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Importance of Public Finance, The study of public finance assumed real importance towards the beginning of the 20th century,, especially after the great depression of the 1930s., , Every modern state is forced to raise revenues at an increasing rate to meet the expenses. A, modern state acts as a welfare state and performs many functions for increasing social welfare., , It spends on education, public works etc. The governments have started assuming more and, more responsibilities towards planning and development of the economy, construction of social, overheads, investment in human capital etc., , Fiscal Policy, , ●, , ●, ●, ●, , Fiscal policy including the tools of taxation, public expenditure and public debt have, become important instruments influencing the economic life and to achieve the desired, social and economic goals., Fiscal measures are an effective means of bringing about stability in a highly, industrialised or advanced economy., Fiscal measures help an economy in achieving and maintaining full employment,, controlling inflation, overcoming depression and achieving rapid economic growth., They are also very important instruments for an equitable distribution of income and, wealth., , Public finance plays an important role in the economy of a country both in the case of developed, and developing.
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Concept of Public Finance, Meaning of Public Finance, Public finance is that branch of general economics which deals with financial activities of the, state or government at national, state and local levels., It is a study of income and expenditure of central, state and local government and the principles, underlying them., , According to Dalton "Public Finance is concerned with the income and expenditure of public, authorities and with the adjustment of the one to the other., , Scope of Public Finance, , It was J. M. Keynes, who for the first time emphasized that the financial or fiscal operations of, the government can be used to remove imbalances in the economy by influencing the level of, income and employment.
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According to Keynes the operations of the Government helps to mobilise resources for rapid, and balanced development of the economy., As a result, the study of economic and social effects of fiscal policy and operations have been, considered as an integral part of the theory and practice of public finance'. Thus the scope of, public finance has widened with increased responsibilities of the Government., It studies the fiscal policy and operations relating to taxation and borrowing More importantly it, studies their socio economic effects, i.e., allocation of resources, distribution, stabilisation and, economic growth., , Prof. Dalton categories the scope of public finance into four areas which includes public income,, public expenditure public debt and financial administration, 1. Public Income or Revenue, , The first area of public finance is public revenue. It refers to the main sources of income for the, government like taxes, fees, fines, special assessments and commercial revenues, from public, undertakings. In publie revenue section, the canons and principles of taxation are very, important. It also includes the different types of taxes like direct and indirect taxes, their impact, and incidence, the effects of taxation, the problems of tax evasion and avoidance and the, measures to solve these problems in order to increase public income., 2. Public Expenditure
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The money collected as public revenue is used for public expenditure. According to Plehn,, "Public expenditure is the end and aim of collection of revenues and of other financial activities, of the statesman". In public expenditure, we study the various types of classifications, the, canons or principles which govern public expenditure and its effects on various factors like, production, employment, income distribution, stability and growth. The study includes the, reasons for increase in public expenditure and changes in the pattern, , 3. Public Debt, When public expenditure exceeds public revenue the gap is filled by public borrowing or public, debt. In this we study the types and different types of burden of public debt and the effects on, production consumption and distribution., 4. Financial Administration, The scope of public finance includes financial administration. It means that the various financial, processes and operations of public revenue, public expenditure and public debt come under the, purview of public finance. The scope of financial administration includes the collection, custody, and disbursement of public money, the co-ordination of expenditure according to a, well-formulated plan, the management of public debt and the general control of the financial, operations of the state. It covers the preparation of the budget, the execution of the budget and, also auditing the finances of the state., , Public finances are assigned three functions i.e. the distribution function, allocative, function and stabilisation function., 1. Distribution Function, This refers to the process of redistribution of resources between individuals and legal entities,, involving public authorities. This function manifesto in the form of public funds or income from, various sources like taxes, fees, fines etc. The funds collected are distributed through public
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expenditure according to the criteria of equity and social justice. The distribution function is, reflected in the sharing of GDP among the members or society or nation., Distribution function of public finance is aimed at satisfaction of social wants. The objective is to, secure adjustment in the distribution of the income and wealth that is considered. "fair" or "just", by the society. The existing or prevailing distribution of income may or may not be fair from the, point of view of society and the market forces cannot be trusted to achieve the results desired, by the society. So a budgetary process is required. The market system results in meritocracy, whereby merit and income are accorded to those who have the ability or productivity. Except for, private charity and philanthropy the market system makes no provision for the support or even, the survival of those who lack the required abilities to produce. Presence of monopoly also, leads to inequalities in the market system. So distributive function is to ensure fair and equal, distribution through the budgetary process., , 2. Allocative Function, Allocative function of public finance is reflected in the use of public finances to meet social, needs by providing public utilities and thus for achieving socio-economic objectives of, development. This involves providing services or goods to members of society, either free or at, prices which are well below their real value. Thus public funds are utilized to provide for public, consumption of goods and services for welfare of the society., Allocation function of budgetary policy deals with the determination by how the total resources, of the community are divided between private and social goods. It also chooses the mix of, social goods. There are many areas where market forces cannot attain optimal results even, when the correct distribution of income exists and full employment and price stability are, secured. Lack of information on the part of consumer and producers leads to imperfections even, in a highly developed market system. Fiscal action is required to correct these imperfections., Fiscal action is also required in the case of lumpiness of productive factors and of production, process too External economies or diseconomies generated by the operation of individual firm is, yet another area where budget policy is required. The production of a commodity may give rise, to incidental uncharged services or uncompensated disservices to a third party, Example: A rail road into new territory may lead to gain in economic development which may be, more than the profits to the particular rail road. The price harged is small compared to the, services rendered by the rail road. So it is unprofitable to the rail road but useful and of great, utility from the public point of view. Taxation and spending are the two important fiscal, instruments which the government can use to influence the allocation of resources in the, economy., 3. Stabilisation Function
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This function refers to the stabilising influences on the social and economic life. These, influences have the capacity to contribute to ensuring price stability, higher labour employment,, maintaining external balance and helps to sustain an acceptable rate of economic growth Public, finance management must help to stimulate expansion of economy, modernisation and, restructuring as well as adopting to the situation. It should help in internal stability,, This is the newest function of fiscal policy which has come to the limelight since the late thirties., Stabilisation function also known as compensatory finance which attempts at maintaining a high, level of employment and a reasonable degree of price stability. To maintain full employment and, stability, budget action in the form of expansionary and contractionary fiscal policy is needed., This is necessary to maintain stable aggregate demand. Thus during depression aggregate, demand is to be raised through an expansionary revenue - expenditure policy and in a periods, of inflation, restrictive policy is needed to reduce expenditure. For developing economies, stability and growth are fundamental importance., , Causes of Market Failure, Markets do not function in a perfect manner as they are expected to do so in a theoretical, model. They fail to perform efficiently due to a number of reasons such as availability of public, goods, business corporations acquiring monopoly power in the real world market which is full of, imperfections, externalities arising out of economic activities, imperfect or asymmetric, information, unequal income distribution and many other factors. Let us briefly discuss these, factors., 1. PUBLIC GOODS, Most goods in the economy are allocated in markets, where buyers pay for what they receive, and sellers are paid for what they provide. For these goods, prices are the signals that guide the, decisions of buyers and sellers, and these decisions lead to an efficient allocation of resources., A public good is a special type of good that can be consumed by everyone, regardless of, whether they have paid for the good. When goods are available free of charge, however, the, market forces that normally allocate resources in the economy are absent., 2. MARKET POWER, An imperfectly competitive market is one where the assumption of a large number of buyers and, sellers does not hold. These types of market organisations include monopoly, monopsony,, oligopoly, and monopolistic competition.
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None of these markets are efficient. In general, the firms do not produce the socially optimal, quantities (they tend to under-produce) and the price is higher than it would be under perfect, competition The condition P = MC does not hold, and the system does not produce the most, efficient product mix,, Market control (or market power) arises when buyers or sellers are able to exert influence, over the price of a good and/or the quantity exchanged. The ability to control the market,, especially the market price, prevents a market from equating demand price and supply price., Market control on the supply side allows sellers to set a demand price, the value of the good, produced, above the value of goods not produced. An extreme example of market control on the, supply side exists with monopoly, a market with a single seller. A less extreme, but more, common example is oligopoly, a market with a small number of large sellers., Market control on the demand side allows buyers to set a supply price, the value of goods not, produced, below the value of the goods produced. An extreme example of market control on the, demand side exists with monopsony, a market with a single buyer. A less extreme, but more, common example is oligopsony, a market with a small number of large buyers., Common examples of markets with supply-side or demand-side control include city-wide, electrical distribution (monopoly), automobile manufacturing (oligopoly), employment in a, company in town (monopsony), and employment in professional sports (oligopsony)., The existence of monopoly power is often thought to create the potential for market failure and a, need for intervention to correct for some of the welfare consequences of monopoly power., The classical economic case against monopoly is that:, (a) Price is higher and output is lower under monopoly than in a competitive market., (b) This causes a net economic welfare loss of both consumer and, producer surplus., (c) Price > marginal cost - leading to allocative inefficiency and a Pareto suboptimal equilibrium., (d) Rent seeking behaviour by the monopolist might add to the standard costs of monopoly. This, includes high (possibly excessive) amounts of spending on persuasive advertising and, marketing, (e) If the monopolist allows cost efficiency to drop then an upward drift in costs takes place., Lack of effective competition in the market-place can lead to consumers facing higher prices, and a reduction in their real standard of living.
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3. EXTERNALITIES, An externality arises when a person engages in an activity that influences the well-being of a, bystander (or third party) and yet neither pays nor receives any compensation for that effect., Third parties are individuals, organisations, or communities indirectly benefiting or suffering as a, result of the actions of consumers and producers attempting to pursue their own self-interest., The potential market failure arising from externalities is that the social optimum output or level of, consumption diverges from the private optimum., If the impact on the bystander (or third party) is adverse, it is called a negative externality (e.g.,, consumers and producers may fail to take into account the effects of their actions on, third-parties, such as car drivers, who may fail to take into account the traffic congestion they, create for others; or producers fail to take into account pollution, radiation, and other production, byproducts). If it is beneficial it is called a positive externality (e.g., the benefits of education, extend beyond those receiving the education and thus beyond the market exchange.), Negative externalities lead markets to produce a larger quantity than is socially desirable. e.g.,, when the firms do not pay for the pollution their cost would be low and they would produce, more., Positive externalities lead markets to produce a smaller quantity than is socially desirable., e.g., if an entrepreneur stages a fireworks show, people can watch the show from their windows, or backyards. Because the entrepreneur cannot charge a fee for consumption, the fireworks, show may go unproduced, even if demand for the show is strong, To remedy the problem, governments can internalise the externality by taxing goods that have, negative externalities and subsidising the goods that have positive externalities., , 4. ASYMMETRIC INFORMATION, Asymmetric information is a market situation in which one party in a transaction has more, information than the other party. This can affect the firm's strategy. It can lead to market failures., The lack of information among buyers or sellers often means that the demand price does not, reflect all benefits of a good or the supply price does not reflect all opportunity costs of, production. That is buyers might be willing to pay more or less for a good because they don't, know the true benefits generated. Or sellers might be willing to accept more or less for a good, than the true opportunity cost of production, In many cases, sellers have better information about a good than buyers. Sellers own and, control the good, they have direct contact with the good. If there are defects or problems with, the good, they are likely to know. Buyers, in contrast, have much less familiarity with a good,
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perhaps only knowing the information provided by the sellers. In this case, buyers are likely to, have a different demand price than the value of the good produced, a value based on more, complete information. In other words, markets may not provide enough information because,, during a market transaction, it may not be in the interest of one party to provide full information, to the other party., Asymmetric information can lead to poorly functioning markets, that is, too much or too little of a, good may be produced. Consumers may fear purchasing goods when they know that the seller, knows more about the quality of a good than they do. The greater the information asymmetry, between sellers and consumers, the greater the scope for deception and fraud., A downward economic activity may be due to asymmetric information between economic, agents., Asymmetric information leads to market inefficiencies and thus to market failures. Thus, the, government has to take measures to improve the information for consumers, investors and, other market participants., , 5. INEQUALITY, Markets may also fail to limit the size of the gap between income earners, the so-called income, gap. Market transactions reward consumers and producers with incomes and profits, but these, rewards may be concentrated in the hands of a few. There is nothing in the market mechanism, that guarantees an equitable distribution of income in the society., Market failure can also be caused by the existence of inequality throughout the economy. Wide, differences in income and wealth between different groups within an economy lead to a wide, gap in living standards between wealthy households and those experiencing poverty. Society, may come to the view (a value judgement) that too much inequality is unacceptable or, undesirable., , 6. MISSING MARKETS AND INCOMPLETE MARKETS, A market is considered to be complete when it provides all goods and services for which the, cost of provision is less than what individuals are willing to pay. Whenever private markets fail to, provide a good or service even though the cost of providing it is less than what individuals are, willing to pay, they are considered as incomplete markets. Incomplete markets are the cases of, market failures., Markets may fail to perform, resulting in a failure to meet a need or want, such as the need for, public goods, like defence, street lighting, and highways. In the latter case (incomplete markets), markets may fail to produce enough merit goods, such as education and healthcare.
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A missing market is a situation where resource allocation based on a competitive market does, not exist. Missing markets are nothing but market failures. Externalities, public goods, etc. are, the cases of missing markets., 7. MERIT, , GOODS, , Merit Goods are those goods and services that the government feels that people left to, themselves will under-consume and which therefore ought to be subsidised or provided free at, the point of use., Both the public and private sector of the economy can provide merit goods and services., Consumption of merit goods is thought to generate positive externality effects where the social, benefit from consumption exceeds the private benefit., Examples include; health services, education, work training, public libraries, vaccinations., , 8. UNSTABLE MARKETS, Sometimes markets become highly unstable, and a stable equilibrium may not be established,, such as with certain agricultural markets, foreign exchange, and credit markets. Such volatility, may require intervention, , 9. DE-MERIT GOODS, Markets may also fail to control the manufacture and sale of goods like cigarettes and alcohol,, which have less merit than consumers perceive., , 10. PROPERTY RIGHTS, Markets work most effectively when consumers and producers are granted the right to own, property, but in many cases property rights cannot easily be allocated to certain resources., Failure to assign property rights may limit the ability of markets to form., , PUBLIC GOODS, A public good is a special type of good that can be consumed by everyone, regardless of, whether they have paid for the good. When goods are available free of charge, however, the, market forces that normally allocate resources in the economy are absent.
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To understand how public goods differ from other goods and what problems they present for, society consider their characteristics:, (a), , Non-excludability: where it is not possible to provide a good or service to one, , person without it thereby being available for others to enjoy. A good is not excludable because it, is impossible to prevent someone from using the good or availing of its benefits., (b), , Non-rivalry: where the consumption of a good or service by one person will not, , prevent others from enjoying it. A good is nonrival in consumption because one person's, enjoyment of the good/s does not reduce anyone else's enjoyment of them, Since the benefits of such goods are available to all, consumers will not voluntarily pay for those, goods. This is the free-rider problem that accompanies public goods. Since it is difficult to, exclude anyone from using them, those who benefit from the public goods have an incentive to, avoid paying for them. Hence, the market failure occurs in the provision of public goods., Common examples of public goods include street lighting/ lighthouse protection, national and, domestic security i.e., national defence and police services, public health, flood defence, systems, public parks and beaches, public welfare programmes, education, roads, research and, development, and a clean environment. In each case consumption by one does not impose an, opportunity cost on others and nonpayers cannot be excluded from consumption. In each case,, markets fail to efficiently allocate the production, consumption, or provision of the goods., Markets will not supply public goods or if they supply they will not supply enough of public, goods. Since the markets fail in the above cases, public goods provide a rationale for many, government activities, , ROLE OF GOVERNMENT, The state or the government can play an important role to correct market failures and improve, economic efficiency. The presence of government may reflect the political and social ideologies, prevailing in the country. More importantly, the prevalence of governments reflects the fact that, the market mechanism alone cannot perform all economic functions. Government intervention is, needed in the economy for the following reasons., 1. To improve economic efficiency by correcting market failures., 2. To pursue social values of equity by altering market outcomes, 3. To pursue other social objectives by the provision of public and merit goods and at the, same time prohibiting the consumption of demerit goods., According to R. A. Musgrave and P. B. Musgrave, government policy is needed to guide,, correct, and supplement the market mechanism in certain respects. The operation of the
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government includes not only financing but has a broad bearing on the level and allocation of, resource use, the distribution of income, and the level of economic activity. These functions are, carried out through government budget, The role of the state or the government is explained below:, 1. Securing conditions for the functioning of market mechanism:, It is argued that market mechanism leads to an efficient allocation of resources, that is, it, produces what consumers want most and does so in the cheapest way. This argument is based, on the condition that there is perfect competition in the factor and product markets. For this,, there must not be any obstacles to free entry into and exit from the market. It also requires that, consumers and producers have complete knowledge about the market. Government regulation, and measures will be needed to secure the conditions necessary for the functioning of market, mechanisms., The government has an important role in correcting market failures arising from imperfect, information, imperfect competition, externalities and public goods. In the case of imperfect, competitions, firms use their market power to raise prices and reduce output. The Monopoly, MRTP Act or Competition Policy Act of the government of India can help to maintain competitive, force and restrain firms from abusing their monopoly power. Similarly, imperfect information can, lead to inefficient functioning of product and labour markets. Government can set up regulatory, authorities such as SEBI (Securities Exchange Board of India) to compel the firms to provide, information about their financial conditions and other aspects., 2. Providing legal framework:, The contractual arrangements and exchanges needed for market operation cannot exist without, the protection and enforcement of a governmentally provided legal framework. In this respect,, the government can provide necessary legal structure and ensure their implementation by the, firms and other parties in the market. In India regulatory authorities like SEBI provide the legal, framework., 3., , Provision of public goods and merit goods:, , Even if the legal structure is provided and barriers to competition are removed, the production or, consumption characteristics of certain goods like public goods and merit goods are such that, they cannot be provided through the market. In the case of public goods there is the free-rider, problem. As a consequence the market fails in the provision of public goods. Thus, the, government has to ensure their provision. On the other hand merit goods are the goods that the, governments consider as good for the people, for example education. If they are provided by, the market people may under consume such goods. Thus they have to be subsidised or, provided free by the government., 4. Correcting the problems arising from externalities:, Externalities lead to "market failure". This requires correction by the government either by way, of budgetary provisions, subsidies or taxation. In the case of goods with positive externalities, (like research), firms produce too little of goods and in the case of goods with negative
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externalities (such as that generate pollution), firms produce too much of goods. Governments, can subsidise the production of goods with positive externalities and tax or regulate those with, negative externalities, 5. Correcting unequal distribution of income and wealth: The distribution of income and wealth, which results from the market system and from the transfer of property rights through, inheritance is likely to be unequal. In the market system, individual's incomes are related to their, ownership of assets and their productivity. In most of the countries, wealth is concentrated in the, hands of a few. In many countries inequalities are linked to inheritance. Even in wages and, salaries there is an unjustified gap between the lowest and highest payment. The government, has to work towards redistribution of income from the rich to the poor through welfare, programmes and taxation policies., 6. Securing important social objectives: The market system does not necessarily bring high, employment, price level stability, socially desired rate of growth, poverty eradication and, economic development. Government policies are needed to secure these objectives., Provision of social security: The market system cannot provide social security to citizens,, suffering from unemployment, sickness, old age disability and so on. The government has to, step in to provide social security to its citizens, 8.Guiding the use of natural resources: Public and private points of view on discounts used in, the valuation of future relative to present consumption differ. This considerably affects the use of, natural resources. The market mechanism cannot bring about appropriate allocation of natural, resources for the present and future. Similarly, the market mechanism may not be able to, control the pollution of the environment. Therefore, consumption of natural resources, pollution, control, etc should be guided by government policies., 9. Public ownership: If the government feels that, under free market conditions, some industries, would charge unreasonably high prices and earn abnormal or monopoly profit, it could, nationalise the industry and provide goods and services at a desired price. Alternatively, the, government may apply rules and regulations to force industries to charge a reasonable price., Nationalisation of major commercial banks in India in 1969 was aimed to meet the financial, needs of the poor section of the society at reasonable conditions and price (interest)., The above discussed measure may help to mitigate the market imperfections to a certain extent, or at times to a very great extent. It is, however, unrealistic to expect to make markets function, freely without inhibitions. Currently, in most of the countries, the nexus between the government,, politicians and industry in the form of Crony capitalism' would prevent the markets perform their, function freely and efficiently
