Public Finance

Public finance is the branch of economics that studies the income and expenditure of the government — how the government raises money (public revenue), how it spends money (public expenditure), and how it borrows when needed (public debt). Just as a household manages its income and spending, the government manages the finances of the whole country.

The main instrument of public finance is the government budget — an annual statement of the government's estimated receipts and expenditure for the coming financial year. In India the budget is presented in Parliament each year. The budget has two parts:

• The revenue budget — the government's revenue receipts (like taxes) and revenue expenditure (day-to-day spending like salaries).
• The capital budget — capital receipts (like borrowing) and capital expenditure (like building roads and bridges that create assets).

The relationship between receipts and expenditure gives the budget's balance: a balanced budget (receipts = expenditure), a surplus budget (receipts > expenditure), or a deficit budget (expenditure > receipts). The fiscal deficit — the gap that the government must borrow to fill — is one of the most watched figures in the economy. Through the budget, the government pursues important objectives: providing public goods and services, redistributing income to reduce inequality, promoting economic growth and stability, and managing employment.

Public revenue is the income the government receives. It has two kinds:

• Tax revenue — compulsory payments to the government for which no direct service is given in return (the main source).
• Non-tax revenue — income from sources other than taxes, such as fees, fines, profits of public enterprises, and interest on loans given by the government.

A tax is a compulsory contribution to the government, without any direct benefit in return. Taxes are of two main types based on who finally bears the burden:

• Direct tax — a tax whose burden falls directly on the person who pays it, and cannot be shifted to someone else. Examples: income tax and corporate (company) tax. Direct taxes are usually progressive — the rich pay a higher rate — which helps reduce inequality.
• Indirect tax — a tax whose burden can be shifted from the person who pays it to another (usually the final consumer). It is levied on goods and services. The main example today is the Goods and Services Tax (GST); earlier examples were excise duty and sales tax. Indirect taxes are easy to collect but can be regressive (they take the same amount from rich and poor).

The key test: a direct tax is paid and borne by the same person (income tax), while an indirect tax is paid by the seller but borne by the buyer (GST on a product). Taxes are the government's most important tool for raising revenue and for influencing the economy (e.g. taxing harmful goods more heavily).

Public expenditure is the spending done by the government to perform its functions and promote the welfare of the people. It has grown enormously in modern times because governments now do far more than just defence and law and order. Public expenditure can be classified in several ways, the most important being:

• Revenue expenditure — day-to-day spending that does not create assets, e.g. salaries, pensions, interest payments, subsidies.
• Capital expenditure — spending that creates assets or reduces liabilities, e.g. building roads, schools, dams and hospitals.

Governments spend on defence, education, health, infrastructure, subsidies, welfare schemes for the poor, and the salaries of employees. Wise public expenditure promotes growth, reduces inequality and provides public goods that the market would not supply.

When the government's expenditure exceeds its revenue (a deficit), it must borrow — this borrowing is the public debt (also called government debt). The government borrows from within the country (internal debt — from banks, the public, the RBI) and from abroad (external debt — from foreign governments and institutions like the World Bank). Public debt is useful for financing big development projects and meeting emergencies, but if it grows too large, the burden of interest payments rises and can strain future budgets. So governments aim to keep their debt and fiscal deficit at sustainable levels. Together, public revenue, public expenditure and public debt are the three pillars of public finance through which the government manages the economy.