PUBLIC EXPENDITURE

Overview
 Public expenditure refers to the expenses which the government incurs for its own maintenance
as also for the society and the economy as a whole.
 Public expenditure has increased significantly in both relative and absolute terms during the 20th
century in almost every state.
 The following table shows the public expenditure of Bangladesh in both relative and absolute
terms in selected years
(Taka in Crores)
Relative expenditure (% of
Year Absolute expenditure
GDP)
1990/91 12.16 13,436
1995/96 13.38 22,261
2000/01 14.37 36,440
2005/06 13.98 58,120
2010/11 14.18 112,980
Source: Bangladesh Economic Review

Causes of increasing public expenditure

 Expanding traditional function: defense, administration, justice, social overheads
 Increasing coverage of state activities: welfare measures such as old age pension, family
allowance etc.
 Change in attitude towards government
 Growing population
 Increasing per capita income
 Upward tendency of price
 Quality improvement of public goods and services
 Urbanization
 Industrialization
 Government role for correcting market mechanism
 Redemption of public debt
 Attitude of vested interest
 Increasing government bureaucracy

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  Productivity lag
 Development of democracy
 Increasing concern for underdeveloped area

Wagner’s law of increasing state activities

 Adolph Wagner (1835-1917) a German political economist propounded the theory basing on
historical facts, primarily of Germany.
 According to this theory
 There are inherent tendencies for the activities of different layers of a government to
increase both intensively and extensively.
 There is a functional relationship between the growth of an industrializing economy and
the growth of the government activities so that the government sector grows faster than
the economy.
 F. S. Nitti supported Wagner’s thesis and concluded with empirical evidence that this law was
not only applicable to Germany but also to various government which differed widely from each
other.
 Wagner mentioned three causes of increasing government expenditure
 Increasing traditional functions
 Increasing coverage of the state activities
 Increasing recognition of the need to provide and expand the sphere of public goods

Graphical representation

Figure 1
PG

PG2

PG1

2
  In Figure 1, along PG1 PGa/Ya= PG0/Y0 and along PG2 PGa/Ya> PG0/Y0. The subscript a refers
to a “later” and the subscript o to an “earlier” point of time. Figure 2 also implies the same. As
economy expands expenditure on public goods rises more than proportionately.

Figure 2

Public goods

600

400

250 a

100 o

300 350 400 600 Private goods

 In an industrialization stage, the state is to expand its activities quite fast in various fields like
education, health, civic amenities, transport, communications, and so on.
 But when such an initial deficiency is met, then the increase in state activities may be at a rate
slower than the overall growth in the economy (post-industrialization stage).
 In pre-industrialization stage, the economy is characterized by subsistence level. Most
subsistence wants and goods have traditionally been provided by the private sector.
Consequently, the gradual economic expansion of pre-industrial society causes the real per capita
output to become a declining proportion of real per capita income.

Wiseman-Peacock hypothesis
 Jack Wiseman and Allan T. Peacock put forth the hypothesis in their study titled “The Growth of
Public Expenditure in the United Kingdom, 1890-1955” in 1961.
 The main thesis of the authors is that relative public expenditure does not increase in a smooth
and continuous manner, but in jerks or step-like fashion.

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 Figure 3

𝐺
𝐺𝑁𝑃

New fiscal level

Old fiscal level

O t1 t2 t

 Their approach includes three separate concepts- displacement, inspection and concentration
effects.
 Displacement effect: At times some social or other disturbance takes place creating a need for
increased public expenditure which the existing public revenue cannot meet. While earlier, due
to insufficient pressure for public expenditure, the revenue constraint was dominating and
restraining an expansion in public expenditure, now under changed requirements such a restraint
gives way. The movement from the older level of expenditure and taxation to a new and higher
level is the ‘displacement effect’. In Figure 3, displacement effect is seen to take place at times t1
and t2.
 Inspection effect: War or other social disturbances frequently force people and their governments
to seek solutions to important problems which previously had been neglected. This is referred to
as an ‘inspection effect’. The govt. 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.
 Concentration effect: This concept refers to the apparent tendency for central govt. economic
activity to become an increasing proportion of total public sector economic activity when a
society is experiencing the above phenomena. This means that sub-national government
necessarily will decline in relative importance within the public sector.

Classifications of public expenditures

 Optional vs. obligatory expenditure: The expenditure which the public authority is free to
increase or decrease at its pleasure is called optional and the expenditure, in respect of which,
owing to past contacts and other legal commitments, it is not free is called obligatory. Spending
for building a park is optional, while paying government employees’ salaries is obligatory.

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  Real vs. transfer expenditure: A transfer expenditure is a payment without corresponding receipt
of goods and services by the state. Examples are old-age pensions, unemployment benefit etc. In
contrast, real expenditure is that by which the state pays for its purchases or use of goods and
services. Expenditure on making bridge is an example of real expenditure.
 Productive vs. unproductive expenditure: The expenditure incurred for productive purposes is
called productive expenditure. Expenditure on roads and highway is a productive expenditure.
Unproductive expenditure, on the other hand, is that expenditure which is incurred for
unproductive purposes. War expenditure is an example of unproductive expenditure.
 Development vs. non-development expenditure: Development expenditure refers to the
expenditure on development activities like various investment programs. On the other hand, non-
development expenditure includes expenditures on different functions and operation of
government.

Canons of Expenditure
 Canons of public expenditure refer to the rules which should govern the public expenditure
decisions. The canons reflect the philosophy of a judicious use of public funds.
 Canon of economy
 The resources are scarce compared with its needs. No wastage should, therefore, be
permitted. The process of public expenditure should not involve the use of resources
more than what are just necessary. Utmost care must be taken to avoid wasteful usage of
public funds. Greater care and scientific approach towards the assessment of the required
expenditure is needed.
 One form of wastage of public expenditure is the delay that often accompanies in
formulating the plans of public expenditure, their sanction and their execution. On
account of faulty planning and execution and delays involved, some benefits are lost, i.e.,
for given benefits the authorities pay more. Furthermore on account of delays, when
prices are rising, costs themselves go up.
 Various costing methods should be applied for continuous check on various cost elements
of projects. Cost-benefit approach may be adopted to decide the worthwhile ness of
projects.
 Canon of sanction
 This canon asserts that no public funds should be used without proper authorization.
Further those funds must be used only for the purpose for which they have been
sanctioned. The idea is that such a restriction would avoid unscrupulous and unwanted
expenditure and will also be a check against misappropriation of funds. Since, however,
there can always be emergencies and delays in getting the sanction of the legislature for
additional funds, a certain flexibility is granted in a number of cases up to a margin.

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  Canon of benefit
 This canon says that the public expenditure should be incurred only if it is beneficial to
the society. Any expenditure is to be viewed against the benefits that will accrue from it.
It may be possible to reallocate the same public expenditure between different items in a
manner which increases social benefits. The authorities should, therefore, try to choose
that combination of items for public expenditure which collectively maximize the social
benefit.
 Canon of surplus
 The govt. should avoid deficit budgeting, at least a persistent one. It should not over-
spend and run into debt. Unavoidable deficit during some years must be offset by
surpluses during other years.
 This canon, however, no longer finds favor with the fiscal authorities or with economists
in general. These days the regulatory role of the govt. is recognized in an increasing
measure and therefore the choice of surplus or deficit budget is left to be decided on the
merits of the case. During depression govt. would do well to run into a deficit to stimulate
demand and production. Resource mobilization efforts in a country often necessitate
deficit financing. In the growth process, the barter sector of an economy gets increasingly
monetized. In order to help and sustain this process, the financial and credit structure of
the economy must develop along healthy and efficient lines. To this end, deficit financing
through resultant increase in money supply and public debt, provides the necessary credit
base.

Effects of public expenditure upon labor supply

 Curve indicating wage rate
Figure 4
Income

O
V Leisure

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 Income-leisure preference schedule
Figure 5
Income
A’
A

’
A
A

O
Leisure
 Income-leisure equilibrium
Figure 6
Income

A’
A
W

’
A
A
O
V Leisure

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 Reaction to wage increase
Figure 6
Income

W’
A’

A
W
E1

E0 ’
A

A
O
M N V Leisure
 Income effect (IE) of wage increase:

 Substitution effect (SE) of wage increase:

 Whether labor supply will increase or decrease in response to wage increase depends on
the relative strengths of IE and SE.
 If IE > SE, labor supply will decrease.
 If IE < SE, labor supply will increase.
 If IE = SE, labor supply will remain the same.
 Effects of transfer payment proportional to income
 Transfer payment proportional to income makes work more rewarding.
 So the effects will be the same as those of wage increase.
 Effects of transfer payment not related to current income
 Honorarium for freedom fighters is an example of such transfer payment.
 This transfer payment makes work neither more rewarding nor less rewarding, thereby
producing no substitution effects.
 It has only income effect. Increased income induces workers to enjoy more leisure and
work less.
 Figure 7 illustrates how work is reduced. Since the transfer payment ̅ is lump sum (not
related to income), it causes the wage curve to undergo a parallel upward shift by the
amount of ̅ . As a result, equilibrium point changes from E0 to E1 causing reduction of

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 work by MN.
Figure 7
Income

W’ A’
𝑇̅
A
W
E1

E0 ’
A
V’
A
O
M N V Leisure

 Effects of government services



 The income effect will be strong if

 Govt. services are direct substitutes for privately produced alternatives. For
example, the provision of public education free of charges lessens the necessity
for earning additional income to finance education of one’s children at private
schools.
 Govt. services are complementary to leisure. For example, if recreational facilities
are provided workers will have more opportunity to spend their leisure time. As a
result, they will have tendency to have more leisure and do less work.
 The income effect will be less strong if
 The services are complementary to work. For example, free commuter
transportation or free meals in work place will reduce the incentive to work less.
 Effects of government services on supply of workers
 Compulsory education system
 Decreases number of workers by taking teen-agers out of labor market.
 Social security system such as old age pensions
 Decreases the number of workers by taking older persons out of the labor market.
 Public health and welfare programs
 Reduce infant mortality and chronic illness and lengthen the life-span. As a result,
the number of workers in the economy increases in the long run.

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 Rehabilitation of the disabled
 Increases the number of workers by training the disabled.
 Grants for child
 Reduces cost of having more children, thereby raising the birth rate. As a result,
one can expect a larger work force in future.
 Education
 Increases skilled workers and decreases unskilled workers.

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