Role and Scope of Public Finance in Classical Theory of Economics

Role and Scope of Public Finance in Classical Theory of Economics:

The classical economic theory assumes that supply creates its own demand and, therefore, there can never be any significant unemployment or over-production. It assumes full employment, i.e., full utilization of public resources. The argument is, if labor is mobile and wages flexible, full utilization will be brought about by private enterprise and unemployment is due to the immobility of labor or rigidity of wages. The classical economists were of the opinion that one man’s expenditure was another man’s income, but they held that a reduction in one man’s expenditure would not lead to a reduction in another man’s income, because what was saved was automatically invested, i.e., expenditure on capital goods industries. Hence, there was no reduction in one man’s income as a result of a reduction in another man’s expenditure. This means that there was no lack of effective demand.

The classical theory of public finance is based on classical general economic theory. Since private enterprise ensures full employment, the State is incapable of increasing the level of economic activity. If the State raises its expenditure by taxation it would be merely a substitution for expenditure by private persons, i.e., it would not increase the total demand for productive factors. If the State raises its expenditure through borrowing, it would be competing with private individuals and this would lead to a rise in prices and inflation. It means that they believed the State should not increase the level of economic activity within the country. Since taxes always have some effect on private savings; a reduction in private savings may result in a low level of private investment. Hence, taxes have an adverse effect on the accumulation of capital. Therefore, they believed that the best budget is a small budget. The most undesirable taxes are those that impinge most heavily on private savings namely death duties, super-tax, and business taxes, in fact, all direct taxes on the wealthier class. Indirect taxes on the other hand affect consumption and could thus be considered economically harmless, although socially undesirable. It means that they favored indirect taxes. A budget deficit leads to inflation if it is financed by the issue of paper money or short-term Government debt because then the rate of interest does not rise sufficiently to produce a fall in private investment, which offsets the increase in State expenditure. If it is financed by the issue of long-term Government bonds, such bonds are simply substituted for the bonds or shares of private business and may not lead to inflation. A budget deficit will lead to a reduction in the rate of progress unless the Government uses borrowed funds exclusively for the creation of capital equipment. Thus, they believed that the budget should be balanced. The following conclusions are drawn from the above analysis:

• The State should not increase the level of economic activity within the country.
• The best budget is a small budget.
• Taxes that are injurious to the community are those that impinge most heavily on savings, like income-tax, death duties Per-Contra taxes on consumption are less harmful.
• If a deficit can not be avoided, issue long-term bonds.
• Borrow only for the purpose of productive investment.

On the basis of the above analysis, it can be said that the scope of Public Finance was very limited according to Classical economists.