Public Finance Lecture Note for 4th year Economics Students Compiled

by Abdissa D.

Chapter One
Introduction

1. Meaning and Scope of public finance 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.

1.1 Definition of public Finance

The name of the subject is given by different economists differently such as; fiscal economics,
public sector economy, public economics, fiscal science and public finances etc.
Schultz and Harris define public finance as adjective; it describes public which refers to not
only government but also utility enterprise and charitable organizations.

According to Dalton, “public finance is one of those subjects which lie on the borderline between
economics and politics.
Public finance, according to the traditional definition of the subject, is that branch of Economics
which deals with, the income and expenditure of a government. In the words of Adam Smith:
"The investment into the nature and principles of state expenditure and state revenue is called
public finance".
AC. Pigious define public finance is the study of public revenue and expense.
The earlier economists were perfectly justified in giving this definition of the science of public
finance because the functions of the public authorities in those days were simply to raise revenue
by imposing taxes for covering the cost of administration and defence.
Public finance is the study of how the government collects and spends revenue and real resources.
It is the field of economics concerned with how the government raises money, how that money is
spent, and the effects of these activities on the economy and on the society. Public finance studies

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Public Finance Lecture Note for 4th year Economics Students Compiled
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how the governments at all levels- national, state and local provide the public with desired
services and how they secure the financial resources to pay for these services.

1.2 Scope of Public Finance

It is the coverage of public finance. Since activities of government are wide, then scope of public
finance is also too. The scope of the science of public finance now a day has widened too much.
It is due to the fact that modern states have to perform multifarious functions to promote the
welfare of its citizens. In addition to maintaining law and order within the country and provision
of security from external aggression, it has to perform many economic and commercial functions.
Due to the increased activities of the state, there has taken place a vast increase in the expenditure
of the public authorities. The sources of revenue have also increased. Taxes are levied not for
raising the revenue alone but are used as an important instrument of economic policy. Public
finance now includes the study of financial administration and control as well. We, therefore,
agree with Professor Bastable when he defines public finance as that. Branch of economics
which deals with income and expenditure of public authorities or the state and their mutual
relation as also with the financial administration and control the term public authorities includes
ail bodies which help in carrying on the administration of the state).
The study of public finance is split up into the following parts (scopes);

1) Public Revenue: it deals with the sources of the public revenue, the principles and the effects
of public revenue on the economy. Public revenue is the means for public expenditure. Public
revenue has two main sources
1. Tax revenue: Taxes are compulsory payments to government without expectation of direct
return or benefit to tax payers. Tax is one of the most important sources of revenue.
We have two major types of tax revenue source based on impact or incidence
A. Direct tax: those tax whose burden or impact and incidence fall on the same person such as
employee income tax, business income tax, rental income tax, agricultural income tax and other
income tax interest income, royalty tax, capital gain tax, property tax, gift tax and inherent tax.
B. Indirect tax: are those tax whose impact (immediate burden) and incidence (ultimate burden)
fall on different person such as value added tax (VAT), excise tax, turnover tax (TOT), sure tax,
customs duty and stump duty etc.

The objectives of taxation are to minimize income and wealth inequalities, stabilize the economy,
discourage the consumption of harmful products, provide incentives for capital formation in the
private sector, reduce regional imbalance ,enhance standard of livings ,utilize the scarce resources
for the production of more essential goods ,minimize unemployment and encourage export .

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Public Finance Lecture Note for 4th year Economics Students Compiled
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1. Non tax revenue: This is revenue collected from public undertakings, income from issuing of
currency, income from the sale of public assets, gift and donation, foreign debt etc. Major
constituents of non-tax revenue in Ethiopia are charges, fees, fines, pension contribution, and
investment revenue.

2) Public Expenditure: This consists of the study of the principles and the effects of public
expenditure. Government may have three type of expenditure

A. For maintain ace of the government

B. For the society

C. To help other countries

Public expenditure has two broad headings
i. Developmental: it includes social and community services, economic services, and grants in
aid.

ii. Non developmental: it consists of interest payments, administrative services, and defence
expenses.

3) Public Debt: this part studies the causes and the methods of public borrowing as well as public
debt management. They are two types of public debt.

1. 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 internal sources.

2. External debt: In under developed and developing countries, internal sources are limited.
Under developed and developing countries, therefore go for external debt.
Public debt has the objective raising normal current expenditure, exigencies like war, finance
productive government enterprise, finance public social welfare and economic development.
External debt is an immediate source of funds for development. However, such debt has
drawbacks political subordination, other obligation and Excess supply of goods and services in
debtor country.
4) Budget (fiscal policy): this part is dealing with budget allocation process which is a key to the
government’s roles of allocation, redistribution of resources, and economic stabilization. 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.
Resources are obtained through taxation and borrowing both within the country and from abroad.

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Spending is done mainly on defence 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. The annual budget for the Federal
Government of Ethiopia is prepared by the Ministry of Finance and Economic Development
(MoFED) and the budgets for the regional governments by the respective regional finance
bureaus. Taking the recent example, The Ethiopian government budget 45% of annual budget for
capital budget and 55% for recurrent expenditure for year 2011E.C.Budget is divided into two
parts: Revenue Budget and Expenditure Budget.
1) Revenue budget: This forecasts the total revenue collections of the government from tax and
non-tax sources. In Ethiopia, it is classified into three parts:

i. Ordinary Revenue: tax and non- tax source ordinal revenue

ii. External Assistance: External assistance received from friendly countries is called bilateral
assistance; whereas assistance (grant) received from multilateral or international institutions
is known as multilateral assistance.

iii. Capital Revenue: It comprises the money received by the government from the sale of
government assets, collection of loans, counterpart fund and external loans

2) Expenditure Budget: Expenditure budget is a forecast of the total expenditure by the

government, in a year. In Ethiopia, it is classified into two parts:
i. Recurrent Expenditure: Recurrent expenditure represents expenses made by the government
which are recurrent in nature. The recurrent expenditure is classified in Ethiopia under four
functional categories:

A) Administrative and General Services: it expense spend for activities as performed by

political organs of the state such as council of representatives, ministries, defense etc..

B) Economic Services: budget expenditure for agricultural, industrial and service sector
activates.

C) Social Services: Health, education, and culture…

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Public Finance Lecture Note for 4th year Economics Students Compiled
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D) Other Expenditures: Other Expenditures include pension payments, repayment of public

debts, provision of unforeseen expenses and similar items

ii. Capital Expenditure: Capital expenditure represents expenses made by the government for
the implementation and expansion of development projects, research and development
programme, government expenditure on construction, infrastructure, industry, machinery,
building and equipment. However, in most developing countries, recurrent expenditure is mostly
financed from domestic revenue sources i.e, from tax and non-tax revenues, whereas capital
expenditure is usually financed by external borrowing and grants.
5) Financial admiration (fiscal policy and 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.

6) Economic stabilization: it is only one aspects of the broader field which includes income
policy, development policy, price policy and employment policy.
1.3 Public Finance and Private Finance
Before directly embark on the public and private finance let us define the two basic terms as
follow; The public sector includes public institutions at the local, regional, national and inter- or
supranational level. The private sector includes small- and medium sized, as well as large and
trans- or multinational companies. Something distinct from the private finance, the question,
which we are faced is, what are the differences between private and public finance? That leads to
the separate treatment of public finance.
Similarities

1. Rationality: both kinds of finance are based on rationality i.e. maximum satisfaction. If
sometimes the individual is tempted by circumstances to act in an irrational and wrong way, the
government is also subject to such circumstances in regard to expenditures. Of course there may
be unwise use by the government to its income.

2. Borrow Funds as a common feature: just as an individual cannot have enough income to
cover his expenses and fills it by borrowing from others, the government also unable to meet all
its targets due to budget constraint and borrow funds from others.

3. 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.

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Public Finance Lecture Note for 4th year Economics Students Compiled
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4. 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.

5. Both are engaged in economic activities: Including production, exchange, saving, capital
accumulation investment etc.

6. Balancing of Income and Expenditure: Both individual and Government have incomes and
expenditures and trying to balance each other.
Differences
In spite of the above similarities there are however, there are glaring differences between them.
The differences between the two kinds of finances are more remarkable than similarities in them
and are discussed as follows;
1) Final goal (objective)
 Private interest (the greatest good for one number) that is the want and satisfaction of
household and firm.

 Public collective or social interest (the greatest good for the greatest number) or deal with
collective want and satisfaction.
2) Cost adjustment of income and expenditure
 Private start from revenue calculation; then expenditure.

 Public start from expenditure and then revenue.

3) Nature of resources
 Individuals have limited resources at their disposable while;

 Public has power to borrow from external, revenue can collect from tax, and from entire
wealth of the community through force.
4) Motive of expenditure
 Private is the expenditure return is curtained?

 Public profit and surplus is not a matter rather for max welfare in which financial return is
uncertain.
5) Expenditure and welfare
 Private marginal utility of money spent on all goods more or less the same.

 Public spend income in such a way that welfare of community should be maximized.
6. Impact on the society/economy.
 Private has little impact on the economy

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 Public can change the entire nature of the economy, unemployment, inflation, deflation and
etc.
7. Secrete and Publicity: Private finance is secreting except for taxation while public finance is
widely discussed and disclosed.
8. 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, defence, etc.
9. 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.
10. 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.
11. 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.

12. Nature of Budget: In private finance individuals prefer surplus budget as virtue and a deficit
budget is undesirable to them but for the government budget surplus is undesirable by the
government since it will result negative opinion for the government.
1.4 Significance of Public Finance
Justification for public finance in modern state is the need for public sector economy.
1. Failure of unregulated market economy: The pattern of consumption, production, distribution
and resource allocation will be inconsistent with the social need due to

 Existence of public goods and externality

 Uncertainty

 Incomplete information

 Increase and return to scale in natural monopoly

2. Produce or supply more goods as per capital income of the society increase, at least, public
goods e.g road and straight line.
3. The larger complementarities between government and private sector in sphere of
infrastructure and merit goods.

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The importance of public finance could be view from the following angle
1. Taxation: Taxation is a system of raising the government revenue through tax. When we say
tax it is a compulsory contribution payable by an economic unit to a government without direct
and equivalent return from the government for the contribution made. The governments often
levy taxes to discourage the consumption of harmful commodities. Such as the consumption of
cigarette, alcohol and other commodities that fall within that general category needs to be
discouraged by introducing excise tax.

2. Protection of Infant Industries: If the infant and newly started firm or industries in
developing nations are allowed to struggle with foreign firms especially from those
technologically advanced countries, they may not survive due to many reason and factors. These
industries need protection and government often levies duties in order to protect them.

3. Provision Public Goods: Governments provide public good, the government-financed items
and services such as roads, military forces, lighthouses, and streetlights. Private Citizens even the
wealthy ones would not voluntarily pay for these services, and therefore businesses have no
incentive to produce them.
4. Side Effects of a Market Economy: Public finance also enables governments to correct or
offset undesirable side effects of a market economy. These side effects are called spill overs or
externalities. Example: households and industries may generate pollution and release it into the
environment without considering the adverse effect pollution has on others. Pollution is a spill
over because it affects people who are not responsible for it.
1.5 Economic Rationale of a Modern State
In modern state basically every government has at least three functions, defence of the country,
maintenance of law and order and socio-economic development.
The government in a modern state provides the following services
 Security both in internal and external

 To control and regularize the economy

 Justice or the settlement of disputes

 The social and cultural welfare of the people through education, social welfare schemes
 To make proper utilization of natural resource
 The regulation of moral standards
 The administration of the financial system, expenditure, revenues and fiscal control
 Proper and efficient administration

1. Why government provides specific goods and services?

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Public Finance Lecture Note for 4th year Economics Students Compiled
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The reason is that due to market failure for this we have two options
 Under production due to positive externality
 Over production due to negative externality
 No production due to the presence of public goods

1) Allocating role: one assumption of market economy is well defined and enforceable property
right, however some time there may be ambiguity in defining and enforcing property right which
reduce tradability and marketability which reduce price and results underground or black market
economy due to absence of well defied property right and hence government will play allocate
role for common propriety resource, externality and market imperfections created market failure
through;
 Government legislation or legal measure
 Fiscal instrument
 Legal reform
 Creating market for pollutant
 Moral code and social sanctions
 Developing liability schemes
 To bring allocative efficiency when there is negative externality
 Well defined property right
 Per unit tax
 Private bargaining
 To bring allocative efficiency when there positive externality
 Property right
 Per unit subsidy
 Private barging

2) Distributive role: it is the role of the government to provide distribution of income. Initially
there is inequality in income due to difference in individual capacity, inherited and accumulated
wealth, educational status etc. There source may be market imperfection hence to minimize the
above problem the government may
 Progressive employee tax on rich and cash benefit for the poor.

 Progressive tax on goods and services consumed by the rich and subsidize the goods and
services consumed by the poor.

 Provision at subsidy price

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Public Finance Lecture Note for 4th year Economics Students Compiled
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3) Regulatory role: regulation is important for society and for the government because it reduce
cost of information for society, and for the government it help to protect public interest
(selfishness and irrationality), to replace invisible hand of the government by divisible fist and to
maximize welfare of the group .The instruments of regulation may be regulation of money
demand and money supply, price, controlling commercial broad casting, standardizing product,
control over biased advertising . The regulator satisfies the interest of the government and the
public interest regulates the regulators. The efficiency of regulation depends on profit of the firm,
implantation capacity and efficiency of the instrument, the presence of illegal evasion and fraud.
4) Stabilizing role: stabilization is necessary when there is inflation or deflation, inequality
between aggregate demand and supply, inequality between money demand and money supply,
inequality between saving and investment, inequality between expenditure and output. The
instruments of stabilization may be fiscal policy instrument (tax and government expenditure)
and monetary policy (income and interest rate).

5) Merit goods: even if the market is pareto efficient i.e. the competitive market will lead to
undesirable distribution income and merit goods. The good that the government compels
individuals to consume like elementary education and seat belt. Individual may not act in their
own best interest. It is often argued that an individual perception of his own welfare may be
unreliable criteria for making welfare judgment. The view that the government should intervene
because it knows what is in the best interest of individuals better than they do them themselves is
referred us paternalism.

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