Public Finance

1. Public Finance Principle of Maximum Social Benefit

2. Principle of Maximum Social Advantage: This principle deals with: • Size of public budget • The level at which the state should operate • The boundaries of its activities. The purpose should be to design the policy and the operations of the state so as to achieve maximum possible advantage or welfare as a whole.

3. Older concepts of public finance made unrealistic assumptions and reached faulty conclusions regarding the best possible public finance policy or the optimum level of budgetary activities of the state. They assumed that- • The state was an entirely extraneous body to maintain the economy • It was also an economic burden • Every tax cause a disutility to the society.

4. J.B Say pointed out in the nineteenth century 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”. It amounted to saying that the State activities must be kept to the minimum possible.”

5. By agreeing with the unrealistic assumption which is- “all taxes drain economy’s resources and that all public expenses restore these resources to theeconomy”we can lay down prescriptions regarding government's budgetary policy aimed at achieving maximum net social advantage.

6. In this view the following assumptions can be made: • The public revenue consists of only taxes( and not of gifts, loans and fees etc) and the State has no surplus or deficit budget. • Public expenditure will be first directed towards those uses which are most beneficial to the society and the state taxes will be paid by withdrawing resources from the lines where they are least useful.

7. As the state increases its taxation and expenditure activities, the social benefit from each additional money falls, while dissatisfaction from each additional money taxed increases. This way , a stage is reached when the rising marginal dissatisfaction of taxation becomes equal to the falling marginal benefit of expenditure.

8. Thus, At this stage the state should stop expanding its activities. It is no longer beneficial to further expand state activities because the social benefit of the marginal unit of public finance operations is no longer larger than the corresponding social dissatisfaction.

9. B P N B’ M O Amount of Taxation and Public Expenditure D N’ C D’ The proposition of maximum social advantage can be depicted graphically. Through this Graph the optimum tax and expenditure activity can be determined Where, X- axis the public expenditure and taxation is being measured Y-axis social benefit and cost are measured.

10. B P N B’ M O Amount of Taxation and Public Expenditure D N’ C D’ • The Quantity measured along Y-axis will be positive if measured aboveX-axis • And negative if measured belowX-axis. So, Marginal social benefit from public expenditure will lie above X-axis And Marginal disutility from taxation will lie below X-axis

11. B P N B’ M O Amount of Taxation and Public Expenditure D N’ C D’ The difference between BB’ and DD’ measures the net social benefit or advantage to the society, and is depicted by the curve NN’. BB’ represents marginal social benefit accruing to the society from alternative amount of public expenditure DD’ represents marginal social cost to the society levied by the State.

12. B P N B’ M O Amount of Taxation and Public Expenditure D N’ C D’ When an amount OM is taxed and spent by the State, • Marginal social benefit= marginal social disutility Or, MP= MC • Till then, gain to the society is more than loss. • It is here where the State should stop expanding their activity.

13. B P N B’ M O Amount of Taxation and Public Expenditure D N’ C D’ The net gain to the society is equal to the area OMN • If the state stops its public finance operations at a level below OM, the society forgoes possible gain. • If the operations are expanded beyond OM, the net benefit again stats falling.

14. ANALYSIS OF PUBLIC FINANCE: POSITIVE AND NORMATIVE APPROACH: POSITIVE APPROACH: Positive economics deals with refutable hypothesis about the implementation or effects of government policies. Positive approach deals with “What it is". Positive approach describes the facts of a an economy. Through this analysis, all questions can be resolved by reference to analysis and empirical evidence that puts them in the realm of positive economics. What is

15. NORMATIVE APPROACH: Normative economics deals with the desirability of government policies (optimal policies) i.e., with social value judgments. It involves the ethical precepts and norms of fairness. This approach deals with “What ought to be". There are no right and wrong answers to different questions because they involve ethics and values rather than facts. They can be resolved by political debates and decisions, not by economic analysis alone.

16. WELFARE ECONOMICS: Welfare economics is that branch of economic theory that deals with the social desirability of alternative economic states. The theory is used to distinguish the circumstances under which markets can be expected to perform well from those under which market fail to produce desirable results.

17. One of the role of the government is public interest or social welfare. The largest concept of public finance is “public interest”. Public utility is ensured by public interest.

18. Minimalist Approach: Least involvement of government in social concern. • Public interest: Government’s activity for the benefit or maximizing public utility. If government for all he citizen of the country take any decisions which ensures benefits, then government serves the maximum public benefit.

19. Around 200 years back Jeremy Bentham define- “ Public goods for the greatest number of citizen”. The implementation of this definition is very hard by taking only one government decision, as public interest is conflicting factor. So the definition is weak in the sense of utility measurement.

20. John Stuart Mill another economists also define public interest like Bentham, but he also measures the level of utility. • Ordinal Utility: Utility is measured in absolute term. • Cardinal Utility: Utility can be measured through pricing.

21. The government cannot ensure the benefit of all the people at a time. It can be benefited for one and also harmful for another. For example: Giving ‘Old Age pension’ by redistributing the money from the pocket of the taxpayer. So, the gainer is the old age people and the looser is the general people.

22. The problem of J.Mills definition: But on the other hand, by other economists govt. activity is not possible to measure the level of utility, that is the loss and gain of utility measurement.

23. Finally. The Italian Economist Vilfredo Pareto develops the concept of “Pareto Efficiency” which includes- • Pareto optimality (one-sided view) • Pareto Superiority (two-sided view)

24. The clarification oif Pareto Optimality: To understand the pareto efficiency, we begin with the concept of “Edgeworth Exchange Box” which means the contrast of two parties’ utility which is shown by the edgeworth box proposed by the economists.

25. Apple Apple 0 0 Orange Orange EDGEWORTH EXCHANGE BOX • We begin with the Edgeworth exchange box

26. Apple Apple 0 0 Orange Orange EDGEWORTH EXCHANGE BOX (cont) Consumer 1 (C1) Consumer 2 (C2)

27. Apple Apple 0 0 Orange Orange EDGEWORTH EXCHANGE BOX (cont)

28. DERIVING PARETO OPTIMAL POINT As we can see, point A and B represents same level of satisfaction for consumer C2 but represents higher level of satisfaction for Consumer C1. Hence, we can say point B is more socially desirable to A. We can also note here that, given the production possibility, even better satisfaction for C1 is achievable. Apple A B 0 Orange

29. DERIVING PARETO OPTIMAL POINT (cont) Orange Given this situation, we can see that the satisfaction for C1 would be maximized at point C where both these two indifference curves are tangent. Hence, if C2 consumes 01A2 unit of Apples and 01R2 unit of orange then C1 achieves the highest indifference curve without hampering C2’s satisfaction. At this point, C1 will consume 0A1 apples and 0R1 oranges. R2 01 A B A1 A2 Apple Apple C 0 R1 Orange

30. DERIVING PARETO OPTIMAL CURVE/CONTRACT CURVE Now, if we find out all these tangents between these two sets of indifference curves and join them in free hand, we will get the Pareto optimal curve which is better known as contact curve. Before we describe the characteristics of contact curve and Pareto optimal point, let us briefly refresh our understanding of the micro-economic concept of marginal rate of substitution. Apple 0 Orange

31. DERIVING PARETO OPTIMAL CURVE/CONTRACT CURVE Apple This is the same indifference curve that we have used at the beginning of this session for consumer 1. Notice that, consumer 1 is willing to sacrifice 20 apples for 2 oranges, that is if he is asked to forgo 20 apples he would ask for 2 additional oranges or vice versa. Here 20/2=10 is the marginal substitution rate of Apples for Oranges or .10 is the MRS of Oranges for Apples. 50 30 0 12 10 Orange

32. DERIVING PARETO OPTIMAL CURVE/CONTRACT CURVE Now, given our understanding of MRS we can see that, at every point of the contact curve, the MRS of consumer 1 is the same as MRS of consumer 2. Hence come the first condition of Pareto optimality. When a distribution is Pareto optimal, the MRS of all the consumers will be equal. Before we describe the second condition of Pareto optimality, let us refresh our understanding of Marginal Rate of Transformation. Apple 0 Orange

33. DERIVING PARETO OPTIMAL CURVE/CONTRACT CURVE Apple Given the fixed quantity of productive resources in a Economy, suppose, if production of Apple go to be increased from 70 unit to 90 units, the production of orange got to be decreased from 130 units to 100 unit. That is the marginal rate of transformation (MRT) of Apple would be 30/20=1.5 Oranges at this point. In other word, 1.5 unit of orange got to be sacrificed for producing another unit of Apple. 90 70 0 100 130 Orange

34. DERIVING PARETO OPTIMAL CURVE/CONTRACT CURVE Now suppose at point A the MRS apple for orange is 1/3. That is, one unit of orange would require 3 units of Apple to enable the consumers to stay at the same indifference level. However, if at this level the MRT is say ¼ then more apple can be produced by forgoing 1 orange. That is more efficient allocation is still possible between the two consumer. However, according to our definition of Pareto optimality that should not happen. Hence, MRT must be equal to 1/3 or MRS. Hence the second condition, at Pareto optimal point MRSC1=MRSC2=MRT Apple A 0 Orange

35. SECOND THEOREM OF WELFARE ECONOMICS • The first theorem tells us that we should allocate resources on the contact curve. However, it tells us nothing about where in the contact curve should we make our allocation. • The second theorem emphasizes this point that, the society must make explicit value judgment about which point is more desirable than the other. In other words, this theorem reminds us of the issue of fairness and social justice. Apple A B C D 0 Orange

36. The drawbacks or limitations or problems of pareto optimality: • Applicability: It is very difficult to apply in the real life situation. In a complex society, people have the contrasting demand .As because it is not possible to achieve all the demands for all of the people of the society, so the optimality is not achieved.

37. Status Quo: Pareto optimality must be achieved by fair means or in a legitimate way. If pareto optimality is achieved by illegal way then the problem of status quo arrived. The status queo problems arise by unfair legitimate means.

38. Measurement problem: Public interest is conflicting from the viewpoint of utility measurement. Utility was regarded as relative factor and no absolute factor is identified to determine the level of measuring the public utility. So the measurement should be taken by comparing the suitability of the decision taken by the govt. If the portion of the losers is greater than the benefited group, govt. should withdraw the decision. But in optimality there is no consideration of measurement. Here, micro sense is working by analyzing one by one. The extent of benefit and loss may differ from one to one.