Public finance and taxation revision study notes

This public finance and taxation revision study notes can be used by students pursuing the following Kasneb courses:

Certified public Accountants (CPA)

Certified credit professionals (CCP)

Certified investment and financial analysts(CIFA)

Certified secretaries(CS)

 

INTRODUCTIONS TO PUBLIC FINANCIAL MANAGEMENT LEGAL FRAMEWORK

INTRODUCTION TO PUBLIC FINANCE

Meaning of Public Finance

Public finance is related to the financing of the state activities and a narrow definition of the public finance would try to say that public finance is a subject which discusses the financial operation of  the fiscal or of the public treasury.

Nature of Public Finance

Public finance has been held as a science which deals with the income and expenditure of the government’s finance. It has been held as a study of principles underlying the spending and raising of funds by the public authorities. The various theories which form the basis of the collection; maintenance and expenditure of the public income constitute the subject and matter of finance.

Scope of Public Finance

The scope of public finance is not just to study the composition of public revenue and public expenditure. It covers a full discussion of the influence of government fiscal operations on the level of overall activity, employment, prices and growth process of the economic system as a whole.
According to Musgrave, the scope of public finance embraces the following three functions of the
government’s budgetary policy confined to the fiscal department the:

  • allocation branch,
  • distribution branch, and
  • stabilization branch.

These refer to three objectives of budget policy, i.e., the use of fiscal instruments to secure:

  • Adjustments in the allocation of resources
  • Adjustments in the distribution of income and wealth, and
  • Economic stabilization.

Public finance is composed of the following constituents public:

  • Expenditure
  • Revenue
  • Debt
  • ( Financial ) administration

Private finance

This the study of the income, debt and expenditure of the individual or a private company or business venture or an association. It includes the study of their own view regarding earning expenditure and borrowing.

Similarities between Public Finance and Private Finance.

Based on Similar Theories

The basis of public as well as private finance is the same. Both seek the help of various principles of economics in determining various interrelated problems. For example, a person wants to secure maximum utility on count of minimum expenditure and government too wants to secure public  utility by spending the least possible amount of public money.

Both Face the Problem of Scarcity

Limitation of the resources is the problem before private as well as public finance. Individuals’ resources are limited up to this earnings; past savings and ancestral property similar governments’ resources also depend on taxable capacity of the individuals earnings of the various corporations etc. None of the two is capable of extending its expenditure beyond a certain limit; hence non can afford to go to the infinity in the use of finance.

Both Require Efficient Administration

Private as well as public finance require efficient administration to look after the various acts of  extravagance. In the event of the failure of an efficient administration both might be compelled to face ‘dire-consequence’ in their financial field, individual never wants any kind of wastage or misuse of his income, so the government if it is alive to the sense of duty.

Both Borrow and Must Repay

To run the administration of finance sometimes money in hand fails to fulfill the requirements  especially in the times of emergency, governments borrow money from individuals and also  borrow from different sources like relatives, banks, at the same it is obligatory for both the public finance as well as the private finance to repay the debt. The point here is that none can live without repaying the amount.

Both are Based on Rationality of Thought

When an individual spends some money he makes it certain in his mind that money is spent in the best way. He applies his rational faculties. In the same way any irrational step taken by the  government may bring wastage and misuse of finance. This irrationality lead them to damages while rationality to prosperity and achievement of goals.

Differences between Public Finance and Private Finance

i. Individual determines his expenditure on the basis of his income but government  determines its income on the basis of its expenditure. As far as an individual is concerned he determines his expenditure on the basis of the income, in the sense that he cannot think  of spending more than his income. He distributes the amount of income to be spent on various subjects with income at his finger tips. The position is quite contrary in the case of government. The government first decides the amount of expenditures to be done during a period of time, and then frames scheme to secure money to meet the expenditure. Government has the power to increase its income be internal borrowings but this is not possible for an individual.

ii. Government’s source of income is more flexible in comparison to private source. Government has legal power to extend the sources of its income according to the needs of the time. Government has the control over the whole national property but individual has to rely upon his own individual standing. The last resort available to the government is the printing of new currency notes to increase its income. But an individual will be definitely but behind the bars for such an office.

iii. It is easy for an individual to base his expenditure on the law of equal marginal utility, but far difficult for governments. Individual is free to measure his expenditure in the sense of  utility and spends his money on the certain weighted subjects. These subjects may not be of social need or may not add anything to social advantage. Such expenditures are very prominent in the democratic countries for example building of hospitals, roads, parks.

iv. Private finance is narrow and short lived in comparison to public finance. Private finance faces suspension with the end of the individual’s life or with the closure of the particular business enterprise. But governments are more tenable. It is well said in this context is that ‘king may come and king may go but government is eternal.’ Governments keep on moving form generation to generation interlinking past from present with an eye on future.

v. Public finance is subject to public censor but not the private finance. A complete secrecy may be maintained by an individual regarding his income and savings. But the government records are furnished to let the people see through the desirability of the expenditure. Public is entitled to know, criticize and the press is free to comment on the public finance outlays,
its drawbacks and failures.

vi. There are pre-determined policies behind public expenditure but not so in the case of private expenditure. Public expenditure is done to achieve the goals which are predetermined in their nature.

vii. There is difference in the budgeting process of the public finance and the private finance. The budget of the government is subject to the approval of the parliament of the concerned country. It is now a well established principal no taxation without representation and no tax shall be without the due/process of law. Unless the demand gets approval of the parliament of the executive cannot spend even a single penny. But individual is his own master and he need not ask for parliamentary approval for spending his bricks.

viii. Governments’ accounts are audited by constitutional authorities but private finance has its own arrangement. An individual can audit his accounts without performing formalities  about it. But there is procedural necessity in the case of public finance. The budget is to be prepared in the prescribed manner and to be presented according to the settled norms.

ix. A private individual can face the crises of being bankrupt but no government can be bankrupt. An individual may ‘run-riot’ his money and thus may become an insolvent, but the question of the government being bankrupt is impracticable. It is funny to talk of the bankruptcy of the government; since all the currencies are printed and circulated by it.

Functions of Modern Government

We should know the role of the government to enable us to appreciate the importance of  government sector. Government of a modern state generally undertakes the following functions:

1. Security – Both external and internal involving outlay for military, police and other protective services.
2. Justice or settlement of disputes
3. The regulation and control of economy – including the services such as coinage,
a. weights and measures, the business practices , operation of public sector
b. undertakings
4. Of social and cultural welfare through education, social relief, social insurance, health and
other activities.
5. Conservation of natural resources.
6. Promotion of the unity of the state by control of transportation and communication.
7. Administration and financial system, government revenue expenditure and fiscal control.
8. Education and employment.
9. Housing.
10. Public health.
Functions of modern governments are broadening due to socio-political reasons. Therefore, to discharge these increasing functions, the government has to increase its expenditure. To meet out the enormous amount of expenditure it has to mobilize funds with the help of public finance policy. Hence public finance has developed into an important branch of economics.

Scope of Public Finance

Public finance deals with the income and expenditure pattern of the Government. Hence the  substances concerned with these activities become its subject matter. The subject matter of the public finance is classified under five broad categories of which the first two are discussed. They
are,
1. Public Revenue
2. Public Expenditure
3. Public Debt
4. Financial Administration
5. Economic Stabilization

Public Revenue

Under this category, the sources of the public revenue, principles of taxation, effects of taxes on  the economy, methods of raising revenue and the like are dealt with. Public revenue is the means for public expenditure. Various sources of public revenue are:

Tax Revenue

Taxes are compulsory payments to government without expectation of direct return or benefit to tax payers. It imposes a personal obligation on the taxpayer. Taxes received from the taxpayers,  may not be incurred for their benefit alone. Tax revenue is one of the most important sources of revenue.
Taxation is the powerful instrument in the hands of the government for transferring purchasing power from individuals to government. The objectives of taxation are;

  • to reduce inequalities of income and wealth;
  • to provide incentives for capital formation in the private sector, and
  • to restrain consumption so as to keep in check domestic inflationary pressures.

Elements of taxation are as follows:

a. it is a compulsory contribution

b. government only imposes taxes
c. in payment of tax an element of sacrifice is involved

d. taxation is aimed at welfare of the community
e. the benefit may not be proportional to tax paid
f. tax is a legal collection.

The various types of taxes can be listed under three heads. First type can be titled taxes on income  and expenditure which include income tax, corporate tax etc. The second is taxes on property and capital transactions and includes estate duty, tax on wealth, gift tax etc. The third head, called taxes on commodities and services, covers excise duties, customs duties, sales tax, service tax etc.
These three types can be reclassified into direct and indirect taxes. The first two types belong to the category of direct taxes and the third type comes under indirect taxes.

Non-tax Revenue

This includes the revenue from government or public undertakings, revenue from social services like education and hospitals, and revenue from loans or debt service. To sum up, non-tax revenue consists of:

i) interest receipts
ii) dividends and profits
iii) fiscal services and others.

Public Expenditure

Recently, there has been both quantitative and qualitative change in government’s expenditure. This category deals with the principles of public expenditure and its effect on the economy etc.

Government of a country has to use its expenditure and revenue programs to produce desirable effects on national income, production, and employment. The role of public expenditure in the  determination and distribution of national income was emphasized by Keynes.The term “Public Expenditure” is used to designate the expenditure of government-central, state and local bodies. It differs from private expenditure in that governments need not pay for themselves or yield a pecuniary profit. Public expenditure plays the dual role of administration and economic achievement of a nation. Wise spending is essential for stability of government and proper earnings are a prerequisite for wise spending. Hence planned expenditure and accurate foresight of earnings are the important aspects of sound government finance  Public expenditure is done under two broad heads viz., developmental expenditure and non-developmental expenditure. The former includes social and community services, economic services, and grants in aid. The latter mainly consists of interest payments, administrative services, and defense expenses. Expenditure can also be classified into revenue and capital expenditure.

Expenditure is classified under the following heads:

Non-plan Expenditure

Non-plan expenditure of central government is divided into revenue and capital expenditure. Under non-plan revenue expenditure we include interest payment, defense expenditure, major subsidies, interest and other subsidies, debt relief to farmers, postal deficit, police, pensions, other general services, social services, grants to states and union territories. Non-plan capital expenses include defense expenses, loan to PSUs, loans to states and union territories and foreign governments.

Plan Expenditure

The second major expenditure of central government is plan expenditure. This is to finance the following:

  •  Central plans such as agriculture, rural development, irrigation and flood control, energy, industry, and minerals, communication service and technology, environment, social service and others.
  • Central assistance for plans of the states and union territories.

Expenditure can also be categorized into revenue and capital expenditure. Revenue expenditure  relates to those, which do not create any addition to assets, and covers activities of government departments’ services, subsidiaries and interest charges. Capital expenditure involves that expenditure, which results in creation of assets. Finance ministry is responsible for plan
expenditure. This includes grants to the state. Hence the expenditures are classified as capital and revenue. Alternatively, these expenses can be  re-classified into plan and non-plan expenditure.

Social Expenditure

Government takes the responsibility of protecting the interests of the community as a whole and promotes the implementation of welfare programs. Government spends huge amounts for  providing benefits such as old age pensions, accident benefits free education and medical services. This expenditure on human resources comes under social expenditure.

Governments are moving towards the objective of achieving maximum social welfare.Expenditure on education, public health, welfare schemes for workers, relief and displaced persons and such other services may not yield direct benefit in the short run. But in the long run they contribute to improvement in the quality at human resources. Governments are moving towards the objective of achieving maximum social welfare. Expenditure on education, public health, welfare schemes for workers, relief and displaced persons and such other services may not yield direct benefit in the short run. But in the long run they contribute to improvement in the quality at human resources.

The main classifications of Government expenditure can be seen in the following diagram

Role of Fiscal Policy- Its Significance to Business Economy in Developing Countries

The main goal of the fiscal policy in developing countries is the promotion of the highest possible rate of capital formation. Underdeveloped economies are in the constant deficit of the capital in the  economy and thus, in order to have balanced growth accelerated rate of capital information is required. For this purpose the fiscal policy has to be designed in a way to raise the level of
aggregate savings and to reduce the actual and potential consumption of people. .

  • The approach to fiscal policy must be aggregate as well as segmental. The sectoral imbalances can be curbed by appropriate segmental fiscal measures.
  • The government expenditure on developmental planning projects must be increased. For this deficit financing can be used. It refers to creation of additional money supply either by creation of new money by printing by government or by borrowing from the central bank.
  • Public borrowing, loans from foreign nations etc can be used in the development of the resources for public sector.
  • Fiscal policy in the developing economy has to operate within the framework of social,cultural and political conditions which inhibit formation and implementation of good economic policies.
  • In order to reduce inequalities of wealth and distribution, taxation must be progressive and government spending must be welfare-oriented.
  • The hindrances in the effective implementation of fiscal policy in the developing countries are loopholes in taxation laws, corrupt tax administration, a high population growth, extravagant governmental spending on non-developmental items, an orthodox society etc.