Having studied the causes of large increase in public expenditure, it will be useful to explain the effects of public expenditure on the production and distribution in the economy. Public expenditure, if properly allocated and efficiently used, can have a wholesome effect on the economy.
Public expenditure can augment productive capacity of the economy and improve productivity of its working class. It can also reduce inequalities in income distribution, if properly designed. In the following we shall spell out in detail the impact of public expenditure on production and income distribution in the economy.
Effect of Public Expenditure on Production:
It is generally pointed out that all kinds of expenditure by Government are not productive. For instance, Government expenditure on defence and civil administration (police, jail and judiciary) is said to be unproductive for it does not apparently add to the volume of production of the economy.
It is true that public expenditure on defence and civil administration are unproductive directly, but even they can under certain circumstances in an indirect way promote production and employment. This will be made clear a bit later.
Further, the effects of public expenditure on production may be different in the case of a developed economy from that of a developing economy, for the circumstances in them differ a good deal. Let us first take the case of a developed economy.
Effect of Public Expenditure on National Output at Times of Depression:
Developed economies often find themselves in the grip of a depression or recession caused by lack of aggregate effective demand. At certain times in the developed countries effective demand falls due to the decline in private investment.
At times of depression in an industrialised developed economy, there is idle productive capacity on the one hand and unemployed manpower on the other. Under these circumstances, the increase in Government expenditure on public works or any other type of investment or even expenditure on defence and civil administration will lead to the manifold increase in income and employment through the process of multiplier, as has been explained by J.M. Keynes.
The increase in aggregate demand will cause fuller utilization of the existing productive capacity and unemployed manpower resulting in expansion in volume of production, employment and national income. This will become clear from Fig. 30.1 where along the X-axis we measure national product or income and on the Y-axis aggregate demand which comprises consumption demand (C) and investment demand (I). It will be seen from Fig. 30.1 that prior to the Government expenditure the aggregate demand curve cuts the 45° line representing aggregate supply curve at point E. Thus OY1 is the equilibrium level of national product or income determined by aggregate demand and supply.
This equilibrium level may not be established at full-employment level. Suppose full employment of labour and other resources corresponds to OY2 level of national product.
This implies that in equilibrium at OY1, level of income aggregate demand is not sufficient to ensure full employment. If under these circumstances the Government undertakes extra expenditure, say equal to EH or G. then the aggregate demand curve will shift upward to C + I + G position (dotted).
As will be seen from the figure the increase in Government expenditure will cause the equilibrium level to shift to OY2 level of national product resulting in higher level of employment. It will be further noticed that the increase in national output (i.e., income) equal to Y1Y2 (i.e., AY) will be greater than the Government expenditure (G) depending upon the magnitude of multiplier. It may be noted that the magnitude of multiplier depends upon the marginal propensity to consume of the people.From the foregoing analysis we conclude that the increase in Government expenditure preferably financed by borrowings from the banks or printing new notes at times of depression will raise aggregate demand and thereby lead to the multiple increases in national output and employment. But once the level of full employment is attained the increase in Government expenditure cannot raise production through raising aggregate demand. Instead, prices will rise.
However, even in the developing countries such as India are ways in which government expenditure, if judiciously planned, can promote production.
First, if the Government expenditure is incurred on investment projects for capital formation, for instance on building of canals, railways, and other infrastructural facilities, it will expand productive capacity and generate long-term economic growth. Secondly, if public expenditure is directed to scientific research and development (R & D), it will ensure progress in technology and raise productivity or power to produce of workers.
Thirdly, it has now been found that Government expenditure on education and public health helps in building “human capital” which also greatly enhances productivity or power to produce of the people. Against these, it may be pointed out that certain types of Government expenditure may adversely affect production.
Government expenditure on social insurance like health insurance, unemployment insurance, and old age pensions is said to be of such a type. By insuring against their future and uncertain contingencies like sickness, unemployment and old age, they blunt the edge of the desire to work and save more.
The social security expenditure by the Government makes the people indifferent towards the future and makes them neglect savings. This is bound to affect adversely productive efforts in the present. Because of the future security, people will work less and save less.
However, in our view, if such social security expenditure is kept within proper limits and if it is used to help the really needy and helpless, the adverse effects of social security expenditure on productive efforts and savings may be negligible. Further, Government expenditure on social security makes the working people contented and create healthy social environment and industrial peace which is conducive to production.
Apart from augmenting total production, the Government expenditure also affect allocation of resources as between different industries and can divert resources to socially desirable channels. Through subsidies and grants and also through its purchase policy, the Government may succeed in diverting resources to hitherto neglected industries.
Thus, besides raising the level of production, the Government expenditure can influence the pattern of production or composition of output. Likewise, by diverting resources through subsidies and bounties to the backward regions it can promote growth of output in backward regions.
We thus see that public expenditure, if wisely conducted, can promote production by raising the levels of productivity or powers to produce and save. It can also cause reallocation of resources between industries and regions and exert wholesome influence on the pattern of production work by the Government undertaken through public enterprises.
Effects of Public Expenditure on Distribution:
In the modern times the Government modifies the free working of market mechanism in respect of income distribution not only through devising proper tax structure but also through various forms of public expenditure.
Through public expenditure the Government redistributes income in favour of the poor. Too large inequalities in income distribution as produced by the free working of market system are not only socially unjust, but also not conducive to the maximisation of social output. Not all types of public expenditure reduce inequalities in income distribution. The following forms of public expenditure redistribute income in favour of the poor and thus reduce inequalities.
- Social Security Measures:
Expenditure on unemployment insurance, sickness benefits, old age pensions is some of the social security measures which help the people at times of contingencies. In India only in recent years some State Governments such as those of Haryana, Punjab, Delhi have introduced old age pension scheme. In capitalist countries such as U.S.A., Great Britain the social security system to help the people emerged with the idea of a Welfare State and in these countries Governments spend a large sum of money on the social security system.
- Expenditure on Subsidies:
Expenditure on various types of subsidies has also a redistributive effect. In India subsidies on food-grain, sugar, kerosene oil, handloom cloth, fertilizers are provided to the people and Government spend a good part of its budget on these subsidies.
Food-grain, sugar, kerosene oil are sold through ration shops (i.e., public distribution system) at prices below the market prices and the difference is borne by the Government as a subsidy. It may be noted that at present benefits of these subsidies are enjoyed not only by the poor but all those who are relatively well off. If the public expenditure on subsidies is to have a real redistributive effect, these subsidies should be targeted to the poor.
- Expenditure on Social Infrastructure:
Public expenditure by the Government on social infrastructure such as education, health care of the people, housing for the poor also tend to reduce income inequalities. With free or subsidised education, free or highly subsidised health care facilities the poor people’s real income go up.
The modern government spends a lot of money on schools, colleges, etc., to promote education. In most states in India education upto the middle class is free and for higher levels wards of the poor people are either given free education or charged only low fees.
Similarly, the Governments spend a lot on public hospitals and dispensaries to provide health care to the poor people. Likewise, in many countries poor people are given financial aid by the Government to build houses: In India under Indra Awas Yojna, poor people are being given aid to build their low cost houses.
Expenditure on Anti-Poverty Programmes:
An important step for increasing incomes of the poor people is starting of several employment generating anti-poverty schemes. Prominent among these anti-poverty schemes in India are Jawahar Rozgar Yojna, Employment Assistance Scheme (EAS), Integrated Rural Development Programme (IRDP).
Recently in India, employment guarantee scheme under National Rural Employment Guarantee Act (NREGA) has been started which greatly help the rural poor. By generating employment these schemes raise incomes of the poor.
Encouragement to Labour-intensive Industries:
The Indian Government gives various types of subsidies to the cottage and small-scale Industries which adopt labour-intensive technique. Being labour-intensive, the growth of these industries generates a large number of employment opportunities which improve income distribution.
Negative Income Tax to Achieve More Equal Distribution of Income:
Last but not the least, to achieve more equal distribution of income and make a big dent into the poverty problem, a proposal which has been recently put forward by some economists in the USA and Great Britain is introduction of negative Income Tax.
Though the name shows it is a tax, but in fact it is a form of expenditure, called transfer expenditure. In this negative income tax scheme, payments are made by the Government to the poor to raise their incomes.
Under this system, the Government has first to define poverty income standard for families of different sizes. Then it makes payment in the form of direct money transfer to bring the incomes of all families upto that standard or at least to close a large part of the gap between their income and poverty income standard.
But the use of public expenditure to reduce inequalities in income distribution has certain bad effects also. The first and foremost evil effect is that it adversely affects incentives to work and save of the people. Thus, when people know that in times of difficulties such as unemployment, old age, sickness, the Government will come to their help they will be less willing to work hard.
The poor would not work more when they know whatever their income, the gap between the minimum income and there will be filled by the Government. Likewise, many people save to live comfortably in old age, in periods of sickness. But when all these difficult periods are taken care of by the Government their willingness to work more and save more will be badly hurt. Thus, expenditure to reduce income inequalities will tend to affect adversely incentives to work, save and invest more. All these discourage production and growth.
It is important to note that redistributive effects of public expenditure must be considered in the light of how it is financed. For example, if redistributive public expenditure is financed through taxation and if the tax system of the country is regressive, it will work against the desirable distributive effects of public expenditure.
For example, if public expenditure is financed through deficit financing, as has been the case in India for several years, it causes inflation in the economy. This inflation hurts the poor most and will therefore cancel out the desired distributive effects of public expenditure. Thus, if reduction in income inequalities has to be achieved not only the pattern of public expenditure, but also method of financing it and the system of taxation has to be suitably designed and adjusted.