Professional's Academy of Commerce IEF (CAF-02)

Chapter 10: Public Finance

10.1. Pubic Finance and Private Finance

Public Finance: Public finance deals with the allocation of resources to meet the set budgets for government
entities. This branch of economics is responsible for the scrutiny of the meaning and effects of financial policies
implemented by the government. This sector examines the effects and results of the application of taxation and
the expenditures of all economic agents and the overall economy.
Private Finance: Private finance can be classified into two categories the personal finance and business
finance.
• Personal finance deals with the process of optimizing finances by individuals such as people, families
and single consumers. Personal finance involves financial planning at the lowest individual level. It
includes savings accounts, insurance policies, consumer loans, stock market investments, retirement
plans and credit cards.
• Business Finance involves the process of optimizing finances by business organizations. It involves
asset acquisition and proper allocation of funds to in a way that maximizes the achievement of set goals.
Businesses can require finances on either of the three levels; short, medium or long term.

10.1.a. Basic Differences Between Public Finance and Private Finance

1. Adjustment of income and expenditure: An individual determines his expenditure according to his
revenue and the government adjusts its revenue to its expenditure. Public finance approach is to estimate
the amount of total expenditure and then meet the expenditure through multiple possible ways. For
instance; while an individual knows his fixed income and spends his money accordingly, the state first
estimates the total expenditure and then imposes the taxes accordingly.
2. Budgeting: Public authorities need to budget on yearly basis; however, individuals have no such
restrictions whatsoever. Besides an individual if he makes a budget then would rather like to follow a
balanced budgeting approach and would prefer having a surplus at the end of the period than a deficit.
Whereas, on the other hand, budgets of in such cases public authorities are not necessarily balanced. A
surplus budget may not stimulate economic activities.
3. Borrowing: Another important difference is the financing resources available for both i.e. the individual
and the government. The government has multiple, varied and flexible options of borrowing from home
and abroad, whereas an individual can only go for external loans and there is no internal loan available
for him.
4. Deficit financing: In case of deficit financing and other difficult times, the government has an option to
print currency notes and create money to meet the expenditure thus it is a crucial source of income
which is taken advantage of in trying times by belligerent state authorities. On the other hand, individual
cannot create money by printing currency notes or by such other means.
5. Different objectives: Broadly speaking, both the types of finance have the same objective of welfare.
The only difference is, private finance safeguards individual welfare and public welfare serves for the
overall social benefit of the community.
6. Provision for the future: The State is liberal and far-sighted in terms of providing for the future, it
would naturally plan for generations being the custodian of future generations, and on the other hand, an
individual aim for quick returns and discounts the future at a very heavy rate.

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Professional's Academy of Commerce IEF (CAF-02)

7. Secrecy: Private finance is certainly a secret affair. An individual would always prefer maintaining
confidentiality as far as his earning and spending matters are concerned. Whereas, the government for
the purpose of transparency has to make public all the 9iksources of finance and the expenditure.

10.1.b. Functions of Public Finance

According to Musgraves, the major functions of public finance are the following,
1. Allocative function: The allocative function refers to the role of government that it plays in providing
resources to extend support to the public goods. The budgetary policy divides the total resources among
private and social goods by which the mix of social goods is chosen.
2. Distributive function: The government plays the distributive role by way of deciding as to whom the
resources should be allocated. Practically it means setting the balance between free market outcomes
and distribution through taxes and other means with a view to reducing economic inequalities and
yielding optimal income distribution.
3. Stabilization function: stabilization refers to the overall role of ensuring economic stability particularly
in the context of devising monetary and fiscal policies to help overcome the challenges an economy
faces. Steps might include maintaining high level of employment, a practical price level stability, a
fitting rate of economic growth and stability in the balance of payments etc.

10.1.c. Importance of Public Finance

1. Provision of public goods: Governments shoulder the responsibility of the provision of public goods.
Private individuals even the wealthy ones would not like to voluntarily pay for services such as roads,
national defense, public schools and hospitals and therefore the enterprises have no incentive to produce
them. So, the public finance addresses the key area through its allocative function and finances public
goods for social welfare of the community.
2. Equity: Public finance targets at eliminating or at least reducing economic inequalities prevailing in the
society. It devises policies and suggests ways for transferring the purchasing power from rich to the
poor.
3. Tax: The power of tax is actually the power to control the economic activity. The tool if used properly
can stimulate it but if used adversely will retard it. Besides, the progressive taxation helps eliminating
inequalities. Also, it can be levied in a way to encourage certain industries by giving exemptions and
discourage harmful industries like tobacco, alcohol etc. by raising higher taxes.
4. Economic planning: Public finance serves as a tool for economic planning. Governments usually plan
for a longer period of time. These rolling plans are for a period of more than a year and usually up to
five years or more. For these plans to work, government needs to combine resources, taxation,
borrowing altogether that ultimately is facilitated by public finance. Public expenditure can stimulate
economic activity by providing assistance for new industries by way of facilitating their establishment
and can also initiate activities not yet undertaken by the private sector.

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Professional's Academy of Commerce IEF (CAF-02)

10.2. Public Expenditure

Public expenditure is spending made by the government of a country on collective needs and wants such as
pension, provision, infrastructure, etc.

10.2.a. Causes of Continuous Increase in Public Expenditure

1. Welfare state ideology: The modern state is a welfare state. It bears higher and heavier responsibilities
than before. It is expected to promote the well-being of its citizens in every respect i.e. politically,
economically and socially. With increased number of functions and higher expectations, State needs
more to invest in to the public expenditure than before.
2. Size of population: Another major and basic reason of increase in the public expenditure is the ever-
increasing size of population. With increased size of population, the government has to cater to the
structural and social needs, which consequently increases the expenditure.
3. Technological developments: Technological advancements play an integral role in the economic
growth of the country but at the same time also cost a lot.
4. Ability to tax: It is difficult to levy taxes in a low-income economy, however, a wide range of taxes are
imposed and collected in a high-income economy. Thus, the expenditure increases with increased ability
to tax as the ability to tax increases the ability to spend.
5. Expansion in social services: Looking around the world we see that there has been a remarkable
expansion in social services such as education and public health services etc. This has led to the
development of schools, colleges, educational institutes, hospitals and medical centers that in turn
require finances for establishment and stability.
6. Provision of public utility services: Another significant increase in the public expenditure is due to an
augmented provision of public utility services such as electricity, water and transport services.
Development of improved transport network, an efficient electric supply system and provision of clean
and safe drinking water to masses naturally increases the government expenditure.
7. Political and social factors: The government expenditure also increases due to various political and
social factors. In a democratic state the functions have increased both intensively and extensively.
8. Economic development: Whether developed or under-developed, every country eye on the economic
development in order to reach economic stability and higher standard of living of its people. Developed
countries wish to retain their progress and aim for even higher milestones whereas developing countries
are anxious to reach there. And this comes at a price as economic development is a costly affair. Loads
of expenditure is to be incurred on social and economic fronts and many costly projects are to be
undertaken.
9. War and the national defense: Wars have always been a great threat for every country. Even in
modern times the fear has only increased, making countries spend more on the national defense. The
condition worsens when the countries have archrivals in the neighborhood. The best and relevant
example would be of Pakistan and India. Both the countries invest heavily to maintain a minimum
deterrence level.

10.2.b. Role of Public Expenditure in a Developing Country

1. Social and Economic expenditure: Public expenditure plays a vital role in development and promotion
of social overheads such as hospitals, schools and colleges and other educational and technical
institutions. Likewise, huge investments are needed for the establishment of economic overheads such as
a viable transport network, roads, railways, irrigation projects and installation of power plants. Since

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Professional's Academy of Commerce IEF (CAF-02)

private sector is unable to gather such huge investments, the social and economic overheads depend on
the public expenditure entirely.
2. Growth of rural and urban areas: The growth of rural and under developed areas is entirely
dependent on public expenditure. It is the government that has to balance out the development of rural as
well as urban areas.
3. Development of Agriculture and Industry: Development of agriculture and industry is vital to the
overall economic progression of a country. Public expenditure is used extensively in the agricultural
sector for formulating irrigation network, seed farms, fertilizers, power generation, green houses, storage
facilities etc. Similarly, industrial sector requires large investments in form of textile factories,
engineering and steel plants etc.
4. Exploration and extraction of Mineral Resources: Mineral resources such as salt, oil, gas and coal
etc. are an integral part of economic development of a country. The time, effort and money spent on the
exploration and extraction of these essential minerals are derived out of the public expenditure.
5. Subsidies and Grants: Subsidies and grants are meant to increase the production of certain goods as
well as to increase and promote exports to earn much needed foreign exchange.

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