Public Finance Notes – CA Inter Economics Notes is designed strictly as per the latest syllabus and exam pattern.
Public Finance Notes – CA Inter ECO Notes
1. Richard Musgrave’s Three Branch Taxonomy on Public Finance:
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the three branch taxonomy of the role of government in a market economy:
- Resource Allocation (efficiency),
- Income Redistribution (fairness), and
- Macroeconomic Stabilization.
2. The Allocation Function:
Resource allocation refers to the way in which the available factors of production are allocated among the various uses to which they might be put. One of the most important functions of an economic system is the optimal or efficient allocation of scarce resources so that the available resources are put to their best use and no wastages are there.
3. Main Reasons of Need of Efficient Allocation:
- Imperfect competition and presence of monopoly power,
- Markets typically fail to provide collective goods,
- Factor immobility which causes unemployment and inefficiency,
- Imperfect information, and
- Inequalities in the distribution of income and wealth.
4. State/Government and Allocation:
The allocative function in budgeting determines who and what will be taxed as well as how and on what the government revenue will be spent. It is con-cerned with the provision of public goods and the process by which the total resources of the economy are divided among various uses and an optimum mix of various social goods (both public goods and merit goods).
5. Allocation Instruments:
- Government may directly produce the economic good,
- Government may influence private allocation through incentives and disincentives,
- Government may influence allocation through its competition policies, merger policies etc.,
- Governments’ regulatory activities such as licensing, controls, minimum wages etc.,
- Government sets legal and administrative frameworks, and
- Any of a mixture of intermediate techniques may be adopted by gov-ernments.
6. Redistribution Function:
It is concerned with the adjustment of the distribution of income and wealth so as to ensure distributive justice namely, equity and fairness. The distribution function also relates to the manner in which the effective demand over the economic goods is divided among the various individual and family spending units of the society.
7. Aim of Redistribution Function:
- To achieve an equitable distribution of societal output among households,
- Advancing the well-being of all,
- Providing equality in income, wealth and opportunities,
- Providing security for people who have hardships, and
- Ensuring that everyone enjoys a minimal standard of living.
8. Redistribution Function Performed By Government:
- Progressive taxation of the rich and subsidy to the poor households,
- Financing public services, especially those-that benefit low-income households,
- Employment reservations and preferences,
- Regulation of the manufacture and sale of certain products to ensure the health and well-being of consumers, and
- Special schemes for backward regions and for the vulnerable sections.
9. Stabilization Function:
The stabilization function is one of the key functions of fiscal policy and aims at eliminating macroeconomic fluctuations arising from suboptimal allocation.
10. Concern of Stabilization Function:
- Labour employment and capital utilization,
- Overall output and income,
- General price levels,
- Balance of international payments, and
- The rate of economic growth.
11. The Concept of Market Failure:
Market failure is a situation in which the free market leads to misallocation of society’s scarce resources in the sense that there is either overproduction or underproduction of particular goods and services leading to a less than optimal outcome. There are four major reasons for market failure. They are:
- Market power,
- Public goods, and
- Incomplete information.
12. Market Power or Monopoly Power:
Market power or monopoly power is the ability of a firm to profitably raise the market price of a good or service over its marginal cost.
Sometimes, the actions of either consumers or producers result in costs or benefits that do not reflect as part of the market price. Such costs or benefits which are not accounted for by the market price are called externalities because they are “external” to the market. The four possible types of externalities are:
- Negative production externalities,
- Positive production externalities,
- Negative consumption externalities, and
- Positive consumption externalities.
1. Negative production externalities: A negative externality initiated in production which imposes an external cost on others may be received by another in consumption or in production.
2. Positive production externalities: A positive production externality initiated in production that confers external benefits on others may be received in production or in consumption.
3. Negative consumption externalities: A negative consumption external-ities initiated in consumption which imposes an external cost on others may be received by another in consumption or in production.
4. Positive consumption externalities: A positive consumption externality initiated in consumption that confers external benefits on others may be received in consumption or in production.
14. Private Cost and Social Cost:
Private cost includes direct cost of labour, materials, energy and other indirect overheads.
Social Cost = Private Cost + External Cost
15. Public Goods/Collective Consumption Goods/Social Goods:
Paul A. Samuelson who introduced the concept of ‘collective consumption good’ in his path-breaking 1954 paper ‘The Pure Theory of Public Expenditure’is usually recognized as the first economist to develop the theory of public goods.
A public good (also referred to as collective consumption good or social good) is defined as one which all enjoy in common in the sense that each individual’s consumption of such a good leads to no subtraction from any other individuals’ consumption of that good.
16. Classification of Public Goods:
Food, clothing, cars etc.
Fish stocks, forest resources, coal etc.
Cinemas, private parks, satellite television etc.
Pure public goods:
17. Pure Public Goods: Which perfectly satisfy non-rivalness and non-ex-cludability.
18. Impure Public Goods:
Hybrid goods that possess some features of both,public and private goods. These goods are partially rivalrous or congestible.
- Club goods; first studied by Buchanan, Examples: Swimming pools, fitness centres etc.
- Variable use public goods; first analyzed by Oakland and Sandmo, Examples: Roads, bridges etc. They can be excludable or non excludable.
19. Quasi Public Goods (Mixed Goods) or Near Public Goods:
Possess nearly all of the qualities of the private goods and some of the benefits of public good.
Examples: Education, health services etc.
20. Common Access Resources or Common Pool Resources:
Non-excludable and rival in nature. Some important natural resources fall into this category.
21. Global Public Goods:
There are several public goods benefits of which accrue to everyone in the world. The WHO delineates two categories of global public goods:
- Final public goods which are ‘outcomes’, and
- Intermediate public goods, which contribute to the provision of final public goods.
World Bank identifies five areas of global public goods:
- The environmental commons,
- Communicable diseases (including HIV/AIDS, COVID-19),
- International trade,
- International financial architecture, and
- Global knowledge for development.
22. Free Rider Problem:
Free riding is benefiting from the actions of others without paying. Due to free-rider problem, the following two outcomes are possible:
- No public good,
- Under production public goods.
23. Incomplete Information:
Complete information is an important element of competitive market. Perfect information implies that both buyers and sellers have complete information about anything that may influence their decision making.
24. Asymmetric Information and Lemons (poor items in market) Problem:
Asymmetric information occurs when there is an imbalance in information between buyer and seller.
25. Adverse selection:
A situation in which asymmetric information about quality eliminates high- quality goods from a market.
26. Moral Hazard:
An informed person’s taking advantage of a less-informed person through an unobserved action. It arises from lack of information about someone’s future behaviour.
27. Government Intervention to Minimize Market Power:
- By establishing rules and regulations,
For example, in India, we have the Competition Act, 2002 (as amended by the Competition (Amendment) Act, 2007)
- Price regulation in the form of setting maximum prices that firms can charge,
- Determines an acceptable price, called as rate-of-return regulation,
- Setting price-caps based on the firm’s variable costs, past prices, and possible inflation and productivity growth.
28. Government Intervention to Correct Externalities:
- Prohibit specific activities or limited to a certain level,
- Stringent rules are in place in respect of tobacco advertising, packaging and labelling etc.,
- Governments may pass laws to alleviate the effects of negative exter-nalities,
- Government stipulated environmental standards are rules. For example, India has enacted the Environment (Protection) Act, 1986.
The Market Based Approaches:
- Setting the price directly through a pollution tax (Pigouvian taxes),
- Setting the price indirectly through the establishment of a cap-and-trade system (tradable emissions permits).
29. In Case of Positive Externalities:
Subsidies involve government paying part of the cost to the firms in order to promote the production of goods having positive externalities.
30. Government Intervention in the Case of Merit Goods:
- Merit goods are goods which are deemed to be socially desirable.
Examples:Education, health care, welfare services, fire protection, waste management, public libraries, museum and public parks etc.
- Free of cost direct provision of merit goods by government.
31. Government Intervention in the Case of Demerit Goods:
- At the extreme, government may enforce complete ban,
- Negative advertising campaigns,
- Prohibit the advertising or promotion of demerit goods,
- Strict regulations to limit access to the good,
- Regulatory controls in the form of spatial restrictions e.g. smoking in public places,
- Imposing unusually high taxes,
- Fix a minimum price.
32. Government Intervention in the Case of Public Goods:
- Direct provision of a public good (free of cost),
- Excludable public goods can be provided by government and the same can be financed through entry fees.
- Grant licenses to private firms to build a public good facility.
33. Price Intervention:
Price controls may take the form of either:
- A price floor (a minimum price buyers are required to pay), or
- A price ceiling (a maximum price sellers are allowed to charge for a good or service).
34. Government Intervention for Correcting Information Failure:
- Accurate labelling and content disclosures by producers,
- Public dissemination of information,
- Regulation of advertising and setting of advertising standards.
35. Government Intervention for Equitable Distribution:
- Progressive income tax,
- Targeted budgetary allocations,
- Unemployment compensation,
- Transfer payments,
- Social security schemes,
- Job reservations,
- Land reforms,
- Gender sensitive budgeting etc.
36. Government Failure in Intervention:
- Cost of intervention is higher than benefit from intervention,
- Intervention produces fresh and more serious problems.
37. Objectives of Fiscal Policy:
- Achievement and maintenance of full employment,
- Maintenance of price stability,
- Acceleration of the rate of economic development, and
- Equitable distribution of income and wealth.
38. Automatic Stabilizers Versus Discretionary Fiscal Policy:
- In automatic or non-discretionary fiscal policy, the tax policy and ex-penditure pattern are so framed that taxes and government expenditure automatically change with the change in national income.
- Discretionary fiscal policy refers to deliberate policy actions on the part of government to change the levels of expenditure, taxes to influence the level of national output, employment and prices.
39. Instruments of Fiscal Policy:
- Government expenditure,
- Public debt, and
40. Government Expenditure as an Instrument of Fiscal Policy:
Government expenditures include:
- Current expenditures to meet the day to day running of the government,
- Capital expenditures (capital equipments and infrastructure), and
- Transfer payments.
41. Taxes as an Instrument of Fiscal Policy:
- During recession and depression, the tax policy is framed to encourage private consumption and investment,
- During inflation, new taxes can be levied and the rates of existing taxes are raised to reduce disposable incomes and to wipe off the surplus purchasing power.
42. Public Debt as an Instrument of Fiscal Policy:
- Borrowing from the public through the sale of bonds and securities curtails the aggregate demand in the economy,
- Repayments of debt by governments increase the availability of money in the economy and increase aggregate demand.
43. Budget as an Instrument of Fiscal Policy:
- A balanced budget will have no net effect on aggregate demand,
- A budget surplus has a negative net effect on aggregate demand since leakages exceed injections,
- A budget deficit has a positive net effect on aggregate demand since total injections exceed leakages from the government sector.
44. Types of Fiscal Policy:
- Expansionary fiscal policy is designed to stimulate the economy during the contractionary phase of a business cycle or when there is an anticipation of a business cycle contraction,
- Contractionary fiscal policy is designed to restrain the levels of economic activity of the economy during an inflationary phase or when there is anticipation of a business-cycle expansion which is likely to induce inflation.
45. Fiscal Policy for Reduction in Inequalities of Income and Wealth:
- A progressive direct tax system,
- Indirect taxes can be differential,
- A carefully planned policy of public expenditure helps in redistributing income from the rich to the poorer sections of the society.
46. Crowding Out:
An increase in the size of government spending during recessions will ‘crowd- out- private spending in an economy and lead to reduction in an economy’s ability to self-correct from the recession, and possibly also reduce the economy’s prospects of long-run economic growth.