Prof. Hugh Dalton points out that “in the sphere of public finance, we are still haunted by the superficial views and shallow percepts of an early age”.
The principles that shaped the financial policies and operations of the state during the nineteenth century have lost its validity and applicability in the twentieth century and even today.
The doctrine of Laissez-faire, which governed the operation of the state in earlier days, lost its charm, since it could not find a solution to the growing needs of a complex society. With the advent of the socialist ideas, the state was forced to give up its traditional attitude to the needs and problems of the society.
The 19th century was aptly pictured by Keynes as an “Accountants Nightmare” His feeling was that the financial activities of the government during the 19th century was profoundly influenced by the eagerness to keep their expenditure below income level.
This naturally led to the neglect of the needs of the common man – for more schools, hospitals, and employment opportunities. Profit motive influenced ail financial operations and the rout of self-destructive financial calculations governed every walk of life.
The worldwide depression of 1930’s and the two global wars brought about far reaching changes in the pet theories and dogmas of the 19th century. One of such pet theory was propounded by J.B. Say.
According to J.B. Say “the very best of all plan of finance is to spend little and the best of all taxes is that which is least in amount”. But today even theorists embracing capitalism could not accept the views of J.B. Say as valid.
Tax is no longer regarded as a “necessary evil”. Taxes on narcotic drugs, alcohol, and other intoxicants help to reduce their consumption, which are injurious to health and may generate a positive social effect.
Adam Smith and Ricardo imagined that private expenditure is ‘productive’ and state expenditure is ‘unproductive’. They considered the state as a ‘police state’; assigned with the duty to maintain law and order.
Another shallow concept prevalent in the 19th century relate to the function of the economy. Economy was wrongly identified with little spending or parsi-money. But mere parsi-money is not economy.
Expenses and larger expenses may be essential in the interest of free economy. Economy is a distributive virtue and consists not in saving but in selective spending. Really economy consists in spending wisely.
If the assumption of an earlier age are to be rejected as unrealistic and unsound, what should be the guiding principle of public finance?, if public finance is to be treated as a branch of the science of economics, or political science and not merely as a string of Catch Penny maxims, one fundamental principle should lie at the root of it. This principle has been referred as the Principle of Maximum Social Advantage.
Prof. Dalton and Prof. A.C. Pigou are the two prominent economists, responsible for formulating and popularizing this fundamental principle of public finance. Pigon calls it as the Principle of Maximum Aggregate Welfare.
Most of the operations in public finance are centered around the mechanism of transfer of resources; every activity in public finance is brought about from one section to another. For example, taxation shifts resources from the taxed individual to the community.
Progressive taxation transfers resources from the rich community to the poor. Public borrowing transfers resources from individual (generally the richer section) to the society. The state is the media through which such a transfer is affected.
The state spends these resources on socially beneficial programmes like the unemployment relief, free education, health service, social security activities and developmental activities.
If these transfers, in the aggregate lead to the maximum social advantage, the operations are desirable otherwise not.
The transfer of purchasing power by means of taxation from the rich to the poor has the philosophical justification based on justice. The science of economics justifies such transfers on the basis of diminishing marginal utility.
The marginal utility of income to a rich man is less than that of a poor. Therefore utilities in the aggregate would be maximized if transfer of resources were made from the rich to the poor. In other words, it is the duty of the state to transfer income from areas where they have less utility to the areas where the utility is high.
Whenever a transfer or dislocation of resources is affected by the government it releases certain consequences on the community. These consequences may be for the advantage or disadvantage of the community.
The theory of Optimum Social Welfare stipulates that the transfer of resources affected by the state through operation in public finance should maximize the welfare of the community. The best system of public finance is that which secures the maximum social advantage from the operations which it conducts (Dalton).
According to this principle state should collect revenue and spend the same money to maximize the welfare of the people. When a tax is imposed it creates disutility to the taxpayers.
On the other hand, when the state incurs public expenditure some utility is created. Hence the revenue expenditure programme of the state should be adjusted in such a way as to maximize utility and to minimize disutility.
It should be noted that the individual welfare of all the people cannot be maximized. But if the operation leads to the welfare maximization of the majority, the society gains. Dalton calls this principle as the Principle of Maximum Social Advantage and Prof. A C. Pigou calls it as the Principle of Maximum Aggregate Welfare.
Extent of Public Revenue and Expenditure Activity:
Prof. Dalton has suggested the manner and extent in which public expenditure and revenue should be incurred and collected.
According to him “public expenditure in every direction should be carried just so far that the advantage to the community of a further small increase in any direction is just counter-balanced by the disadvantage of a corresponding small increase in taxation or in receipt from any other source of public income. This gives the ideal total both of public expenditure and public income”.
Raising resources through taxation or borrowing creates disutility, for those individuals who are compelled to part with their resources to government.
Spending resources by government creates utility for those who stand to gain from government expenditure policies. The point of optimum social welfare is that at which the disutility caused by the marginal unit of money raised is equal to the utility caused by the marginal unit of expenditure. This is the optimum limits of states public finance utility.
This principle can be explained with the help of the above diagram. On the X axis we indicate the unit of money raised by government from people through taxes as well as spend by the government on the community.
On the Y axis we indicate the sacrifice caused by marginal unit of taxation and borrowing as well as the benefit derived from government spending. MSS curve indicate the sacrifice caused by taxation and borrowing; it is an upward tending curve because sacrifice increases along with increased taxation and borrowing.
MSB is downward slopping curve because the benefits accruing from continuous expenditure are subject to the operation of diminishing returns. ‘P’ is the point at which the sacrifice or disutility caused by marginal unit of money raised become equal with benefit or utility caused by marginal unit of government expenditure.
Hence OM represents the optimal level of government’s financial activities and PM represents the line of optimum social welfare. Both under taxation and over taxation are harmful.
Over taxation brings about unavoidable sufferings to the community. But under taxation also indicates an unsatisfactory state of affairs in economy because it implies the existence of underutilized resources of the community.
Suppose the government collects OM1 amount by way of taxation, it results in loss of welfare to the society, because at this level the Marginal Social Benefit (M1P1) is higher than Marginal Social Sacrifice (M1E1).
It indicates that there is scope for additional resource raising and spending up to the level OM. However if it exceeds the limit OM, and collects OM2 amount of taxation, to finance public welfare programmes, the Marginal Social Sacrifice (M2P2) is higher than the Marginal Social Benefit (M2E2).
This is a situation of net loss to the society. Thus only at point ‘P’ Marginal Social Sacrifice (MSS) exactly equals Marginal Social Benefit (MSB). Thus point ‘P’ is the point of Maximum Social Advantage or the point of least aggregate sacrifice. Hence doctrine of optimum social welfare insists that benefits of expenditure and sacrifice of taxation and borrowing should be made equal.
Distribution of Resources:
The principle of maximum social advantage is derived from the principle of equi-marginal utility. Thus if it is found that marginal utility from public expenditure on medical and public health measures is greater than the marginal utility derived from the same amount spent on provision of unemployment benefit, then the government should transfer the public funds from the later to the former activity.
This will help to maximize social advantage. In this context, Prof. A.C. Pigou points out that “the expenditure be distributed between battleships and poor relief in such a way that the last shilling devoted to each of them yields the same return of satisfaction”.
Distribution of Burden of Taxation:
In the case of taxation the equi-marginal principle means that the marginal sacrifice of tax from one source of public revenue is equal to the marginal sacrifice from another source.
Prof. Pigou advocates that the burden of taxation on different sources should be distributed according to the principle of least aggregate sacrifice.
In the words of Prof. Pigou, “in order to secure least aggregate sacrifice, taxes should be so distributed that the marginal utility of money paid in taxation in equal to all the tax payers”.
Musgrave’s Approach to Maximum Social Advantage:
Prof. R.A. Musgrave states that the principle of maximum social advantage is a logical extension of the Pigouvian Welfare approach to taxation incorporated in the theory of minimum aggregate sacrifice.
Musgrave is of the opinion that optimum size of the budget should be determined at a point where the marginal net benefit is zero. Fundamentally there is not much difference between the approach of Prof. Dalton and Musgrave.
Musgrave re-designate Dalton’s principle of maximum social advantage as the maximum welfare principle of budget determination. Even though Musgrave pursued the line of reasoning advocated by Dalton and Pigou, his treatment is based on valuation of individual preferences.
Musgrave’s approach is illustrated in the following diagram:
In the above figure the size of the budget is measured on the horizontal axis. The marginal social sacrifice and the marginal social benefits are shown separately on the vertical axis. The marginal utility of successive dollars of public expenditure allocated optimally between public uses is shown by the line MSB in the figure.
MSS indicate the marginal disutility of taxes, imposed so as to cause least total sacrifice. The line NSB shows the net social benefit curve. It is derived by deducting MSS from MSB. Hence it indicates the net social benefits derived from successive expansion of the budget.
We find that the optimum size of the budget is determined at OM where marginal net benefit is zero. When an amount OM is raised through taxation and spend by the state, then the marginal social benefit and the marginal social sacrifice are equated (MP = MQ).
Till then the gain to the society is more than the loss. The net gain to the society is equal to the area OMN.
It is here that the state should stop expanding its activities. If the state stops its budget operation at a figure less than OM, the society will be forgoing a possible gain; on the contrary, if operations are expanded beyond OM, the total net benefit will again start falling.
The difficulty to determine the preference on which the values of MSB and MSS schedules are to be based and the problem of choosing between alternate solutions are the basic limitations of this approach, admitted by Musgrave himself. The fundamental problem is that of planning the budget efficiently.
The following three fundamental principles of budget operations help the state to achieve the principle of maximum social advantage:
1. The marginal social benefit of public expenditure and the marginal social sacrifice of taxation must be equal.
2. The resources of the state should be so distributed on different heads of expenditure in such a way that the marginal return of satisfaction from each of them is the same
3. The tax burden should be so distributed that the marginal social sacrifice of taxation to each tax payer should be equal.
Objective Test of Social Advantage:
How far we to apply this doctrine of optimum social welfare in the field of actual administration of financial policies. Dalton prescribes two practical tests that should be achieved by the Finance Minister who pursue his policies in accordance with the concept of optimum social welfare.
These two tests are:
(a) Political test, and
(b) Economic test.
1. Political Test:
Preservation of the community:
The first test is the provision for defense against external aggression and the maintenance of internal law and order. That is to preserve the community and to ensure confidence and promote the economic life of citizens, thereby enhancing the social advantage.
These duties must be performed by every government, apart from other considerations. It is therefore essential to maintain army, police and judiciary to meet the external threat of the enemy successfully.
Economic life would be difficult if not possible, in the absence of a sense of security in the minds of the people. For this reason, adequate sum spent on the armed forces, the police and judiciary may be justifiable.
At the same time, as Dalton points out, a peaceful and just policy must be followed both at home and abroad.
A belligerent foreign policy should increase the dangers of the war and thus necessitates increased expenditure on defense.
Similarly an unwise political, economic and social policy may perhaps necessitate increased expenditure on the maintenance of law and order.
2. Economic Test:
The Second test-Economic Test is divided into two:
(i) Improvement and expansion in the production of Wealth and
(ii) Reduction in economic inequalities. A sound financial policy should serve the fundamental purpose of better production and distribution.
(a) Improvement in Production:
It means increase in the amount of wealth produced per head. This in turn necessitates optimum utilization of all factors of production.
It also implies minimization of the wastage of resources, resulting from misdirection and unemployment. It also means improvements in the composition or pattern of production, so as best to serve the needs of the community.
(b) Improvement in Distribution:
Another important consideration is that the distribution of wealth should be improved. The operation of public finance can bring about changes in the distribution of wealth, if the purchasing power is taken away from tax payers and transferred to others in the shape of public expenditure.
If this transfer takes place from the relatively rich to the relatively poor sections of people the distribution of wealth can be made more equal. Taxation and public expenditure can be very useful instruments for bringing about redistribution. Hence proper distribution of income and wealth is essential for increasing the economic welfare.
According to Dalton improvement in distribution resolves them-selves into:
(1) Reduction in the glaring inequality, which is found in most civilized communities, in the incomes of different individuals and families and
(2) A reduction in the great fluctuations, between different periods of time, in the incomes of particular individuals and families especially among the poorer sections of the community.
3. Other Conditions:
(a) Stability and Full Employment:
Still another consideration is the maintenance of stability in the level of economic activity and full employment. Instability is the fundamental feature of free economy and is a cause of much misery and sufferings.
Boom and depression should be properly controlled. The social advantage to the community can be enhanced if business conditions in the country are stable and when all fluctuations are eliminated.
Less fluctuation means more stability, through time, in the economic life of the community, and particularly in the income and employment of individuals. More stability is another aspect of the better organization of production.
However it should be stability at a high level of employment, not merely a less fluctuations around a lower level. Full employment is now generally accepted as one of the first economic aims of a well-organized society. It is favored, because it helps to increase production and to promote a greater equality of income.
(b) Provision for Future:
Finally as Dalton has pointed out, another important criterion is the effect on future generations. Individuals are mainly concerned with the present only and not with the future.
The state is a permanent association and is concerned with the welfare of future generations. Therefore the operation of public finance should be such as to safeguard the interest of the future generation also.
In the words of Dalton “it should be added that the statesman is a trustee for the future, no less than for the present. Individuals die, but the community, of which they form part, lives on. The statesman, therefore, should prefer a larger social advantage in the future to a smaller one today”.
Limitations of the Principle of Maximum Social Advantage:
There is no doubt that the principle of maximum social advantage occupies a pivotal position in the domain of states fiscal activities.
Its theoretical significance cannot be under estimated. Yet there are certain difficulties in the application of this principle.
It has to be noted that a fiscal operation promoting production and better distribution cannot be easily reconcilized with one another. A policy that favours investment and increased production might not be promoting the welfare distribution. For example, taxation that encourages investment, profit and risk taking cannot be progressive to a sharp extent.
At the same time inadequacy of progressive taxation widens economic inequalities and hampers distribution of income and wealth. Similarly a policy that favours distribution might be inimical to production.
For example, steeply progress we taxes on income and wealth discourages capital formation and investment, though it helps distribution of wealth and income. A lot of practical difficulties may emerge in the execution of this principle in governments fiscal operations.
The important difficulties are summarized below:
1. It is impossible to make a comprehensive estimate of the resources that will have to be raised and spend by government, before it obtains the point of optimum social welfare. The theory of optimum social welfare is no doubt attractive, but it does not suggest a practical code of conduct, for a government in its financial activity
2. The point of optimum social welfare is an elusive concept. Even if this point is wanted to become a tangible reality, it is a moving point subject to endless fluctuations. Therefore the finance minister is not comfortably placed to formulate his policies on the basis of such a rapidly variable factor.
3. It is very difficult for the state to measure and balance the marginal utility and marginal disutility arising from expenditure and taxation policies. Utilities as we know are highly subjective phenomenon, which cannot be measured precisely.
It is very difficult to compare and measure the marginal utility and disutility of so many individuals in a society. Likewise it is not possible to measure social benefit and social sacrifice in fiscal operations of the state.
4. Seligman doubts the wisdom contained in the concept of optimum social welfare. He points out that war and other emergencies may compel a country to use up a larger amount of her resources that it can normally afford.
A government may be given by circumstances to increase its allowances to certain spending department at the expense of other departments, whose place may be not less important, but may not be so urgent. The conception of a point of maximum social advantage is thus relative to the prevailing circumstances and it is admitted by in our present state of knowledge more of theoretical than of practical significance.
But Dalton himself realizes the practical difficulties inherent in the process of determining the point of optimum social welfare. But this difficulty, Dalton points out, does not take away the substance of truth from the theory.
Dalton quotes the old Greek saying “it is not the easy thing, but the difficult things, which are beautiful”. Therefore whatever might be the practical difficulty in regard to the implementation of the theory of optimum social welfare, it provides an excellent basis for the conduct of the financial activities of the government.