CHAPTER III THEORETICAL FRAMEWORK OF PUBLIC EXPENDITURE

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1 necessitated. Therefore, the present study is a and improvements in some other with extended period of study. follow-up work in some aspects CHAPTER III THEORETICAL FRAMEWORK OF PUBLIC EXPENDITURE This chapter presents the theoretical background of public expenditure. The present study is covering theories of public expenditure with special reference to Wagnerian approach, Peacock Wiseman hypothesis and determinants of public expenditure. Moreover, the controversial issues between Wagnerian and Keynesian approach pertaining to the relationship between public expenditure and gross national product are also discussed in the present study. Public Expenditure A Theoretical framework To know the meaning of public expenditure in traditional sense, it is necessary to understand the meaning of two words Public and Expenditure. The word public is the antonym of private. Private usually concerns an individual and is often used in the singular sense. Its plural version is public which signifies an association or group of two or more than two people. But in practice, the word has acquired somewhat specialized sense. A heterogeneous group of people is not always regarded as constituting a public body, but public here means the people should have something in common, should posses some common characteristic and have a common bond uniting them for some purpose for some time. It is not necessary that the word public should suggest always and

2 for all purposes all the people inhabiting a big territory or all the citizens of state. The chief characteristics of a public body is that it consists of a number of people. Thus, the concept of public is contrasted to the private. The word expenditure ordinarily means expenditure of money. But in economics it signifies not exactly the coins and the currency notes of a country but rather the resources of an individual or a group of persons denominated in terms of money. In the language of layman, money is used in its narrow sense and it is identical with the currency in use. But in wider sense, money includes anything that can perform the function of money or can assume its role 96. Thus, the word Expenditure is used in its wider sense. Compounding the two words Public and Expenditure the term public expenditure, which is the subject matter of this study, is got. According to the two words, public expenditure expresses the pecuniary resource of public body. The science of expenditure would study the principles underlying the acquisition and use of such resources by the public body owning it. Based on the above concept, the word Public expenditure is used to signify state or government. Naturally it would be better to use Government Expenditure or State Expenditure in the place of public expenditure. Thus, with the orbit of demarcation kept in mind, public expenditure is defined as the 96 Bhargava, R.N. (1971), The Theory and Working of Union Finance in India, Chaitanya Publishing, Allahabad, p.1.

3 expenditure of the public sector where relationships are adequately integrated for a common pursuit. Expenditure includes revenue as well as capital expenditure. Public expenditure involves the behaviour of the government in relation to the pattern and trend of expenditure. It is a branch of public finance, constituting a study of the money spending activities of the government from the financial viewpoint. It studies how finances both in cash and kind are spent or should be spent to enable the government to perform its activities according to this defined goals. The attainment of the defined goal of a society mainly depends upon the type of economic system which prevails in the country. Depending upon the prevailing system of the country, the principles laid down by the government will also vary. In this context, some main theories of public expenditure are presented below. Maximum Social Advantage Theory Public Expenditure should be made in such a way as to maximize social benefit. Pigou pointed out Expenditure should be spent in all directions upto the point at which satisfaction obtained from the additional shilling spent is equal to the satisfaction cause in respect of the last shilling called upon by the government to be paid by the people by way of revenue. For attaining maximum satisfaction to the people in the areas of public expenditure, government has to distribute the various items in such a way that the marginal return from every item of expenditure is equal.

4 The appropriate principles of taxation have to be considered in formulating the principle of public expenditure. The principles of public expenditure cannot be built up without the principles of taxation. In maximizing social advantage the values of both expenditure and tax variables are to be determined simultaneously. The maximum social advantage is determined by the optimum allocation of resources. The optimum level is reached when the marginal return is equal to the marginal cost. Hence, the optimum level of public expenditure is attained by equating the marginal social cost and marginal social benefits. The marginal social cost and marginal social benefits are determined on the basis of taxation and public expenditure respectively. Hence the government has to spend its expenditure on each item in such a way that its marginal social benefit should be equal to marginal social cost of taxation. Classification of Public Expenditure Theories The scope of public expenditure analysis mainly depends upon the scope of the function of the government. Adam Smith confined the subject of public expenditure to defence, administration of justice and certain public works 97. In modern democracies, public expenditure has multiplied manifold. In the context of modern democratic political system, a summary of nature and scope of public Smith, Adam (1961), Wealth of Nations, (Ed.) Edwin Canon, London, Vol.II, pp.230-

5 expenditure has been given by Sahni B.S (1972) 98. He states that the analysis of the broad spectrum of public expenditure deals with questions relating to appropriate level and composition of public expenditure and various operational aspects of public expenditure decision making. In the above context, it is difficult to classify the theory of public expenditure due to the existing vast voluminous literature. However, a three fold division may serve to provide an overview of scope of public expenditure analysis. They are: (1) Normative aspects, (2) Positive aspects and (3) Applied aspects. (1) Normative Aspects of Public Expenditure The normative aspects of public expenditure are concerned with the study of the appropriate levels and composition of public expenditure. It determines the norm of the operations for the satisfaction of social wants. Besides, it examines the effect and consequences of public expenditure and assesses the aims and objectives of public expenditure programmes. Hence, the normative aspect of public expenditure approach is also known as welfare approach. The main debated issues in the normative approach are: (a) The question of social choice (b) Market failures and concept of public good and (c) Normative solutions for allocation and distribution of resources which is nothing but a pure theory of public expenditure. 98 Sahni B.S. (1972), Public Expenditure Analysis: Selected Readings, Rotterdam University Press, Rotterdam.

6 The concept of public good is reviewed here on the basis of Samuelson contribution 99. People require public goods to lead the life in the civilized society. The service of public goods is provided to the people in such a way that they are consumed equally whether they pay or not and the principles of price mechanism, cannot hold good in this context. These services are provided to the people by the government because of failures of the market. Market failure gives rise to various degrees of intervention for the government. The benefits of production of public goods are too costly to be divided into units to which prices can be assigned. Hence, it is difficult to exclude any one of the citizens from consuming these benefits if they refuse to pay for them. (2) Positive Theory of Public Expenditure Normative theory of public expenditure has not added much to the understanding of government behaviours in the real world. Hence, there is a need to shift attention from the problem relating to What should be to What is? In doing so, it is necessary to know how expenditure policies, in fact, be determined which reached to the positive theory of public expenditure. Bird (1970) 100 has defined the positive theory of public expenditure as that body of economic and political analysis which attempts to understand and explain the observed pattern and level of government expenditure and the changes in 99 Samuelson, P.A. (1954), The pure Theory of Public Expenditure, Review of Economics and Statistics, Vol.35, p Bird R.M. (1970), Growth of Government Spending in Canada, Canadian Tax Foundation, Toronto, p.4.

7 those expenditure overtime. The positive theory of public expenditure deals with the formulation and empirical verification of relevant behavioral hypothesis. In this context, it is worth explaining the following main two behavioural hypotheses: (i) Wagner hypothesis, and (ii) Peacock-Wiseman hypothesis (i) Wagner Hypothesis Adolf Wagner (1890) 101 states that a cause and effect relationship existed between the growth of economy and relative growth of public sector. He states in the theory that as increase in per capita income and output in industrialized nations lead to increase in the size of public sector as represented by the percentage of public expenditure to gross national product. The main reasons for this tendency are social problems, expansion of traditional functions of the state, growth of population, urbanization, rise in prices and national income. 101 Wagner A. (1890), Finanziissens Chift Leip Zig.

8 However, experts like Allen T.Peacock and Jack Wiseman (1961) 102 have criticized Wagner s hypothesis in the following ground: (i) Wagner s hypothesis ignores the influence of war on government spending activities. (ii) The hypothesis possess the attributes of accumulating and partially explain the important historical facts, its lack of comprehensive analytical framework causes it to fall short in these explanations. (iii) Wagner stresses a long term trend of public economic activity which tends to over look the significant time pattern or process of public expenditure growth, and (iv) Wagner hypothesis deals with inter-disciplinary phenomenon although it is not essentially interdisciplinary in its analytical framework. However, the Wagner s law of public expenditure can be verified with the help of ratio of income elasticity test and causality test. The proper function of specification of government expenditure and national income is essential to divide income elasticity co-efficient. In this context, it is essential to note that the ratios of government expenditure to gross national product are no substitute for the more rigorous concept of elastic co-efficient because with an increase in income there may be absolute decline in expenditure 103 when cross section empirical data are used to test the law its validity may be 102 Allen T. Peacock and Jack Wiseman (1961), The growth of pubic Expenditure in the United Kingdom, National Bureau of Economic Research, Princeton. 103 Madavachari, R., (1982), "Wagner's Law of Public Expenditure An Empirical Test", Margin, Vol.14, No.2, p.48.

9 distorted because it is not necessarily implicit the high income states will have higher government share in total expenditure than low income state. Controversial Issue Between Wagner and Keynes The ratio of income elasticity test is not in a position to verify the Wagner s law of public expenditure since it considers gross national product as an explanatory variable. While the conventional macro economic theory generally assume that public expenditure is an exogenous variable and national income is an endogenous variable which is in the opposite direction of Wagner s law (Keynes, 1936) 104. The approach of Wagner and Keynes will speak only causal relationship between government expenditure and national income. Besides, the approaches of Wagner and Keynes have different policy implications. Under Wagnerian approach public expenditure is assumed to be behavioral variable with a passive role, where as under the Keynesian approach it is treated as an exogenous policy variable, formulated mainly to ease out short term cyclical fluctuations in aggregate expenditure in the economy. (ii) Peacock-Wiseman Hypothesis It stresses the time pattern of public spending trends and highlights the fact that the increase in public expenditure does not follow any smooth and continues trend. The increase in public expenditure overtime has occurred in sets of step like manner. In their own words, apart from the secular trend of public 104 Keynes J.M. (1936), The General Theory of Employment, Interest and Money, Hercourt Brace and co., New York.

10 expenditure there are other aspects of development of public expenditure such as the time pattern of public expenditure growth which seems to us equally significant 105. Peacock and Wiseman make the following assumptions about the nature of state to explain their theory: (i) Decision about public expenditure on different plan is political are and it can be influenced through the ballot box or by whatever media citizens can bring pressure to bear up on the government. (ii) Political choices about the use of resources differ from choices made through the market system, and (iii) Citizens can have ideas about desirable public expenditure which are quite different from tolerable burdens of taxation. On the basis of the above assumptions they explained their theory which consists of three concepts. They are as follows: (i) Displacement effect (ii) Inspection effect (iii) Concentration effect 105 Peacock A.T. and Wiseman J. (1967), Growth of Public Expenditure in the United Kingdom, Revised Edition, George Allen and Unwin Ltd, London, p.23.

11 The absolute and relative increases of tax spending take place during social disturbances or war. This will create displacement effect, by which previous lower tax and expenditure levels are replaced by the new and higher budgetary levels. Here displacement effect means a discontinuity in the growth pattern which produces expenditure peak during social disturbances. After the social disturbances are ended the newly emerged levels of tax tolerance make the society willing to support higher levels of public expenditure. Since the society realizes that it is capable of carrying a heavier tax burden than the previous had thought possible to bear. War and other social disturbances frequently forced the people and the government to find solutions of important problems which previously had been neglected and it is known as inspection effect. The concentration effect refers to the apparent tendency for the central government activities to become an increasing proportion of total public sector economic activities when society is experiencing economic growth. 3) Applied Aspects The applied theory of public expenditure deals with the operational aspects of public expenditure. It covers the whole gamut of budgetary process. It has been suggested that any approach to public expenditure should be operationally meaningful. It is for this reason that some experts maintain that in addition to being analytical, the approach should be prescriptive also. But prescriptions should be based not merely on wishful thinking or utopian idealism, but on

12 practical idealism. The Plowden Committee on Control of Public Expenditure in the UK (1961) has suggested that 'a wider application of mathematical techniques and statistics, to the problem of public expenditure 106 would be essentially required in order to streamline the approach. The success of the proposal for handling public expenditure, the need fro taking the aid of quantitative techniques in economic analysis. Hence, along wit qualitative analysis, quantitative methods also should be used as much as possible. Determinants of Public Expenditure The earlier works pertaining to determinants of public expenditure is based on the framework of the hypothesis of Wagner (1958) 107, and peacock and Wiseman (1967) 108 Adolf Wagner studied the growth of public expenditure by establishing a functional relationship between the growth of economy and the growth of public sector. He explained it as larger levels of economic growth leads to larger levels of public expenditure. Peacock and Wiseman have made an empirical study of growth of public expenditure in the United Kingdom during the period They explained the growth of public expenditure in terms of displacement effect that is emergencies like war, and depressions cause a larger impact on public expenditure. 106 Plowden Committee Report on Control of Public Expenditure (1961), London, p.11. London, p Adolf Wagner (1958), Three Extracts of Public Finance, Mac Millan and Co.Ltd, 108 Peacock A.T. and Wiseman J. (1967), Op.cit., p.23.

13 The pioneering study pertaining to the determinants of public expenditure has been the one by fabricant (1952) 109 in the U.S.A. and Triko three variables, cover percapia income, degree of urbanization and density of population to explain 72 per cent of the variations in expenditure difference among the states. After the fabricant studies a number of studies have been conducted by including larger number of explanatory variables such as tax revenue, unemployment rate, grants, primary sector contribution, inflation, percentage of weaker section of society etc. In the later literature, political party in power variable has also been introduced to examine the determinants of public expenditure. CHAPTER IV METHODOLOGY terms of: This chapter presents the methodology adopted in the analysis of data in (i) (ii) Data Base a) Period of study b) Source of data Statistical tools used for the analysis of data (i) Data Base 109 Fabricant S. (1952), The Trend of Government Activity in the U.S. Since 1900, National Bureau of Economic Research, New York, pp