Keynes Theory of Public Finance:
The Keynes- “General Theory of Employment” rests on the simple proposition that one man’s expenditure is another man’s income. If the whole income is spent, it results in a corresponding income for someone else, and if everyone else is also spending the whole of his income, the circuit of incomes and expenditures remains constant. But, if a part of the income received by an individual is not spent and if this deficiency of expenditure is not made up by way of investment expenditure, the reduced expenditure of one will lead to a fall in the income of others. With a lower income, he will be able to spend less and the income of all others will also, thereby, be reduced. This will lead to unemployment or to employment at a lower level of real income, i.e., a fall in national income.
Hence, Keynes did not accept the contention:
- that abstention from consumption leads to accumulation of capital, but, on the contrary, he believed, the attempt to save leads to unemployment and a fall in national income.
- that employment should be provided at a low level of wages, but, on the contrary, he believed, a cut in wages will reduce the demand for the commodity, which may cause retrenchment of workers.
- that there is a tendency for the economic system based on private property to be self-adjusting at full employment but on the contrary, he observed unwanted distortion and suggested that fiscal methods should be used to remove such fluctuations in the economy.
Now, it is to be analyzed how this profound change in the general theory of economics effects the principles of public finance:
(1) The nation, therefore, that a balanced budget is desirable in all circumstances, falls to the ground as soon as we abandon the classical assumption of automatic full employment. The budget today is regarded as a powerful instrument for achieving certain aims:
- Full employment.
- A high level of investment.
- Non-inflation, i.e., avoidance of both inflation and deflation.
- A better distribution.
In practice, it may be difficult to achieve all these aims at once.
Broadly speaking, if there is too much inflation, the cure is a budget surplus; if there is too much deflation, the cure is a budget deficit. If there is to be non-inflation, the total volume of new savings (public and private) must be equal to the total volume of new investment (public and private). If savings are less than investment, we have inflation and rising prices. On the other hand, if savings are more than investment, we have deflation, falling prices, and rising unemployment.
(2) As employment and income increase, the new investment must increase to take up new savings, but with the lower propensity to consume of persons with more income, consumption does not increase as fast as income, and hence savings are increased, and effective demand is decreased, the decrease in effective demand results in unemployment. It is here, the importance of public finance lies, the State should increase the effective demand by spending money on public investments like roads, railways, public utilities, and industries run by the state. The amount so invested may have been borrowed from the people; this may represent that part of income that people have not spent on consumption goods and maybe keeping with them as liquid cash. The State is further in a happy position to undertake investment out of “created money”. i.e., deficit financing, to compensate for the fall in total expenditure, resulting from the savings of the individuals, which are not available for investment. Classical economists could never conceive of this important role of public expenditure. Moreover, they opposed State interference in economic activity, and they believed that State can not increase the level of economic activity. Similarly, they were opposed to deficit financing and public borrowing while modern economists considered them as important methods of public finance to bring economic stability or accelerate economic growth.
Thus the old percepts vanished, and economists began to visualize the instrument of fiscal policy as a means for promoting the healing of their economy. Public Finance became “Functional Finance” signifying a study of the fiscal functions of the government that could eliminate unwanted distortions and fluctuations in economic activity.
(3) Taxation and Equitable Distribution- The use of taxation as an instrument of transferring income from the rich to the poor was not favored by classical economists. While, in the modern concept of public finance, taxation is considered as an important means of reducing economic inequalities of income and thereby promoting social justice. Moreover, classical economists favored taxing the poor rather than the rich, i.e., they favored indirect taxes over direct taxes. But modern economists believed in taxing those who are able to save rather than those who are anxious to consume, i.e., taxing the rich rather than the poor. Again contrary to the classical economists, modern economists favored progressive and direct taxation as an instrument of collecting public revenues and making an equitable distribution of income in the country. Unearned income is considered socially undesirable, and therefore, an attempt is also made to confiscate a portion of unearned income through direct taxes (i.e., death duty, tax on lotteries, etc.) which were not favored by classical economists. Indirect taxes also play an important role in public finance, but modern economists do not believe in taxing every item of consumption, but, only those which do not adversely affect the general welfare of people, i.e., commodities that are consumed by the rich and not by the poor.
(4) National Debt- Under the assumption of Classical economists, the National Debt did represent a dead weight- not in sense of mortgage, but in the sense of wasted opportunity. But modern economists consider public borrowing as an important technique of public finance. Public loans in modern times are necessary to meet important situations, i.e., to meet a deficit in the budget, flood, famines, etc. Public borrowings are also important, because modern warfare, has become so costly that the normal income through taxation falls short of the actual war expenditures. Many economists like Keynes have advocated increased public expenditure financing through borrowings and not through taxation as a means to remove depression. Public borrowings are considered very useful for the development of the natural resources of underdeveloped countries.
(5) Economic Welfare and Growth-The challenge of the concept of a balanced budget has received a great deal more attention in less developed countries. In the context of the growth objectives of low-income countries, a consideration of the incident of the tax burden and the benefits of public expenditure led to what might be termed the “Production Principle” of public finance which may be stated thus, an increase in public expenditure on productive effort, including the formation of capital exceeds the disincentive effects of higher taxes. The static canon that an increase in welfare is achieved by a re-distribution of income is substituted by the dynamic concept that the most important factor enhancing the material welfare of the economy and its constituents is the growth of the total economic product.
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