’ is money resource i.e. coins.

Scope of Public Finance 

The scope of public finance may be summarised as under:

1.       Public Revenue

2.       Public Expenditure

3.       Public Debt

4.       Financial Administration

5.       Economic Stabilisation

1.       Public Revenue: Public revenue concentrates on the methods of raising public revenue, the principles of taxation and its problems. In other words, all kinds of income from taxes and receipts from public deposit are included in public revenue. It also includes the methods of raising funds. It further studies the classification of various resources of public revenue into taxes, fees and assessment etc.

2.       Public Expenditure: In this part of public finance we study the principles and problems relating to the expenditure of public funds. This part studies the fundamental principles that govern the flow of Government funds into various streams.

3.       Public Debt : In this section of public finance, we study the problem of raising loans. Public authority or any Government can raise income through loans to meet the short-fall in its traditional income. The loan raised by the government in a particular year is the part of receipts of the public authority.

4.       Financial Administration : Now comes the problem of organisation and administration of the financial mechanism of the Government. In other words, under financial or fiscal administration, we are concerned with the Government machinery which is responsible for performing various functions of the state.

5.       Economic Stabilization : Now –a-day’s economic stabilization and growth are the two aspects of the Government economic policy which got a significant place in the discussion on public finance theory. This part describes the various economic polices and other measures of the government to bring about economic stability in the country.

From the above discussion, we can say that the subject-matter of public finance is not static, but dynamic which is continuously widening with the change in the concept of state and functions of the state. As the economic and social responsibilities of the state are increasing day by day, the methods and techniques of raising public income, public expenditure and public borrowings are also changing. In view of the changed circumstances, it has given more responsibilities in the social and economic field.

Importance of Public Finance

1. Increasing the growth rate of Economy – The role of public expenditure in economic development lies in increasing the growth rate of the economy, providing more employment opportunities, raising incomes and standard of living, reducing inequalities of income and wealth, encouraging private initiative and enterprise and bringing about regional balance in the economy. All these are achieved by spending on public works, agriculture: industry, transport and communications, power, financial and banking institutions, social services etc. The government is able to increase public expenditure through a budget deficit.

2. Emergence of Social Services – The importance of public finance as also increased due to emergence of social services which can be performed more conveniently, efficiently and also at the minimum cost as against individual. Such services are education, health, social security and protection from certain uncertainties. The need for such social services is increasing day by day and with them is increasing the importance of public finance.

3. Reduction in Economic Inequalities – Public finance can playa vital role in reducing economic inequalities which is the source of dissatisfaction, class-struggles, poverty etc.

The state can levy heavy taxes on richer sections of the society and thereby spend the income so received on providing food, cheap housing, free medical aid etc. for the poorer sections of the society. Similarly, heavy taxes can be imposed on the use of harmful commodities, such as harmful drugs, wine, opium, hashish etc.

4. Increases Employment – Public finance can play vital role in increasing employment which is the burning problem of almost all the countries of the world, The Governments these days establish, give grants, subsidies, grant exemption from excise duty, sales tax etc. to employment-oriented cottage and small-scale industries. Unbalanced budget is also an indispensable measure of increasing volume of employment during depression.

5. Capital Formation –The economic development, as is well known, depends upon the rate of capital-formation in the country. Public finance can play a vital role in increasing the rate of capital-formation in the economy. It can be managed in such a manner as to step up the rate of saving and investment in the economy. For example, the tax system can be so managed as to discourage the consumption of non-essential goods and thereby release the resources for being invested in more productive industries. Further, the tax system can be employed to increase the rate of private saving which in turn, can be used as the basis for an increase in public investment.

6. Industrial Development – The governments these days give subsidies and grants to different industries to enable them to increase the production of essential goods in the country. These subsidies and grants have special place in the government expenditure of underdeveloped and backward countries.

Differences or Dissimilarities between public and private finance

The following are the main points of differences or dissimilarities between public and private finance:

1. Adjustment between Income and Expenditure – An individual determines his expenditure on the basis of his income. He prepares his family budget on his expected income during the month. On the other hand, the government first estimates about its expenditure and then finds out means to raise the necessary income. As pointed out by Bastable, 'The individual says, I can spend so much', the Finance Minister says, 'I have to raise so much'

2. Elasticity of Finance – Public Finance is more elastic than private finance. There is not much scope for changes in private finance while drastic changes can be made in government finance. For example, a private individual cannot effect any special increase in his income. As against this the government can increase its income by imposing fresh taxes on the people.

3. Differences in Objectives – There are a fundamental difference in theobjective of private and public finance. The motive of private expenditure is personal benefit whereas the objective of public expenditure is social benefit. An individual always tries to save and a firm to earn profit. But there are no such considerations on the part of the government, except the public welfare. However, there are some public enterprises which are run on profits that are utilised for public welfare.

4. Nature of Expenditure – There are differences in the nature of expenditure between the two". An Individual's expenditure is governed by his habits, customs, fashions etc on the other hand. The government expenditure depends on its economic and social policies, like removing unemployment and poverty, reducing income inequalities, providing' infrastructure facilities, etc

5. Compulsion – There is compulsion in public finance. People have to pay taxes. If they do not pay, they are punished by fine and imprisonment. BA an individual or firm cannot force anybody to pay him money. He can file a suit in the court. But even then he may not receive his money back. The same is the case with loans. The government can force the people to lend it during war or emergency. But a individual cannot compel any person to lend him money.

6. Law of Equi-marginal Utility – The private individual spends his me on various items in such a manner as to secure equal marginal utilities from them. It is only by equalizing the various marginal utilities that he can secure maximum utility out of his expenditure.

The government on the contrary, does not give as much importance to this law as a private individual does. Moderngovernments sometimes incur certain types of expenditure from which they do not derive any advantage, but they o incur this expenditure to satisfy ertain sections of the community

7. Present Vs Future – An individual is more concerned with his present needs and tries to satisfy them. Life being uncertain and short, he has his immediate gain or profit in view.

On the other hand, government is a permanent organisation. Only the ruling party changesit is concerned not only with the welfare of present generation but also I with future generations. It therefore, undertakes and spends on those activities which also benefit future generations

8. Nature of the Budget – A surplus budget is always good for a private individual. Bin a surplus budget may not be good for the government. It implies two things: (i) The government is levying more taxes on the people than is necessary, (ii) The government is not spending as much on the welfare of the public as it should. Keynes supported a deficit budget to meet the situation created by depression. Further, the government budget is passed by the parliament. But the budget of an individual or firm is a private affair without any controlling authority.

9. Nature of Borrowing – In the case of an individual, there can no internal borrowing". An individualcannot borrow from himself. He can borrow only from an external agency. The State, however, can borrow both from internal as well as external sources. It borrows not only from its own citizens, but also from foreigners.

Budgetary activities of the government results in transfer of purchasing power from some individuals to others. Taxation causes transfer of purchasing power from tax payers to the public authorities, while public expenditure results in transfer back from the public authorities to some individuals, therefore financial operations of the government cause ‘Sacrifice or Disutility’ on one hand and ‘Benefits or Utility’ on the other.

This results in changes in pattern of production, consumption & distribution of income and wealth. So it is important to know whether those changes are socially advantageous or not. If they are socially advantageous, then the financial operations are justified otherwise not. According to Hugh Dalton, “The best system of public finance is that which secures the maximum social advantages from the operations which it conducts.”

THE PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE

One of the important principles of public finance is the so – called Principle of Maximum Social Advantage explained by Professor Hugh Dalton. Just like an individual seeks to maximize his satisfaction or welfare by the use of his resources, the state ought to maximize social advantage or benefit from the resources at its command.

The principles of maximum social advantage are applied to determine whether the tax or the expenditure has proved to be of the optimum benefit. Hence, the principle is called the principle of public finance. According to Dalton, “This (Principle) lies at the very root of public finance” He again says “The best system of public finance is that which secures the maximum social advantage from the operations which it conducts.” It may be also called the principle of maximum social benefit. A.C. Pigou has called it the principle of maximum aggregate welfare.

Public expenditure creates utility for those people on whom the amount is spent. When the volume of expenditure is small with a slighter increase in it, the additional utility is very high. As the total public expenditure goes on increasing in course of time, the law of diminishing marginal utility operates. People derive less of satisfaction from additional unit of public expenditure as the government spends more and more. That is, after a stage, every increase in public expenditure creates less and less benefit for the people. Taxation, on the other hand, imposes burden on the people.

So, when the volume of taxation becomes high, every further increase in taxation increases the burden of it more and more. People under go greater scarifies for every additional unit of taxation. The best policy of the government is to balance both sides of fiscal operations by comparing “the burden of tax” and “the benefits of public expenditure”. The State should balance the social burden of taxation and social benefits of Public expenditure in order to have maximum social advantage.

Attainment of maximum social advantage requires that;

a) Both public expenditure and taxation should be carried out up to certain limits and no more.

b) Public expenditure should be utilized among the various uses in an optimum manner, and

c) The different sources of taxation should be so tapped that the aggregate scarifies entailed is the minimum.

Assumptions of this theory:

1.All taxes result in sacrifice and all public expenditures lead to benefit.

2. Public revenue consists of only taxes and there is no other source of income to the government.

3. The govt. has no surplus or deficit budget but only a balanced budget. 

Diagrammatical Explanation of the theory of maximum social advantages

In the above diagram, MSS is the marginal social sacrifice curve sloping upward from left to right. This rising curve indicates that the marginal social sacrifice goes on increasing with every additional dose of taxation.   MSB is the marginal social benefit curve sloping downwards from the left to right. This falling curve indicates that the marginal social benefit diminishes with every additional dose of public expenditure. The two curves MSS and MSB intersect each other at the point P. PM represent both marginal social sacrifice as well as marginal social benefit. Both are equal at OM which represents the maximum social advantage.

Criticism of the theory of Maximum Social Advantages

1. Non measurability of social sacrifice and social benefit: The major drawback of this principle is that it is not possible in actual practice to measure the MSS and MSB involved in the fiscal operation of the state.

2. Non applicability of the low of equimarginal utility in public expenditure: The low of equimarginal utility may be applicable to private expenditure but certainly not to public expenditure.

3. Neglect non-tax revenue: The principle says that the entire public expenditure is financed by taxation. But, in practice, a significant portion of public expenditure is also financed by other sources like public borrowing, profits from public sector enterprises, imposition of fees, penalties etc.

4. Lack of divisibility: The marginal benefit from public expenditure and marginal sacrifice from taxation can be equated only when public expenditure and taxation are divided into smaller units. But this is not possible practically.

5. Assumption of static condition: Conditions in an economy are not static and are continuously changing. What might be considered as the point of maximum social advantage under some conditions may not be so under some other.

6. Misuse of government funds: The principle of Maximum social advantage is based on the assumption that the government funds are utilized in the most effective manner to generate marginal social benefit. However, quite often a large share of government funds is misused for unproductive purposes

7. "The govt. has no surplus or deficit budget but only a balanced budget."- is an invalid assumption.

CATEGORIES OF GOODS

 PUBLIC GOODS

The indivisible goods, whose benefits cannot be priced, and therefore, to which the principle of exclusion does not apply are called public goods. The use of such goods by one individual does not reduce their availability to other individuals. For example, the national defence.

Characteristics of Public goods

1) Non-rival in consumption: - One person’s consumption does not diminish the amount available to others. Once produced, public goods are available to all in equal amount.

Marginal cost of providing the public goods to additional consumers is ZERO.

2) Non-excludable:- Once a public good is produced, the suppliers cannot easily deny it to those who fail to pay. That is, those who cannot (or do not agree to) pay its market price are not debarred or excluded from its use.

3) Free-rider problem: - People can enjoy the benefits of public goods whether pay for them or not, they are usually unwilling to pay for public goods. This act is the so-called free-rider problem.

PRIVATE GOODS

Private goods refer to all those goods and services consumed by private individuals to satisfy their wants. For example, food, clothing, car etc.

FEATURES

1) Excludable: - The suppliers of private goods can very well exclude those who are unwilling to pay.

2) Rivalry in consumption: - One person’s consumption reduces the amount available to others. That is, the amount consumed by one person is unavailable for others to consume.

3) Revealed Preference: - The consumers reveal their preferences through effective demand and market price. These revealed preferences are the signals for the producers to produce the goods the individuals want.

Market demand for private goods is obtained by horizontal summation of individual demand curves and that of a public good is obtained by vertical summation of individual demand curves.

MIXED GOODS

Mixed goods are those goods having benefits which are wholly internalized (rival) and others, the benefits of which are wholly externalized (non-rival). The cost of producing such goods partly covered by private contributions and partly by government subsidy. 

MEANING OF PUBLIC REVENUE AND ITS SOURCES

A government needs income for the performance of a variety of functions and meeting its expenditure. Thus, the income of the government through all sources like taxes, borrowings, fees, and donations etc. is called public revenue or public income.

However, Prof. Dalton has defined the term in two senses – broader and narrow sense. In broad sense, it includes all the income and receipts, irrespective of their sources and nature, which the government happens to obtain during any period of time. In the narrow sense, it includes only those sources of income of the government which are described as revenue resources. In broader view of the concept is that is includes all loans which the government raises under the term ‘public revenue’ or public income. The distinction in both can also be explained as the term ‘public revenue’ used in public finance. It includes only those sources of government income which are not subject to repayment. In a broad sense, it means all receipts of the government irrespective of the fact whether they are subject to repayment or not.

In a modern welfare state, public revenue is of two types:

(a)    Tax revenue and

(b)   Non-tax revenue.

(a) Tax Revenue: A fund raised through the various taxes is referred to as tax revenue. Taxes are compulsory contributions imposed by the government on its citizens to meet its general expenses incurred for the common good, without any corresponding benefits to the tax payer. Seligman defines a tax thus: “A tax is a compulsory contribution from a person to the government to defray the expenses incurred in the common interest of all, without reference to specific benefits conferred.

Examples of Tax Revenue 

Ø  Income Tax(on income of the individual as well as joint Hindu families) 

Ø  Corporation Tax (on income of the companies both domestic and foreign companies operating in India ) 

Ø  Interest Tax (on the gross interest income of the financial institutions like Bank) 

Ø  Expenditure Tax(expenditure incurred in luxury hotels and restaurants) 

Ø  Wealth Tax(total wealth of individuals and Hindu undivided families) 

Ø  Custom Duty.(import and export duty) 

Ø  Central excusive Duty.(duties on industrial products) 

Ø  Service Tax.(on services provided by hotels,telephones,port services etc.) 

(b) Non Tax Revenue: The revenue obtained by the government from sources other then tax is called Non-Tax Revenue. The sources of non-tax revenue are:

1. Fees: Fees are another important source of revenue for the government. A fee is charged by public authorities for rendering a service to the citizens. The government provides certain services and charges certain fees for them. For example, fees are charged for issuing of passports, driving licenses, etc.

2. Fines or Penalties: Fines or penalties are imposed as a form of punishment for breach of law or non fulfillment or certain conditions or for failure to observe some regulations. Like taxes, fines are compulsory payments without quid pro quo. But while taxes are generally imposed to collect revenue. Fines are imposed as a form of punishment or to prevent people from breaking the law.

3. Surplus from Public Enterprises: The Government also gets revenue by way of surplus from public enterprises. In India, the Government has set up several public sector enterprises to provide public goods and services. Some of the public sector enterprises do make a good amount of profits. The profits or dividends which the government gets can be utilized for public expenditure.

4. Special assessment of betterment levy: It is a kind of special charge levied on certain members of the community who are beneficiaries of certain government activities or public projects. For example, due to a public park in a locality or due to the construction of a road, people in that locality may experience an appreciation in the value of their property or land. Thus, due to public expenditure, some people may experience 'unearned increments' in their asset holding.

5. Grants and Gifts: Gifts are Voluntary contributions by individuals or institutions to the government. Gifts are significant source of revenue during war and emergency. A grant from one government to another is an important sources of revenue in the modern days. The government at the Centre provides grants to State governments and the State governments provide grants to the local government to carry out their functions.

6. Deficit Financing: Deficit means an excess of public expenditure over public revenue. This excess may be met by borrowings from the market, borrowings from abroad, by the central bank creating currency. In case of borrowing from abroad, there cannot be compulsion for the lenders, but in case of internal borrowings there may be compulsion.

SIGNIFICANCE OF PUBLIC REVENUE

The public revenue of one country differs in amount from that of another country. The difference is due partly to the size of country and partly to other causes. India is not a small country. It is sub-continental in itself. Its stages are as big as some counties of the west. But its public revenue is not very big in size. What does the size of public revenue then indicate. It depends on the following aspects.

1. Sign of Prosperity: A man who has a big income is in general respected more than the other who has a smaller income. It is only rarely that people with small income are held in high esteem by society. And in the same way a country that has a small volume of public revenue is not regarded as a big power and consequently not respected by other counties. A State that has a big volume of public revenue considered as a power to be reckoned with. America and United Kingdom have public revenue that is several times higher than that of our country. And we knows they do, that they can afford to do things that require much money.

2. Welfare of Country: Other things being equal, however, the welfare of a country can be judged from the size of its public revenue. A country whose resources, both natural and human, are not fully developed is a poor and backward country. And the government of such a country must necessarily be poor also. And with poverty of wealth goes also the poverty of welfare unless other things are not the same.

3. Composition of Public Revenue: Yet, it is not merely the size of public revenue the one should look to in order to form some idea of the prosperity or otherwise of a country. The composition of public revenue is as much important as its size. If a large part of the wealth of the government comes from the poor it is not a sign of a healthy state of affairs.

4. Mere Availability of Means: Public revenue is only, a means and the mere availability of means indicates nothing. All depends on how the means are utilized. It is not safe, therefore, to reckon with merely the size of revenue. Some countries of the world have public revenue in thousands of millions. The tendency today is on the one hand to spend an increasing percentage of public revenue on social services and social security. On the other hand, everywhere more and more money is being diverted to the building up of strong defensive and offensive force.

5. Manner of Public Revenue: A word may again be said about the manner in which revenue is obtained from the people. Every government tries to get more money from the rich that from the poor. But not all succeed in so doing. Some fail because they are ignorant and some fail because they are careless. And we have to say also that some fail because they are mischievous.

Difference between Progressive, Regressive and Proportional tax system

Basis	Progressive	Proportional
Meaning	A tax, the rate of which increases with every increase in income is called progressive tax.	If a tax on all incomes is levied at the same rate, it is called proportional tax.
Assessment	Tax is charged on income.	Tax is charged on income.
Type of tax	It includes direct taxes.	It includes direct taxes.
Benefits	Low income group people are benefited.	High income group people are benefited.
Ability to pay	Payer’s ability to pay is considered.	Payer’s ability to pay does not matters.
Revenue	It generates more revenue to the government.	It generates less revenue as compared to others.
Equality	It leads to equality to sacrifice.	It does lead to equality to sacrifice.

Merits of Progressive Taxation

1.          Based on the Principle of Equity: Progressive tax rates increase with the increase in income group as the higher income group people have high ability to pay because of rapid fall in the marginal utility of money with the increase in income.

2.          Powerful Tool for Reducing Inequality: Progressive taxation is a powerful tool for reducing the inequalities of income because the rich people are bound to pay more taxes.

3.          More Elastic: The progressive tax system is more elastic because the state can change the rate of taxation during any time (like war, famines or drought etc.) for collection of more funds and a minor change in the rate of taxation in the higher income group can bring substantial increase in the income.

4.          Economical: Progressive taxes can be justified on the ground that they are more economical as the cost of collection does not rise with the rates of taxes.

5.          Based on Social Justice: This type of tax is also advocated from the socialistic pattern of society. It is powerful instrument in narrowing down the gap between the rich and the poor sections of the society.

6.          More Productive: It is more suitable because the government revenue automatically increases with the increase in economic activities.

7.          Based on Modern Social Ethics: Progressive tax is also justified on the ground of modern social ethics as rich should contribute more than the poor. It has proved its worth through revenue productivity, social usefulness and fair justice.

8.          Automatic increase in Revenue: Progressive taxes lead to an automatic increase in public income.

Demerits of Progressive Taxation System

1.          Difficult to Understand: The progressive tax system is very difficult to understand as it can have infinite number of progression and one has to take the help of an expert in evaluation and calculation of the tax money to be paid.

2.          Difficult to Measure Utility: The marginal utility of an individual cannot be measured easily because the mental and psychological satisfaction varies from individual to individual. All human beings have different mentality and law of marginal utility cannot be applied universally.

3.          Retards Capital Formation: The degree of progressive taxation has an important bearing in the process of saving and capital formation in an economy.

4.          Scope of Tax Evasion: In the progressive tax, there is a large scope of evasion of tax. There may be false declaration of the income just to save from the heavy taxation. Here the motives for evasion is stronger and the means of prevention less effective than in the case of proportional tax.

5.          Breeds Corruption: Generally, it is argued that progressive taxation breeds corruption in public life. This depends upon a number of factors such as administrative efficiency, social consciousness and purpose of financial operations etc.

6.          Wrong Assumption: It is based on wrong assumption of marginal utility of money which is less to a rich person as compared to a poor person. But satisfaction is a mental or psychological phenomena.

c) Regressive Tax: In regressive taxation, the larger the income of tax-payer, the smaller is the proportion that he contributes. A schedule of regressive tax rate is one in which the rate of taxation decreases as the base increases.

d) Degressive Tax: A Degressive tax is one on which tax is progressive up to a certain limit, after that it is proportional, i.e., charged at flat rate.

Merits of Proportional Taxation

1.          Simple and Uniform: Proportional tax system is simple and uniformly applicable. The tax can be administered relatively easily. Since the simple and uniformly applicable. The tax can be administered relatively easily. Since the tax rate is uniform, there is no problem of computing the tax liability for different individuals. Since everyone pays the same proportion of his income the system has a popular appeal and the revenues can be raised with minimum opposition from the tax payers.

2.          Free from Harmful Effects: Proportional tax is free from the harmful effects like disincentive to saving and productivity that are associated with progressive taxation when imposed steeply. If the government follows stringent communistic ideas, the richer sections may be very steeply taxed under progressive system. This needs not usually occur to a proportional system.

3.          Easy to Calculate: Proportional taxes are levied at certain proportion of the income and the rate of tax does not vary. Therefore, they are easy to calculate.

4.          Equality of Sacrifice: Proportional taxes are sometimes justified on the ground that the real burden of taxes must be equal to the money burden. If this principle is accepted, then the proportional taxes can be justified.

5.          Certain: Such taxes enjoy the benefit of certainty. Both the tax payer and the state can know the amount of the tax.

Demerits of Proportional Taxation

1.          Not Equitable: Proportional taxes are unjust as the burden is heavier on poor sections. They have been justified on the wrong notion that the real burden of a tax is equal to its money burden. The fact, however, is that real burden is heavier on small income groups.

2.          Less Elastic: Proportional taxes are less elastic as compared to progressive taxes. The taxes cannot increase beyond a certain limit because of low taxation capacity of the poor people. Thus it is not easy for the state to increase its revenue through such taxes.

3.          Adverse Effect on Distribution of Wealth: Revenue is not the only motive of Tax. The idea that taxes are only for revenue only has long been discarded. The weapon of taxation is increasingly used to promote social justice. It is in this field that proportional taxes miserably fail. They fail to narrow down the inequalities in the distribution of wealth.

4.          Lack of Elasticity: Proportional tax fails to follow the rule of elasticity. As a result, Government is unable to increase its revenue.

5.          Not According to Ability to Pay: it is not according to ability to pay of the individual. Low income groups feel heavy burden of taxation. The marginal utility of money decreases rapidly with the increase in income. So, the rich income group people have negligible burden.

b) Progressive Tax: A tax, the rate of which increases with every increase in income is called progressive tax. A schedule of progressive tax rate is one in which the rate of taxation increases as the tax base increases. In India, we have progressive tax rate system.