Fiscal Functions: An Overview

Fiscal Functions: An Overview

As we know beyond the budgetary function, public policy influences the course of economic activity through monetary, regulatory, and other devices. The modem “capitalist” economy is thoroughly a mixed system in which public and private sector forces interact in an integral fashion. The economic system, in fact, is neither public nor private but involves a mix of both sectors. The operation of public economics includes not only financing but has a broad bearing on the level and allocation of resource use, the distribution of income, and the level of economic activity. Since the public sector operates in interaction with the private, both sectors enter the analysis.

According to modern economists, public finance performs three important functions which may be set forth ahead:

1.The Allocative function:

The allocation function concerned with the provision of social goods inevitably departs from the market process but nevertheless poses the type of problem with which economic analysis has traditionally been concerned, i.e. the efficient use of resources given a prevailing distribution of income and pattern of consumers preferences. A modern government has to perform a large variety of functions, such as, maintenance of internal law and order, defence against foreign aggression, settlement of disputes among citizens, promotion of agriculture and industry, building up of infrastructural facilities, such as, roads, railways, posts and telegraphs, promotion of general and technical education etc. The performance of these functions necessitates large-scale government expenditure on these items. The function of public finance is to allocate the total expenditure to the various heads in such a way as to maximize the social welfare of the people.

There are two basic types of goods can be explained under this section. One is private goods and another one is public goods. We know that the private goods have the property of rivalry and excludability.  In the case of private goods, those who pay enjoys the benefits and others are excluded from those services. The market mechanism of these goods is based on exchange and exchange can occur only where there is an exclusive title to the property which is to be exchanged. Nothing is lost and much is gained when consumers are excluded unless they pay. Application of exclusion principle tends to be an efficient solution.

On the other hand, public goods are of the nature of non-excludability and non-rivalry. Here it would be inefficient to exclude any one consumer from partaking in the benefits since such participation does not reduce consumption by anyone else.  The benefits from the social goods are not vested in the property rights of particular individuals and the market cannot function. With benefits available to all, consumers will not voluntarily offer payment to the suppliers of such goods. No, voluntarily payment is made when many consumers are involved. When the linkage between producer and consumer is broken and the government must step in to provide for such goods.

The government has to decide the type and quality of goods to be produced and how much a particular consumer should be asked to pay. The benefits from national defense accrue nationwide while those from streetlights are of only to local residents. This suggests that the nature of social goods has some interesting bearing on the issue of fiscal federalism i.e. centralization and decentralization.

Before considering how such public provisions is to be arranged, we must draw a clear distinction between the public provision of social goods, as the term is used here and public production. These are two distinct and indeed unrelated concepts which should not be confused with one another.

Private goods may be produced and sold to private buyers either by private firms, as is normally done or by public enterprises. Social goods such as spaceships or military hardware, similarly may be produced by private firms and sold to the government; or they may be produced directly under public management, as are services rendered by civil servants.  If we say that social goods are provided publically, we mean that they are financed through the budget and made available free of direct charge. How they are produced does not matter. When looking at the public sector in the national accounts, we will see that the cost of such provision is divided about equally between compensation paid to public employees and outputs purchased from private firms. Public production of private goods which are then sold in the market plays very important role in the financial system.

 2. The Distributive Function:

The issue of distribution is more difficult to handle. Yet distribution issues are a major point of controversy in the budget debate. In particular, they play a key role in determining tax and transfer policies. There are large disparities of income and wealth in a capitalist economy between the ‘haves’ and the ‘have-nots’ which are not conducive to the maintenance of peace and tranquility in a country. The function of public finance in such a state is to lessen these inequalities as far as possible through redistribution of income and wealth in favor of the ‘have-nots’. Public finance correlates revenue, expenditure and borrowing policies with the objective of reducing economics inequalities plaguing a capitalist society. This, in fact, is looked upon as the most important function of public finance these days.

In the absence of policy adjustments, the distribution of income and wealth depends first of all on the distribution of factor endowments, including personal learning abilities and the ownership of accumulated and inherited wealth. Secondly, it is determined by the process of factor pricing, which in a competitive market sets factor returns equal to the value of the marginal product. The distribution of income among individuals depends on their factor endowments and the prices which they fetch in the market.

Economics helps to determine what constitutes an efficient use of resources, based on a given pattern of distribution and effective demand, but there is the further question of what constitutes a fair or just state of distribution. For efficiency modern economists considers the concept of Pareto efficiency. “someone gains, no one loses” rule has served well in assessing the efficiency of the market and of certain aspects if the public policy, it contributes little to solving the basic social issues of fair distribution.

The answer to these questions of fair distribution involves considerations of social philosophy and value judgment.  Philosophers have come up with a variety of answers including the view that persons have the right to the fruits derived from their particular endowments, that distribution should be arranged so as to maximize total happiness or satisfaction, and should meet certain standards of equity, which in, a limiting case, may be egalitarian.

There are two major problems involved in the translation of a justice rule into an actual state of the income distribution. First, it is difficult or impossible to compare the levels of utility which varies individuals derive from their income. There is no simple way of adding up utilities so that criteria based on such comparisons are not operational. This limitation has led people to think in terms of social evaluation rather than subjective utility management.  Second, the size of the pie which is available for distribution is not related to how it is to be distributed. As noted before, redistribution policies may involve an efficiency cost which must be taken into account when one is deciding on the extent to which equity objectives should be pursued.

Among the fiscal instruments of Distribution policy, redistribution is implemented most directly by:-

  1. A tax-transfer scheme, combining progressive taxation of high income with the subsidy to low-income households.
  2. Redistribution may be implemented by progressive taxes used to finance public services, especially those such as public housing, which particularly benefits low-income households.
  3. It can also be achieved by a combination of taxes on goods purchased largely by high-income consumers with a subsidy to other commodities which are used chiefly by low-income consumers.

In choosing among different policy instruments, allowance must be made for resulting deadweight losses or efficiency costs, i.e., costs which arise as consumer or producer choices are interfered with. Redistribution via an income tax transfer mechanism has the advantage that it does not interface with particular consumption or choices. However, even this mechanism is not without its “efficiency cost,”  since the choice between income and leisure will be distorted.

While redistribution inevitably involves an efficiency cost, this consequence by itself establishes no conclusive case against such policies. It merely tells us that

  1. Any given distributional change should be accomplished at the least efficiency cost.
  2. A need exists for balancing conflicting equity and efficiency objectives.

An optimally conducted policy must allow both concerns.

3. The Stabilization Function:

A capitalist economy is generally bedeviled by the frequent operation of the business cycle, according to which the country is visited by booms and depressions at almost regular intervals. By causing instability, these fluctuations inflict untold damage on the economy. The function of public finance is to eliminate or reduce these business fluctuations by correlating its taxation, expenditure and public debt policies. According to Keynes, the twin policies if deficit budgeting (at a time of depression and unemployment) and surplus budgeting (during inflation) will help promote economic stabilization in the country.

The targets of the economy like high employment, a reasonable degree of price level stability, soundness of foreign accounts, and an acceptable rate of economic growth does not come about automatically but requires policy guidance. Without it, the economy tends to be subject to substantial fluctuations and may suffer from sustained periods of unemployment or inflation.  The overall level of employment and prices in the economy depends upon on the level of aggregate demand, relative to potential or capacity output valued at prevailing prices. The level of demand is a function of the spending decisions of various customers, corporate managers, financial investors, and unincorporated operators. These decisions depend on many factors such as past and present income, wealth positions etc.