B.A.

(LAW) PART II

ECONOMICS (213)

CHAP 11: PUBLIC FINANCE

LEARNING OBJECTIVES: A)Sources of Public Revenue and Various Forms of Taxes
B)Major Heads of Public ExpenditureC) Concept of Budget Deficit and Source of Filling the
Gaps, Deficit FinancingD)Fiscal Policy: Meaning and Objectives

A. SOURCES OF PUBLIC REVENUE AND VARIOUS FORMS OF

TAXES
The income of the government through all sources is called public income or public revenue.The
following points highlight the nine main sources of PUBLIC revenue.

Source # 1:Tax:

A tax is a compulsory levy imposed by a public authority against which tax payers cannot claim
anything. It is not imposed as a penalty for only legal offence. The essence of a tax, as
distinguished from other charges by the government, is the absence of a direct quid pro quo (i.e.,
exchange of favor) between the tax payer and the public authority.

Tax has three important features:

a) It is a compulsory contribution, to the state from the citizen. Anyone refusing to pay tax
is punished under law. Nobody can object to taxation on the ground that he is not getting
the benefit of certain state services,
b) It is the personal obligation of the individual to pay taxes under all circumstances,
c) There is no direct relationship between benefit and tax payment.

Source # 2: Rates:

Rates refer to local taxation, i.e., taxation levied by (or for) local rather than central government.
Normally rates are proportional to the estimated rentable value of business and domestic
properties. Rates are often criticized as being unrelated to income.

Source # 3: Fees:

Fee is a payment to defray the cost of each recurring service undertaken by the government,
primarily in the public interest.
Source # 4: License fee:

A license fee is paid in those instances in which the govern­ment authority is invoked simply to
confer permission or a privilege.

Source # 5: Surplus of the public sector units:

The government acts like a business­ person and the public acts like its customers. The
government may either sell goods or render services like train, city bus, electricity, transport,
posts and telegraphs, water supply, etc. The government also earns revenue from the production
of commodities like steel, oil, life­saving drugs, etc.

Source # 6: Fine and penalties:

They are the charges imposed on persons as a punishment for contravention of a law. The main
purpose of these is not to raise revenue from the public but to force them to follow law and order
of the country.

Source # 7: Gifts and grants:

Gifts are voluntary contribution from private individu­als or non­government donors to the
government fund for specific purposes such as relief fund, defence fund during war or an
emergency. However, this source provides a small portion of government revenue.

Source # 8: Printing of paper money:

It is another source of revenue of the govern­ment. It is a method of creating extra resources.

This method is normally avoided because if once this method of financing is started, it becomes
difficult to stop it.

Source # 9: Borrowings

Borrowing from public is another source of govern­ment revenue. It includes loans from the
public in the form of deposits, bonds, etc. and also from the foreign agencies and organizations.

VAIOUS FORMS OF TAXES

Taxes may be classified as direct and indirect.

Direct taxes are levied on a person’s or a firm’s income or wealth and indirect taxes on spending
on goods and services. Thus, direct taxes are paid directly by the person or firm on whom the
assessment is made, while indirect taxes are paid indirectly by consumers in the form of higher
prices. Direct taxes cannot be legally evaded but in direct taxes can be avoided because people
can reduce their purchases of the taxed goods and services.
Direct Taxation include income tax, corporation tax (on companies’ profits), capital gains
tax (a tax on the profits of sales of certain assets), wealth tax (which is a tax on ownership of
property or wealth) and a capital transfer tax (a tax on gifts to replace death duties).

Indirect Taxation includes customs duties, motor vehicles tax, excise duty, octroi and sales
tax. Indirect taxes are collected both by the central and provincial governments but mainly by the
central government.

B. MAJOR HEADS OF PUBLIC EXPENDITURE

In order to carry on their functions, governments must obtain the services of labor and other
factor units and acquire goods produced by private business firms.

Public expenditure consists of expenditure by the federal government and provincial

governments, local authority (such as municipalities and public corporations), with central
government accounting for the major portion of such expenditure. Thus the central government
is required to maintain good roads, bridges, defense activities, canals and harbors, to protect
trade, to maintain the coinage and to provide social security, education and religious instruction.

Categories of Government Expenditures:

Government expenditures can be classified into several categories.

Firstand prime outlay is for direct government purchases of goods and services. Purchases of
goods and services include government expenditures on the services of individuals, such as those
in the armed forces, and on goods, such as food, medicine schools, hospitals, highways, and
motor cars. Many of the purchases the government makes are for goods and services that are
provided for all members of the society — including those who have not paid for then use.

When a good or service is provided for everyone and no one can be excluded from its use, it is
termed a public good. Flood control and national defence systems are examples of public goods.
When government provides a good or service that could be sold in a private market, such as
education or fire protection, it is providing a quasi­public good. The provision of public and
quasi­public goods is a widely recognized function of the government.

Second category of government expenditure is transfer payments, which are payments from the
government for which nothing is received in return. Social security benefits, compensation to
unemployed people, benefits to senior citizens and pensions to retired govern­ment employees
and freedom fighters are all examples of transfer payment programs.

Third category is about Interest paid on borrowed funds is another type of government
expenditure. At times, government units finance some of their activities through borrowing, and
the interest on those borrowed funds is an expense that the government unit must meet.
Fourth major category is that government may also incur expenses for running or contributing to
the operation of various public enterprises such as toll roads, airports, and hospitals, or for
providing intergovernmental grants. These grants are given primarily by the Central Government
to State and Local Governments.

The main heads of Federal Government’s expenditure are:

a) Defense Services,
b) Development Services,
c) Administrative Services,
d) Debt Services, and
e) Assistance to Provinces.

Defense Services:

They account for nearly 20% of the total revenue expenditure of the Central Government in
India.

General Services:

The expenditure on civil administrative services and also on tax collection, police, pensions, etc.
come under this heading.

Social and Development Services:

Expen­diture on social and development services are now the most important head of Central
Government’s revenue expenditure and fall into the following two broad groups of services:

(a) Social and Community services, which seek to improve and build­up the human
capital and social infrastructure of the country; and

(b) Economic Services, which are directed toward the development and strengthening of
the economic infrastructure and other economic activities in the country.

Interest Payments:

India has been raising more and more loans — both internal and foreign — for the execution of
its development plans. So it has to pay interest on borrowed funds.

C. CONCEPT OF BUDGET DEFICIT AND SOURCE OF FILLING THE

GAPS, DEFICIT FINANCING
Definition: The Budget Deficit is the financial situation wherein the expenditures exceed the
revenues. The Budget Deficit generally relates to the government’s expenditure and not the
business or individual’s spending.
The government’s collective deficits are termed as “National Debt”. In the case of a budget
deficit, be it the Government or any business, it has to resort to the external borrowings in order
to escape the bankruptcy. The Investors or analyst study the budget deficit of the country or
business to judge its financial health.

There can be different types of budget deficits that can be classified on the basis of types of
receipts and expenditures taken into the consideration. These are:

a) Revenue Deficit
b) Fiscal Deficit
c) Primary Deficit
d) Monetized Deficit

The Budget surplus is opposite of budget deficit where the revenues exceed the expenditures,
and when the spending is equal to the revenues, the budget is said to be balanced. The major
implications of a Government budget deficit are:

a) Slower economic growth

b) Increased tax revenue
c) High unemployment rates
d) High Government spending

Sources of Financing Deficit or Filling Financial Gaps

There are three methods or sources which are used to finance budgetary deficits in Pakistan.
Each method of financing has its own macroeconomic implications which are discussed in brief.

The methods of deficit financing are:

1) Bank Borrowing
2) Non­bank Borrowing / Domestic Borrowing
3) External Borrowing

1- Bank Borrowings: The government meets the deficit in budget by borrowing from the
central ban of the country in twoways­ (1) The Central ban(SBP) issues new currency
notes in the amount borrowed by the government (2) The government draws upon the
cash balances of the past for meeting the budget deficit. The effect of deficit financing
through bank borrowing is that it increases money supply in the country and generally
creates inflationary pressure in the economy.
2- Non-bank Borrowing: The government of Pakistan is also financing fiscal deficit
through non­bank borrowing. The funds to meet the deficits in the budget are mobilized
through the sale of Government Treasury Bills,Short Term Federal Bonds Defense
Saving Certificate etc. If there isa continuous rise in borrowing through this source, it
 creates inflationary pressure in the economy, increases domestic interest rates, and
discourages private investment in the country.
3- External Borrowing: The persistence of large fiscal deficits has forced the government
of Pakistan to borrow from overseas. External Debt in Pakistan increased to 99108 USD
Million in the fourth quarter of 2018 from 96735 USD Million in the third quarter of
2018. External Debt in Pakistan averaged 55161.64 USD Million from 2002 until 2018,
reaching an all time high of 99108 USD Million in the fourth quarter of 2018 and a
record low of 33172 USD Million in the third quarter of 2004.

The initial impact of borrowing is that it adversely affects the exchange rate. The balance of
trade deteriorates. There is also flight of capital from the country. On average, external financing
of budget deficit remains one fourth of total financing in Pakistan.

Deficit financing is a delicate fiscal weapon for stimulating economic development. If it is

wisely used, it is beneficial for the economy.

If mobilizes additional resources for economic development.

1) it helps in utilization of unutilized and underutilized resources of the country.

2) it helps in building up social and economic overheads.
3) it helps in ensuring higher level of employment in the country by productive use of
resources.

D. FISCAL POLICY: MEANING AND OBJECTIVES

MEANING

Fiscal policy refers to the use of taxes and government spending to achieve desirable changes in
aggregate demand.There are three components of fiscal policy:

Discretionary changes in tax rates ­ It generally means making changes in tax rates at times
when they are needed. These changes are typically implemented in a country's annual budget,
though they can be implemented outside of the official budget if required. There are many
administrative costs to firms associated with changing tax rates ­ hence changes tend to be made
only once a year ­ on budget day.

Discretionary public spending changes ­ which occur either at the time of the annual budget, or
at some other fixed time ­ in the UK such changes are normally made in what is called the
'Autumn statement' in November.

Automatic stabilizers ­ This involves the stabilization of the economic cycle through two
processes called fiscal drag and fiscal boost. When combined they help automatically stabilise
the macro­economy when faced with an economic shock.
Fiscal policy must be designed to be performed in two ways­by expanding investment in public
and private enterprises and by diverting resources from socially less desirable to more desirable
investment channels.

OBJECTIVES OF A FISCAL POLICY

1) Full employment: The first and foremost objective of fiscal policy in a developing
economy is to achieve and maintain full employment in an economy
2) Price stability: There is a general agreement that economic growth and stability are joint
objectives for underdeveloped countries.
3) Accelerating the rate of economic development: Primarily, fiscal policy in a developing
economy, should aim at achieving an accelerated rate of economic growth. But a high
rate of economic growth cannot be achieved and maintained without stability in the
economy
4) Optimum allocation of resources: Fiscal measures like taxation and public expenditure
programs, can greatly affect the allocation of resources in various occupations and
sectors
5) Equitable distribution of income and wealth: It is needless to emphasize the significance
of equitable distribution of income and wealth in a growing economy
6) Economic stability: Fiscal measures, to a larger extent, promote economic stability in the
face of short­run international cyclical fluctuations.
7) Capital formation and growth: Capital assumes a central place in any development
activity in a country and fiscal policy can be adopted as a crucial tool for the promotion
of the highest possible rate of capital formation.
8) Encouraging investment: Fiscal policy aims at the acceleration of the rate of investment
in the public as well as in private sectors of the economy.