PRINCIPLES OF SOUND FINANCE
Prior to 1930s, classical economists did not include fiscal policy their analysis of an economy. It was believed that the less the government interfered in the economy the better it is. This belief along with private ownership of factors of production, was the foundation of laissez faire capitalism, which is a system where economic transactions are largely between private owners of factors of production and such transactions are free from government restrictions, taxation and subsidies.
The following are some of the features of sound finance:
1. Say's Law
Like many other classical principles, the prince of sound finance is also based on Say's Law, that is, su creates its own demand." Since one man's expenditure another man's income, aggregate demand will always be vays be equal to aggregate supply. This belief forms the base of the argume on which classical economists argued in favour of sound finance.
2. Full employment
The classical economists argued that since AD = AS, there cannot be over-production and under of consumption. In other words, the economy cannot suffer from fluctuations like unemployment and inflation.Driven by profit motive, the private sector will ensure optimum use of resources
3. 'Invisible hand'
Private owners of factors of production will always achieve maximum level of efficiency in their use of resources, as they are driven by self-interest and profit motive.
4. Taxation
According to the classical school of thoughts, taxes are harmful because they adversely affect willingness and ability to work, save and invest. Taxation was expected to be kept at a minimal limit. High progressive taxation will lead to slow economic progress. They believed that taxes should not be used to redistribute income.
5. Public expenditure
Government spending was expected to be in the traditional areas like defence, law and order, justice and provision of civic amenities. Since government budget was not expected to be large in size, government spending was not large relative to total spending in the economy.
6. Balanced budget
In laissez faire capitalism, since all factors of production are normally owned and used by private individuals, the government can make use of such factors only by depriving the private sector Expenditure incurred by the government would not increase total demand for factors of production as there is already full employment.
7. Market efficiency
The market mechanism is assumed to achieve maximum level of efficiency. Market failures are only temporary and the market is fully capable of correcting itself. Therefore there is no justification of any government regulation and restrictions on the market.
8. Ricardian Equivalence Theorem
Budget deficits are uneconomical, harmful and socially undesirable. They lead to inflation and harm economic progress. This belief was based on Ricardian Equivalence Theorem. According to this theorem, deficits will not boost the economy. Deficits will have to be later met by raising taxes. This is known to the people and they will increase their savings to pay higher taxes later. As their savings increase, they will not increase consumption and therefore, increased public expenditure will not be able to boost demand, production and boost growth.
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