Professor Academy

PG – TRB ECONOMICS
(Subject Code: P09)
 Unit – XIII
Public Economics
✓ Theories of Public expenditure

✓ Canons of public expenditure

✓ Growth of public expenditure in recent times

✓ Public expenditure in India

✓ Public debt- Burden and effects of Public debt

✓ Methods of repayment of public debt

✓ Public borrowing and development finance in India.

Public Expenditure The expenditure incurred by public authorities is called
public expenditure. Public expenditure has to provide not only social welfare
but it has also to ensure economic stability and economic growth. Prof.
Shirras given canons of Public Expenditure.
a) Canons of Public Expenditure: The following are the rules or canons that
should guide the public authorities in the administration of public
expenditure.

1) Canon of Maximum Benefit: Public expenditure should promote the

maximum welfare of the society as a whole.

2) Canon of Economy: Unnecessary expenditure and wastage of financial

resources should be avoided.
3) Canon of Sanction: The public expenditure has to be sanctioned
by a competent authority before it is actually incurred.

4) Canon of Elasticity: It should be possible to the government to

vary the expenditure according to the need or circumstances.

5) Canon of Surplus: Public expenditure should be always kept

well within the revenue of the state so that a surplus is left at the
end of the year.
Theories of Public Expenditure:
Wagner’s law of Increasing State Activities:
According to Wagner’s Law, there exists a casual
relationship between government expenditure and
economic development.
According to him, During the course of economic
development, government expenditure increases more
than proportionally with per capita community output.
The income elasticity of demand for government
expenditure is more than one. The explanation is that
the very growth of the economy gives rise to
complexities in economic life and government has to
incur increasing expenditure to deal with them.
Wagner distinguished three types of activities which cause an increase in
government expenditure. These are:
A) Maintenance and enforcement of law and order, internally and externally.
B) Participate in the material production
C) Provision of Social Service
Additional Factors which contribute to this
tendency of increasing public expenditure
are :
A) Population increase
B) Migration
C) Deficit Financing
1890 - 1955
Wiseman – Peacock Hypothesis:
The Main Idea is that public expenditure
does not increase in a smooth and
continuous manner, but in jerks or step like
Fashion. At times some social or other
disturbance takes place creating a need for
increased public expenditure which the
existing public revenue cannot meet. The
public expenditure increases and make
inadequacy of the present revenue quite
clear to everyone. The movement from the
older level of expenditure and taxation to a
new and higher level is the “ Displacement
effect”.
The Inadequacy of the revenue as compared with the required public
expenditure creates an “ Inspection effect”. The Government and the people
review the revenue position and the need to find a solution of the important
problems that have come up and agree to the required adjustments to finance the
increased expenditure.

They attain a new level of tax tolerance. They are now ready to tolerate a greater
burden of taxation and as a result the general level of expenditure and revenue
goes up. In this way, public expenditure and revenue get stabilized at a new
level till another disturbance occurs to cause “ Displacement Effect.”
This theory is also called critical limit hypothesis. This hypothesis concern with the
tolerance level of taxation. If government expenditure is more than 25% then it will lead to
inflation. So the limit of government activities/share is 25%. If aggregate government
expenditure reaches 25% then people produce less than before. This hypothesis concern
with the tolerance level of taxation. The ongoing discussion on three theories of Public
expenditure it is revealed that most of the developed and developing nations have followed
a similar course to public expenditure.
Rahn Curve
The Rahn Curve suggests that there is an optimal level of government spending
which maximizes the rate of economic growth. Initially, higher government
spending helps to improve economic performance. But, after exceeding a certain
amount of government spending, government taxes and intervention diminishes
economic performance and growth rates.
Importance of Public Expenditure:
An old-fashioned dictum says that “The very best of all plans of finance is to
spend little, and the best of all taxes is that which is least in amount.” No one
today believes this philosophy. In the 1930s, J. M. Keynes emphasized the
importance of public expenditure.

i. Economic Development:
Public expenditure has the expansionary effect on the growth of national income,
employment opportunities, etc. Economic development also requires development
of economic infrastructures. A developing country like India must undertake various
projects, like road-bridge-dam construction, power plants, transport and
communications, etc.
ii. 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. Thus, public expenditure can prevent periodic cyclical fluctuations.
During depression, it is recommended that there should be more and more
governmental expenditures on the ground that it creates jobs and incomes.

iii. Redistribution of Income:

Public expenditure is used as a powerful fiscal instrument to bring about an
equitable distribution of income and wealth. There are good much public
expenditure that benefit poor income groups. By providing subsidies, free education
and health care facilities to the poor people, government can improve the economic
position of these people.
iv. 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.
This is what is required to maintain integration and unity among people of all the
regions. Unbalanced regional growth encourages disintegrating forces to rise. Public
expenditure is an antidote for these reactionary elements.
Thus, public expenditure has both economic and social objectives. It is necessary to
ensure that the government’s expenditure is made solely in the public interest and
does not serve any individual’s interest or that of any political party or a group of
persons.
Classification of Public Expenditure:

Revenue Expenditures are recurrent or consumption expenditures

incurred on public administration, defense forces, public health and
education, maintenance of government machinery, subsidies and interest
payments.

These expenditures are recurrent in nature and they do not create any
capital assets.

Revenue expenditure is classified into development and non-

development expenditure
i)Development Expenditure: The part of revenue expenditure that directly or
indirectly contributes to the development of the country is known as development
revenue expenditure. It includes expenditures on the maintenance and functioning
of social and community services and physical infrastructure. For example,
maintenance of education and public health infrastructure like schools, hospitals,
irrigation facilities, electricity boards etc.

ii) Non-Development Expenditure: The part of revenue expenditure that may not
directly contribute to economic development is known as non-development revenue
expenditure. They include expenditures on the maintenance of defense
establishments, administrative expenditure, interest payments, payment of old age
pension etc
Capital Expenditures are incurred on building durable assets, like highways,
multipurpose dams, irrigation projects, buying machinery and equipment. They are
a non-recurring type of expenditure in the form of capital investments. Such
expenditures are expected to improve the productive capacity of the economy.

i) Not all capital expenditures are productive. Non-development capital

expenditure on defense establishment which does not have any direct impact on
economic development but is necessary for the security of the nation.

ii) Capital expenditures on social infrastructure like government schools,

hospitals, primary health centers may not generate revenue and therefore cannot be
termed productive in that sense, but they indirectly contribute to improving
productivity.
Productive and Unproductive Expenditure

(a) Productive Expenditure: Expenditure on infrastructure development, public

enterprises or development of agriculture increase productive capacity in the
economy and bring income to the government through tax and non-tax revenues.
Thus they are classified as productive expenditure.

(b) Unproductive Expenditure: Expenditures in the nature of consumption, such

as defense, interest payments, expenditure on law and order, public administration
do not create any productive asset which can bring income or returns to the
government. Such expenses are classified as unproductive expenditures.
Non-Transfer and Transfer Expenditure:

(a) Non-transfer Expenditures: Are incurred for buying or using goods and
services. These include expenditure on defense, education, public health etc.
Investment expenditures on capital assets are also non-transfer expenditures as the
government gets capital goods and assets in return for them.

(b) Transfer Expenditures: Refer to those expenditures against which there is no

corresponding transfer of real resources i.e. goods or services. These include
expenditures incurred on old age pension, unemployment allowance, sickness
benefits, interest payments on public debt and subsidies.
Plan and Non-Plan Expenditure:

(a) Plan Expenditures: Refer to the spending of the annual funds allocated by the
Central government for development schemes outlined in the ongoing Five Year
Plan. For example: Industrial Development, Agricultural Development,
Infrastructure, Education & Health etc.

(b) Non-Plan Expenditures: Include all those expenditures of the government that
are not included in the ongoing Five-Year Plan. They include both development and
non-development expenditure. Part of the expenditure is obligatory in nature e.g.
interest payments, pensions etc. and a part is essential obligation e.g. defence and
internal security
Dalton’s Classification: Economist Hugh Dalton has provided the following
comprehensive classification of public expenditure:

i) Expenditures on political executives i.e. maintenance of ceremonial heads of

state, like the President.

ii) Administrative expenditure to maintain the general administration of the country,

like government departments and offices.

iii) Security expenditures to maintain armed forces and the police forces.

iv) Expenditures on administration of justice include maintenance of courts, judges,

public prosecutors.
v) Developmental expenditures to promote growth and development of the
economy, like expenditure on infrastructure, irrigation etc.

vi) Social expenditures on public health, community welfare, social security etc.

vii) Public debt charges include payment of interest and repayment of principal
amount.
Growth of public expenditure in recent times:
1. Income Elasticity and Increase in Per Capita Income:
According to Musgrave, a rising share of public expenditure in national income is
associated with a rise in per capita income. Thus, an increase in per capita income
over a period of time may cause a relative rise in public expenditure. This is
because the demand for public goods tends to expand with the rise in per capita
income.
2. Welfare State Ideology and Wagner’s Law:
The modern State is a welfare state. It aims at promoting the economic, political,
and social well-being of its citizens. It makes every effort to improve the living
standard of the common people. For this purpose, it has to undertake may
functions and services never visualized before.

Even in an avowedly capitalistic economy, there has been increasing State

intervention through legislative and administrative measures for augmenting
production and improving distribution. Many wants which were formerly
satisfied individually by private means are now satisfied collectively through
public expenditure.

This tendency, in economic literature, is known as “Wagner’s law of increasing

expansion of State activities”.
3. Effects of War and the Need for Defense:
The tremendous growth in public expenditure may also be attributed to wars and
threats of war in modern times. In the Second World War, countries like England
incurred heavy war expenditures, amounting to £ 15 million per day. Wars and
threats of war and the consequent defence needs compel governments to spend
more and more on the production of war goods.

Peacock and Wiseman have referred to the ‘displacement effect’ in the post-war
period when higher taxes and higher revenue collection drive of the war period
are continued by the government, finding them easy and attractive. The
displacement effect may further be supplemented by a ‘scale hypothesis’, i.e.,
adoption of new social welfare schemes by the government on a permanent
basis.
4. Resource Mobilization and Ability to Finance:
When the government innovates more and more methods of taxation
and resource mobilization, its ability to finance public expenditure
increases and the size of public expenditure grows. Public sector
outlays could be increased by more taxation yields, public debt,
foreign aid and deficit financing.
5. Inflation:
With the rising prices, the government has to keep on increasing public
expenditure to carry out its functions and maintain the supply of public goods
intact. During inflation, the government has to pay additional DA to its
employees which obviously call for an extra burden on public expenditure.

6. The Role of Democracy and Socialism:

The recent growth of democracy and socialism everywhere in the world has
caused public expenditure to increase very much. A democratic structure of
government is inevitably more expensive than a totalitarian government. In
India, democracy has certainly become a costly affair. Expenditure on elections
and bye-elections is increasing.
7. The Urbanization Effect:
The spread of urbanization is an important factor leading to the relative growth
of public expenditure in modern times. With the growth of urban areas, there has
been an increasing tendency of expenditure on civil administration. Expenses on
water supply, electricity, provision of transport, maintenance of roads, schools
and colleges, traffic controls, public health, parks and libraries, playgrounds, etc.
have increased enormously these days. Likewise, the expenditure on courts,
prisons etc. is increasing, especially in the urban sector.
8. 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 other social measures.

9. The Population Effect:

A high growth of population naturally calls for increase in the expenses as all
State functions are to be performed more extensively. Rising population also
poses various problems in poor countries.
The State will have the added responsibility of solving such problems as food,
unemployment, housing and sanitation. Further, overpopulated countries like
India will have to check the population growth. The State has, therefore, to spend
more and more on family planning campaigns every year.
10. The Growth of 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. Hence, railway and passenger transport is
nationalized.

Government has, therefore, to run transport services even at a loss. This

obviously calls for a high expenditure for maintenance and expansion. Further,
the government in a poor country has to spend a lot on constructing new railway
lines, new roads, national highways, bridges and even canals to connect the
different areas with a smooth transport system as a precondition of growth.
11. The Planning Effect:
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, public expenditure obviously shows an increasing trend.
In India, for instance, the public sector outlay during the First Five Year Plan was
just Rs. 1,960 crores, which is now estimated at Rs. 2, 47,865 crores during the
Eighth Plan period (1992-97).
Meaning of Public Debt:
Public Debt defined as the total outstanding borrowings of the
Central government exchequer. It represents the stock of
borrowing as opposed to the annual increase in total borrowing,
Represented by the government deficit. In a broader sense, all
kinds of obligations of a government are included in public debt.
Objectives of Public Debt:
1. To Cover Budget Deficit: The
Government may borrow because
its current revenue falls short of its
expenditure. Sometimes the
government has to borrow to meet
large expenditure arising because
of some unforeseen contingencies.
2. To Finance War and Natural
Calamities: There could be wars or
natural calamities in which case the
government would be committed to a
much large expenditure and would
therefore run into a debt.
3. To Finance Development Plans:
The Government of an underdeveloped
country should play an active role in the
development of economy. This may be
done through borrowing and investing
those funds in various projects
4. To Finance External Debt: India's external debt rises 2.1 pc
Underdeveloped countries need foreign to USD 570 billion

exchange in the early stages of economic

development to undertake high level of
investment, Purchase capital equipment and
raw materials from abroad and to cover the
balance of payment deficits. Therefore,
resources have to be obtained from abroad
by way of external debt.
Classification of Public Debt:
1. Internal and External Public Debt: Internal Debt refers to the public loans
floated within the country, while external debt refers to the obligations of country
to foreign government and International Institute.

2. Marketable and Non- Marketable Public Debt:

If loan can be slod by the existing holders to others, they would be called
marketable loans. On the other hand, non-marketable loans ate those which have
been issued in favor of particular debt holders only and cannot be sold to others.
3. Productive and Unproductive Public Debt:
Productive debt is the debt which is used by the government for directly
productive purpose. For instance , the loan may be used for the construction of
Physical Infrastructure. Unproductive loans are those which are incurred on
those projects which do no yields any income.
4. Interest – Bearing and Non – Interest Bearing Public Debt:
There are two types of interest bearing loan. In the first category, a lone carries
interest what is called a coupon. The holder of such a loan is entitled to given
interest payment periodically. In India T-Bills are sold in this way. Some loans do
not bear interest at all and are called non-interest bearing loans.
5. Redeemable and irredeemable:
Redeemable loans are those loan which the government promises to pay off at
some further date. Those loans, for which no such promises is made is known as
irredeemable loans.

6. Funded and Unfunded debt:

Funded debt is that public debt for the payment of which the government
establishes a separate fund. On the other hand an unfunded debt is that debt for
the repayment of which the government create no separate fund.
Effects of Public Debt:
1. Effects on Consumption: When people purchase government securities, it is
not always necessary that they do it out of past saving. Sometimes people buy
these securities out of their present income. The small saving schemes in India is
of this nature. Hence, the money invested in the NSC must , to certain extent,
reduce the expenditure of the people at present. Therefore, in this way
consumption is affected in the same way.
2. Public Debt and Savings: In the case of borrowing from the market, the net
effect on savings and capital accumulation in the country will depend upon the
source out of which market borrowing come. One possibility could be that the
public reduces its own consumption and contributes its savings to the public loan.
In this case there will be obviously a net increase in the speed of savings and
capital accumulation. Actually most savings are affected only by the richer
sections and firms from whom the contribution to public loans should be expected.
Here, however, the danger is that savings which would have gone into investment
on private account would diverted to public loan. But Public loan will generate
reallocative effect.
3. Public Debt and Inflation: Most governments while raising loans claim that
such an activity is not going to add to the inflationary forces. But in reality when
the government borrow from the central bank of the country, the effect is
equivalent to restoring to the printing press. By printing additional currency, the
authorities add to the demand forces in the market, causing an upward pressure of
price. In an underdeveloped countries, a sizeable portion of public debt is likely to
owned by the commercial banks. The commercial banks consider their holdings of
government securities as a good investment which can be encashed at any time
without much capital loan. This assured liquidity position, therefore, tempts them
to increase their loans and market advance and thus add to inflationary pressure in
the market.
4.Public debt and distribution:
The purchasers of government securities are mostly rich people of the community.
But the burden of taxes , imposed for finding money for interest payment fall on
the poorer classes also. Therefore, the tendency of public debt would be increase
the inequality of the income and wealth.
4.Public debt and distribution:
The purchasers of government securities are mostly rich people of the community.
But the burden of taxes , imposed for finding money for interest payment fall on
the poorer classes also. Therefore, the tendency of public debt would be increase
the inequality of the income and wealth.

•Article 292 of the Indian Constitution states that the Government of India can
borrow amounts specified by the Parliament from time to time.
•Article 293 of the Indian Constitution mandates that the State Governments in
India can borrow only from internal sources.
•Thus the Government of India incurs both external and internal debt,
while State Governments incur only internal debt under Article 293.
Sources of Public Debt
These are listed as follows:
•Dated government securities or G-secs.
•Treasury Bills or T-bills
•External Assistance
•Short term borrowings
•Public Debt definition by Union Government
The Union government describes those of its liabilities as public debt, which are
contracted against the Consolidated Fund of India. This is as per Article 292 of the
Constitution.
The debt-to-GDP ratio indicates how likely the country can pay off its debt.
Investors often look at the debt-to-GDP metric to assess the government’s
ability of finance its debt. Higher debt-to-GDP ratios have fuelled economic
crises worldwide.

The NK Singh Committee on FRBM had envisaged a debt-to-GDP ratio of

40 per cent for the central government and 20 per cent for states aiming for
a total of 60 per cent general government debt-to-GDP.
Importance of Public Debt Management in India
As per Reserve Bank of India Act of 1934, the Reserve Bank is both the banker and
public debt manager for the Union government. The RBI handles all the money,
remittances, foreign exchange and banking transactions on behalf of the Government.

The Union government also deposits its cash balance with the RBI. However, of late,
there is a demand for creating a specialized agency for managing public debt as exists
in some advanced economies.

For instance, the Niti Aayog has advocated the creation of a separate public debt
management agency (PDMA).
Debt Repudiation Debt Repudiation means to deny
the payment of debt by government. In 1917 it had
done by Soviet Govt. Whereas he denied to pay
Czarian debts.
When government denies to pay debt then the faith
of people and banks in government shatters. Because
of it, government has to face difficulty in issuing
new debentures to government in near future. This
step of government is considered very inconsistent
and discriminative because this affects only that
group who buys debentures debt consistent and it
leaves other groups ineffective.
Refunding If government issues new bonds for the payment of its current
debts then it is called refunding, Refunding is a name of that process by
which new bonds are changed in place of maturing bonds. Sometimes,
payment is done before maturing date of bonds. It happens so whenever the
rate of interest is low or government wants to change the maturity date of
remaining debts.

Conversion of Debts Conversion of Debts means change of old debts into

new debts. According to this theory, the payment of debt is not done in
reality, but only the form of debt is changed. The, process of conversion of
debts means to change high interest rate debt into low interest rate debt.
Actual Repayment Following methods are adopted for actual payment of
public debt.

1. Sinking Fund: - The method which is normally adopted for regular

repayment of debt is the construction of sinking fund, means the
construction of such fund in which a definite part of government income is
submitted every year and the payment of debt is done from this fund. This
fund is used for the purchase of debts and for the last payment when their
duration completes.
2. Surplus Revenues: - The policy of surplus budget is also adopted for
settlement of public debts slowly and slowly each year, instead of this that
firstly, one fund is constructed and then their repayment is paid on
completion of duration. But, these days, government expenditures are
increasing rapidly. Therefore, surplus budgets are rarely therefore, surplus
are rarely made.

3. Terminal Annuities: - Government can issue such terminal annuities, a

part of which matures every year according to a serial number and their
payment is paid every year. The determination of serial number is either
done in the starting or by lottery. Debt is reduced each year in this system
the burden of interest reduces each year in same quantity, in this way, it is a
system of returning instalments of debts.
4. Capital Levy: - Capital levy is an indicator of very heavy taxes on
property and wealth. It is imposed only once on properties of capital of more
from a definite value. Capital levy has been instructed to be imposed just
after war so that wartime proportional debts can be paid