CHAPTER FOUR

4. PUBLIC EXPENDITURE

4.1 Meaning and Objectives of Public Expenditure

4.1.1 Meaning of Public Expenditure

Public expenditure is incurred by public authorities --Central, State and local Governments either
for the satisfaction of collective needs of the citizens or for promoting their economic and social
welfare.

Public expenditure is not only the most important but also the central part of the study of public
finance. It is incurred by the government for the attainment of public good. Every government
has to maintain law and order, armed forces for providing protection, public parks, schools,
health of the people. Government has to perform certain other welfare measures like maternity
protection, arranging for cheap food, cloth and low-cost housing for the poor and so on. All these
multifarious activities which are increasing every year require huge funds. Therefore public
expenditure, deals with the expenditure which a government incur for its own maintenance, the
society and the economy and helping other countries.

4.1.2 Objectives of Public Expenditure

Dalton divided the aims of public expenditure into two parts:
(i) Security of life against the external aggression and internal disorder and injustice.
(ii) Development or up gradation of social life in the community.
 The public authority works in many ways for the benefit of the people. The government
organizes the generalized services like public health and education. The whole society is
benefited by these functions of the state.
 Secondly, through public expenditure, the government influences directly or indirectly,
the industrial and commercial system of the nation thereby helps towards the economic
and social development of the society.

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  Thirdly, in modern times, the responsibilities of the government are increasing every
year. For the economic development of the country, the government has started, on its
own accord, industries and commercial business. This sector of the economy which is
under the direct control of state has come to be known as public sector. Expenditure on
this sector is increasing rapidly every year.
 Fourthly, Dalton points out that the public expenditure should be carried on up to that
limit where the marginal benefits a rising from different branches of expenditure are
equal. These marginal benefits must be equal to the marginal sacrifice incurred by the
public.
 Public spending should be designed to optimize the level of investment in such a way as
to maintain full employment--with growth.
 Public spending may be incurred at an increasing rate in the backward region to uplift
their economy.

4.2 Reasons for Growing Public Expenditure

A multitude of factors have caused the rising trend of public expenditure in modern times. The
followings are few of them:

1) Welfare State: The modern state is a welfare state. It aims at promoting the economic,
political and social well being of citizens. It has to spend increasing amounts on such items as
social insurance, unemployment relief, free medical aid, free education, child welfare, women
welfare, labor welfare, concessional rates of water supply, food stuff, electricity etc., to improve
the economic and social welfare of the country. As a result, the public expenditure is bound to
increase.

2) Defense: Due to the invention of nuclear weapons there is always a danger of foreign
aggression. International political situation is uncertain and insecure. As such, every nation has
to prepare itself for a strong defense. The defense expenditure in the form of expenditure on war
materials, maintenance and growth of armed forces, pension to retired war personnel etc. are, are
perpetually rising.

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3) Population Growth: It is an admitted fact that the population is increasing rapidly. As a
result, the government has to incur greater expenditure to meet the requirements of the increasing
population.

3) Transport and Communication: With the expansion of trade and commerce, the state has to
provide and maintain a quick and efficient transport system. Transport being a public utility, the
state has to provide it cheaply also. The government has to spend a lot on constructing new
railway lines, good roads, new roads, highways, bridges and even canals to connect different
areas with a smooth transport system as a precondition of growth.

4) Urbanization Effect: The spread of urbanization is an important factor leading to relative

growth of public expenditure in modern times. Urbanization is responsible for the increase in
expenditure on water supply, electricity, construction and maintenance of hospitals, schools and
other public services.

5) Growth of Democracy: Growth of democracy and socialism has been responsible for the
increasing tendency of public expenditure to a great extent. In a democracy, to achieve the
goodwill of the public, the ruling party has to incur heavy expenditure on providing variety of
services and facilities to the public. Expenditure on elections and by elections is increasing every
year. Number of ministries and executive offices has also been increased. As a result of this the
public expenditure increases rapidly.

6) Rising Trend of Prices: Public expenditure is also increasing in every country due to rising
trend of prices. The reason is that the government has to buy goods and services from the market
at higher prices. The government has also to increase the salaries, dearness allowance etc., of
government employees leading to a rapid increase in government expenditure.

7) Increase in the Activities of the State: In recent years, activities of the state, particularly in
the social and economic fields, such as education, public health, public recreation, public works,
commerce and industry, five year plans, etc. have increased tremendously.

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8) The planning effects: In a less developed economy, the government adopts economic
planning for the development of the country. In a planned economy, thus, when the public sector
is expanding its role, the public expenditure shows an increasing trend. Huge sums are also spent
by the government on formulating and implementing plans.

9) The Rural Development Effect: In an underdeveloped country, the government has also to
spend more and more for rural development. It has to undertake schemes like community
development projects and social measures. The government also incurs expenditure on imparting
training to personnel for implementing rural development programs.

10) General Expenditure and Internal Security: Internal situation of a country is becoming
uncertain and insecure day by day. Government has been constantly facing communal and
political riots. Hence, to check and control these troubles, the government has to spend more on
the maintenance of law and order. Moreover, the government is bound to spend huge amounts, as
in a free country it is essential that the just demands of the public are duly considered.

4.3 Canons of Public Expenditure

The expression “canons of public expenditure” it used for the fundamental rules or principles
governing the spending policy of the government .the following canons of public expenditure
have been laid down Prof. Findley Shirras:
1) Canon of Benefit: This cannon suggest that every public spending must ultimately be
used for the cause of social benefit i.e. for the general well-being of the common people.
In other words, the state spending should confer benefits on the entire community at large
than on an individual group or section. It means public funds should be spent in such
directions which pursue common interest and promote general welfare.

2) Canon of Economy: it implies that public expenditure should be incurred carefully and
economically. Economy here means that wasteful and extravagant expenditure should be
avoided at all levels. Public expenditure must be productive and efficient. Hence, it must
be incurred only on every essential items of common benefit- without duplication in a

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 way that involves minimum cost. An efficient system of financial administration is
therefore, very essential in any country.

3) Canon of sanction: this cannon suggests that no public spending should be made without
the approval of proper authority. Only obtaining prior sanction is not sufficient. It must
be properly inspected and examined whether the sanctioned amount of money is being
spent properly on sanctioned items or not. As a rule, therefore, money must be spent on
the purpose for which it is sanctioned by the highest authority and accounts properly
audited.
4) Canon of Surplus: this cannon suggests that saving is a virtue even for the government,
so an ideal budget is one which contains an element of surplus by keeping public
expenditure below public revenue. In other words, public authorities should aim at
surplus of income over expenditure and they should avoid deficits. Frequent and huge
deficits lead to uncontrollable financial situation with dire consequences of inflation.
Therefore, every government should attempt to balance its income and expenditure.

5) Canon of Elasticity: this canon requires that the expenditure policy of the state should be
such that changes must be possible in the expenses according to the change in
requirements and circumstances. In other words, there should be scope for charges in
public expenditure according to the requirements of the country.
6) Canon of Productivity: This canon or principle implies that the expenditure policy of
the Governments should be such that would encourage production in a country. That
means a large part of public expenditure must be allocated for development purpose.

7) Canon of Equity: One of the foremost aims of public expenditure is also to ensure the
just and equitable distribution of is more significant for the countries where the gap
between the highest income and the lowest income groups is very wide.

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4.4 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. A brief
account of these effects may be given as under:

4.4.1Effects of public expenditure on production

(i) Effects upon ability to work, save and invest
Ability to work, save and invest depends upon the health and efficiency possessed by the
persons. Health and efficiency depends upon the level of consumption and level of
consumption depends upon the public expenditure incurred by the government. Public
expenditure on education, medical services, cheap housing facilities, means of transport
and communication etc, will increase the efficiency of persons to work. Some of the
expenditure, like the expenditure on free education, unemployment benefit and free
medical facilities etc., are helpful in increasing the purchasing power of the people
especially of the low income groups and hence it helps to protect and promote the
efficiency of the people and their ability to work and save. Public expenditure on
increasing the salaries and wages of the people and the supply of goods and articles at
cheap rates to them will increase their purchasing power, standard of living, health,
efficiency and hence their ability to work and save may increase. Likewise, public
expenditure on the maintenance of law and order, creates confidence in the minds of the
people and hence it encourages them to make investment in productive activities. As
production increases, income of the people also increases; hence their ability to work,
save and invest also goes up. Thus it is evident that public expenditure can promote
ability to work, save and invest and thus promote production and employment.
(ii) Effects upon willingness to work, save and invest
Public expenditure also affects the willingness of the people to work, save and invest.
Pension, provident fund, interest loan, free medical and unemployment allowances and
other government payments provide security to a person and, therefore, reduces the
willingness of persons to work and save, when a person knows that will be looked after

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 by the government when he is not in a position to earn any income. In the absence of any
saving, the question of investment does not arise at all.

On the contrary, expectation of larger amenities and higher standard of living would
stimulate people to work hard. It is this encouragement which would encourage them to
save more and to invest their savings for production purposes. Expenditure on benefits
such as sickness benefits would certainly increase the desire of the people to work more,
since they are assured of relief if they fall sick due to hard work.
(iii) Effects on diversion of resources
Public expenditure also affects the diversion of resources. Government incurs public
expenditure in the form of giving financial assistance to productive sector. In the same
way, if the government wishes to attract productive resources to a particular area or
region, it will start giving variety of incentives in the form of tax holidays and other
allowances or concessions etc. to the industrialists.

4.4.2 Effects of public expenditure on distribution

Public expenditure also helps the government in bringing about equitable distribution on income
and wealth. Not only taxation policy but public expenditure policy can also remove inequalities
in the distribution of income and wealth. To bring about equitable distribution of income and
wealth, the government should impose higher taxes on the richer section of society and the
amount realized from them should then be spent on the poorer section of society by way of
providing social amenities, and subsidies to them. Public expenditure has, thus, an important role
in reducing economic inequalities in the society.

4.4.3 Effects of public expenditure on employment

Public expenditure affects employment as well as employment opportunities. It can increase
employment in the country. Therefore, the public expenditure policy of the government should
be so devised as to create additional jobs both in the public and private sectors. The following
expenditures of the government increase employment opportunities.
(i) Heavy expenditure in the public sector

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 For the economic development of the country, the government should make investment
in public sector such as heavy engineering, iron and steel coal etc. Production goods
sector provides direct employment to the people by creating millions of jobs. Thus it
clearly becomes the responsibility of the state to prevent a situation of unemployment.
(ii) Expenditure on public utilities
Public expenditure incurred by the government on public utilities, such as supply of
water, electricity, telephone services, etc., create a large volume of employment.
(iii) Public expenditure to encourage small-scale industries
To promote employment in small-scale industries, the government should provide tax
incentives and allowances to such industries. The government should incur public
expenditure on small-scale sector in the form of cheap credit, supply of raw materials at
concessional rates, free technological assistance, helping these industries in the marketing
of goods etc. In this way, large employment is created in the small-scale sector.
(iv) Public expenditure during the period of depression
Public expenditure plays an important role during the periods of depression and
recession. Depression is a period of falling prices, falling demand due to falling incomes.
Recession is a period of rising prices, falling demand and rising cost of production. It is
the responsibility of the government to check these situations by incurring public
expenditure on public works, programs and producers by way of providing tax incentives
and reducing the rates of sales tax, duties, custom duties etc. Such expenditure creates
employment and income in the country and consequently, effective demand starts rising.

(v) Public expenditure to create employment in backward areas

To create employment opportunities in back ward regions, the government should
promote industries in the public sector and private sector in backward areas. To
encourage industries in the public as well as private sectors, the government should grant
deductions and concessions to such industries. If public expenditure is directed towards
the promotion of industries in the public and private sectors in backward areas, not only
will additional jobs be created, but the markets will be also widened and there will be all
round economic development of the country.

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4.4.4 Effects of public expenditure on economic stability
Economic stability is judged by the behavior of prices. Price stability is related to the manner in
which price behaves in an economy. There should be a normal rise in price because normal is
considered as a sign of a healthy economy problem arises whenever there are price fluctuations.
Price fluctuations may be known as abnormal economic situations.
There may be three state of abnormal price behavior:
(i) Inflation,
(ii) Deflation or depression, and
(iii) Recession.
(i) Effects of public expenditure in Inflation
Inflation is a state of rising money supply, rising demand but stable supply. Public
expenditure may be useful in controlling inflation. In this situation the aim of the
government should be to spend than its revenue. Inflation may be averted by reducing
public expenditure on civil services, defense, interest payments etc. The funds acquired
by means of a surplus budget may be used to provide capital to those sectors which
experience shortage of capital so that the total productive capacity of the economy may
increase. Therefore, public expenditure should be incurred on minor irrigation projects,
better quality of seeds, manure, etc., in the field of agriculture. In the field of industries,
public expenditure may be incurred on providing facilities for the establishment of new
industries and for the expansion of the existing ones.

(ii) Effects of public expenditure in deflation/depression

Depression is a state of falling price, falling money supply and falling demand. Falling
prices cause losses among business-men and manufactures and this leads them to curtail
production and employment. Thus, a large number of workers are thrown out of
employment. In such a situation, the government should employ workers on public works
projects. The employed workers receive wages from the government and can thus
increase the demand for various commodities. The increased demand leads to increase in
production. Thus, the objective of public expenditure during depression should be to
create effective demand for consumer goods, which would create employment and thus,
would help to maintain economic stability.

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 (iii) Effects of public expenditure on recession
In a state of recession prices continue to rise in spite of continuously falling demand.
Recession or in other words, prices could be kept under control through proper public
expenditure policy. To sustain demand, it becomes essential to bring down prices. This is
only possible if cost of production is kept under control. To keep the cost of production
under control, fiscal support may be extended to the producers in the form of reduction in
the rates of sales tax, excise duties, custom duties etc. This would create demand for the
products which would increase employment. Increased demand would induce the
government to incur expenditure in the form of higher wages to the workers.

4.4.5 Effects of public expenditure on economic development

Economic development depends on the rate at which the per capital income increase. It also
refers to the structural changes in the economy. Economic development also refers to the
problems of under developed countries and economic growth of advance countries. In
underdeveloped countries, the problems are concerned with un used resources even though their
uses are well-known, while those of advanced countries are related to growth, most of the
resources, being, already known and developed. However, the problem of underdeveloped
countries is to make rapid and accelerated economic development.

Public expenditure --a powerful remedy

(1) Public expenditure, if properly planned can play an important role in the economic
development of the country. The biggest problem, which the developed and
underdeveloped countries face, is the problem of unemployment and increasing incomes.
Public expenditure programs may directly help to provide employment to many
individuals and increase in peoples demand for goods and services will lead to greater
production and, thus, will provide employment to large number people.
(2) Secondly, in order to increase employment and production, the government should make
investment in basic and heavy industries such as iron steel, atomic power, hydro-electric
multipurpose projects, heavy electricals and engineering, which are needed for making
rapid economic development. However, the objective of public expenditure in mixed

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 economy should not be to compete with the private sector, but to act as supplementary
and complimentary to it.
(3) Thirdly, the aim of public expenditure to give fillip to private sector by providing loans,
grants and subsides, tax concessions and exemptions, market and other information and
research facilities. The government may set up special banking and financial facilities
such as an industrial development bank and financial corporation to provide finance for
medium and long term loans at low interest rates to provide adequate finance for private
sector industries.
(4) Lastly, for the economic development of the country the government must provide
indirect fillip by incurring public expenditure on such heads as education, public health,
training and research and development and on creating employment opportunities in
backward regions etc. Besides, economic overheads include transport and
communication, water and power facilities, etc.
Thus in the development programs, all sectors of the economy should grow
simultaneously so as to keep a proper balance between industry and agriculture, and
between production for home consumption and production for export.

4.5 The principle of maximum social advantage

The fiscal or budgetary operations of the state have manifold effects on the economy. The
revenue collected by the state through taxation and the disposal of public expenditure can have
significant influence on the consumption, production and distribution of the national income of
the country.

Public revenue and public expenditure are two important financial operations of a state. Every
government has to obtain revenue to incur expenditure. These two financial operations of the
state must be governed by some fundamental principle, so that they may result in maximum
social benefit.

Both public revenue and public expenditure are known as public finance. Pigou and Dalton were
the two prominent economists, who formulated and popularized the fundamental principle of

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public finance. The principle says that the State should collect revenue and spend money so as to
maximize the welfare of the people.
The best system of public finance is that which secures maximum social advantage from the
operation which it conducts. Dalton called this principle as the principle of maximum social
advantage. Maximum social advantage is the maximum for the states. It has already been
mentioned above that maximum advantage to the society depends on public revenue.

There are two important sources public revenue:

(i) Tax sources
(ii) Non-tax sources
To provide maximum advantage to the society, the government imposes taxes on the people to
incur expenditure on social welfare apart from other heads of expenditure, e.g., defense,
maintenance of law and order. Only the expenditure incurred on social welfare i.e., social
amenities, provides direct benefit to the people.
While explaining how to achieve maximum social advantage, it is necessary to understand two
important concepts:
(1) Increasing marginal social sacrifice due to additional taxation
As it has been discussed that to maximize the welfare of the people, the government
has to impose taxes. Taxes put a real burden on the people. Whenever tax is imposed,
tax-payers have to sacrifice their consumption and other wants to pay taxes. In other
words, tax payers are forced to curtail their expenditure which cause inconvenience to
them.
According to Dalton, every additional taxation leads to additional sacrifice. But with
every increase in taxes, the additional sacrifice goes on increasing with every
additional birr collected by way of tax. This involves a greater additional sacrifice on
the part of the people. This, on other words, is called “increasing marginal social
sacrifice (MSS) due to additional taxation. “ In simple words, it means with every
additional tax collected, the marginal social sacrifice goes on increasing.

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 (2) Diminishing marginal social benefits (MSB)
When the government spends money, it confers benefit on the people: Since the tax
revenue is to be spent to provide welfare to public at large, the benefit from the
expenditure of the government keeps on declining. In other words, as more and more
benefits are conferred on the people, its utility to the people goes on diminishing.
Hence, Dr. Dalton says as more and more money is spent on the people, the total
benefit increases but additional public expenditure leads to diminishing marginal
social benefit (MSB). In other words, the main reason for this downward trend is that,
when more and more people and more and more areas are brought within the purview
of welfare amenities, social benefit form public expenditure declines.

Extent of public revenue and expenditure

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To maximize the social welfare, the state should so adjust the revenue and expenditure that the
surplus of utility is maximized and disutility is minimized. In other words, to provide maximum
advantage to the people, the state should adjust revenue and expenditure up to the point where
marginal sacrifice is equal to the marginal benefit. This is the optimum limit of state’s public
finance activity. Thus public expenditure should be incurred up to the point, where marginal
utility, due to public expenditure, is just equal to the marginal disutility due to taxation of public
income.

Tests of social advantage

Dalton has suggested certain tests of social advantage i.e certain objectives which are to be
achieved, which enhance social advantage of the community as a whole. Social advantage may
be judged by certain objective tests,
(1) Preservation of the community
The duty of every government should be to preserve the community against internal
disorders and external attack. Public expenditure should be so devised by the government
as to preserve the interests of the community. More the public expenditure on defense
and maintenance of law and order, more the preservation of society against foreign attack
or internal disorder like terrorism, theft etc. Thus, defense expenditure, expenditure on
police, etc., to maintain law and order, security and democracy are justifiable. In fact,
preservation, protection and maintenance of the community is the prime requisite of
social advantage. It is, therefore, essential to maintain army, police and judiciary etc. to
meet external and internal threats of the enemy successfully. If there is political disorder
and fear of foreign attack, the welfare or advantage in general will deteriorate. For this
reason, the large sum of money spent on armed forces, police and judiciary may be quite
justifiable. In any case, it is the duty of the state to increase welfare, both economic and
non-economic, of its members. To preserve the community, peaceful and just policy may
be followed. Any unsound public policy may cause discontent in the country, and may
perhaps necessitate increased expenditure for maintaining law and order.
(2) Improvement in production
The second objective of the operations of public finance should be to increase the level of
production, so that the economic welfare of the community may increase. Economic

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 welfare depends on the income generation from agricultural sector and industrial sector.
To increase income from these sectors, the government should incur expenditure on the
development of these sectors by way of creating infrastructure in the form of canals,
electricity generation etc. The expenditure incurred by the government on the
infrastructure will increase production. With the increase in production, more and more
people will get employment; their purchasing power will also go up. Thus improvement
in production implies (i) increase in productive power, so that a larger product per worker
shall be obtained with a small effort; (ii) improvements in the organization of production,
so as to reduce, to a minimum, the waste of economic resources through unemployment;
(iii) improvement in the composition and pattern of production, so as to serve the needs
of the community.
(3) Improvement in distribution
Public expenditure and public revenue seeks to reduce economic inequality by
distributing whatever is produced equitably among different groups of the community. To
bring about improvement in distribution, the government should follow the policy of
progressive taxation, Progressive taxation, if followed will reduce the capacity to pay of
the richer section of society. The amount so realized from them will then be spent on
social welfare which will provide direct advantage to the poorer section of society. As
Dalton puts “Improvement in distribution implies (i) reduction in inequality, which is
found in the incomes of different individuals and families, and (ii) a reduction in great
fluctuation between different periods of time, incomes of particular individuals and
families, especially among the poor section of society”
(4) Stability and full employment
Economic instability (booms and depressions) i.e. inflation and deflation is the cause of
unemployment and over production. Social advantages to the community can be
increased if business conditions in the country are stable and all fluctuations are
eliminated. Hence, the aim of taxation should be to bring and maintain economic stability
at high level of employment. Fiscal operations designed to maintain economic stability
benefit social advantage. Control of economic fluctuations means economic stability.
Reduction in tax liability and expenditure on public works etc,., can reduce the effects of
depression and thus may increase employment and effective demand. Similarly public

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 borrowing and heavy taxation during the period of inflation may help to bring the price
level down.
(5) Provision of future
Public expenditure and taxation policy can provide stable future if the principle of
maximum social advantage is adhered to by the government. In other words, the
government should stop public expenditure at a level where utility of public expenditure
is maximum and disutility of public taxes is minimum. This will prove to be good for the
present as well as for the future. If the government allows public expenditure beyond this
level, the level of sacrifice will be much higher than the benefit derived by the public at
large. The operations of public finance should, therefore, prefer a larger social advantage
in the future period to a smaller one of today.

Limitations of principle of maximum social advantage

Although the principle of maximum social advantage is regarded as an ideal and the best guiding
principle of the state’s financial activities yet there are certain limitations and difficulties in the
way of practical application of this principle.
(1) The society gets maximum advantage when the government incurs expenditure on the
people. This principle is criticized on the ground that it is very difficult to measure the
benefit derived by the people from the expenditure incurred by the government. How
much benefit an individual derives from the expenditure incurred by the government on
army, police education, cannot exactly be estimated. So also, it is difficult to measure the
marginal dissatisfaction caused to each individual separately from each additional tax. In
other words, when some public spending is made for the future benefits, measurement of
its utility cannot be determined in the present. As such, the government may find it
impossible to compare the marginal social benefits and sacrifice related to its fiscal
operations.
(2) It is incorrect to say that every tax is burden on society and every state expenditure is a
benefit. For example, a tax on excess profit or inheritance tax is not a burden on each and
every tax-payer. On the other hand, expenditure incurred by the government on potato
chips cannot be called a benefit.

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(3) There is no direct relationship between the tax and the expenditure incurred during a
period of one financial year. In other words, the tax imposed in one year and expenditure
incurred by the government in the same year may not have direct benefit to the people in
the same year. The benefit may spill over subsequent years. For e.g. expenditure incurred
by the government on the construction of dam may not provide benefit in the year of
incurring expenditure. People may derive benefit in subsequent years.
(4) The principle of maximum social advantage takes into account only tax revenue. But in
public finance, it is not only the tax revenue which is important, even non-tax revenue
such as loans, borrowing constitute a sizeable portion of revenue. Non-tax revenue, like
tax revenue, may also be spent for the public good. Hence, the entire principle of
maximum social advantage based on tax revenue and expenditure is incorrect.
(5) The Government is obliged and committed to certain expenses -a liability it cannot free
itself from easily. These expenses include maintenance of law and order, defense of the
country and certain welfare measures such as old age pension etc. Even if authorities
believe that some of these expenses should be reduced, it is not so easy to do, because
these heads are vital for the existence of society.
(6) Lastly, the principle of maximum social advantage becomes inoperative when the
government seeks to realize revenue objective only. Revenue objective implies
optimizing revenues which may be possible more often by taxing some of the necessaries
of life. The tax imposed on the necessaries of life does not bring about any shortfall in
demand. Hence, the government earns maximum revenue. This is against the principle of
maximum social advantage.

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