PUBLIC FINANCE AND TAXATION

UNIT 1; BASICS OF PUBLIC FINANCE

1.1. Definition of 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.
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.
1.2. 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
subject matter of the public finance is classifies under five broad categories. They are,
1. Public revenue
2. Public Expenditure
3. Public debt
4. Financial administration

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 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:
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.
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:
i) Interest receipts
ii) Dividends and profits
iii) Fiscal services and others.
2. Public 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

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 emphasized by Keynes.
The term “Public Expenditure” is used to allocate 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.
I. Plan and Non-plan Expenditure
Expenditure is classified under the following heads:
a. Non-plan Expenditure: Non-plan expenditure of central government is divided into
revenue and capital expenditure. Under non-plan revenue expenditure we include interest
payment, defense expenditure, major subsidies, interest and other subsidies, debt relief to
farmers, police, pensions, other general services, social services, grants to states. Non-
plan capital expenses include defense expenses, loan to PSUs, loans to states and union
territories, foreign governments etc.
b. Plan expenditure: The second major expenditure of central government is plan
expenditure. This is to finance the following
i) Central plans such as agriculture, rural development, irrigation and flood control,
energy, industry, and minerals, communication service and technology, environment,
social service and others.
ii) Central assistance for plans of the states and union territories.
Expenditure can also be categorized into revenue and capital expenditure. Revenue
expenditure relates to those, which do not create any addition to assets, and covers
activities of government departments’ services, subsidiaries and interest charges.
Capital expenditure involves that expenditure, which results in creation of assets. Finance

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 ministry is responsible for plan expenditure. This includes grants to the state. Hence the
expenditures are classified as capital and revenue. Alternatively, these expenses can be
re-classified into plan and non-plan expenditure.
II. Social expenditure: Government takes the responsibility of protecting the interests of
the community as a whole and promotes the implementation of welfare programs.
Government spends huge amounts for providing benefits such as old age pensions,
accident benefits, free education and medical services. This expenditure on human
resources comes under social expenditure. Governments are moving towards the
objective of achieving maximum social welfare. Expenditure on education, public health,
welfare schemes for workers, relief and rehabilitation of displaced persons and such other
services may not yield direct benefit in the short run. But in the long run they contribute
to improvement in the quality at human resources. The main classifications of
Government expenditure can be seen in the following diagram.

2.1. Principles of Public Expenditure

1. Principle of Benefit: Expenditure should bring increased production, preservation of

social whole against external aggression and internal disorder, and as far as possible
reduction in income inequalities. Public funds must be spent in those directions which are

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 most conducive to public interest. Public expenditure must result in the achievement of
maximum social advantage.
2. Principle of Economy: Wasteful extravagant expenditure should be avoided. The public
authorities should not waste the limited resources at their disposal. It is, therefore,
necessary that Government should incur expenditure with greatest care and prudence. It
should aim at maximum benefit.
3. Principle of Sanction: The canon requires that there should be in place a proper
procedure for authority to incur expenditure out of public funds and that accountability
for expenditure should be inbuilt in the scheme of sanction and incurring of expenditure.
The spending authority should obtain proper sanction from the authority vested with the
power of sanction. The canon also sees that there should be adequate control and audit of
public expenditure to ensure that expenditure is as per sanction and likelihood of
avoidable and dishonest expenditure and misappropriation of funds is avoided.
4. Principle of Surplus: This canon enjoins that public expenditure should be, as far as
possible, met from current public revenues, without resorting to deficits or borrowings.
5. Principle of Elasticity: According to this canon, expenditure policy of the Government
should be such that it may be possible to change the size and direction of public
expenditure according to requirements of different circumstances.
6. Principle of Productivity: This canon implies that public expenditure should be such
that would encourage production and productive efficiency in the country.
7. Principle of Equitable Distribution: This canon is particularly important for the
countries where obvious inequalities of income and wealth are present.

2.2. Focus of Public Expenditure

Public expenditure is primarily aimed to provide governance (Administration), security

(Defense and Policing) and justice (Courts) to citizens. Public expenditure is also
incurred to provide citizens with certain goods and services /public goods/which an
individual cannot acquire because of cost factor or which an individual does not solely
need for his individual need. Such goods and services are called ‘Public Goods’.

[Link] Goods VS Private Goods

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 A. Private Goods: Refer to all those goods and services, which are consumed by people to
satisfy their personal and private wants or needs. Priced in the market on the basis of
their cost of production on the one side and the nature of demand on the other. There is
no compulsion that everyone will have to buy them. The distribution of these goods is
based on effective demand and market price. Private goods are divisible in the sense that
price mechanism divides people in to two groups: who want to consume them and those
do not. 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.
B. Public Goods: Collective wants are those which are demanded by all members of the
community in equal or more or less equal measures. Defense, education, public health,
infrastructure facilities like power, transportation and communication, etc., are examples
of public goods. Public goods are Goods and services produced to satisfy collective
wants. 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. Unlike private goods,
public goods are not divisible but have to be collectively consumed. Produced and
supplied by the public authorities to meet collective wants. The price mechanism does not
apply and these goods cannot carry a price tag, as everyone is a beneficiary.

[Link] of Public Expenditure

I. Effects on Production and Employment: The beneficial effect of public expenditure is

in the form of greater production of output and more equitable distribution of wealth and
income in the society. Public expenditure on generalized social services like health,
education, public health, etc. tends to raise the efficiency of the nation. Consequently
such expenditure tends to increase the productivity of the nation leading to greater
prosperity of individuals. Public expenditure on infrastructure like roads, ports, railways,
etc. create tremendous employment avenues for the citizens, raising their income.
Government has to choose the particular region or area and industry for incurring public
expenditure so that it maximizes national production and follows it with maximum
community welfare.

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 II. Effects on Distribution: Public expenditure is also most powerful fiscal instrument
available to the Government to bring about an equitable distribution of income and
wealth in the country. While formulating its expenditure policies, government takes into
account as to which of the socio-economic group in the country are being specially
benefited by it. Part of public expenditure will help bring about a more equal distribution
of income and wealth and the consequential removal of existing disparities in people’s
living standards in the society.

III. Effects on Economic Stability: Major Nation state economies are affected by
business cycles whereby a cycle of growth is generally followed by a cycle of
stagnation or even negative growth. Increased public expenditure during the stages or
cycles of stagnation or negative growth reinvigorates the economy and lessens some
of the pain of stagnation.

IV. Effect on Economic Growth: Public expenditure has a tremendous impact on

economic growth. Public expenditure on infrastructure like roads, ports, railways,
electricity, shipping, etc. results in opening up of more and more areas of the country,
industrialization of backward areas and Philip to both industrial and agricultural
production. This type of expenditure makes it easier to move surplus production to
deficit areas of the country and even for export of surplus production.

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: 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
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, exigency like
war, finance productive government enterprise, finance public social welfare and

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 economic development. Capital receipts mainly consist of market borrowings, small
savings and external loans, disinvestments 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:
 Financial aid through grants and loans
 Commodity aid
 Technical assistance
External debt is an immediate source of funds for development. However, such
debt has following drawbacks.
 Political subordination & other obligations
 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
generally under developed countries have the following features.
1. Predominantly agriculture based economy
2. Low capital formation
3. Inferior technical knowhow
4. Low per capita income
5. Over population and poor health and educational facilities.
6. High propensity to consume leading to low capital formation.
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.

1.3 Functions of Modern Government in the economy

Government of a modern state generally undertakes the following functions:

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 1. Security - Both external and internal involving outlay for military, police and other
protective services.
2. Justice or settlement of disputes
3. The regulation and control of economy – including the services such as coinage, weights
and measures, the business practices, operation of public sector.
4. Undertakings of social and cultural welfare through education, social relief, social
insurance, health and other activities.
5. Conservation of natural resources.
6. Promotion of the unity of the state by control of transportation and communication.
7. Administration and financial system, government revenue expenditure and fiscal control.
8. Education and employment.
9. Housing.
10. Public health.
11. Up-liftmen of weaker sections of the society.
12. Restore social justice in the society.
1.3. 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 the government. It follows that fiscal policy relate to those activities of the
state that are concerned with raising financial resources and spending them. Resources are
obtained through taxation and borrowing both within the country and from abroad. Spending
is done mainly on defense development and administration. Financial accounts of the income
and expenditure position are shown in budgetary statement. Budget can act as an important
tool of economic policy. The state by its policy of taxation-regulated expenditure can
influence the economic activities and development.
Private outlay is insufficient to produce maximum national income. An increase in state
outlay beyond its revenue can increase national income. Keynes emphasized the effects of
government revenue and expenditure upon the economy as a whole and argued that they
should be used deliberately and consciously to secure economic stabilization. This
underscores the importance of budget in economic development.

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 Fiscal policy relates to the government’s decision making with respect to the following:
[Link], [Link] spending, [Link] borrowing and [Link] 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.
1.3.1. Role of Fiscal Policy in the Economic Development:
1. 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.
2. 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

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 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.
3. 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.
4. 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.
5. 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 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

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 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.
1.4. Public finance Vs Private finance
there are both similarities and differences between public finance and private
finance. Let us discuss the similarities first.
1.4.1. 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, via, the satisfaction of human wants.
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 incomes become 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.
1.4.2. 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.

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 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 kike social welfare measures and thus cannot postpone the
certain expenses like relief measures, defense, etc.
4. Allocation of Resources: In private finance the individual can allocate or distribute his
income to various expenditure in such a way to get the maximum satisfactions. But it is not
possible in the case of public finance; Government cannot aim at maximum satisfaction on
the expenditures made.
5. 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.
6. 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 economic policy
of the Government.
7. Nature of Perspective: In private finance, the individual strives for immediate and quick
return. Since his life span is definite and limited him 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 ling
term perspective.
8. 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.

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 9. Nature of resources: In private finance the individuals have limited resources. They
cannot raise the income, as they like. They 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.
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.
11. Publicity: 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.
12. 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.

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