Basics of Public Finance [ECON236]

M1 Introduction to Public Finance

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Nature, Scope and Importance of Public Economics; Role of government- Public Finance v/s
Private Finance; Failures of market economy - public goods, private goods; externalities;
Role of Public Finance in Developing and Developed economies; Principles of Maximum
Social Advantage
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Public economics or public finance refers to the finances or monetary resources of public
authorities or the government bodies at all levels – central, state, and regional or local. Dalton
has said that “Public finance is one of those subjects which lie on the borderline between
economics and politics. It is concerned with the income and expenditure of public authoriiies,
and with the adjustment of the one with the other.”
According to Musgrave, the complex problems that centre around the income – expenditure
process of government are traditionally studied as a public finance.
Public Finance in modern times is a complex phenomenon as the modern state is a welfare
state performing many functions. So, while Taylor limited the scope of public finance as
dealing with the finance of the public as an organised group under the institution of
government……..
Public finance is concerned with the operation of the fisc or public treasury. “Hence, to the
degree that it is a science, it is a fiscal science, its policies are fiscal policies, its problems are
fiscal problems.”
With the interaction and interdependence between the state and private sectors gaining
importance in modern economics, the public sector plays a significant role both in theory as
well as in practice. Hence apart from functions such as maintaining law order, screening
internal peace and justice, safeguarding democracy, defending the country from external
invasion and violence, providing stability to the economy, a modern state has to create
conditions of social upliftment and betterment , provide social and economic justice, provide
conditions for rapid economic growth and take steps to cure various economic ills.
Thus, modern public finance studies fundamental problems associated with fiscal activities
such as:
 The extent to which state should intervene in the economic field?
 What should be the scope of public sector economy?
 What should be the size of public revenue?
 In what ways should taxes be raised and what should be the characteristics of the tax
system?
 What should be the distribution of the tax system? How can equity be realised?
 What should be the formal and effective incidence of taxation on production
consumption distribution and welfare?
 What should be the pattern of growth of public expenditure?
  How should public expenditure be incurred to improve public welfare?
 What should be the criterion for public budget? Ow should it be balanced?
 What should be the extent of public borrowing and how should public debt be
managed?
 What is deficit financing? What should be its limit?
Clearly modern public finance has a complex structure. It studies the economic behaviour of
the state in a systematic manner examining the relationships between multiple social wants
and scarce public resources with alternative uses, with the aim of ensuring the general well-
being of the citizens.
Subject matter of Public Finance
The subject matter of Public Finance pertains to the financial aspect of administration by the
government. With this focus, the study of public revenue and public expenditure become
important divisions of the subject of Public Finance. Apart from these two, there is the issue
of organisation of raising and disbursal of resources, as well as meeting the situation of
mismatch in requirements and availability of resources. These lead to the development of
Fiscal Administration and Public Debt as further divisions in the subject of Public Finance.
Scope of Public Finance
The scope of public finance encompasses public revenue as well as public expenditure as it
relates to the process of raising and dispersal of funds for the functioning of the government.
It also discusses the impact of the government’s fiscal operations on the level of overall
economic activity, employment, prices and growth process of the economic system as a
whole.
Apart from the problem of raising and spending of revenue, public finance also discusses the
disbursal of resources among various agencies and the situation of excess of public
expenditure over public revenue. The disbursal of resources is dealt under financial
administration while public borrowing or ‘public debt’ explains solutions to problem of
revenue deficit.
Thus, the four major divisions of Public Finance are:
1) Public Revenue dealing with the method of raising funds and the principle of taxation.
It takes up issues pertaining to classification of public revenue, canons and
justification of taxation, incidence and shifting of taxes, effects of taxation and related
matters.
2) Public expenditure deals with the principles and problems relating to the allocation of
public spending. It examines the fundamental principles governing the flow of public
funds into different channels, classification and justification of public expenditure,
expenditure policies of the government and the measures adopted for public welfare.
3) Public Debt pertains to the study of the causes and methods of public loans and public
debt management.
4) Financial Administration where the problem of how the financial machinery is
organised is dealt with.
 The study of budgetary operations of the government comprising of public
expenditure and taxation is important as these affect the economic behaviour and
daily life of the people and the working of the economic system as a whole.

Importance of public finance

1) Effective mobilisation of resources: Fiscal methods like taxation and public spending
provide opportunities to mobilise resources into desired productive channels. Taxation
implies forced savings as people are forced to curb their consumption. This leads to
saving of real resources which may now be used for investment purposes. Further, in
poor countries the per capita income is low while propensity to consume is high, so
the saving-income ratio tends to be low. In such scenario, taxation is an effective
method for mobilising savings.
2) Allocation of resources: a judicious fiscal policy ensures reallocation of resources
from unproductive to productive uses. Imposition of taxes can curb the demand for
non-essential luxury goods resulting in reduced profitability of investment in
producing these goods. The surplus funds thus released can be used in producing
much needed essential goods. Also, provision of tax rebates to economic entities
involved in production of essential commodities goes a long way in increasing private
investment in these sectors.
3) Provision of social goods: the government undertakes public expenditure in order to
produce public goods to satisfy social wants like water supply, electricity, transport
roads etc. Provision of such public utilities enhances general economic welfare.
4) Creation of social overhead capital: the public sector has to ensure construction of
social infrastructure in the country. Fiscal operations need to be directed towards
provision of facilities for public health, general education, transport and
communication, housing, construction of bridges and canals, roads etc. through such
public spending the government can ensure the improvement of human capital in the
country.
5) Capital formation: rate of capital formation in the country can be accelerated through
appropriate physical operations. Public sector investment can help create additional
stocks of physical capital assets. The creation of social overhead capital by the
government facilitates capital formation activities of the private sector. Tax
concessions subsidies ec promote an accelerate the rate of capital formation in the
country.
6) Redistribution of income and wealth: Taxation and public expenditure can help reduce
the inequalities of income and wealth and ensure fair distribution of economic
powers. Progressive taxation can be used for levelling down the top incomes while
public expenditure can help level up the bottom incomes.
7) Economic stabilisation: judicious fiscal policy helps in ensuring economic stability in
the country. Public policy can be made anti-inflationary during inflation and anti-
deflationary during deflation. Increase in direct taxation helps reduce surplus
spending power effectively reducing the forces of inflation. Similarly at times of
depression and increase in public expenditure stimulates effective demand will stop in
this way modern public finance becomes anti cyclical and growth oriented.
 Fiscal operations of the government can be effectively utilised to achieve various social
and economic goals such as:
Public finance serves the interests of economic policy. Government spendings can
stimulate private sector for example through expenditure on setting up of industrial
areas and export zones.
Public finance is designed to bring about an appropriate allocation of productive
resources so that national product is maximised, and income distributed equitably.
Public finance can be an instrument of social policy. With the help of proper fiscal
policy national income can be equitably distributed bringing about harmony between
the different classes of people.
Financial operations can improve general welfare if major public spendings are used
for welfare projects.
Government financial operations do an important role in developing economies like
India by promoting capital formation and investment.
The policy of taxation and public expenditure affects the growth and pattern of
production in the country.
Properly designed fiscal operations can help break the vicious circle of poverty in a
developing economy or poverty in the midst of plenty in a developed economy.
Fiscal operations can check trade cycles and lead to economic stabilization.

Role of government- public versus private finance

Similarities between public and private finance:
1. Same objectives: Both private and public finance have broadly the same
objective that is the satisfaction of human wants. Private finances concerned
with the utilization of available resources in order to satisfy the personal wants
whereas public finances designed by the state to utilise the country's resources
to satisfy social or collective wants.
2. Rational behaviour: both kinds of finance are based on rationality. Or rational
individual seeks to maximise personal benefits or total utility utility from his
expenditure. Or rational government seeks to maximise social benefits from
public expenditure.
3. Economising: the scarcity of resources being a common factor the problem of
economising is common to the operations of both kinds of finance.
4. Need for borrowing: when expenditure exceeds income resort is made to
borrowings in both types of finance. Like an individual, the state has to repay
the loans obtained under the deficit budget.
5. Need for income: in private finance income precedes expenditure. Similarly in
case of state also revenue is to be raised before expenditure is carried out.
Differences between public and private finance
1. Personal benefits versus social benefits: the government tries to fulfil ends and
objectives which are different from the objectives aimed at by most private
sector entities. Basically, the motive of private expenditure is personal benefit.
The motive of public expenditure is social benefit which largely depends on
 the effects of such expenditure on consumption, production, employment, and
income of the community. Thus, individual sets a subjective standard of utility
of his expenditure while the government must set an objective standard of
utility of public expenditure.
2. Income versus expenditure: An individual’s income determines the
expenditure pattern but in case of public finance, government’s expenditure
determines its income. In other words, individual’s budget is formulated
keeping in mind the income of the person. The government usually first
decides what it will spend on and then the resources required for ensuring
those are procured.
3. Differences in methods and resources of budgeting: the resources of an
individual are limited as compared to the government. The government has the
power to levy taxes and to print notes to raise its revenue. Individuals have no
such power. Also, governments can raise internal and external loans. An
individual cannot borrow from himself nor can approach international
monetary institutions like the IMF or the World Bank. So public revenues are
more elastic than private incomes.
4. Short-sightedness versus long-sightedness: the state being a permanent
institution, has a long-term perspective of its expenditure. Immediate returns
or benefits do not hold as much interest for the state as they do for individuals.
5. Individual versus Social preference functions: In private finance, the economic
decisions are taken in view of the individual preferences in satisfying private
wants. The market mechanism plays an important role in this regard. For
public finance, the budgetary operations are decided by group discussions of
the parliament in a democracy. In private finance, there are value judgements
based on private welfare. In public finance, the value judgements of the
statesmen are driven by assuring social benefits for all.
6. Narrow versus wider repercussions: An individual’s spending has little effect
on the society as a whole. The impacts of the state’s decisions are much more
pronounced with financial policy affecting society strongly.
7. Surplus versus deficit budgets: For individuals, a surplus budget is regarded as
a good thing. In case of public finance, a surplus budget is not always
considered good nor is a deficit budget always frowned upon. While a
balanced or even surplus budget is a good thing in normal times, deficit
financing is considered a good remedy during recession for economic
development.
8. Secret versus open affairs: Private affairs are always secret while public
finance is always an open affair. The government’s budget is given wide
publicity and discussed in the parliament but individuals do not like to share
details of their finances.
Failures of market Economy: public good, private goods, externalities
The following are the major areas of market failures which call for government intervention
for corrections: Externalities, public goods, uncertainty, distribution, growth and
development.
1. Externalities: externalities refer to spillover or neighbourhood effects. Externalities
exist both in consumption and production. Externalities and consumption exist when
the level of consumption of some commodity by a consumer has a direct effect on the
welfare of another consumer. This effect is not transmitted through the price
mechanism in the market system. Examples of consumption externalities are- suppose
a person wants privacy for which he builds a high fence which may obstruct sunshine
to his neighbour’s house. Similarly, if a person plays loud music, it may create noise
pollution or disturb the sleep of the neighbours.
Production externalities exist when the production activity of a firm affects the
production activity of another firm. For example, when firm X discharges effluents
into a river, it may greatly increase costs of firm Y downstream. Externalities can be
negative or positive. Positive externalities are also called external economies and have
a beneficial external effect. For example, when a firm A establishes a training school
for computer programmers, there is an easy availability of train programmers to firm
B.
The government should intervene by introducing tax subsidy schemes for correcting
the externality effects. The government may put penalties or levies on activities
causing reduction in welfare or increase in costs. For example, chemical and other
such industries causing pollution may be taxed additionally and the funds so raised
may be used for corrective measures.
The essence of externalities - in consumption as well as production - is that their costs
of benefits are not reflected in the market prices. Decision of consumer or producer
does not consider the effect of the externalities. Market fails to correct adverse
externalities effect, or the externalities make it impossible for the market to reach a
Pareto-optimum. The existence of externalities provides a strong argument for
government intervention into the market economy. The government may give
subsidies on activities which add to welfare. Farm subsidies are justified in poor
countries on this ground. The government may also create economic legislation to
prevent externalities effect. For example, smoking may be prohibited in public areas,
there may be one way entry to avoid congestion in the street, mounting of horn may
be prohibited in certain areas cutting of trees may be prohibited and so on.
2. Public goods: public goods are goods which satisfy collective wants or social wants in
general. An important characteristic of public or social goods is that they are not
subject to the exclusion principle in their use. This means individuals cannot be
excluded from consuming a public good even if they do not pay for it. Further
consumption by one individual does not prevent any other individual from consuming
it.
Since market may fail to provide public goods or it may be under produced in the
market system it becomes necessary for the government to accept the responsibility
for providing public goods by spending out of tax revenue. Social wants cannot be
satisfied through the process of market mechanism because the satisfaction or
enjoyment cannot be accounted for by price payments. A major difference between
private and social wants is that the former can be adequately provided by the market,
 but the latter cannot be satisfied in the market as they enjoyment cannot be related to
direct price payment.
In private wants the exclusion principle can work successfully. This cannot be the
case with social wants, for the satisfaction of social wants is independent of the
individual’s contribution. For example, police services maintain peace for all, or a
public health project intends to raise the general level of health of the area as a whole.
Unlike private wants, in the satisfaction of social wants, consumers preference cannot
be registered so that the market mechanism fails to work. Hence it is very difficult to
evolve any rule of thumb to affect optimum allocation of resources and satisfying
social wants. It involves a considerable amount of value judgment and
According to Musgrave, the public wants that can be satisfied through provision of
public goods are of two types – social wants and merit wants. Merit wants are those
public wants which can be satisfied on the basis of the consumers choice. Such wants
can be subjected to the principle of exclusion and satisfied by the market process.
These are taken on public budget on meritorious account of utility orientation of
public goods hence their name merit wants. Satisfaction of social or collective wants
is possible only through public goods which are enjoyed by all members of the society
equally without any exclusion. Wants like defence, education, public health, social
overhead capital like roads, bridges, etc., are collective wants. They are satisfied
through the provision of social goods whose production and pricing depends on
arbitrary but rational method adopted by government. Since the payment part of social
goods cannot be decided on the market basis, budgetary provision is inevitable for
their supply. Investment in social capital and human capital is essential for the
development of any economy. It is the government's role to provide them as private
sector does not come forward in this field. Thus, there is a need for public sector even
under capitalism.
3. Uncertainty: there is a lot of uncertainty in business as the probability of outcomes
resulting from specific decisions and actions is not known and cannot be predicted
because of their subjective nature. The fluctuation in investment activity in private
sector due to changes in marginal efficiency of investment, or expected rate of profit,
business and entrepreneurial psychology etcetera, lead to fluctuations and trade
cycles. Government intervention is needed for introducing anti-cyclical measures and
creating economic stabilization.
4. Distribution: the distribution of incomes under free market system is generally lop-
sided. It favours the rich who already have control over the productive resources. So,
the haves tend to get more, while the have-nots are deprived. The unfair distribution
of income and wealth endangers economic efficiency. It is therefore necessary for the
government to correct income distribution through appropriate fiscal measures. The
government may resort to progressive taxation on income and wealth and the revenue
so collected can be redistributed in favour of the poor sections through public
expenditure on welfare projects. Even in a capitalist economy the government can
provide social justice through appropriate fiscal policy.
5. Growth and development: In less developed countries, growth and development are
slow and lopsided and free market mechanism. To break the wishes circle of poverty,
capital deficiency, no investment common low productivity and no incomes public
sector investment and planning are needed. Modern governments attempt to achieve
 and maintain full employment level in the economy through optimum utilization of
resources and accelerate the tempo of economic growth. This requires use of
appropriate fiscal and monetary measures and the active participation by the public
sector for securing economic stability, proper resource allocation, resource
management, and resource mobilization, to attain full employment and to promote
economic development.

Role of Public Finance in Developing and Developed economies

Role of public finance in developing economy:
1. Promotion of competition: public finance works to remove market imperfections
through promoting competition in monopolistic industries.
2. Control of price and output: To safeguard the interests of consumers and prevent their
exploitation by monopolistic concerns, the government may fix the maximum
statutory prices (MRP in India).
3. Fiscal measures: Government may undertake various fiscal measures to reduce
inequalities of income distribution and prevention of concentration of economic
power.
4. Planning: government may undertake planning – indicative or sectoral, to ensure
desirable productive activity and to channelise resources in a desirable manner for
rapid economic development.
5. Provision of public goods: Due to failure of market mechanism in providing public
goods like defence, police, judiciary, roads, streetlights, water supply etc., government
can provide for these through budgetary means.
6. Creation of social overheads and industrial infrastructure: Due to huge budgetary
requirements and long gestation periods, private sector is not interested in providing
social overheads and infrastructural facilities (bridges, canals, hydroelectric projects,
railways, highways etc.). The government must step in to provide these facilities.
7. Economic stabilisation: The government often needs to play a proactive role in
controlling business cycles and maintain economic stability.
8. Check on growth of monopolies: the government has to take measures to check the
undue growth of monopolies and concentration of economic power in the hands of a
few individuals.
9. To save consumer from exploitation: In a market economy, consumers may be
exploited by the producers of certain public utilities or merit goods such as transport,
electricity etc., by charging high prices.
10. To reduce inequality: the government has to correct inequalities in income distribution
in a market economy by appropriate fiscal measures like progressive taxation and
public works programme for the redistribution of income and wealth.
Role of public finance in developed economies:
Public finance plays an important role in developed economies which are mainly capitalist in
nature. The market mechanism becomes inapplicable to many cases of public goods, like
defence, streetlights, police protection, roads, etc., as it is difficult to apply the principle of
exclusion to these goods. So, the public goods are not provided by the market and the
government has to provide such goods.
The main reasons why the private sector fails to provide certain goods and services are:
a) Goods like defence, police, streetlights etc. cannot be determined by the working of
price mechanism.
b) Existence of ‘externalities’ in benefits means that the benefits of production cannot be
controlled by individual producer as they are widespread.
c) The unit price of public goods cannot be determined, nor can its costs be collected
from each individual in society.
d) May involve huge expenditure which may be beyond the capacity of individual
producer.
e) Returns are not immediate or very large in case of many public goods
f) In case of social wants, since consumer preferences cannot be registered, the market
mechanism cannot work in allocation of resources for producing public goods.
Given the above reasons, governments in developed economies need to play an important
role in overcoming the deficiency of market economy and regulate the working of the
invisible hand. Developed economies also have a need or scope for government
intervention due to the following reasons –
a) Economic instability due to business cycles and fluctuations often require
government intervention to prevent market imperfections, growth of monopolies
etc.
b) Inequality: Market mechanism tends to promote inequalities due to concentration
of economic power in the hands of a few. The institution of private property is a
major cause for socio-economic inequality. So governments often need to step in
to prevent the self-perpetuating nature of such inequality.
c) Cyclical unemployment: capitalist economies are often faced with cyclical
unemployment. The government can play an important role in reducing such
unemployment through public investment measures.
d) Solving national economic problems such as poverty, unemployment, inflation etc
is the duty of modern states.
e) Prevention of wastage of resources: In market economies there is no automatic
optimum utilisation of resources. The existence of monopolies further aggravates
the wastage of resources due to existence of excess capacity. Government
intervention can control wastage of resources.
f) Inefficiency: The existence of large number of small firms in developed
economies leads to firms working at inefficient sizes where they are unable to
enjoy economies of scale. In such cases governments may need to step in to
ensure efficient use of resources.
g) Distortion of consumers’ sovereignty: Consumers are often mislead by aggressive
marketing tactics of huge multinational companies which prevent the reflection of
true consumer demand. Government may need to step in to prevent such
aggressive activities.
h) Sluggish functioning of market mechanism: Lack of perfect knowledge and
imperfect mobility of labour can prevent proper and free functioning of price
mechanism.
 i) Failure to satisfy all needs: while market mechanism can ensure fulfilment of
private needs, the fulfilment of social wants cannot be ensured. So, the
government in developed economies needs to provide these social goods.
To fulfil above roles the government can undertake the following measures or tools:
(1) Legislative measure, (2) promotion of competition, (3) control of price and
output, (4) fiscal measures, (5) nationalisation and expansion of public sector
and (6) planning.
Principles of Maximum Social Advantage
The principle of maximum social advantage provides a guideline to level of government
budget to ensure completion of all state activities. It suggests that government policy should
be directed in a way that maximum social advantage or welfare may be provided to the entire
economy. The criteria adopted in this regard are called the principles of maximum social
advantage.
The classical economists considered the State as an extraneous body to the economic system.
They viewed it as a necessary evil and advocated minimal state activities. Since they felt that
every tax imposed a disutility to the society as there was transfer of resources from society to
the state, J.B. Say held that “the very best of all plans to finance is to spend little and the best
of all taxes is that which is least in amount.”
In modern welfare states, the government undertakes many activities to ensure economic
welfare. The fiscal activities of the state affect the allocation of resources among various
sectors and regions and redistribute the use of resources to bring about changes in national
income, output, and employment. In this regard Hugh Dalton has pointed out that the best
system of public finance is that which secures the maximum social advantage from its fiscal
operations.
Dalton has further pointed out that all public expenditure may not necessarily be good; and
every tax is not an evil. For example, while expenditure on defence is necessary, but
expenditure on unnecessary wars is clearly unwarranted. Similarly, a tax on tobacco or
alcohol will reduce their consumption by raising prices which is a socially beneficial step.
However, unduly high taxation and extravagant public expenditure are also not advisable.
It may be said that incomes and expenditures of the government should be managed in such a
way that there is the greatest net advantage to society, comparing the social burden of
taxation and social benefits of public expenditure. Just as individuals aim at maximum
benefit, the state too aims at maximum net advantage (maximum social advantage).
Assuming that taxation by itself is a loss of utility to the society while public expenditure is a
gain of utility to the community, from social advantage is achieved when this state roots
financial activities maximising the surplus of social game or utility over the social sacrifice or
disk utility.
The principle of public finance this requires the state to compare sacrifice and benefits of the
society in all its fiscal operations full star as long as the aggregate of social benefits exceeds
social sacrifice amnet gain or utility a cruise to society an increase in financial activity of the
state is justified. But as more and more public revenue is risk of taxation, that this utility of
sacrifice involved will go on increasing at an increasing rate. The law of increasing marginal
disk utility is experienced as people pay more and more tax switch stop the benefits resulting
from public expenditure will have a diminishing tendency as more and more money is
percent. The law of diminishing marginal social benefit is thus experienced with increasing
public expenditure.
Rational state seeks to maximise the best net social advantage of its fiscal operations. The
social net advantage is maximum when the aggregate of social benefits resulting from public
expenditure is maximum and the aggregate social sacrifice involved in increasing the public
revenue is the minimum. The positive gap between total social benefit and sacrifice
determines net total social benefit. Symbolically,
NTSB = TSB – TSS where,
NTSB is net total social benefit,
TSB is total social sacrifice,
TSS is total social sacrifice.
Thus, the net social benefit NTSB is maximised or the maximum social advantage is realised
where the gap between TSB and TSS is the largest one. In the figure, the curve TSB
represents total social benefits derived from given amount of fiscal operations. The slope of
curve is rising upward but it is such that it implies that TSB is increasing at diminishing rate
after a point. Similarly, TSS curve represents total social sacrifice undergone in the process. It
is also upward sloping implying that after a point sacrifice tends to rise sharply.

total social benefits

and sacrifice

amount of fiscal operations

To know the maximum gap between TSB and TSS, two tangents to the respective curves
Aare drawn parallel to each other. Tangents T1 and T2 are drawn accordingly, at points A and
B to the respective curves TSB and TSS. Thus, AB is the maximum gap between TSB and
TSS curves, where the state’s fiscal operations amount to OQ. The distance QA measures the
total amount of social benefits derived and QB measures the total social sacrifice involved.
The net social benefit or maximum social advantage so derived is the distance AB or CD.
The equilibrium of maximum social advantage can also be depicted using marginal social
sacrifice of taxation and marginal social benefit of public expenditure. The point of equality
between the marginal social benefit and the marginal social sacrifice is referred to as the point
of aggregate maximum social advantage or least aggregate social sacrifice. In the figure,
MSS is the marginal social sacrifice curve. It is an upward sloping curve implying that the
social sacrifice per unit of taxation goes on increasing with every additional unit of money
raised. MSB is the marginal social benefit curve. It is a downward sloping curve implying
that social benefits per unit diminish as public expenditure increases. The two curves intersect
at point P. This equality point P of MSS and MSB curve is regarded as the optimum limit of
state’s financial activities. As long as MSB curve lies above the MSS curve, each additional
unit of revenue raised and spent by the state leads to an increase in net social advantage. This
beneficial process continues till the marginal social sacrifice becomes just equal to the
marginal social benefit at point P. Beyond this point, further increasing state’s financial
activity means that social sacrifice exceeds marginal social benefit hence there is net social
loss. The quantum of maximum social advantage is represented by the area APB, while OQ is
the optimum amount of financial activity of the state.

According to the principle of maximum social advantage, thus the public expenditure should
be carried up on up to the point where marginal social benefit of the last rupees spent is equal
to the marginal social sacrifice of the last unit of taxed.
Musgrave’s presentation
Professor Musgrave has rightly pointed out that the principle of maximum social advantage is
the logical extension of Pigouvian welfare approach to taxation as incorporated in the theory
of minimum aggregate sacrifice. Musgrave has designated Dalton’s principle of maximum
social advantage as the ‘maximum welfare principle of budget determination’. He has pointed
out that the optimum size of budget is determined at the point where marginal net benefits of
fiscal operations according to the society becomes zero. In the drawing figure the size of the
budget is measured on OX axis. The OY axis measures marginal social benefits or utility.
MSB is the marginal social benefits curve measuring the marginal utility of successive units
of public expenditures. MSS is the marginal social sacrifice measuring the marginal disutility
of taxes imposed. The line NB is the net social benefit curve. It is obtained by deducting MSS
from MSB. It, thus, measures the net social benefits derived from successive expansion of the
budget. The curve nb intersects the horizontal axis at point Q, where marginal net benefits are
zero. Point Q indicates the optimum size of the budget common for at this point, the total net
social benefit advantage is maximum. It can also be seen that at this point marginal social
benefit equal to marginal social sacrifice.

marginal social benefit

size of
budget

marginal social sacrifice Net social benefit curve

Criticisms limitations of the principle

Although the principle of maximum social advantage is regarded as an ideal and the best
guiding principle for state’s financial activities, it has been severely criticised on some
fundamental grounds.
1. Difficulties in the measurement of social benefits and sacrifice: the theoretical
considerations of marginal utility at this utility underlying the principle are very
difficult to put into practice. It is not easy to balance the marginal utility of
expenditure. It is difficult to measure marginal benefits of expenditure accruing to
each individual from each and every public outlay as it involves interpersonal
comparison of utilities. Similarly, it is difficult to measure the marginal dissatisfaction
caused to each individual separately from each additional tax. The problem of such
measurement is further aggravated by the fact that actual spending and taxing is done
by large number of people at different places in different government departments.
Secondly, when certain public spending is made for further benefits measurement of
its utility is obviously indeterminate in the present. As such, the government may find
it impossible to compare the marginal social benefits and sacrifice related to its fiscal
operations. Even if the government somehow succeeds in doing so it may become
difficult to act accordingly as the governmental activities are greatly affected by many
non-economic forces as well as personal and political considerations.
2. Methodological inconsistency: Critics have pointed out that the disutility of taxation
to the taxpayer is a micro problem relating to individuals, whereas the utility of public
expenditure to the society is a macro problem concerning all collectively. Thus, there
is a serious methodological inconsistency involved in balancing the marginal sacrifice
of safe taxation with the marginal social benefits from public expenditure.
3. No disutility in public borrowing: Disutility arises in payment of taxation, but in
public borrowing no such disutility is involved. Hence, there can be no limit to public
 expenditure financed through public loans. The marginal equality principle of
maximum social advantage hence loses significance to the extent that .
4. The principle is the least significant in case of functional finance: when fiscal
operations are adopted as a countercyclical measure no consideration of equalising
marginal benefits and sacrifice can be made. This is because as part of counter
cyclical measures, taxes sometimes cannot be reduced or increased beyond a certain
limit. Similarly, when public funding under public works projects is just to reduce
unemployment and improve the level of effective demand, there can be little
consideration of its marginal social benefits and sacrifice. Further, in the growth
oriented functional finance which calls for a perpetual increase in public expenditure,
principle of marginal social benefit is completely ignored.
It is thus concluded that the principle of maximum social advantage has its due place only
under the study of full employment model, but it has little significance if the fiscal policy
has the objective of controlling the cycles of pursuing rapid economic growth.