The objective of this study session is to expose you to the introductory concepts in Public Finance and thereby ensuring that you are acquainted with the three theories of Public Finance namely, The Classical, Keynesian and Modern theories. In addition, this session also explains the sources of government revenue, meaning, characteristics and elements of taxation as well as the subject matter of Public Finance (Public Revenue, Public Expenditure, Public Debt and Financial Administration).
Meaning of Public Finance
Public Finance is a term that derives from two words, ‘Public’ an adjective, of, for, or concerning the people (of a Community or Nation) and ‘Finance’, a verb connoting the money that has to be spent. Therefore Public Finance means finances of the people. Since the government is a constituted authority of the people we can see the term as implying the revenue and expenditure of the people. We can therefore formally define Public Finance as a branch of Economics that deals with revenue and expenditure activities of the government as well as the consequences of such revenue and expenditure actions of the state.
Theories of Public Finance
The Classical Theory Of Public Finance
By Classical Economics we mean the traditional Economic theory or the Orthodox principles of economic theory that has been handed down from generation to generation since the period of David Ricardo. These principles have been elaborated, refined and modified from time to time by succeeding economists. Nevertheless, these principles constitute, by themselves, a well-defined body of economic thought which is deeply rooted in free market ideology. This essentially limited the role of the government in the economy.
The Classical Theory and Employment “Say’s Law: The classical theory of employment assumes that there is always full employment of labour and other resources. It considers full employment to be the normal situation and any lapses from full employment are considered abnormal. If at any time there is no actual full employment, the classical theory asserts that there is always a tendency towards full employment. Hence the basic logic in the classical theory contends that a free play of economic forces brings about a fuller utilisation of human and natural resources in the economy. The above, therefore, carries an implication that an interference with a free play of all the market forces shall not bring about full employment. It becomes obvious that the classical system is based on non-operation of the economic forces. A further analysis of the above reveals that the classical system advocates government’s exclusion from the economic field if full employment is to be realised. The assumption of the classical economists that there is always full employment is buttressed by the Say’s Law of Markets. One may in fact say that the entire classical economic theories are constructed around the “Say’s Law of Markets”. According to Say’s Law, general over production and general employment are logical impossibilities. This is based on the statement of the law that: “Supply creates its own demand”. In Say’s own words: “It is production which creates market for goods” According to Say, the main source of demand is the flow of factor incomes generated from the main source itself.
Whenever any new production process is initiated and a certain output results, the demand for that output is also simultaneously generated on account of the employment or remuneration to the factors of production. In other words, any output brought into existence, injects an equivalent amount of purchasing power in circulation which ultimately leads to its sale – so that there is no surplus output or overproduction. Say, however admits that there might be temporary over supply on account of incorrect calculations by a particular entrepreneur. The implication of the Say’s law therefore is that there is automatic adjustment of every element with the working of the economy, i.e., if supply increases, demand must increase as well. It must be noted from the above analysis that the state, according to the classical and their laissez faire philosophy, was considered as something extraneous to the economy, which was believed to be more or less the private sector economy only. It was considered best that the public sector should only help and supplement the private sector and should never supplant it. Accordingly, the states were to be tolerated as a necessary evil and were to be kept to the minimum possible scale. It was in the light of the above that J.B. Say advocates that:
“The encouragement of mere consumption is no benefit to commerce, for the difficulty lies in supplying the means, not in stimulating the desire from consumption, and we have seen production alone furnishes that means. It is the aim of good government to stimulate production, of bad government to encourage consumption”.
The contribution of Classical Theory to Public Finance: The following conclusions are drawn from the classical theory with respect to Public Finance. The state should not increase the level of economic activity within the country.
This is based on the assumption that the private sector ensures full employment. Hence, the state is incapable of increasing if the state raises its expenditure by taxations, it would be merely a substitution for expenditure by private sector. It would not increase the total demand for employment factors if the state raises its expenditure through borrowing, it would be competing with private individuals and this will lead to rise in prices and inflation. Since taxes will always have one effect or the other on private savings, a reduction in private savings may result to low level of private investment. Hence taxes have adverse effect on the accumulation of capital. Here, the classical theorists believe that the best budget is a small budget and that the budget should be balanced. Taxes that are injurious to community are those taxes that impinge most heavily on savings, i.e., direct taxes. Hence the theory favoures indirect taxes. If deficit cannot be avoided, the government should increase same by long term bonds which are not inflationary. Such bonds are simply substituted for private sector bonds or shares. The deficit should not be financed by issuing paper money or short term borrowing. The government must borrow for the purpose of productive investment. From the above we therefore can conclude that the role which the classical theorists assigned to Public Finance is limited.
Keynesian Theory and Public Finance
The classical economic theory had no explanation for the Great Depression of 1930s. This was basically for the reason that the automatic adjustment of the markets which formed the basis of the classical theory could not hold during the depression. Hence, there was overproduction and general unemployment. The main flaw of the classical theory according to Keynes was the assumption of self-regulating credit. That is, the supply and demand of loanable funds were determined by interest rate alone.
According to Keynes, whereas the rate of interest influences both savings and investment, there are other factors which would stop interest rate from achieving equality between savings and investment. Expectations of profit are the primary determinant of investment. Given the above, Keynes suggests that there is the possibility of savings being greater than investment at full employment level. Therefore, severe unemployment and overproduction are logical possibilities in a capitalist economy.
The existence of trade unions and legislations make wage rates downwardly inflexible. Price, therefore, may not be downwardly flexible as well. Consequently, the automatic adjustment of the classical economists may not work. Keynes focuses attention on the determinants of believing that a solution that question will resolve the issue of possible determinants of unemployment. The level of employment is directly related to the level of production. In a modern capitalistic economy the level of business production will be determined by the amount of planned spending to purchase business products or aggregate demand. Therefore, business will adjust their production to accommodate demand for their products. The above means that: “Supply adjust to demand” This by implication means that the level of employment depends on planned spending or aggregate demand. Private spending (C) and business spending (1) may not be adequate to allow an economy operate at full employment level. Hence, the need for the government to increase its expenditure in order to augment the private and business spending.
The Keynesian theory
The General Theory of Employment is based on a simplistic proposition that “one man’s expenditure is another man’s income”. If the whole income is spent, it results in a corresponding income of someone else. And if everyone else is also spending the whole of his income, the circuit of incomes and expenditures remains constant. But if part of the income received by an individual is not spent and if this deficiency of expenditure is not made up by way of investment expenditure, the reduced. expenditure of one will lead to a fall in the income of others. With a lower income, he will be able to spend less and the income of all others will also, thereby be reduced. This will lead to unemployment or to employment at lower level of real income, i.e., a fall in national income. Based on the above, Keynes contends that:
• Attempts to save leads to unemployment and a fall in national income.
• A reduction in the money wage rate will result to a reduction in the demand for commodities.
• Some distortions exist in the economy which can only be removed through fiscal measures
Effect of Keynesian Theory on Public Finance
A comprehensive analysis of the Keynesian theory reveals a special role of the government in macro-economic management. Some of them are highlighted below;
The notion, that a balanced budget is desirable in all circumstances, falls to the ground as soon as we abandon the classical assumption of automatic full employment.
The budget today now plays crucial roles in:
• Securing full employment
• Achieving high level of investment
• Achieving price stability (stability in general price level)
• Providing a more equitable distribution of income
While budget surplus is preferred during inflation and budget deficit is recommended in deflation, for a zero inflation in an economy, the total value of new savings (public and private) must be equal to the total of the new investment.
W S < I = inflation, and If S > I, we have deflation.
As employment and income increases, investment is normally supposed to rise to absorb the new savings. But with the lower propensity to consume of the relatively richer sections of the society, it becomes apparent that consumption does not increase at the same rate with income. Some distortions exist in the economy which can only be removed through fiscal measures.
The above implies that while savings are increased, effective demand is decreased. The reduction in effective demand results in unemployment. It is here that the importance of Public Finance in Keynesian Economics lies. The state should increase the aggregate demand in the economy by stimulating its own expenditure. The state can do so by borrowing from the public – as this may represent that proportion of income which they could not consume but saved. The government can also increase its expenditure by “creating more money to make good of leakages in the form of saving by individuals which may have lowered private investment. This would imply deficit financing which the classical theorists frown at.
The Keynesian theory explicitly and implicitly favoures equitable distribution of income through taxation. This is clear from its recommendation of direct taxation as against indirect one – which is more progressive than regressive.
Under the assumptions of the classical economists, National Debt constituted a Dead Weight not in the sense of mortgage but in the sense of wasted opportunity and creation of avoidable burden. On the other hand, Keynesian economists recognise public debt as an instalment of growth and stability. This stems from its role as the prime mechanic of deficit financing.
Thus, the old precepts vanished, and economists began to visualise Public Finance (and more specifically, fiscal policy) as means for promoting economic growth and stability in the economy. Hence, Public Finance becoming “Functional finance” signifying a study of the fiscal functions of the government that could eliminate unwanted distortions and fluctuations in the economy.