PUBLIC FINANCE

CHAPTER-I
1.1. Introduction
The participation of the government in the economic activities is essential to accomplish
the goals of any welfare state. Classical economists advocated minimum functions for the
government. Subsequently, the economists Keynes demonstrated that it was possible through
fiscal activities of the state to increase employment and to maintain it at high level. This
realization led to emphasis on the active participation of the state in the economic activity.
The governments of advanced countries are committed to stability and full employment.
In case of under developed countries the government aims at accelerated economic
development. Government sector can play a decisive role in shaping and charting the path of
any economy. Depending on the level of development of each country the roles of
government sector differ. However, in all cases the aim is to attain full employment and
economic development through the development of agriculture, industry and service sector.
Today the communication sector has also been included in these vital sectors of the economy.
The Private finance deals with the wants and the satisfaction of households and firms. But the
public finance deals with the collective wants and their satisfaction. The objective of both
private and public finance is similar. Private finance aims at maximizing social welfare or
social benefit by efficient use of public goods. Distinction between private and public goods
is important in the study of public finance.
1.2. Private Goods:
Private goods refer to all those goods and services, which are consumed by people to
satisfy their personal and private wants or needs. They relate to articles of food, clothing,
shelter, recreation, transportation, communication etc. These goods are priced in the market
on the basis of their cost of production on the one side and the nature of demand on the other.
All those who want them and are willing to pay the market price will buy them. Those who
do not want them or who are not in a position to pay for them will be excluded from the
consumption of these goods. In other words there is no compulsion that every one will have
to buy them. Thus, private goods are divisible in the sense that price mechanism divides
people in to two groups, viz., those who want to consume them and those do not; and private
goods are subject to the principle of exclusion; in the sense that price mechanism excludes
the group of people who are not willing to consume a particular good.
But price mechanism or market mechanism may fail when ever private goods are
associated with the concept of externalities. Now, externalities refer to favourable and

1
unfavourable effects which are associated with the production of those goods. The setting up
of a factory in a backward region will help to open up the former and help to develop it; this
is an example of an externality in the form of an economic gain. On the other hand, an
atmospheric and water pollution of a chemical and fertilizer factory in an area is an example
of unfavourable economic effect. The externalities are also referred to as spill over effects,
neighbourhood effects or third party effects.
1.3. Public Goods:
Collective wants are those which are demanded by all members of the community in
equal or more or less equal measures. Defences, education, public health, infrastructure
facilities like power, transportation and communication, etc., are examples of collective
wants. Goods and services produced to satisfy collective wants are known as public goods.
These goods are produced and supplied by the society to meet its collective wants for
increasing social welfare. These goods are supplied by the country to all its citizens. But the
degree of benefit a person derives will depend upon the use he can put it to. For example
medical and educational facilities are made available for all the people of Ethiopia.
It is important to recognize two features of public goods. First, they can not be divided
and their benefits can not be shared between the people on the basis of each man’s
requirements. In other words, unlike private goods, public goods are not divisible but have to
be collectively consumed. If public goods are made available to meet collective wants, the
question is: who will pay for them or in what proportion they will bear the cost of production
of these goods and services.
Secondly the principle of exclusion easily associated with private goods is not applicable
in the case of public goods since they are not consumed distributive basis. Hence these goods
will not be produced by the private sector. On the other hand, they will have to be produced
and supplied by the public authorities to meet collective wants. The price mechanism does
not apply and these goods can not carry a price tag. As everyone is a beneficiary - directly or
indirectly of the public goods, everyone is asked by the public sector authorities to pay
towards the cost of production of the public goods. No one can refuse to pay for the supply of
public goods on the ground that they are direct beneficiaries. For example, an abiding citizen
can not refuse to pay towards the maintenance of police or a childless can not refuse to pay
towards the expenditure on education on the plea they do not benefit by them.
Actually, everybody wants to enjoy the benefits of public goods be they defence goods,
law and order, education etc., but no one wants to pay for them. At the same time, the
consumers do not have any system of priority in the case of public goods. Again the taste,

2
preferences etc., of consumers are not relevant and the public authorities do not attach any
importance to the consumers while producing and supplying public goods. As the people too
may not show any interest or any inclination in the production of these goods, the
government has the sole responsibility to decide about how much of these goods should be
produced, the method of production and the technique of distribution. Since the public goods
are supplied to all the people irrespective of their ability and willingness to pay for them, the
pricing system is useless and therefore, a method of compulsory payment will have to be
designed to finance their cost of production.
1.4. Merit Wants:
Certain types of collective wants such as educational facilities have been called as merit
wants since they command overwhelming importance in the attainment of social welfare.
Provision of public goods meant to satisfy such wants will help the economy to achieve a
high level of efficiency and welfare. If education is left to the private sector and accordingly
educational facilities are supplied by the private sector on the basics of cost of production, the
educational facilities will cost so much that many people in the lower income brackets will
not be able to get them. Many an intelligent but poor student will be denied educational
facilities. This will reduce economic efficiency and social welfare of the community. In the
same way, if hospital facilities are provided by the private sector units, they will be so
expensive that only the rich will be able to make use of them and vast majority of people
belonging to middle and lower income groups will be denied these facilities. It is for this
reason that the state should either supply these goods to the community or at least supplement
private effort directly or indirectly- directly by government schools and colleges or indirectly
by subsidizing education to make it within the reach of every body.
The important difference between the satisfactions of merit wants and of social wants is
that the former calls for interference with consumer preferences. Besides, the provision of
merit wants will confer immediate benefits on those groups of people who are in immediate
need of them but the community benefits in general as the society becomes more educated
and healthier. It is for this reason that merit wants must have substantial element of social
wants. The above analysis of private costs and social costs is based on the objective of
efficient allocation of resources of an economy between private and public goods with a view
to maximize social welfare. The use of price mechanism to determine efficiency in the
allocation of resources assumes the existence of free market. This type of analysis may be
suitable to predominantly capitalist economy such as U.S.A. but is not applicable to a fully

3
collectivist or partly socialist economies in which market mechanism does not either exist o is
not allowed play a free role.

1.5. FUNCTIONS OF MODERN GOVERNMENT AND FISCAL POLICY

Fiscal policy is also called as budgetary policy. In broad terms, fiscal policy refers to that
segment of national economic policy, which is primarily concerned with the receipts, and
expenditures of these receipts and expenditures. It follows that fiscal policy relate to those
activities of the state that are concerned with raising financial resources and spending them.
In general, Fiscal policy relates to the governments decision making with respect to the
following: [Link] [Link] spending [Link] borrowing and [Link]
of government debt.

It was only in the 20 th century and particularly after Keynes demonstrated the necessity of
state interference for stabilizing an economy and to bring about full employment that the full
importance of fiscal operations of tax, public expenditure and public debt policy was
appreciated. We should know the role of the government to enable us to appreciate the
importance of government sector. Government of a modern state generally undertakes the
following functions:
1.5.1. Allocation Function:
The government operations basically involve the efficient provision of government
funds in maximizing the welfare of the community. The government taxes the public and
uses the amount in providing certain facilities and services considered essential by the by the
people and the community. These facilities are such that they could not be provided by the
people themselves such as defence, or they could be provided but only at a high cost such as
education and Medicare. Fiscal operations of taxation and public expenditure have the effect
of transferring resources form the public which would have been used for consuming private
goods to produce public goods which would satisfy collective wants. The objective of fiscal
operations is to provide for the proper allocation of resources between private and public
goods so as to maximize social welfare.
1.5.2. Distribution function:
In a free enterprise economy, distribution of income and wealth is unequal and many
times it is grossly unequal resulting in exploitation of the lower income gropes. Inequality of
income and concentration of economic power in the hands of a few are responsible for

4
distorting production in favour of the rich and for reducing the social welfare of the
community. Fiscal operations have been used to reduce the incomes and wealth of the rich
(through progressive taxation) and using the money collected to raise the income and
standard of living of the lower income group (through public expenditure}. The use of fiscal
policy to reduce inequality of incomes and wealth has been quite common in many countries.
1.5.3. Stabilization Function:
Modern economies are subject to fluctuations, viz., business boom and inflations on
one side and business recessions and depressions on the other. Such fluctuations are not in the
interest of the country. Fiscal operations have been used to moderate these fluctuations and if
possible to eliminate them altogether. For instance, business booms and inflations are sought
to be controlled through heavier taxation while business recession is sought to be checked
through public expenditure.
Functions of modern governments are broadening due to socio-political reasons.
Therefore, to discharge these increasing functions, the government has to increase its
expenditure. To meet out the enormous amount of expenditure it has to mobilize funds with
the help of public finance policy. Hence public finance has developed into an important
branch of economics.
2. MEANING AND SCOPES OF PUBLIC FINANCE
2.1 Public Finance
The study of state is called “Public Finance”. 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. Hence, it can be defined as the science that deals
with the nature and principles of the income and expenditure of the government.

5
 Ethiopia has adopted the policy of welfare state for bringing about social and economic
justice. Public finance policy of the country is drawn up in tune with the constitutional
commitment Welfare state. Under the welfare state, government performs important
functions and takes up certain public or collective welfare measures which private sector
cannot provide.
2.2 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 scope of the
public finance is classifies under five broad categories. They are,
1. Public revenue
2. Public Expenditure
3. Public debt
4. Financial administration
5. Economic stabilization
We shall now explain them briefly.
1. Public Revenue:
Under this category, the sources of the public revenue, principles of taxation, effects of
taxes on the economy, methods of raising revenue and the like are dealt with. Public revenue
is the means for public expenditure. Various sources of public revenue are: Tax revenue and
non tax revenue.
A. Tax 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.
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.
2. Public Expenditure
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

6
expenditure and accurate foresight of earnings are the important aspects of sound government
finance.
3. Public debt:
This 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: 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.
b. External debt: The transfer of capital at international level may take the form of financial
aid through grants and loans, Commodity aid and Technical assistance
External debt is an immediate source of funds for development. However, such debt has
following drawbacks.
i) Political subordination
ii) Other obligation
iii) Excess supply of goods and services in debtor country
However, such external inflows help to achieve faster growth.
4. Financial Administration
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.
5. Economic Stabilization
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.
2.4. Public finance Vs Private finance
There are both similarities and differences between public finance and private finance. Let us
discuss the similarities first.
Similarities between 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, viz, the satisfaction of human wants.

7
2. Balancing of Income and Expenditure: Both individual and Government have incomes
and expenditures and trying to balance each other.
3. Maximum Satisfaction: Both private and public finance aim at maximum satisfaction.
4. Borrowing a Common Feature: As and when the current income becomes insufficient to
meet the current expenditure, the individuals and Governments rely upon borrowings. Both of
them are having loan repayment plans.
5. Economic Choice a Common Problem: Both the individual and Government face the
problem of economic choice. That is their sources of revenue are limited, comparing with
their expenditure. Hence they have to satisfy the unlimited ends with limited means.

Dissimilarities between Public Finance and Private Finance

Even though the private and public finances look alike, there are certain fundamental
differences between them. They are,
1. Adjustment 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 raisins 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.
2. Nature of Benefit:
The private finance aims at individual benefit i.e. the benefit of individual household.
But the public finance aims at collective benefit, 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 certain commitments like
social welfare measures and thus cannot postpone the certain expenses like relief measures,
defence, 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. Influence on expenditure:

8
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 economic policy of the Government.
6. Nature of Perspective:
In private finance, the individual strives for immediate and quick return. Since his life span is
definite and limited he 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.
That is 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. Nature of resources:
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.
9. 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.

10. Publicity:

9
Individuals do not like to disclose their financial transactions to others. They want to keep
them secret. But, the Government gives the greatest publicity to its budget proposals and the
allocation of resources to different heads. It is widely discussed. Publicity strengthens the
confidence of the people in the Government.
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.

10