Showing posts with label Public Expenditure. Show all posts
Showing posts with label Public Expenditure. Show all posts

Fiscal Policy: Role and Evolution of Fiscal Policy

Fiscal Policy: Concept

Governmental financial policies and operations, concerning the raising and disbursement of funds, influence the economic behaviors and activities, and so the national income, employment, income distribution, price situation, international trade, etc. This realization has led to make deliberate adjustments in governmental income and expenditure policies and programs to attain the economic objectives. Such an adjustments is called the fiscal policy. So fiscal policy is concerned with the adjustments in the operation of the treasury to solve and attain economic problems and objectives.

Arthur Smithies defines fiscal policy as, "a policy under which the government uses its expenditure and revenue programs to produce desirable effects and avoid undesirable effects on the national income, production and employment."
According to Due and Friedlander, “By fiscal policy we refer to the governmental determination of the level and structure of taxes and expenditures, and the manner of financing a budgetary surplus or deficit to achieve the various macro-economic goals of full employment, price stability, growth, balance of payments equilibrium, and so forth.”
Ursula Hicks defines, “Fiscal policy is concerned with the manner in which all the different elements of public finance may collectively geared up to forward the aims of the economic policy.”
J. M. Keynes defines, “Fiscal policy is a policy that uses public finance as a balancing factor in the development of the economy.”

Evolution of Fiscal Policy


Since late 18th. Century until 1930’s, the ‘Laissez-faire’ policy guided public finance to make least possible interference on the functioning of free market mechanism. Then the ideals of sound public financial policy were:
  1. reduction of public expenditure to the minimum possible limit;
  2. tax structure be designed in such a way so that the market or price mechanism be disturbed to a little extent as far as possible; and
  3. budget to be annually balanced.
The traditional belief did not recognize the possible effects of taxes and expenditure upon the level of national income and employment. Taxes were considered only a means to finance government expenditure, and not a means to regulate the economy. Similarly, borrowings to finance government expenditures in maintaining economic stability were not realized.

The Great Depression of 1930’s was a milestone in the evolution of fiscal policy with the operation public financial operation in influencing the economic activities. At that time, governments were to provide relief to the unemployed people and to revive the economy from depression by increasing the effective demand. J.M. Keynes advocated the use of public financial operation in this regard.

In 1940’s. the followers of Keynes like Lerner, Hansen, Dalton, and Beveridge added new dimension to fiscal policy to control inflation as well. Then the flexible or managed budgetary policy was realized and practiced as needed by the economic situation.

After the Second World War the importance of fiscal policy was further recognized in the developing countries. The urge for fast economic growth led to adopt planning in most of the developing countries. This led to the need for increasing governmental investments and regulate the private sectors’ investment activities in consistent with the plan objectives. In the late 1960’s, the significance of fiscal policy to promote distributive justice was realized. And in the 1970’s, the need for maintaining ecological balance (environmental protection) also became the part of fiscal policy.

Role of Fiscal Policy


1. Fiscal Policy and Economic Growth

In a simple way economic growth can be understood as the increase in the level of national production, and thus the national income. It is measured as the increase in Real GDP/GNP or Real Per Capita Income. Economic growth has a process. For growth the productive capacity of the economy should be increased, which is possible with the increase in capital formation. Capital formation needs increase in national investments. To increase national investments there is necessity to mobilize domestic savings by both the private and government sectors. Besides, attraction of foreign capital also helps in this concern.

Growth (G) = Investment Ratio (I) / Incremental Capital Output Ratio (ICOR)

So, economic growth depends on the size of the national investments and the size of the incremental capital output ratio. In the underdeveloped countries the necessary amount of savings and investments can not be generated only by the market system. And the government is to play the leading role with functioning as an investor, facilitator and regulator of the economy by using necessary fiscal policy.

Increase in national savings includes both the private savings and government savings (in the form of revenue surplus). Private savings can be increased and mobilized with establishment and expansion of the financial institutions of different nature supporting through expenditure (including subsidies), and tax incentives as tax-holidays, concessions, depreciation allowances, carry-over losses, expansion of business activities, etc. for the private sector.

National savings can also be increased with the imposition of taxes generating maximum potential revenue and minimizing the recurrent expenditure of government with substantial amount of revenue-surplus, borrowings and creation of extra money. Resource gap in development finance can be supplemented by receiving foreign aids as well as attracting private foreign investments. 

The public income from different sources may be used as expenditures on production activities by government itself, creation of physical infrastructures, research activities, promotional activities to increase the productive capacity of the economy. These investments also attract private investments.

2. Fiscal policy and Distributive Justice

In the underdeveloped countries there is wide inequality in the distribution of national income. One of the basic objectives of a welfare state is to minimize the inequality in national income distribution. For this, people in the lower income strata and underprivileged should be enabled to earn more. Fiscal policy can help in this concern.

Higher income in the UDCs largely goes on luxurious consumption and unproductive investments. Progressive taxes on higher income and wealth, luxurious consumption and unproductive investments generate substantial revenue for the government. At the same time, low rate of taxes or exemptions on production and consumption of mass consumption goods, if necessary even on imports and subsidy increases income of the low income people in an indirect way with reduction or control of prices.

Public expenditure on socio-economic upliftment of the poor people with the provision of free or subsidized education and training, health, safe drinking water and sanitation, housing, subsidy on financial support and special development programs help in enabling their earning capacity.

Similarly, priority for labor intensive technology helps to increase employment opportunities. Public expenditure on different developmental activities using labor intensive technology is desirable. Along with this, tax incentives for private sector absorbing more labor also help in this regard.

Public expenditure on social welfare activities like old-age pension and other allowances, operation of charitable institutions also promotes distributive justice. 

Minimization of regional disparities and rural-urban disparities through the creation of socio-economic infrastructures, fiscal incentives, subsidy and special development programs help in attracting economic ventures, creation of employment opportunities and utilization of local resources, and promote economic status of the relatively less developed regions.

3. Fiscal policy and Balanced Development

Development in totality refers to simultaneously development of all sectors (at least the major sectors) of the economy. It needs balanced development of the all sectors. There is interdependent relationship among the different sectors in the economy, which is indicated by the Input-Output Analysis. The output of a sector is used as inputs by different sectors, and for the output of a sector it needs the output of other sectors or industry as inputs.

So with the information about the inter-industrial or sectoral relationship from the Input-Output analysis, fiscal policy can help in maintaining balanced development of the economy. For this, fiscal policy in the form of tax incentives like holidays, concessions, depreciation allowances for both the input supplying and absorbing sectors or industries is desirable. Similarly, public expenditure on creation of infrastructures and provision of subsidy also help in this concern. 

The next aspect of balanced development is the proportional development of different regions or areas of the country to minimize the disparities in economic prosperity. Fiscal policy, in consistent with the regional planning strategy, can help in this concern. Discriminator tax-policies favoring or providing incentives to the investors in relatively less developed areas along with public expenditure on creation of infrastructures and provision of subsidy may attract and promote economic activities in such regions. This will lead to prosperity of the less developed areas, and will promote the proportional balanced development of all regions of the country.

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Public Debt: Concept and Need for Public Debt

Public Debt: Concept

The practice of raising public debt by the state to finance government expenditure started only since 19th. Century. But the royalties used to borrow on their personal goodwill even since ancient times. These days government borrowing has been almost a normal method of financing government expenditure.

J.L.Hansen, “Public debt is the debt owned by a government to people and institutions within its own borders and/or to foreign creditors.”
Philip E. Taylor, "Government debt arises out of borrowing by the treasury from banks, business organizations and individuals. The debt is in the form of promises by the treasury to pay back the holders of these promises a principal sum and interest on the principal."

Public debt is raised internally by floating the securities like bonds and treasury bills, and overdrafts from the central bank. Externally, it is raised from foreign individuals and organizations, donor governments and international financial institutions. Normally, government borrowing is voluntary in nature, but sometimes it may be coercive or with some influence.

Generally, the classical economists were against public debt. They strongly believed on the laissez-faire policy, and so favored minimum size of the government as far as possible to them. Government borrowings is mostly unproductive, inflationary and burdensome. However, they approved debt financing in the productive projects called as the self-liquidating projects. According to Musgrave, "The self-liquidating projects may be defined as investment on public enterprises that provide a fee or sales income sufficient to serve the debt incurred in their financing. It can be defined in a broader way as expenditure on projects that increase future income and the tax-base. Such projects permit serving of the debt incurred in their financing without requiring an increase in the future level of tax-rates.”

The Keynesian view after the 1930’s Great Depression advocated the need for the use of public financial operations as fiscal policy for maintaining economic stability. To them borrowing may not necessarily be unproductive, inflationary and burdensome always. It is accepted as the best option in a period of depression, and to some extent even to control inflation. According to Lerner, government should borrow only when it wants to make people hold more bonds in place of money. The desirability or otherwise of public borrowing should be judged in terms of its effects on aggregate demand and the economic situation.

The modern view is concerned about its importance in raising and mobilization of financial resources, its management, and relationship with the monetary policy. It has been accepted that debt financing beyond the limit is certain to invite severe economic problems.

Need for Public Debt

Borrowing by the state has been a normal method to finance public expenditure in both the developed and developing countries. In different situations or for different purposes public debt is raised.
  1. To manage current budget deficit: Governments do not have large accumulated reserves or cash balances to meet any current budget deficits. Normally, it is said that the regular expenditure should be financed from revenue sources. But due to many reasons sometimes income from revenue sources may not be sufficient to meet even the regular expenditure as required. Besides, the unexpected emergencies like fire, floods, famines earthquakes and other natural disasters necessitates a large amount of government expenditure for rescue and relief works. In such situation governments are compelled to borrow.
  2. To meet war expenses: Borrowing to finance wars is in practice since ancient times. In modern times, the cost of warfare has been tremendously increased with the development in war technology and techniques. In a situation of war, income from revenue sources will not be sufficient to meet war expenses. Besides, in such situation, economic activities generally decreases leading to low level of national income and low yield from taxation sources. In such situation it is not desirable to increase rate of taxes beyond desirable limits which may create serious socio-economic and even political problems in the country. So, it is better and convenient for government to borrow in a warfare situation.
  3. To maintain economic stability: The idea of compensatory finance and functional finance has recognized the importance of borrowings to maintain economic stability. In a situation of depression. Government is to increase its expenditure, mainly by borrowings, to increase effective demand in the economy. To control inflation, government is to borrow out of the peoples’ fund which is likely to be used for increasing consumption expenditure. At the same time, the borrowed money is to be invested on production of goods and services by itself or private sector, Besides, government may borrow from external sources to manage trade deficit.
  4. To promote the rate of economic growth: One of the main constraints in the process of economic growth in the developing countries is lack of sufficient investment resources. To exploit or utilize the potentiality of natural and human resources, it is necessary to make a significant investments on them. For this, the savings of individuals and private corporate bodies can be increased voluntarily by borrowings with attractive monetary benefits. Borrowing from banking and financial institutions including central bank, is needed for productive use of unused or idle resources. Besides, borrowing from external sources in a wise way and effective investments helps in increasing productive capacity of the economy and national production.
  5. To manage the problem of Balance of Payments: In a situation of deficit in the balance of payments, government may borrow from external sources for funding the import requirements.
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Public Expenditure: Nature and Principles of Public Expenditure

Concept of Public Expenditure

 

“Public expenditure refers to the expenses of the public authorities – central, state and local governments – either for protecting the citizens and/or for promoting their economic and social welfare.” - Sundharam and Andley

 

“Public expenditure refers to the expenses which the government incurs for its own maintenance as also for the society and the economy as a whole. These days governments are also incurring expenditure to help other countries.” - Bhatia.

There are two schools of thoughts or attitudes in relation to the scope of public expenditure. The first is led by Adam Smith and other by classical writers restricted state activities to mainly the primary functions. Adam Smith has pointed out ‘the sovereign has only three duties: protecting the society from violence and invasion from other independent societies; establishing the exact administration of justice; and erecting and maintaining certain public works and certain public institutions.'

J.B.Say said, “The very best of all plans of finance is to spend little.” 

 

H.Parnell says, “Every particle beyond which necessity absolutely requires for the preservation of social order and for protection against foreign attack is waste and unjust oppressive imposition on the public.”

The second school of attitude after 1880’s did not restrict public expenditure only to the primary functions. Writers like Pigou, Dalton advocated public expenditure on social welfare activities. Similarly, after 1930’s depression, writers like Keynes advocated for state role to control economic fluctuations for maintaining economic stability in the developed countries. Prof. Musgrave advocated public expenditure for the activities such as: reallocation of resources, redistribution of national income and wealth, stabilization of economy, and some necessary commercial activities. 

Reasons for Growth in Public Expenditure


Public expenditure in all countries is increasing throughout the passes of time. In this regard, Adolf Wagner, a noted German fiscal theorist, propounded an empirical law named as ‘Law of the increase of state activities’ in the late 19th century. The law is expressed as, “Comprehensive comparisons of different countries and different times show that an increase regularly takes place in the activity of both the central and local governments. This increase is both extensive and intensive. The governments constantly under-take new functions, while they perform both old and new functions more efficiently and completely.”

Similarly, the Italian economist F.S. Nitti observed that whatever be the nature of governments or nations, they have similar tendencies towards marked increase of public expenditure.

The factor behind the increase in state activities, and thus, the public expenditure are of different nature and purposes. They are:

1. Concept of welfare state

In the past, governments were restricted to perform minimum activities just to maintain an environment necessary for efficient working of the private sector economic activities being guided by the market mechanism. Now, governments are to perform so many activities to promote social welfare beside the traditional activities. There is no sphere where the state can not enter or undertake. The basic reason for this is the change in the philosophy of police-state until late 19th century to the welfare-state with the main objective of promoting socio-economic well-being of the citizens. It has been the responsibility of the state to take care of citizens from womb-to-tomb, and so, expenditure of modern governments has increased a lot.

2. War related activities

War and threat of war have compelled governments to be militarily strong with well equipped weapons and technology. The cost of defense due to the progress in war techniques along with the development of science and technology have made the war weapons highly expensive. And also, the rate of obsolesce of the weapons is extremely high. Besides, war obligations for governments even in peace time after war in the form of pensions, relief aids to war veterans and victims, repayment of war debt and reconstruction of war devastated infrastructures.

3. Growth of population

Population growth, mainly in the underdeveloped countries, has necessitated increase in government activities to fulfill the demand for more educational, health, housing, employment opportunities, social security and benefits.

4. Urbanization

The process of urbanization impose additional responsibilities upon governments to provide community benefit which are normally not possible from individual efforts. Such community benefits like supply of safe drinking water, sewage facility, link roads, public parks, sports and recreation centers, communication networks, public security services, etc. are to be provided by the governments.

5. Economic needs

The great depression of 1930’s recognized the need for state intervention in the economy. Accordingly, undertaking of new economic functions by the state to maintain economic stability, encourage economic activities and promotion of economic welfare have increased the volume of public expenditure in the developed countries. In the developing countries, after the Second World War, governments are to play the leading role in the development process performing the role of an investor, facilitator and regulator along with promotion of distributive justice, maintenance of economic stability and environmental protection. All these economic needs have caused increase in public expenditure a lot.

6. Rise in price level

Universal rise in price level has led to increase in public expenditure for purchasing the goods and services by the governments. There is a cause and effect relationship between increase in price level and public expenditure.

7. Political factors

Modern governments have to make expenses on the political institutions, organizations and constitutional bodies. The system of election in the democratic countries needs more expenses. In an authoritarian regime, governments are spending a huge amount to suppress the political opponents and voices, and popularizing the image of the ruler through propaganda.

8. Growth in international relations

Establishment of international organizations like UNO and many agencies under its regional co-operation organizations like European Union, ASEAN, SAARC, OAU, BIMSTEC, etc. have made the member countries to subscribe financial contribution for their operation, expenses on permanent and conference delegates. Besides, establishment of diplomatic missions and the practice of foreign aids are also responsible for increase in expenditure of modern governments.

Principles of Public Expenditure

Principles of public expenditure are the criterion or guidelines for making public expenditure decisions. Prof. Alfred Buckler has made an attempt to state some guidelines for public expenditure to be followed by public authorities. They are:
  1. Public expenditure should promote welfare of the society, even it may be to promote welfare of a particular class or group.
  2. Careful judgment should be exercised to ensure the advantages of expenditure on each public service exceed the costs in comparison to that from the private sector.
  3. Priority should be given to services that will best promote social welfare than the services that promote least social welfare.
The principles of public expenditure can be discussed as the Canons of Public Expenditure and the Principle of Maximum Social Advantage. The canons of public expenditure are accepted as the general guiding principles for overall public expenditure mechanism. The principle of maximum social advantage is accepted as the basic principle of public expenditure.

Canons of Public Expenditure

Prof. Findlay Shirras advocated the following canons of public expenditure: 
  1. Canon of Benefit- The ideal of public expenditure should be the promotion of maximum social benefit or advantage.
  2. Canon of Economy- It refers to be economical in spending public money as well as help to expand its revenue base.
  3. Canon of Sanction- It implies that there should be no public expenditure without proper sanction by the proper authority.
  4. Canon of Elasticity- It refers that public expenditure should be changeable as per the need of the country.
  5. Canon of Equitable Distribution- It implies that public expenditure should be carried out to reduce the inequality in national income distribution.
  6.  Canon of Productivity- It implies that public expenditure should encourage increase in national production.
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