Principles of Public Finance Textbook PDF

PRINCIPLES OF PUBLIC FINANCE A TEXTBOOK FOR THIRD YEAR STUDENTS DR. AHMED ABDELSABOUR ALDELJAWI Table of Contents PREFACE................................................................................................................. 6 PART Ⅰ: INTRODUCTION TO PUBLIC FINANCE........................................ 10 Chapter Ⅰ: Meaning and Scope of Public Finance.......................................... 11 Section Ⅰ: Meaning of Public Finance.......................................................... 11 Section Ⅱ: Scope of Public Finance.............................................................. 15 Chapter Ⅱ: Public Finance and Private Finance............................................ 17 Introduction.................................................................................................... 17 SectionⅠ: Similarities between Public and Private Finance........................ 18 Section Ⅱ: Dissimilarities between Public and Private Finance................ 20 Chapter Ⅲ: Need of Public Sector................................................................... 25 Introduction.................................................................................................... 25 Section Ⅰ: History of Government Intervention ()........................................ 26 Section Ⅱ: Reasons for Government Intervention...................................... 28 Chapter Ⅳ: Major Functions of Public Finance............................................ 38 Section Ⅰ: The Protection Function............................................................... 38 Section Ⅱ: The Resource Allocation Function............................................. 38 Section Ⅲ: The Distribution Function......................................................... 40 Section Ⅳ: The Stabilization Function........................................................ 42 Section Ⅴ: Dynamic Optimization ().............................................................. 43 PART Ⅱ: PUBLIC EXPENDITURE.................................................................... 46 Chapter Ⅰ: Meaning and Nature of Public Expenditure................................. 47 Section Ⅰ: Meaning of Public Expenditure................................................... 47 Section Ⅱ: Scope of Public Expenditure...................................................... 48 Section Ⅲ: Objectives of Public Expenditure............................................. 49 Chapter Ⅱ: Classification of Public Expenditure............................................ 51 Introduction.................................................................................................... 51 Section Ⅰ: Functional Classification.............................................................. 51 Section Ⅱ: Economic Classification.............................................................. 52 Section Ⅲ: Cross Classification or Economic-cum-Functional Classification ()................................................................................................ 53 Section Ⅳ: Accounting Classification.......................................................... 54 Section Ⅴ: Optional and Obligatory Expenditure....................................... 55 Section Ⅵ: Transfer and Non-transfer Expenditure.................................. 55 Chapter Ⅲ: Canons of Public Expenditure.................................................... 57 Introduction.................................................................................................... 57 Section Ⅰ: Canons of Public Expenditure..................................................... 57 Section Ⅱ: Other Canons of Public Expenditure........................................ 62 Chapter Ⅳ: Growth of Public Expenditure.................................................... 65 Section Ⅰ: Increasing of Public Expenditure................................................ 65 Section Ⅱ: Causes of Public Expenditure Growth...................................... 67 Chapter Ⅴ: Effects of Public Expenditure....................................................... 74 Introduction.................................................................................................... 74 Section Ⅰ: Effect of Public Expenditure on Production............................... 75 Section Ⅱ: Effect of Public Expenditure on Distribution........................... 77 Section Ⅲ: Effect of Public Expenditure on Consumption....................... 79 Section Ⅳ: Effect of Public Expenditure on Economic Stability ()............ 79 Section Ⅴ: Effect of Public Expenditure on Economic Development........ 81 Section Ⅵ: Undesirable Effects of Public Expenditure.............................. 82 PART Ⅲ: PUBLIC REVENUE............................................................................ 85 Chapter Ⅰ: Meaning and Sources of Public Revenue...................................... 86 Section Ⅰ: Meaning of Public Revenue......................................................... 86 Section Ⅱ: Main Sources of Public Revenue................................................ 88 Chapter Ⅱ: Taxes............................................................................................... 90 Section I: Definition of tax............................................................................. 90 Section II: Elements of Tax ()......................................................................... 91 Section III: Canons of tax ()........................................................................... 93 Section IV: purposes of taxes...................................................................... 101 Section V: Classification of Taxes............................................................... 105 Section VI: Types of Taxes........................................................................... 122 Section VII: Tax Evasion............................................................................. 125 Section VIII: Double Taxation.................................................................... 130 Chapter Ⅲ: Commercial Revenues............................................................... 133 Section Ⅰ: Meaning of Commercial Revenues............................................ 133 Section Ⅱ: Difference between Tax and Price............................................ 134 Chapter Ⅳ: Administrative Revenues........................................................... 136 Section Ⅰ: Fees............................................................................................... 136 Section Ⅱ: Licence or Permit Fees.............................................................. 138 Section Ⅲ: Special Assessment................................................................... 139 Section Ⅳ: Fines and Penalties:................................................................. 141 Section Ⅴ: Forfeitures:................................................................................. 141 Section Ⅵ: Escheat...................................................................................... 141 Chapter Ⅴ: Gifts and Grants.......................................................................... 143 Section Ⅰ: Gifts.............................................................................................. 143 Section Ⅱ: Grants......................................................................................... 143 PART Ⅳ: PUBLIC DEBT.................................................................................. 145 Chapter Ⅰ: Meaning and Definition of Public Debt....................................... 146 Chapter Ⅱ: Comparison between Private and Public Debt......................... 150 Section Ⅰ: Similarities between Private and Public Debt.......................... 150 Section Ⅱ: Dissimilarities between Private and Public Debt.................... 151 Chapter Ⅲ: Classification of Public Debt..................................................... 154 Section Ⅰ: From Source Point of View........................................................ 154 Section Ⅱ: From Time Point of View.......................................................... 155 Section Ⅲ: From Nature Point of View..................................................... 156 Section Ⅳ: From Payment Point of View.................................................. 157 Section Ⅴ: From Production Point of View................................................ 157 Chapter Ⅳ: Importance of Public Debt........................................................ 159 Chapter Ⅴ: Burden of Public Debt................................................................. 163 Section Ⅰ: Burden of Internal Public Debt................................................. 164 Section Ⅱ: Burden of External Public Debt............................................... 166 Chapter Ⅵ: Effects of Public Debt................................................................. 169 Section Ⅰ: Effects on Production and Investment...................................... 169 Section Ⅱ: Effects on Consumption............................................................ 170 Section Ⅲ: Effects on Distribution............................................................ 170 Chapter Ⅶ: Redemption of Public Debt...................................................... 172 Section Ⅰ: Public Debt Redemption and Its Advantages........................... 172 Section Ⅱ: Methods of Public Debt Redemption....................................... 173 PART Ⅴ: PUBLIC BUDGET.............................................................................. 179 Chapter Ⅰ: Meaning of Public Budget............................................................ 180 Chapter Ⅱ: Objectives of Public Budget........................................................ 184 Chapter Ⅲ: Types of Public Budgets............................................................. 187 Chapter Ⅳ: Procedures of Public Budget..................................................... 190 Section Ⅰ: Preparation Phase....................................................................... 190 Section Ⅱ: Appropriation Phase................................................................. 192 Section Ⅲ: Implementation Phase............................................................. 193 Section Ⅳ: Audit and Evaluation Phase.................................................... 194 References......................................................................................................... 196 PREFACE Public finance implies broadly the money that is with the government. It is the branch of economics that assesses the government revenues and expenditure, and its adjustment is to achieve the desirable objectives. Thus, comprehending the essence of public finance depends upon an understanding of the nature of economics. Public finance touches our everyday lives in many ways, hence how governments manage their public finances is an issue that concerns all of us. It is great to understand how a government works and manages the economy, this understanding of the principles of public finance can help in more effective governance, also knowledge of the working of the government and the public sector can help form better public choices. World over government expenditure and revenues form substantial portion of a country’s total gross domestic product (GDP). As such, government spending can have far reaching effects on the economy. Therefore, it is imperative to understand the resource allocation by the government, how the voters’ choices are translated into public sector policies. Furthermore, the study of the public sector decision-making process can help us better comprehend what the government does and why. As well as an understanding of public finance can help determine the right size and nature of government intervention in the economy, what activities a government should undertake, and what activities are better left to the market. Additionally, the study of public finance helps us understand and analyze the impact of tax, expenditure, and debt policy on the allocation of resources and the distribution of income in the economy. Therefore, the objective of this book is to address all aspects that are related to public finance and how they are managed by the government. It is titled “Principles of Public Finance”, it is an introductory textbook on public finance designed primarily for third-year students in the faculty of law. This book introduces the basic concepts and theories of public finance, it has a wide range Coverage of public finances, provides a precise and concise exposition of the principles and theories, written in a lucid and easy-to understand language. This book material contains a simple outline of the things which are necessary to prepare law student for the basic understanding of public finance. Principles of Public Finance can be intelligently studied by any person already familiar with the general principles of Political Economy. Technical details and wearisome tables of statistics have been avoided. Regular study throughout the book leads to better outcomes for students. This book also seeks to encourage dialogue and more open conversation among students about the public finance and financial management capabilities of governments. Hope this book material satisfies students and serves their needs. The book is divided into five major parts, each part dealing with a subject of the public finance. The first part reviews an introduction to public finance. The second part gives us a complete picture over public expenditure. The third part addresses the public revenues. The fourth part deals with the public debt. Finally, the fifth part discusses the public budgeting. Dr. Ahmed Abdelsabour Aldeljawi PART Ⅰ INTRODUCTION TO PUBLIC FINANCE PART Ⅰ: INTRODUCTION TO PUBLIC FINANCE Brief Content: Chapter Ⅰ: Meaning and Scope of Public Finance. Chapter Ⅱ: Public Finance and Private Finance. Chapter Ⅲ: Need of Public Sector. Chapter Ⅳ: Major Functions of Public Finance. Chapter Ⅰ: Meaning and Scope of Public Finance Section Ⅰ: Meaning of Public Finance Public finance is a branch of economics that has grown in importance and scope over the past couple of centuries. It would have not existed if all individuals acted in a purely individual capacity and in strictly selfish or personal interests; if there were no collective needs; and if there were no community authority. Public finance would have also not existed (1). Public finance is made up of two words: public and finance. The word ‘Public’ refers to Government and the word ‘Finance’ refers to revenue and expenditure. Consequently, Public Finance refers to a study of the revenue and expenditure of the public authorities. Public authorities include all sorts of Governments like Central, State and Local. The finances of the Government include the raising and disbursement of Government funds. Public Finance is also called ‘Fiscal Economics’. Public Finance also deals with the problems of adjustments of income and expenditure of the Government. The methods of income and expenditure of the public bodies as well as borrowing by the public bodies are known as operations of public finance. (1) Vito Tanzi, “Advanced Introduction to Public Finance”, Elgar Advanced Introductions series, 2020, P.3. They are also known as Fiscal operations. Therefore, fiscal problems and fiscal policies are integral parts of public finance (1). Public finance is a field of economics concerned with how a government raises money, how that money is spent and the effects of these activities on the economy and society. It studies how governments at all levels- Central, State, and Local- provide the public with desired services and how they secure the financial resources to pay for these services (2). Public finance deals with the finances of public bodies at all levels for the performance of their functions. The performance of these functions leads to expenditure. The expenditure in incurred from funds raised through taxes, fees, sale of goods and services and public loans. The different sources constitute the revenue of the public authorities. Public finance studies the manner in which revenue is raised; the expenditure is incurred upon different items etc. thus public finance deals with the income and expenditure of public authorities and principles, problems and policies relating to these matters (3). (1) D. Bose, S. Ganesan and A. Marimuthu, “An Introduction to Public Finance (Fiscal Economics)”, S. Chand & Company PVT. LTD., 2016, P.1. (2) A. Senthilkumar, “Public Finance and IT Law”, P.1. (3) A. Senthilkumar, “Public Finance and IT Law”, P.1. According to Professor Huge Dalton, the term ‘Public authorities’ refers to the Government or state at all levels- National, State, and local (1). Public Finance is properly called a science, because: (1) It deals with a definite and limited field of human knowledge; (2) It admits of an orderly arrangement of its facts and principles, and contains many laws of general progress belonging exclusively to its own field; (3) It admits of the scientific methods application of investigation; (4) It foresees as well as explains a certain class of phenomena; (5) It is generally, if not universally, so regarded (2). Different experts have defined public finance. Some important definitions are as follow: − The definition of public finance by Carl C. Plehn states that: “Public finance deals with the way in which the state acquires and expends its means of subsistence” (3). − According to prof. Hugh Dalton “Public finance is concerned with the income and expenditure of public authorities, and with the adjustment of the one to the other” (4). (1) Huge Dalton, “Principles of Public Finance”, Routledge & Kegan Paul Ltd, London, 1954, P.1. (2) Carl C. Plehn, “Introduction to Public Finance”, The Macmillan Company, USA, 1902, P.1-2. (3) Carl C. Plehn, “Introduction to Public Finance”, The Macmillan Company, USA, 1902, P.1. (4) Huge Dalton, “Principles of Public Finance”, Routledge & Kegan Paul Ltd, London, Twenty Fourth Printing, 1954, P.1. − Professor Richard Musgrave defined public finance as, “The complex of problems that centers on the revenue-expenditure process of government is referred to traditionally as public finance” (1). It has been clear after studying various definitions of public finance given by various scholars that the basic meaning of public finance is about income and expenditure of public authorities of center, states and local. But, according to Dilfraz Singh in today’s context this meaning has become more vast and expand. Now, public finance is not related to the government’s income and expenditure only, but also financial administration, accounts auditing and financial control can also be included under this. Therefore, he defines public finance this way - It is that science which study the reactions upon society and economy of fiscal policy (2) and fiscal activities and public income - expenditure, debt (1) Richard A. Musgrave, “The Theory of Public Finance: A Study in Public Economy”, McGraw Hill; 1st Edition, January 1, 1959, P.3. (2) fiscal policy refers to the government measures to control the inflation and achieve the economic growth by increasing or decreasing the tax rate. It totally deals with government spending/expenditures and taxation and is totally controlled by the government. For economic growth, government adopts two types of fiscal policies, expansionary fiscal policy, and contraction fiscal policy. Expansionary fiscal policy means to increase the government expenditures and decrease the taxes to increase the budget deficit and decrease the budget surplus. It is adopted by the government to control inflation in the country. Contractionary fiscal policy means to decrease the government expenditures and increase the taxes to decrease the budget deficit and increase the budget surplus. Fiscal policy is imposed by the government through legislation. The tools of fiscal policy are Expenditure policy, revenue policy, public borrowing, and deficit financing. See: Kavita and financial administration, basic principles of accounts auditing and financial control (1). Section Ⅱ: Scope of Public Finance the scope of public finance is categorized into four areas which includes public income, public expenditure public debt and financial administration (2): 1) Public expenditure: The study of the way public expenditure is classified, the principles guiding public expenditure (canons of public expenditure), causes of growth and effects of public expenditure. 2) Public revenue: The study of various sources of government’s income, the principles guiding the raising of income (e.g., canons of taxation), their relatives’ merits and demerits and their effects on the economy (e.g. impact and incidence of taxation). 3) Public debt: The study of public debt forms a very important part of public finance in modern times as governments are increasingly resorting to debt to meet the growing needs of the Vats, “A Textbook of Macro Economics for Class XII”, S. Chand Publishing, 1st Edition, 2014, P.8.4, Difference between Monetary Policy and Fiscal Policy | Welcomenri (1) Dilfraz Singh, “Public Finance” Laxmi Publications (P) LTD. New Delhi, India, P.2. (2) Vito Tanzi, “Advanced Introduction to Public Finance” Edward Elgar Publishing, Cheltenham, UK Northampton, MA, USA, 2020, P.11. people. Public finance studies the sources, burden, and impact of public debt. 4) Financial administration: This includes the study of the preparation, passing and implementation of the budget, budgetary policies and their socio-economic impact, inter- governmental financial relations, fiscal management, and fiscal responsibility. Chapter Ⅱ: Public Finance and Private Finance Introduction The word 'finance' is used for both - the public and the private finances. private finance is meant the financial problems and policies of an individual economic unit (which does not form a part of state organs) as compared with those of public authorities. While some people believe that the principles of public finance are the same as the principles of family budget, others believe that the principles of public finance and private finance are different from each other. Both these views are justified to some extent because of the existence of similarities and dissimilarities between the principles of public and private finances. a) Public Finance: Public finance is the study of the income, debt and expenditure of the government. It also includes various policies and methods employed to secure money and policies framed to pay the debt taken. b) Private Finance: Private finance is the study of the income, debt and expenditure of an individual, or a private company or business venture or an association. It includes study of their own view regarding earning, expenditure and borrowing (1). It is instructive to compare public with private finance, both public and private finance are fundamentally similar in nature but different from each other on various operational aspects. The similarities and dissimilarities between public and private finance have been explained below: SectionⅠ: Similarities between Public and Private Finance The similarities found between Public and Private Finance are as follow: 1. Objective: Both the individual persons and the Government have the same objective, namely, the satisfaction of human needs. Private Finance is concerned with the satisfaction of private needs, whereas Public Finance is concerned with the satisfaction of social needs, i.e., welfare of the society (2). 2. Policies: Both the private and public finances adopt policies for maximizing welfare. In Private finances as well as in public finance only sound policies will enable maximization of welfare and benefits. (1) S.N Chand, “Public Finance” Volume 1, Atlantic Publishers, and Distributors (P) Ltd., 2008, P.11- 12. (2) D. Bose, S. Ganesan and A. Marimuthu, “An Introduction to Public Finance (Fiscal Economics)”, S. Chand & Company PVT. LTD., 2016, P.7. 3. Principles: Both kinds of finance are based on the principle of rationality. A rational individual tries to maximize his personal benefits through his expenditure. A rational government tries (1) to maximize social benefits through public expenditure. Therefore, the principle of maximum social benefits is the guiding principle followed by the government while spending its income. Individuals also follow the principle of maximum satisfaction when spending out their given income. 4. Administration: The effectiveness and success of measures adopted by private and public sector depends on the administrative machinery. If the administrative machinery is inefficient and corrupt it will lead to losses and wastages. 5. Purchase, Sales and Production: Both finances engage in purchases, sales, production, exchange, income, expenditure, saving, capital formation, investment etc.(2). 6. Income, Expenditure and borrowing: Both private and Public Finance have income and expenditure. The ultimate aim of both is to balance their income and expenditure. When expenditure is greater than income, both try to borrow to meet (1) Cauvery R, Uk Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.5. (2) D. Bose, S. Ganesan and A. Marimuthu, “An Introduction to Public Finance (Fiscal Economics)”, S. Chand & Company PVT. LTD., 2016, P.7. the gap. Both individuals and governments have to plan to return these loans (1). 7. Economic Choice: Both Public and Private Finance want to get maximum satisfaction and target by minimum resources, so both must face the problem of adjustment of income and expenditure and problem of selection of the economic choice (2). Section Ⅱ: Dissimilarities between Public and Private Finance The dissimilarities found between Public and Private Finance are as follows: 1. Adjustment of income and expenditure: According to Dalton, while an individual's income determines the amount of his possible expenditure, a public authority's expenditure determines the amount of its necessary income. In other words, while an individual adjusts expenditure to income, a public authority adjusts income to expenditure. To an individual, the simple rule is: "Cut your coat according to your cloth”. On the contrary. the public authorities first decide the dimensions of the coat and then proceeds to arrange the cloth required. Thus, the (1) Cauvery R, Uk Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.5. (2) Dilfraz Singh, “Public Finance” Laxmi Publications (P) LTD. New Delhi, India, P.8. rule for the public authority is “cut your cloth according to coat” (1). 2. Determination of Expenditure: Public authority first decides the amount of expenditure and after that it searches for the resources to fulfill that expenditure. Whereas a person first considers his income, and he decides the amount of expenditure after that which he has to consume on different aspects of consumption. The reason for this is that public finance can increase or decrease its needs of income accordingly, but no such flexibility is found in the income of a person (2). 3. Compulsory Character: Individuals can plan to postpone their private expenditure. But the state cannot afford to put off vital expenditure like defense, famine relief etc. Findlay Shiraz says that compulsory character is an important feature of public finance (3). 4. Principle of Equi-marginal Utility: In case of private finance a rational consumer seeks to maximize his total satisfaction by allocating his income as per the law of equi-marginal utility. He tries to spend his income in such a way that the last unit of money, spent on each good, yields the same satisfaction. Even an individual firm has to maximize its total profits by equating (1) M. Maria John Kennedy, “Public Finance”, PH learning private limited New Delhi, 2012, P. 13. (2) Dilfraz Singh, “Public Finance” Laxmi Publications (P) LTD. New Delhi, India, P.9. (3) A. Senthilkumar, “Public Finance and IT Law”, P.5. marginal cost with marginal revenue. The government on the other hand seeks to get maximum social advantage. The fiscal policy of the modern government aims to achieve an equitable distribution of income in the society and to promote economic growth. Private finance is free from all such social considerations. Therefore, private finance has more features of Positive Economics while Public Finance has more features of Welfare Economics. As Seligman points out, the chief objective of private economy is wealth getting and wealth using. But the chief objective of public economy is welfare (1). 5. Nature of Budget: Surplus budget is essential for individual persons, while the Government may find it useful to have a deficit budget. If the Government bring surplus budget, it will create negative opinion on the Government. This is because, surplus budget is the result of high level of taxation or low level of public expenditure, both of which may affect the Government adversely (2). 6. Sources and Nature of Income: An important difference between Public and private finance is with regard to the nature of resources at their disposal. Resources of an individual are relatively limited while the state's resources are wider. The (1) Cauvery R, Uk Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.6-7. (2) D. Bose, S. Ganesan and A. Marimuthu, “An Introduction to Public Finance (Fiscal Economics)”, S. Chand & Company PVT. LTD., 2016, P.8. government has the power to impose taxes or even print notes to raise its resources. The individuals have no such powers. The state can raise internal as well as external loans. An individual cannot borrow from world monetary institutions like International Monetary Fund or the World Bank. In short public revenues are more elastic than individual incomes (1). 7. Motive of Expenditure: In case of public finance, the decisions are reached through political and administrative procedure and based on common social objectives, not for the objectives of profit. But private finances are governed by profit motive for businesses or satisfaction of wants of individuals and households. Government spends on projects for which financial return is uncertain and long gestation period is involved. Likewise, in certain services such as provision of drinking water or sanitation facilities from which the government may not earn any revenue. The modern governments seek to achieve full employment, equitable distribution of income or rapid economic growth through its fiscal operations for which there is no counterpart in private finance (2). (1) Cauvery R, Uk Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.6. (2) M. Maria John Kennedy, “Public Finance”, PH learning private limited New Delhi, 2012, P. 13. 8. Long Term Consideration: Individuals always seek quick returns they save only a small amount for future and spend more to satisfy their current needs. Individuals tend to think more on present as they are dead in the long run. Similarly, they seldom spend if it does not yield any money income. On the other hand, State has a long term perspective of its expenditure. It does not care only for immediate benefit. State spends on projects having long gestation period. The burden of taxation is borne by the present generation in the interest of long run welfare of the community. Similarly, sometimes government may have to spend on schemes which may not yield any money income at all (e.g., Public Health) (1). 9. Coercive Method - Government or public: An individual has to earn his income by working. He cannot force any one to get his income. But the government can use force or coercive power to raise revenue especially taxation (2). Suppose a person does not pay due income tax then he can be punished by the court, or he can be punished economically for increasing tax - payable on him. In this way, a person cannot deny the payment of taxes if it is due on him, but private individuals cannot use force to get their income in the way the government does. That is the reason that in comparison to private persons or businessman, the income of government is more assured. (1) A. Senthilkumar, “Public Finance and IT Law”, P.5. (2) Cauvery R, Uk Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.7. Chapter Ⅲ: Need of Public Sector Introduction Fundamental questions to start with when examining public finance are the following: In a country with private property and that has a free market, a market that produces goods and services that citizens want and can buy, and that creates jobs and generates incomes to the factors of production (capital and labor), why is there a need for public finance? Why does the state have to play an economic role, when the market is expected and is assumed to be able to deal with the economic activities and the needs of private individuals and enterprises? Put another way, should the government play an economic role in such an economy? If the government must play an economic role, what role, and how big, ought it to be? (1) The previous questions have concerned philosophers, social scientists, economists, and just plain citizens for centuries. The answers to these questions can follow purely technical lines, or they can recognize their political nature. These answers have changed over the years, and they continue to differ today among economists and countries. These answers cannot be strictly scientific and must (1) Vito Tanzi, “Advanced Introduction to Public Finance” Edward Elgar Publishing, Cheltenham, UK Northampton, MA, USA, 2020, P.11. be seen as significantly time-determined and, inevitably, political, and subjective. We shall start with some technical answers on which there ought to be more agreement among economists (1). Section Ⅰ: History of Government Intervention (2) (3) The classical economists, from Adam Smith onward, favored a minimal role for the public sector, focusing on essential public works, maintaining law and order, and defense. They believed that the government should guarantee property rights, sanctity of contracts, and protect economic and political liberties of individuals. This conservative attitude was partly a reaction to the widespread interference of governments with the market, which had characterized 18th century Europe. The classical economists considered this interference as damaging to economic activity and as an obstacle to growth. Perhaps, as a consequence of this attitude and experience in the 19th (1) Vito Tanzi, “Advanced Introduction to Public Finance” Edward Elgar Publishing, Cheltenham, UK Northampton, MA, USA, 2020, P.11. (2) Vito Tanzi, “The Changing Role of the State in the Economy: A Historical Perspective” IMF Working Paper, 1997, P.9-10. (3) Adam Smith (1723-1790) was an 18th-century Scottish economist, philosopher, and author who is considered the father of modern economics. Smith argued against mercantilism and was a major proponent of laissez-faire economic policies. In his first book, The Theory of Moral Sentiments, Smith proposed the idea of an invisible hand—the tendency of free markets to regulate themselves using competition, supply and demand, and self-interest. Smith is also known for creating the concept of gross domestic product (GDP) and for his theory of compensating wage differentials. According to this theory, dangerous or undesirable jobs tend to pay higher wages to attract workers to these positions. Smith’s most notable contribution to the field of economics was his 1776 book, An Inquiry into the Nature, and Causes of the Wealth of Nations. century, the economic role of the government tended to be much more limited. For example, in most of the industrial countries, public spending was around 10 percent of GDP and laissez-faire was the dominant economic philosophy. The 20th century saw a gradual but large expansion in the role of the state in the economy, with public spending as a share of GDP growing from about 12 percent in 1913 to about 45 percent in 1995. Both political and ideological factors contributed to this growth. Marxist and socialist thinking emphasized income equality among individuals, leading to the pressure for governments to play a significant role in redistributing income. Such a role had not even been contemplated by the classical economists who had focused their attention on the allocative function of the state. The appearance of communism and central planning pushed many countries toward a "mixed" economy, with income redistribution becoming a major policy objective. Keynesian thinking also created pressures on the government to help sustain disposable income during cyclical fluctuations and stabilizing the economy. Public works programs, unemployment compensation, public pension schemes, and public enterprises were introduced to maximize public employment and reduce exposure to fluctuations. Section Ⅱ: Reasons for Government Intervention There are two reasons governments may want to intervene in market economies: Provision of Public Goods and market failures. 1. Provision of Public Goods: In casual use, the term public goods and services is used to describe whatever it is that governments provide, from streetlights to defense a system of courts. Economists, however, use the term public good in a more precise sense to describe goods (or more often, services) that have two key characteristics: non-rivalry in consumption and non-excludability. These two characteristics must both be present in a significant degree for something to qualify as a public good (1). - Non-Rivalry: First unique characteristic that they are nonrival in consumption. You and I can both consume them simultaneously without affecting one another’s consumption of the good. One person’s consumption does not limit the amount available to others. The private market will not provide such goods since private entrepreneurs cannot make a profit producing them. As a result, there is a role for government to provide public goods that provide (1) Holley H. Ulbrich, “Public Finance in Theory and Practice” Routledge – Taylor & Francis e- Library, 2nd Edition, 2011, P.93. benefits that citizens value but that the private market will not provide. - Non-Excludability: A second important characteristic of public goods is that they are nonexcludable. If the government provides a public good such as national defense, making the nation safe for its residents, that safety is provided for everyone. There is no possibility of excluding some from being safe while protecting others. Hence, if the public good is provided to anyone, it is provided to all. This is not true of a private good that can be provided exclusively to those willing to pay for its provision. Free-Riding Problem and Public Goods: An issue that inevitably arises with the provision of public goods is the “free rider” problem. Because public goods are available to everyone when available to anyone, there is a strong incentive for individuals to avoid contributing to their cost. Accordingly, people are encouraged to become “free riders” — those gaining benefits without paying for them. If free riding becomes too prevalent, it will be hard to finance a good or service (1). (1) Joshua E. Greene, “Public Finance an International Perspective”, World Scientific Publishing Co. Pte. Ltd., 2021, P.33. Where the number of users/residents is large, free riders know that the availability of the public good is largely independent of their small contribution to its cost. One person reasoning this way will gain the benefit of having the public good and not bearing any of the cost. Large numbers of people reasoning this way will make it impossible to finance the public good, and it will not come into being. It is for this reason that goods and services with both very low rivalry and very low excludability are usually provided through the public sector and paid for with compulsory taxes (1). Private Goods: In contrast to public goods, private goods refer to all those goods and services consumed by private individuals to satisfy their wants. For example, food, clothing, car etc. A private good is rival in consumption; that is, the act of consumption necessarily prevents others from consuming the good. When you buy and eat an apple, no one else can consume that same apple. When you buy twenty liters of gasoline for your car, you are obtaining a private good, since no one else may use that gasoline. Thus, private goods provide ownership only to the purchaser of goods. It follows, then, that the amount of a private good available for consumption must be divided among all consumers. For example, if 100 cars are produced in an economy composed of 101 (1) Holley H. Ulbrich, “Public Finance in Theory and Practice”, Routledge, 2nd Edition, 2011, P.95. individuals, at least one individual will not be able to own a car. Public goods, on the other hand, are equally available to all consumers (1). The main characteristics of private goods are the following (2): − Excludability: The suppliers of private goods can very well exclude those who are unwilling to pay. − Rivalry in consumption: One person's consumption reduces the amount available to others. That is, the amount consumed by one person is unavailable for others to consume. − Revealed Preference: The consumers reveal their preferences through effective demand and market price. These revealed preferences are the signals for the producers to produce the goods the individuals want. Merit Goods: A special category of public goods that deserves some attention because of their unique characteristics is merit goods. The term “merit good” is often used to define those goods that society considers meritorious, based on the common perception of what is good for society. Although the market can provide these goods since they are excludable, but, if left up to the market, it will (1) Michael L. Marlow, “Public Finance Theory and Practice”, Harcourt Brace & Company, USA, 1995, P.118. (2) A. Senthilkumar, “Public Finance and IT Law”, P.12. either not provide them or provide for only those who can afford the price, which can easily lead to under provision (1). Two good examples of merit goods are education and health care. The poor people need standard schooling, hospitals etc. But private schools and hospitals are maintained at high cost, which the poor cannot pay. Hence, the Government should provide these goods to the poor people directly or indirectly. Direct provision means, starting of Government schools and hospitals. Indirect provision means, the Government gives subsidy to private educational institutions and hospitals. Hence, these goods are merit goods (2). At last, private goods are not necessarily provided exclusively by the private sector, there are many publicly provided private goods —rival and excludable commodities that are provided by governments. Medical services and housing are two examples of private goods sometimes provided publicly. Similarly, public goods can be provided privately. For example, individuals donating money to maintain public spaces. In short, the label private or public does not by itself tell us anything about which sector provides the item. As well, public provision of a good does not necessarily mean that it is also produced by the public sector (1) Aman Khan, “Fundamentals of Public Budgeting and Finance”, Palgrave Macmillan, 2019, P.32. (2) D. Bose, S. Ganesan and A. Marimuthu, “An Introduction to Public Finance (Fiscal Economics)”, S. Chand & Company PVT. LTD., 2016, P.5-6. consider garbage collection. Some communities produce this service themselves—public sector managers purchase garbage trucks, hire workers, and arrange schedules. In other communities, the local government hires a private firm for the job and does not (1) organize production itself. 2. Market Failures: The second reason for the need for Government activity is market failure under private sector. If the market mechanism has to work efficiently, there should be perfect competition. That means, there should be homogeneous products, free entry and exit of firms, perfect knowledge, perfect mobility of factors etc. But in real world, there is no perfect competition. On the contrary, we see imperfect competition (Monopoly, Duopoly, Oligopoly etc.). Hence, the Government has to take necessary measures against monopoly. Therefore, the market failure and the need for protecting the consumers makes the government enter the economic activity (2). What are the main market failures? Here, we discuss some common types of market failure: (1) Harvey S. Rosen and Ted Gayer, “Public Finance”, The McGraw-Hill Companies, Inc., 9th Edition, P.56. (2) D. Bose, S. Ganesan and A. Marimuthu, “An Introduction to Public Finance (Fiscal Economics)”, S. Chand & Company PVT. LTD., 2016, P.6. A. Lack of Competition: A natural monopoly exists when an industry is characterized by increasing returns to scale. As a firm in the industry increases its output, its average total cost falls. The natural result is that the industry will be made up of one firm -a monopoly-resulting in a lack of competition and monopolistic pricing and output. The problem of a monopoly is that too little is produced and sold at too high a price, compared to the competitive market outcome. In this case, there is a role for government to regulate monopolies to prevent the ill effects of monopolistic behavior (1). B. Asymmetry in Information (2): The classical example of asymmetric information is the sale of a used car. The seller knows exactly what is wrong with the car. The buyer can identify some flaws but will definitely miss others. This may lead to a situation where the buyer refrains from entering into a transaction altogether, i.e., a market does not evolve. The seller could also refrain from finally selling the car if he or she is not certain why the buyer is arguing for a certain price. This failure works in both directions. Thus, asymmetric information occurs where one party in a market transaction has more information than the other. This (1) John E. Anderson, “Public Finance Principles and Policy”, Houghton Mifflin Company., 2003, P.15-16. (2) Shawn Cunningham, “Understanding market failures in an economic development context”, Mesopartner Monograph 4, Pretoria, South Africa, 2011, P.15-16. may result in the misallocation of resources due to inefficient decision making on the part of organizations or individuals, or the collapse of whole markets. This does not imply that all the sellers’ or buyers’ information must be known for transactions to take place. Markets with imperfect information exist because products are differentiated, and in imperfect markets price is not balanced between supply and demand because price becomes a medium of communication from sellers to buyers. Thus, it can be concluded that certain kinds of information in a complex modern economy will remain incomplete and imperfect – a market failure occurs only when there are major differences of information between buyers and sellers. Adverse selection is related to asymmetrical information and is defined as making a sub-optimal decision because of incomplete or imperfect information regarding either risks or quality. C. Distribution of Income: The market mechanism provides an allocation of resources that determines the distribution of income. A society may determine that it finds such an allocation of income too unequal. It may then require government intervention to change the distribution of income through welfare programs, redistributive taxes, and other means in order to bring about a socially acceptable income distribution. For all of these reasons (and more reasons which we will not consider), there is a legitimate role for government to be involved in affecting the working of the market mechanism (1). D. Externalities: The term externality is used by economists to refer to a benefit or cost imposed on one economic agent by another economic agent when that effect is external to the working of the market. For example, in the process of producing automobiles and computer hardware, the economic system also produces as a by-product contamination of air, water, and other natural resources. Pollution is a negative externality. Since these negative externalities occur outside the working of the market mechanism, markets fail to allocate resources properly. In other words, we get too much pollution when we rely on the market mechanism alone. There is a role for government to correct for this failure of the market (2). E. Activities Involving Risks: There are certain activities which involve risks and heavy cost, and the gestation period will be very long. Hence, these activities cannot be undertaken by the private entrepreneurs, but can be undertaken only by the Government. For example, investment in railways. F. Maintain Economic Stability: The maintenance of economic stability is essential for the economic development of developing (1) John E. Anderson, “Public Finance Principles and Policy”, Houghton Mifflin Company., 2003, P.16. (2) John E. Anderson, “Public Finance Principles and Policy”, Houghton Mifflin Company., 2003, P.15. countries. The Government is responsible for economic policy and guards the economy against fluctuations in economic activities such as price, production, employment, export and import. This could be done only by the Government, not by private sector. G. A Source of Initiative: In order to give initiative to improve the quality of goods and services, there is a need for Government activity. The managers in the public sector should take initiative to improve the quality of existing goods and services or to introduce a new commodity or service. H. Change the Pattern of Consumption: It is the responsibility of the Government to enter into the field of economic activity, production and distribution in order to change the pattern of consumption. They should encourage the consumers to use the quality products and to discourage the use of harmful goods, drugs etc. (1). (1) D. Bose, S. Ganesan and A. Marimuthu, “An Introduction to Public Finance (Fiscal Economics)”, S. Chand & Company PVT. LTD., 2016, P.6. Chapter Ⅳ: Major Functions of Public Finance There are five primary functions of the public Finance: protection, allocation, distribution, stabilization, and Dynamic Optimization: Section Ⅰ: The Protection Function The public finance provides a protection function when it safeguards the personal property and rights of individuals. Police, the military, and the courts protect the rights of individuals to own property, enforce contracts, and exercise freedoms of religion and speech. Private market economies are predominantly characterized by individual ownership of resources, and individuals are therefore the stewards, or guardians, of resources. Private owners assign values on their resources and determine their usage. For example, market suppliers and demanders determine which plots of land are developed into housing developments as well as the purchase price of each homesite. However, even in economies dominated by private ownership of resources, some resources such as air, water, and public parks are often jointly owned by all citizens (1). Section Ⅱ: The Resource Allocation Function Resource allocation is the process of allocating production factors among various uses in an economy, determining the (1) Michael L. Marlow, “Public Finance Theory and Practice”, Harcourt Brace & Company, USA, 1995, P.13. production of goods and services. It is crucial for efficient resource allocation, preventing wastage, and maximizing the use of scarce resources. Private sector resource allocation is characterized by market supply and demand and price mechanisms determined by consumer sovereignty and producer profit motives. In the real world, resource allocation is both market-determined and government-determined. Market failures, which hold back efficient resource allocation, occur due to factors such as imperfect competition, market failures in providing collective goods, externalities that affect people's decision-making, factor immobility, imperfect information, and inequalities in income and wealth distribution. The state, as the instrument by which citizens' needs and concerns are fulfilled, is connected with economic mechanisms that should ideally lead to the effective and optimal allocation of limited resources. In the absence of appropriate government intervention, market failures may occur, and resources are likely to be misallocated by too much production of certain goods or too little production of certain other goods. Market failures provide the rationale for government's allocative function, which involves providing goods and services that cannot be produced or bought at a price from the market. This includes property rights, law enforcement, and courts for goods that involve externalities not met by the market. Merit goods that are greatly beneficial to society also fall under the purview of government provision; these interventions do not imply that markets are replaced by government action. In its allocation role, the government acts as a complement rather than as a substitute to the market system in an economy. The resource allocation role of government's fiscal policy focuses on the potential for the government to improve economic performance through expenditure and tax policies. The allocative function in budgeting determines who and what will be taxed and how and on what government revenue will be spent. It is concerned with the provision of public goods and the process by which the total resources of the economy are divided among various uses, ensuring an optimum mix of social goods. Section Ⅲ: The Distribution Function The very important feature of a market economy is the disparity in the distribution of income and wealth. The distribution function of public finance deals with the adjustment of the distribution of wealth and income to ensure "fair or just" state of distribution. That is, the distribution function of public finance deals with the determination of taxes and transfer payments policies of the governments (1). (1) A. Senthilkumar, “Public Finance and IT Law”, P.8. Therefore, the distribution function is aimed at changing the final recipients of the goods and services produced by the economy. The primary goal of this function is to provide an equitable distribution of income. The essential issue that the distribution function addresses is whether the distribution policies of the public sector lead to a better or worse distribution of income than when the private sector allocates our resources. Progressive income tax policies, guaranteed loans provided to students and farmers, and programs that subsidize agriculture and automotive industries are examples of policies that influence the distribution of income in the economy (1). Because reasonable people have diverse perceptions regarding what constitutes a fair or equitable distribution of income, the distributive role is an area of considerable controversy. While positive analysis may show how various policies may affect different measures of the income distribution, a sizable portion of the analysis must be normative in nature. Our judgments about who should receive the benefits of public programs and who should pay for them emerge from the interactions of voters and policymakers in the policy process (2). (1) Michael L. Marlow, “Public Finance Theory and Practice”, Harcourt Brace & Company, USA, 1995, P.14. (2) Michael L. Marlow, “Public Finance Theory and Practice”, Harcourt Brace & Company, USA, 1995, P.14. Section Ⅳ: The Stabilization Function The stabilization function of the public sector is carried out by monetary and fiscal policymakers who attempt to smooth out ups and downs in the macroeconomy. One of the most divisive macroeconomic debates in the twentieth century is over the question of how stable or unstable the private macroeconomy is. On one side there are economists who believe that the private market is inherently stable and that in the event of recessions and high unemployment, market forces quickly stabilize the macroeconomy. The other side argues that although the price system of the private economy is a natural stabilizing device, periods of instability can dominate the economy (1). Developed economies experience business cycles. Economic stability implies absence of sharp cyclical movements in the form of booms and depressions. To bring about such stability, countercyclical fiscal operations are adopted. To counter depression and recession, government expenditure is increased to generate employment and taxes are reduced to encourage consumption and investment. During inflation, public expenditure is reduced, and taxes are raised. The stabilization function explains the macroeconomic aspect of budgetary policy. In other words, the stabilization function deals (1) Michael L. Marlow, “Public Finance Theory and Practice”, Harcourt Brace & Company, USA, 1995, P.15. with the use of budgetary policy as a means of maintaining high employment, a reasonable degree of price stability and an appropriate rate of economic growth, with allowances for effects on trade and balance of payments. The major instruments of stabilization policy are monetary policy (1) and fiscal policy (2). This function is otherwise known as compensatory finance (3). Section Ⅴ: Dynamic Optimization (4) The attainment of optimal economic growth is also an important objective of government. The market economy does not necessarily achieve optimal growth. This is because private decisions on consumption, saving, and investment do not consider the interest of future generations appropriately. If the current generation only (1) Monetary policy refers to the state (central banks measures) to control the supply and demand of money in the country in order to control the inflation and interest rate in the country to stable the national currency. Economic growth, achievement of lower unemployment and dealing with exchange rates with other currencies are also the objectives of monetary policy. Like fiscal policy, central bank also implements two types of monetary policies, expansionary monetary policy, and contractionary monetary policy. Expansionary policy means increase in supply of money and low credit conditions by decreasing interest rates with the hope of decreasing unemployment, increasing economic growth. Contractionary monetary policy is imposed by the central bank by decreasing the money supply, toughing the credit conditions by increasing the interest rates in order to control the inflation in the country and decreasing the supply of currency in the country. Monetary policy is imposed by the state/central bank. Difference between Monetary Policy and Fiscal Policy | Welcomenri (2) The monetary policy and fiscal policy are macroeconomic policies whose purpose is to regulate economic activities. Their primary focus is on stabilizing the economy and economic growth. (3) A. Senthilkumar, “Public Finance and IT Law”, P.8. (4) Toshihiro Ihori, “Principles of Public Finance”, Springer, 2017, P. 4. considers its own interest, optimal growth is not realized from the viewpoint of generational equity. Thus, it becomes the government’s responsibility to consider the interest of future generations. The dynamic optimization problem of fiscal policy encompasses fiscal deficits, the burden of debt, and the productivity of public investment. Further, a high level of economic growth is not always desirable. We have to consider the effect on the environment, among others. Public finance investigates how we should grow the economy in a way that is consistent with environmental quality as well as the interest of future generations. Researchers also investigate the effect of fiscal policy on growth. Public investment enhances economic growth. However, if the government raises taxes to finance various kinds of public spending, it may depress capital accumulation and economic growth. Similarly, an increase in government deficits and public pensions would crowd out private capital accumulation, thereby harming economic growth. The dynamic effect of fiscal variables is an important topic of macroeconomic public finance. PART Ⅱ PUBLIC EXPENDTURE PART Ⅱ: PUBLIC EXPENDITURE Brief Content: Chapter Ⅰ: Meaning and Nature of Public Expenditure. Chapter Ⅱ: Classification of Public Expenditure. Chapter Ⅲ: Canons of Public Expenditure. Chapter Ⅳ: Growth of Public Expenditure. Chapter Ⅴ: Effects of Public Expenditure. Chapter Ⅰ: Meaning and Nature of Public Expenditure Section Ⅰ: Meaning of Public Expenditure The expenses incurred by the governments for its own maintenance, preservation and welfare of the economy as a whole is referred to as public expenditure (1). In other words, public expenditure is the expenditure incurred by the public authorities- central, states and local governments-to satisfy those collective needs which the people in their individual capacity are unable to satisfy efficiently (2). Public expenditures are carried out by national and local government and public sector enterprises. The public expenditure functions include education, public health, social security, irrigation, canals, drainage, roads, buildings, etc. The major cause of the increase in public expenditure is nothing but these developmental functions. Public expenditure is incurred basically to maximize social welfare. Hence, public expenditure occupies a very important place in the study of public finance. It is the end of all financial activities of the government. The advantages of public expenditure were not fully appreciated by the traditional economists. They considered market mechanism as a better method whereby the working of the economy could be guided, and the allocation of resources could be decided. But today (1) A. Senthilkumar, “Public Finance and IT Law”, P.63. (2) M. Maria John Kennedy, “Public Finance”, PH learning private limited New Delhi, 2012, P. 159. due to the continuous expansion of state activities and other public bodies the volume of public expenditure has been increasing in almost all countries of the world. As the scope of the functions of the government was restricted in the past there was no need for the theory of public expenditure. In the present century the development of the functions of the state in social matter and public utilities has increased public expenditure in a large degree. Accordingly, the importance of public expenditure has also increased (1). With the increase in the size of the government, it became essential that public expenditure is to be guided by proper guidelines, rules, laws, and principles where activities in government need funds for their execution. Section Ⅱ: Scope of Public Expenditure Regarding the scope of public expenditure, one could study two schools of thought viz., the classical and the modern. The classicals believed in police state. This school restricts the functions of the government to defense, law and order, public debt, and the necessities of civil administration. The classical economists never (1) Cauvery R, Uk Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.27. fully appreciated the advantages of public expenditure. They called for minimum taxation (1). As for, modern economists want state intervention in every field. Therefore, these days, the above-mentioned view of classical economists cannot be considered appropriate, because the states of present time are welfare states which is different from Police state of classical time. Welfare state has to do more welfare works of public in which government has to spend in bulk quantity for fulfilling many objectives for social welfare and economic development. That’s the reason that the tasks of present states have been increased (2). Section Ⅲ: Objectives of Public Expenditure Public expenditure as a financial mechanism provides a helping hand to the government to realize its core economic and social objectives. As we mentioned before, the traditional economists had confined the functions of the state mainly for providing protection to the people from internal rebellion and foreign aggression, administration of justice and provision of public works. Robert Peel argued that "money would fructify more in the hands of the people than in those of the state". According to Parnell, "Every particle of expense that is incurred beyond what necessity requires for the preservation of social order and for protection against (1) Cauvery R., Uk. Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.27. (2) Dilfraz Singh, “Public Finance” Laxmi Publications (P) LTD. New Delhi, India, P.178. foreign attack is a waste and unjust and oppressive imposition upon the public". The Great Depression of 1930's dealt a severe blow to this narrow view. The Keynesian revolution in the 1930's shifted a paradigm from laissez-faire to active state intervention (1). Modern economists conceive that public expenditure has a positive role to achieve the goal of maximum social welfare. Public expenditure is much essential in correcting market failure and providing public goods (2). The major objects of public expenditure are summarized below: 1. Administration of law and order and justice. 2. Maintenance of police force. 3. Maintenance of army and provision of defense goods. 4. Maintenance of diplomat in foreign countries. 5. Public administration. 6. Servicing public debt. 7. Development of industries. 8. Development of transport and communication. 9. Provision for public health. 10. Creation of social goods. (1) M. Maria John Kennedy, “Public Finance”, PH learning private limited New Delhi, 2012, P. 164. (2) M. Maria John Kennedy, “Public Finance”, PH learning private limited New Delhi, 2012, P. 164- 165. Chapter Ⅱ: Classification of Public Expenditure Introduction Classification of public expenditure refers to the systematic arrangement of different items on which the government incurs expenditure. The purposes of expenditure classification has grown over the years and has generally kept pace with the growth and increasing complexity of public expenditures. Moving from accountability to management and to planning, classifications were improved for several reasons. The need for uniformity in the structures and better synchronization with other classifications, on one hand, and the introduction of program budgeting, on the other, have contributed to major changes in the classification of expenditures (1). Public expenditure may be classified in several ways: Section Ⅰ: Functional Classification The functional composition is based upon the purpose or function toward which the expenditure is directed and is also referred to as sectoral expenditures. this in turn can be classified under four general headings: (1) A. Premchand, “Government Budgeting and Expenditure Controls: Theory and Practice”, International Monetary Fund, Washington, D.C., 1983, P.306. 1. Economic Services: It covers expenditures associated with the regulation or more efficient operation of businesses, including transport, electricity, agriculture and industry. 2. Social Services: It covers government services supplied to the community and households directly, such as education, health, sanitation, etc. 3. General Government Services: It include general public administration, defense, public order and safety. 4. Other Functions: It include interest and general transfers to other organs of government (1). Section Ⅱ: Economic Classification The economic composition of expenditures depends upon the type or economic characteristics of the transactions on which (2) resources are spent. according to this classification public expenditure is divided into current expenditure and capital expenditure. If public expenditure brings benefits in the present, it is called current public expenditure, if it brings future benefits, it is (1) Pradhan, Sanjay, “Evaluating public spending: a framework for public expenditure reviews”, world Bank Discussion Papers, Washington, D.C., 1996, P.33-34. (2) Pradhan, Sanjay, “Evaluating public spending: a framework for public expenditure reviews”, world Bank Discussion Papers, Washington, D.C., 1996, P.34. (1) known as capital expenditure. Hence, this in turn can be classified as follows (2): 1. Capital Expenditures: It covers payments for the purchase or production of new or existing durable goods, or goods with a life of more than one year, to be used for nonmilitary productive purposes e.g., bridges, roads, school buildings, health clinics, etc. 2. Current or Recurrent Expenditures: It includes wages and salaries, other goods, and services (including non-wage operations and maintenance "O&M"), interest payments, and subsidies and other current transfers. Section Ⅲ: Cross Classification or Economic-cum-Functional Classification (3) Cross Classification or Economic-cum-Functional Classification: Cross classification provides the breakup of government expenditure not only-by economic categories but also by functional heads. For instance, expenditure on medical facilities (a functional head) is split between economic categories such as (1) Cauvery R, Uk Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.30-31. (2) Pradhan, Sanjay, “Evaluating public spending: a framework for public expenditure reviews”, world Bank Discussion Papers, Washington, D.C., 1996, P.34. (3) Egyankosh, Classification of Government Expenditure, Ignou, 2017, Unit 9, P. 7. http://egyankosh.ac.in//handle/123456789/19306 current expenditure, capital expenditure, and various types of transfers and loans. Conversely, cross classification shows how expenditure on a particular economic category, say capital formation, is divided according to different public activities like education, labor welfare, family planning etc. Under a scheme of cross classification, functional classification of expenditure can be analyzed according to its economic character and economic classification of expenditure can be analyzed according to the functions performed by it. The two types of classification therefore supplement each other and give a clear picture of the total transactions of government. Section Ⅳ: Accounting Classification Accounting classification of government expenditure can be analyzed under (1): 1. Revenue Expenditure and Capital Expenditure: this classification indicates how much government expenditure results in creation of assets in the economy and how much expenditure is unproductive. 2. Developmental Expenditure and Non-Developmental Expenditure: This classification indicates how much (1) Egyankosh, Classification of Government Expenditure, Ignou, 2017, Unit 9, P. 7. http://egyankosh.ac.in//handle/123456789/19306 government expenditure is spent on social and community services and economic services as against general services. 3. Plan Expenditure and Non-Plan Expenditure: this classification helps the Planning Commission and Finance Commission in determining the pattern of central assistance on plan schemes to state governments, and union territories. Thus, each classification of government expenditure serves one objective or other in government. Section Ⅴ: Optional and Obligatory Expenditure This type of classification considers the nature of expenditure, whether it is obligatory or optional. Some kinds of expenditure are optional while others are obligatory. For instance, expenditure on defense, justice and maintenance of economic institutions are obligatory but that of social security is optional. This classification is also called the secondary and primary classification of public expenditure. Nowadays however many kinds of optional expenditure have assumed importance and become obligatory (1). Section Ⅵ: Transfer and Non-transfer Expenditure Pigou has classified public expenditure by considering the principle whether it involves the use of goods and services or not. When it does, it is called real or non-transfer public expenditure. (1) Cauvery R, Uk Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.30. On the other hand, if public expenditure does not involve the use of goods and services, it is known as transfer expenditure. Payments for the purchase of raw materials fall under real expenditure and pensions under transfer expenditure. Subsidies to industries also fall under this heading because they do not involve any direct use of goods and services (1). (1) Cauvery R, Uk Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.30. Chapter Ⅲ: Canons of Public Expenditure Introduction In economic literature, the expression canons of public expenditure are used for the basic principles governing the expenditure policy of the government. The canons or principles of public expenditure are concerned with the enunciation of those fundamental rules which should govern the expenditure policy of the government. Though the size of the public expenditure is not less important, yet the method and the direction in which the public expenditure is executed is of paramount importance. In fact, the principles of public expenditure determine the efficiency of the expenditure itself (1). Section Ⅰ: Canons of Public Expenditure According to Prof. Findlay Shirras there are four principles of public expenditure which are as follows (2): 1. Canon of Benefit: The most important canon of the public expenditure is the canon of benefit. According to Prof. Findlay Shirras “Other things being equal, public expenditure should be made in such a way that society gets major benefits which, in turn, may increase production, protect (1) Cauvery R., Uk. Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.32. (2) George Findlay Shirras, “The Science of Public Finance” Macmillan and Company, limited, 1925. again external aggression, maintain the internal order, and may, possibly, reduce the economic inequalities.” Achievements of these objectives can be possible only when public expenditure is made not for an individual or a class, but for the whole society. By studying the effect of public expenditure on the distribution of income and wealth, production, economic development, etc., assessment can be made regarding their benefits. A major canon of public expenditure is the canon of maximum social benefit (1). In the words of Prof. Dalton, “Government expenditure must be used in every direction up to that extent that equal balance can be maintained in loss caused due to increase in any other source of taxation or any Government income. This rule presents an ideal limit for both Government expenditure and Government income.” Its meaning is that by every additional unit of imposing tax, the weight of sacrifice by public will increase, but by the expenditure of that tax, the quantity of benefit received by public will decrease continuously. In this way, by imposing tax and regarding spending it, a point will come where profit received by any unit of money spent by state, will be equal to the sacrifice by the public due to any unit of tax imposed by Government. This is that state when the Government has to stop its extending step regarding to income and expenditure because it is that point on which marginal sacrifice is equal to marginal benefit. This is the optimum limit of financial (1) T. R. Jain, “Public Finance and International Trade” publications Educational Publishers, P.14. task of Government. In this way, the Government expenditure must be done up to that extent where marginal utility received by Government expenditure must be equal to the marginal disutility due to taxation or Government income (1). 2. Canon of Economy: Economy here, does not mean miserliness or niggardliness, rather it means that all possible waste should be avoided and for this duplication of expenditure and overlapping of authorities should be done away with. In short, the state should be economical in spending money. Firstly, the state should not spend more than the necessary amount on the items of expenditure. This condition has reference to the present. Secondly, the state should develop productive powers of the community as much as possible. This condition has reference to the future. The main aim of this canon is to avoid extravagance and corruption. This canon is a good practical rule to be followed by the public authorities (2). In the present times, the economists apply several principles in order to check the misuse of public expenditure and to make its proper use. We have, for example, Cost- Benefit Analysis. By this analysis, assessment can be made regarding how much economy in the public expenditure on a project can be affected. In the words of (1) Dilfraz Singh, “Public Finance” Laxmi Publications (P) LTD. New Delhi, India, P.23-24. (2) Cauvery R., Uk. Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.34. Findlay Shirras, "Economy means protecting the interests of tax- payers not merely in effecting economies in expenditure but in developing revenue (1). 3. Canon of Sanction: According to this canon, no expenditure should be incurred without the proper approval of the sanctioning authority. It also implies that the spending authorities should spend the amount for which it has been sanctioned and to see that the sanctioned amount is properly utilized, and money sanctioned for one purpose should not be spent for another purpose. Public accounts are to be audited at the end of financial year. This canon acts as check on arbitrary, unwise and reckless spending of public funds. Therefore, the absence of proper sanction, there is every likelihood of misuse and misappropriation of public funds (2). 4. Canon of Surplus: This canon supports avoiding deficit in public expenditure. In other words, government should aim at achieving balanced budget where public expenditure is lower than or at most equal to public revenue. If public expenditure exceeds public revenue by a large gap it will lead to government debt and might impact the fiscal sustainability of the government. (1) T. R. Jain, “Public Finance and International Trade” publications Educational Publishers, P.14. (2) A. Senthilkumar, “Public Finance and IT Law”, P.70. According to surplus principle in public expenditure one should avoid loss. In Prof. Shiraz words, “In the matter of income received and expense governments should behave like common citizens”. Like a private person who does not exceed his expense by his income government should also make a habit of balance budget. Yearly expense should be balanced without any new loan. “This principle seems solid and safe. This principle tells that like a private person government should also expand in its periphery, but this does not mean that government can never take loans. If actually required, he should borrow the loan. But its income has to be more so that it can pay interest and also made a sinking fund for the return of loan (1). But modern economist not always like the balance budget. How to make budget is totally depends on county’s economic condition. Surplus budget seems more likeable in inflation as it lessens the purchasing power of the people which intern make the effective demand low and in this way it maintains a balance between current demand and current production in its opposite, in deflation deficit budget seems good because it increases the purchasing power of the people and also effective demand and in this way balance current demand and production (2). (1) Dilfraz Singh, “Public Finance” Laxmi Publications (P) LTD. New Delhi, India, P.186-187. (2) Dilfraz Singh, “Public Finance” Laxmi Publications (P) LTD. New Delhi, India, P.186-187. Section Ⅱ: Other Canons of Public Expenditure 1. Canon of Elasticity: There should be flexibility in government expenditure. That is, the government may be able to change its public expenditure policy with changing conditions. It means that public expenditure should increase during periods of emergency and reduce during normalcy (1). For instance, government should be able to increase public expenditure during periods of emergency such as war, flood, drought, etc. or during economic depression when the economic growth is low. An increase in government expenditure during the time of depression ensures that the economy is lifted from low levels of production and employment. The multiplier effect of the public spending will pave the way for economic recovery. The opposite is the case during the period of boom and high inflation when government should reduce public expenditure. In other words, public expenditure should be elastic which can be used as a fiscal policy instrument to stabilize the economy during the time of high inflation or depression. 2. Canon of Neutrality: According to the canon of neutrality, public expenditure should only have positive effects on the economy and should not have any negative ones. Therefore, government expenditure should result in (1) A. Senthilkumar, “Public Finance and IT Law”, P.70-71. higher production and productivity, not lower levels. In a similar vein, it ought to lessen rather than widen income disparity. In other words, government expenditure should strengthen rather than deteriorate the link between production, distribution, and exchange. 3. Canon of Productivity: Public expenditure should be incurred in such a way that promotes production and creates employment opportunities in the economy. It should lead to capital formation and increase the working efficiency of the people. Development activities should be given priority in the government budget. In other words, the aim of public expenditure should be maximum production, employment, and income. The expenditure policy of the government should encourage production and productive efficiency in the country. This means that the major part of public expenditure should be allocated for production and developmental purposes (1). 4. Canon of Equitable Distribution: Public expenditure should help equitable distribution of wealth. The government should make its expenditure in such a way as to provide more benefit to the backward classes of the society. For example, arrangement should be made for free education, health (1) Cauvery R., Uk. Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.35. and recreation facilities for the poor and backward classes, more welfare projects should be launched for them (1). 5. Canon of Certainty: The public authorities should be clear about the purpose and extent of public expenditure to be incurred. The canon requires the preparation of public budgets with the government taking into account both the short term and long-term impacts of public expenditure with the modes of spending clearly spelt out. The areas and the part in which public expenditure is to be made, should be certain so that the development works may be carried out properly. The government should, determine with certainty the allocation of public expenditure to various uses (2). (1) T. R. Jain, “Public Finance and International Trade” publications Educational Publishers, P.15. (2) T. R. Jain, “Public Finance and International Trade” publications Educational Publishers, P.15. Chapter Ⅳ: Growth of Public Expenditure Section Ⅰ: Increasing of Public Expenditure Developing economies have been faced with an increasing size of government operations and its impact on economic growth has become an emerging major public debate. However, the observed growth in public spending appears to apply to most countries regardless of their level of economic development (1). Writing in the 1880's, the German economist Adolph Wagner (2) advanced his ''law of rising public expenditures.'' He felt, perhaps in anticipation of trends to be realized fifty to a hundred years later, that the development of modem industrial society would give rise to increasing political ''pressure for social progress'' and call for increased allowance for ''social consideration'' in the conduct of (1) C. Okafor and O. Eiya, Determinants of Growth in Government Expenditure, Research Journal of Business Management, 5, 2011, P.44. (2) Adolf Heinrich Gotthelf Wagner (1835-1917), German political economist, and public finance scholar. He studied jurisprudence and political economy in Heidelberg and Gottingen. Between 1858 and 1870 he held teaching positions in Vienna, Hamburg, Dorpat, and Freiburg im Breisgau. In 1870 he was appointed to a chair of political economy at the University of Berlin, which he held for 46 years. He exerted a powerful influence as a writer of textbooks, monographs, and policy pamphlets and as a teacher of two generations of higher civil servants. Adolf Wagner propounded an empirical law to analyses and explains the trend in the growth of public expenditure. Wagner argued that a functional, cause and effect relationship exists between the growth of an industrializing economy and the relative growth of its public sector. industry. In consequence, continual expansion of the public sector and its share in the economy should be expected (1). Wagner (1883), on the basis of empirical findings, came up with a view that there was a long-run tendency for state activities to grow relative to the growth in national income. The conventional interpretation of Wagner’s law implies a continuous relative expansion of public spending as a consequence of the development process. Wagner explained that as a society becomes industrialized, the set of social, commercial and legal relationship within it become more complex. Government would be called upon to play a more prominent role in setting up and running institutions to control this complexity. These regulatory and protective functions of the state would cause an enlargement in the size of the public budget. Wagner reasoned that many public outputs are income elastic so that as development progresses and per capita income increases demand for these public output increases by a larger percentage. As the public sector responds to the increasing demand for its goods and services, the budgetary outlays which accompany them increase and consequently, the relative size of public expenditure expands (2). (1) Richard A. Musgrave and Peggy B. Musgrave, “Public Finance in Theory and Practice”, McGraw Hill; 5th Edition, 1989, P.114. (2) C. Okafor and O. Eiya, Determinants of Growth in Government Expenditure, Research Journal of Business Management, 5, 2011, P.44-45. According to Dalton, the rules of Wagner are applied in three conditions (1): 1. The work efficiency of public organizations due to economic growth becomes more than private institutions because: a) The produced goods by public institution are of good quality. b) There is the no dearth of goods in the market. c) The capital is easily available in public sector. 2. By the public expenditure, those services are incurred which are useful for the whole society like school, hospitals, parks etc. 3. Those service which non-government agencies unable to do, completed by the state itself. In this way public expenditure is increasing day by day. Section Ⅱ: Causes of Public Expenditure Growth Public expenditure has increased manifold in recent times, and it continues to be increasing with the passage of time due to the following causes: 1. The new concept of welfare state: The basic reason for the enormous growth of public expenditure in recent times is due to a paradigm shift from police state to welfare state. In the 19th century, it was widely believed that public expenditure beyond what would be absolutely necessary to protect (1) Dilfraz Singh, “Public Finance” Laxmi Publications (P) LTD. New Delhi, India, P.182. the country from external aggression and internal disorder was a waste. This laissez-faire policy emphasized a view that, that government is the best which governs the least. The essence of the argument is that "private individuals spent money better than government does". For instance, Gladstone used to say, "leaving money to fructify in the pockets of the people". Therefore, minimum of government expenditure and least taxation was emphasized. Coverage of New Functions (1). But with the committed goal to welfare state the government was expanding its activities in the field of various welfare measures. These measures included the steps to enrich the cultural life of the society and also those designed to provide social security in the form of old age pension and so on. State activities were increasing on account of subsidies and its efforts at redistributing income and wealth (2). 2. Increase in National Income: As a result of economic development, the national income of the countries has increased many times. Consequently, public revenue (1) M. Maria John Kennedy, “Public Finance”, PH learning private limited New Delhi, 2012, P. 160. (2) Cauvery R., Uk. Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.53. by way of taxation has also increased and this has led to an increase in public expenditure. 3. Rise in Price Level: Another noteworthy factor has been the rampant increase in price level all over the world since World War II. Rise in price level or inflationary pressure has two implications for the concerned government. First, the government has to pay more for the goods and services purchased in the market, for its requirements. Secondly, the government has to find huge financial resources to meet its growing expenditure. As a result of increasement in price level, costs have been increased in every country. But it is also true that the increased government expenditure is itself partly responsible for the rise in price. During inflation the government has to pay additional dearness allowance to its employees which obviously calls for an extra burden on public expenditure. 4. Increase in Population: Increase in population in most cases becomes a major contributing factor to the growth of public expenditure. In harmony with the increase in population the public services have to increase. For example, more schools, more hospitals, more houses have to be provided to meet the needs of the growing population (1). (1) Cauvery R., Uk. Sudha Nayak, et al., “Public Finance Fiscal Policy” S Chand & Company Pvt Ltd - Se, 3rd Edition, 2007, P.54. 5. Urbanization: There is a close link between urbanization and the necessity for increased civil administration. There is no doubt that increasing urbanization of population is an important reason of increment in government expenditure also. The rule of increasing costs in cities applies completely. With the increase in size of city, per person cost of expenditure spent on services like expenses on public health, public education, public transport, and libraries have increased considerably in these days. 6. War and Prevention of War: The simple most dominant factor in pushing public expenditure upward in recent times is war. War and threat of wars have forced countries to be armed all the time and be ready for war. The cost of war and defense have increased considerably in modern times. Maintenance of a modern army, navy and air force claims a large part of the government budget. Modern wars are technology based and are very costly (1). Even if there is no war, the constant fear of war and the measures to prevent it have obliged the governments to maintain large armies and spend the major portion of their national income on the manufacture of war weapons. According to Wagner, there is always an arms race going on between the (1) M. Maria John Kennedy, “Public Finance”, PH learning private limited New Delhi, 2012, P. 160. countries. This has obviously led to a huge increase in public expenditure (1). 7. Rural Development: Balanced regional development is one of the accepted goals of economic planning and the government has been undertaking many poverty alleviation and employment generation programs. National Rural Health Mission, Bharat Nirman, Sara Shiksha Abhiyan, Food Security Mission and Mahatma Gandhi National Rural Employment Guarantee Progra

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