CHAPTER ONE: BASICS OF PUBLIC FINANCE

Unit description
This chapter deals with the definition of public finance, roles of government in economic
activities, scope of public finance and fiscal federalism. To deliver these contents, active learning
methods such as brainstorming, interactive lecture, group discussion, and independent learning
will be used. And also to assess students’ achievement, continuous assessments such as quiz,
test, class activities, assignments and others will be used.
Objective: At the end of this unit students will be able to:
 Define public finance
 Explain the role of government in economic activities
 Identify the scope of public finance
 Explain fiscal federalism
1.1 Definition of public finance
Public finance is a compound term of the words “public” and “finance”.
The word ‘public’ stands for a collection or conglomeration of individuals, i.e., people taken
as a whole. It still stands for all the citizens of a state which may consist of a number of
people and
The word finance refers to money matters (revenue, expenditure, debt, receipt, payment and
e.t.c.) and their management. Then what is public finance?
Public finance is a subject which discusses the financial operation of fiscal or public treasury.
Or
Deals with optimal mobilization and utilization of financial resources by the government to
the citizen benefits.
Different economists have defined public finance as follows:
1) “Public finance is concerned with the income and expenditure of public authorities and with
the adjustment of one to the other.” Huge Dalton
2) “Public finance deals with the provision custody and disbursement of resources needed for
conduct of public or government functions.” Lutz
3) “Public finance is a science which deals with the activity of the statement in obtaining and
applying the material means necessary for fulfilling the proper functions of the state.”
CarlPlehn
4) “Public finance is the study of the principles underlying the spending and raising of funds of
public authorities.” Findley Shirras
5) “The government, considered as a unit, may be defined as the subject of study of public
finance. More specifically, public finance studies the economic activity of government as a
unit.” Buchanan
6) “Public finance deals with expenditure and income of public authorities of the state and their
mutual relations as also with the financial administration and control.” Bastable

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 All of them say that it is a study of income and expenditure of the central, state, and local
governments. Government performs many functions which the individual cannot or do not
perform. Therefore, rising of funds for the expenditure and their disbursement constitutes
the subject of Public finance.
1.2 Roles of government in economic activities
Government has a major responsibility in
 Economic well-being
 Assuring peace and stability
 Plays significant role in market failure area of the economy.
In doing these the role of the government has three folds
 Efficient allocation of resources
 Distribution of income
 Macroeconomic stabilization
The existence of :
 Market failure due to exercise of monopoly power in market
 Failure to internalize externality
 Failure to provide or insufficient provision of public goods
 Incomplete information... etc forces contemporary writers to admit the role of
government is not a luxury but a vital necessity and government should do in:-
 Establishing a foundation of law
 Maintaining a non-distortionary policy environment
 Investing in a basic social services and infrastructure
 Protecting the vulnerable, and
 Protecting the environment
1.3 Scope of Public Finance
In your personal logic, what should be the role of government in economic activities?

The contents of the science of public finance are divided into five categories of financial
activities of the government: They are,
1.3.1 Public Revenues
Revenue includes all incomes irrespective of the source they are obtained from.
Thus, in wider sense we can include:
 Taxes, non tax revenues as well as borrowing under public revenue.
But in the interest of clarity we study such incomes separately.
Hence, in public revenue, we include only those incomes which do not carry with them the
obligation of repayment for the state.
Thus, public revenue implies raising income by way of taxation. (We will discuss more
about it on the following chapters)

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1.3.2 Public Expenditure
Explain Public revenues and show the main sources of Public revenues?

It is the allocating and using of resources responsively, efficiently and effectively. It includes all
outlays of the government made to keep the society welfare.
Public expenditures are made in those areas, which cannot be commercially available in the
market by the private sectors but are deemed very crucial to the well being of the society.
In a free market economy government expenditure focuses on those sectors, which are not
profitable to undertaken by the private sector.
Different economists and public finance experts have used different bases to classify public
expenditure. But most governments classify public expenditure in to two
1. Current expenditures, (recurrent expenditure): - non development expenditures. They are
intended for continuing the existing flow of goods and services and maintain the capital of
the country intact.
2. Capital expenditure:-contribute to increased productive capacity of the nation & therefore
known as developmental expenditure.
E.g. Expenditures on construction of dams, roads, public works, state enterprise, agriculture
and industrial development …etc. Recurrent expenditure is usually financed by tax & non tax
revenues whereas; capital expenditures, b/c of their huge financial requirements, are financed
mostly by external loans or assistances.
Reasons for Growth of Expenditures
 Welfare state
 Defense
 Population growth
 Transportation & communication
 Urbanization effect
 Growth of democracy
 Raising trend of prices
 The rural development effect
 Canons of Public Expenditures
A canon of public expenditures refers to the fundamental rules & principles that govern the
spending policy of the government. These are;
a) Benefit: - every public spending must ultimately be used for cause of social benefit, not
to individual benefit.
b) Economy: - wistful & extravagant expenditure should be avoided at all levels.
c) Sanction: - no public spending should be made without the approval of proper authority.
d) Surplus: - the government should avoid deficits.
e) Elasticity: - changes must be possible in the expenditure according to the requirements
& circumstances.
f) Productivity: - expenditure should encourage production of the country.
g) Equity: - more expenditure should be made for the poor to have better income & wealth
distribution & less for the rich. The applicability of this principle is differing from
principles of public revenue.

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 Effects of Public Expenditure
Public expenditure, in modern government finance, is regarded as a means of securing social
ends rather than just being a mere financial mechanism.
Public expenditure is significant in a modern economy because it produces many direct and
indirect socio-economic effects.
1) Effects of Public Expenditure on Production
a) Effects upon Ability and Willingness to Work, Save and Invest
 Public expenditure can influence the ability and willingness to work, save and invest.
 This is because a sufficient amount of public expenditure will ensure the production
activities.
 For instance, government’s public expenditure on developing basic infrastructural
facilities will create the ability and willingness to work.
 This means that, public expenditure can create employment opportunities.
 Therefore, income of the people will increase. It will gradually create a tendency among
people to save. This saving will convert in to investment. That means more growth of
the economy.
b) Effects on diversion of resources
 Similarly, public expenditure can able to control the resources in to various uses and
locations.
 By understanding the requirements of the economy, government can take reasonable
policies to improve backward locations and efficient utilization of the resources.
 Sometimes government starts industrial activities, projects, schemes etc. which will
directly generate employment opportunities, more income, effective demand, and mass
production and so on, finally economic growth and development.

2) Effects of Public Expenditure on Distribution

Public expenditure may be in any of the following three modes based on the ability to
receive.
a) Progressive public expenditure: is very essential for any economy to bring economic
equality. It aims more flow of income to the poor class like providing subsidies, social
insurance, special schemes etc.

b) Regressive public expenditure: It is not good for any economy to bring economic
equality. Here the flow of income is concentrated to the richer class. This will widen the
gulf between two classes and by inequality in the society.
c) Proportional public expenditure: Here the flow of income is based on the proportion of
income or wealth held by the people. This method never helps to bring any improvements
in the society.
3) Effects of Public Expenditure on Economic Stability
Attaining economic growth and development and maintaining its stability are the two main
aims of any economy.
Economic stability can be achieved only by eliminating the barriers of growth.
Public expenditure has a big deal in bringing economic stability.
Simply, economic stability is a condition of an economy where there is no
o Inflation

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 o Deflation
o Unemployment
o Flexible exchange rate etc.
To cure inflation government must follow surplus budget policy by reducing its public
expenditure.
On the contrary, government must follow deficit budget policy during deflation by
expanding public expenditure.
This is simply because public expenditure can simply adjust the volume of money in the
economy.
4) Effects of Public Expenditure on Economic Development
 Public expenditure is one of the crucial tools of determining the speed of economic
growth and development.
 By trying to achieve economic growth and development, public expenditure creates wide
effects on the improvements in:
o Infrastructural facilities
o Increasing of social overheads
o Maximum social advantage
o Welfare
o Safety
o Security
o Reducing inequalities and
o Improvements in the standard of living etc
1.3.3 Public Debt
It refers to the money a government borrows from various parties such as from individuals,
institutions, foreign governments and international financial lending institutions which is
subject to repayment at some future date (maturity) including its interest.
It is also refers to the cash inflows of a government in the form of borrowing.
Nature of Public Debt
Public debt can be comparable with that of private debt and tax-revenue in terms of various
parameters from different angels

Public Debt vs. Private Debt

The following are the glaring dissimilarities between public and private debt.
 Source
 Purpose
 Mode of payment
 Effect on the economy
 Durability
 Interest rate
 Compulsion

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Public debt vs. tax (public revenue)
Both significantly differ from each other in the following ways.
 Compulsion
 Maturity
 Commitment
 Burden
Reasons/Need for public debt/borrowings
 Deficit budget
 Sudden increase in government expenditure
 Economic development
 Economic stability
Classification of public debt
We can classify public debt on different basis of classification.
Basis of classification Classified as
Origin/Source  Internal/domestic debt
 External debt/loan
Redemption  Redeemable/terminable debt
 Irredeemable/non-terminable/perpetuity debt
Purpose  Productive/reproductive debt
 Unproductive/dead weight debt
Compulsion  Voluntary debt
 Compulsory/forced debt
Time To Maturity  Funded/long-term debt
 Unfunded/floating/short-term debt
Transferability  Marketable debt
 Non-marketable debt
Interest Payment  Interest bearing debt
 Interest-free/non-interest bearing debt
Sources of public debt
Identify differences among public debt, private debt and tax?
Identify the various parameters to classify public debt? And explain them?
The following are the main sources of public borrowings:
 Individuals and individual firms
 Non-banking financial institutions
 Commercial banks
 Central/national bank of the country
 Foreign governments/foreign countries
 International financial lending institutions

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Limit of raising public debt
In order to borrow, government should consider the following elements before accepting a debt
 Legal restrictions on public borrowing.
 Higher interest cost.
 National income, growth & credit structure.
 Effect on investment, economic stability & balance of payment.

Q: What are the various sources of public debt?

Effect of public debt

Transferences of money from one set of people to the other through public debt affect
 Consumption
 Production
 Income distribution
 Price level

How does public debt affect consumption, production, income distribution and price level?
Debt burden & future generation
It is sometimes claimed that debt financing of current expenditures leads to a burden upon future
generation of the society. However, debt financing for capital goods does not bring a burden for
future generation. The future generation will suffer if the present generation reduces its saving
i.e. consume more, to meet the debt finance. It is to be known that debt is paid in the future by
tax the future generation. Thus public debt will put a burden on future generation if;

 The current generation reduces its saving to service the debt finance.
 the government doesn’t add to the capital stock & productive capacity of the country
The burden of public debt may be
 Direct Money Burden
 Indirect Money Burden
 Direct Real Burden
 Indirect Real Burden.
Both internal and external sources of public debt impose the above burden on the society.

According to Ethiopia role (proclamation no 57/1996 and regulation 17/1997), public debt could
take different forms. The debt could be internal one, which is secured from persons that are
subjected to the borrower’s governments. It could also be an external one where the loan is
secured from foreign persons. In Ethiopia the regional governments could borrow from the
federal government. This form of borrowing is called internal borrowing to adjust financial
imbalances.

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Redemption/retirement of public debt
There are four methods to retire (redeem) public debt by the government.
A. Out-of-pocket method
B. Sinking fund method
C. Serial bonds redemption method
D. Debt conversion method
1.3.4 Financial administration & control
The scope of public finance is not confined only to public revenue, public expenditure and
public debt.
We have to examine the mechanism by which the above processes are carried on.
Without a study of relevant dimensions of financial administration the subject of public
finance remains incomplete.
Thus financial administration and control include the following:
a) Study of budgets and their procedure.
b) Budget as a instrument of securing certain objectives, such as promotion of employment,
economic growth with stability, welfare of the weaker sections, infrastructural development
for promoting private investments, etc.
c) Financial and physical controls through different fiscal tools for controlling private
expenditure in the economy to avoid the effects inflation deflation, recession etc.
1.3.5 Economic Stability and Growth
The study of public finance includes fiscal policy of the government in dealing with
inflationary and deflationary situations, instability of the price level, promotion of full
employment, growth of economy, welfare of the people, etc.
Economic stabilization is of recent origin.
It has a wide scope to play especially in the less developed countries. The main task of this
section is to frame and look after the implementation of various policies required for
economic stabilization and growth.
1.4 Fiscal federalism
Fiscal federalism is the division of governmental functions and financial relations between
different levels of government in a non-unitary government, where the levels may include
national, province/state, and local government.
1.4.1 Meaning of federalism
There are three ways of organizing government structures and the flow of power
 Unitary system
 Co federal system
 Federal system

1.4.2 Characteristics of federalism

 At least two set of government
 Supremacy of constituting

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  Independence of judiciary
 Freedom of interstate movement
 Equality of citizen
1.4.3 Meaning of federal finance
It refers to the system of allocating the source of revenue to the central and state governments for
the efficient discharge of their respective functions. Thus, the federal finance system of a country
should identify the finance sources exclusively reserved for the central government; the finance
resources exclusive reserved for the state government; and the finance sources concurrently
reserved for both the central and state government.
1.4.4 Principles of federal finance
 Independence/autonomy principle
 Equity/fairness principles
 Uniformity principles
 Adequacy and elasticity principle
 Fiscal access principles
 Principle of integration and coordination
 Administrative efficiency principle
 Administrative economy principle
 Accountability principles