CHAPTER ONE

BASICS OF PUBLIC FINANCE

Unit description
This chapter deals with the definition of public finance, roles of government in economic activities, scope of
public finance and fiscal federalism. To deliver these contents, active learning methods such as brainstorming,
interactive lecture, group discussion, and independent learning will be used. And also to assess students’
achievement, continuous assessments such as quiz, test, class activities, assignments and others will be used.
Objective: At the end of this unit students will be able to:
 Define public finance
 Explain the role of government in economic activities
 Identify the scope of public finance
 Explain fiscal federalism
1.1 Definition of public finance
Public finance is a compound term of the words “public” and “finance”.
The word ‘public’ stands for a collection or conglomeration of individuals, i.e., people taken as a whole. It
still stands for all the citizens of a state which may consist of a number of people and
The word finance refers to money matters (revenue, expenditure, debt, receipt, payment and e.t.c.) and
their management. Then what is public finance?
Public finance is a subject which discusses the financial operation of fiscal or public treasury. Or
Deals with optimal mobilization and utilization of financial resources by the government to the citizen
benefits.
Different economists have defined public finance as follows:
1) “Public finance is concerned with the income and expenditure of public authorities and with the adjustment
of one to the other.” Huge Dalton
2) “Public finance deals with the provision custody and disbursement of resources needed for conduct of
public or government functions.” Lutz
3) “Public finance is a science which deals with the activity of the statement in obtaining and applying the
material means necessary for fulfilling the proper functions of the state.” CarlPlehn
4) “Public finance is the study of the principles underlying the spending and raising of funds of public
authorities.” Findley Shirras
5) “The government, considered as a unit, may be defined as the subject of study of public finance. More
specifically, public finance studies the economic activity of government as a unit.” Buchanan
6) “Public finance deals with expenditure and income of public authorities of the state and their mutual
relations as also with the financial administration and control.” Bastable
All of them say that it is a study of income and expenditure of the central, state, and local governments.
Government performs many functions which the individual cannot or do not perform. Therefore, rising
of funds for the expenditure and their disbursement constitutes the subject of Public finance.
Private goods: refers to all those goods and services which are consumed by people to satisfy their
personal/private/individual wants.
They are not equally available to all members of the society.
Characteristics of private goods
 Excludability: can be obtained or consumed by only those who are both willing and able to pay their
market price.
 Rivalry in consumption: implies that one person’s consumption of such good reduces the availability or
use of the good to others.
 Financing by market mechanism: the distribution of private goods is based on market mechanism i.e.
based on dd and ss (market price).
 Ownership by resource provider: the resource provider/owner has exclusive right to use the good or
prevent others to use the goods.

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 Proportionate benefit for resource provider : there is quid pro quo (direct and equivalent benefit in return)
relationships b/n the resource provider and the resource.
Public goods: are goods and services w/c are produced to satisfy collective wants (w/c are demanded by all
members of the society) and w/c are used collectively (jointly) by the community.
 Goods freely available to all rather than being sold in the markets.
 Equally available to all members of the society irrespective of their ability or willingness to pay for it. For example:
Defense, law and order, free education, free health care, street lighting…..
Characteristics of public goods:
 Non-excludability: it’s too costly to exclude those who refuses to pay for defense from enjoying the benefits of a
given amount of defense service, once it has been supplied for the benefit of other people.
 Non-rivalry: consumption by one person does not alter/reduce its availability for another person.
 Financing by compulsion: unlike private goods, there is no way to charge for the usage of it. So the gov’t needs
finance to supply such a good. The gov’t has to finance it through compulsory contributions (tax) by the
members of the society.
 No ownership by resource providers: the people are the resource provider but they can’t claim the ownership of
public goods to him. i.e he can’t exclusively use or prevent the non-tax payers from receiving the benefits of such
public goods.
 No proportional benefit from the resource provider : no quid pro quo exists (there is no direct and equivalent r/n
s/p b/n the amount of taxes paid and the consumption of public goods)
 No expected return by the supplier: the gov’t doesn’t expects return in benefit from the supply of public goods
except social welfare and economic development.
1.2 Roles of government in economic activities
Government has a major responsibility in
 Economic well-being
 Assuring peace and stability
 Plays significant role in market failure area of the economy.
In doing these the role of the government has three folds
 Efficient allocation of resources
 Distribution of income
 Macroeconomic stabilization
 The existence of :
 Market failure due to exercise of monopoly power in market
 Failure to internalize externality
 Failure to provide or insufficient provision of public goods
 Incomplete information... etc forces contemporary writers to admit the role of government is not a
luxury but a vital necessity and government should do in:-
 Establishing a foundation of law
 Maintaining a non-distortionary policy environment
 Investing in a basic social services and infrastructure
 Protecting the vulnerable, and
 Protecting the environment
Governments of a state generally undertakes the following functions:
 Allocation function: the gov’t taxes the public and uses the amount in providing certain facilities and
services considered essential by the people and the community. Proper allocation of resources between
private and public goods so as to maximize social welfare.
 Distribution function: reduce the incomes and wealth of the rich (Via taxation) and using the money
collected to raise the income and standard of living of the lower income group (Via public expenditure).
o Reducing inequality of incomes and wealth
 Stabilization function: modern economies are subject to fluctuations, viz., business boom and
inflations on one side and business recessions and depressions on the other. Governments are
responsible to moderate, if possible, to eliminate these fluctuations.
 Functions of modern governments are broadening due to socio-political reasons.
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  Therefore, to discharge these increasing functions, the government has to increase its expenditure.
 To meet out the enormous amount of expenditure it has to get funds/revenue from the public.
The similarity and dissimilarity b/n public finance and private finance
 Distinguish between public finance and private finance.
 Public finance deals with study of income, Expenditure, borrowing and financial administration of the
government.
 Private finance is the study of income, expenditure, borrowing and financial administration of individual or
private companies.
 Both public and private finance are fundamentally similar in nature but different from each other on various
operational aspects .
The Similarities and Dissimilarities Between Public Finance and Private Finance.
SIMILARITIES:
1. Objective:- Satisfaction of human wants is the main objective of both public and private finance. The
main aim of public finance is to satisfy social wants and that of private finance to satisfy individual
wants.
2. Principles:- The principle of maximum social benefits is the guiding principle followed by the
government while spending its income. Individuals also follow the principle of maximum satisfaction
when spending out his given income.
3. Income, Expenditure and borrowing:- The resources or the income for both government and the
individuals are limited .In case of shortage, borrowing can be done for both and both are under obligation
to repay the borrowed money.
4. Policies:- Both the private and public finances adopt policies for maximizing welfare. In Private finances
as well as in public finance only sound policies will enable maximization of welfare and benefits.
5. Administration:- The effectiveness and success of measures adopted by private and public sector
depends on the administrative machinery.If the administrative machinery is inefficient and corrupt it will
lead to losses and wastages.
The Similarities and Dissimilarities Between Public Finance and Private Finance
Dissimilarities: (Distinction between public and private finance)
1. Magnitude :
 The most significant difference between the two types of finances is in terms of size and magnitude.
Households and businesses have relatively smaller amount of resources available to them and hence
their budgets are smaller in size as compared to those of governments.
2. Public Scrutiny:(critical observation)
• Personal budgets of households are a private affair and not made public.
• In case of business finance, the budget is made known to the stakeholders and General public for
information and scrutiny.
• In case of public finance, every budgetary decision has to be made known to the people of the nation.
3. Source of revenue:
 Private economic units earn their income by using assets owned by them.
 Their sources of income are salaries, wages,interest, rent and profits, which arise out of transactions.
 In case of governments, the source ofincome are taxes and non-tax revenues.
 In case of taxes, fees, fines, fines there in an element of compulsion/force
4. Sources of borrowing:
• Private economic units may borrow from informal sources like friends, relatives, moneylenders as well
as fromformal sources like banks and financial institution.
• Public bodies can borrow almost on a continuous basis from internal and external sources. They can
borrow from the people, the central bank, Commercial banks and other financial institutions as well
from external sources.
6. Motive:

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  In case of public finance, the decisions are reached through political and administrative procedure and
based on common social objectives.
 Private finances is governed by profit motive businesses or satisfaction ofwants of individuals and
households.
 Both private and public financial activities try to balance between the immediate objectives and future
goals. But private economic units, especially households, are primarily focused on fulfillment of present
and immediate wants. In case of public authorities, the focus is on both present and future.
7. Income Expenditure adjustment:
 Generally, while a private economic unit adjust its expenditure to income, public
bodies adjust expenditure.
 Private finance will try and adjust expenditure according to income and in order to do so may even
forego fulfillment of certain wants. On the other hand, Government are guided by welfare and growth
consideration for which expenditure have to be predetermined. Since they have the power to raise fund
through taxation, borrowing, deficit financing, they try to adjust their revenues to the predetermined
expenditure requirements.
8. Assessment of outcomes:
 It is much easier to measure and evaluate the outcome of private financial activities than the outcome
of public financial activities.
 In case of private economic units, the outcome may be measured by profits of business, fulfillments of
wants of households.
 In case ofpublic finance, the outcome has to measured and evaluated in terms of multiple
parameters.These are social welfare, economic growth, security, Productivity andefficiency.
9. Nature of the budget:
 Private economic units aim at surplus budget.
 Having a surplus is considered economically prudent. This is not the case with government budgets. In
countries that need to grow and develop rapidly, deficit budgets need to be followed. A long term
surplus budget indicates that the government may not be fulfilling some of its obligation.
In your personal logic, what should be the role of government in economic activities?

1.3 Scope of Public Finance

The contents of the science of public finance are divided into five categories of financial activities of the
government:They are,
1.3.1 Public Revenues
 Revenue includes all incomes irrespective of the source they are obtained from.
 Thus, in wider sense we can include:
 Taxes, non tax revenues as well as borrowing under public revenue.
But in the interest of clarity we study such incomes separately.
Hence, in public revenue, we include only those incomes which do not carry with them the obligation of
repayment for the state.
Thus, public revenue implies raising income by way of taxation. (We will discuss more about it on the
following chapters)
Explain Public revenues and show the main sources of Public revenues?

1.3.2 Public Expenditure

It is the allocating and using of resources responsively, efficiently and effectively. It includes all outlays of
the government made to keep the society welfare.
Public expenditures are made in those areas, which cannot be commercially available in the market by the
private sectors but are deemed very crucial to the well being of the society.

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 In a free market economy government expenditure focuses on those sectors, which are not profitable to
undertaken by the private sector.
Different economists and public finance experts have used different bases to classify public expenditure.
But most governments classify public expenditure in to two
1. Current expenditures, (recurrent expenditure): - non development expenditures. They are intended for
continuing the existing flow of goods and services and maintain the capital of the country intact. It is all
sorts of administrative and defense and debt services expenditure.
 It is relate to those routine governmental expenditure which do not create any addition to capital assets
rather they are intended for continuing the existing flow of goods and services and maintaining the
capital of the country intact.
 It is a recurring spending on items that are consumed in the process of providing goods and services.
Example: Defense, administrative, education, medical, pension/old-age security payments, unemployment
relief payments, debt service/interest payments.
2. Capital expenditure:-contribute to increased productive capacity of the nation & therefore known as
developmental expenditure.
A. It is relate to non-routine governmental expenditure that result in creation of physical or capital assets or
that increases the production capacity of the nation.
B. Includes:
i. Construction, enhancement or replacement of roads, buildings, bridges and other structures and their
associated consultancy services.
ii. Exp for acquisition, installation and replacement of movable plants such as machinery and apparatus,
vehicles, furniture,…
iii. Exp for the acquisition of shares or debt securities.
iv. Advances, loans, grants, transfer payments related to projects and programs, debt repayments, e.t.c.
E.g. Expenditures on construction of dams, roads, public works, state enterprise, agriculture and industrial
development …etc. Recurrent expenditure is usually financed by tax & non tax revenues whereas; capital
expenditures, b/c of their huge financial requirements, are financed mostly by external loans or assistances.
Reasons for Growth of Expenditures
 Welfare state  Urbanization effect
 Defense  Growth of democracy
 Population growth  Raising trend of prices
 Transportation & communication  The rural development effect
Canons of Public Expenditures
 A canon of public expenditures refers to the fundamental rules and philosophies which govern in the
expenditure policy of the government, i.e., the size, method and direction in which the public expenditure is
executed.Some of these canons are in the nature of administrative safeguards while others are expected to
help the economy and society in achieving their adverse objectives.These are;
a) Canons of benefit (principle of maximum social advantage): states that public expenditure should be
incurred on various items in order to benefit the society as a whole than on an individual, particular group
or section.
b) Canon of economy: It implies that public expenditure should be incurred carefully and economically.
 No wastage of these limited resources(revenue) is permitted.
 The government should spend only the minimum of very essential items on any given head of
expenditure.
c) Canons of sanction: This cannon suggests that no public spending should be made without the approval
of proper authority and those funds must be used only for the purposes for which they have been
sanctioned.
 It must be properly inspected and examined whether the sanctioned amount of money is being spent
properly on sanctioned items or not. Sanction - no public spending should be made without the
approval of proper authority.
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 d) Canon of surplus: states that public authorities should aim at surplus of revenues over expenditure and
they should avoid deficits so that an ideal government budget is the one which contains an element of
surplus by keeping public expenditure below public revenue.It isthe government should avoid deficits
 Frequent and huge deficits lead to uncontrollable financial situation with dire consequences of
inflation.
 NB: though this canon is sound, it has no longer favored by the economist.
e) Canons of elasticity: states that government expenditure policy should change according to the needs and
requirements of the economy.
 Elasticity is changes must be possible in the expenditure according to the requirements &
circumstances.
 It should be quit flexible so that it can be increased during depression and reduced during inflation.
f) Canon of productivity: states that public expenditure policy should be such that it would encourage
production and production efficiency (productivity) in the country.
 Productivity is expenditure should encourage production of the country.
 Thus, a larger part of public expenditure should be allocated for development process such as, for
infrastructure facilities (road, bridges, railways, transport, communication, power, e.t.c….. )
g) Canon of equity: states that PE should be in such away that it helps reducing the inequalities of income
and wealth among the society.
 Hence, the pattern of PE should be such that the poor and weaker sections of the community should
receive maximum benefit in the form of increased PE incurred on providing free education, free
health facilities in less developed regions/areas, subsidized low-cost housing to the poor, old age
pension, e.t.c. NB: Canon of benefit deserves serious consideration.
Effects of Public Expenditure
Public expenditure, in modern government finance, is regarded as a means of securing social ends rather
than just being a mere financial mechanism.
Public expenditure is significant in a modern economy because it produces many direct and indirect socio-
economic effects.
1) Effects of Public Expenditure on Production
a) Effects upon Ability and Willingness to Work, Save and Invest
 Public expenditure can influence the ability and willingness to work, save and invest.
 This is because a sufficient amount of public expenditure will ensure the production activities.
 For instance, government’s public expenditure on developing basic infrastructural facilities will create
the ability and willingness to work.
 This means that, public expenditure can create employment opportunities.
 Therefore, income of the people will increase. It will gradually create a tendency among people to save.
This saving will convert in to investment. That means more growth of the economy.
b) Effects on diversion of resources
 Similarly public expenditure can able to control the resources in to various uses and locations.
 By understanding the requirements of the economy, government can take reasonable policies to improve
backward locations and efficient utilization of the resources.
 Sometimes government starts industrial activities, projects, schemes etc. which will directly generate
employment opportunities, more income, effective demand, and mass production and so on, finally
economic growth and development.
2) Effects of Public Expenditure on Distribution
Public expenditure may be in any of the following three modes based on the ability to receive.
a) Progressive public expenditure: is very essential for any economy to bring economic equality. It aims
more flow of income to the poor class like providing subsidies, social insurance, special schemes etc.

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 b) Regressive public expenditure: It is not good for any economy to bring economic equality. Here the
flow of income is concentrated to the richer class. This will widen the gulf between two classes and by
inequality in the society.
c) Proportional public expenditure: Here the flow of income is based on the proportion of income or
wealth held by the people. This method never helps to bring any improvements in the society.
3) Effects of Public Expenditure on Economic Stability
Attaining economic growth and development and maintaining its stability are the two main aims of any
economy.
Economic stability can be achieved only by eliminating the barriers of growth.
Public expenditure has a big deal in bringing economic stability.
Simply, economic stability is a condition of an economy where there is no
o Inflation o Unemployment
o Deflation o Flexible exchange rate etc.
To cure inflation government must follow surplus budget policy by reducing its public expenditure.
On the contrary, government must follow deficit budget policy during deflation by expanding public
expenditure.
This is simply because public expenditure can simply adjust the volume of money in the economy.
4) Effects of Public Expenditure on Economic Development
 Public expenditure is one of the crucial tools of determining the speed of economic growth and
development.
 By trying to achieve economic growth and development, public expenditure creates wide effects on the
improvements in:
o Infrastructural facilities o Safety
o Increasing of social overheads o Security
o Maximum social advantage o Reducing inequalities and
o Welfare o Improvements in the standard of
living etc
1.3.3 Public Debt
It refers to the money a government borrows from various parties such as from individuals, institutions,
foreign governments and international financial lending institutions which is subject to repayment at some
future date (maturity) including its interest.
It is also refers to the cash inflows of a government in the form of borrowing.
Nature of Public Debt
Public debt can be comparable with that of private debt and tax-revenue in terms of various parameters from
different angels
Public Debt vs. Private Debt
The following are the glaring dissimilarities between public and private debt.
 Source  Durability
 Purpose  Interest rate
 Mode of payment  Compulsion
 Effect on the economy
Public debt vs. tax (public revenue)
Both significantly differ from each other in the following ways.
 Compulsion  Commitment
 Maturity  Burden
Reasons/Need for public debt/borrowings
 Deficit budget  Economic development
 Sudden increase in government expenditure  Economic stability
Classification of public debt
We can classify public debt on different basis of classification.
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 Basis of classification Classified as
Origin/Source  Internal/domestic debt
 External debt/loan
Redemption  Redeemable/terminable debt
 Irredeemable/non-terminable/perpetuity debt
Purpose  Productive/reproductive debt
 Unproductive/dead weight debt
Compulsion  Voluntary debt
 Compulsory/forced debt
Time To Maturity  Funded/long-term debt
 Unfunded/floating/short-term debt
Transferability  Marketable debt
 Non-marketable debt
Interest Payment  Interest bearing debt
 Interest-free/non-interest bearing debt
Identify differences among public debt, private debt and tax?
Identify the various parameters to classify public debt? And explain them?
Sources of
public debt
The following are the main sources of public borrowings:
 Individuals and individual firms  Central/national bank of the country
 Non-banking financial institutions  Foreign governments/foreign countries
 Commercial banks  International financial lending institutions
Limit of raising public debt
In order to borrow, government should consider the following elements before accepting a debt
 Legal restrictions on public borrowing.  National income, growth & credit structure.
 Higher interest cost.  Effect on investment, economic stability &
balance of payment.
Q: What are the various sources of public debt?
Effect of
public debt
Transferences of money from one set of people to the other through public debt affect

 Consumption  Income distribution
 Production  Price level
How does public debt affect consumption, production, income distribution and price level?
Debt burden & future generation
It is sometimes claimed that debt financing of current expenditures leads to a burden upon future generation of
the society. However, debt financing for capital goods does not bring a burden for future generation. The future
generation will suffer if the present generation reduces its saving i.e. consume more, to meet the debt finance. It
is to be known that debt is paid in the future by tax the future generation. Thus public debt will put a burden on
future generation if;
 The current generation reduces its saving to service the debt finance.
 the government doesn’t add to the capital stock & productive capacity of the country
The burden of public debt may be

 Direct Money Burden  Direct Real Burden
 Indirect Money Burden  Indirect Real Burden.
Both internal and external sources of public debt impose the above burden on the society.
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According to Ethiopia role (proclamation no 57/1996 and regulation 17/1997), public debt could take different
forms. The debt could be internal one, which is secured from persons that are subjected to the borrower’s
governments. It could also be an external one where the loan is secured from foreign persons. In Ethiopia the
regional governments could borrow from the federal government. This form of borrowing is called internal
borrowing to adjust financial imbalances.
Redemption/retirement of public debt
There are four methods to retire (redeem) public debt by the government.
A. Out-of-pocket method C. Serial bonds redemption method
B. Sinking fund method D. Debt conversion method
1.3.4 Public administration
• “Administration is determined action taken in pursuit of a conscious purpose.
• It is the systematic ordering of affairs and the calculated use of resources aimed at making those happen
which one wants to happen.”
• Organizing and maintaining human and fiscal resources to attain a group’s goals.”

What is Public Administration?

‘Public administration’ is like any other administration which is carried out in public interest.

1.3.4.1.
1.3.4.1.
1.3.4.1.
Financial administration & control
The scope of public finance is not confined only to public revenue, public expenditure and public debt.
We have to examine the mechanism by which the above processes are carried on.
Without a study of relevant dimensions of financial administration the subject of public finance remains
incomplete.
Thus financial administration and control include the following:
a) Study of budgets and their procedure.
b) Budget as a instrument of securing certain objectives, such as promotion of employment, economic growth
with stability, welfare of the weaker sections, infrastructural development for promoting private
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 investments, etc.
c) Financial and physical controls through different fiscal tools for controlling private expenditure in the
economy to avoid the effects inflation deflation, recession etc.
1.3.5 Economic Stability and Growth
The study of public finance includes fiscal policy of the government in dealing with inflationary and
deflationary situations, instability of the price level, promotion of full employment, growth of economy,
welfare of the people, etc.
Economic stabilization is of recent origin.
It has a wide scope to play especially in the less developed countries. The main task of this section is to
frame and look after the implementation of various policies required for economic stabilization and growth.
1.4 Fiscal federalism
Fiscal federalism is the division of governmental functions and financial relations between different levels
of government in a non-unitary government, where the levels may include national, province/state, and local
government.
1.4.1 Meaning of federalism
There are three ways of organizing government structures and the flow of power
 Unitary system  Federal system
 Co federal system
1.4.2 Characteristics of federalism
 At least two set of government  Freedom of interstate movement
 Supremacy of constituting  Equality of citizen
 Independence of judiciary
1.4.3 Meaning of federal finance
It refers to the system of allocating the source of revenue to the central and state governments for the efficient
discharge of their respective functions. Thus, the federal finance system of a country should identify the finance
sources exclusively reserved for the central government; the finance resources exclusive reserved for the state
government; and the finance sources concurrently reserved for both the central and state government.
1.4.4 Principles of federal finance

 Independence/autonomy principle  Principle of integration and coordination

 Equity/fairness principles  Administrative efficiency principle
 Uniformity principles  Administrative economy principle
 Adequacy and elasticity principle  Accountability principles
 Fiscal access principles
Peer group discussion questions
 What does government mean?
 What could happen in a country without a government?
 Why do we demand government services?
 List four government services and the benefits they provide to you and your family. Try to put a monetary
value on the benefits by thinking about what you would be willing to give-up to receive them if they were
not available.
 Make a rough estimate of how much you & your family pay in taxes each year. Compare this estimate with
the value of services received from the government. Do you think government provides you with benefits
that are worth what you give up in taxes?
 How much should governments do, and how much should left to private enterprise?
 Explain the socio-economic effects of public expenditure?

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