Principles of Sound and Functional finance

According to the classical economists, however, fiscal policy should have the minimum range of operations and the budget should be balanced annually. They firmly stuck to the doctrine of laissez faire and Say’s law of markets. As such, they believed that when supply creates its own demand, general overproduction or involuntary unemployment is well-nigh impossible.

According to Adam Smith, economic equilibrium and progress are attained through inherent and self-oriented endogenous forces of the economic system. In classical opinion, thus, when full employment is supposed to reach automatically, productivity of government services in the economic field is nil.

And, since government services are rendered at the cost of the national product (because any government spending causes transfer of resources from the private sector to the government thereby causing reduction in the output of private enterprises), it amounts to a cut in the aggregate national product.

Thus, when government’s productivity is zero in a free enterprise economy, it is desirable that government confines itself only to its primary functions of protection and security of life and property and does not interfere with the free working of the economic system.

Even if government efforts are productive, it cannot increase national income and level of economic activity above the level reached without its intervention. Thus, when full employment, optimal allocation of resources and equitable distribution can be achieved automatically through the operation of free economic forces, fiscal operations have to be of a non-regulatory, non-interfering nature.

As such, the smallest budget was considered to be the best in the classical era. Further, the classicists condemned all budget deficits which necessitated borrowing by the government, for they led to inflation and even if they did not, they caused reduction in the accumulation of private capital (because, the resources in private hands were depleted due to government borrowings), thus, inhibiting the rate of progress.

As such, classicists firmly advocated a balanced budget, in the sense that current annual revenue and expenses of the government must be equal. It, thus, does not provide for borrowings. The balanced budget principle was thus recognised as a principle of sound finance in orthodox economics.

Under the theory of sound finance, classicists favoured a balanced budget criterion for the following reasons:

(i) If the budget is unbalanced, the government has to borrow. The government’s market borrowings cause reduction in loanable funds available to private productive employment and investment activities.

(ii) Unbalanced budgets imply a wide extension of state functions beyond the capacity of the government, which may invite irresponsible governmental action.

(iii) Unbalanced budgets may generate inflation on account of large and unproductive public expenditure.

(iv) A balanced budget, on the other hand, is a limited budget designed in a rational way.

(v) Economic stability is secured by the adoption of a balanced budget policy. Unbalanced budgets, on the other hand, cause economic uncertainty and promote instability.

(vi) A series of unbalanced budgets imply an increase in the burden of public debt.

Furthermore, when the public debts mature, the government will have to impose additional taxes to obtain resources for their repayment. Thus, additional taxation would again tend to have an adverse effect on the incentive to work and save. It would also cause the accentuation of income distribution.

Moreover, government borrowings cause the rate of interest in the money market to rise, as the demand for loanable funds rises. A rise in the rate of interest adversely affects investment activity in the private sector.

In short, according to the principles of sound finance, a budget must be balanced annually and the gap between. revenue and expenditure should be minimum. That is, a government should tax the least and spend the least, and it should not resort to borrowing as far as possible.

Thus, classical economists firmly advocated a laissez faire policy and were confident of the unhampered optimum operations of the free enterprise economic system. Neo-classical economists however, realized the socially undesirable effects of unregulated free enterprise on the economic system.

Marshall stated that in conditions of laissez faire, maximum social advantage is hardly realized. It was argued that careful state action for raising income and public spending was essential to attain maximum social welfare under the concept of welfare state developed in the neo-classical era.

Under the welfare state criterion, it was accepted that the state should take up the responsibility of correcting the misallocation of resources guided by private profit motive. The state has, therefore, to discourage private investment in certain sectors of the economy through fiscal restrictions and encourage private as well as public investment in essential sectors through appropriate public spendings. Pigou and Marshall, in this regard, favoured equimarginal social sacrifice and benefits as essential in the government budget.

The concept of fiscal policy, however, received a new vista with the inception of “new economics” (Keynesian economics) in modern times. Keynesian theory shattered the basic foundations of the classical doctrine when the former asserted that the competitive process of free enterprise economy does not necessarily ensure an effective demand such as to absorb all productive resources at full employment, supply does not create its own demand and the economy may attain equilibrium at underemployment level.

Unemployment may persist due to secular forces causing under-consumption and over-saving in an advanced economy, thereby creating a condition of plenty in the midst of poverty on account of deficiency of aggregate demand. Keynes, therefore, regarded the inevitability of a positive fiscal policy as follows.

At a level of income corresponding to full employment, the gap between total income and total consumption is so high in a mature economy that private investment is inadequate to fill it. If unemployment is to be avoided, the gap must be filled either by government expenditure or by increasing the propensity to consume.

But, in a capitalist economy, which is characterized by wide inequalities in the distribution of income and other institutional factors which make for a high propensity to save, the propensity to consume cannot easily be raised enough to have a significant effect on employment.

Therefore, the chief responsibility for maintaining high levels falls on the public sector expenditure, designed to narrow the gap between income and consumption at full employment. Further, in Keynes’ view, a depression in an advanced industrial economy occurs due to the deficiency of aggregate demand.

Thus, during a depression, when the aggregate spending is inadequate to achieve full employment, the government must increase spending directly by undertaking public works programmes on a large scale and indirectly by inducing people to spend more.

In short, the Keynesian fiscal policy for attaining full employment implies a technique by which total outlay in manipulated, i.e., when private outlays are deficient, public outlays should be increased which ensures the full use of economic resources available in the country.

Functional finance

Though the lead in the development of “functional finance” concept was taken by Keynes, credit goes to Prof. A.P. Lerner for coining this concept. Lerner puts that: The principle of judging fiscal measures by the way they work or function in the economy, we may call functional finance.

He contends that the fiscal operation of the government — taxing, borrowing; public spending, management of public debt, etc., deficit financing, etc. — should be designed with the objective of fulfilling certain functions which have an immediate bearing and far-reaching effects on the economic system as a whole.

In economic philosophy, the term functional finance embraces public expenditure, public revenue and debt management which were regarded as fiscal instruments effectively used to achieve objectives like attainment and maintenance of full employment with economic stability.

As Prof. Chelliah points out, the functional concept of fixed policy, thus, implies that:

(i) the fiscal operations of the government should be conducted on a functional basis and public finance should not be considered as being induced solely by the need for securing social goods meant for collective consumption

(ii) the budget need not always be balanced. As a matter of fact, the fiscal norm of functional finance is the complete antithesis of the orthodox rule of balanced budget. The functional finance norm suggests the formation of large budgets with a wider functional coverage of government spending to promote basic economic goals, e.g., (a) to obtain optimal allocation and efficient use of scarce resources at full-employment level, (b) to achieve economic stability and bring about an equitable distribution of income and wealth in the best possible manner.

Quite contrary to the classical notion, the concept of functional fiscal policy suggests that the state need not and should not assume a passive role in the economic affairs of the country.

It implies that public spending may be incurred not merely for the sake of its direct benefits, but for the sake of indirect effect it produces in raising the level of income, output and employment; and the public revenue may be raised not to meet an anticipated expenditure, but to curtail excessive demand and curb inflationary potentials in the economy. Taxation is, thus, regarded as an important and effective weapon in the hands of government to promote economic progress with stability.

Lerner suggests the following rules for government’s responsibility and activity under functional finance:

(i) The government budget should be directed towards the achievement of full employment and price stability. For this purpose, the government budget need not necessarily be balanced.

(ii) The government should incur public debt by borrowing money from the private sector only during inflation when it is, absolutely essential to mop up the excessive purchasing power from the public, thereby reducing the pressure of excess monetary demand.

(iii) During depression only, public expenditure in excess of current public revenue may be met by deficit financing, i.e., printing additional currency notes.

In short the main tenet of functional finance is the formation of unbalanced budget from time to time for perfecting the counter-cyclical goal of fiscal policy. A surplus budget is recommended during inflation and a deficit budget for recovery through excessive public spending during a deflation or depression.

Functional finance, thus, deliberately aims at unbalancing the budgets with a view to attaining and maintaining full employment level in a developed economy. In an underdeveloped economy, however, the main problem is not one of full employment but that of rapid economic growth. In a developing economy, thus, the functional aspect of fiscal policy is to be conceived in the context of a planned process of economic development.