Public Expenditure: Meaning and Importance

The expenses incurred by the governments for its own maintenance,

preservation and welfare of the economy as a whole is referred to as public

expenditure. In other words, it refers to the expenses of public authorities-central,

state and local governments in a federation-for the satisfaction of collective needs of

the citizens or for promotion of economic and social welfare. The development

functions include education, public health, social security, irrigation, canal, drainage,

roads, buildings, etc. The major cause of increase in the public expenditure is nothing

but, these developmental functions. Hence, the study of public expenditure has

become very significant in the study of public finance.

The two major reasons for the same are: a) the economic activities of the state

has increased manifold and b) nature and volume of public expenditure have greatly

affected the economic life of the country in a different manner. i.e., it has affected

production and distribution and general level of economic activities.

In the laissez-faire era the state was assigned a very limited role to play. The

functions assigned to the state where based on the principle of least interference or

‘that government is the best which spends the least.’ According to the classical

school led by Adam Smith restricted the functions of the state to ‘Justice, Police and

Arms.’ They considered government expenditure wasteful and that money could be

used much well by private persons than by the government. Adam Smith in his

magnum opus ‘TheWealth of Nations’ published in 1776 observed that the

sovereign has three main duties to perform as a) to protect the society from violence

and invasion of other independent societies b) to protect against injustice and c)

erecting and maintaining certain public works.

According to David Ricardo, ‘If you want a peaceful government you must

reduce the budget’. JB Say opined that ‘the very system of all plans of finance

is to spend little and the best of all taxes is that which is least in amount’.

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In recent time, public expenditure has been increased enormously. The main

reason is that the functions of governments have been increased manifold. The

modern states are no more police states but welfare states. Adolph Wagner, a German

economist, presented his famous ‘Law of Increase of State Activities.’ He states

that ‘comprehensive comparison of different countries and different times show that

among progressive people with which alone we are concerned, an increase regularly

takes place in the activity of both central and local governments.’ This increase is both

intensive and extensive.

Prof. RA Musgrave, the twentieth century economist, advocated public

expenditure since a government is forced to do many activities such as 1) activities to

secure a reallocation of resources 2) redistribution activities, 3) stabilizing activities

and 4) commercial activities.

Governments constantly undertake new functions while they perform both old

and new functions more efficiently and completely. In this way the economic needs of

the people, to an increasing extent and in a satisfactory fashion are satisfied by the

central and local governments.

Causes for the Increase in Public Expenditure:

One of the most important features of the present century is the phenomenal

growth of public expenditure. Some of the important reasons for the growth of public

expenditure are the following.

1) Welfare state: Modern states are no more police states. They have to look in to

the welfare of the masses for which the state has to perform a number of functions.

They have to create and undertake employment opportunities, social security

measures and other welfare activities. All these require enormous expenditure.

2) Defence expenditure: Modern warfare is very expensive. Wars and

possibilities of wars have forced the nation to be always equipped with arms. This

causes great amount of public expenditure.

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3) Growth of democracy: The form of democratic government is highly

expensive. Theconduct of elections, maintenance of democratic institutions like

legislatures etc. cause great expenditure.

4) Growth of population: tremendous growth of population necessitates

enormous spending on the part of the modern governments. For meeting the needs of

the growing population more educational institutions, food materials, hospitals, roads

and other amenities of life are to be provided.

5) Rise in price level: Rises in prices have considerably enhanced public

expenditure in recent years. Higher prices mean higher spending on the part of the

govt. on items like payment of salaries, purchase of goods and services and so on.

6) Expansion public sector: Counties aiming at socialistic pattern of society

have to give more importance to public sector. Consequent development of public

sector enhances public expenditure.

7) Development expenditure: for implementing developmental programs like

Five Year Plans, Modern governments are incurring huge expenditure.

8) Public debt: Along with debt rises the problem like payment of interest and

repayment of the principal amount. This results in an increase in public expenditure.

9) Grants and loans to state governments and UTs: It is an important

feature of public expenditure of the central government of India. The government

provides assistance in the forms of grants-in-aid and loans to the states and to the

UTs.

10) Poverty alleviation programs: As poverty ratio is high, huge amount of

expenditure is required for implementing alleviation programmes.

Classification of public expenditure:

Public expenditure has been classified in to a) Revenue expenditure and b)

Capital expenditure. Revenue expenditure is current expenditure. For example, it

includes administrative expenditure and maintenance expenditure. This expenditure

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is of a recurring type. Capital expenditure is of capital nature and is incurred once for

all. It is non-recurring expenditure. For example, expenditure in building, multi- purpose projects or
on setting up big factories like steel plants, money spent on land,

machinery and equipment.

Revenue Budget or Revenue Account is related to current financial transactions

of the government which are of recurring in nature. Revenue Budget consists of the

revenue receipts of the government and the expenditure is met from this

revenues.Revenue Account deals with Taxes, duties, fees, fines and penalties, revenue

from Government estates, receipts from Government commercial concerns and other

miscellaneous items, and the expenditure therefrom.

Revenue Receipts include receipts from taxation, profits of enterprise, other

non-tax receipts like administrative revenue (fees, fines, special assessment etc.), gifts

grants etc. Revenue expenditure includes interest-payments, defense expenditure,

major subsidies, pensions etc.

The Capital Account is related to the acquisition and disposal of capital assets.

Capital budget is a statement of estimated capital receipts and payments of the

government over fiscal year. It consists of capital receipts and capital expenditure.

The capital account deals with expenditure usually met from borrowed funds with the

object of increasing concrete assets of a material character or of reducing recurring

liabilities such as construction of buildings, irrigation projects etc.

Capital Receipts include a) Borrowings b) Recovery of loans and advances c)

Disinvestments and d) Small savings. Capital Expenditure includes a) Developmental

Outlay b) Non-developmental outlay c) Loans and advances and d) Discharge of debts.

This can be explained as follows:

Theories of growth of public expenditure

As we know in modern times all the countries of the world have witnessed an

enormous increase in public expenditure. The three important theories of the growth

public expenditure are the following:

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1) Adolph Wagner’s hypothesis

2) Wiseman – Peacock hypothesis and

3) Colin Clark’s Critical Limit Hypothesis.

Adolph Wagner’s Hypothesis:

Adolph Wagner (1835-1917) believed that there was a cause-effect relationship

between economic growth and public expenditure. His hypothesis of‘Law of Increasing

State Activity’‘lays that as a percapita income and output increase in industrialized

counties, the public expenditure of those counties necessarily grows as a proportion to

total economic activity. He explained that ‘comprehensive comparisons of

different countries and different times shows that among progressive

people, with which alone we are concerned, an increase regularly takes

place in the activity of both central and local governments. The increase is

both extensive and intensive, the central and local governments. Constantly

undertake new functions, while they perform both old and new functions

more effectively and completely.’He explained the trend of public expenditure.

Conclusions:- 1) As the national income increases in amount, the percentage of outlayfor

government supplied goods is greater.

2) Increased public expenditure was the natural result of economic growth and

continued pressure for social progress.

Wiseman – Peacock hypothesis:

According to Wiseman and Peacock Public Expenditure does not increase in a

smooth and continuous manner. The increasing public expenditure over time has

occurred in a step-like manner. They studied the experience of the United Kingdom

for a secular period (1890-1955). Instead of studying the trend of public expenditure,

they studied the fluctuations in government expenditure over time. The general

approach to the hypothesis refers to the three related concepts.

1) Displacement effect 2) Inspection effect and 3) concentration effect.

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The movement from older level of expenditure and taxation to a new and higher level

is called the displacement effect.

War and other social disturbances force the people and governments to find

solutions of important problems, which had been neglected earlier. This is called the

inspection effect. That is, new obligations imposed on state, in the form of increased

debt interest and war pensions etc.

The concentration effect refers to the apparent tendency for the central govt.

economic activities to become an increasing proportion of the total public sector

economic activity when the society is experiencing economic growth.

Critical Limit Hypothesis: (Colin Clark):

The hypothesis was developed by Colin Clark immediately after the Second

World War. It is concerned with the tolerance level of taxation. By maximum limit of

the tolerance level is 25% of GNP. When the share of government expenditure exceeds

25% in the GNP, inflation occurs even in balanced budget.

CANONS OF PUBLIC EXPENDITURE

The canons or principles of public expenditure are the fundamental rules which

govern the public expenditure policy of the governments. The method and direction in

which the public expenditure utilized is of paramount importance

Professor Alfred G.Buchler made some guidelines for the utilization of expenditure by

the public authorities. They are as follows: - a) Public expenditure should promote the welfare of the
society.

b) Careful judgement should be exercised by the public authority and the

electorate to ensure that the advantages of the public expenditure should

exceed the costs and that the fund utilized by the governments will be more

conducive to social welfare than the same funds would, if privately utilized.

c) Public expenditure should be utilized in the order of priority of welfare. That is,

the services which will bring about maximum welfare should be undertaken

first.

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Prof. Findlay Shirras has explained four canons of public expenditure. They are

canon of benefit, canon of sanction, canon of economy and canon of surplus.

CANON OF BENEFIT

The ideal of this is maximum social advantage. That is, public expenditure should be

planned so as to yield maximum social advantage and social welfare of the

community as a whole and not of a particular group. Public expenditure must be

spent in those directions which will maximise utility. It is possible only when the

marginal utility from different uses is equal. The public authorities should distribute

resources so as to increase production, reduce inequalities of income distribution,

preserve social life of the people, and improve the quality of social life etc. “Other

things being equal, expenditure should bring with itsimportant social

advantages such as increased production, the preservation whole against

external attack and internal disorder and as far as possible a reduction in

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the inequalities of income. In short, public funds must be spent in those

directions most conducive to the public interest. i.e., maximum utility is to

be attained in public expenditure.”---Findlay Shirras.

CANON OF ECONOMY

This implies that the state should be economical in spending money.It should not

spend more than the necessary amount on items of expenditure. The sole aim is to

avoid extravagance and corruption. Social benefit can be maximised when

resources are not wasted. While incurring public expenditure social costs are to be

minimised. To satisfy this canon Project Appraisal and Cost Benefit Analysis are

to be adopted. “Economy means protecting the interests of the tax payers

not merely in effecting economies in expenditure, but in developing

revenue.”—Shirras.

CANON OF SANCTION

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According to this canon, no expenditure should be incurred without the proper

approval of the sanctioning authority. It also implies that the spending authorities

should spend the amount for which it has been sanctioned and to see that the

sanctioned amount is properly utilized. Public accounts are to be audited at the

end of financial year. This canon acts as check on arbitrary, unwise and reckless

spending of public funds.

CANON OF SURPLUS

This canon believes in the avoidance of deficit in public expenditure. According to

Findlay Shirras,”Public authorities must earn their living and pay their

way like ordinary citizens. Balanced budget must, as in the private

expenditure; the order of the day. Annual expenditure must be balanced

without the creation of fresh credits unrepresented by the new assets.”

Modern governments does not consider balanced budget a virtue always. In an

inflationary condition a surplus budget is desirable as it reduces purchasing power

of the individuals. Similarly, in the time of depression a deficit budget is

recommended in order to enhance the purchasing power of the people.The canon of

surplus is not relevant in modern public finance.

OTHER CANONS OF PUBLIC EXPENDITURE

CANON OF PRODUCTIVITY

Public expenditure should promote production and increase the working efficiency

of the people. Major part of public expenditure should be incurred on

developmental activities. The aim of public expenditure should be maximum

production, employment and income.

CANON OF ELASTICITY

There should be flexibility in government expenditure. That is, the government

may be able to change its public expenditure policy with changing conditions. It

means that public expenditure should increase during periods of emergency and

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reduce during normalcy.

CANON OF EQUALITY

This implies that public expenditure should be incurred in such a way that

inequality in the distribution of income should be reduced. For achieving this

canon the benefit of public expenditure should conferred more on the poorer section

of the society.

CANON OF NEUTRALITY

Public expenditure should not worsen the production-distribution-exchange

relationship instead of improving it. Public expenditure should result in increased

production and productivity, reduced inequality of income and wealth and

increased economic activity and exchange relationship.

CANON OF CERTAINTY

The public authorities should clearly know the purposes and extent of public

expenditure to be incurred. This anon explains the preparation of public budgets.

EFFECTS OF PUBLIC EXPENDITURE

The traditional economists held the view that the state should least interfere in

economic activities and the government is merely an agent for the people to keep

political organization intact. During the time of Adam Smith the government that

interfered least in the economic activities of the state was considered the

bestgovernment. Till the beginning of the 20th century, state performed only

limited functions-the maintenance of law and order and protection of the country

from the external attack. Therefore, the state had to collect only small revenue

andspend little. Recently, in almost all countries of the world there has been a

phenomenal increase in the magnitude and the variety of governmental activities.

The acceptance the principle of welfare state, the necessity of maintaining full

employment and economic development etc. the significant role of the government

has been increased. All these show the need for an ever increasing public

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expenditure. In the following few paragraphs we can explain the important effects

of public expenditure.

EFFECTS OF PUBLIC EXPENDITURE ON PRODUCTION

“Just as taxation, other things being equal, should reduce production as

little as possible so the public expenditure should increase it as much as

possible.”---Prof.Dalton. The effects of public expenditure on production can be

evaluated by examining its effects on the following.

a) Effects upon ability to work, save and invest.

b) Effects upon willingness to work, save and invest.

c) Effects upon diversion of economic resources as between different uses and

localities.

Ability to work, save and invest

Public expenditure may tend to influence the ability of the people to work, save

and invest. This is described as ‘efficiency effect’. Public expenditure designed to

increase the efficiency of the people will certainly improve their ability to work. When

a person’s ability to work is increased, his earnings will also increase. As a

consequence his ability to save also improves. For example, expenditure on education,

health services, and cheap housing facilities, subsidised food, free education means of

transportation, communication etc. will increase the efficiency of the people to work.

Similarly, public expenditure incurred for maintaining law and order build up the

confidence in the minds of the people which will in turn encourages them to invest in

production activities. Public expenditure may have adverse effects also. If public

expenditure is spent on wasteful social functions or on the production of intoxicants

and drugs which are detrimental to health, the ability to work, save and invest of the

people may adversely be affected. Hence, public expenditure should be incurred in

such a way that it is most beneficial to entire society

B) WILLINGNESS TO WORK SAVE AND INVEST

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Public expenditure may tend to affect the willingness of the people to work,

save and invest which is described as ‘incentive effect’.As far as the will to, save and

invest is concerned, it depends to great extent on the character of public expenditure

and public policy of the governments. For example, old age pension, provident fund

benefit, insurance against sickness and unemployment allowances etc., have an

adverse effect on the willingness of the people to work, save and invest. This is

because people will have a feeling that the governments will look after them, when

they are unable to earn an income. Therefore, public expenditure should be incurred

in such a way that it may not adversely affect the incentive to work of the people. If,

however, the benefit increases with the increase in work and the volume of savings,

the willingness to work, save and invest will increase and vice-versa. Similarly, the

willingness to work can be increased by making the benefits conditional, i.e., the

people may be required to contribute something in order to avail the benefits of social

security measures. In brief, public expenditure should be incurred systematically and

in a planned manner in order to provide social security measures to the maximum

extent. Public expenditure should also provide opportunities under which savings and

investments are properly rewarded and do not enlarge inequalities.

DIVERSION OF RESOURCES BETWEEN DIFFERENT USES AND AREAS

Public expenditure can significantly influence the level and pattern of

production through the diversion of economic resources between different uses and

areas. Therefore, the government has to incur public expenditure in those areas and

regions which would secure maximum national production and maximum social

advantage.

For example, the public expenditure on projects like roads, railways, irrigation

energy etc. helps in accelerating the tempo of economic development. Creation of such

essential projects through diversion of economic resources from private use to public

use is very essential in developing countries. Similarly, concessions and subsidies by

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governmentsmay help many industries and agricultural activities. According to

Dalton the role of public expenditure in the diversion of economic resources from

private use to government use and as among different regions is important only when

the area of economic activities of the government is limited i.e. in a capitalistic

economy.

The forms of public expenditure which increase the productive power and are

socially very much desirable for the transfer of resources are generally of the following

nature. a) Debt redemption b) Developmental projects like irrigation, power and

transport, roads, railways etc. c) Promotion of education, research, inventions training

etc. d) Provision of public health and e) Social security etc.

Public expenditure also results in the diversion of resources among different

regions. This will reduce the regional inequality- one of the important objectives of

Indian economic panning. In order to bring about regional balanced growth the

government has to provide special expenditure programmes to economically backward

regions. Such diversion of resources among regions is made possible by setting up a

federal system of government. Grants-in-aid from Central government to state

governments and from state governments to local governments are examples of

diversion of resources.

In short, the public expenditure does have many favourable effects on

production. To conclude the effect of public expenditure on production we can quote

Dalton once again.“Whereas taxation, taken alone, may check production,

public expenditure, taken alone, should almost certainly increase it.

EFFECTS OF PUBLIC EXPENDITURE ON DISTRIBUTION

One of the important modern state policies, especially in developing countries

and socialistic countries, is reduction of inequalities in the distribution of income and

wealth. Public expenditure plays vital role in realising this objective. According to

Dalton, “The system of public expenditure is the best, which has the

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strongest tendency to reduce inequality of income.” Public expenditure which is

in the form of money grants, supply of social goods and services, social security

measures, subsidies etc. certainly affects the distribution of income in a country in

socially desirable way. Expenditures carried out for benefiting the poor people such as

those on social services like free medical treatment, free education, unemployment

benefit etc. will enhance the benefit of the poor section than the rich. This will help in

reducing the gulf between the rich and the poor in the distribution of income and

wealth, thus bringing about justice in the economy.

PUBLIC EXPENDITURE AND STABILITY

Economic stability refers to a fairly stable level of national income,

employment, prices, savings and investments in the economy. The economy may face

cyclical fluctuations on account of imperfections in the market (Depression and

Inflation). Public expenditure can be used to check the fluctuations. According to Lord

J.M.Keynes economic instability implies departure from full employment at stable

price level. It is the deficiency of the effective demand caused by a low marginal

propensity to consume coupled with low marginal efficiency of investment in

developed countries. (“The General Theory of Employment, Interest and

Money-1936”)

During depression the effective demand falls short of what is required.

Deficiency in effective demand leads tounemployment which in turn reduces

consumption and finally to fall in production.In order to solve the situation public

expenditure is to be enhanced to compensate the deficiency in effective demand. The

increased public expenditure during the time of depression is described as

compensatory public expenditure. In a period of depression the suitable public

expenditure policy will be Deficit Budgeting. (i.e., Current expenditure should be

inexcess of current revenue.)

Similarly, during the time of inflation-rising prices- the public expenditure has

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an entirely different role to play. The government has to adopt Surplus Budgeting

policy. That is, the government should spend less than its revenue.During inflation

that part of the public expenditure which reduces the funds going to the people with

higher propensity to consume is reduces. After full employment, public expenditure is

likely to add to inflationary pressure, for public expenditure will further increase the

purchasing power of the people without any corresponding increase in production.

MODEL QUESTIONS

1) What is the importance of public expenditure?

2) Explain developmental and non-developmental expenditure.

3) What are the canons of public expenditure?

4) Explain Wagner’s hypothesis of public expenditure.

5) Explain Peacock-Wiseman hypothesis of public expenditure.

6) How does public expenditure affect the economy?

7) What are the causes for increasing public expenditure?

8) Distinguish between revenue expenditure and capital expenditure

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