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Classical Public Finance Theories Explained

The document discusses the evolution of public finance theories, starting from Adam Smith's classical approach, which emphasizes minimal government intervention and indirect taxation, to the Keynesian theory advocating for significant government involvement during economic downturns. It also introduces the Musgrave Approach, which focuses on income redistribution and resource allocation. The subject matter of public finance includes public revenue, expenditure, debt, and fiscal federalism, highlighting the importance of taxation in funding government activities.

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7 views4 pages

Classical Public Finance Theories Explained

The document discusses the evolution of public finance theories, starting from Adam Smith's classical approach, which emphasizes minimal government intervention and indirect taxation, to the Keynesian theory advocating for significant government involvement during economic downturns. It also introduces the Musgrave Approach, which focuses on income redistribution and resource allocation. The subject matter of public finance includes public revenue, expenditure, debt, and fiscal federalism, highlighting the importance of taxation in funding government activities.

Uploaded by

johncarlovocales
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

CHAPTER NINE

Classical Public FinanceClassical treatmentsof public finance started very largely from
thefoundations provided by Adam Smith in book V of the Wealth of [Link] Smith’s
discussion of equality stemmed both the “ability-to-pay” and “benefit” approaches to taxation, which
were to be the centralthreads of the nineteenth-century literature. On this basis there devel-oped
an extensive framework of ideas dealing with the taxable capacityof a country, and the appropriate (and
least harmful) tax base, with mostwriters (though not all) showing a detailed appreciation of the
existingtax [Link] from dealing with taxes on wages, profits, and rent, as Smithhad done,
and with the general case for direct and indirect taxes, the lit-erature went far beyond him in considering
the appropriate form of in-come tax (itself a form of taxation developed after Smith’s death) and,
inparticular, the questions of progression and whether permanent and tem-porary incomes should be
taxed at the same [Link] was the focus of the discussion, as it is of this chapter, be-cause it
had clearly to be the main long-run source of revenue. But theBritish state was a frequent borrower, and
the country had built up a sub-stantial public debt by 1815. The Classical economists devoted a
gooddeal of attention to the problems caused by the existing debt, as well asconsidering under what
circumstances it might be appropriate for gov-ernment to create new [Link] we begin with the
general principles of public finance.I. General Principles of Public FinanceThe Classical treatment of
public finance started from the position thatthere were four main sources of revenue for the state:
taxation, debt cre-ation, state property (mainly land) ownership, and state enterprise. Wecan dismiss the
last two quickly. There was fairly widespread agreementthat state ownership of property was unlikely
to yield much revenue;Smith had argued persuasively that the land languished under state own-
ership.1James Mill, it is true, favored state ownership of land in newcountries, with revenue
being raised through auctioning of the ground

PUBLIC FINANCE The study of Economics seeks to minimize the problem of scarcity and choice. This
study has a whole lot of branches. However, Public finance is a branch of economics amongst others. The
term Public finance is a branch of economics that deals with the "flow of revenue and expenditure" of
government within an economy that further seeks to achieve a desirable objectives. In essence, it deals
with the financing of the state. THEORY OF PUBLIC FINANCE There are three theories of public finance,
which are outlined as follow; The Classical theory of public finance The Keynesian theory of public
finance The modern theory of public finance otherwise known as the Musgrave Approach. The classical
theory believes that government intervention must be minimal/ minimum, Government must be
entrusted only with small budget within an economy, thereby public borrowings is not allowed as
regards small government, the method of taxation adopted is indirect taxes and the small government
must operate on Balanced Budget. Although, the classical theory reveals that government intervention is
a necessary evil yet on the premise of maintenance of security, judicial system and infrastructural
development the intervention of government must be minimal. The classical school is driven by self-
interest and competition which further determines prices through market forces. Adams smith in his
work on wealth of nations 1776 proposed the practice of Laissez flare within an Economy. Later on, the
classical school proposed a model which was formerly known as the classical model. Mathematically,
This model was deeply rooted in say's Law of markets, which further states that supply will always create
demand as the price system automatically attains Equilibrium. Where, quantity demanded is equal to
quantity supplied.

In the final analysis, it was believed that supply will unequivocally determine national income and full
employment will be attained within an economy. However, in 1930s the Keynesian theory became a
revolution to the classical theory.

The Keynesian theory:The economic issue of 1930s led to great depression, under employment and so
on. TheKeynesiantheory believes that there is a great need for government intervention on a large scale,
Government must be entrusted only with large budget within an economy, whereby public
borrowings/debts is allowed as regards large government, the method of taxation adopted is both direct
and indirect taxation and the large government should operate on Deficit Budget (because of public
debt) The Musgrave Approach: This theory was proposed by the Richard Musgrave. This theory seeks to
redistribute income (between the two major classes of individuals; the rich and the poor), allocate
resources and stabilize macroeconomic variables. According to Richard Musgrave, the presence of
government is quite necessary within an economy. Thus, it can be deduced that the modern theory is
fully in support of the Keynesian theory.

SUBJECT MATTER OF PUBLIC FINANCE

In the final analysis, it was believed that supply will unequivocally determine national income and full
employment will be attained within an economy. However, in 1930s the Keynesian theory became a
revolution to the classical theory. The Keynesian theory:The economic issue of 1930s led to great
depression, under employment and so on. TheKeynesiantheory believes that there is a great need for
government intervention on a large scale, Government must be entrusted only with large budget within
an economy, whereby public borrowings/debts is allowed as regards large government, the method of
taxation adopted is both direct and indirect taxation and the large government should operate on Deficit
Budget (because of public debt) The Musgrave Approach: This theory was proposed by the Richard
Musgrave. This theory seeks to redistribute income (between the two major classes of individuals; the
rich and the poor), allocate resources and stabilize macroeconomic variables. According to Richard
Musgrave, the presence of government is quite necessary within an economy. Thus, it can be deduced
that the modern theory is fully in support of the Keynesian theory. SUBJECT MATTER OF PUBLIC FINANCE
The subject matter was largely coined from the theories of public finance. These are as follows; Public
Revenue: The term Revenue refers to the amount of money earned from the sale of a product. With
regard to the scope of public finance, the term public revenue is a narrow concept of Public receipts. This
is defined as the funds expended by the government in an activity without the use ofpublic borrowings/
public loan. More importantly, this is done through the use of tax revenue and non-tax revenue. Public
Expenditure Public debt Financial administration Fiscal federalism. Sources of Public Revenue: This is
further branched out into Tax revenue and Non-tax revenue. The tax revenue are mostly generated
through taxation. However, the non-tax
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PUBLIC FINANCE The study of Economics seeks to minimize the problem of scarcity and choice. This
study has a whole lot of branches. However, Public finance is a branch of economics amongst others. The
term Public finance is a branch of economics that deals with the "flow of revenue and expenditure" of
government within an economy that further seeks to achieve a desirable objectives. In essence, it deals
with the financing of the state. THEORY OF PUBLIC FINANCE There are three theories of public finance,
which are outlined as follow; The Classical theory of public finance The Keynesian theory of public
finance The modern theory of public finance otherwise known as the Musgrave Approach. The classical
theory believes that government intervention must be minimal/ minimum, Government must be
entrusted only with small budget within an economy, thereby public borrowings is not allowed as
regards small government, the method of taxation adopted is indirect taxes and the small government
must operate on Balanced Budget. Although, the classical theory reveals that government intervention is
a necessary evil yet on the premise of maintenance of security, judicial system and infrastructural
development the intervention of government must be minimal. The classical school is driven by self-
interest and competition which further determines prices through market forces. Adams smith in his
work on wealth of nations 1776 proposed the practice of Laissez flare within an Economy. Later on, the
classical school proposed a model which was formerly known as the classical model. Mathematically,
This model was deeply rooted in say's Law of markets, which further states that supply will always create
demand as the price system automatically attains Equilibrium. Where, quantity demanded is equal to
quantity supplied. Note: The price system is the most efficient tool for Resource Allocation.

In the final analysis, it was believed that supply will unequivocally determine national income and full
employment will be attained within an economy. However, in 1930s the Keynesian theory became a
revolution to the classical theory. The Keynesian theory:The economic issue of 1930s led to great
depression, under employment and so on. TheKeynesiantheory believes that there is a great need for
government intervention on a large scale, Government must be entrusted only with large budget within
an economy, whereby public borrowings/debts is allowed as regards large government, the method of
taxation adopted is both direct and indirect taxation and the large government should operate on Deficit
Budget (because of public debt) The Musgrave Approach: This theory was proposed by the Richard
Musgrave. This theory seeks to redistribute income (between the two major classes of individuals; the
rich and the poor), allocate resources and stabilize macroeconomic variables. According to Richard
Musgrave, the presence of government is quite necessary within an economy. Thus, it can be deduced
that the modern theory is fully in support of the Keynesian theory. SUBJECT MATTER OF PUBLIC FINANCE
The subject matter was largely coined from the theories of public finance. These are as follows; Public
Revenue: The term Revenue refers to the amount of money earned from the sale of a product. With
regard to the scope of public finance, the term public revenue is a narrow concept of Public receipts. This
is defined as the funds expended by the government in an activity without the use ofpublic borrowings/
public loan. More importantly, this is done through the use of tax revenue and non-tax revenue. Public
Expenditure Public debt Financial administration Fiscal federalism. Sources of Public Revenue: This is
further branched out into Tax revenue and Non-tax revenue. The tax revenue are mostly generated
through taxation. However, the non-tax

revenue are largely generated throughcommercial revenue, Administrative revenue (This is properly
examined under the stated forms; Administrative fees and License fees) Grants and Aids. Taxation is a
compulsory levy imposed on the economic activities of households and firms without a direct benefit of
payments. By and large, this compulsory contribution paid by individuals and firms to the government
helps to defray the expenses incurred for common welfare. Ideally, it is only fair to expect something in
returns. However, government only provide public goods because of the welfare of the people. Hence,
taxes are aimed for the provision of public expenditure. Intuitively, not every compulsory payment
should be regarded as a TAX. Whence, the imposition of betterment levy, fines, and voluntary gifts
comes with a benefit.

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The Keynesian belief in deficit spending stems from addressing the economic challenges of the 1930s like the Great Depression. It considers government intervention and large budgets necessary to stimulate demand and employment through public spending, even if it results in public borrowing and a deficit budget . On the other hand, classical preference for balanced budgets is rooted in minimal state intervention, emphasizing that the market should naturally reach equilibrium through self-interest, thereby limiting government's fiscal role to avoid long-term debt and ensure economic stability through indirect taxation .

Classical public finance advocates minimal government intervention with a focus on small budgets and balanced budgets through indirect taxation, reflecting the belief that government interference is a necessary evil primarily for maintaining security, judicial systems, and infrastructure . In contrast, the Keynesian approach emerged as a reaction to the economic issues of the 1930s, emphasizing significant government intervention, larger budgets, allowance for public borrowing, and the use of both direct and indirect taxation to manage the economy, with a preference for deficit spending to stimulate demand and address underemployment .

Classical economists favored minimal government budgets with no public borrowing, reflecting a cautious stance on public debt to maintain economic stability and avoid the potential for future financial burdens on the state . Modern theories like Musgrave's, which align with Keynesian principles, accept public debt as a tool for economic intervention and redistribution efforts, seeing it as essential for stabilizing and stimulating the economy, instead of being inherently problematic .

Richard Musgrave's theory suggests that the government plays a crucial role in redistributing income between rich and poor, allocating resources efficiently, and stabilizing macroeconomic variables. This theory supports the Keynesian view that government intervention is essential within an economy, aimed not only at economic stability but also at ensuring equitable wealth distribution .

The classical model of public finance is built on the premise of Say's Law, which asserts that supply creates its demand. This model posits that supply will unequivocally determine national income, as the price system ensures that the quantity supplied will meet the quantity demanded, achieving market equilibrium. Thus, the classical perspective sees the full employment of resources and a naturally regulated economy without needing government intervention, as supply-side activities drive national income and economic growth .

Adam Smith's discussions on equality introduced the 'ability-to-pay' and 'benefit' approaches to taxation, which became central themes in 19th-century public finance literature. These concepts laid the groundwork for discussions on the appropriate tax base and methods, influencing how classical economists viewed taxable capacity and the effects of taxes on wages, profits, and rents. His arguments set the stage for the detailed exploration of income tax forms, progression, and the taxation of different income types, although income tax itself was developed posthumously .

Classical economic principles are reflected in present-day economic policies that prioritize market-led growth, deregulation, and privatization. For example, policies emphasizing reducing government budgets and reliance on market forces for resource allocation align with classical tenets of minimal state interference. Additionally, measures like tax cuts and reduced public sector involvement reflect the classical preference for indirect taxation and small government, as seen in some contemporary fiscal strategies aiming to stimulate competition and economic efficiency .

Classical economists focused on the British state's borrowing practices as the country had accumulated substantial public debt by 1815. They were concerned about the long-term effects of such debt on the economy. Classical thought favors minimal government budgets and disallows public borrowing, instead relying on balanced budgets and indirect taxes. Therefore, the management and reduction of existing debt and careful consideration of circumstances for new debt were crucial issues .

Sources of public revenue, divided into tax and non-tax revenue, impact government policy by shaping how fiscal resources are generated and allocated. Tax revenues, primarily through compulsory levies, influence government's capacity for public expenditure on welfare, and non-tax revenues supplement these by coming from administrative fees, grants, and commercial activities. This distribution guides policy decisions on where to focus fiscal initiatives, how to balance budgets, or whether to adopt deficit financing .

The Keynesian theory identified several limitations in the classical model during the 1930s, notably the inability to achieve full employment. The classical reliance on self-correcting market forces and Say's Law fell short under the Great Depression conditions, where insufficient demand led to prolonged underemployment and economic instability. Keynes argued that active government intervention was necessary to stimulate demand and achieve full employment, countering the classical assumption that markets would naturally adjust to these imbalances .

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