What is Public Finance?

In simple layman terms, public finance is the study of finance related to government entities. It revolves
around the role of government income and expenditure in the economy. It is the management of a
country’s revenue, expenditures, and debt load through various government and quasi-government
institutions. This guide provides an overview of how public finances are managed, what the various
components of public finance are, and how to easily understand what all the numbers mean. A country’s
financial position can be evaluated in much the same way as a business’ financial statements.

THE SCOPE OF PUBLIC FINANCE:

1. PUBLIC INCOME

As the name suggests, public income refers to the income of the government. The government earns
income in two ways – tax income and non-tax income. Tax income is easy to recognize, it’s the tax paid
by people of the country in the form of income tax, sales tax, duties, etc. On the other hand non-tax
income includes interest income from lending money to other countries, rent & income from
government properties, donations from world organizations, etc.

This area studies methods of taxation, revenue classification, methods of increasing government
revenue and its impact on the economy as a whole, etc.

2. PUBLIC EXPENDITURE

Public expenditure is the money spent by government entities. Logically, the government is going to
spend money on infrastructure, defense, education, healthcare, etc. for the growth and welfare of the
country.

This area studies the objectives and classification of public expenditure, effects of expenditure in
different areas, effects of public expenditure on various factors such as employment, production,
growth, etc.

3. PUBLIC DEBT

When public expenditure exceeds public income, the gap is filled by borrowing money from the public,
or from other countries or world organizations such as The World Bank. These borrowed funds are
public debt.

This area of public finance explains the burden of public debt, why it is necessary and its effect on the
economy. It also suggests methods to manage public debt.

4. FINANCIAL ADMINISTRATION

As the name suggests this area of public finance is all about the administration of all public finance i.e.
public income, public expenditure, and public debt. Financial administration includes preparation,
passing, and implementation of government budget and various government policies. It also studies the
policy impact on the social-economic environment, inter-governmental relationships, foreign
relationships, etc.
FUNCTIONS OF PUBLIC FINANCE

There are three main functions of public finance as follows –

1. THE ALLOCATION FUNCTION

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

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

2. THE DISTRIBUTION FUNCTION

There are large disparities of income and wealth in every country in the world. These income
inequalities plague society and increase the crime rate of the country. The distribution function of public
finance is to lessen these inequalities as much as possible through redistribution of income and wealth.

In public finance, primarily three measures are outlined to achieve this target –

 A tax-transfer scheme or using progressive taxing, i.e. in simpler words charging higher tax from
the rich and giving subsidies to the low-income
 Progressive taxes can be used to finance public services such as affordable housing, health care,
etc.
 A higher tax can be applied to luxury goods or goods that are purchased by the high-income
group, for example, higher taxes on luxury cars.
3. THE STABILIZATION FUNCTION

The stabilization function explains the macroeconomic aspect of budgetary policy. In other words, the
stabilization function deals 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 and fiscal policy. This function is otherwise known as compensatory finance.
Importance of Public Finance:

1) Provision of public goods: For providing public goods like roads, military services and street lights etc.
public finance is needed. Business firms will have no incentive to produce such goods, as they get no
payment from private individuals.

2) Public finance enables governments to tackle or offset undesirable side effects of a market economy.
The side effects are called spill overs or externalities. For example, pollution. The governments can
introduce recycling programmes to lessen pollution or they can make laws to restrict pollution or
impose pollution charges or taxes on activities that bring about pollution.

3) Public finance helps governments to redistribute income. To reduce the inequality in the economy,
the governments can impose taxes on the richer people and provide goods and services for the needy
ones.

4) Public finance provides many a programme for moderating the incomes of the rich and the poor. Such
programmes include social security, welfare and other social programmes.

5) The acceptance of the principle of welfare state, the role of public finance has been increasing.
Modern governments are no more police states as the classical economists viewed.

6) As the scope of state participation in the economic activity is widening, the scope of public finance
has also been increasing. Generation of employment opportunities, control of economic fluctuations like
boom and depression, maintaining economic stability etc. are some of the thrust areas of the
governments through fiscal operations.

Public Finance and Private Finance

The understanding and the study of public finance is facilitated by a comparison of the public or
government finance with private or individual finance. Such a comparison will help us to know how the
aims and objectives and methods of public Finance operation are similar or differed from the financial
operations of the individual.

Similarities

1. Both the State as well as individual aim at the satisfaction of human wants through their financial
operations. The individuals spend their income to satisfy their personal wants whereas the state spends
for the satisfaction of communal or social wants.

2. Both the States and Individual at times have to depend on borrowing, when their expenditures are
greater than incomes.

3. Both Public Finance and Private Finance have income and expenditure. The ultimate aim of both is to
balance their income and expenditure.

4. For both kinds of finances, the guiding principle is rationality. Rationality is in the sense that
maximization of personal benefits and social benefits through corresponding expenditure.
5. Both are concerned with the problem of economic choice, that is, they try to satisfy unlimited ends
with scarce resources having alternative uses.

Dissimilarities

1. The private individual has to adjust his expenditure to his income. i.e., his expenditure is being
determined by his income. But on the other hand the government first determines its expenditure and
then the ways and means to raise the necessary revenue to meet the expenditure.

2. The government has large sources of revenue than private individuals. Thus at the time of financial
difficulties the state can raise internal loans from its citizens as well as external loans from foreign
countries. In the case of private individual, all borrowings are external in nature.

3. The state, when hard pressed, can resort to printing of currency, as an additional source of revenue.
In fact, during emergencies like war, it meets its increased financial obligations by printing new currency.
But an individual cannot raise income by creating money.

4. The state prepares its budget or estimates its income and expenditure annually. But there is no such
limitation for an individual. It may be for weekly, monthly, or annually.

5. A surplus budget is always good for a private individual. But surplus budgets may not be good for the
government. It implies two things. a) The government is levying more taxes on the people than is
necessary and b) the government is not spending as much as the welfare of the people as it should.

6. The individual and state also differ in their motives regarding expenditure. The individuals hanker
after profit. Their business operations are guided by private profit motive. But the states expenditure is
guided by the welfare motive.

7. The private individual spends his income on various items in such a manner as to secure equi-marginal
utilities from them. The government on the contrary does not give as much importance to this law as a
private individual does. Modern government sometimes incur cretin types of expenditure from which
there do not derive any advantage but they do incur this expenditure to satisfy cretin sections of the
community.

8. An individual’s spending policy has very little impact on the society as a whole. But the state can
change the nature of an economy through its fiscal policies.

9. The pattern of expenditure in the case of private finance is often influence by customs, habits social
status etc. The pattern of government expenditures is guided by the general economic policy followed
by the government.

10. Private Finance is always a secret affair. Individual need not reveal their financial transactions to
anyone except for filing tax returns. But Public Finance is an open affair. Government budget is widely
discussed in the parliament and out sides. Public accountability is an important feature of public finance.

11. 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
future of public finance.
THE PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE

One of the important principles of public finance is the so – called Principle of Maximum Social
Advantage explained by Professor Hugh Dalton. Just like an individual seeks to maximize his satisfaction
or welfare by the use of his resources, the state ought to maximize social advantage or benefit from the
resources at its command. The principles of maximum social advantage are applied to determine
whether the tax or the expenditure has proved to be of the optimum benefit.

Public expenditure creates utility for those people on whom the amount is spent. When the volume of
expenditure is small with a slighter increase in it, the additional utility is very high. As the total public
expenditure goes on increasing in course of time, the law of diminishing marginal utility operates.
People derive less of satisfaction from additional unit of public expenditure as the government spends
more and more. That is, after a stage, every increase in public expenditure creates less and less benefit
for the people. Taxation, on the other hand, imposes burden on the people. So, when the volume of
taxation becomes high, every further increase in taxation increases the burden of it more and more.
People under go greater scarifies for every additional unit of taxation. The best policy of the government
is to balance both sides of fiscal operations by comparing “the burden of tax” and “the benefits of public
expenditure”. The State should balance the social burden of taxation and social benefits of Public
expenditure in order to have maximum social advantage.

Attainment of maximum social advantage requires that;

a) Both public expenditure and taxation should be carried out up to certain limits and no more.

b) Public expenditure should be utilized among the various uses in an optimum manner,

c) The different sources of taxation should be so tapped that the aggregate scarifies entailed is the
minimum.

Assumptions of the Principle

 The public revenue consists of only taxes (and not of gifts, loans, fees etc.) and the state has no
surplus or deficit budgets.
 Public expenditure is subject to diminishing marginal social benefits and the taxes are subject to
increasing marginal cost or disutility.