Understanding Public Finance: Meaning, Scope, and Principles

Meaning and Scope of Public Finance Dr Parmeshwar Bhagwanrao Gore Assistant Professor in Economics, Pragati College of Arts and Commerce, Dombivli (E)

Meaning of Public Finance In 1922, Hugh Dalton published Principles of Public Finance. According to Hugh Dalton, Public finance is concerned with the income and expenditures of public authorities and with the adjustment of one with the other. Other definitions of public finance According to Otto Eckstein, public finance is the of the budgets on the economy, particularly the effects on growth, stability, equity and efficiency. According to Philip E. Taylor, Public finance deals with the finances of the government. The finances of the government include raising and disbursement of government funds. According to Ursula Hicks, "the main content of public finance consists of the examination and appraisal of the methods by which government bodies provide for the collective satisfaction of wants and secure necessary funds to carry out their purposes study of the effects

Two important concepts associated with public finance are (i) Fiscal policy (ii) Budgetary policy. SCOPE OF PUBLIC FINANCE In a narrow sense, public finance is the branch of economics which deals with the financial activities of the government at national, state and local levels. In a broader approach, the study of public finance is used to understand and analyze the role of the State in the economy.

Classical economists advocated minimal role of the government. During the Great Depression and the period that followed it, the Concept of functional finance began to emerge. Scope of public finance 1. Public Revenue 2. Public Expenditure 3. Public debt 4. Financial Administration

Principle of Maximum Social Advantage 1. Dalton s View on Principle of maximum social advantage Objective: Maximization of Social Advantage(MSA) Assumptions: 1. All taxes result in sacrifice 2. All public expenditures lead to benefits 3. Public revenue consists of only taxes 4. The government has only balanced budget 5. Public expenditure is subject to diminishing marginal social benefit 6. Taxes are subject to increasing marginal social sacrifice

Maximization of Social Advantage(MSA) stats that public finance leads to maximum economic welfare when public expenditure and taxation are carried out up to that point where the benefits derived from the marginal utility of expenditure is equal to marginal disutility of the sacrifice imposed by taxation. 0, 1, 2,3,4,5,6,7,8,9,10 Sacrifice - Tax 10,9,8,7,6,5,4,3,2,1,0 benefit expenditure Marginal social benefit of govt exp. = Marginal social sacrifice of the taxation

Marginal Social Sacrifice (MSS) Government policy: if More revenue more tax will be imposed result will be more sacrifice- Increase marginal social sacrifice 4 5 6 10 If less revenue less tax will be imposed result will be less sacrifice- Increase marginal social sacrifice 0 1 2 3 Addition unit of tax will increase sacrifice ( Consumption, saving, .) Marginal Social Sacrifice MSS Curve S3 S2 S1 O M1 M2 M3 Unit of Tax

Marginal Social Benefit (MSB) Public Expenditure result in benefit Gov t provides social goods : defense, justice system, free & subsidized food, housing, education, transport system and .. Diminishing Marginal Social benefit Marginal Social Benefit B1 B2 B3 MSB curve O M1 M2 M3 Unit of Public expenditure

Maximum Social Advantage Marginal Social Benefit of govt exp. = Marginal Social Sacrifice of the taxation Marginal Social Benefit & Sacrifice MSS Curve P1 R1 P R MSB curve O Q1 Q Q2 Unit of Tax & Expenditure MSA will be obtained at the point where MSS = MSB

Musgraves Approach Maximum welfare principle of budget determination The optimum size of the budget is given by the point where the marginal net benefit is zero. MSS = MSB P Expenditure curve O X M1 M M2 Amount of taxation & Public expenditure Q N= Marginal net benefit (MNB) MSB = MSS Taxation curve

The Principle in Practice 1. Defense and preservation of community 2. Improvement in the production of wealth 3. Improvement in income distribution 4. Stability of economics activity 5. Provision for the future Limitations 1. Objective measurement is not possible 2. Large budget size 3. Unrealistic assumptions 4. Lack of divisibility 5. Ignores non tax revenue 6. Changes in conditions 7. Different periods

Productive and Allocative Efficiency Productive Efficiency Efficiency: society is getting the maximum benefits from the use of scarce resources A b f Y1 Y Goods d c Y a PPC = Production Possibility curve O X B X1 X goods a shows production inefficiency X = OX , Y = OY Movement from a to c production of X = OX1, Y= OY Movement from a to b production of X = OX, Y = OY1 Productive efficiency in the economy is achieved when an economy produces at any point on its production possibility curve and not at any point inside the PPC

Allocative Efficiency: refers to a situation when it is impossible to change the allocation of resources in such a way as to make a person better off without making another person worse off Allocative inefficient = a, g, f Allocative efficient= b, d, c At a point = Ox and OY at c point = OX1, OY At a point = Ox and OY at b point = X goods OX, y good = OY1 A g b f Y1 Y Goods d a c Y PPC = Production Possibility curve O X B X1 X goods Movement from a to c production of X increased from OX to OX1, without changing production Y= OY - allocative efficient Movement from a to b production of X = OX but production of Y has increased from OY to OY1 - - allocative efficient Movement from a to g production of X reduced, and production of y has increased - allocative inefficient

Market Failure Market: is a place where sellers (producers) and buyers meet for settling a transaction A group of firms and individuals that are in touch with each other in order to buy and sell some goods Causes of Market Failure 1. Public goods: a special type of good that can be consumed by everyone, regardless of whether they have paid for the good. A) Non excludability B) Non rivalry Free rider problem 2. Market Power: 3. Externalities: Positive & Negative An externality arises when a person engages in an activity that influences the well-being of a bystander (third party) and yet neither pays or receives any compensation for that effect. 4. Asymmetric Information 5. Inequality 6. Merit Goods: Health services, education, Public libraries, vaccinations 7. De- Merit goods : cigarettes, alcohol.

Role of the Government 1. Securing conditions for the functioning of market mechanism 2. Providing legal framework 3. Provision of public goods and merit goods 4. Correcting the problems arising from externalities 5. Correcting unequal distribution of income and wealth 6. Provision of social securities 7. Guiding the use of natural resources

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