Public finance and taxation

CHAPTER ONE
NATURE AND SCOPE OF PUBLIC FINANCE
 Overview and Definition of Public Finance
Governments, all over the world have started number of public projects, such as social security, protection and
other services of public utilities like electricity, water supply, railways, heavy electricity, atomic energy, etc.
To provide social amenities in the form of education, health and sanitation facilities and public utilities, the
government requires adequate revenue.

Public Finance, therefore, deals with the income and expenditure of public authorities. It deals with the
financial operations or finances of the government. Central, state and local government raises revenues from
various tax sources and non-tax sources, such as revenue from general, administrative and economic services,
borrowings from individuals, corporations and friendly foreign countries. The government raises revenue
from internal as well as external sources to incur huge expenditure on various functions the government has to
perform. The important ones being maintenance of law and order, defense, socio-economic development,
etc...Public finance is thus concerned with the use and accomplishment of essential monetary resources of the
government. In fact, public finance deals with how and through what different sources the government gets
income, how it spends it and how it controls and administers its incomes and expenditures. These two
activities, i.e. raising of revenue through taxation and other sources, and spending it on various services plus
borrowings from internal as well as external sources, together constitute “Public Finance.” Therefore, the
subject matter of public finance deals with public revenue, public expenditure, and public debt.

Public finance is the study of income and the expenditure of the government. Rising of necessary funds for
incurring expenditure constitutes the subject matter of public finance. The methods of public finance have
certain effects on economic life and can, therefore, be used as an instrument for bringing about desired social
and economic changes. Public finance also deals with the problems of adjustments of income and expenditure
of the government. It is also known as fiscal operations of the treasury. Thus, fiscal operations and fiscal
policies are integral part of public finance.

Public Finance deals with the income and expenditure of the public authorities. Here the term Public means
the Government that is Central, state and local authorities. According to Prof. Dalton, public finance is one
of those subjects, which lie on the borderline between Economics and Politics. It is concerned with the
income and expenditure of public authorities and with the adjustment of one to another.

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Hence, it can be defined as the science that deals with the nature and principles of the income and expenditure
of the government.
 Scope of Public Finance
Public finance deals with the income and expenditure pattern of the Government. Hence the substances
concerned with these activities become its subject matter. The subject matter of the public finance is classified
under five broad categories. These are:
1) Public revenue 4) Financial administration& control
2) Public Expenditure 5) Economic stabilization& growth
3) Public debt
 Public Revenue: Revenue includes all incomes irrespective of the source they are obtained from.
Thus, in the wider sense, we can include taxes as well as borrowings under public revenue.Public revenue
implies raising income by way of taxation. Public revenue is the means for public expenditure. Various
sources of public revenue are:
a. Tax revenue, and
b. Non-tax revenue
Increasing activities of the government are the cause of increasing public expenditure. Methods of public
revenue and their volumes have significant impact on production and distribution of wealth and income in the
country. It has effects on the nature and the volume of economic activities and on employment.
a) Tax revenue: Taxes are compulsory payments to government without expectation of direct return
or benefit to tax payers. It imposes a personal obligation on the taxpayer. Taxes received from the
taxpayers, may not be incurred for their benefit alone. Tax revenue is one of the most important
sources of revenue.
Taxation is the powerful instrument in the hands of the government for transferring purchasing power from
individuals to government. The objectives of taxation are to reduce inequalities of income and wealth; to
provide incentives for capital formation in the private sector, and to restrain consumption so as to keep in
check domestic inflationary pressures.
From the above discussion we can conclude that the elements of taxation are as follows:
1. It is a compulsory contribution 4. Taxation is aimed at welfare of the
2. Government only imposes taxes community
3. In payment of tax an element of 5. The benefit may not be proportional
sacrifice is involved to tax paid

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6. Tax is a legal collection.

The various types of taxes can be listed under three heads. First type can be titled taxes on income and
expenditure which include income tax, corporate tax etc. The second is taxes on property and capital
transactions and includes estate duty, tax on wealth, gift tax etc. The third head, called taxes on commodities
and services, covers excise duties, customs duties, sales tax, service tax etc. These three types can be
reclassified into direct and indirect taxes. The first two types belong to the category of direct taxes and the
third type comes under indirect taxes.
b) Non-tax revenue: This includes the revenue from government or public undertakings, revenue
from social services like education and hospitals, and revenue from loans or debt service. To sum up,
non-tax revenue consists of:
 Interest receipts  Fiscal services and others.
 Dividends and profits
 Public Expenditure: There has been both quantitative and qualitative change in government‟s
expenditure. This category deals with the principles of public expenditure and its effect on the economy
etc. Government of a country has to use its expenditure and revenue programs to produce desirable
effects on national income, production, and employment. The role of public expenditure in the
determination and distribution of national income was emphasized by Keynes.
The term “Public Expenditure” is used to designate the expenditure of government-central, state and
local bodies. It differs from private expenditure in that governments need not pay for themselves or yield
a pecuniary profit. Public expenditure plays the dual role of administration and economic achievement of
a nation. Wise spending is essential for stability of government and proper earnings are a prerequisite for
wise spending. Hence planned expenditure and accurate foresight of earnings are the important aspects of
sound government finance.
Public expenditure is done under two broad heads viz., developmental expenditure and non-
developmental expenditure. The former includes social and community services, economic services, and
grants in aid. The latter mainly consists of interest payments, administrative services, and defense
expenses. Expenditure can also be classified into revenue and capital expenditure.
 Public debt: A public authority can obtain income through loans and public borrowings. The loans
raised in a particular year constitute receipts for that year. It is an income of a capital nature, while the
provision for repayment of the capital sum for the year constitutes expenditure of a capital nature. This

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category deals with the causes, methods and problems of public borrowings and its management. This
includes both internal debt and external debt.
a) Internal debt: Increasing need of government for funds cannot be fully met by taxation alone in
under developed and developing countries due to limited scope of taxation. Government therefore has
to resort to alternate sources. Rising of debt is one of such source. Debt, though involves withdrawal of
resources by curtailing private consumption, has certain advantages. Transfer of funds from public to
government is voluntary. Loans do not reduce the wealth of the lenders. Debt raised for productive
purpose will not be a burden on the economy.There are many objectives of creation of public debt.
Debt may be raised to meet the normal current expenditure, exigencies like war, finance productive
government enterprise, finance public social welfare and economic development.Capital receipts
mainly consist of market borrowings, small savings and external loans, disinvestments of PSUs and
recoveries of loans.
b) External Debt: In under developed and developing countries, internal sources are limited. Under
developed and developing countries, therefore go for external debt. The transfer of capital at
international level may take the form of:
i) Financial aid through grants and ii) Commodity aid
loans iii) Technical assistance
External debt is an immediate source of funds for development. However, such debt has following
drawbacks.
i) Political subordination iii) Excess supply of goods and
ii) Other obligation services in debtor country
However, such external inflows help to achieve faster growth.
 Financial Administration& control: The scope of public finance is not confined only to public
revenue, public expenditure and public debt. We have to examine the mechanism by which the above
processes are carried on. Without a study of relevant dimensions of financial administration the subject of
public finance remains incomplete. This category includes the preparation of financial budget, the control
and administrations of the budget relevant problems auditing etc. The term budget includes „Annual
Financial Statements‟ which incorporates all the annual statements of receipts and expenditures of the
government. Thus financial administration and control include the following:
(i) Study of budgets and their procedure.

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(ii) Budget as an instrument of securing certain objectives, such as promotion of employment,

economic growth with stability, welfare of the weaker sections, infrastructural
development for promoting private investments, etc.
(iii) Financial and physical controls through different fiscal tools for controlling private
expenditure in the economy to avoid the effects inflation deflation, recession etc.
 Economic Stabilization& growth: The study of public finance includes fiscal policy of the
government in dealing with inflationary and deflationary situations, instability of the price level,
promotion of full employment, growth of economy, welfare of the people, etc. Economic stabilization is
of recent origin. It has a wide scope to play especially in the less developed countries. The main task of
this section is to frame and look after the implementation of various policies required for economic
stabilization and growth. This category analyses the use of public finance to bring the economic stability
in the country. It studies the use of financial policies of the Government from the view of economic
development.
 Public Finance and Private Finance
Finance in general means public as well as private finance. Public finance relates to the money-raising and
income-expenditure functions of the government. Private finance refers to the income-expenditure
phenomenon of an individual or private business firm. By private finance we mean the financial problems and
policies of an individual economic unit.
It is a convention to look into similarities and dissimilarities between the two so as to provide an analytical
foundation for the decision making aspects of public finance
Similarities Public Finance and Private Finance
1) Satisfaction of Human Wants: Individual is concerned with the personal wants, while the
Government is concerned with the social wants. Thus, both the private and public finance have the
same objective, via, the satisfaction of human wants.
2) Balancing of Income and Expenditure: Both individual and Government has incomes and
expenditures and trying to balance each other.
3) Maximum Satisfaction (Advantage): Both private and public finance aim at maximum satisfaction.
Both the public finance and private finance try to secure maximum advantage or maximum benefit.
An individual or a corporation or a private business firm tries to obtain maximum advantage from
his expenditure. Similarly, the government also tries to obtain maximum good of the people by
incurring expenditure on the society.

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4) Borrowings: As and when the current incomes become insufficient to meet the current expenditure,
the individuals and Governments rely upon borrowings. Both of them are having loan repayment
plans. Whenever the expenditure of either the government or any individual or firm exceeds their
income/revenue.
5) Economic Choice (Scarcity of Resources): Both the individual and Government face the problem
of economic choice. The scarcity of resources is an important factor which is common to both. They
have unlimited objectives, whereas the resources are limited. This means that their sources of
revenue are limited, comparing with their expenditure. Hence they have to satisfy the unlimited ends
with limited means.
6) Engagement in Similar Activities: Both the private and public sectors are engaged in activities that
involve lots of purchases, sales and other transactions. Similarly, they are engaged in production,
exchange, saving capital accumulation, investment, and so on. In order to finance these operations,
the government, creates money, raises loans and makes payments etc. Similarly, a private economic
unit lends, borrows, receives payments, and makes payments and so on. In these respects, therefore,
both the public and private finance are quite similar to each other.
7) Problem of Adjustment of Income and Expenditure: Another similarity between public and
private finance is that both the public as well as private sectors face the problem of adjustment of
income and expenditure.
Dissimilarities Public Finance and Private Finance
1) Adjustment Approach of Income and Expenditure: In private finance, the individual first
considers his income and then decides about his expenditure. But the case of public finance, the
government first estimates the volume of expenditure and then tries to find out the methods of
raising the necessary income. That is the private finance tries to adjust its income to expenditure,
whereas the public finance tries to meet the expenditure by raising income. In other words, the
government first determines its expenditure and then devises ways and means to raise the requisite
revenue to meet its expenses.
2) Motive (Nature of Benefit): The private finance aims at individual benefit (personal interest)i.e.
the benefit of individual household. But the public finance aims at collective benefit(social benefit
or public welfare) i.e. the benefit of the nation as a whole.
3) Postponement of Expenditure: In private finance, the individual can postpone or even avoid
certain expenditure, as he likes. But in the case of public finance, the Government cannot avoid

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certain commitments like, social welfare measures and thus cannot postpone the certain expenses
like relief measures, defense, etc.
4) Motive of expenditure: In the case of private finance, the individual expects return in benefit from
the expenditure made. But the government cannot expect return in benefit from various
expenditures made. That is profit or benefit is the motive of private finance whereas the social
welfare and economic development is the motive of public finance.
5) Deliberation in Expenditure (Influence on expenditure): The expenditure pattern of private
finance is influenced by various factors such as customs, habits culture religion, business conditions
etc. But the pattern of expenditure of public finance is influenced and controlled by the deliberate
economic policy of the Government.
6) Nature of Perspective (Long/Short-term Consideration): In private finance, the individual
strives for immediate and quick return. Since his life span is definite and limited gives importance
to the present or current needs and allots only a little portion of income for the future.But, the
Government is a permanent organization and is the caretaker of the present and the future as well.
Thus, the Government allots a considerable amount of its income for the promotion of future
interests. Such as construction of dams, multi-purpose hydro-electric projects, etc.private finance
has a short-term perspective whereas the public finance has a long term perspective.
7) Nature of Budget: In private finance individuals prefer surplus budget as virtue and a deficit
budget is undesirable to them. But the Government does not prefer a surplus 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.
8) Secrecy of Budget (Publicity): Public finance is an open affair as the government gives utmost
publicity to its budget by publishing it in newspapers and by showing it on television. For example,
the Ethiopian government tells to the public the yearly approved budget by parliament, whereas
private finance is a secret affair. An individual tries to keep his accounts secret as he does not want
his competitors to know his real financial position.
9) Nature of resources (Right to Print Currency): In private finance the individuals have limited
resources. They cannot raise the income, as they like. Thy do not have the power to issue paper
currencies. But, in the case of public finance the Government has enormous kinds of resources.
Besides the administrative and commercial revenues the Government can get grants-in-aid and
borrow from other countries. The government can print currency notes to increase its revenue.
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10) Coercion: Under private finance the individuals and business units cannot use force to get their
income. But, in public finance the governments can use force in the form of imposing taxes to get
income i.e. taxes are compulsory in nature. It is an obligation on the part of the tax payer. No one
can refuse to pay taxes if he is liable to pay them. Besides the above the Government can undertake
any of the existing private business by way of nationalization, which is not possible in the hands of
individuals. Private individuals or bodies have no such powers.
11) Audit: In the case of private finance, auditing of the financial transactions of the individuals is not
always necessary. But the accounts of the public authorities are subject to audit and inspection.
12) Elasticity of Finance: Public finance is elastic in nature-as compared to private finance. Public
finance can be increased by imposing various taxes as public finance is open to drastic changes.
Private finance on the other hand, cannot be increased as there is not much scope for changes in
private finance.
 Economic and Social Significance of Public Finance
A. Economic Significance: Economic Stability and maintenance of full employment are the two main goals
of public finance in advance countries like the U.K* and the U.S.A*. In developing countries it is of the
view that the fiscal policies should be formulated for the rapid economic development. Public Finance
occupies great significance in an under developed or developing country. According to R.J. Chelliah,
“Public Finance has a positive and significant role in the context of economic development.” The
importance of public finance in an under developed/developing country discussed as follows:
(1) Capital Formation: Since the economic development of the country depends on the rate of capital
formulation, the first and the foremost aim of public finance is to promote capital formation. In a
developing country, the government‟s economic policy should concentrate on production and fiscal
policy should act as a tool of capital formation. For rapid capital formation, the government should
incur expenditure on the establishment of basic and heavy industries, infrastructural development,
such as power projects, transport sector, means of communications etc.
(2) Economic Stabilization: Economic stabilization is yet another economically significant
responsibility of the government. The problem arises whenever there is economic instability such as
inflation, deflation and recession. Public finance (revenue and expenditure process of the
government) may be, therefore, used to secure economic stability or to remove economic
fluctuations in the economy.

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(3) Full Employment: Public finance also plays an important role in increasing employment. In an
underdeveloped/developing country, major problem faced by the people is the problem of
unemployment. This problem leads to low standard of living, poverty, backwardness, ignorance and
above all starvation. It is the function of public finance to provide employment opportunities.
Therefore, expenditure should be incurred by the government for increasing employment and for
achieving full employment. To generate employment, public expenditure should be incurred on
setting up new industries, encouraging small-scale and cottage industries through financial
subsidies, expenditure on training schemes etc.
(4) Balanced Regional Development: For the economic development of a country, balanced regional
development is very essential. Balanced regional development is possible by setting up private
industries in backward areas instead of in urban areas. To encourage this diversion, the government
should provide fiscal or tax concessions in the form of or… year tax holiday, communication
facilities should also be provided. If the private industries fail to divert to backward regions, should
be taxed heavily.
(5) Reduction in Economic Inequalities: One of the major problems of underdeveloped countries is
the unequal distribution of income and wealth. There is a gap between the rich and the poor. Public
finance has an important role to play in this context. To bring about equitable distribution of income
and wealth, the government should follow the system of progressive taxation. In other words, the
government should impose heavy taxes on the richer section of society, and the amount realized
from the rich should then be spent on the poor by way of providing them social amenities such as
free education, medical facilities, public utilities like road, water facility, recreation facilities etc.
(6) Mobilization of Resources: Mobilization of resources is another important role of public finance.
The government can mobilize or raise resources by imposing taxes on the people and industries, by
encouraging savings through various saving schemes, surplus of public enterprises and borrowings
and making them available for investment for the rapid economic development of the
underdeveloped country.
(7) Optimum Utilization of Resources: Optimum utilization of scarce resources is very essential for
the economic development of the underdeveloped countries. In a developing country it is not
uncommon to find non-utilization or destruction of scarce resources. The solution of this problem
lies in the optimum utilization of available resources by means of adopting planned monetary and
public finance policies. The state can direct the flow of consumption, production and distribution in
the right direction by adopting balanced budgetary policy.
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B. Social Significance: Social justice or equitable distribution of income and wealth is another
responsibility of the government in its public finance operations. As already been discussed there is
unequal distribution of income and wealth in developing countries. There is a wide gap between the rich
and the poor. For example according to Fikreyesus (2006), the top 20 percent of the population have
control about 50 percent of the Ethiopian economy. This gap can be bridged by adopting a rational fiscal
policy, such as taxation and public expenditure. In other words luxury items purchased mainly by the rich
should be subjected to higher rates of taxation, and necessary items should be exempted from taxation.
Social justice also requires investment expenditure on the establishment of enterprises in the public
sector. By doing so, the government would be able to produce goods of mass consumption to make
available cheap goods to the people.
 Satisfaction of Social Wants and Merit Wants
Another significant point of public finance is the satisfaction of social or collective wants and merit wants.
Wants are divided under three heads:
 Private Wants:  Merit Wants
 Social Wants(Collective Wants)
(a) Private Wants: Private wants are those wants which are satisfied by individuals according to their
personal incomes. Degree of satisfaction depends upon their respective incomes. Wants for houses,
food, clothes, entertainment or recreation etc. are satisfied according to individual preferences.
(b) Social Wants or Collective Wants: Social or collective wants require public goods which are
demanded by all members of society equally whether the people have the capacity to pay or not.
Wants like defense, education, public health, flood control provisions, weather forecasting
bureaus, research centers, police protection, social overhead capital like roads, bridges, etc. are
collective wants which must be available to all the people, irrespective of whether they are rich or
poor, whether they can afford to have them or not. In other words, consumer is supreme. Public
expenditure onthese heads is necessary to satisfy social or collective wants. Since nobody is ready
to pay for them, therefore, taxes are imposed on the people to meet expenditure for the satisfaction
of these wants.
(c) Merit Wants: Merit wants are essential private such as food, clothing, housing etc., which are
satisfied by the government at low prices for the poor due to their low level of income. Merit wants
are, thus, provided by the government for the benefit of the poor. These wants are satisfied by the
government for the uplift and progress of the poor. Such wants are food, clothing, low cost housing

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(e.g. condominium), free nutritious means to school children, free education to the children of the
poor, low priced milk to the poor, old age pensions and social security measures, maternity
benefits etc. Satisfaction of these wants for the poor increases their productivity efficiency and
there by their income.
 Fiscal policies to curb or prevent undesirable wants
Important aspect of public finance is that the government not only satisfies social wants and merit
wants, but also discourages and curbs certain undesirable wants of the people from the social point of
view. Undesirable wants are cigarette-smoking, liquor drinking, chewing of opium and tobacco etc.
Such harmful wants are discouraged and curbed by imposing heavy taxes and spending large amount
on publicity, health measures for the affected people, etc.
Fiscal policy relates to the government‟s decision making with respect to the following:
 Taxation  government borrowing and
 Government spending  Management of government debt.
The policy relates to government decisions, which influence the degree and manner in which funds are
withdrawn from private economy. Basically fiscal policy in these different facets deal with the flow of funds
out of the private spending and saving stream into the hands of government and the recycle funds from
government into the private economy.
It is thus obvious that fiscal policy deals quite directly with matters, which immediately influence
consumption and investment expenditure. Therefore, it influences the income, output and employment in the
economy. Fiscal policy is primarily concerned with the aggregate effects of public expenditure and taxation
on income output and employment. In developed economies the propensity to consume leads to stability.
Excess saving by the community leads to lowering of demand for goods and services resulting in sub optimal
employment level. Fiscal policy should balance the economy by sustaining the consumption in the economy.
In under developed and developing countries main objectives are rapid economic development and an
equitable distribution of the income. Fiscal policy can be an important instrument for attaining these
objectives. Fiscal policy influences the economy by the amount of public income that is received and on the
other by the amount and direction of public expenditure. The important fiscal means by which resources can
be raised for the public exchequer are taxation, borrowing from public and credit creation. These means must
be used in harmonious combination so as to produce the best overall effects on the economic life of the people
in terms of economic progress and social welfare.

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 Role of Fiscal Policy in the Economic Development:

 In under developed and developing countries development is the main concern. The primary task of
fiscal policy in an under developed and developing countries is to allocate more resources for
investment and to restrain consumption.
 The fiscal policy should reduce the economic inequalities of income and wealth. This can be
achieved by taxation and public distribution measures. Poverty and unity cannot co-exist.
Therefore fiscal policy should attempt economic development of the socially unfortunate to bring
about national unity. Private section is not interested in investing in social and economic overheads.
Investments in social and economic overheads like education, medical facilities, infrastructure, dams
etc. are very essential to accelerate the rate of economic growth.
 In under developed and developing countries the requirement of growth demands that fiscal policy
has to be used progressively for raising the level of investments and savings rather than keeping the
consumption level. In under developed and developing countries fiscal policy has to be used as an
instrument of resource mobilization. In order to attain growth with stability the goal of fiscal policy
should be promotion of highest possible rate of capital formation and should reduce the actual and
potential consumption. Further fiscal policy should encourage private investment and attract foreign
funds for development projects.
 The existing pattern of investment may differ from the optimum pattern of investment. Thus it
becomes a responsibility of government to undertake investments in such a way that it is most
beneficial for the people of the country.
 Fiscal policy should control inflation within tolerable levels since inflation mostly affects the poor.
In under developed and developing countries there exist regional imbalances in addition to social
inequalities. Fiscal policy should aim at reducing both regional and social imbalances by directing
investments to less developed regions. Their marginal propensity to consume is very high.
Therefore, a small increment in investment can bring manifold employment due to multiplier effect.
 Fiscal policy should direct available resources for providing basic physical, infrastructural needs like
irrigation, roads, basic industries, railways, ports, telecommunications etc. Fiscal policy should
assign high priority to the creation of overhead capital. Spending of the government should also take
care of education and health of the community. Returns on these investments are long-term and
private sector cannot provide above investments. Therefore government of a country through its
fiscal policy is able to increase rate of investment and also alter the pattern of investment. It follows

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that the main role of fiscal policy in an under developed and developing countries is to expand
productive capacity by raising the level of real capital including skills as well as plants and
equipment and to check the demand generating effect of expanding investment. In developed
countries its role is to expand both production capacity as well as the level of aggregate monetary
demand in relation to their economic growth. In under developed countries the better approach is to
transfer resources to capital formation without inflation.Fiscal policy through its different measures
such as taxation policy, budgetary policy, public debt policy and a co-ordination with monetary
policy can direct the economic destiny of a nation. Fiscal policy can be used to mitigate the effects
of trade cycles such as inflation and depression

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