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Modern Trends in Public Finance – Principles of Functional Finance

Sound Finance and Functional Finance

The fiscal policy primarily involves decisions related to tax rates, for raising government revenue, and the level and pattern of public expenditure. It comprises tax policy, expenditure policy, investment or disinvestment strategies and budget management.

A key challenge in formulating fiscal policy is achieving the right balance between the short-run stabilization objectives and long-run growth and development goals.

The two conflicting views that dominate the theory of public finance are

  1. The Principle of Sound Finance
  2. The Principle of Functional Finance

Features and Principle of Sound Finance

  1. Say’s a law (supply creates its own demand)
  2. Full employment in the economy
  3. Invisible hand (private self-interest leads to social good)
  4. Taxation at minimal levels
  5. Less public expenditure
  6. Balanced budget
  7. Market efficiency (market corrects itself)
  8. Ricardian equivalence
  9. Compatible with political view

Principle of Functional Finance

The Principle of Functional Finance was proposed by Abba P. Lerner. It states that fiscal policy can be used to offset undesirable cyclical fluctuations in the output.

Lerner’s three fundamental rules of functional finance are:

The government shall maintain a reasonable level of demand at all times. If there is too little spending and thus, excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation by reducing its own expenditure or by increasing taxes.

By borrowing money when it wishes to raise the rate of interest, and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.

If either of the first two rules conflicts with the principles of ‘sound finance’, balancing the budget or limiting the national debt, so much the worse for these principles. ‘The government press shall print any money that may be needed to carry out rules 1 and 2.’

Features and Principle of Functional Finance

The features of the Principle of Functional Finance are

  1. Market failure
  2. Importance of fiscal policy
  3. Aggregate demand
  4. Budget adjustments
  5. Income redistribution
  6. Welfare capitalism
  7. And Social objectives


Taxes serve as a major source of government revenue and offer incentives or disincentives for certain activities. In addition, the correct market failures and help ensure income redistribution by reducing income inequality.

According to Musgrave, the following are the roles of a country’s tax system:

  1. Allocation
  2. Distribution
  3. And Stabilization
  4. The two important concepts of taxation have been listed below:
  5. Redistributive Taxation
  6. Anti-inflationary Taxation

Redistributive Taxation

Modern economists believe that taxation should be redistributive, that is, it should be used for transferring income from the rich to the poor. Redistributive taxation aims to reduce the savings of the rich and use the resources generated to raise the consumption of the poor.

A redistributive fiscal policy involves measures such as progressive direct taxation and public expenditure on social security, job creation and promotion of social equity. Such public expenditure can be in the form of old unemployment allowances, free and subsidized housing or facilities such as education, healthcare and food distribution.

The transfer of income from the rich to the poor improves the income distribution in the economy, resulting in an increase in the consumption level of a larger number of people. This increases aggregate demand and leads to increased investment and employment.

Limitations of Highly Progressive Direct Taxes

  1. Results in tax evasion, giving rise to a black economy.
  2. Highly progressive taxing reduces people’s willingness to work, save and invest.
  3. The government may use the redistributive fiscal policy to accomplish its political agenda ahead of elections, causing inflation and reducing the value of money.
  4. It may result in deficit and increased public borrowing, driving the interest rate upward.
  5. High-interest rate and inflation harm growth prospects.

Anti-Inflationary Taxation

Redistributive taxation measures such as progressive direct taxes aim to reduce savings, whereas anti-inflationary taxes aim to reduce consumption. When the government uses taxation policies to reduce savings (redistributive taxation), funds raised from such taxes maybe those left idle by the people.

However, when anti-inflationary taxes are levied to reduce consumption, funds raised from such taxes are those that would otherwise be used for consumption by the people. Therefore, these funds should be used productively. The general classical view is that all taxes are anti-inflationary and all public expenditures are inflationary.

Modern economists are of the view that neither all taxes are anti-inflationary nor expenditures are inflationary; their impact depends on the state of the economy. Under normal circumstances, any tax that reduces consumption and promotes investment may be anti-inflationary.