Chapter:4

Public finance

Meaning
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. But public is collected name
for individual within an administrative territory and finance.
On the other hand, it refers to income and expenditure. Thus public finance in this manner
can be said the science of the income and expenditure of the government.

Definition
According to prof. Dalton “public finance is one of those subjects that lie on the border lie
between economics and politics. It is concerned with income and expenditure of public
authorities and with the mutual adjustment of one another. The principal of public finance are
the general principles, which may be laid down with regard to these matters.
According to Adam Smith “public finance is an investigation into the nature and principles of
the state revenue and expenditure”

Public finance v/s private finance

What is Public finance?
Public finance is a study of the income and expenditure activities of the government.

“public finance is the branch of economics that studies the revenue and expenditure of the
government. And the change of one or the other to achieve desirable effects and avoid
undesirable ones.”  The goal of public finance is to benefit the public. Government has many
resources to gain income. Public finance has three main functions.

 The effective use of available resources.

 Income distribution among citizens.
 The economy’s stability.
There are five main components of public finance. – tax collection, expenditure, budget, the
national debt. Government has many resources to get revenue. Collecting tax is the main
resource of the government. The government spends that money on projects. Those projects
are beneficial to the general public. Such as building roads, providing electricity, water, etc.
 Government usually makes a budget for the expenditures of projects. When expenditure is
more than income then budget is deficit budget. To increase the collection of taxes, the
government borrows money. Which increases the national debt. Governments usually prefer
deficit budgets. Because it helps in economic growth, causes positive inflation. The
development of entire nations depends on the effective management of public finance. Public
finance plays an important role in reducing economic inequalities.

What is private finance?

The study of private finance includes the income and expenditure of a person or company.
The goal of private finance is to make a profit and fulfill private desires. In private finance,
individuals or a company have fewer resources to earn an income. Individuals or companies
prefer surplus budgets to make a profit.

There are two types of private finance –Personal finance and business finance. Personal
finance is only limited to an individual or household level. It includes investment, banking,
saving, loans, tax management, and retirement planning.  Individuals make short-term
investments where they can earn quickly. They always consider their income before making
investments. Business finance means the management of the financial activities of a
company. In this, we study how to get capital and use it for the growth of the company. Well,
management of finance can help increase the capital of a company.

Difference between public finance and private finance

Basis Public finance Private finance

Public Finance is a  study of Private finance is the study of the

Definition government revenue and revenue and expenditure of
expenditure activities. individuals and private entities.

The objective of private finance

The objective of public finance
Objective
is to benefit the public. is to make a profit.

The government chose a deficit Private individuals prefer surplus

Budget
budget. budgets…

Government make a transaction private individuals make

for business transactions for
Motive of Expenditure
public benefit. profit.

Financial transaction government make its In private finance, an individual

 can keep their transaction
budget proposals and allocation
secret.
of resources to the public.

 
 

Government has full control over Private individuals have control

Currency ownership
the currency. over the currency.

The government invests in Private investors put their money

Long term consideration projects that are beneficial for where the returns are quick and
the public. immediate.

The government first decides the

amount of  A private individual considers
Determination of expenditure. expenditure and then finds income first and then decides
resources of income. how much to spend.

The government have more

resources to make money such as
printing
currency, passing laws to Individuals have fewer resources
Resources
increase its income to make income.

etc.

Private individuals cannot use

Government can use coercive force to get income.
Coercive methods methods to get income such as
taxes.  

Components of public finance

1. Public revenue
2. Public expenditure
3. Public dept
4. Financial administration
5. Economic stabilization
Public revenue :
' Public revenue ' ( or Government revenue ) is concerned with the Income of the Government
through various sources . The Government collects / earns money through various forms of
tax and non tax revenue , and use this money to meet its administrative and other
expenditures .
It is the money received by a government from taxes and non - tax sources to enable it to
undertake government expenditures .
The income of the government through all the sources is called public income or public
revenue .

Public expenditure :
Public expenditure is spending made by the government of a country on collective needs and
wants , such as pension , provisions , security , infrastructure , etc.
Expenses incurred by the public authorities - central , state and local self - governments - are
called public expenditure . Such expenditures are made for the maintenance of the
governments as well as for the benefit of the society as whole .

Public debt :
Public debt is the total amount , including total liabilities , borrowed by the government to
meet its development budget .
Government borrow money from the public when it's expenditure exceeds it's revenue .
Public debt in simple words loan raised by a government within the country and outside the
country .

Public administration :
Financial administration is that part of government organisation which deals with the
collection , preservation and distribution of public funds , with the coordination of public
revenue and expenditure with the management of credit operations on behalf of the state and
with the general control .
Financial Administration includes all the activities which generate , regulates , and distribute
monetary resources needed for the sustenance and growth of the members of a political
community .

Economic stabilization :
Economic stabilization policies are macroeconomic policies implemented by governments
and central banks in an attempt to keep economic growth stable and less volatile .
Policymakers carefully monitor the business cycle , and make adjustments to fiscal and
monetary policy in an attempt to create stable and sustainable growth and reduce the damage
caused by downturns .
 Economic stabilisation is one of the main remedies to effectively control or eliminate the
periodic trade cycles which plague capitalist economy

Maximum social advantage

Principles of maximum social advantage
Introduction
The principle of Maximum social advantage is the ‘Principle of Public Finance’.
It is the fundamental principle which should determine fiscal operations of the government.
This principle is formulated and popularized by Dr. Dalton and Prof. Pigou.
Dr. Dalton calls it as the principle of maximum social advantage and Prof. Pigou describe as
principle of Maximum Aggregate Welfare.
The principle provides guidance to the Govt. regarding public revenue and public expenditure
or public finance operations so as to maximize social advantage or welfare
Taxation by itself is a loss of utility to the people,
while public expenditure by itself is a gain of utility to the community.
The principle of maximum social advantage implies that public expenditure is subject to
diminishing marginal social benefits and taxes are subject to increasing marginal social costs.
Assumptions
1. All taxes result in sacrifice and all public expenditures lead to benefits.
2. Public revenue consists of only taxes and no other sources of income to the
government.
3. The government has no surplus or deficit budget but only balanced budget.
4. Public expenditure is subject to diminishing marginal social benefit and taxes are
subject to increasing marginal social sacrifice.
Explanation
The Principle of Maximum Social Advantage states that public finance leads to economic
welfare when public expenditure & taxation are carried out up to that point where the benefits
derived from the MU (Marginal Utility) of expenditure is equal to the Marginal Disutility or
the sacrifice imposed by taxation.
Hugh Dalton explains the principle of maximum social advantage with reference to
1.Marginal Social Sacrifice
2. Marginal Social Benefits
Marginal social sacrifice
Marginal social sacrifice (MSS): Amount of social sacrifice undergone by the public due to
the imposition of an additional unit of tax.
Dalton says that the additional burden (marginal sacrifice) resulting from additional units of
taxation goes on increasing i.e. the total social sacrifice increases at an increasing rate.
This is because, when taxes are imposed, the stock of money with the community diminishes.
As a result of diminishing stock of money, the marginal utility of money goes on increasing.

 This diagram indicates that the Marginal Social Sacrifice (MSS) curve rises upwards
from left to right.
 This indicates that with each additional unit of taxation, the level of sacrifice also
increases.
 When the unit of taxation was OM1, the marginal social sacrifice was OS1, and with
the increase in taxation at OM2, the marginal social sacrifice rises to OS2 and so on.
Marginal social benefits
Marginal social benefit (MSB): benefit conferred on the society by an additional unit of
public expenditure.
Just as the marginal utility from a commodity to a consumer declines as more and more units
of the commodity are made available to him, the social benefit from each additional unit of
public expenditure declines as more and more units of public expenditure are spent.
In the beginning, the units of public expenditure are spent on the most essential social
activities. Subsequent doses of public expenditure are spent on less and less important social
activities.
  In the above diagram, the marginal social benefit (MSB) curve slopes downward from
left to right.
 This indicates that the social benefit derived out of public expenditure is reducing at a
diminishing rate.
 When the public expenditure was OM1, the marginal social benefit was OB1, and
when the public expenditure is OM2, the marginal social benefit is reduced at
OB2and so on
The point of maximum social advantage
Social advantage is maximized at the point where marginal social sacrifice cuts the marginal
social benefits curve.

• In the diagram, the marginal disutility or social sacrifice is equal to the marginal
utility or social benefit at the point P. Beyond this point, the marginal disutility or
social sacrifice will be higher, and the marginal utility or social benefit will be lower.
• At point P social advantage is maximum. If we consider Point P1, at this point
marginal social benefit is P1Q1. This is greater than marginal social sacrifice S1Q1.
Since the marginal social sacrifice is lower than the marginal social benefit, it makes
more sense to increase the level of taxation and public expenditure.
• This is due to the reason that additional unit of revenue raised and spent by the
government leads to increase in the net social advantage. This situation of increasing
taxation and public expenditure continues, as long as the levels of taxation and
expenditure are towards the left of the point P.
 • At point P, the units of taxation and public expenditure moves up to OQ, the marginal
utility or social benefit becomes equal to marginal disutility or social sacrifice at this
point.
• Therefore at this point, the maximum social advantage is achieved. If we moved
forward to OQ levels of units, the marginal social sacrifice S2Q2 is greater than
marginal social benefit P2Q2.
• Therefore, beyond the point P, any further increase in the level of taxation and public
expenditure may bring down the social advantage. This is because; each subsequent
unit of additional taxation will increase the marginal disutility or social sacrifice,
which will be more than marginal utility or social benefit.
• This shows that maximum social advantage is attained only at point P & this is the
point where marginal social benefit of public expenditure is equal to the marginal
social sacrifice of taxation.
Criticism
( i) Difficulties in Measuring Social Benefits:
The principle of maximum social advantage is theoretically explained with the help of the
marginal utility analysis. The Marginal benefits of public expenditure and the marginal
disutility on sacrifice of public revenue are concepts, the objective measurement of which is
extremely difficult.
(ii) Unrealistic Assumptions:
It is unrealistic to assume that government expenditure is always beneficial and that every tax
is a burden to society. For example, taxes on cigarettes or alcohol can provide benefit to
society; expenditure on social overheads like health care will give rise to social benefit
whereas unnecessary increase in expenditure on defense may divert resource from productive
activities causing loss of welfare to society.
(iii) Neglect of 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. Dalton
fails to take into account all such other sources.
(iv) 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 it is not
possible practically.
(v) Large Budget Size:
The financial operations of the government involve collection of large sums of money from
taxation and other sources and the disbursement of large amounts by way of public
expenditure. The effects of small additional amounts of these on the community are difficult
to measure. Therefore, in practice, the public authorities are not in a position to estimates the
marginal benefits and the marginal sacrifice.