Public Finance
Introduction to Public Finance
Principle of Maximum Social Advantage
The fiscal or budgetary operations of the state have manifold effects on the economy. The revenue collected by the state through taxation and the dispersal of public expenditures can have significant influence on the consumption, production and distribution of the national income of the country.
Thus, a rational state seeks to maximise the net social advantage of its fiscal operations. The social net advantage is maximum when the aggregate social benefits resulting from public expenditure is maximum and the aggregate social sacrifice involved in raising the public revenue is minimum. According to the principle of maximum social advantage, thus, the public expenditure should be carried on up to the marginal social sacrifice of the last unit of rupee taxed.
Diagrammatic Representation:
In technical jargon, the maximum social net advantage is achieved when the marginal social sacrifice (disutility) of taxation and the marginal social benefit (utility) of public expenditure are equated. Thus, the point of equality between the marginal social benefit and the marginal social sacrifice is referred to as the point of aggregate maximum social advantage or least aggregate social sacrifice.
The equilibrium point of maximum social advantage may as well be illustrated by means of a diagram, as in Fig. 1.
In Fig. 1, MSS is the marginal social sacrifice curve. It is an upward sloping curve implying that the social sacrifice per unit of taxation goes on increasing with every additional unit of money raised. MSB is the marginal social benefit curve. It is a downward sloping curve implying that the social benefits per unit diminishes as the public expenditure increases.
The curves MSS and MSB intersect at point P. This equality (P) of MSS and MSB curves is regarded as the optimum limit of the state’s financial activity. It is easy to see that so long as the MSB curve lies above the MSS curve, each additional unit of revenue raised and spent by the state leads to an increase in the net social advantage.
This beneficial process would then be continued till marginal social sacrifice (MSS) becomes just equal to the marginal social benefit (MSB). Beyond this point, a further increase in the state’s financial activity means the marginal social sacrifice exceeding the marginal social benefit, hence the net social loss.
Thus, only under the condition of MSS = MSB, the maximum social advantage is achieved. Diagrammatically, the shaded area APB (the area between MSS and MSB curves, till both intersect each other) represents the quantum of maximum social advantage. OQ is the optimum amount of financial activities of the state.
The curves MSS and MSB intersect at point P. This equality (P) of MSS and MSB curves is regarded as the optimum limit of the state’s financial activity. It is easy to see that so long as the MSB curve lies above the MSS curve, each additional unit of revenue raised and spent by the state leads to an increase in the net social advantage.
This beneficial process would then be continued till marginal social sacrifice (MSS) becomes just equal to the marginal social benefit (MSB). Beyond this point, a further increase in the state’s financial activity means the marginal social sacrifice exceeding the marginal social benefit, hence the net social loss.
Thus, only under the condition of MSS = MSB, the maximum social advantage is achieved. Diagrammatically, the shaded area APB (the area between MSS and MSB curves, till both intersect each other) represents the quantum of maximum social advantage. OQ is the optimum amount of financial activities of the state.
Further, the ideal of maximum social advantage is attained by the state, if the following principles of financial operation are followed in the budget.
1. Taxes should be distributed in such a way that the marginal utility of money sacrificed by all the tax-payers is the same.
2. Public spending is done, such that benefits derived from the last unit of money spent on each item becomes equal.
3. Marginal benefits and sacrifices must be equated.
To sum up, all fiscal operations, both as regards revenue and
expenditure, should be treated as a series of transfer of purchasing
power that must ultimately increase the economic welfare of the people.
In this context, Dalton enunciated the principle of maximum social
advantage and asserted that financial operations of the government must
be in accordance with this principle in a welfare state.
Public Budget:- The word 'Budget' is said to be have its origin from the french word 'Bougett' which refers a small leather bag.
"It is a document containing a preliminary approved plan of public revenue and expenditure."- Prof. Rene Stourn
"A budget is a financial and/ or quantitative statement prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective." - I.C.W.A
"A budget is at once a report on estimates and proposals, that it is the instrument by which all the processes of financial administration are correlated and coordinated." - Bastable
Public budget contains the following features:-
(i) It is a statement of expected revenue and proposed expenditure of the public authorities concerned.
(ii) It possesses periodicity which is generally in the year.
(iii) It has a sanction of public authority.
(iv) Budget proposals should be clear.
(v) It sets procedure in which the collection of revenue and administration of expenditures is to be executed.
(vi) The anticipation of revenue and expenditures should make positive contribution to economic goal.
Four Main Types of Budgets/Budgeting Methods
There are four common types of budgets that companies use: (1) incremental, (2) activity-based, (3) value proposition, and (4) zero-based. These four budgeting methods each have their own advantages and disadvantages, which will be discussed in more detail in this guide.
1. Incremental budgeting:- Incremental budgeting takes last year’s actual figures and adds or subtracts a percentage to obtain the current year’s budget. It is the most common method of budgeting because it is simple and easy to understand. Incremental budgeting is appropriate to use if the primary cost drivers do not change from year to year. However, there are some problems with using the method:
- It is likely to perpetuate inefficiencies. For example, if a manager knows that there is an opportunity to grow his budget by 10% every year, he will simply take that opportunity to attain a bigger budget, while not putting effort into seeking ways to cut costs or economize.
- It is likely to result in budgetary slack. For example, a manager might overstate the size of the budget that the team actually needs so it appears that the team is always under budget.
- It is also likely to ignore external drivers of activity and performance. For example, there is very high inflation in certain input costs. Incremental budgeting ignores any external factors and simply assumes the cost will grow by, for example, 10% this year.
2. Activity-based budgeting:- Activity-based budgeting is a top-down budgeting approach that determines the amount of inputs required to support the targets or outputs set by the company. For example, a company sets an output target of $100 million in revenues. The company will need to first determine the activities that need to be undertaken to meet the sales target, and then find out the costs of carrying out these activities.
3. Value proposition budgeting:- In value proposition budgeting, the budgeter considers the following questions:
- Why is this amount included in the budget?
- Does the item create value for customers, staff, or other stakeholders?
- Does the value of the item outweigh its cost? If not, then is there another reason why the cost is justified?
Value proposition budgeting is really a mindset about making sure that everything that is included in the budget delivers value for the business. Value proposition budgeting aims to avoid unnecessary expenditures – although it is not as precisely aimed at that goal as our final budgeting option, zero-based budgeting.
4. Zero-based budgeting:- As one of the most commonly used budgeting methods, zero-based budgeting starts with the assumption that all department budgets are zero and must be rebuilt from scratch. Managers must be able to justify every single expense. No expenditures are automatically “okayed”. Zero-based budgeting is very tight, aiming to avoid any and all expenditures that are not considered absolutely essential to the company’s successful (profitable) operation. This kind of bottom-up budgeting can be a highly effective way to “shake things up”.
The zero-based approach is good to use when there is an urgent need for cost containment, for example, in a situation where a company is going through a financial restructuring or a major economic or market downturn that requires it to reduce the budget dramatically.
Zero-based budgeting is best suited for addressing discretionary costs rather than essential operating costs. However, it can be an extremely time-consuming approach, so many companies only use this approach occasionally.
Deficit financing:- Deficit Financing is defined as financing
the budgetary deficit through public loans and creation of new money. Deficit
financing in India means the expenditure which in excess of current revenue and
public borrowing.
Various indicators of deficit in the budget are
1.
Budget deficit = total expenditure – total
receipts
2.
Revenue deficit = revenue expenditure – revenue
receipts
= 1286109 – 935685
= 350424 Cr.Rs.
3 Fiscal Deficit = total expenditure – total
receipts except borrowings
= 1490925 - 977335
= 513590 cr.rs.
4 Primary Deficit = Fiscal deficit - interest
payments
= 513590 - 319759
= 193831 Cr.Rs.
Fiscal deficit in India
1974-75 23 billion
rupees
1990-91 425 billion rupees
2012-13 5135 billion rupees
2019- 20 9,33,51
billion rupees
Sources of deficit financing •
1.
By running down its accumulated cash reserve from RBI.
2.
Issue of new currency by government it self.
3.
Borrowing from reserve bank of India and RBI gives the loans
by printing more currency notes.
Objectives of deficit financing :
1. To
finance war
2. Remedy
for depression
3.
Economic development
4.
Mobilization of Resources
5. For
granting subsidies
6. Increase
in aggregate demand
7. For payment of interest
ADVERSE EFFECTS OF DEFICIT FINANCING:-
1. Leads
to inflation
2.
Adverse effect on saving
3.
Adverse effect on Investment
4. Inequality
5.
Problem of balance of payment
6.
Increase in the cost of production
7. Change
in the pattern of investment
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UNIT II
Public Expenditure: In order to carry on their functions, governments must obtain the services of labour and other factor units and (except in a completely socialist economy) acquire goods produced by private business firms. Public expenditure consists of expenditure by central government, state governments and local authorities (such as municipalities and public corporations), with central government accounting for the major portion of such expenditure. Thus, the state is required to maintain good roads, bridges, defense activities, canal's and harbor's, to protect trade, to maintain the coinage and to provide social security, education and religious instruction.
Public expenditure refers to the expenditure
incurred by the central government. There are different types of such
expenditure. The usual distinction is between consumption expenditure and
investment expenditure. Another distinction is between revenue expenditure and
capital expenditure.
The main items of government
spending are the following: Social services such as education, health and welfare and
social security; defense, that is the cost of maintaining the armed forces;
environmental services, that is, spending on roads, transport services, law and
order, housing and the art; national debt interest, that is, interest payments
on money borrowed by the government. At present, public expenditure is about
one-third of India’s national income.
Since national income is a fixed number, spending in one
direction can be achieved only at the expense of spending elsewhere. Thus, if
the government spends a larger part of the national income on defense, less
will remain with the people for their own personal consumption, thereby leading
to a reduction in their standard of living.
Principles of Public
Expenditure: Public expenditure is likely to
have beneficial effect on society, i.e., reduction of income inequality,
control of business cycles, achievement of full employment and so on.
It is guided by the following
five principles:
1. Economic Development: A developing
country like India must undertake various projects such as road and bridge
construction irrigation dam power plants and so on. These constitute
infrastructure of the economy or social overhead capital and are of vital
importance for accelerating the pace of economic development.
2. Fiscal Policy: Public expenditure is
justified on the ground that it creates jobs and incomes during depression and
unemployment. This is why Keynes advocated the policy of increasing public
expenditure for creating effective demand and thus helping the economy to face
the Son. Such variation in public expenditure is necessary to control business
cycles. In other words, variation of public expenditure is a part of the
anti-cyclical fiscal policy.
3. Maximum Social Advantage: One of the objectives of a
modem government is to achieve the social goal of income equality. For this, it
is necessary to reduce poverty and inequality. This is why the government
transfers income or purchasing power from one section of society to another
through various tax-subsidy measures.
The government collects revenue S by imposing taxes and
selling bonds. The money raised in the process is utilized to pay wages and
compensation of government employees and the suppliers of various materials to
government departments and public sector Undertakings.
4. Economy: It may also be noted, in this
context, that it is not just the amount of public expenditure that is incurred
which is of importance to toe economy. What is equally, if not more, important is
the purpose of such expenditure. The use or purpose of such expenditure
determines the adequacy and effectiveness of such expenditure. Excessive
expenditure may cause inflation.
5. Avoidance of Harmful Effect:
Finally, it
is of considerable importance to ensure that government expenditure does not
have any injurious effect on production and distribution. It is equally vital
to ensure that the government expenditure is solely in the public interest and
does not serve any private interest or that of any group of persons.
Wagner's View of increasing state activities :- Adolph Wagner, a German economist, conducted an in-depth study about rising government expenditures in the late 19thcentury. Based on his research, he proposed a law titled "The Law of Increasing State Activity".
According to Wagner's law, the government's activities and functions will increase as the economy develops over time.
According to Adolph Wagner, "Comprehensive comparisons of different countries & different times indicate that, among progressive peoples (societies), which encompass the only ones we are concerned with, there is a consistent increase in both the policy and the activity of the central government".
According to Wagner, the following points are indicated:
1. A progressive society is characterized by an increase in the activities of both the central and local government.
2. The government's activities have increased in both scope and intensity.
3. For the society's benefit, governments are taking on new responsibilities.
4. The old & new functions are performed more efficiently and completely than before.
5. The purpose of the government activities is to meet the economic needs of the people.
6. The Expansion & intensification of the government function & activities lead to increase in public expenditure.
7. Though the Wagner studied the economic growth of Germany, It applies to other countries too both developed & developing.
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