Chapter 4
PUBLIC EXPENDITURE
4. PUBLIC EXPENDITURE
• Public expenditure refers to the expenses which the government incurs
for its own maintenance, for the society and the economy as a whole.
• Historically, public expenditure has recorded a continuous uptrend over
time in almost every country.
• However, classical thinking and philosophy did not favor the growth of
public expenditure.
• It was argued that each economic unit was the judge of its own
economic interests and the government was certainly not able to decide
on behalf of others.
4.1 Causes of Growth in Public Expenditure
– Population growth
– Increasing urbanization
– Provision of economic overheads
– Maintenance of law and order
– Welfare activities
– Provision of public goods and utility services
– Servicing of public debt
– International obligation
4.2. Public expenditure: Canons, Theories and
Accountability
4.2.1. Canons of public expenditure
I. Canon of Benefit.
• PE should be so planned and implemented as to bring about the
greatest possible benefit to society. It means that all such
expenditures which do not bring benefit to society should be
avoided.
• Benefit from PE may be identified with achievement of proper
allocation of economic resources, proper distribution of income in
society and stability of price level and growth of economy.
• This canon also points to the need of undertaking a cost-benefit
analysis of the competing schemes of public expenditure before
the final selection of investment project is made.
ii. Canon of economy
– Public expenditure should be incurred carefully so that there is no
wastage of funds. Since resources are limited in the society, they
have to be most properly utilized.
– Economical use means most proper utilization.
– Most important reasons of wasteful expenditures are poor
planning, execution, corrupt practice and delay due to time lag
between plan and execution and, hence, escalation of prices.
– These types of wastage have to be avoided at any cost
iii. Canon of surplus
– This canon requires that expenditure of public authorities should
be kept within the limits of current revenues.
– If possible, the expenditure should be less than the earnings of
government so that it can be used when there is deficit.
– Surplus can be generated either by controlling expenditure or by
increasing current revenues.
iv. Canon of sanction
– This canon requires that the public authorities should
not be allowed to spend funds without having a
previous sanction from appropriate authority for the
purpose.
– It also requires that funds sanctioned for a particular
expenditure should not be diverted to a different
purpose and spent thereon. In a democracy, such
sanctioning authority is vested on the legislature.
– Since there are different agencies in the governmental
set up for executing public expenditure programs,
detailed authorizations are worked out for different
spending agencies so that misuse and wastage of
expenditure can be avoided.
v. Canon of elasticity
– Canon of elasticity requires that the rules of public
expenditure should not be too rigid to achieve the real
purpose and that it should be allowed to vary according
to the needs and circumstances.
– For example, if the economy suffers from
unemployment and deficiency of demand, there should
not be a rigidity that the budget should be balanced.
– Under such situation, the government should go for a
deficit budget and inject additional purchasing power
into the economy so that effective demand is increased
and factors of production are employed on larger scale.
vi. Canon of certainty.
• This canon requires that public authorities should clearly
know the purpose and extent of public expenditure.
• The spending unit should be certain as to the amount
and objective of public expenditure.
• This requires a proper expenditure plan well thought out
beforehand.
• The canon of certainty is followed through the
preparation of budget.
4.2.2 Theories of Public Expenditure
[Link] Classical Theory of Minimum Expenditure
• According to classical theory, public expenditure must be
limited to the bare minimum and must not exceed public
revenues.
• This theory is based on the assumption of full – employment
and laissez-faire doctrine.
– Since the economy operates at full employment level, the problem of
economy in the classical system is not attainment of growth.
– The economy functions with maximum efficiency.
– Moreover, with the philosophy of ‘laissez-faire’ followed, most of the
economic activities are performed by the private sector. Hence, the
size of PE is always small and the budget should always be balanced.
– If public expenditure becomes more and is financed by public
borrowing, there will be withdrawal of funds from private sector
where they are more productively employed. Such diversion of
resources will cause a decline in overall economic efficiency.
[Link] Principle of Maximum Social Advantage
• The principle of maximum social advantage lays down
that public expenditure should be so planned and, hence,
revenue resources raised so as to bring about benefit
larger than sacrifice.
• Large investment of expenditure means large sacrifice of
tax payers.
• Even then if it is a capital investment, the ultimate benefit
may be much larger than the communities’ sacrifice.
• Secondly, the method of taxing to raise resources for
expenditure has to be thoughtful.
• That method should be employed which will result in least
sacrifice.
• Thirdly, tax-expenditure programme should be so structured
as to result an increased productive capacity of community
and, hence, enhanced national income.
• The principle of maximum social advantage is derived from
the principle of equi-marginal returns as applied to an
individual.
• Thus, if it is found that marginal utility from public
expenditure on medical and public health measures is
greater than the marginal utility derived from the same
amount spent on provision of public parks, then the
government should transfer the public funds from the latter
to the former account. This will maximize social advantage.
Figure 4.1 Public expenditure on public parks Figure 4.2 Public expenditure on
medical and public health
•As shown in figures the limited amount of PE totals OA and the amount O 1B spent
respectively on public parks and medical and public health.
• The allocation of expenditure at OA results in lower marginal utility than at O 1B.
• Hence, transfer of expenditure of the amount AK (=BL) from public parks to the
provision of medical and public health will raise aggregate utility because the
increase of utility area BLMD is larger than reduction of utility area KACN.
•This is how equality in MU from PE in all directions will maximize social
advantage.
The main defect of the theory is that
I. It is not possible to measure precisely the difference
in benefits from different directions of public
expenditure.
II. The requirement of the principle that expenditure
should not be specially made for a particular section
of society is not followed in many underdeveloped
countries where special attention is paid to the
benefits of backward sections of society in preference
to other communities
[Link] Principle of Maximum Aggregate Benefit
• Pigou also argues that expenditure should be made in such a way
that it leads to maximum welfare of the maximum number.
• In his words, “expenditure should be pushed in all directions up to
the point, at which satisfactions obtained from the last shilling
expended is equal to the satisfaction lost in respect of the last
shilling called upon government service.”
• Pigou's theory requires the application of two rules, viz.,
a) the principle of equi-marginal returns whereby individuals maximize
satisfaction by spending their income on different goods in such a way that
marginal utility from each type of expenditure is equal and
b) the principle of equality between marginal social sacrifice and marginal
social benefit. This is illustrated in figure 4.3 below.
MSB and MSS are shown by the curves EEl and TTl respectively. The net
benefit is shown by NN1 curve. Thus, when the amount of PE or taxation
increases from OC to OL, MSB from expenditure is reduced from AC to KL,
while MSS of taxation increases from CD to LM.
At OL amount of expenditure, MSB and MSC are equal because KL = LM. It
is here that optimum size of budget is determined and maximum
aggregate benefit is secured to the society.
• Though this theory is excellent in outlook, is not
practically applicable.
– There is neither a scientific measure for MSB and MSC
nor a convincing method of constructing utility graphs
without assuming the impracticable inter-personal utility
comparison.
• However, the theory has enough materials to guide
the public authority in the direction of achieving
greatest good of the greatest number.
[Link] Bowen's Model of Public Expenditure
• Since social goods, by definition, are those goods and
services which are consumed equally by all, the cost of
supplying them have to be contributed by all
beneficiaries.
• How much amount of social goods is to be supplied will be
determined at that level where MC of supplying the social
goods becomes equal to the sum of MUs received by the
beneficiaries.
Assuming that there are only two individuals in society, viz., A
and B and only one type of public goods, X, the following
condition will hold for the determination of PE or, what it
means the same thing, the amount of social goods to be
supplied by the government. MUA + MUB= MCx
Px + Px = MCx, Hence, TC = QPx + QPx,
-The demand schedules for social goods of A and B are shown by the lines aa and bb
respectively. The line tt shows the aggregate demand schedule of both A and B.
- Let SS be the supply schedule of social goods which are assumed to be produced under
conditions of increasing cost.
- Since the same amount of social good will be consumed by both A and B, the
aggregate demand schedule, tt is made up of vertical summation of aa and bb.
• The equilibrium output will be determined at OQ because it is at this
level of production that the aggregate DD and aggregate SS schedule
intersect at point P, where the equilibrium price will be PQ.
• This is the combined unit price which will be contributed by both A
and B. Of the unit price PQ, A contributes QN and B contributes QR,
their respective demand prices.
• If the output is less than this, say, OC, the demand price or the
combined contribution will be much larger (CG) than the supply price
(CE).
• Since the combined offer price exceeds the unit cost, this will lead to
increase in supply of social goods.
• On the other hand, if supply is more than OQ, say, OD, the unit cost
(DK) exceeds the combined offer price (DL). This will lead to
reduction in supply of social goods.
• In this way, equilibrium output is established at OQ.
• The total cost of supplying OQ amount of social
good equals OQPU which is covered by A's
contribution OQRV plus B's contribution OQNW
since OQRV + OQNW = OQPU.
[Link]. Lindahl’s Model of Voluntary Exchange
• The voluntary exchange model of public expenditure
theory is concerned with what Erik Lindahl calls 'purely
fiscal' problem of providing for the satisfaction of public
wants. It does not concern itself with the problem of just
distribution of income. This is taken as given.
• The determination of public expenditure and taxation is to
be made on the basis of individual preferences.
• For this purpose, says Lindahl, three sets of decision are
necessary, i.e.
I. the determination of total amount of PE and taxes,
II. allocation of total PE among various social wants, and
III. allocation of total taxes among various individuals.
All these have to be done simultaneously.
• if 'A', the purchaser of his benefit share, is willing to
contribute x % of the total joint cost, B will be called upon
to contribute the rest, i.e. (1-x) percent for purchasing his
own benefit share.
• Thus, one will have to pay more if the other contributes
less so that the joint contribution of both A and B covers
total cost of supplying the social good.
• It follows that A's offer to contribute certain percentage of
total cost may be looked upon as B's supply schedule of
social goods; and B's offer may be similarly interpreted
from A’s point of view.
• We measure quantity of social goods along horizontal axis,
percentage of total cost contributed by 'A' along left
vertical axis and percentage of total cost contributed by 'B'
along right vertical axis.
• The total unit cost of supplying social goods is OV. The
curve aa is the demand schedule of individual 'A‘ and bb is
for individual ‘B’ calculated by inverted scale on the right
axis.
• The demand schedule of 'A' may be viewed as supply
schedule of 'B' and the vice versa
• A' will be willing to contribute 100 percent of cost for
output OD, which will be available free to 'B'.
• At the output level OG, individual 'A' is willing to
contribute 75 percent of the cost (GS) and, hence, the output
is available to 'B' at 25 percent of cost (RS) since the
vertical distance between upper horizontal axis and B's
supply schedule at this level of output is RS percent.
• However, B will be willing to contribute 50 per
cent, i.e. RT because T is the point on his demand
schedule.
• Thus the total contribution of both A and B will
exceed the cost of supplying the social good by ST
percent (25 %).
• This is an indication of their preference for larger
scale of social goods.
• The optimum level of social goods is given by' OE
at which' A' contributes EQ percent and B
contributes PQ percent of cost and, hence, the
combined contribution is exactly equal to the total
cost of supplying this level of output.
• If, now, 'A' contributes KC Per cent and 'B' contributes NC
per cent so that OK amount can be supplied, both will be
paying larger than what they are willing to pay.
• Hence both 'A' and 'B' will vote for smaller amount of social
goods. In the same way it can be shown that both the
individuals will vote for larger amount of social goods at
the -level of supply lesser that the optimum scale of OE
output.
• If we relax the assumptions and allow for a number of
social goods and many tax payers, the theoretical validity
of the model will not be affected though some complexity
will arise.
[Link] Samuelson's Benefit theory of Public Expenditure
• Application of market principle to the pricing of social
goods to determine optimum allocation of resources
becomes the starting point of Samuelson's theory.
• In the case of a private good, MU and MC are equal for all
consumers. Since utility schedules of individuals are
different, such equality and, hence, efficient level of output
will be attained with different consumers consuming
different amounts of output at the same price.
• It follows that the aggregate demand schedule will be the
horizontal summation of individual demand schedules.
However, in the case of public goods which are, by
definition, consumed equally by all, different individuals
will pay different prices for the same quantity of output.
• Here the sum of MUs to consumers will be equal to the MC.
It follows that the individual demand schedules will be
vertically added in this case.
• Thus under such circumstances, “even if all preferences are
revealed, there is no single best solution analogous to the
pareto optimum in the satisfaction of purely private wants.
Instead, we are confronted with large number of solutions,
all of which are optimal in the Pareto sense.”
[Link] Musgrave's Optimum Budget Theory
• The Optimum Budget theory of Musgrave seeking
to determine the optimum amount of PE is a
normative approach to budget policy.
• Musgrave built up an ideal theory according to
which a budget should realize three objectives, viz,
• proper allocation of resources,
• proper distribution of income, and
• price stability with full employment.
• For each of three objectives, Musgrave would
consider as a sub-budget.
• When these three sub-budgets are prepared
according to their objectives, they will be
consolidated into a single whole budget plan.
• The optimum budget theory seeks to achieve the
purpose of allocation branch of the budget.
• Musgrave's theory of determination of optimum
public expenditure in the allocation branch of the
budget is based on benefit approach.
• The people have a choice pattern or preference
schedule between public goods, private goods and
leisure.
• Optimum budget theory seeks to allocate public
expenditure or provide for public goods in such a
manner and, to that extent, whereby the
community, as a whole, is able to derive the
greatest attainable satisfaction.
• This is possible when allocation of public expenditure in
different lines of state activity is so determined in the
budget that the community is able to reach the highest
possible indifference surface as between public goods,
private goods and leisure.
• Practical difficulty, however, lies in the fact that the people
cannot be made to reveal their preference pattern and
that it is difficult, if not impossible, to construct
community indifference surface from individual
indifference patterns.
Control and Accountability of Public Expenditure
• “It means that expenditures are justified in terms of the
whole welfare of society and in terms of the financial
means at the disposal of government. Control implies that
expenditures are economic by which we mean that
resources not unlimited in quantity are devoted to their
most productive uses.”
• Control of public expenditure is sought to be ensured
multi-dimensionally at a number of stages.
• The most important means of control are:
(a) budgetary control
(b) legislative control,
(c) executive control,
(d) audit control, and (e) parliamentary control.
a) Budgetary Control
Budget preparation is the most primary stage of expenditure
control. Budget is a well thought-out plan of governmental
activities during the coming year and speaks of much more than
a mere statement of income and expenditure of public
authorities.
It specifies the functions and objects of public expenditure.
How much of the public funds is to be spent for which particular
purpose, and which particular department,
what should be attainment of physical targets against the
specific expenditure amount and
what should be the allocation of funds for the use of a particular
department
are all specified in the budget frame.
b) Legislative Control.
After the budget plan is prepared, it has to be presented in the
legislature for its approval.
There occurs debate in the legislature where the members seek
clarification and justification of expenditure programmes.
C, Administrative Control.
The rules and regulations ensure that no amount is spent without
proper sanction or diverted to some other purpose for which it is
not sanctioned.
There is elaborate body of rules to fix responsibility on specific
executive personnel for the funds spent.
The rules ensure that there is no fraud or misuse or
misappropriation or any other kind of leakage during the
execution of public expenditure programmes.
(d) Audit Control.
– The next stage is scrutiny of accounts and audit control.
– There is the system of both internal and external audit.
Every department has its accounts section which
scrutinizes all accounts of expenditure and ensures that
public funds are spent according to rules of propriety,
economy and efficient utilization.
(e) Parliamentary Control.
– The last of these stages of expenditure control is the
parliamentary right to enquire into any particular item of
expenditure deal.
– There are two committees constituted by the parliament
to go into such scrutiny. They are (i) Public Accounts
Committee and (ii) the Estimates Committee.
• Public accounts committee is entrusted with the
responsibility of
– examining audit reports and appropriation accounts.
– They also examine profit and loss accounts of
government undertakings and autonomous bodies.
– They follow up cases of impropriety, unauthorized and
illegal expenditure, misuse and misappropriation and go
into further investigation if necessary.
• Estimates committee
– looks into the financial operation of the executive and
suggests measures to achieve maximum economy of
expenditure consistent with maximum efficiency.
– The parliamentary committees pinpoint the erring
officials, examine them and suggest follow-up measures
for suitable punishment to them.
4.3 Effects of public expenditure on production
and distribution
4.3.1 Effects on Production and Employment
• The level of production and the level of
employment in any country depends upon
three factors, viz.,
a. Ability of the people to work, save and invest,
b. Willingness to work, save and invest, and
c. Diversion of economic resources as between
different uses and localities
Reflective activity II (25 minutes) (5 point)
•Make a group of 4 to 5
•Discuss and write a report on
An economic effects of public expenditure
-- on resource allocation
-- on employment
-- on Price stability
-- on national income (GDP)
-- on distribution of income
a. Ability to Work, Save and Invest.
• If public expenditure can increase the efficiency of a
person to work, it will promote production and national
income.
• Public expenditure on education, medical services,
cheap housing facilities and recreational facilities will
increase the efficiency of persons to work. At the same
time, public expenditure can promote income of the
people.
• Finally, public expenditure, particularly repayment of
public debt, will place additional funds at the disposal of
those who can invest. Thus, it will be seen that public
expenditure can promote ability to work, save and invest
and thus promote production and employment.
b. Willingness to Work, Save and Invest.
• The effects of public expenditure on the
willingness-as different from ability to work and
save and invest on production are not clear
enough.
• Pensions, interest on loans, provident fund and
other government payments provide security and
safety to a person, and therefore, reduce the
willingness of persons to work and save;
• why should a person work hard and save when he
knows well that he will be looked after by the
government when he is not in a position to earn an
income?
c. Diversion of Economic Resources.
• Public expenditure has far-reaching effects on the utilization
of economic resources as between alternative uses – present
and future.
• In a free capitalist society very little provision is made for
the future. This is because people prefer the present rather
than the future and, therefore, they do not make adequate
provision for the future.
• Public expenditure on transport, irrigation and other projects
which yield both immediate return as well as social and
economic benefits for generations to come, are some
examples.
• Secondly, the government spends money in the
conservation of economic resources which are very essential
for the future.
• Thirdly, the government spends money for encouragement
of research and invention, promotes education and training,
looks after public health and sanitation and also takes the
responsibility of social security measures.
• It is necessary to emphasize that the diversion of economic
resources in all these ways will greatly increase
production.
4.3.2 Effect of public expenditure on distribution of income
• Public expenditure (as part of fiscal policy) can be used by
the government to achieve this aim.
• While taxes, particularly progressive direct taxes, have the
effect of reducing the incomes and wealth of the higher
income groups, public expenditure has the effect of raising
the incomes of the lower income groups.
• Government's expenditure on education, public health and
medicine, housing, etc., is directed to help the poor and the
lower income classes (who make use of government schools
and hospitals).
• At the same time, social security schemes are run by the
government for the benefit of the working classes so that
they may be protected from unemployment, accidents,
sickness and old age.
4.4 Public expenditure and control of inflation
• the most serious type of inflation has always been due to enormous
government expenditure. This type of situation may be due to war
when large sums are spent for military purposes.
• However, the government can suitably adjust its expenditure during
an inflationary period so that the inflationary pressure may be
reduced.
• For instance, all those schemes which may be justified during a period
of depression and low level of employment may be omitted during an
inflation.
• At the same time, the government can postpone the construction of
social capital such as post offices, schools, etc., which will increase
the size of income of people but will not contribute to the increase of
goods.
• Secondly, the government can give subsidies to those industries which
are producing inflation-sensitive goods so as to accelerate their
production or to enable producers to sell them at lower prices.
4.5 Content of Development Expenditure
• Development expenditure of the government should aim at
stimulating and supplementing private initiative and
enterprise.
• It is possible-and some governments of developing
countries have attempted to do so-to eliminate the private
sector altogether and plan for the entire economy as a
whole.
• There is some advantage in that. But many may not like a
communist pattern of economic development which is
rapid, of course, but may prove to be nevertheless ruthless
and inhuman
• In a democratic setup, with parliamentary institutions,
emphasis will have to be not on the elimination of the
private sector but the setting up of a mixed system in
which private enterprise will be given active
encouragement and, at the same time, the government will
become an interested and active participant in
development activities.
a. Stimulating private initiative.
Direct stimulation is done by the Government helping the
private sector through loans, subsidies, tax concessions and
exemptions and providing market and other information and
research facilities.
b. Provision of social and economic overheads.
Indirect stimulation of the private sector may be done through
the provisions of social and economic overheads -education
and public health, and provision of power, transportation,
communication, etc.
• The private sector industries would reap enormous
benefits of economies of production from these facilities
provided by the government.
• Social and economic overheads are necessary and
essential prerequisites for economic growth.
c. Public enterprises.
– The government will have to start and run such undertakings
which the private sector may be unwilling to undertake, either
because profit margins are low or almost nothing, or because they
require huge capital investment and a long time to yield returns.
– These enterprises may not be appealing to the private sector from
the commercial point of view but may be of great significance
from the point of view of economic welfare of the community as
well as that of economic progress.
– In this group will come all the key and basic industries,
development of irrigation resources, electric power, etc.
– In fact, any industry which is necessary for the country and which
will help in the growth of the economy can be taken up by the
government.
– The idea, however, is not to compete with the private sector but
really to supplement and complement it.