Unit 4

Concept of Public Finance

Public finance is concerned with the methods employed by the public authorities to raise revenue and the
principles underlying government expenditure as well as borrowing. Public finance is also known as
government finance. The word 'public' is a collective term which stands for the collection of individuals. In a
wider sense, it refers to all the members of a community. The ordinary meaning of term 'finance' is money
resources in a specified area (generally a country). Thus the public finance is that branch of economics
which deals with the income and expenditure of the public authorities, including all types of government
organizations and local bodies.
According to Prof Dalton, "Public finance is concerned with the income and expenditure of public
authorities and with the adjustment of the one to the other."
According to Philip E. Taylor, "Public finance deals with the finance of the public as an organized group
under the institution of the government. It, therefore, deals only with the finance of the government."
According to Bastable, "Public finance deals with income and expenditure of public authorities of the state
and their mutual relation as also with financial administration and control.”
In precise, word public finance studies and analyses the effects of government budgetary practices of
taxing and spending as, (i) allocation of scarce productive resources, (ii) distribution of income and wealth,
(iii) economic stability and full employment and (iv) economic growth.
Difference between Government and Private Finance
Generally, the word ‘finance’ is used in both government and private sector. By private finance, we mean the
study of the income, debt, and expenditure of an individual or a private business venture. On the other hand,
government finance deals with income, expenditure, and borrowings of the government. However, the major
differences between them are given in Table:
Government finance Private finance
It refers to the revenue and expenditure of the It refers to the revenue and expenditure of
nation an individual.
A government adjusts its income to its An individual attempts to adjust his
expenditure. expenditure to his income
A government spends for welfare of An individual spends for profit
community.
A government has unlimited source of An individual has limited source of income.
income.
Government gives the greatest publicity to its Private sector does not like to show his
budget proposal. financial affairs to others.

Importance of Public Finance

1. Efficient allocation of resources
2. Maintenance of economic stability
3. Social goods and infrastructures
4. Capital formation
5. Redistribution of income and wealth
6. Efficient mobilization of resources
7. Democratic planning
8. Promotion of economic development
Government Revenue
Government revenue or the public revenue refers to the income of the government from various sources.
There are two sources of the government: tax revenue and non-tax revenue.
The main objective of the study of public revenue is to find out how the government income can be raised
from different sources, what will be the effect of raising income on the people, and how the adverse effects
can be minimized.
Sources of government revenue
Simply government revenue refers to the income raised from public by the government through taxes. But taxes
are not the only source of public revenue. The sources of public revenue are usually classified into three heads;
tax revenue, non-tax revenue and foreign grants. However, tax revenue yields the largest revenue in any country
since it has wider implication.
(A) Tax Revenue
A tax is a compulsory contribution to the government by the tax payers. Taxation is the major source of public
revenue. In all countries, the largest part of the public revenue is raised through taxes. Taxes may be imposed
on goods, services and income or wealth. Mainly, the tax revenue constitutes of the following headings.
(1) Customs duties
It is collected at custom point located at the border of a nation. It includes export tax and import taxes. It has a
significant share in government revenue.
(2) Tax on consumption and production of goods and services
The government imposes various types of indirect taxes on goods and services. It includes income obtained
from excise duties, sales tax; value added tax, entertainment tax, road tax etc. It is also a major source of public
revenue.
(3) Tax on property, profit, and income
It includes income obtained from the imposition of income tax, urban house tax, vehicle taxes etc. These are the
direct taxes.
(4) Land revenue and registration tax
It is the regular source of income of a government. It includes income obtained from imposition of land tax, land
registration tax and house registration tax to the citizens of a nation.
(B) Non-tax Revenue
Another source of government revenue is non-tax revenue. Following are the main sources of non-tax revenue.
(1) Fees:
Fee is the revenue charged by the government for rendering special services to the beneficiaries. Hence, fees
are to be paid only by those individuals who receive some special benefits from services rendered by the
government such as education fee, training fee etc.
(2) Fines and penalties:
Fines and penalties are imposed of a certain law. The objective of fines and penalty is to prevent the crime and
undesirable acts. However, the collection of revenue from this is insignificant.
(3) Special assessment:
The government charges special assessment to those people, who are directly benefited from construction of
roads, street lighting, irrigation and infrastructure etc. The government, therefore, may impose some special levy
to recover a part of the expenses incurred.
(4) Escheats:
The government may under some circumstances take possession of the property of person who had died
without any heir.
(5) Profits of public sector enterprises:
The government can also earn income from the sale of goods and services produced by public enterprises.
Railways, post offices, public sector bank etc. earn profit which constitutes income of the government.
(C) Foreign Grants
A government may receive grants from foreign government and international institution for development
programs, security expenses and to meet even regular expenses. Most of the developing countries like Nepal
also depend upon the foreign grants to fulfill their deficit budget.

Government Expenditure
Government expenditure refers to the expenses of the public authorities, central government, state
government and local government either in protecting the citizens or in promoting their economic and social
welfare. The concept of public expenditure has changed over the time along with changes in economic
condition of a country. Till 19th century, economists believed that it would be better if the role of
government was limited. After the World War II, the responsibility of government has been increased.
In recent days, public expenditure has emerged great importance for two reasons. Firstly, the economic
activities of the state have increased manifold. Secondly, the nature and volume of public expenditure have
important effects on production, distribution and the general level of economic activity.
Importance of Government Expenditure
1. Maintain law and order in the country
2. Investment in social and economic overheads
3. Utilization of natural resources
4. Development of agriculture and industry
5. Subsidies and grants
6. Provide administration service
7. Balanced growth
8. Other expenses
Classification of government expenditure
The functional classification has been used in Nepalese budget document. Generally, all
expenditures are broadly classified first into two categories.
(A) Regular or Administrative Expenditure
It is related to expenditure on day to day activities. It constitutes the expenditures made on the
following government organization:
1. Constitutional organs
It constitutes expenditures of government on constitutional organs like Supreme Court, Auditor
General Office, Election Commission, Public Service Commission, Attorney General Office,
Council of Ministers and Parliamentary Secretariat.
2. General administration
It includes expenditure of Council of Ministers, Various Ministries, District Administration office,
Police Force, Jail administration, etc.
3. Revenue administration
It consists of expenditure made on collection of land revenue, custom office, land tax
department, etc. To manage these administrative job government has to bear variable cost.
4. Economic administration and planning
It comprises the expenditure of the National Planning Commission, Central Bureau of Statistics
and Department of Metric Measurement, and so on.
5. Judicial administration
It consists of expenditure of Court and judicial commissions.
6. Defence
It constitutes expenditure on defences through national security organizations. It means the
cost of Nepal Army comes under the heading of regular expenditure.
7. Economic services
It includes the expenditure on agriculture, irrigation, land reform, forest, industry, mining,
communication, transport, electricity and other economic services.
8. Social services
It includes the expenditure on education, drinking water, health local development and other
social services.
9. Loans and investment
It includes the expenditure on loans and investments.
10. Loan repayment and interest
It includes expenditure on payment of principal and interest on loan borrowed from different,
such as public, foreign government and international organization.
11. Miscellaneous
It includes the expenditure on travelling expenses of dignitaries and government
delegation, hospitality, pension, allowances, emergency help etc.

(B) Development or Capital Expenditure

It is related to expenditure on development activities/ projects of the government.
It is not recurrent expenditure rather it is the expenditure on development related activities. It consists
of following heads.

1. Constitutional organs
It includes the expenditures on infrastructure development of constitutional organs like
Supreme Court, Auditor General Office, Election Commission, Public
Service Commission, Attorney General Office, Council of Ministers and Parliamentary
Secretariat.

2. General administration
It includes expenditure on administration reform of government organizations. It refers to
different administrative offices such as police department.
3. Economic administration and planning
 It includes the expenditure on planning and statistics of nation.
4. Economic services
It includes the expenditure on development of agriculture, irrigation, land reform, forest,
industry, mining, communication, transport, electricity and other economic services.
5. Social services
It includes the expenditure on development of education, drinking water, health, local
development and other social services.
6. Miscellaneous
It includes the expenditure on miscellaneous and contingency expenses of the nation.
Based on this board categories of regular and development expenditure, the functional
classification is made. Under functional classification, total budget – regular and
development expenditure, are classified into different purposes (functions).
Taxes
Taxation is a main source of public revenue of the government. A tax is a compulsory contribution to
the government by the tax payers. It may be levied on income, property and even at the time of
purchasing a commodity. The tax payers do not get direct or immediate benefit from tax payment to
the government. However, they get indirect benefit from the state in the form of public utilities such as
in the form of road, health, education, irrigation, security and so on.
According to Dalton, "A tax is a compulsory contribution imposed by a public authority irrespective of
the exact amount of service rendered to the tax-payer in return and not imposed as a penalty for any
legal offence."
According to Bastable, "Tax is a compulsory contribution of the wealth of a person for the service of
the public powers."
So, tax is a necessary contribution by the tax-payer to social objectives, like reducing inequalities in
income and wealth, securing high level of employment as well as promoting economic stability with
growth.
Types of tax
Direct Tax
Direct taxes are those taxes, which are imposed on income and wealth. Income tax, profit tax, land tax,
registration tax etc. are the example of direct tax. The burden of direct taxes cannot be shifted.
According to Dalten, "A direct tax is one, which is really paid by the person on whom it is legally imposed
while an indirect tax is imposed on one person but is paid partly or wholly by another."
Features of Direct Tax
The merits and demerits of direct tax are also known as features, which are given below:

Merits
The major merits of direct tax are as follows
1. Equity
Direct tax is imposed in accordance with the ability of tax-payer to pay so that the burden of
taxation is distributed among the taxpayers in an equitable manner. These taxes fall more
heavily on the richer persons than on the poor.
2. Progressive in nature
The rate of direct taxes are fixed in such a way that the rich people with higher income pay
higher rate of taxes compared to people with lower income. Being progressive in nature, direct
tax can serve as a means of reducing inequalities in the distribution of income and wealth.
3. Certainty
The burden of direct tax is certain to the taxpayer. A salaried person knows beforehand when,
where and how much tax is to be paid. Such certainty enables taxpayers to make provision of
the payment of tax in advance. On the other hand, the government is almost certain of the
revenue yield from direct taxes.
4. Elastic
Direct tax is elastic in nature. It is elastic in the sense that the government can change rate of
taxes according to its needs. The income from direct taxes will also increase with the increase
in income of the people.
5. Anti-inflationary
Direct tax is a powerful instrument to control the inflation. In the period of inflation, government
charges the higher tax on income. It reduces real income or purchasing power of consumer.
 This will result in a decline in disposable income. Thus, direct taxes serve as an important anti-
inflationary instrument.
Demerits
The major demerits of direct tax are as follows:
1. Inconvenience
The main demerit of the direct taxes is inconvenience because it requires numerous
accounting and other formalities to be observed. On the other hand, it is paid to lump sum, it
becomes inconvenient to the taxpayers particularly when they experience liquidity crises.
2. Narrow in scope
The scope of direct tax is so narrow because it is levied only on certain group of persons. Due
to this, it is suitable only in developed countries. In this way, its applicability is limited.
3. Obstacle to capital formation
Direct tax discourages the initiative to work saving and investment. High rate of taxes discourage
people to work more since bulk of the income earned will have to be paid as taxes. It is claimed
that the higher rate of tax, adversely affects the people's desire, ability to work, saving and
investment. Therefore, it hampers the growth of capital formation.
4. Unpopular
It is unpopular since its burden is directly felt by the taxpayers. Nobody likes to pay this tax.
5. Possibility of evasion
A direct tax is calculated on the basis of honesty of tax payers. So, there is always a possibility
of tax evasion. People do not show their correct income and wealth to the tax officials. Tax
evasion then leads to the emergence of a parallel economy of black income.

Indirect Tax
Indirect taxes are those taxes, which are imposed on goods and services. Sales tax, value added
tax (VAT), customs duties etc. are some examples of indirect tax. The burden of indirect tax can be
shifted from one person to another.
Merits of indirect tax
(1) Convenience: An indirect tax is convenient since taxes are included in the price of the taxed
commodity, so the taxpayer does not feel the burden of taxes. We pay the tax when we buy a
commodity and at a time when we can afford it.
(2) Broad based: Indirect taxes are broad based since the effects are felt more or less by all the
people in the community. It is levied almost on all the goods which are consumed in daily life.
(3) Elasticity: Elasticity is the other important merit of indirect tax. It is flexible or elastic in the sense
that it can be revised in accordance with the requirements of the government. A very small rate of
change in tax may provide large amount of revenue to the government.
(4) Progressive in nature: The indirect tax is also progressive in nature in a sense that the
government imposes higher tax rates on luxurious goods and does not impose taxes on basic
goods.
(5) Difficulty in evading taxes: It is difficult to evade indirect tax since. Such tax is included in the
price of the commodity so to evade the tax consumer must stop the consumption of goods
which is not possible.
Demerits of indirect tax
Indirect taxes have been criticized on following grounds;
(1) Regressive in nature: Indirect taxes are generally regressive in nature because every
consumer of the taxed commodity, rich or poor, pay the tax at the same rate. Therefore,
real burden of the tax on the poor is greater than on the rich.
(2) Uncertainty: Indirect taxes are uncertain. The revenue collected by the government is very
difficult to anticipate. As soon as a tax on a commodity is imposed, its price raises which
results the fall in demand. Therefore, it is difficult to anticipate the fall in demand with the
imposition of tax.
(3) Uneconomical: Indirect taxes are uneconomical because government spends more for the
collection than actual amount of taxes. Government has to give large number of manpower
 to collect the tax. In this sense, some of the indirect taxes are unproductive.
(4) Inflationary: The indirect taxes create the inflationary condition. When the rate of indirect
tax is increased it raises the price of goods. So, the indirect taxes lead to an unending
spiral of higher prices, higher costs, higher wages and again higher prices.
(5) Inequitable: Indirect taxes are imposed at the same rate on the commodity, whether it is
consumed by rich or poor people. Due to this reason poor section of the society has to pay
more than the rich. This is because the poor have lower level of income than the rich.

Difference between direct and indirect taxes

Direct Tax Indirect Tax
The burden of direct tax cannot The burden of indirect tax can be shifted.
be shifted.
It is imposed on income and It is imposed on goods and
wealth. It is based on narrow services. It is based on wider
scope. scope.
It is progressive in It is regressive in nature.
nature. It is difficult to It is easy to pay.
pay. It cannot be used to control the inflation.
It can be used to control the inflation. It is relatively inelastic in nature.
It is relatively elastic in nature.
Concept of progressive, proportional , Regressive and Degressive taxation
Progressive Tax
If the tax rate is imposed according to the level of income of the tax payer, it is defined as
progressive tax. Progressive tax is the system in which the rate of tax increases with the rising level
of income and wealth. Thus, as income increases, tax rate increases and as income decreases tax
rate decreases. In other words, progressive tax means imposition of higher tax rate on the rich and
lower tax rate on the poor people. This type of tax system helps to reduce unequal distribution of
income and wealth in the society. The progressive tax system can be explained with the help of
following example.
Table : Progressive Tax Rate and Income Level
Income Tax Rate Tax Amount
(in Rs) (in %) (in Rs)
10,000 5 500
50,000 10 5000
1,00,000 15 15000
The above table shows that the rate of tax and income level. When the income level of
people/organization increases from Rs. 10,000 to Rs. 50,000 and Rs. 100,000, the tax rate also
increases from 5% to 10% and 15%. As a result the amount of tax rises rapidly from Rs 500 to Rs
1500. It can be shown from following figure.

B
R
3

R
2

A
O X
Y1 Y2 Y3
Incom
 Progressive taxation

In the above figure tax rate is measured on Y-axis while tax base or income on X-axis. AB line
shows the progressive rate of taxation. When the income is OY 1, the tax rate is OR1. As the amount
of total income increases from OY1 to OY2 and OY3 the tax rate also increases OR1 to OR2 to OR3
respectively.

Proportional Tax
If the rate of tax is imposed at the same rate to all class of people irrespective of their income level, it is
called proportionate tax. A proportional tax is that tax rate which remains constant, even if income rises.
Whatever the level of income, the rate of tax remains unchanged in proportional tax system. In other
word, if the rate of tax remains the same at every level of income and wealth, it is called proportional
tax. The amount of tax paid by different persons may be different but the rate of tax does not change.
Further it can be explained with following example.
Table 7.3: Proportional Tax and Income Level
Tax base Income (in Tax Rate (in %) Tax Amount (in
Rs) Rs)
10,000 10 1000
50,000 10 5000
1,00,000 10 10,000
The table 7.3 shows that the tax rate does not change to any change in amount of income. As
income of tax payer increases from Rs 10000 to Rs 100000, the rate of tax remains at 10% on every
level of income. The proportional tax can be analyzed with the help of the following figure.

O Y Y X
Y 2
1 3
Proportional Taxation
Tax
In the above figure tax base and tax rate are measured along X-axis and Y-axis respectively. The
RP line shows the proportional tax rate. The rate of tax is fixed at OR at the different level of income
OY1, OY2 and OY3.

Regressive Tax
If the high rate of tax is levied to the lower income class and low rate of tax to higher income class, it is
called regressive tax. Regressive tax is a system in which the rate of tax decreases with the rising
level of income. Under the regressive tax system, lower rate of tax is charged on the higher level of
income and higher rate of tax is charged in the lower level of income. Thus it can be said, it is just the
reverse of the progressive tax system. This type of tax increases income inequality and social injustice
in the society so this type of tax system is rarely found in real world. Further it can be explained with
the following example.
Table 7.4: Regressive Tax and Income Levels
Tax base Income (in Tax Rate (in Tax Amount (in
Rs.) %) Rs.)
1000 10 100
2000 7 140
3000 5 150
 The given table 7.4 shows that as amount of income increases, tax rates decreases in the opposite
direction. As income of tax payer is Rs. 1000, the rate of tax is 10 percent but the income increases
from Rs. 1000 to Rs. 3000 the rate of tax also decreases from 10 percent to 5 percent. The
regressive taxation has also been explained with the help of the following figure.
Y

A
R
3

R
2

B
O Y Y X
Y 3
1 2

Tax ba
Regressive Taxation
Above figure shows that system of regressive taxation. The tax rate and tax base are measured
along Y-axis and X-axis respectively. The AB line shows regressive tax rate. According to this tax
system as income increases from OY1 to OY2 to OY3, the tax rate decreases from OR3 to OR2 to OR1
respectively. Line AB moves downward with every increase in income and vice-versa.

Digressive Tax
In a digressive tax system, tax increases with an increase in tax base, but the rate of increase of tax
diminishes with every increase in the tax base. This kind of tax puts more burden on the poor and
relieves the rich. The rate of tax is disproportionate to the ability of payment of taxpayers. According
to the digressive tax, the tax rate in increased up to a certain level of income and after that, the tax
rate is uninformed. Further it can be explained with the following example.
Table 7.5: Digressive Tax
Tax base Income (in Tax Rate (in Tax Amount (in Rs)
Rs) %)
1000 2 20
2000 4 80
3000 6 180
4000 8 320
5000 8 400
The given table 7.5 shows that when the income is Rs. 1000 the tax rate is 2%. And when the
income increases to Rs. 5000 then the tax rate is 4%. When the income level increases from
Rs.4000 to Rs. 5000 the tax rate becomes uniform that is 8%. The digressive taxation has also been
explained with the help of the following figure.
Y
This figure shows that system of digressive
taxation. The tax rate and tax base are
measured along Y-axis and X-axis
c d
R respectively. According to this tax system
R
b as income increases from OY1 to OY2 OY3
to OY4 the tax rate increases from OR1 to
R a OR2 to OR3 respectively. Under this tax
system, after the OY3 level of income rate
of tax is fixed at OR3, thus after the point C,
digressive tax curve become parallel to X
o
Y Y Y Y X axis.
2

Digressive taxation
 Budget
The world 'Budget' has been derived from the French word 'Bougette' which refers a small leather
bag. The concept of budget in formal way was introduced in 1733 by a member of House of
Commons in England. Every democratic government makes the welfare of the community in the
modern times. In order to achieve, the government takes in hand various socio-economic activities.
This requires proper manipulation of the budgetary policy of the government. Therefore, a budget is
not only a financial statement of actual and anticipated revenue and outlays of the government but is
also a document of detailed programmes and policies of action which they desire to pursue in the
coming years by raising the level of economic activity.
According to Bastable, "The annual budget is usually the legal authority for public spending."

According to Bastable, "The budget has come to mean the financial arrangement for a given
period with the usual implication that they have been submitted to the legislature for approval."
Contents of Budget
The complete budget contains the following components;
 Actual report of revenue and expenditure of previous year.
 It is the statement of expected revenue and proposed expenditure of the public authorities
concerned.
 New tax proposal and change in tax rates.
 It sets procedure in which collection of revenue and administration of expenditure is to be
executed.
Types of Budget
1. Deficit budget
2. Surplus budget
3. Balanced budget