Solution Manual for Principles of Corporate Finance 14th Edition by Richard B...
Review of theories of public expenditure and public revenue
1. REVIEW OF THEORIES OF PUBLIC EXPENDITURE AND PUBLIC REVENUE
1.0 INTRODUCTION
In a democratic setting, public expenditure is an expression of people's will, managed through
political parties and institutions .According to Wikipedia, Public expenditure is spending made by
the government of a country on collective needs and wants such as pension, provisions (such as
education, healthcare and housing), security, infrastructure while Muley (2020) says public
expenditure are Expenses incurred by the public authorities (central, state and local self-
government) in which Such expenditures are made for the maintenance of the governments as well
as for the benefit of the society as whole. Thus, Public expenditure can be summarized as the
expenditure on the developmental and non-developmental activity in a country.
In the 19th century, academic scholars believed public expenditures were wasteful and must be
kept low as far as practicable because the main function of government spending then was on
defense and maintaining law and order, however, this conservative thinking died down in the 20th
century as a result of the second world war which necessitated increase in government participation
in the length and breadth of the economy and this led to emergence of modern state known as
welfare state. Government increases government expenditure in an economy because of the
following reasons:
1. Size of the Country and Population
2. Defense Expenditure
3. Provision of social security benefit
4. Economic Development
5. Price increment
Keynesian economist believe that contraction in the economy is as a result of government deficit
in public spending, hence increased government spending is thought to raise aggregate demand
and increase consumption while classical economist believe that increased government spending
exacerbates economic contraction by shifting resources from the private sector, which they
consider productive, to the public sector, which they consider unproductive.
Many scholars have categorized government expenditure into many forms, however, the following
are the broad areas of government expenditure.
2. 1. Government acquisition of goods and services for current use to directly satisfy individual
or collective needs of the members of the community is classed as government final
consumption expenditure
2. Government acquisition of goods and services intended to create future benefits, such as
infrastructure investment or research spending, is classed as government investment (gross
fixed capital formation), which usually is the largest part of the government gross capital
formation
3. Government expenditures that are not acquisition of goods and services, and instead just
represent transfers of money, such as social security payments, are called transfer
payments.
Government does not spend in isolation just to satisfy budgetary needs only rather there are some
principles or canons that guides government focus on certain area of public spending. The canon
of public spending is below:
1. Canon of benefit
2. Canon of economy
3. Canon of sanction
4. Canon of surplus
The political structure of an economy does not have any effect on the reasons why government
spend, be it, democratic government, monarchy government and autocratic government, public
expenditure reasons are all the same universally. The following are the reasons of public
expenditure:
1. Economic Development: Without government support and backing, a poor country cannot
make huge investments to bring about a favorable change in the economic base of a
country. That is why massive investments are made by the government in the development
of basic and key industries, agriculture, consumable goods, etc.
2. Fiscal Policy Instrument: Public expenditure is considered as an important tool of fiscal
policy. Public expenditure creates and increases the scope of employment opportunities
during depression
3. Redistribution of Income: Public expenditure is used as a powerful fiscal instrument to
bring about an equitable distribution of income and wealth.
3. 4. Balanced Regional Growth: Public expenditure can correct regional disparities. By
diverting resources in backward regions, government can bring about all-round
development there so as to compete with the advanced regions of the country.
2.0 THEORIES OF PUBLIC EXPENDITURE
Elucidating the trend of increase in government expenditure has always been a wide field in the
science of Public Finance which has necessitated many scholars and economists to propound
theories relating to public expenditure. The aim of those theories is not only to explain government
growth but also to find solutions in order to distribute public expenses more efficiently and to
derive the “optimal” size of the government.
2.1 WAGNER’S LAW OF STATE
Wagner's law of state, is known as the law of increasing state spending, is a principle named after
the German economist Adolph Wagner (1835–1917). He first observed it for his own country and
then for other countries. The theory holds that for any country, that public expenditure rises
constantly as income growth expands. The law predicts that the development of an industrial
economy will be accompanied by an increased share of public expenditure in gross national
product. The critiques to this theory are
1. The law is assumed to mirror Germany economic condition
2. The law make use of subjective and normative assumption in which Wagner reveals his
opinion on what ought to happen to an economy when it is industrialized
3. Wagner did not include the conditions of war in his theory
4. Wagner completely ignores the relation-ship between individual preferences and
government actions which is a strong simplification and thus a major shortcoming of his
theory. According to Wagner, the state represents a superior individual who makes
decisions without paying atten-tion to the individual human beings that actually form the
state.
2.2 MUSGRAVE’S HYPOTHESES
Based on Wagner’s theory, Musgrave also observes the changing role of the public sector during
the development process and therefore relies on structural factors in order to explain government
4. growth. According to Musgrave, economies situated in an early development stage are faced with
a high demand of public capital formation in order to install a basic infrastructure etc. At later
development phases, institutions for private capital for-mation become more developed and
therefore the share of public expenditure may decrease.
Despite the fact that this theory is quite plausible, it has one strong limitation which Musgrave
admits himself: While the stages-of-development approach is indubita-bly applicable in early
development phases, the size of public expenditure cannot be clearly predicted in later stages. It
need not always be the case that the share of the public sec-tor further decreases during later stages.
Due to the fact of changing private consumption pat-terns because of rising per capita income
during the late industrialization stages, it is possible that the public share rises again in order to
meet the growing demand of public goods such as education, infrastructure, social security, health
systems etc. It thus depends on the stage of income and on the individual needs of the citizens if
the public share rises or declines. Hence, Musgrave “remains ambivalent” concerning which
tendency of public expenditure will dominate at late development stages.
Wagner's statement in formal terms has been interpreted by Richard Musgrave as follows: As
progressive nations industrialize, the share of the public sector in the national economy grows
continually. The increase in State Expenditure is needed because of three main reasons. Wagner
himself identified these as
1. social activities of the state,
2. administrative and protective actions
3. welfare functions
2.3 PURE THEORY OF PUBLIC EXPENDITURE
In 1954 Paul Samuelson published his landmark paper The Pure Theory of Public Expenditure,
which formalized the concept of public goods (which he called "collective consumption goods") -
- i.e. goods that are non-rival and non-excludable. He highlighted the market failure of free-riding
when he wrote: "it is in the selfish interest of each person to give false signals, to pretend to have
less interest in a given collective consumption activity than he really has". His paper showed that
"no decentralized pricing system can serve to determine optimally these levels of collective
consumption".
5. Excludability is the ability of producers to detect and prevent un-compensating consumption of
their products. Rivalry is the inability of multiple consumers to consume the same good. A public
good is defined as a non-rival non-excludable good, such as national defense. Because public
goods are not excludable, they get under-produced. The pricing system cannot force consumers to
reveal their demand for purely non-excludable goods, and so cannot force producers to meet that
demand.
2.4 PEACOCK WISEMAN HYPOTHESIS
Peacock and Jack Wiseman advanced the study of growth of public expenditure through peacock
wiseman hypothesis by their study of public expenditure at Great Britain during the period 1890
to 1955.
peacock wiseman hypothesis focused on the pattern of public expenditure and stated the public
expenditure does not follow a smooth or continuous trend but the increase in public expenditure
takes place in jerks or steps. They gave three separate concepts to justify the hypothesis, they are
1. displacement effect: when a social disturbance occurs, the government raises taxes to
increase revenue and increases public expenditure to meet the social disturbance. This
creates a displacement effect by which low taxes and expenditures are replaced by higher
tax and expenditure levels. However, after the disturbance ends, the newly emerged level
of tax tolerance makes the people willing to support higher level of public expenditure
since it is capable of bearing heavier tax burden than before. As a result, the new level of
public expenditure and public revenue stabilize but are soon destabilized by another new
disturbance which causes another displacement effect.
2. Inspection effect: even if there is no new disturbance there is a no strong motivation to
return to lower level of taxation as the increased revenue can be used to support a higher
level of public expenditure. Therefore, government expands its fiscal operations partly due
to disturbance and partly to expand economic activity and take up new functions that were
earlier neglected.
6. 3. Concentration effect: when an economy is experiencing economic growth there is a
tendency of central government’s economic activities to grow at a faster rate than that of
state and local government activities. It is related to the political set up of the country
Thus, peacock wiseman hypothesis of government spending tend is more convincing than in
Wagner’s hypothesis. The natural course of advancement and structural changes in an economy
leads to constant and systematic expansion of public expenditure. An increase in public
expenditure can also be accredited to urbanization, population growth, awareness of civil rights,
awareness of duties by the state government etc.
3.0 PUBLIC REVENUE
3.1 INTRODUCTION
The income of the government through all the sources is called public income or public revenue.
According to Dalton, the term public income has two parts:
1. Public Receipts: Considering public income in wider sense, it includes all the incomes or
receipts which a public authority may secure during any period of time.
2. Public Revenue: Considering public income in narrower sense, it includes only those sources of
income of public authorities, which are ordinarily known as "revenue resources."
Major chunk of government revenue do come from taxes. Taxation is also used by Government as
a fiscal policy instrument to ensure redistribution of income among its citizens. Adam Smith’s
contribution to this part of economic theory is still regarded as classic. His presented theory on
taxation is still considered as the foundation of all discussions on the principles of taxation. There
are four essentials of his theory of taxation, i.e., equality, certainty, convenience, and economy.
The first canon is ethical and other three are administrative in character:
1. Canon of Equality: means the principle of justice, i.e., in accordance to ‘ability to pay’. This
is the most important canon of taxation. It lays the moral foundation of the tax system. The cannon
of equality does not mean that every taxpayer should pay at the same sum. That would be
manifestly unjust. Nor does it means that they should pay at the same rate, which means
proportional taxation, for a proportional tax is also not a very just tax. What this canon really
7. means is the equality of sacrifice. The amount of the tax paid is to be in proportion to the respective
abilities of the taxpayers. This clearly points to progressive taxation, i.e., taxing higher incomes
at higher rates.
2. Canon of Certainty: means the tax which each individual is bound to pay ought to be certain,
and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought to
be clear and simple to the taxpayer. According to Adam Smith, uncertainty in taxation encourages
insolence or corruption.
3. Canon of Convenience: Every tax, according to Adam Smith, ought to be levied at the time or
in the manner in which it is most convenient for the taxpayers to pay their dues. The canon of
certainty says that the time and the manner of payment should be certain. But the canon of
convenience states that the time of payment and the manner of payment should be convenient. For
example, if a tax on land or house is collected at a time when rent is expected to be received, it
satisfies the canon of convenience. If the tax can be paid through cheque, or credit card, or internet,
the manner is convenient, but not so if it is to be paid personally to the taxing authority. In the
latter case there will be a lot of inconvenience and harassment.
4. Canon of Economy: The tax will be economical if the cost of collection is very small. If, on
the other hand, the salaries of the officers engaged in collecting the tax eat up a big portion of the
tax revenue, the tax is certainly uneconomical. Similarly, such other huge and unnecessary
administrative costs will make the tax collection an extravagant task. If there is corruption or
oppression involved in the frequent visits to the income tax office and the odious examination by
the taxing officer, the canon of economy is not satisfied.
In broader sense, the canon of economy means a tax must not obstruct in any manner the ultimate
prosperity of the country. It would infringe the canon of economy if it retards the development of
trade and industry in any manner. If incomes are subjected to a very heavy tax, saving may be
discouraged, capital will not accumulate, and the productive capacity of the community will be
seriously impaired.
3.2 SOURCES OF PUBLIC REVENUE
Sources of Public Revenue are as follows:
8. (1) Non-tax Revenue
(a) Administrating Revenue: (i) Fee (ii) License fee (iii) Special assessment (iv) Fines and
Penalties (v) Forfeitures (vi) Escheat.
(b) Commercial Revenue: (i) Postage (ii) Toll (iii) Funds borrowed (iv) Prices paid for liquor (v)
Payment for electricity (vi) Railway tax/freight (vii) Irrigation charges
(c) Gifts and Grants
(2) Tax Revenue :
Types of taxes (i) Direct & Indirect Tax (ii) Specific & Advalorem tax (iii) Progressive taxes (iv)
Regressive taxes (v) Degressive taxes.
3.3 THEORIES OF PUBLIC REVENUE
3.3.1 DALTON’S CLASSIFICATION THEORY
Dalton provides a very systematic, comprehensive and instructive classification of public revenue.
In this opinion, there are two main sources of public revenue — taxes and prices. Taxes are paid
compulsorily whereas prices are paid voluntarily by individuals, who enter into contracts with the
public authority. Thus, prices are contractual payments.
Taxes are sub-divided into: (i) Taxes in the ordinary sense; (ii) Tributes and indemnities; (iii)
Compulsory loans, and (iv) Pecuniary penalties for offences.
Prices are sub-divided into: (i) Receipts from public property passively held such as rents received
from the tenants of public lands; (ii) Receipts from public enterprises charging competition rates;
(iii) Fees or payments charged for rendering administration services, such as birth and death
registration fees, and (iv) Voluntary public debt.
To these two groups must be added another group to make the classification exhaustive. Under
this group, the following items are included: (i) receipts from public monopolies, charging higher
prices; (ii) special assessments; (iii) issue of new paper money or deficit financing; and (iv)
voluntary gifts.
3.3.2 TAYLOR’S CLASSIFICATION THEORY
9. The most logical and scientifically based classification of public revenue is however provided by
Taylor. He divides public revenue into four categories:
(i) Grants and gifts
(ii) Administrative revenues
(iii) Commercial revenues
(iv) Taxes
REFERNCES
Eckhard, S. (2002) . A critical appraisal of the theories of government expenditure growth.
Seminar Paper. https://www.grin.com/document/16172
Muley, R. (2020). Public Expenditure: Causes, Principles and Importance
Musgrave, R.A. and Peacock, A.T. (1958). Classics in the Theory of Public Finance,
Macmillan and Co. Ltd., London.
Peacock, A.T. and Wiseman, J. (1967). Growth of Public Expenditure in the United Kingdom,
Rev edn., George Allen & Unwin Ltd., London.