THEORY AND PRACTICE

Unit 1: INTRODUCTION TO PUBLIC FINANCE

By Nadya Narsidani
 Unit 1: INTRODUCTION TO PUBLIC FINANCE
PUBLIC FINANCE Vs PRIVATE FINANCE

Meaning – private finance includes the income and

expenditure of a person or company. Public finance is a study
of the income and expenditure activities of the government.

Objective - The goal of private finance is to make a profit
and fulfill private desires. The goal of public finance is to
benefit the public social benefit vs personal benefit

Adjustment of income & expenditure – In private finance,
individuals or a company have fewer resources to earn an
income. Individuals or companies prefer surplus budgets
to make a profit. Government usually makes a budget for
the expenditures of projects. When expenditure is more
than income then budget is deficit budget.

Motive of Expenditure - Government make a transaction
for public benefit. private individuals make business
transactions for profit.

Long term consideration - 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.
The government spends that money on projects that are
beneficial to the general public. Such as building roads,
providing electricity, water, etc. Government usually
 makes a budget for the expenditures of projects. Public
finance plays an important role in reducing economic
inequalities.

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

Publicity of Finance – published vs secrecy government
make its budget proposals and allocation of resources to
the public. In private finance, an individual can keep
their transaction secret.

Coercive methods - Government can use coercive
methods to get income such as taxes. Private individuals
cannot use force to get income.
Public refers to general people and finance means resources.
Public finance deals with how resources of the masses is
collected and utilised.

Public finance is the study of the role of the government in the

economy. It is the branch of economics that assesses the
government revenue and government expenditure of
the public authorities and the adjustment of one or the other to
achieve desirable effects and avoid undesirable ones.

Dalton wrote in his book “Principles of Public Finance”…

Public finance is concerned with income and expenditure of
public authorities, and with adjustment of one to the other.
 Definition

“Public finance is a study of the principle underlying the

spending and raising funds by Public Authorities.” ~ G
Findlay Shirras, Economist, London

“Public finance is a branch of economics which deals with

income and expenditure of public authorities or the state and
their mutual relation as also with the financial administration
and control.” ~ Prof. Bastable, Professor of Political Economy
in the University of Dublin
Functions of Public Finance:

Public finance has three main functions:

The effective use of available resources.

Income distribution among citizens.

The economy’s stability.

When Government intervenes & takes action within economy,

outcomes are classified into one of three categories:

Economic efficiency – Economists use a standard to evaluate a

variety of resources. Economic efficiency focuses on
eliminating waste to provide as much value as possible whereas,
technical efficiency looks to maximize value, while sacrificing
as much as is needed to create best initiative.

Distribution of income – Calculation of wealth & income of a
nation once it is divided by its total population. Wealth is the
overall value of a population’s physical possessions and
financial assets whereas, Income is the exact monetary value of
a population’s net intake over a selected period of time.

Macroeconomic stabilization – Process by which stabilization &

growth of economy is monitored through development of fiscal
& monetary policies, laws & regulations.
SUBJECT MATTER OF PUBLIC FINANCE
The subject matters of Public Finance can be broadly
classified into five categories –

Public revenue

Public expenditure

Public debt

Financial administration

Economic stabilization
Scope of Public Finance:

The scope of public finance can be divided into 4 parts:

1. Public Revenue – tax income & non-tax income (interest
income from lending money to other countries, rent &
income from government properties, donations from world
organizations, etc.)
2. Public Expenditure – money spent by government entities for
the growth and welfare of the country (infrastructure,
defense, education, healthcare, etc.)
3. Public Debt – borrowed funds are public debt (The World
Bank, etc.)
4. Financial Administration – preparation, passing and
implementation of government budget & various government
policies, policy impact on the social-economic environment,
inter-governmental relationships, foreign relationships, etc.
 IMPORTANCE OF PUBLIC FINANCE

Provision of public goods like roads, military services and

street lights etc.

Enables governments to tackle or offset undesirable side
effects of a market economy like pollution.

It helps governments to redistribute income.

It helps in introducing social programmes.

Generation of employment opportunities, control of
economic fluctuations like boom and depression,
maintaining economic stability etc. are some of the thrust
areas of the governments through fiscal operations.
 ROLE OF GOVERNMENT IN ORGANISED SOCIETY
• To impose law and order. Without a government, an
organized society would cease to be organized.
• To keep control of its people. To give the appearance of
some equality in society. To make communal
expenditures for society as a whole.
• To protect its citizens from fraud, aggression, theft, and
breach of contract. As well it is their job to represent the
people of each nation in the international community,
and protect them with police and military forces.
• The role of government is broken down into three main
branches - legislative makes the laws, executive
implements the laws and the judiciary interprets the
various laws.
 CHANGING ROLE OF GOVERNMENT IN
AN ORGANISED SOCIETY
The shortcomings of the free market mechanism under which there
is no role of government in the economic development of a nation.
Due to the failure of the free market mechanism, the intervention
of government became indispensable for the growth of an economy.
Now, the question arises of determining the extent of government
in regulating and managing economic activities.

This remains a debatable issue among various economists. This is

because of the reason that the government intervention is also not
able to eradicate the economic problems of a nation completely.
Different economists have given different viewpoints for the role of
government in an economy.
 CHANGING ROLE OF GOVERNMENT IN
AN ORGANISED SOCIETY
Societies construct patterns of behavior by deeming certain actions
or speech as acceptable or unacceptable. These patterns of behavior
within a given society are known as societal norms. Societies, and
their norms, undergo gradual and perpetual changes.

Modern societies are expected to provide protection, law and order,

economic security, and a sense of belonging to their members.

Note, that world's economies are undergoing a fundamental

transformation to knowledge-based industries.. Need a focus on
establishing partnerships, networks and an innovation system that
enhance a country’s ability to share knowledge and information.
 CHANGING ROLE OF GOVERNMENT
IN INDIA
•1947 till 1979 – Country was poor and shattered after partition,
most of the population was employed in agriculture. Government
intervention brought public sector into dominance in heavy
industry, transportation and communication. Emphasized self-
sufficiency than foreign trade with imposed controls on import
and export.
•1980 till 1990s – Beginning 1979, government started reducing
state control of economy. Rate of growth started improving. The
gestation period of projects brought the need of high investment
requirements which was fulfilled by private savings. As a result
mid 1980s saw balance of payment crisis, which pave it’s way to
economic liberalisation in 1991
•1991 onwards – Foreign trade regulations were eased, restrictions
of private firms lifted. By mid 1995, the foreign direct investment
made the ground steady for Indian economy.
 ECONOMIC SYSTEMS

On the basis of the ownership and distribution of resources, the economic

system can be grouped into three categories, which are shown in Figure-1:
 ECONOMIC SYSTEMS
The private ownership of resources, in a socialist economy, is
changed by state ownership. Encouraging factor is the social
welfare.

Public sector of an economy, such as India, is based on socialist
pattern of society.
A capitalist economy refers to an economy that works on principle
of free market mechanism. It is also termed as laissez faire system.
Main force of motivation is the private profit.
In a capitalist economy, role of government is very limited, the
main responsibilities performed by Government are:

Developing & sustaining free market mechanism system

Eliminating any kind of restrictions on the working of free
competitive market

Increasing effectiveness of free competitive market system
through various measures
 ECONOMIC SYSTEMS

Mixed economy refers to an economy that-comprises the

features of both, the socialist economy and capitalist
economy.

Working of a mixed economy is based on principles of free
market mechanism & centrally planned economic system.

Private sector is encouraged to work on the principle of
the free market mechanism

Public sector is involved in growth & development of
public utilities, which is based on principle of socialist
economy
Public Finance deals with income and expenditure of public
authorities (includes all sorts of governments – Central, State
and local).

A mixed economy is comprised of private and publicly owned

businesses that are regulated by governmental organizations.

The private sector comprises of business which is owned,

managed and controlled by individuals. On the contrary, public
sector comprises of various business enterprises owned and
managed by Government

Thus, the total finance of the country includes public finance

and private finance.
Public Sector is divided into :
• General Government:
• Central Government
• State Government
• Local Government
A government is a group of people that governs a
community or unit. It sets and administers public policy
and exercises executive, political and sovereign power
through customs, institutions, and laws within a state.
• Public Corporations
Public corporation means an entity that is created by the
state to carry out public missions and services.
 ROLE OF GOVERNMENT IN ECONOMIC SYSTEMS

Role of Government in a free market mechanism

Developing and sustaining the free market mechanism
system

Eliminating any kind of restrictions on the working of
free competitive market

Increasing the effectiveness of free competitive market
system through various measures
 ROLE OF GOVERNMENT IN ECONOMIC SYSTEMS

Role of Government in socialist economy

The objective of the government in a socialist economy is
same as in the capitalist economy, such as growth, efficiency,
and maintaining justice. However, the ways adopted by the
socialist economy to achieve those objectives are different
from the capitalist economy.

For example, in the capitalist economy, the main force of
motivation is the private profit, whereas in the social
economy, the encouraging factor is the social welfare

The socialist way of managing an economy facilitates the
elimination of various evil activities of the capitalist economy,
such as labour exploitation, unemployment, and inequality in
the society. This is only the classical view of the socialist
economy.
 ROLE OF GOVERNMENT IN ECONOMIC SYSTEMS

Role of Government in mixed economy

Mixed economy refers to an economy that-comprises the
features of both, the socialist economy and capitalist
economy. This implies that working of a mixed economy is
based on the principles of the free market mechanism and
centrally planned economic system.

In a mixed economy, the private sector is encouraged to work
on the principle of the free market mechanism under a
political and economic policy outline decided by the
government. On the other hand, the public sector, in a mixed
economy, is involved in the growth and development of
public utilities, which is based on the principle of socialist
economy.
 ROLE OF GOVERNMENT IN ECONOMIC SYSTEMS

Role of Government in mixed economy

In a mixed economy the public sector comprises certain industries,
businesses, and activities that are completely owned, managed, and
operated by the government. Moreover, in a mixed economy, certain
laws have been enacted by the government to restrict the entry of
private entrepreneurs in industries reserved for the public sector.

Apart from this, the government also strives hard for the expansion
of the public sector by nationalizing various private ventures. For
example, in India, the government has nationalized several private
banks, which has resulted in the expansion of the public sector.
Besides working for the growth and development of the public
sector, the government, in a mixed economy, controls the activities
of the private sector by implementing various monetary and fiscal
policies.
 ROLE OF GOVERNMENT IN ECONOMIC SYSTEMS

Role of Government in mixed economy

Maintain framework

Provide public goods and services

Maintain competition

Redistribute income

Stabilize the economy.
WELFARE ECONOMICS:

Welfare economics is defined as a branch of economics that

studies how the distribution of income, resources and goods
affects the economic well-being.
An example of welfare economics is the study of how certain
health services help bridge the barrier between different
classes of people.

• Welfare economics is concerned with the evaluation of

alternative economic situation from the point of view of
society’s well being.
WELFARE THEOREM: WALRASIAN EQUILIBRIUM

Fundamental theorems of welfare economics

WALRASIAN EQUILIBRIUM: Leon Walras

First Fundamental theorem of Welfare Economics (Invisible

hand theorem)

First Welfare Theorem is the “invisible hand” result presented

and proved mathematically. Invisible hand was pioneered by
Adam Smith is the cornerstone of the most important model
in economics.
WELFARE THEOREM: WALRASIAN EQUILIBRIUM
French economist Leon Walras in his Elements of Pure
Economics argued that all prices and quantities in all markets are
determined simultaneously through their interaction with one
another.

In Walrasian model the behaviour of each individual decision-

maker is presented by set of equations. There are as many
markets as there are commodities and factors of production.

Since the number of equations (demand function and supply

function) is equal to the number of unknowns (prices and
quantities of all commodities and all factor inputs); a general
equilibrium solution exists.
WELFARE THEOREM:
First Fundamental theorem of Welfare Economics (Invisible
hand theorem) states that any competitive equilibrium leads
to a Pareto efficient allocation of resources.

The main idea here is that markets lead to social optimum.

Thus, no intervention of the government is required, and it
should adopt only “laissez faire” policies.

Basically when at a competitive equilibrium, (also called:

Walrasian equilibrium) that is a set of prices such that goods
and services are traded where supply equals demand of them,
it would be impossible to redistribute the goods and services
to make anyone better off without also making someone
worse off, i.e. Pareto efficient. All this means is that self
interested behavior under a certain set of technical
assumptions generates trading and market prices that
distribute labour, resources, and goods without leftovers or
potential to redistribute more efficiently in the economic
sense.
WELFARE THEOREM:
However, those who support government intervention say that
the assumptions needed in order for this theorem to work, are
rarely seen in real life.

The second theorem allows a more reliable definition of

welfare.

Second Welfare Theorem of Welfare Economics states that, any

efficient allocation can be attained by a competitive
equilibrium, given the market mechanisms leading to
redistribution.

This theorem is important because it allows for a separation of

efficiency and distribution matters
The Second Welfare Theorem says that, again under certain
technical assumptions, it's possible to achieve any conceivable
Pareto efficient outcome (that is one where redistribution of
goods can't make anyone better off without also making
someone worse off ) by redistributing initial resources and then
letting them trade in a competitive market. Basically, markets
taking place after an appropriate redistribution of income could
theoretically achieve any efficient allocation of resources
desired by a 'social planner‘.
 Welfare theorem: Concept, Walrasian equilibrium
and Pareto – Optimality .

First
Fundamental Second
theorem of Welfare
Welfare Welfare economics is
Welfare theorem of It states that, any
Economics defined as a branch of It states that, welfare
Economics efficient allocation can
economics that studies any competitive Economics be attained by a
how the distribution of (Invisible equilibrium leads to competitive equilibrium,
income, resources and hand a Pareto given the market
goods affects the theorem)
economic well-being. efficient allocation of mechanisms leading to
resources. redistribution.

An example of welfare
The main idea here is This theorem is
that markets lead to important because it
economics is the study of
social optimum. Thus, no
how certain health allows for a
intervention of the
services help bridge the separation of
government is required,
barrier between different efficiency and
and it should adopt only
classes of people.
“laissez faire” policies distribution matters
First theorem is all about implicit assumptions. It says that in order for any market to
be efficient consumer only needs to know the price of the good which he wants to buy.
They don't need to know how certain good is made, who is the owner of the good or
where are the goods coming from. Only thing the consumer needs to know is the price.
If he knows the price he can formulate demand for that good, and if the market
functions properly, efficient outcome is guaranteed. Because of the fact that consumer
needs to know only one information, it is said that competitive markets economize
with information. This is important because it gives a strong argument in favor of
using competitive markets as way of resource allocation - they don't need much
regulation.
Theorem makes sense when:
•goods consumption and not the consumption of others, smoking is a good example of
negative externality. This is important because cigarette smoker doesn't per se care for
non smoker in the same room, he doesn't have 'natural' incentive to reduce his
smoking. Similarly, steel factory whose output is polluting a river doesn't really care for
the output of the local fisherman, etc. In these cases final outcome won't be efficient
and theorem won’t work.
•there are enough participants in the market, so that they have an incentive to act
competitively. When there only 2 participants in the market they are more prone to
form a monopoly/oligopoly.
Second theorem is also all about implicit assumptions: One of the main issues
of economics is how to optimize efficiency with distribution. Often you have to
sacrifice one in favor of the other. Second theorem says you should think about
these problems separately. It says that if you want to make position of one group
of people better (at the expense of other groups), don't mess with prices! Prices
of each good are there to indicate the social costs of producing certain good,
when you change one price, i.e. make it artificially cheaper through subventions
or more expensive through taxes, all other prices get messed up! One chocolate
before price change can be worth 2 breads, 1 litre of milk, 100g of peanut and
after (artificial) price change these relations can get drastically changed. This in
turn confuses consumers and leads them to make suboptimal choices when
buying goods. That is also why high inflation is bad: it makes price distortions
(and is sometimes called hidden tax), prices change so quickly that people do
not have time to adapt, or prices of certain goods change faster than others.
Conclusion of second theorem is that if you have to tax people, taxation should
be neutral: it should be made in such a way that it doesn't change behavior of
consumers. If you tax a person for the amount work he does he will probably
choose to work less. If you tax every person for flat 10 hours of work he does,
then he probably won't choose to work less.