Indian Public Finance
Topic-1
Prof. Balu
GIPE, Pune
The Role of the Govt
The Role of the Govt
• Substantial share in the total expenditure
• Including that of the states and local bodies expenditure would even be higher.
• Beyond the budgetary functions, public policy influences the course of economic activity through
monetary, regulatory and other devices.
• Public enterprise also plays an important role
• Modem economies - mixed system - public and private sector forces interact
• Neither public nor private - involves a mix of both sectors.
• Public sector economics
• Financing
• Allocation of resources
• Distribution of income
• Stabilisation
• Level of economic activity
• This course majorly focuses - budgetary implications vis-à-vis others - monetary & regulatory.
Modes of analysis (considerations)
• Criteria while judging the merit of various budget policies
• Requires normative perspective – should. This is different from the welfare economics that is
used to analyse consumers and producers.
• Public economics is influenced by politics and therefore the need of a normative perspective
• What are the responses of the private sector to various fiscal measures
• Who bears the burden of taxes – responsiveness of the private sector
• How public expenditure influences expenditure by consumers
• This requires a positive perspective.
• What are the social, political and historical forces that have shaped the fiscal institutions?
• How do interest groups influence the fiscal processes & responses of legislators?
• Requires a positive approach.
Why do we need a public sector?
• The composition of output should be in line with the preferences of individual consumers
• There is a preference for decentralized decision making.
• Importantly,
• Market cannot perform all economic functions – public policy is required to guide, correct and
supplement the economic functions
• The market is efficient only with the conditions of perfect competition – in the absence of these,
public policy is required
• The contracts required for competition need enforcement from the government’s legal structure
• In case of externalities, a correction is required
• Social values may demand correction in the income distribution
• Objectives of employment in highly developed economy
Major functions of the public policy
• Allocation function – provision of public goods
• Distribution function – fair distribution of income and wealth
• Stabilization function – high employment, reasonable price level, rate of economic growth
Major functions of the public policy - Allocation
• Allocation function
• Market fails to provide public goods
• Because the benefits are not private but have externalities
• Rival relationship – shoes, clothes, food etc.
• Non-rival – if I take measures to reduce pollution, others too benefit – benefits to one
individual do not reduce benefits available to others
• Market mechanism is well suited for the provision of private goods
• Exchange involved - exclusive title.
• Market system is a giant auction - exclusion is possible, and desirable.
• For public goods - exclusion not desirable, does not stop consumption.
• Property rights are not vested with the individuals - exchange not possible.
• Consumers don’t willingly pay due to non-exclusion & market mechanism is missing,
therefore the government is required.
• Public provision of private good, e.g. city road - consumption is rival but hardly excludable.
Major functions of the public policy - Allocation
• The public provision of public goods
• How much to provide and how to charge? Consumers are not willing. And how do we measure
the benefits availed by individuals to charge them.
• Individual payment does not make much difference on the cost. Do all pay then?
• Therefore, estimating the supply of public goods is difficult. It can’t be done through market
mechanism.
• So now, voting by ballot substitutes voting by money as a bid and then a collection of the
cost of the provision of public goods by the tax system.
• The tax system generates deadweight losses compared to the market mechanism
• The solution by voting may not please everyone but approximates the efficient solution
• The public goods can have boundaries – especially spatial. National defence affectseveryone,
but streetlights do not, and therefore, there can be a case for the provision of various public
goods by different levels of government.
Major functions of the public policy - Allocation
• Public provision vs public production
• Provision and production are distinct processes
• Private goods can be produced publicly and provided privately and public goods can be
produced privately and provisioned publicly through budget provisions
Major functions of the public policy - Redistribution
• Distribution Function
• The issues of distribution are key and they influence the tax and transfer policies
• wealth depends first of all on the distribution of factor endowments, including personal earnings
abilities and the ownership of accumulated and inherited wealth.
• The distribution of income based on factor endowments depends on the factor prices – in
competitive markets, the factors are paid according to their marginal product.
• \Two principles:
• Factors should be priced respecting the competitive valuation – for efficiency
• The distribution of incomes should (or shouldn’t) be fixed by the market process
Major functions of the public policy - Redistribution
• How should income be distributed?
• What constitutes a fair income distribution?
• The redistribution problem does not satisfy the Pareto criterion
• and redistribution has not been part of modern economic analysis.
• This criterion does not help in solving the income distribution problem
• The answer to the fair income distribution problem depends on the social philosophy and value
judgment – various social philosophies,
• The redistribution has efficiency costs and therefore it becomes important to decide how much
to pursue the redistribution
• Fiscal instruments for redistribution
• Tax-transfer schemes – progressive taxation with subsidies
• Progressive taxes used for financing public services – housing etc.
• Progressive taxation on goods being consumed by rich & subsidies on others consumed by poor.
• In all of the redistributive measures, efficiency costs are involved giving rise to equity vs efficiency.
Major functions of the public policy - Stabilization
• Stabilization function
• The bearing of allocation and distribution functions on stabilization function
• Stability: employment, price level, economic growth
• These require policy guidance
• The major lever is related to the aggregate demand
• The instability induced by the shocks to aggregate demand may not automatically stabilise
• Instruments of stabilization policy
• Monetary instruments:
• Money does not regulate itself – therefore money supply may not be automatically
stabilising.
• Therefore monetary policy is required
• Fiscal instruments:
• Fiscal policy influences the aggregate demand.
• Expenditure and taxation.
