Public Finance(C# 306)

Ch-01:Introduction
Issues to be learned
✔ Concept, nature constituents and objective of public finance
✔ Theories of public finance - classical theory, Keynesian
theory, and Musgrave theory.
✔ Allocation and distribution of Resources – Pareto Optimality
and social Efficiency; the competitive solution: Efficiency in
consumption, Efficiency in production
✔ Good governance – Accountability and Transparency.

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 Public Finance

Text book
1. Musgrave and Musgrave
2. Reference book
i. Public finance –by Stigliz
ii. Public finance by Hyman
3. Budget Docs
4. Fiscal and Monetary Policy
5. Web docs

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 Public Finance(Course code#----)
Ch-01:Introduction
Issues to be learned
✔ Concept,nature , views and constituents of public finance
✔ Role of Government
✔ Theories of public finance - classical theory, Keynesian
theory, and Musgrave theory.
✔ Allocation and distribution of Resources – Pareto Optimality
and social Efficiency; the competitive solution: Efficiency in
consumption, Efficiency in production
✔ Good governance – Accountability and Transparency.

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 1.1 Understanding Public Finance

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 1.1 Understanding Public Finance
The word ‘public’ refers to general people and the word
‘finance’ means resource. So public finance means resources of
the masses, how they are collected and utilized and to
understand the proper role of the government in the economy.
Public finance is the field of economics that studies government
activities and the alternative means of financing government
expenditures. Thus, Public Finance is the branch of economics
that studies the taxing (income) and spending (Expenditure)
activities of government.
Finally, we understand that Public finance the systematic study of the
operations of public income and expenditures of the public authorities.
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 1.2 Concepts and meaning of Public Finance

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 Definition of Public Finance
Public finance is the approach to managing the public
funds in the country’s economy that plays the most
important role in the development and growth of the
nation, both domestically and internationally. It also
affects every stakeholder of the country, whether a citizen
or not. The public finance economics accounts for the
government revenue and expenditure and the assessment
of desired outcomes is calculated accordingly.

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 Expert definitions and opinions of Public Finance

In simple sense, public finance is the study of finance

related to government entities. It revolves around the
role of government income and expenditure in the
economy.
Prof. Dalton in his book Principles of Public Finance
states that “Public Finance is concerned with income and
expenditure of public authorities and with the
adjustment of one to the other”.

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 Expert Opinions about public finance
Prof.R.R.Musgrave,
“Thecomplexofproblemsthatcenteraroundthereve
nueexpenditureprocessofthegovernmentisreferre
dtoaspublicfinance”.
Prof. P. E. Taylor, “Public finance deals with the
finances of the public in an organized group
under the institutions of government”.
According to Findley Shirras, “Public finance is
the study of the principle underlying the
spending and raising of funds by public
authorities”.

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 So, public finance is the study of how governments
collect and spend money and real resources.
Public finance also analyses-
• How do governments collect/spend money? Positive
analysis
• How should governments collect/spend money?
Normative analysis
From this definition, we can understand that public
finance deals with income and expenditure of
government entity at any level be it central, state or
local. However in the modern day context, public
finance has a wider scope – it studies the impact of
government policies on the economy.

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 1.3 Government and its Economic Role
Governments are organizations formed to exercise authority over the
actions of persons who live together in a society and to provide and
finance essential services.
The main Role played by government in the society:

To maintain and improve the welfare of the people;

To protect the people from harmful activities;
To provide the institutions that allow market to function (e.g. protection
of property rights);
To provide the essential goods and services that markets fail to
adequately provide

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 Adam Smith on the Role of the State
• The three duties of the sovereign –
– protecting society from the violence and
invasion of other societies – by maintaining a
standing armed force
– protecting every member of society from
injustice or oppression by others by establishing
an exact administration of justice
– erecting and maintaining those public
institutions and public works which, though they
may be in the highest degree advantageous to a
great society .the profit could never repay the
expense of any individual or small number of
individuals to erect (raise) or maintain.
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 Role of Modern Government
• To use regulation, taxation and public provision/
nancing to correct for market failures, improving
the e ciency of the economy and overall growth
• To use public policy instruments to improve equity
and protect the vulnerable
• Need to take into account the scope for
government failure
• Political and economic ideology determines size
and scope for government (welfare state,
urbanization, health pandemics, regional
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 1.4 Nature and views of Public Finance
Nature of public finance
✔ Public finance as an art- As an art, public finance enables the concerned
personnel to adopt the principles and policies in solving the financial
problems of the Government in the best possible way to the maximum
benefit of the society. The way to be adopted should be logical, suitable and
proper according to the time. Besides, Public finance is defined as an art as it
applies knowledge for obtaining various objectives. Its essential component
that is fiscal policy uses knowledge of government income and expenses for
achieving numerous goals like full employment, economic equality, and
development.

✔ Public finance as a Science -It is referred to as a science as it systematically

studies the relationship between various facts of government finance. Public
finance studies the relationship between income and expenditure of the
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government.
 Contd.

✔ Public finance as a subject

The scope of public finance is not just to study the
composition of public revenue and public expenditure. It
covers a full discussion of the influence of government fiscal
operations on the level of overall activity, employment, prices
and growth process of the economic system as a whole. So ,
public finance has been treated as a subject.

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 1.5 Objectives of Public Finance

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 1.5 Objectives of Public Finance
We should understand the objectives of the public finance
economics which is highly regarded and one of the highest forms of
assessing the performance of a government or its tenure within an
economy. Understanding the basis for such a theory to govern the funds
collected from the citizens of the country would help us put things
relating to the government and its management into perspective.
• # 1 – Managing Public Needs
• The main objective is managing the basic needs of the public like food,
shelter, health, infrastructure, and education. All these are the
government’s responsibilities so that the fundamental public needs are
fulfilled and contribute to the development of the economy.

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 Contd
#2 – Economic Developments
Proper management leads to economic development
that leads to the nation’s growth.
#3 – Removes Inequality
It also aims at removing the inequality by proper
allocation of resources, i.e., providing relief to the poor
by collecting taxes from the rich class people.
• #4 – Maintaining Price Stability
It helps control in ation by various packages and
means for its development.
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 Contd
Some objective other than the ones
mentioned above could be:
• Ful lling the basic needs of the nation.
• Generating employment.
• Maintaining the currency value in the
international market.
• Ensuring economic stability.
• ----
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 Views of Public Finance
i. Narrow view

ii. Broad view and

iii. Exact view

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 1.5 The scope/ constituents of Public Finance
If we explain the definition of public finance, we find the the
scope of public finance. Besides, Prof. Dalton classifies the scope
of public finance into four areas as follows :
• Public Income(revenue)
• Public Expenditure
• Public Debt
• Public Administration (Financial)

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 Public Income
i) Public Income
public income refers to the income of the government. The government
earns income in two ways – tax income and non-tax income. Tax income is
easy to recognize, it’s the tax paid by people of the country in the form of
income tax, sales tax, duties, VAT etc.
On the other hand non-tax income includes interest income from lending
money to other countries, rent & income from government properties,
donations from world organizations, etc.
This area studies methods of taxation, revenue classification, methods of
increasing government revenue and its impact on the economy as a whole,
etc.
RQ – What is tax income and non-tax income of Govt? Give example

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 Public Expenditure
ii) Public Expenditure
Public expenditure is the money spent by government entities.
Logically, the government is going to spend money on infrastructure,
defense, education, healthcare, etc. for the growth and welfare of
the country.
This area studies the objectives and classification of public
expenditure, effects of expenditure in different areas, effects of
public expenditure on various factors such as employment,
production, growth, etc.
RQ :List out some recent govt. expenditure of GOB.
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 Public Debt
iii) Public debt,
When public expenditure exceeds public income, the gap is filled by
borrowing money from the public, or from other countries or world
organizations such as The World Bank, IMF These borrowed funds
are public debt.
So, this area of public finance explains the burden of public debt,
why it is necessary and its effect on the economy. It also suggests
methods to manage public debt efficiently and effectively.
RQ: Write down some good and bad effects of govt. debt in
Bangladesh

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 Public Financial Administration
iv) Financial Administration- This is a more practical part of public finance. It
studies the procedure to be followed by the government in imposing taxes,
collecting the taxes, spending the collected money and getting the government

income & expenditure audited by the competent authority.

This area of public finance is all about the administration of all public finance i.e.
public income, public expenditure, and public debt. Financial administration
includes preparation, passing, and implementation of government budget and
various government policies. It also studies the policy impact on the social-
economic environment, inter-governmental relationships, foreign relationships, etc.
• RQ- What do you meant by public administration in PF? Explain their
functions and role.

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 1.6 Functions of Public Finance
There are three main functions of public finance as follows –

• The Allocation Function- The government has to perform

various functions such as maintaining law and order, defense
against foreign attacks, providing healthcare and education,
building infrastructure, etc. The list is endless. The
performance of these functions requires large scale
expenditure, and it is important to allocate the expenditure
efficiently.
The allocation function studies how to allocate public
expenditure most efficiently to reap maximum benefits with
the available public wealth. However, The allocation function
deals with the allocation of public goods.

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 Contd.
There are two types of goods in an economy – private
goods and public goods. Private goods have a kind of
exclusivity to themselves. Only those who pay for these
goods can get the benefit of such goods, for example – a
car.
In contrast, public goods are non-exclusive. Everyone,
regardless of paying or not, can benefit from public goods,
for example – a road, primary education, defense

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 Contd
• The Distribution Function
There are large disparities of income and wealth in every country in the world.
These income inequalities plague society and increase the crime rate of the country.
The distribution function of public finance is to lessen these inequalities as much as
possible through redistribution of income and wealth.
In public finance, primarily three measures are outlined to achieve this target such
as :
A tax-transfer scheme or using progressive taxing, i.e. in simpler words charging
higher tax from the rich and giving subsidies to the low-income

Progressive taxes can be used to finance public services such as affordable housing,
health care, education etc.

A higher tax can be applied to luxury goods or goods that are purchased by the high-
income group, for example, higher taxes on luxury cars, other luxury goods.

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 Contd
• The Stabilization Function-
Stabilization policy is a strategy enacted by a
government or its central bank that is aimed at
maintaining a healthy level of economic growth and
minimal price changes. Sustaining a stabilization
policy requires monitoring the business cycle and
adjusting fiscal policy and monetary policy as needed
to control abrupt/ rapid changes in demand or supply.

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 Contd.
Every economy goes through periods of booms and depression.
It’s the most normal and common business cycles that lead to
this scenario. However, these periods cause instability in the
economy. The objective of the stabilization function is to
eliminate or at least reduce these business fluctuations and its
impact on the economy. Policies such as deficit budgeting
during the time of depression and surplus budgeting during the
time of boom helps achieve the required economic stability.

• RQ: Why is stabilization function necessary?

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Other important functions of public fiancé

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 1.7 Public & Private finance
Private finance is financial planning or management at the

individual as well as company, firms and corporation levels. It

uses monetary, personal, and family resources, considering
future events and the associated risks. It involves saving for
future needs, investing to earn a return, and borrowing to
finance investments or large purchases.

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Similarities between Public and Private Finance
• Public finance deals with managing government
revenue and expenditures, while private finance deals
with managing personal and business finances.
• Public finance involves saving through taxation and
investing in public goods and services. Private finance
involves saving for future needs, investing to earn a
return, and borrowing to finance investments or large
purchases.
• Public finance aims to achieve financial security for
the nation by promoting economic growth and
development, reducing poverty and inequality, and
maintaining economic stability. Private finance aims to
achieve financial security for individuals, households,
and businesses by helping them to maximize profits,
minimize costs, and grow wealth.
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 Contd
• Public finance promotes economic growth and development by
providing public services, funding infrastructure, and managing
the economy through fiscal policy. Private finance helps
businesses to invest and grow, and it helps individuals to save
and invest for their future.

In conclusion it can be said that Public and Private finance are two
distinct areas of finance with different objectives and functions.
Public finance involves collecting and managing government
revenue and expenditure to promote public interests. On the
other hand, private finance is focused on the financial activities of
individuals, households, and businesses in the private sector.
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 1.8 Key Players of Public Finance
A. Ministry of Finance- the ministry of finance (mof),
a key player in the stewardship of public finances, is
responsible for government finance operations, including
annual budget preparation, fiscal management, public debt
management, taxation, and economic policy formulation. it
oversees the operations of the country’s financial institutions,
and it plans, implements, and controls the public expenditure
policies and programs of the government.

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 Contd.
together with other relevant ministries and divisions, the mof is
responsible for the preparation of the medium-term budgeting
framework (mtBf) and the annual budget (both non development
and development).

It also develops and updates the medium-term macroeconomic

framework in collaboration with the Planning commission, the
Bangladesh Bureau of statistics, the national Board of revenue,
Bangladesh Bank, and other relevant agencies.

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 Contd.
Economic Relations Division-
The economic relations Division (erD) of the mof plays a key role in
the overall management of external aid including loans and grants.
the aDB Wing of the erD, headed by a joint secretary, is primarily
responsible for selecting aDB-financed programs and projects to
be included in the annual development program (aDP), and for
maintaining the government’s overall relationship with aDB.
according to the “allocation of Business” section of the Rules of
Business (1996), the main functions of the erD are as follows

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 Contd
B. Ministry of Planning-the ministry of Planning oversees
the financial policies of the government and is responsible
for socioeconomic planning and statistical management. it
has three divisions: the Planning Division; the statistics and
informatics Division; and the implementation, monitoring,
and evaluation Division (imeD).

• Planning Commission

• Implementation, Monitoring, and Evaluation Division

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 Contd.
C. Office of the Controller General of Accounts
D. Office of the Comptroller and Auditor General
E. Bangladesh Bank
F. Asian Development Bank

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 1.9 Theories of public finance

• Classical theory,

• Keynesian theory, and

• Musgrave theory.

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 1.9.1 Classical theory,
The fundamental principle of the classical theory is
that the economy is self-regulating. The classical
doctrine is that the economy is always at or near the
natural level of real GDP and is based on two firmly
held beliefs: i) J.B. Say's Law of market which means
that prices, wages, and interest rates are flexible, ii)
Quantity Theory of money.

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 Criticism of Classical theory
The following are the main points of Keynes’ criticisms
against the classical theory:
1. Unrealistic Assumption of Full Employment Condition:
2. Undue Importance to the Long Period-Keynes opposed the classical
insistence on long-term equilibrium; instead, he attached greater
importance to short-term equilibrium.
3. Keynes’ Denial of Say’s Law of Markets-Classical economists rest on
Say’s Law which blindly assumed that supply always creates its own
demand and affirmed the impossibility of general overproduction and
disequilibrium in the economy. Keynes totally disagreed with this view
and stressed the possibility of supply exceeding demand, causing
disequilibrium in the economy and pointed out that there is no
automatic self-adjustment in the economy.

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 Contd
4. Keynes’ Attack on Laissez-faire Policy-Keynes strongly
attacked the classicists for their unrealistic approach to the
problems of contemporary capitalist economic system. Pigou’s
plea for a return to free perfect competition to solve the problem
of unemployment seemed ‘obsolete’ in the changed conditions of
the modern world.
5. Attack on Money Wage Cut Policy-Keynes objected to
the classical formulation of employment theory,
particularly, Pigou’s notion that unemployment will
disappear if the workers will just accept sufficiently low
wage rates (i.e., a voluntary cut in money wage). He
rejected Pigou s plea for wage flexibility as a means of
promoting employment at a time of depression.

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 1.9.2 Keynesian theory,
Keynesian economics gets its name, theories,
and principles from British economist John
Maynard Keynes (1883–1946), who is
regarded as the founder of modern
macroeconomics. His most famous work, The
General Theory of Employment, Interest and
Money, was published in 1936.

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 1.9.2 Keynesian theory,
Keynesians believe that, because prices are
somewhat rigid, fluctuations in any component of
spending—consumption, investment, or
government expenditures—cause output to
change. If government spending increases, for
example, and all other spending components
remain constant, then output will increase.

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 Keynesian Model

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 Money wage Vs Real wage
Labours are generally paid a certain sum of money per day or
week, month etc. The amount of money paid is called the
money wages.
The /Labour, however, is more interested in the goods and
services which he can get with his money wages or otherwise.
The amount of goods and services which the labour actually
gets is called his real wages.
The standard of living and the prosperity of a labor depend
not on his money wages but on his real wages.

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 Contd.
RQ 1: Explain Law of Market as per classical
Economists
RQ 2: Distinguish between Keynesian
Theory and Classical theory
RQ 3; How do you make difference between
real wage and money wage?

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 1.9.3 Musgrave theory
Musgrave, widely regarded as the founder of modern
public finance and an adviser on fiscal policy and
taxation to governments. Musgrave's theory broke down
governmental economic activity into three parts:
i. the allocation of resources;
ii. the distribution of goods and services; and
iii. the stabilization of the broader economy
So, According to Professor Musgrave there are three major
fiscal or budgetary functions of the governments. They are:
a) Allocation functions b) Distribution functions and c)
Stabilization functions

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 Contribution of Musgrave Theory
✔ The use of fiscal instruments to secure adjustments
in the allocation of resources between private and
public goods;
✔ The use of fiscal instruments to secure proper
adjustments in the distribution of Income and
wealth; and
✔ The use of fiscal instruments to secure economic
stability and growth
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 1.10 Allocation and distribution of
Resources
An allocation is efficient if it is impossible to reallocate

resources such that one person can be made better off without
making at least one other person worse off. Moreover, the
people themselves must be the judges of whether they are
better or worse off, by the principle of consumer sovereignty. An
immediate outcome is that the government should pursue all
pareto-superior allocations, those that make at least one
person better off without making anyone else worse off. This is
the basic concept of Pareto-optimality.
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 1.11 Pareto Optimality and Social Efficiency
Pareto-optimality, a concept of
e ciency used in the social sciences,
including economics and political science,
named for the Italian sociologist Pareto. A
state of affairs is Pareto-optimal (or Pareto-
efficient) if and only if there is no alternative state
that would make some people better off without
making anyone worse off.
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 Contd
The Italian Economist Vilferdo Pareto has laid down the
conditions for maximising social welfare or for achieving a
social optimum. A Paretian optimum refers to a situation
in which it is impossible to make any one better off without
making some one worse off. For judging such a situation,
Pareto has enunciated a very simple and straightforward
criterion thus: "Any change which harms no one and which
makes some people better off (in their own estimation)
must be considered to be an improvement."

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 Contd.
Pareto efficiency, or Pareto optimality, is an economic state
where resources cannot be reallocated to make one
individual better off without making at least one individual
worse off. Pareto efficiency implies that resources
are allocated in the most economically efficient manner, but
does not imply equality or fairness. An economy is said to be
in a Pareto optimum state when no economic changes can
make one individual better off without making at least one
other individual worse off.

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 Contd.
Pareto efficiency, named after the Italian
economist and political scientist Vilfredo
Pareto (1848-1923), is a major pillar
of welfare economics. Neoclassical economics,
alongside the theoretical construct of perfect
competition, is used as a benchmark to judge
the efficiency of real markets—though
neither perfectly efficient nor perfectly
competitive markets occur outside of
economic theory.
.
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Understanding Pareto Efficiency
Hypothetically, if there were perfect competition and
resources were used to maximum efficient capacity, then
everyone would be at their highest standard of living or
Pareto efficiency. Economists Kenneth Arrow and Gerard
Debreu demonstrated, theoretically, that under the
assumption of perfect competition and where all goods
and services are tradeable in competitive markets with
zero transaction costs, an economy will tend toward Pareto

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 Contd
In any situation other than Pareto efficiency,
some changes to the allocation of resources
in an economy can be made, such that at
least one individual gains and no individuals
lose from the change. Only changes in the
allocation of resources that meet this
condition are considered moves toward
Pareto efficiency. Such a change is called
a Pareto improvement.

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 Social Efficiency
Social efficiency is the optimal distribution of
resources in society taking into consideration all the
internal and external costs and benefits.
The internal costs and benefits, also known as
the private costs and benefits, are the direct costs
and benefits of an economic decision. This falls
directly on whoever makes the economic decision.
On the other hand, external costs and benefits are
the indirect costs and benefits of an economic
decision felt by third parties. These are also referred
to as externalities.
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 Contd
Social efficiency theory states that the marginal
benefits of an economic decision must be equal to the
marginal costs of that economic decision.
Now, we are supposed to know what is marginal
social benefit? And what is marginal social cost?
Marginal social benefit is the additional benefit
acquired by society as a whole from the consumption
of an additional unit of a good or service. On the
other hand, marginal social cost is the additional cost
paid by society as a whole for the consumption of an
additional unit of a good or service.

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 Contd
Social bene t includes both private bene t
and external bene t whereas social cost
includes both private cost and external cost.
Let's give you the formulas involved.
• For social efficiency,
MSB = MSC
• MSB= MPB+ MEB

• MSC=MPC+MEC

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 Graphical presentation of Social
efficiency

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 1.12 Good Governance- – Accountability and
Transparency
Governance refers to all processes of governing, the
institutions, processes and practices through which issues of
common concern are decided upon and regulated. Good
governance adds a normative or evaluative attribute to the
process of governing. From a human rights perspective, it
refers primarily to the process whereby public institutions
conduct public affairs, manage public resources and
guarantee the realization/ensuring of human rights.
Example

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 Key attributes of good governance
The Human Rights Council has identified the key
attributes of good governance:
• transparency
• responsibility
• accountability
• participation
• responsiveness (to the needs of the people)

RQ: Define Good Governance- Key attributes of

good governance
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 “Transparency”& “Accountability”
Transparency” is government's obligation to
share information with citizens that is needed
to make informed decisions/ issues and hold
officials accountable for the conduct of the
people's business. Transparency exists on
government websites largely at the generosity
of officials.

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 Contd.
Transparency implies openness, communication,
and accountability. The term transparency has a
very different meaning in information security
where it is used to describe security mechanisms
that are intentionally indetectable or hidden from
view.

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 Contd.
To achieve transparency, an organization must provide
information about its activities and governance to
stakeholders that is accurate, complete and made
available in a timely way. Transparency enables
accountability. This does not mean all information
should be made publicly available.

RQ: How do you relate Good Governance, Accountability and

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 What is accountability?
Accountability exists in a relationship between two parties where
one has expectations of the other, and the other is obliged to
provide information about how they have met these expectations
or face the consequences of failing to do so.
There are two components of accountability:
a. Answerability – which means providing information and
justification for how one’s actions align with expectations; and

b. Enforcement – which means being subject to, and accepting

the consequences of, failing to meet these expectations.
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 Contd.
However, accountability in an organization will involve multiple
parties, it is important there is clarity about who is accountable to
whom and how.

The way this accountability is achieved will generally be set out in

an organization's governing documents, such as its constitution,
and any laws that apply to it. For example, an NFP may be
required to provide an annual financial report to its regulator and
the penalty for failing to do this may be a fine.

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 Contd.
It is important that the documents and policies that
enable accountability are made available to relevant
stakeholders.
Subject to necessary confidentiality, usually this is
done by providing such information on the
organization's website, but it should be available on
request at a minimum.
For accountability to be achieved, there must be
transparency.
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 Maximum Social Advantage

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 Contd.

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 Contd.

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 Review Questions
1. Define public finance with stating its characteristics of public finance.

2. Explain the nature and views of Public Finance.

3. Discuss the constituents of Public Finance with examples.
4. State the functions of Public Finance.
5. State the role of government in a modern state.
6. What is private finance? Difference between public finance and private finance.
7. Write down some good and bad effects of government debt in Bangladesh.
8. What do you mean by Public financial Administration? State their role.
9. Define Pareto optimality and Social efficiency from the view point of resource allocation and distribution.
10. “Social efficiency theory states that the marginal benefits of an economic decision must be equal to the
marginal costs of that economic decision”-explain

11. What is marginal social benefit And marginal social cost? Write doen social efficiecny condition in equation
form
12. Explain the statements “ Supply Creates its own demand” as per classical economists.

13. Write down the contribution of Musgrave theory in Public Finance.

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