Business Economics Paper IV (English Version)-munotes

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1 Module 1
1
MEANING OF PUBLIC FINANCE
Unit structure :
1.0 Objectives
1.1 Meaning of Public Finance
1.2 Scope of Public Finance
1.3 Functions of Public Finance
1.4 The Role of Government in an Economy
1.5 Principle of maximum social advantage
1.6 Hugh Dalton’s view of maximum social advantage
1.7 Richard Musgrave: Maximum welfare principle of budget
determination
1.8 Limitations Of The Principle Of Maximum Social Advantage
1.9 Summary
1.10 Questions
1.0 OBJECTIVES
 To know the meaning of public finance
 To understand the scope of public finance
 To understand the functions of public finance
 To understand the role of government in functioning of economy
 To know the principle of Public Finance
 To understand the Hugh Dalton Principle of Maximum socia l
advantage
 To know the limitations of the principle of maximum social advantage
1.1 MEANING OF PUBLIC FINANCE
Public finance is the study of the role of the government in the economy .
It is the branch of economics that assesses the government munotes.in

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2 revenue and gover nment expenditure of the public authorities and the
adjustment of one or the other to achieve desirable effects and avoid
undesirable ones.
Classical and neo -classical economists discussed public finance in the
context of money raising and money spending a ctivities of the
government.
According to Philip E. Taylor, “public finance deals with the finances
of the government. The finances of the government include raising
and disbursement of government funds”.
According to Ursula Hicks, “the main content of pub lic finance
consists of the examination and appraisal of the methods by which
government bodies provide for the collective satisfaction of wants and
secure necessary funds to carry out their purposes”.
According to Richard Musgrave, “public finance is conc erned with the
complex of problems that centre around the revenue – expenditure
process of government”. However, “the basic problems are not issues
of finance. They are not concerned with money, liquidity or capital
markets. Rather, they are problems of so urce allocation, the
distribution of income, full employment, price level stability and
growth”.
From the above definitions it is clear that the subject matter of public
finance includes public revenue, public expenditure, public debt and
financial adminis tration.
Prof. Dalton in his book Principles of Public Finance states that “Public
Finance is concerned with income and expenditure of public authorities
and with the adjustment of one to the other”
From the above definitions it is clear that the subject matter of public
finance includes public revenue, public expenditure, public debt and
financial administration.
The classical and the neo -classical economists generally confined the
study of public finance to the narrow area of government’s financial
activities only. They also believed that government intervention in the
economy should be kept minimal.Economics believed that public
expenditure should be kept to the minimum and taxation should be limited
to what is necessary to fulfill the basic public expe nditure. Governments
should follow balanced budget wherever possible.
It was John Maynard Keynes , in his General Theory of Employment,
Interest and Money published in 1936, who for the first time emphasized
that the role of State needed to expand when the markets failed to correct
themselves. He advocated that the financial or fiscal operations of the
government can be used to remove distortions in the economy. The
financial operations could be used to influence the level of aggregate munotes.in

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3 demand and employment . The public budget could be used to mobilize
resources for rapid growth, balanced development and social justice.
These policies were successful in reviving US economy from the Great
Depression and have been widely followed by most market economies
since then, giving rise to the concept of Functional Finance .
1.2 SCOPE OF PUBLIC FINANCE
The scope of public finance is not just to study the composition of public
revenue and public expenditure . It covers a full discussion of the
influence of government fiscal op erations on the level of overall activity,
employment, prices and growth process of the economic system as a
whole. The scope of public finance is extended to the following fiscal
operational areas through the instrument of budget. The important areas
are :
1. Public Revenue : It is the means for public expenditure. The necessity
of raising the public revenue follows from the necessity of incurring
public expenditure. Public revenue deals with the methods of raising
income from tax and non -tax sources. In this connection we study the
principles of taxation, incidence of taxation and the effects of taxation.
Since tax revenue can be raised from both direct and indirect taxes, we
also study the relative merits and demerits of direct and indirect taxes.
Since non -tax revenues consist of surpluses of public enterprises,
public borrowing and deficit financing, we also study about the
methods of raising revenues through these sources.
2. Public Expenditure : It refers to the expenses of public authorities –
central, sta te and local governments. Public expenditure is a major tool
for implementing various policies of the government with respect to
welfare, growth, stabilization and so on. Thus, public expenditure
occupies an important place in the study of public finance. In this
connection we study the principles of public expenditure, justification
for various kinds of public expenditure and effects of public
expenditure. We also study the changes in the pattern of public
expenditure over the years.
3. Public Debt : With th e increase in the activity of the state, the
shortfalls in income of the state is frequently made up through loans.
Thus, public debt has become an important source of revenue both in
the developed and developing countries. In modern times, borrowing
by th e government has become a normal method of government
finance along with the other sources of public finance. In all countries
of the world, public debt has shown a tendency to increase. Thus, the
study of public debt has become an integral part of public finance.
The problems relating to the raising and repayment of public loans are
studied under this part of the public finance. In this connection we
study about the sources of public loans, methods of raising the public munotes.in

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4 loans, methods of repayment of princ ipal amount of loan and interest,
and burden of public debt.
4. Financial Administration : The scope and subject matter of public
finance is not confined only to the study of public expenditure, public
revenue and public debt. We also have to examine the mech anism by
which these processes are carried out. In this context we are concerned
with the organization and functioning of the government machinery
which is responsible for carrying out the various functions. This is
done by the government through the budge t.
Thus, public finance involves the study of budget which is the
financial plan of the government. The budget gives a complete picture
of the estimated receipts and expenditure of the government during the
year. In India the budget is divided into 2 part s, that is (i) Revenue
budget and (ii) Capital budget. The revenue budget deals with the
receipts from taxation, public enterprises, etc. and the expenditure
incurred on the normal running of government departments and
services, etc. On the other hand, cap ital budget deals with the capital
receipts which include the market loans, borrowing by government
from R.B.I. etc. The Capital expenditure is the expenditure incurred
for the acquisition of assets like land, equipment, etc. for the
development purposes.
1.3 FUNCTIONS OF PUBLIC FINANCE
The scope and functions of public finance has gone to many changes. The
classical idea of sound Finance was no more popular.
At present all the governments through the budget and fiscal operations
aim to discharge the following functions.
(a) Allocation of resources : The most important objective of fiscal
operations is to determine how the country’s resources will be
allocated to different sectors of the economy in order to achieve
predetermined goals. Allocation of resources depen ds upon the
collection of taxes and size and composition of government
expenditure. The national budget determines how funds are allocated
to different heads of expenses. The policy of public expenditure is
used by the government to directly undertake reso urce allocation for
different sectors. On the other hand, the government can use taxation
and subsidies to indirectly influence resource allocation. The market
mechanism cannot provide all goods and services for the satisfaction
of collective wants through public goods like defence, justice and
security. The government has to adjust between allocation of resources
for the provision of public goods and private goods.
In India, the central government through its annual budget allocates
expenditure to differe nt sectors and sub -sectors. These sectors include
the essential activities like defence, law and order, justice and other munotes.in

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Meaning of Public
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5 essential social activities such as education and health, as suggested by
classical economists, but also various developmental activit ies
connected to agriculture, industries and service sectors. Private
investment is promoted or discouraged through positive and negative
incentives.
(b) Distribution : Fiscal operations can be effectively used to affect the
distribution of national income an d resources. Taxation and public
expenditure policies are used by the government to reduce inequalities.
Progressive direct taxes impose heavier burden on the rich than the
poor. Public expenditure on social infrastructure and subsidies on
food, housing, h ealth and education help reduce income inequality.
India’s direct tax system is progressive where tax rates range from 5
percent to 30 percent plus surcharge. The newly introduced Goods and
Services Tax (GST) is also varies depending on the nature of goods
and services. The GST ranges from 5 percent to 28 percent. Essential
goods and services are either exempted from the GST or taxed at a low
percent. Through the budget, Government of India spends money to
provide ‘Food Security’, health care and employment to the poorer
sections of the society. The state governments too have introduced
many welfare schemes to reduce the inequality of income.
(c) Stabilisation : Developed economies expenditure business cycles.
Economic stability implies absence of sharp cyclical movements in the
form of booms and depressions. To bring about such stability, counter -
cyclical fiscal operations are adopted. To counter depression and
recession, government expenditure is increased to generate
employment and taxes are reduced to encoura ge consumption and
investment. During inflation, public expenditure is reduced and taxes
are raised.
In 1930s depression, British economist Lord J.M. Keynes advised the
USA government to use fiscal instruments to spend more to provide
employment, thus mor e income in the hands of people leading more
consumption and additional investment. The entire process was
expected to revive economic activities and bring the economy out of
depression. This approach led to the birth of the concept of functional
finance.
1.4 THE ROLE OF GOVERNMENT IN AN ECONOMY
Two important concepts associated with public finance are (i) fiscal
policy, and (ii) budgetary policy
(i) Fiscal policy is the part of government policy that deals with raising
revenue through taxation and other means an d deciding on the level
and pattern of public expenditure. In most modern economies, the
government deals with fiscal policy while the central bank is
responsible for monetary policy . Fiscal policy is composed of tax munotes.in

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6 policy, expenditure policy, investment or disinvestment strategies and
public debt management.
(ii) Budgetary policy refers to government’s strategies to implement and
manage a budget. It is a more specific policy than fiscal policy.
1.5 PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE
The principle of Maxim um social advantage is the important Principle of
Public Finance. It is the fundamental principle which should determine
fiscal operations of the government. This principle is formulated and
popularized by Dr. Hugh Dalton. The principle provides guidance t o the
Govt. regarding public revenue and public expenditure or public finance
operations so as to maximise social advantage or welfare.
Budgetary activities of the government result in transfer of purchasing
power within society. Taxation causes transfer o f purchasing power from
tax payers to the public authorities, while public expenditure results in
transfers back from the public authorities to people. When the income tax
is paid by an individual to the government he experiences sacrifice or
disutility , and whenever in return government spends or it does
expenditure by providing social benefit an individual receives benefits or
utility .
Therefore, financial operations of the government cause sacrifice or
disutility on one hand and benefits or utility on th e other. This results in
changes in pattern of production, consumption and distribution of
income and wealth . It is important to consider whether these changes are
socially advantageous or not. If they are socially advantageous, then the
financial operatio ns are justified, otherwise not. According to Hugh
Dalton, The best system of public finance is that which secures the
maximum social advantage from the operations which it conducts.
The principle was developed by Hugh Dalton and was later interpreted by
Richard Musgrave .
1.6 HUGH DALTON’S PRINCIPLE OF MAXIMUM
SOCIAL ADVANTAGE
The Principle states: The state should collect revenue and spend the
money so as to maximize the welfare of the people. When the state
imposes taxes, some disutility is created. On t he other hand, when the state
spends some money, there is gain in utility. The state should so adjust
revenue and expenditure that surplus of utility is maximised and disutility
is minimised.
According to Dalton, the main objective of public finance is the
maximization of social advantage and the principle he used to explain the
achievement of this objective is the principle of Maximum Social munotes.in

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7 Advantage (MSA). The MSA is the fundamental principle on which
public finance is based.
The principle of MSA is bas ed on the following assumptions :
1. All taxes result in sacrifice and all public expenditures lead to benefits.
2. Public revenue consists of only taxes. No other source of income to the
government is considered.
3. The government has only balanced budget, that is , revenue is equal to
expenditure.
4. Public expenditure is subject to diminishing marginal social benefit .
5. Taxes are subject to increasing marginal social sacrifice.
The principle of MSA states that public finance leads to maximum
economic welfare when publi c expenditure and taxation are
carried out up to that point where the benefits derived from the
marginal utility of expenditure is equal to marginal disutility of
the sacrifice imposed by taxation . In other words, when marginal
social benefit of government expenditure is equal to marginal social
sacrifice of the taxation of social welfare is maximum.
Marginal Social Sacrifice (MSS)
Taxes cause sacrifice to people who have to give up some part of their
income. The sacrifice that is experienced by the people when the
government imposes an additional unit of taxation is known as the
marginal social sacrifice (MSS) .
The marginal social sacrifice of taxation increases as the revenue collected
by the government from taxes become larger. As the community pays
more and more taxes to the government, the sacrifice they experience, in
paying every additional unit of money in the form of tax increases. Thus
taxes are subject to increasing marginal social sacrifice . This is based on
the principle of marginal utility , acc ording to which the less of a
commodity (or money) an individual has, the more will be the disutility or
sacrifice she will experience in parting with an additional unit of the
commodity (or money).
The curve representing MSS is an upward rising curve. Ta xes put a real
burden on the people as either they have to cut down their consumption to
pay taxes or they have to reduce their level of savings. As additional units
of taxation are imposed on them, individuals are forced to cut more and
more of their cons umption and savings. Therefore, with each additional
unit of taxation, the level of sacrifice also increases. As the government
imposes additional taxes to raise additional revenue the MSS curve is
increasing an increasing rate due to increasing disutility or sacrifice munotes.in

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8 incurred by the taxed people. Therefore, MSS curve rises upward from left
to right

Figure 1.1 Increasing Marginal Social Sacrifice Curve
In Figure 1.1, when the amount of tax is OM, the MSS imposed by
taxation is OS. When the tax rises to O M2, MSS rises to OS 2, and as tax is
further raised to OM 3, MSS rises to OS 3.
Marginal Social Benefit (MSB)
Public expenditure is carried out by the government to provide social
goods like defence, justice system, free or subsidized food, housing and
educat ion, transport system and many other infrastructural facilities to the
people. The primary objective of public expenditure is to generate welfare
or benefits to the society.
While taxes result in sacrifice by the people, public expenditure results in
bene fits to them. All public expenditure, assuming they are wisely and
productively spent by the government, result in some benefits. The benefit
given to society, by an additional unit of public expenditure is known as
marginal social benefit (MSB).
MSB decli nes with increase in public expenditure, that is, with every
additional unit of money spent by the government on the community, the
social benefits tend to decline. In other words, the MSB or the marginal
utility of public expenditure, like that of everyth ing else, diminishes as the
community has more of it. This is based on the principle of diminishing
marginal utility . To a consumer, the marginal utility from a commodity
declines as more and more units of the commodity are made available to
him. In the sa me manner, the social benefit from each additional unit of
public expenditure declines as more and more units of public expenditure
are spent. In the beginning, the units of public expenditure are spent on
the most essential social activities. Subsequent increases in public munotes.in

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9 expenditure are spent on less important social activities. As a result MSB
from public expenditure declines with increase in volume of expenditure.
The curve representing MSB slopes downwards from left to right as
shown in figure 1.2.

Fig. 1.2 : Diminishing Marginal Social Benefit Curve
When public expenditure is OM 1, MSB is OB 1 and when public
expenditure rises to OM 1, MSB falls to OB 2, MSB falls to OB 2. A further
increase in public expenditure to OM 3 results in MSB falling to OB 3.
Maximum Social Advantage
Social advantage is maximized at that level of taxation and public
expenditure at which MSS is equal to MSB. Any other level of taxation
and expenditure will achieve less than maximum social advantage.
The difference between the MS S and the MSB measures net social
advantage (NSA) . As long as MSB is greater than MSS, NSA will be
positive and will add to total social advantage. When MSS is equal to
MSB, NSA is zero and maximum social advantage is achieved. When
MSS is greater than MSB , NSB will be negative resulting in reduction in
total social advantage.
Thus, as long as MSB is greater than MSS (and NSA is positive), the
government should expand the level of taxation and public
expenditure . It should stop its budgetary activities at the point where
MSS is equal to MSB (and NSA is zero). Any further expansion in the
level of taxation and public expenditure will result in MSS being greater
than MSB (and negative NSA), and social advantage will reduce. munotes.in

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Fig. 1.3 : Maximum Social Advanta ge is obtained at the Point of
Intersection of MSS and MSB Curves
In Fig. 1.3 the level of taxation and public expenditure (size of budget
activities) is represented on the X -axis and MSS and MSB are represented
on the Y -axis. Social advantage is maximized at the point where the
MSS curve cuts the MSB curve . This is the point P in the Figure 1.3.
Corresponding to P, on the X -axis, OQ represents that level of taxation
and public expenditure at which the social advantage is maximum. Any
other level of taxatio n and public expenditure will result in less than
maximum social advantage. This is the optimum budget size .
Consider level OQ 1 on the X -axis. At this level of taxation and
expenditure, MSB is P 1 Q1 and MSS is S 1Q1. Since MSB is greater than
MSS, the gov ernment should increase the level of taxation and public
expenditure. This is because, each additional unit of revenue raised
through taxation and spent through public expenditure, will lead to an
increase in net social advantage . This situation will conti nue as long as
the levels of taxation and public expenditure are towards the left of the
point P.
Once the level of taxation and public expenditure reaches OQ, MSS
becomes equal to MSB and the point of maximum social advantage is
reached.
Any further incr ease in the level of taxation and public expenditure will
bring down the social advantage as subsequent units will add more to
sacrifice than to benefits and NSA will become negative. For example, at
point OQ 2, MSS will be S 2Q2 and MSB will be P 2Q2. Since MSS is greater
than MSB, social advantage will reduce and the government should reduce
the level of taxation and expenditure from OQ 2 to OQ to reach maximum
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11 Thus, Maximum social advantage is achieved at the point where the
marginal socia l benefit of public expenditure and the marginal social
sacrifice of taxation are equated, that is MSS – MSB .
1.7 RICHARD MUSGRAVE: MAXIMUM WELFARE
PRINCIPLE OF BUDGET DETERMINATION
The principle of Maximum Social Advantage has been interpreted by
economis t Richard Musgrave who termed it as Maximum Welfare
Principle of Budget Determination. According to Musgrave, the principle
explains that taxation and public expenditure should be carried out up to
that level where satisfaction obtained from the last unit of money spent
is equal to the sacrifice from the last unit of money taken in taxes . In
other words, it should be carried out up to the point where marginal social
benefit is equal to marginal social sacrifice.
To illustrate his interpretation, Musgrave u sed Figure 1.4 in which, the
size of the budget (level of taxation and public expenditure) is shown on
the X -axis. On the positive part of Y -axis MSB is measured and on the
negative part, MSS is measured.

Fig. 1.4 : Gains and Losses from Budget Operatio n
The curve EE represents the marginal social benefit (MSB) of successive
units of money spent as public expenditure, allocated optimally between
different pubic uses. It falls from left to right because of public
expenditure increases, MSB declines. The c urve TT represents the
marginal social sacrifice (MSS). As additional units of taxation are
raised from the people, MSS increases. Accordingly the curve TT slopes
downwards from left to right in Fig. 2.4 showing rising MSS. munotes.in

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12 The curve NN measures marginal n et benefits (MNB) which is derived
from successive addition to public budget. MNB is calculated by
deducting MSS from MSB. The vertical distance between EE curve and
TT curve measures MNB at different sizes of the budget.
The optimum size of the budget is determined at OM, where MNB is
zero. At this size of the budget, the marginal social benefit MP is equal the
marginal social sacrifice MQ (MSB = MSS) . Since MSB and MSS are
measured in opposite directions, marginal net benefit is zero at M (MSB -
MSS = 0). At this point the MNB curve NN cuts the X -axis.
At any point to the left of M, say M 1 MSB will be greater than MSS and
MNB will be positive. It is beneficial to increase size of the budget as long
as MNB is positive. So there will be a tendency to move fro m M 1 towards
M. If the budget size exceeds M , say M 2, then MSS will exceed MSB and
MNB will be negative. Therefore it will be beneficial for the government
to cut down the size of the budget and move from M 2 towards M.
According to Musgrave the optimum siz e of the budget is given by the
point where the marginal net benefit is zero. This point corresponds to
the point of maximum social advantage, as at this point MSB = MSS.
1.8 LIMITATIONS OF THE PRINCIPLE OF MAXIMUM
SCIAL ADVANTAGE
The principle has been cr iticized on some fundamental grounds :
(i) Objective measurement not possible : The principle of maximum
social advantage is theoretically explained with the help of the
marginal utility analysis. The marginal utility analysis. The marginal
utility anlaysis it self is criticized because it is not possible to
accurately measure utility or disutility experienced by people. The
marginal benefits of public expenditure and the marginal disutility or
sacrifice of public revenue are concepts whose objective measurement
is extremely difficult. Besides, the terms “benefit” and “sacrifice” are
vague and abstract. It is not possible to quantify them and find their
exact implications.
(ii) Large budget size : The financial operations of the government
involve collection of large sums of money from taxation and other
sources and the disbursement of large amounts by way of public
expenditure. The effects of small additional amounts of these on the
community are difficult to measure. Therefore, in practice, the public
authorities ar e not in a position to estimate the marginal benefits and
the marginal sacrifices. It is almost impossible to determine the
particular size of budget that will maximize welfare of the community.
(iii)Unrealistic assumption : It is unrealistic to assume that gov ernment
expenditure is always beneficial and that every tax is a burden to
society. For example, taxes on cigarettes or alcohol can provide benefit munotes.in

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13 to society, whereas taxes on education or essential commodities may
harm general interest of society. Simila rly, expenditure on social
overheads like health care will give rise to social benefit whereas
unnecessary increases in expenditure on defence may divert resources
from productive activities causing loss of welfare to society.
(iv) Lack of disability : In orde r to equate the marginal benefit from
public expenditure with marginal sacrifice from taxation, government
resources are required to be divided into smaller units. But it is not
possible because of the lack of divisibility of public expenditure and
taxes i n small units.
(v) Ignores non -tax revenues : This principle takes into consideration the
sacrifice on the part of tax payers and ignores non -tax revenues. Non
tax revenues like fines, fees, market borrowings, profits of public
undertakings etc. are equally i mportant as sources of revenue and in
their effects on social benefit.
(vi) Changes in conditions : Conditions in an economy are not static and
are continuously changing. What might be considered as the point of
maximum social advantage under some conditions ma y not be so
under some other. For example, in times of war government
expenditure and revenue must increase, and the increase is to the
advantage of the community. What is optimum at one level of national
income may not be so at a higher level. Therefore, it is difficult to
determine the point of maximum social advantage and no definite
volume of government expenditure and revenue can be considered as
being the best.
(vii) Different periods : The impact of many public projects is felt over
the long period by bot h the present and the future generations. In order
to determine maximum social advantage it becomes necessary to
calculate social benefits from public expenditure in short period and in
long period separately. It is not possible to equate marginal benefits of
expenditures over projects relating to different time periods.
(viii) Non-economic implications : Public authorities use the principle of
maximum social advantage after carefully estimating the economic
advantages and disadvantages of any proposed expenditure and
taxation policy. They compare the balance of probable gain and loss to
the community from various alternative proposed policies. Such
estimates and comparisons are, however, not easy. They are difficult
partly because all the possible results of a pol icy measure cannot be
correctly visualized and because there are innumerable economic and
non-economic implications of every single measure. Political and
social criteria often put economic criteria in the background. There are
various taxes and public exp enditure measures, whose social and
political impacts are far greater than their economic effects. It is not
possible to objectively measure non -economic effects of public
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14 (ix) Conceptual differences : Taxes are paid by individuals and the
sacrifice i nvolved is felt at an individual or micro level. Whereas,
public expenditure gives rise to public goods that are jointly consumed
by all in a community. The benefits therefore are felt at a macro level.
Many economists argue that it is neither possible nor desirable to
compare micro and macro concepts by using the same criteria. Also, it
is not possible to compare the marginal benefits accruing to people in
one area from a given public expenditure with the marginal sacrifice
underground by people who are ta xed in some other area. Marginal
sacrifice is a subjective concept. Marginal sacrifice of the same
amounts of tax paid by two persons, having different living standard
will be different.
1.9 SUMMARY
1. Public finance is the study of the role of the govern ment in
the economy . It is the branch of economics that assesses the government
revenue andgovernment expenditure of the public authorities and the
adjustment of one or the other to achieve desirable effects and avoid
undesirable ones.
2. The scope of publi c finance is not just to study the composition
of public revenue and public expenditure . It covers a full discussion
of the influence of government fiscal operations on the level of overall
activity, employment, prices and growth process of the economic
system as a whole.
3. All the governments through the budget and fiscal operations aim to
discharge the functions of public finance.
4. Two important concepts associated with public finance are (i) fiscal
policy, and (ii) budgetary policy
5. The principle of Maximum social advantage is the important Principle
of Public Finance. It is the fundamental principle which should
determine fiscal operations of the government. This principle is
formulated and popularized by Dr. Hugh Dalton.
6. According to Dalton, the main objective of public finance is the
maximization of social advantage and the principle he used to explain
the achievement of this objective is the principle of Maximum Social
Advantage (MSA). The MSA is the fundamental principle on which
public fin ance is based.
7. The principle of Maximum Social Advantage has been interpreted by
economist Richard Musgrave who termed it as Maximum Welfare
Principle of Budget Determination. According to Musgrave, the
principle explains that taxation and public expen diture should be carried
out up to that level where satisfaction obtained from the last unit of munotes.in

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15 money spent is equal to the sacrifice from the last unit of money
taken in taxes .
1.10 QUESTIONS
1. Discuss the meaning and scope of public finance.
2. Explain the va rious functions of public finance.
3. Explain the principle of Maximum Social Advantage as stated by
Hugh Dalton.
4. Explain the limitation of Maximum Social Advantage.
5. Explain maximum welfare principle of budget determination.



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16 2
EFFICIENCY – MARKET - GOVERNMENT
Unit structure :
2.0 Objectives
2.1 Meaning of Efficiency
2.2 Concept of Consumer and Producer Surplus
2.3 Market
2.4 Market Failure
2.5 Public Goods
2.6 Role of Government
2.7 Summary
2.8 Questions
2.0 OBJECTIVES
 To know the concept of Allocative and Productive efficiency
 To understand producer and consumer surplus
 To know the concept of Market
 To understand the reasons for market failure
 To know what is public good
 To understand the role of government in the economy
2.1 MEANING OF EFFICIENCY
Economic efficiency is a state where every resource is allocated optimally
so that each person is served in the best possible way and inefficiency and
waste are minimized. Efficiency in economics also explained as “that
society is ge tting the maximum benefits from the scarce resources”. In a
free economy, market allocates scarce resources with forces of supply and
demand, and equilibrium of supply and demand typically implies an
efficient allocation of resources. Under ideal condition s markets ensure
that the economy is pareto efficient. In Adam Smith’s words the “invisible
hand” of market place leads self -interested buyers and sellers in a market
to maximize the total benefit that society derives from that market.
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17 Productive Efficie ncy
Productive efficiency is concerned with producing goods and services
with the optimal combination of inputs to produce maximum output for
the minimum cost.
To be productively efficient means the economy must be producing on
its production possibility frontier . (i.e. it is impossible to produce more of
one good without producing less of another).
In Fig. 2.1 AB is the production possibility curve. The points b, d, c are
the points where the ma ximum (optimum) output of goods X and Y can be
produced. Any point inside the curve such as a, is productively inefficient.
When we move from a to c, we increase the production of X from X to X 1,
without reducing output of Y. similarly if we move from A to b, we
produce more of Y (i.e. YY 1,), without having less of X. When we move
from a to c or a to b , we achieve productive efficiency in terms of goods
X in the first case and in terms of good Y in the second case.

Fig. 2.1
Productive efficiency in an ec onomy is achieved when an economy
produces at any point on its production possibility curve and not at any
point inside the PPC.
Productive efficiency is achieved when it is impossible to reallocate
resources as to produce more of one product without produ cing less of the
other product.
In case of a firm, productive efficiency requires that it produces its output
with least cost input combination. In other words, maximum output is
produced with minimum cost. It is a point where output is produced in
such a way that the ratio of marginal products of each pair of factors is
made equal to the ratio of their prices. munotes.in

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Business Economics
18 When we apply this condition to an industry, productive efficiency is
obtained when the marginal cost of producing the last unit of output of a
firm must be the same for each firm in any industry.
Definition of allocative efficiency
This occurs when there is an optimal distribution of goods and services,
taking into account consumer’s preferences.A more precise definition of
allocative efficiency is at an output level where the Price equals the
Marginal Cost (MC) of production. This is because the price that
consumers are willing to pay is equivalent to the marginal utility that they
get. Therefore, the optimal distribution is achieved when the margin al
utility of the good equals the marginal cost.
Example using diagram

Fig. 2.2
At an output of 40, the marginal cost of the good is Rs 6, but at th is output,
consumers would be willing to pay a price of Rs15. The price (which
reflects the good’s marginal utility) is greater than marginal cost –
suggesting under -consumption. If output increased and price fell, society
would benefit from enjoying more of the good. munotes.in

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Efficiency – Market - Government
19

Fig. 2.3
At an output of 110, the marginal cost is Rs17, but the price people are
willing to pay is only Rs7. At this output, the margin al cost (Rs17) is
much greater than the marginal benefit (Rs7) so there is over -
consumption. Society is over -producing this good.
Allocative efficiency will occur at a price of Rs11. This is where the
marginal cost (MC) = marginal utility.

Fig. 2.4
 Firms in perfect competition are said to produce at an allocative
efficient level because at Q1, P=MC
 Monopolies can increase price above the marginal cost of
produ ction and are allocatively inefficient. This is because munotes.in

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Business Economics
20 monopolies have market power and can increase price to reduce
consumer surplus.

Fig. 2.5
 Monopoly sets a price of Pm. This is allocatively inefficient because at
this output of Qm, price is greater than MC.
 Allocative efficiency would occur at the point where the MC cuts the
Demand curve so Price = MC.
 The area of deadweight welfare loss shows the degree of a llocative
inefficiency in the economy.
2.2. CRITERION OF SUM OF CONSUMER AND
PRODUCER SURPLUS
A free market economy functions to maximize benefit or welfare of both
consumers and producers. One of the measures adopted by economists or
economic planners is the criterion of sum of consumer and producer
surplus.
To understand this measure let us recall the measurement of consumer and
producer surplus.
Consumer’s = The price a consumer is willing to= Price paid by buyers
Surplus pay (Value to buyers)
Producer s’= Market price of the commodity = Minimum price the
Surplus (Price received by sellers) producer must receive
(Cost to sellers)
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Efficiency – Market - Government
21 Total surplus = (Value to buyers – Price paid by buy ers)
+ (Price received by sellers – Cost to Seller)
The price paid by buyers equals to the price received by sellers, therefore
the middle two terms in the above measure cancel each other.
Therefore, Total Surplus = Value to buyers – Cost to sellers
We explain the above concept with help of a diagram.
In a perfectly competitive market both producers and consumers stand to
gain by obtaining surplus.

Fig. 2.6
Fig. 2.6, OQ is the equilibrium output, sold at price OP per unit. The area
above the supply curve (AS x) and below the price line (PE) is the
producer’s surplus. The area below the demand line (D x) and above the
price line (PE) is the consumer’s surplus. At the equilibrium point E, and
output OQ, under perfect competition, the market efficiency e nables
producers and consumers to maximize their surplus. Production less than
OQ reduces surplus of both producers and consumers. Production beyond
OQ, will make producers to incur cost more than the price they receive as
the price is lower than the suppl y curve (cost). Similarly beyond point E,
that is output more than OQ will make consumers to pay more than what
they are willing to pay, as the price is higher than the demand curve. A
perfectly competitive market ensures maximum possible benefit both to
the producers and consumers.
Any point prior to beyond point E, is less efficient in consumption and
production, as explained in Fig. 2.7. munotes.in

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22

Fig. 2.7
Quantity less than equilibrium quantity, e.g. Q 1, the value to buyers
exceeds the cost to sellers. At qua ntity greater than equilibrium quantity
e.g. Q 2, the cost to sellers exceeds the value to the buyers. Only at the
equilibrium quantity (Q), the sum of producer and consumer surplus is
maximum.
From the above analysis we can arrive at the following observat ions :
1. Free markets allocate the supply of goods to the buyers who value
them most highly, as measured by their willingness to pay.
2. Free market allocates the demand for goods to the sellers who can
produce them at the lowest cost.
3. Free markets produce the quantity of goods that maximizes the sum of
consumers and producer surplus.
The above observations tell us that market forces (demand and supply)
maximize the sum of consumers’ and producers’ surplus. The above
outcome is unlikely, if the economy is manage d by the government totally
(Socialist or Communist) or partially, that is mixed economy as it is in
India.
It is, therefore, best to leave the economy to the market forces. The policy
of leaving the economic decisions to the market is called Laissez fair e,
the French expression, which means “allow them to do” .

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Efficiency – Market - Government
23 2.3 MARKET
A market, as we knew, is a place where sellers (producers) and buyers
meet for settling a transaction. A market is defined “as a group of firms
and individuals that are in touch with eac h other in order to buy and sell
some goods:.
According to N. George Mankiw, a market with many buyers and sellers,
trading identical products, so that each buyer and seller is a price taker is
called a competitive market. It is also sometimes called a pe rfectly
competitive market.
Sellers aim at maximizing their profit, and buyers attempt to maximize
their total utility or satisfaction, in an ideal market, what is usually called
perfect competition.
In reality, markets do not fulfill all the required co nditions to make them
perfectly competitive.
2.4 MARKET FAILURE
Market failure occurs when the price mechanism fails to account for all of
the costs and benefits necessary to provide and consume a good. The
market will fail by not supplying the socially o ptimal amount of the good.
Prior to market failure, the supply and demand within the market do not
produce quantities of the goods where the price reflects the marginal
benefit of consumption. The imbalance causes allocative inefficiency,
which is the over - or under -consumption of the good.
The structure of market systems contributes to market failure. In the real
world, it is not possible for markets to be perfect due to inefficient
producers, externalities, environmental concerns, and lack of public goods .
An externality is an effect on a third party which is caused by the
production or consumption of a good or service.
Market failure is an economic term that involves a situation where, in any
given market, the quantity of a product demanded by consumers d oes not
equate to the quantity supplied by suppliers. Market failure occurs when
resources are misallocated, or allocated inefficiently. In other words,
market failure occurs when markets fail to produce and allocate scare
resources in the most efficient w ay; i.e. the market may not always
allocate scarce resources efficiently in a way that achieves the highest total
social welfare.
Michael Todaro explains market failure as a “phenomenon that results
from the existence of market imperfections that weaken t he functioning of
a free market economy i.e. it ‘fails’ to realize its theoretical beneficial
results. He attributes market failure to monopoly power, factor immobility,
significant externalities and lack of knowledge. munotes.in

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Business Economics
24 One is the failure of the market sys tem to achieve efficiency in the
allocation of society’s resources.
The other is the failure of the market system to serve social goals other
than efficiency, such as achieving some desired distribution of income or
preserving our value system.
M.G. Mank iw defines market failure as “a situation in which a market left
on its own fails to allocate resources efficiently”.
Causes of Market Failure
Markets do not function in a perfect manner as they are expected to do so
in a theoretical model. They fail to pe rform efficiently due to a number of
reasons such as availability of public goods, business corporate acquiring
monopoly power in real world market which is full of imperfections,
externalities arising out of economic activities, imperfect or asymmetric
information, unequal income distribution and many other factors. Let us
briefly discuss these factors.
1. PUBLIC GOODS
Most goods in the economy are allocated in markets, where buyers pay for
what they receive and sellers are paid for what they provide. For these
goods, prices are the signals that guide the decisions of buyers and sellers,
and these decisions lead to an efficient allocation of resources.
A public good is a special type of good that can be consumed by everyone,
regardless of whether they hav e paid for the good. When goods are
available free of charge, however, the market forces that normally allocate
resources in the economy are absent.
2. MARKET POWER
An imperfectly competitive market is one where the assumption of large
number of buyers an d sellers does not hold. These types of market
organizations include monopoly, monopsony, oligopoly, and monopolistic
competition.
None of these markets are efficient. In general, the firms do not produce
the socially optimal quantities (they tend or unde r-produce) and the price
is higher than it would be under perfect competition. The condition P =
MC does not hold, and the system does not produce the most efficient
product mix.
Market control (or market power) arises when buyers or sellers are able
to ex ert influence over the price of a good and/or the quantity exchanged.
The ability to control the market, especially the market price, prevents a
market from equating demand price and supply price.
Market control on the supply side allows sellers to set a demand price,
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Efficiency – Market - Government
25 An extreme example of market control on the supply side exists with
monopoly, a market with a single seller. A less extreme, but more
common example is oligopoly, a market with a small number of large
sellers.
Market control on the demand side allows buyers to set a supply price,
the value of goods not produced, below the value of the good produced.
An extreme example of market control on the demand side exists with
monops ony, a market with a single buyer. A less extreme, but more
common example is oligopsony , a market with a small number of large
buyers.
Common examples of markets with supply -side or demand -side control
include city -wide electrical distribution (monopoly), automobile
manufacturing (oligopoly), employment in a company in town
(monopsony), and employment in professional sports (oligopsony).
The existence of monopoly power is often thought to create the potential
for market failure and a need for intervention to correct for some of the
welfare consequences of monopoly power.
The classical economic case against monopoly is that :
(a) Price is higher and output is lower under monopoly than in a
competitive market.
(b) This causes a net economic welfare loss of both cons umer and
producer surplus.
(c) Price > marginal cost – leading to allocative inefficiency and a
Pareto sub -optimal equilibriuim.
(d) Rent seeking behaviour by the monopolist might add to the
standard costs of monopoly. This includes high (possibly
excessive) amoun ts of spending on persuasive advertising and
marketing.
(e) If the monopolist allows cost efficiency to drop then an upward
drift in costs takes place. Lack of effective competitive in the
market -place can lead to consumers facing higher prices and a
reduction in their real standard of living.
EXTERNALITIES
An externality arises when a person engages in an activity that influences
the well being of a bystander (or third party) and yet neither pays nor
receives any compensation for that effect. Third parties ar e individuals,
organizations, or communities indirectly benefitting or suffering as a result
of the actions of consumers and producers attempting to pursue their own
self-interest. The potential market failure arising from externalities is that munotes.in

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Business Economics
26 the social optimum output or level of consumption diverges from the
private optimum.
If the impact on the bystander (or third party) in adverse, it is called a
negative externality (e.g. consumers and producers may fail to take into
account the effects of their act ions on third parties, such as car drivers,
who may fail to take into account the traffic congestion they create for
others; or producers fail to take into account pollution, radiation, and other
production by products). If it is beneficial it is called a positive
externality (e.g., the benefits of education extend beyond those receiving
the education and thus beyond the market exchange).
Negative externalities lead markets to produce a larger quantity than is
socially desirable e.g., when the firms do not pay for the pollution their
cost would be low and they would produce more.
Positive externalities lead markets to produce a smaller quantity than is
socially desirable e.g. if an entrepreneur stages a fireworks show, people
can watch the show from their wi ndows or backyards. Because the
entrepreneur cannot charge a fee for consumption, the fireworks show
may go unproduced, even if demand for the show is strong.
To remedy the problem, governments can internalize the externality by
taxing goods that have neg ative externalities and subsidizing the goods
that have positive externalities.
ASYMMETRIC INFORMATION
Asymmetric information is a market situation in which one party in a
transaction has more information than the other party. This can affect the
firm’s s trategy. It can lead to market failures.
The lack of information among buyers or sellers often means that the
demand price does not reflect all benefits of a good or the supply price
does not reflect all opportunity costs of production. That is, buyers mi ght
be willing to pay more or less for a good because they don’t know the true
benefits generated. Or sellers might be willing to accept more or less for a
good than the true opportunity cost of production.
In many cases, sellers have better information ab out a good than buyers.
Sellers own and control the good, they have direct contract with the good.
If there are defects or problems with the good, they are likely to know
Buyers, in contrast, have much less familiarity with a good, perhaps only
knowing the information provided by the sellers. In this case, buyers are
likely to have different demand price than the value of the good produced,
a value based on more complete information. In other words, markets may
not provide enough information because, during a market transaction, it
may not be in the interest of one party to provide full information to the
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27 Asymmetric information can lead to poorly functioning markets, that is,
too much or too little of a good may be produced. Consumers may fear
purchasing goods when they know that the seller knows more about the
quality of a good than they do. The greater the information asymmetry
between sellers and consumers, the greater the scope for deception and
fraud.
A downward economic activities may be due to asymmetric information
between economic agents.
Asymmetric information leads to market inefficiencies and thus to market
failures. Thus, government has to take measures to improve the
information for consumers, investors and other market participant s.
INEQUALITY
Markets may also fail to limit the size of the gap between income earners,
the so called income gap. Market transactions reward consumers and
producers with incomes and profits, but these rewards may be
concentrated in the hands of a few. Th ere is nothing in the market
mechanism that guarantees an equitable distribution of income in the
society.
Market failure can also be caused by the existence of inequality
throughout the economy. Wide differences in income and wealth between
different gro ups within an economy lead to a wide gap in living standards
between wealthy households and those experiencing poverty. Society may
come to the view (a value judgment) that too much inequality is
unacceptable or undesirable.
MISSING MARKETS AND INCOMPLETE MARKETS
A market considered to be complete when it provides all goods and
services for which the cost of provision is less than what individuals are
willing to pay. Whenever private markets fail to provide a good or service
eventhough the cost of providin g it is less than what individuals are
willing to pay, they are considered as incomplete markets. Incomplete
markets are the cases of market failures.
Markets may fail to perform, resulting in a failure to meet a need or want,
such as the need for public goods, like defence, street lighting, and
highways. In the latter case (incomplete markets) markets may fail to
produce enough merit goods, such as education and healthcare.
A missing market is a situation where resource allocation based on a
competitive m arket does not exist. Missing markets are nothing but market
failures. Externalities, public goods, etc. are the cases of missing markets.

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28 MERIT GOODS
Merit Goods are those goods and services that the government feels that
people left to themselves will u nder-consume and which therefore ought to
be subsidized or provided free at the point of use.
Both the public and private sector of the economy can provide merit goods
and services. Consumption of merit goods is thought to generate positive
externality e ffects where the social benefit from consumption exceeds the
private benefit.
Example include; health services, education, work training, public
libraries, vaccinations.
UNSTABLE MARKETS
Sometimes markets become highly unstable, and a stable equilibrium m ay
not be established, such as with certain agricultural markets, foreign
exchange, and credit markets. Such volatility may require intervention.
DE-MERIT GOODS
Markets may also fail to control the manufacture and sale of goods like
cigarettes and alcohol , which have less merit that consumers perceive.
PROPERTY RIGHTS
Markets work most effectively when consumers and producers are granted
the right to own property, but in many cases property rights cannot easily
be allocated to certain resources. Failure t o assign property rights may
limit the ability of markets to form.
2.5 PUBLIC GOODS
A public good is a special type of good that can be consumed by
everyone, regardless of whether they have paid for the good. When goods
are available free of charge, howeve r, the market forces that normally
allocate resources in the economy are absent.
To understand how public goods differ from other goods and what
problems they present for society consider their characteristics;
(a) Non excludability : where it is not possible to provide a good or
service to one person without it thereby being available for others to
enjoy. A good is not excludable because it is impossible to prevent
someone from using the good or availing of its benefits.
(b) Non-rivalry : where the consumption of a good or service by one
person will not prevent others from enjoying it. A good is non rival in
consumption because one person’s enjoyment of the good/s does not
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Efficiency – Market - Government
29 Since the benefits of such goods are available to al l, consumers will not
voluntarily pay for those goods. This is the free-rider problem that
accompanies public goods. Since it is difficult to exclude anyone from
using them, those who benefit from the public goods have an incentive to
avoid paying for them . Hence, the market failure occurs in the provision of
public goods.
Common examples of public goods include street lighting/light house
protection, national and domestic security i.e. national defence and police
services, public health, flood defence syst ems, public parks and beaches,
public welfare programmes, education, roads, research and development,
and a clean environment. In each case consumption by one does not
impose an opportunity cost on others and non payers cannot be excluded
from consumption. In each case, markets fail to efficiently allocate the
production, consumption, or provision of the goods.
Markets will not supply public goods or if they supply they will not supply
enough of public goods. Since the markets fail in the above cases, publi c
goods provide a rationale for many government activities.
2.6 ROLE OF GOVERNMENT
The state or the government can play an important role to correct market
failures and improve economic efficiency. The presence of government
may reflect the political and social ideologies prevailing in the country.
More importantly, the prevalence of governments reflects the fact that the
market mechanism alone cannot perform all economic functions.
Government intervention is needed in the economy for the following
reasons :
(i) To improve economic efficiency by correcting market failures.
(ii) To pursue social values of equity by altering market outcomes.
(iii) To pursue other social objectives by the provision of public and
merit goods and at the same time prohibiting the consumption o f
demerit goods.
The role of the state or the government is explained below :
1. Securing conditions for the functioning of market mechanism : It is
argued that market mechanism leads to an efficient allocation of
resources, that is, it produces what consume rs want most and does so
in the cheapest way. This argument is based on the condition that there
is perfect competition in the factor and product markets. For this, there
must not be any obstacles to free entry into and exit from the market. It
also requir es that consumers and producers have complete knowledge
about the market. Government regulation and measures will be needed
to secure the conditions necessary for the functioning of market
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30 The government has an important role in correcting mark et failures
arising from imperfect information, imperfect competition,
externalities and public goods. In the case of imperfect competitions,
firms use their market power to raise prices and reduce output. The
Monopoly MRTP Act or Competition Policy Act of the government
of the India can help to maintain competitive force and restrain firms
from abusing their monopoly power. Similarly, imperfect information
can lead to inefficient functioning of product and labour markets.
Government can set up regulatory a uthorities such as SEBI (Securities
Exchange Board of India) to compel the firms to provide information
about their financial conditions and other aspects.
2. Providing legal framework : The contractual arrangements and
exchanges needed for market operation c annot exist without the
protection and enforcement of a governmentally provided legal
framework. In this respect, government can provide necessary legal
structure and ensure their implementation by the firms and other
parties in the market. In India regula tory authorities like SEBI provide
the legal framework.
3. Provision of public goods and merit goods :Even if the legal
structure is provided and barriers to competition are removed, the
production or consumption characteristics of certain goods like public
goods and merit goods are such that they cannot be provided through
the market. In the case of public goods there is the free rider problem.
As a consequence the market fails in the provision of public goods.
Thus, government has to ensure their provision. On the other hand
merit goods are the goods that the governments consider as good for
the people, for example education. If they are provided by the market
people may under consume such goods. Thus they have to be
subsidized or provided free by the governm ent.
4. Correcting the prob lems arising from externalities : Externalities
lead to “market failure”. This requires correction by the government
either by way of budgetary provisions, subsidies or taxation. In the
case of goods with positive externalities (li ke research), firms produce
too little of goods and in the case of goods with negative externalities
(such as that generate pollution), firms produce too much of goods.
Governments can subsidise the production of goods with positive
externalities and tax o r regulate those with negative externalities.
5. Correcting inequal distribution of income and wealth : The
distribution of income and wealth which results from the market
system and from the transfer of property rights through inheritance is
likely to be un equal, in the market system, individual’s incomes are
related to their ownership of assets and their productivity. In most of
the countries, wealth is concentrated in the hands of a few. In many
countries inequalities are linked to inheritance. Even in wag es and
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31 payment. The government has to work towards redistribution of
income from the rich to the poor through welfare programmes and
taxation policies.
6. Securing important social objectives : The market system does not
necessarily bring high employment, price level stability, social desired
rate of growth, poverty eradication and economic development.
Government policies are needed to secure these objectives.
7. Provision of social security : The market system cannot provide social
security to citizens, suffering from unemployment, sickness, old age
disability and so on. The government has to step in to provide social
security to its citizens.
8. Guiding the use of natural resources : Public and pri vate points of
view on discounts used in the valuation of future relative to present
consumption differ. The considerably affects the use of natural
resources. The market mechanism cannot bring about appropriate
allocation of natural resources for the pres ent and future. Similarly, the
market mechanism may not be able to control the pollution of
environment. Therefore, consumption of natural resources, pollution
control, etc. should be guided by government policies.
9. Public ownership : If the government fee ls that, under free market
conditions, some industries would charge unreasonably high price and
earn abnormal or monopoly profit, it could nationalize the industry and
provide goods and services at a desired price. Alternatively, the
government may apply r ules and regulations to force industries to
charge a reasonable price. Nationalisation of major commercial banks
in India in 1969 was aimed to meet the financial needs of the poor
section of the society at reasonable conditions and price (interest).
2.7 SUMM ARY
1. Economic efficiency is a state where every resource is allocated
optimally so that each person is served in the best possible way and
inefficiency and waste are minimized.
2. Productive efficiency is concerned with producing goods and services
with the optimal combination of inputs to produce maximum output
for the minimum cost.
3. A free market economy functions to maximize benefit or welfare of
both consumers and producers. One of the measures adopted by
economists or economic planners is the crit erion of sum of consumer
and producer surplus.
4. A market is defined “as a group of firms and individuals that are in
touch with each other in order to buy and sell some goods. munotes.in

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Business Economics
32 5. Market failure occurs when resources are misallocated, or allocated
ineffic iently. In other words, market failure occurs when markets fail
to produce and allocate scare resources in the most efficient way; i.e.
the market may not always allocate scarce resources efficiently in a
way that achieves the highest total social welfare.
6. Markets fail to perform efficiently due to a number of reasons such as
availability of public goods, business corporate acquiring monopoly
power in real world market which is full of imperfections, externalities
arising out of economic activities, imp erfect or asymmetric
information, unequal income distribution and many other factors.
7. A public good is a special type of good that can be consumed by
everyone, regardless of whether they have paid for the good. When
goods are available free of charge, h owever, the market forces that
normally allocate resources in the economy are absent.
8. The state or the government can play an important role to correct
market failures and improve economic efficiency. The presence /
intervention of government may reflec t the political and social
ideologies prevailing in the country. More importantly, the prevalence
of governments reflects the fact that the market mechanism alone
cannot perform all economic functions.
2.8 QUESTIONS
1. Explain the term Market failure and write down different causes of
market failure?
2. Define and write short note on productive and allocative efficiency?
3. What are public goods? Explain using examples.
4. Explain the role of government in correcting Market failure





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33 Module II
3
PUBLIC REVENUE
Unit Structure
3.0 Objectives
3.1 Introduction
3.2 Meaning of Public Revenue
3.3 Sources of Public Revenue
3.4 Canons of Taxation
3.5 Characteristics of a Good Tax Structure / System
3.6 Direct Taxes : Meaning
3.7 Indirect Taxe s : Meaning
3.8 Objectives of Taxation
3.9 Tax Base and Rates of Taxation
3.10 Summary
3.11 Questions
3.0 OBJECTIVES
 To understand the meaning and sources of Public Revenue
 To study various objectives of taxation
 To study the canons of taxation
 To understand the ty pes of taxes
 To understand the concepts of tax base and rates of taxation
3.1 INTRODUCTION
The study of public finance is the deep study of all finance operations
related to the state which is therefore concerned with complete income and
expenditure of public authorities and administrative structures that are
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34 Public finance is a concept that includes Public expenditure, public debt
and public revenue and income.
Public revenue is exactly income generated from sources of governmen t in
order to meet requirements of expenses of public.
3.2 MEANING OF PUBLIC REVENUE
Public revenue generally refers to government revenue. Some important
sources or concepts that are included in public revenue consist of taxes,
fees, sale of public goods and services, fines, donations, etc.
Public revenue refers to the income side of the financial operations of the
state. It is the revenue or income of public authorities namely central,
State, Local bodies etc.
According to Dalton, public revenue can be vi ewed from a broad as well
as a narrow sense. He therefore, makes a distinction between public
revenue and public receipts. In a broad sense, the income of public
authorities includes all receipts from all possible sources during a specific
period, normally a year. It is called public receipts.
In a narrow sense, it refers only to those sources which bring income to
the government. These sources are known as revenue sources and include
only the non-tax sources of public revenue.
3.3 SOURCES OF PUBLIC REVENUE
The main sources of public revenue are: Tax and Non-tax revenue
1. Tax Revenue:
The chief source of public revenue is Tax. To define tax, it is said that tax
is a mandatory imposition of duty on public authority by government
organizations to meet requiremen ts of general public as a whole.
Therefore, with the above defined term, some points are highlighted as
below:
i) A Tax is a compulsory duty levied by the government. If any
individual refuses to comply with tax payments, he can be punished or
penalized
ii) Tax b asically involves some understanding and sacrifice on the basis
of a tax payer
iii) Tax is a duty and not a penalty
iv) Most part of revenue income is generated from tax by the central
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35 Broad classification of taxes is: Direct and Indirect Taxes Direct taxes:
Direct taxes are levied on wealth and income of individuals or
organizations. These taxes are personal income tax, corporate tax, and gift
or wealth tax. The impact of direct taxes is on the same person.
Direct taxes are developing in nature and the tax rate increases along with
the tax base. Progressive direct taxes are involved in falling income
discrimination especially in rising countries.
Indirect Taxes:
These taxes are levied on manufactured goods and consumable goods in
India. Excise duty is the chief and single largest source to generate
revenue income.
Rates of excise duty faces a declining trend.
Customs Duty is imposed on exports of selective range and imports. With
revenue point of view, Custom duty has less importance. Service Tax is
impos ed by specific category of firms, agencies or persons. Rate of service
taxes have been increased progressively. Goods and service tax includes
range of all taxes like excise duty, service tax, goods tax, VAT, etc. It
covers goods and service charges in mos tly all sectors. It generally
simplifies the complexity of charges on good and services
2. Non tax revenues
Non Tax Revenue comprises all revenues apart from taxes accumulated to
the Government. Non tax revenues are funds that are generated from
internal sources.
The sources of revenue are: Administrative revenue , Commercial revenue ,
Grants and gifts
Important sources of Non tax revenues include
a) Special Assessment:
This can be called as betterment charge. This tax is imposed to a certain
category of members of a community who are generally benefited from
governmental activities or public functions like constructions of road,
railways, parks, etc. Therefore, government imposes special charges on
such properties.
b) Surplus of Public Enterprises
The government has a rranged public sector enterprises that are concerned
in commercial activities. The surpluses generated of these enterprises are a
significant source of non-tax revenue. These incomes are in the form of
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36 c) Fees:
A fee is a significant source of managerial non -tax revenue charged by
Government authorities for depiction services to the members of the
public. There is no compulsion to pay fees. All those utilize services may
pay fees. Fees may be charged for getting licenses, passports or
registrations, filing of court cases, etc.
d) Fine and Penalties
These are general sources of administrative non tax revenues. These may
be applied on public for non compliance with certain rules and
regulations. These are not considered as the major source of revenue for
the government.
e) Grants and Gifts
Grants are financial support. These are provided to public authority to
perform certain social activities. These are generated by higher public
authority to lower ones
e.g. World bank giv es grants to State bank. There is no repayment
compulsion. Gifts and donations are voluntarily made by individuals,
organizations or foreign governments to the Central Government. These
gifts are made by natural feeling in case of disasters or natural cala mities.
Gifts are not considered as a source of income. Therefore, tax plays an
important part in generating government revenue. Non tax is important in
developing revenue.
3.4 CANONS OF TAXATION
Canons of Taxation are the main basic principles (i.e. rules ) set to build a
'Good Tax System'. Canons of Taxation were first originally laid down by
economist Adam Smith in his famous book "The Wealth of Nations".
In this book, Adam smith only gave four canons of taxation. These
original four canons are now known as the "Original or Main Canons of
Taxation".
As the time changed, governance expanded and became much more
complex than what it was at the Adam Smith's time. Soon a need was felt
by modern economists to expand Smith's principles of taxation and as a
respo nse they put forward some additional modern canons of taxation.
Adam Smith's Four Main Canons of Taxation Ļ
A good tax system is one which is designed on the basis of an
appropriate set of principles (rules). The tax system should strike a
balance between the interest of the taxpayer and that of tax authorities.
Adam Smith was the first economist to develop a list of Canons of
Taxation. These canons are still regarded as characteristics or features of a
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37 Adam Smith gave following four import ant canons of taxation.
1. Canon of Equity
The principle aims at providing economic and social justice to the
people. According to this principle, every person should pay to the
government depending upon his ability to pay. The rich class people
should pay hi gher taxes to the government, because without the protection
of the government authorities (Police, Defence, etc.) they could not have
earned and enjoyed their income. Adam Smith argued that the taxes
should be proportional to income, i.e., citizens should pay the taxes in
proportion to the revenue which they respectively enjoy under the
protection of the state .
2. Canon of Certainty
According to Adam Smith, the tax which an individual has to pay should
be certain, not arbitrary. The tax payer should know in advance how much
tax he has to pay, at what time he has to pay the tax, and in what form
the tax is to be paid to the government. In other words, every tax should
satisfy the canon of certainty. At the same time a good tax system also
ensures that the gover nment is also certain about the amount that will be
collected by way of tax.
3. Canon of Convenience
The mode and timing of tax payment should be as far as possible,
convenient to the tax payers. For example, land revenue is collected at
time of harvest incom e tax is deducted at source. Convenient tax system
will encourage people to pay tax and will increase tax revenue.
4. Canon of Economy
This principle states that there should be economy in tax administration.
The cost of tax collection should be lower than th e amount of tax
collected. It may not serve any purpose, if the taxes imposed are
widespread but are difficult to administer. Therefore, it would make no
sense to impose certain taxes, if it is difficult to administer.
Additional Canons of Taxation Ļ
Activities and functions of the government have increased significantly
since Adam Smith's time. Government are expected to maintain economic
stability, full employment, reduce income inequality & promote growth
and development. Tax system should be such that it meets the
requirements of growing state activities.
Accordingly, modern economists gave following additional canons of
taxation.
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38 5. Canon of Productivity
It is also known as the canon of fiscal adequacy. According to this
principle, the tax system s hould be able to yield enough revenue for the
treasury and the government should have no need to resort to deficit
financing. This is a good principle to follow in a developing economy.
6. Canon of Elasticity
According to this canon, every tax imposed by the government should be
elastic in nature. In other words, the income from tax should be capable
of increasing or decreasing according to the requirement of the country.
For example, if the government needs more income at time of crisis, the
tax should be cap able of yielding more income through increase in its rate.
7. Canon of Flexibility
It should be easily possible for the authorities to revise the tax structure
both with respect to its coverage and rates, to suit the changing
requirements of the economy. With changing time and conditions the tax
system needs to be changed without much difficulty. The tax system must
be flexible and not rigid.
8. Canon of Simplicity
The tax system should not be complicated. That makes it difficult to
understand and administer and results in problems of interpretation
and disputes. In India, the efforts of the government in recent years have
been to make the system simple.
9. Canon of Diversity
This principle states that the government should collect taxes from
different sources rather than concentrating on a single source of tax. It is
not advisable for the government to depend upon a single source of tax, it
may result in inequity to the certain section of the society; uncertainty for
the government to raise funds. If the tax revenue comes from diversified
source, then any reduction in tax revenue on account of any one cause is
bound to be small.
3.5 CHARACTERISTICS OF A GOOD TAX STRUCTURE
/ SYSTEM
The tax structure is a part of economic organisation of a society and
therefore fit in i ts overall economic environment. No tax system that does
not satisfy these basic condition can be termed a good one. However, the
state should pursue mainly following principles in structuring its tax
system :-
1. The distribution of tax burden should be equitable. Everyone should be
made to pay as per their ability. It collects more from richer section
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39 2. The tax system should encourage productive efficiency. It should
provide incentive to increase savings and investment. It may lead to
favourable allocation of resources.
3. A tax system should be diversified. It may rely on different bases,
such as , income, wealth and expenditure.
4. The primary aim of the tax should be to raise adequate revenue to meet
public expenditure since the moder n government performs various
functions in the economy.
5. The tax system should be flexible to change with changing
requirements of the government and the economy.
6. A good tax system should recognize the basic rights of the tax payer,
and therefore, it should be simple, certain and convenient.
7. The tax system should be economical. Administrative machinery
should be efficient and honest. It should involve minimum cost of
collection.
8. A good tax system should also facilitate stability and growth
objectives. Growth with stability is an important objective for both
developed and developing countries.
In general a good tax system should run in harmony with important
national objectives and if possible should assist the society in achieving
them. Thus, the good tax sys tem should be designed so as to meet the
requirements of equity in the distribution of tax burden, efficiency in the
tax use, goals of macroeconomic policy and ease of administration.
Direct and Indirect Taxes
With the budget session around the corner, the re is lot of noise about
taxes. Taxes don’t just mean your income -tax; there are many other
forms of tax that an individual pays without directly seeing the hit. While
income -tax is a direct tax, the latter are called indirect taxes. Here’s a look
at what the two categories cover and how they impact you.
3.6 DIRECT TAXES : MEANING
A direct tax is one, which is paid by a person on whom it is legally
imposed and the burden of which cannot be shifted to any other person.
The person from whom it is collected ca nnot shift its burden to anybody
else. The tax-payer is the tax-bearer. The impact i.e. the initial burden
and its incidence i.e. the ultimate burden of direct tax is on the same
person. For e.g. Income tax, wealth tax, property tax, estate duties, capital
gain tax, corporate / company tax, etc. are all direct taxes.
This kind of levy is payable directly by the individual or company, whose
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40 common form of direct tax is income -tax, whic h has to be paid by
individuals, hindu undivided families (HUFs), cooperative societies and
trusts on the total income they earn. This can include income from salary,
income from house property, business and professional income, capital
gains and income from other sources such as interest. The tax liability
depends on the residential status and gender of the person being taxed.
Companies are also taxed on the income they earn. For Indian companies,
tax is obligatory on income earned in India and overseas, w hereas in case
of non -resident companies tax has to be paid on money earned in India.
A house owner has to pay property tax, which is applied as per state rules.
Lastly, if you receive a gift in excess of Rs.50,000 per year, you will have
to pay gift tax.
The onus of declaring income for the purpose of calculating direct tax
liability is on you. Non -payment or tax evasion can incur heavy penalty.
Advantages / Merits of Direct Taxes :
Following are the important advantages or merits of Direct Taxes :-
1. Equity
There is social justice in the allocation of tax burden in case of direct
taxes as they are based on the principle of ability to pay. Persons in a
similar economic situation are taxed at the same rate. Persons with
different economic standing are taxed at a different rate. Hence, there is
both horizontal and vertical equity under direct taxation. Progressive direct
taxation can reduce income inequalities and bring about adequate social &
economic justice.
For example, in the Indian Budget of 2007, individu al with an income of
up to Rs. 1,10,000 are exempted from payment of income tax and in the
case of women tax payer, the exemption limit is Rs. 1,45,000.
2. Certainty
As far as direct taxes are concerned, the tax payer is certain as to how
much he is expected to pay, as the tax rates are decided in advance. The
Government can also estimate the tax revenue from direct taxes with a
fair accuracy. Accordingly, the Government can make adjustments in its
income and expenditure.
3. Relatively Elastic
The direct taxes ar e relatively elastic. With an increase in income and
wealth of individuals and companies, the yield from direct taxes will
also increase. Elasticity also implies that the government's revenue can
be increased by raising the rates of taxation. An increase in tax rates
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41 4. Creates Public Consciousness
They have educative value. In the case of direct taxes, the taxpayers are
made to feel directly the burden of taxes and hence take keen interest in
how public funds are spent. The tax payers are likely to be more aware
about their rights and responsibilities as citizens of the state.
5. Economical
Direct taxes are generally economical to collect. For instances, in the case
of personal income tax, the tax can be deducted at source from the income
or salaries of the individuals. Therefore, the government does not have to
spend much in tax collection as far as personal income tax is concerned.
However, in the case of indirect taxes, the government has to set up an
elaborate machinery to collec t taxes.
6. Anti-inflationary
The direct taxes can help to control inflation. During inflationary periods,
the government may increase the tax rate. With an increase in tax rate, the
consumption demand may decline, which in turn may reduce inflation.
is advan tages / Demerits of Direct Taxes
Though direct taxes possess above mentioned merits, the economist have
criticised them on the following grounds :-
1. Tax Evasion
In India, there is good amount of tax evasion. The tax evasion is due to
High tax rates, Documen tation and formalities, Poor and corrupt tax
administration. It is easier for the businessmen to evade direct taxes. They
invariable suppress correct information about their incomes by
manipulating their accounts and evade tax on it.
In less developed coun tries like India, due to high rate of progressive tax
evasion & avoidance are extensive and led to rise in black money.
2. Arbitrary Rates
The direct taxes tend to be arbitrary. Critics point out that there cannot be
any objective basis for determining tax ra tes of direct taxes. Also, the
exemption limits in the case of personal income tax, wealth tax, etc., are
determined in an arbitrary manner. A precise degree of progression in
taxation is also difficult to achieve. Therefore direct taxes may not always
fulfill the canon of equity.
3. Inconvenient
Direct taxes are inconvenient in the sense that they involve several
procedures and formalities in filing of returns. For most people payment
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42 When people are required to pay a sizeable part of their income as a tax to
the state, they feel very much hurt and their propensity to evade tax
remains high. Further every one who is required to pay a direct tax has to
furnish appropriate evidence in supp ort of the statement of his income &
wealth & for this he has to maintain his accounts in proper form. Direct
tax is considered inconvenient by some people because they have to make
few lump sum payments to the governments, whereas their income
receipts are distributed over the whole year.
4. Narrow Coverage
In India, there is a narrow coverage of direct taxes. It is estimated that
only three percent of the population pay personal income tax. Due to low
coverage, the government does not get enough funds for pu blic
expenditure. Estate duty & wealth tax are equally narrow based and thus
revenue proceeds from these taxes are invariably small.
5. Affects Capital Formation
The direct taxes can affect savings and investment. Due to taxes, the net
income of the people gets reduced. This in turn reduces savings.
Reduction in savings results in low investment. The low investment
affects capital formation in the country.
6. Effect on Willingness and Ability to Work
Highly progressive direct taxes reduce people's ability and willingness to
work and save. This in turn may have a negative impact on investment
and productive capacity in the economy. If tax burden is high, people's
consumption level gets adversely affected and this has an impact on their
ability to work and save. High taxes also discourage people from working
harder in order to earn and save more.
7. Sectoral Imbalance
In India, there is Sectoral imbalance as far as direct taxes are
concerned. Certain sectors like the corporate sector is heavily taxed,
whereas, the agric ulture sector is 100% tax free. Even the large rich
farmers are exempted from payment of personal income tax.
Conclusion on Direct Taxes
In direct tax burden of tax cannot be shifted. The disadvantage of direct
taxation are mainly due to administrative difficulties and inefficiencies.
The extent of direct taxation should depend on the economic state of the
country. A rich country has greater scope for direct taxation than a poor
country. However direct taxation is an important aspect of the modern
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43 3.7 INDIRECT TAXES : MEANING
Indirect tax is levied by the government and collected by an intermediary
from the person who bears the ultimate economic burden of the tax. What
this means is that if you are purchasing goods or services from anywh ere
and you are the final consumer, then the tax levied on the manufacturer
will ultimately get passed on to you. This kind of tax increases the total
amount you pay for something. Sometimes it may be represented
separately from the price of the item or ma y be shown together with the
cost of the product itself. For example, the service tax paid on a food bill
is shown separately, but tax paid on fuel is included in the product price.
An indirect tax is one in which the burden can be shifted to others. The tax
payer is not the tax bearer. The impact and incidence of indirect taxes are
on different persons. An indirect tax is levied on and collected from a
person who manages to pass it on to some other person or persons on
whom the real burden of tax falls. Fo r e.g. commodity taxes or sales tax,
excise duty, custom duties, etc. are indirect taxes.
There are many forms of indirect taxes. Customs duty is a tax levied on
items imported (and exported out of) into India. The central government
also charges an excise duty or a tax payable on goods manufactured in
India for domestic consumption. Service tax is a charge applied on
services such as food and beverage, travel and recreation by the provider,
while value -added tax is applied at each stage of sale of a produc t and the
final tax is borne by the last consumer. Lastly, there is securities
transaction tax levied on all transactions done on a stock exchange.
The reason why these are called indirect taxes is because unlike direct
taxes, the person paying the tax to the government can pass it on to
another person. They are charged first at the manufacturers’ level, but
ultimately get passed on to the consumer, which is you.
Hicks classifies direct & indirect taxes on the basis of administrative
arrangements. In case o f direct tax -there is a direct relationship between
the taxpayer and the revenue authorities. A tax collecting agency
directly collects the tax from the taxpayers, whereas in case of indirect
taxes there is no direct relationship between the taxpayers and the revenue
authorities. They are collected through traders and manufacturers.
Over the years the share of indirect tax has declined in India due to
reduction in the rates of indirect taxes.
Advantages / Merits of Indirect Taxes Ļ
The merits of indirect taxes are briefly explained as follows :-
1. Convenient
Indirect taxes are imposed on production, sale and movements of goods
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44 their burden may be shifted to co nsumers of goods and services who are
the final taxpayers. Such taxes, in the form of higher prices, are paid
only on purchase of a commodity or the enjoyment of a service. So
taxpayers do not feel the burden of these taxes. Besides, money burden of
indire ct taxes is not completely felt since the tax amount is actually
hidden in the price of the commodity bought. They are also convenient
because generally they are paid in small amounts and at intervals and are
not in one lump sum. They are convenient from t he point of view of the
government also, since the tax amount is collected generally as a lump sum
from manufacturers or traders.
2. Difficult to evade
Indirect taxes have in built safeguards against tax evasion. The indirect
taxes are paid by customers, and the sellers have to collect it and remit it
to the Government. In the case of many products, the selling price is
inclusive of indirect taxes. Therefore, the customer has no option to evade
the indirect taxes.
3. Wide Coverage
Unlike direct taxes, the indirec t taxes have a wide coverage. Majority of
the products or services are subject to indirect taxes. The consumers or
users of such products and services have to pay them.
4. Elastic
Some of the indirect taxes are elastic in nature. When government feels it
necessary to increase its revenues, it increases these taxes. In times of
prosperity indirect taxes produce huge revenues to the government.
5. Universality
Indirect taxes are paid by all classes of people and so they are broad
based. Poor people may be out of th e net of the income tax, but they pay
indirect taxes while buying goods.
6. Influence on Pattern of Production
By imposing taxes on certain commodities or sectors, the government can
achieve better allocation of resources. For e.g. By Imposing taxes on
luxury goods and making them more expensive, government can divert
resources from these sectors to sector producing necessary goods.
7. May not affect motivation to work and save
The indirect taxes may not affect the motivation to work and to save.
Since, most of t he indirect taxes are not progressive in nature, individuals
may not mind to pay them. In other words, indirect taxes are generally
regressive in nature. Therefore, individuals would not be demotivated to
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45 8. Social Welfare
The indirect taxes promote social welfare. The amount collected by way
of taxes is utilized by the government for social welfare activities,
including education, health and family welfare.
Secondly, very high taxes are imposed on the consumpt ion of harmful
products such as alcoholic products, tobacco products, and such other
products. So it is not only to check their consumption but also enables the
state to collect substantial revenue in this manner.
9. Flexibility and Buoyancy
The indirect taxes are more flexible and buoyant. Flexibility is the
ability of the tax system to generate proportionately higher tax revenue
with a change in tax base, and buoyancy is a wider concept, as it involves
the ability of the tax system to generate proportionatel y higher tax revenue
with a change in tax base, as well as tax rates.
Disadvantages / Demerits of Indirect Taxes
Although indirect taxes have become quite popular in both developed
&Under developed countries alike, they suffer from various demerits, of
which the following are important.
1. High Cost of Collection
Indirect tax fails to satisfy the principle of economy. The government has
to set up elaborate machinery to administer indirect taxes. Therefore,
cost of tax collection per unit of revenue raised is generally higher in the
case of most of the indirect taxes.
2. Increase income inequalities
Generally, the indirect taxes are regressive in nature. The rich and the
poor have to pay the same rate of indirect taxes on certain commodities of
mass consumption. This may further increase income disparities among
the rich and the poor.
3. Affects Consumption
Indirect taxes affects consumption of certain products. For instance, a high
rate of duty on certain products such as consumer durables may restrict the
use of such products. Consumers belonging to the middle class group may
delay their purchases, or they may not buy at all. The reduction in
consumption affects the investment and production activities, which in
turn hampers economic growth.
4. Lack of Social Consciousne ss
Indirect taxes do not create any social consciousness as the taxpayers do
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46 5. Uncertainty
Indirect taxes are often rather uncertain. Taxes on commodities with
elastic demand are particularly uncertain, since quanti ty demanded will
greatly affect as prices go up due to the imposition of tax. In fact a higher
rate of tax on a particular commodity may not bring in more revenue.
6. Inflationary
The indirect taxes are inflationary in nature. The tax charged on goods and
services increase their prices. Therefore, to reduce inflationary pressure,
the government may reduce the tax rates, especially, on essential items.
7. Possibility of tax evasion
There is a possibility of evasion of indirect taxes as some customers may
not pay i ndirect taxes with the support of sellers. For instance,
individuals may purchase items without a bill, and therefore, may not pay
Sales tax or VAT (Value Added Tax), or may obtain the services
without a bill, and therefore, may evade the service tax.
Conc lusion on Indirect taxes:
Elaborate analysis of merits and demerits of direct and indirect taxes
makes it clear that whereas the direct taxes are generally progressive, and
the nature of most indirect taxes is regressive. The scope of raising
revenue throu gh direct taxation is however limited and there is no escape
from indirect taxation in spite of attendant problems. There is common
agreement amongst economists that direct & indirect taxes are
complementary and therefore in any rational tax structure both types of
taxes must find a place.
3.8 OBJECTIVES OF TAXATION
The first and the foremost objective of taxation is to raise revenue so as to
meet huge public expenditure. Most of the governmental activities are
financed by taxation. Taxation policy has some non -revenue objectives
also. In the modern economies, taxation is used as an instrument of
economic policy. It affects overall economic activities such as total
volume of production, consumption, investment, balance of payments,
income distribution etc.
1. Economic Development: It is one of the important objectives of
taxation. Economic development of any country is largely depend on the
growth of capital formation and most of the developing and
underdeveloped countries suffer from the shortage of capital. For rapid
economic development a rapid capital accumulation is required. With
proper taxation policy and planning, raising the existing rate of taxes or by
imposing new taxes may lead to increase in revenue for capital formation.
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47 tax policy has to be employed in such a way that investment occurs in the
productive sectors of the economy, including the infrastructural sectors.
2. Full Employment : Economic development with full employmen t of
resources is the second objective. To achieve this objective the rates of
taxes must be reduced so as to increase level of employment through
effective demand. It stimulates further investment which in turn results in
rise in income and employment thr ough the multiplier mechanism.
3. Price Stability : Thirdly, an effective tax policy ensures price stability
in an economy by controlling inflation. Increase in direct taxes help to
control private spending so that prices of the commodities remains stable.
Increase in indirect taxes on commodities may lead to inflationary
tendencies. To maintain price stability with effective use of taxes is
therefore necessary for smooth economic development of the country.
4. Control of Cyclical Fluctuations : Fourthly, to control cyclical /
periodic fluctuations occurred due to trade cycles is another objective of
taxation policy. Generally during depression, taxes are cut down to
motivate demand and investment while during boom taxes are increased
so that cyclical fluctuat ions are tamed.
5. Reduction of BOP Difficulties : Indirect taxes like custom duties are
used to control imports of certain goods with the objective of reducing the
burden of balance of payments and to encourage domestic production of
import substitutes.
6. Non -Revenue Objective : One of the important non -revenue objective
of taxation is the reduction of inequalities in income and wealth
distribution. It can be done by taxing the rich at higher rate than the poor
through the system of progressive taxation.
3.9 TAX BASE AND RATES OF TAXATION
Tax base can be defined as the total amount of assets or revenue on which
the government can levy a tax. For example, in the case of income tax, the
tax base is all the income earned by the people. In the case of property
taxes, the tax base is the total value of the property, which changes hands
in a given period of time. Therefore, the tax base is the number to which a
percentage rate is applied to reach the actual amount of the tax that needs
to be paid. For example, if a 30% tax has to be applied to Rs.100000/ -
income, then the Rs.100000/ - is the tax base.
There are different types of taxes that have many different types of tax
bases.
3.9.1 Types of Tax Bases:
1. Value -Based: It is the most commonly used type of tax base. It is used
in taxes, such as income tax and sales tax. If the value of the tax base
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48 the salary of a person increases from Rs.100000/ - to Rs.200000/ - and if
the tax base remains the same, then the amount of tax collected will also
increase. Such kind of tax base is also referred to as ad -valorem.
2. Quantity Based: There are certain other types of taxes, such as excise,
where taxes are levied on per unit of goods produced. Hence, if 100 units
are produced at Rs.10/ - or 100 units are produced at Rs.20/ -, the tax will
remain the same since the base is the number of units, which is
100.Therefore, rising inflation will not have any effect on taxes in such
cases.
3. Market -Based: The true value of many goods and services are
difficult to determine. Therefore, in the case of property taxes, people tend
to show a lower value to the government as compared to the value at
which the transaction has actually taken place. In such cases, to protect the
interest of the people the government decides the circle rates which are
used to derive the tax base instead of the market price. This is because the
market price is subject to manipulation.
4. Broad -Based: It is the one that applies to a lot of items such as sales
tax or excise. Therefore, computing these tax bases is quite complex or
difficult. Such type of broad based taxes will not discriminate between
different forms of activities.
5. Narrow Based: Unlike broad based taxes these taxes are one which
applies on ly to a few items such as housing. Therefore determining and
managing their tax base is relatively easy. Necessary items such as food
are excluded from the tax base in order to make the tax less regressive.
3.9.2 Rates of taxation
The tax structure of an e conomy depends on its tax base, tax rate, and how
the tax rate varies accordingly. The tax base is the amount to which a tax
rate is applied. The tax rate is the percentage of the tax base that must be
paid in taxes. To calculate taxes, it is necessary to know the tax base and
the tax rate. If the tax base equals Rs.100/ - and the tax rate is 9%, then the
tax will be Rs.9 (=100 × 0.09).
1. Proportional taxes : Also known as flat rate taxes. The same tax rate is
applied to any income level, or for any size t ax base. For e.g. Mr. X earns
Rs.50,000/ - and Mr. Y earns Rs.100,000/ - and the tax rate is 10%, then
Mr. X will have to pay Rs.5,000/ - while Mr. Y will have to pay
Rs.10,000/ - towards taxes. In many countries almost all sales taxes, social
security and med icare taxes are proportional taxes.
2. Regressive taxes : A regressive tax is higher for lower income groups.
Regressive taxes especially hurt the poor. The inequitable effects of
regressive or proportional taxes are often mitigated by payments to the
poor and by exempting essential products and services, such as food, from
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49 3. Progressive taxes : In case of progressive taxes a higher tax rate is
applied to higher income groups. For e.g. if the tax rate on Rs.50,000/ - is
10% and 20% for Rs.100,000/ -, then, continuing the above example, Mr.
X still will have to pay Rs.5,000/ - while Mr. Y must pay Rs.20,000/ -
towards taxes. However, almost all progressive taxes are structured as
a marginal tax , meaning that the progressive tax rate only applies to that
part of the income exceeding a certain amount. The portion of the tax base
subject to a particular tax rate is known as a tax bracket which always has
a lower and upper limit, except for the top tax bracket, which has no upper
limit.
3.10 SUMMARY
1. Public revenue refers to the income side of the financial operations of
the state. It is the revenue or income of public authorities namely
central, State, Local bodies etc.
2. The main sources of public revenue are: Tax and Non-tax revenu e
3. The chief source of public revenue is Tax. To define tax, it is said that
tax is a mandatory imposition of duty on public authority by
government organizations to meet requirements of general public as
a whole. Broad classification of taxes is: Direct and Indirect Taxes
Direct taxes
4. Non Tax Revenue comprises all revenues apart from taxes accumulated
to the Government. Non tax revenues are funds that are generated
from internal sources.
5. Canons of Taxation are the main basic principles (i.e. rules) set to build
a 'Good Tax System'. Canons of Taxation were first originally laid
down by economist Adam Smith in his famous book "The Wealth of
Nations".
6. In general a good tax system should run in harmony with important
national objectives and if possib le should assist the society in
achieving them. Thus, the good tax system should be designed so as to
meet the requirements of equity in the distribution of tax burden,
efficiency in the tax use, goals of macroeconomic policy and ease of
administration.
7. A direct tax is one, which is paid by a person on whom it is legally
imposed and the burden of which cannot be shifted to any other
person. The person from whom it is collected cannot shift its burden to
anybody else. The tax-payer is the tax-bearer. The impact i.e. the
initial burden and its incidence i.e. the ultimate burden of direct tax is
on the same person. For e.g. Income tax, wealth tax, property tax,
estate duties, capital gain tax, corporate / company tax, etc. are all
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50 8. An indirec t tax is one in which the burden can be shifted to others. The
tax payer is not the tax bearer. The impact and incidence of indirect
taxes are on different persons. An indirect tax is levied on and
collected from a person who manages to pass it on to some other
person or persons on whom the real burden of tax falls. For e.g.
commodity taxes or sales tax, excise duty, custom duties, etc. are
indirect taxes.
9. Most of the governmental activities are financed by taxation. Taxation
policy has some non -revenue objectives also. In the modern
economies, taxation is used as an instrument of economic policy. It
affects overall economic activities such as total volume of production,
consumption, investment, balance of payments, income distribution
etc.
10. Tax base c an be defined as the total amount of assets or revenue on
which the government can levy a tax. For example, in the case of
income tax, the tax base is all the income earned by the people. In the
case of property taxes, the tax base is the total value of th e property,
which changes hands in a given period of time. Therefore, the tax base
is the number to which a percentage rate is applied to reach the actual
amount of the tax that needs to be paid.
11. The tax structure of an economy depends on its tax base, tax rate, and
how the tax rate varies accordingly. The tax base is the amount to
which a tax rate is applied. The tax rate is the percentage of the tax
base that must be paid in taxes.
3.11 QUESTIONS
1. Explain the meaning and sources of public revenue.
2. Di fferentiate between tax and non -tax revenue.
3. Discuss Adam Smith’s Canons of taxation.
4. What are the characteristics of a good tax system?
5. Discuss the merits and demerits of direct taxes.
6. Explain the advantages and disadvantages of indirect taxes .
7. What are the objectives of imposition of taxes?
8. Explain the meaning and types of tax base.
9. Explain how tax rates are applied.

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51 4
SHIFTING OF TAX BURDEN
Unit Structure
4.0 Objectives
4.1 Introduction
4.2 Impact, Shifting and Incidence of Tax
4.3 Economic Effects of Taxation
4.4 Introduction: Redistributive and Anti -Inflationary Nature of Taxation
4.5 Summary
4.6 Questions
4.0 OBJE CTIVES
 To study the meaning of Shifting of Tax Burden and impact and
incidence of taxation
 To understand various economic effects of taxation
 To understand the concepts of redistributive and anti -inflationary
nature of taxation and their implications
4.1 INTRO DUCTION
 SHIFTING OF TAX BURDEN
Incidence if taxation has got a relevance so far as the effects of taxation
are concerned. Public finance operations are likely to produce various
effects on the level and pattern of economic activity in country. The
systems of public finance becomes acceptable to the people when public
authorities try their utmost to promote and maximise the favourable
effects and to check and minimise the adverse effects of Governmental
budgetary operations.
As per Dr. Dalton taxation pro duces various effects which are as follows: -
1) Effect of taxation on production.
a) Effects of taxation on worker’s ability and willingness to work
b) Effect of taxation on people’s ability and willingness to save.
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52 d) Effect of taxation on resource allocation.
e) Effect of taxation investment.
2) Effect of taxation on distribution of income and wealth.
Effect of proportional, Progressive and regressive taxation on the
distribution of income and wealth
3) Other effects of taxation on employment, structure of industry.
Tendency towards tax etc.
Besides these real effects of taxation there is also a monetary effect of
taxation which is called as incidence of taxation.
Concept : -
The co ncept of incidence of tax is about the answer to the question
as to who bears the ultimate money burden of a tax? When government
imposes a tax on a person, it is quite possible that he may try to shift it to
another person due to the human tendency.
When a person is taxed he may try to shift it to another person say B. If he
succeeds in shifting it to Mr. B, then ultimately Mr. B will bear the money
burden of a tax levied by the government on A. i.e. Mr. A recovers the tax
amount from Mr. B and pays it the Government. Thus incidence of tax
refers to the ultimate money burden of a tax. It also means the final resting
point of a tax.
4.2 IMPACT, SHIFTING AND INCIDENCE OF TAX
These are the interrelated terms which are related to imposition, transfer
and settle ment of tax. Initially it is the impact that occurs first and
incidence is the end result. In between these two lies the phenomenon of
shifting of tax.
The impact of tax is defined as the initial, immediate and legal money
burden of a tax which falls on a person on whom the tax is levied. The
very intention of the government is that the man on whom the tax is levied
should pay the tax. The person who is liable to pay the tax to the
Government bears its impact. Impact of a tax is called immediate money
burde n of a tax because the moment tax gets imposed on him, he stands
immediately to make the payment of the tax to Government. It is also
called as initial money burden of tax because the movement a tax levied
upon a person the initial money burden falls upon him though he may
succeed later in shifting the tax to some other person. It is also called as a
legal money burden of a tax because legally he is held responsible to bear
the burden of a tax though he may pass it on to some other person. Legally
he is to pay the tax to the Government.
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53 4.2.1 SHIFTING OF A TAX
Shifting is defined as a process of transfer of money burden of tax from
one person to another person. Shifting of tax takes place only in case of
indirect taxes. The indirect taxes which are also kno wn as commodity
taxes like excise duty, sales tax, custom duty, etc. which can only be
shifted to the third party. The direct taxes like income tax, wealth tax etc.
cannot be shifted. It is because in case of direct taxes the impact and the
incidence fall on the same person. Hence the direct taxes do not involve
the problem of shifting. The problem if shifting arises only in case of
indirect taxes because the impact of tax is on the person on whom the tax
is levied and the incidence is ultimately borne by t he actual user of a
commodity. The tax is shifted through the vehicle of price. When a tax
imposed the price of a commodity rises because the tax gets mixed up
with the price. So a consumer has to pay the gross price i.e. the price plus
tax. However the ta x may be shifted without raising the price also
specifically in case of backward shifting.
The shifting is of two types viz.
i) Forward shifting and
ii) Backward shifting.

The forward shifting of a tax and the backward shifting of a tax depend
upon the circumst ances.
A forward shifting is one in which the tax is shifted forwardly to the
ultimate users of a commodity through price i.e. the tax gets mixed up
with price and the ultimate user of a commodity has to pay a gross price.
So in case of forward shifting of tax prices is used as a vehicle of tax
shifting.
A backward shifting is one in which the tax is shifted backwardly
to the grower of the raw materials. For example when an excise duty is
levied on a sugar producer. A sugar procedure will shift the excise d uty
backwardly to the growers of sugar cane by asking him to reduce the price
of sugar cane which he sugar for sugar production and thus by shifting the
excise duty backwardly he recovers the amount of excise duty backwardly
from the sugar cane grower. Thi s is done without raising of the price of
sugar. Thus price as a vehicle of tax shifting hardly plays any role so far as
backward shifting is concerned.

Factors influencing shifting: -

1) Magnitude of tax: -
Magnitude means the amount or the quantum of t ax. If the tax amount is
very small like a few thousand rupees then the tax payer doesn’t feel like
shifting the tax. He feels that it is better to bear the burden of tax that to
shift the tax. Conversely if the tax amount is very big which comes to
crores of rupees then only the tax payer feels like shifting the tax.
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54
2) Range of the commodities taxed: -
If exclusively one commodity is taxed then the tax payer hardly think in
terms of shifting the tax. Conversely when tax is levied upon a wide
varieties of goods like soft drinks. Coke, Pepsi, Limka, Fanta etc. Then the
tax payer feels like shifting the tax.

3) The point of tax : -
If tax is levied at the point of a consumer then there is no possibility of tax
shifting. The consumer has to bear the brunt o f the attack made by a tax
conversely when the tax is imposed at the point of a producer or a seller
then there is a possibility of shifting of a tax.

4) Elasticity of Demand : -
When demand is perfectly elastic then tax can’t be shifted. When the
demand is fairly elastic then some tax can be shifted. When the demand is
perfectly inelastic then the whole tax can be shifted.

5) Elasticity of supply: -
When the supply is perfectly elastic then the whole tax can ne shifted.
When supply is fairly elastic t hen tax can be shifted partially. Conversely
when supply is perfectly inelastic then tax cannot be shifted.

6) Period of time: -
During short period of time it is very difficult to shift the tax. Conversely
when the period is very long then only the tax ca n be shifted.

7) Market Situation: -
In a monopoly market situation tax can be shifted while under perfect
competition in the long period there is no possibility of tax shifting.

8) Geographical coverage: -
When the geographical coverage is very narrow i.e . in case of local
markets there is no possibility of shifting conversely when the
geographical coverage of a market is very wide i.e. in case of national and
international markets there is a possibility of shifting.

9) Public policy : -
Shifting depends u pon the following Government. If the government
follows the policy of controls and restriction then tax cannot be shifted.
Conversely when Government follows open policy or free policy then
there is a possibility of shifting.

10) Vehicle :
As per Dr. Dalt on there must be some vehicle through which a tax can be
shifted. Price is a good vehicle through which through which tax can be
shifted.
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55 4.3 ECONOMIC EFFECTS OF TAXATION
Though raising revenue is the primary objective of taxation, taxes are
considered as instruments of control and regulation with the objective of
influencing the pattern of consumption, production and distribution i.e.
taxes affect an economy in various ways. The economic effects of taxes
are explained below:
1. Effects of Taxation on Production:
Effects on production are classified under three heads
(i) Effects on the ability to work, save and invest : In case of poor people,
imposition of taxes results in the reduction of disposable income or the
purchasing capacity of the taxpayers. It reduces their expenditure on
necessities which are required to improve work efficiency. It further
adversely affects savings and investment.
Whereas imposition of taxes on rich people has the least / negligible effect
on the efficiency and ability to wor k. There are some harmful goods, such
as cigarettes, tobacco, alcohol whose consumption has to be reduced to
increase ability to work. Therefore high rate of taxes are often imposed on
such harmful goods to curb their consumption.
All taxes adversely affec t the ability to save of all people. In case of rich
people, they save more than the poor, so progressive rate of taxes reduces
their savings potentiality which results in low level of investment. The
lower rate of investment further adversely affect the e conomic growth of a
country.
(ii) Effects on the will to work, save and invest :
The effects of taxation on the willingness to work, save and invest are due
to the result of money burden of tax as well as the psychological burden of
tax. Temporary taxes m ay not lead to any adverse effect on desire or will
to do work but if these taxes continues to exist then they may lead to
adversely affect the willingness to work. Taxpayers have a feeling that
every tax is a burden. This psychological state of mind of th e taxpayers
has a disincentive effect on the willingness to work for more extra hours.
It is suggested that effects of taxes upon the willingness to work, save and
invest depends on the income elasticity of demand and it varies from
individual to individu al.
If the income demand of an individual taxpayer is inelastic, a cut in
income consequent upon the imposition of taxes will induce him to work
more and to save more so that the lost income is at least partially
recovered. On the other hand, the desire to work and save of those people
whose demand for income is elastic will be affected adversely.
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56 (iii) Effects on the allocation of resources :
In economics resources have several uses. By diverting resources use to
the desired directions, taxation can influ ence the volume and the size of
production in the economy. It may lead to some beneficial effects on
production. High rates taxation on harmful drugs and commodities will
reduce their consumption. It will discourage production of these
commodities and thes e scarce resources will be diverted from their
production to the other products which are useful for economic growth.
Taxation may also promote regional balanced development by allocating
resources in the backward regions.
2. Effects of Taxation on Income Distribution and wealth:
Taxation affect favorably as well as unfavorably on the distribution of
income and wealth. It depends on the type and rates of taxation. A steeply
progressive taxation system tends to reduce income inequality since the
burden of su ch taxes falls heavily on the richer persons.
As against the progressive taxation, regressive tax system increases the
inequality of income and distribution of wealth. Taxes imposed heavily on
luxury and non -essential goods tend to have a favorable impact on income
distribution. Whereas taxes imposed on necessary articles may have
regressive effect on income distribution.
Though the progressive system of taxation has favorable effect on income
distribution but it has disincentive effect on output as rich p eople are
heavily taxed it leads to disincentive effect on savings and investment. A
high rate of income tax will reduce inequalities but it may lead to some
unfavorable effects on the ability to work, save, investment and output.
3. Other Effects of Taxa tion:
i) As taxes have favorable effects on the ability and the desire to work,
save and invest, it may lead to a favorable effect on the employment
situation of a country. If resources collected through taxes are utilized for
development projects, it will increase employment rate in the economy. As
against this if taxes affect the volume of savings and investment adversely
then recession and unemployment problem will arise.
ii) Effect of taxes on the price level may have favorable as well as
unfavorable ef fect. Sometimes, taxes are imposed to curb inflation which
may lead to rising costs of production. It will further aggravate the
problem of inflation.
In this way, taxation creates both favorable and unfavorable effects on
various ways in an economy.
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57 4.4 INTRODUCTION: REDISTRIBUTIVE AND ANTI -
INFLATIONARY NATURE OF TAXATION
Taxes seem to have the greatest anti -inflationary effects. However, the
effectiveness of taxes depend not only on the individual taxes but also on
the overall tax structure.
A tax on per sonal income reduces inflationary pressures by reducing
people’s disposable income. It does have a minimum effect on business
cost, except to the extent that reductions in disposable income lead trade
unions to demand wage increases.
On the contrary, it do es not place a burden on persons who do not fall
under the tax net or who are able to evade taxes or who spend huge sums
from accumulated wealth. Moreover, a major portion of the tax may be
absorbed from savings and thus it may give no direct incentive to curtail
spending. Thus, its anti -inflationary effect will be less per rupee than that
of a tax on spending.
Consequently, “if given inflationary pressures are to be checked by the use
of income -tax increases, the tax rates must be higher than they would need
to be with a tax having a greater effect in curtailing spending.
Accordingly, the adverse effect on incentives to work and produce will be
somewhat greater.”
Excise duty and sales tax affect inflationary pressures in a different way.
Demand -shifting exc ise are designed to discourage persons from buying
particularly scarce commodities. The tax acts as an alternative to the
ration ing system. The policy will prove to be effective only if the demand
for the product is fairly elastic.
Contrarily, demand -absorbing excise are levied upon commodities hav ing
inelastic purchasing power that would otherwise be used for inflation ary
spending. However, the fact is that most commodities of inelastic demand
are of widespread use and the burden of tax will be distribu ted in a
regressive manner (i.e., the poor will pay more than the rich).
However, income -tax on companies may be raised to control inflation.
Such a tax is deflationary in two ways. First, to the extent that dividends
are reduced, individual spending is cu rtailed, at least partly. Secondly,
business firms are left with less funds for expansion and so they must
reduce their investment spending.
4.4.1 ANTI - INFLATIONARY NATURE OF TAXATION
In modem welfare states, the government has to incur huge expenditure to
meet the growing social and economic needs of the people. In such a
situation, taxation becomes an important source of funding such
expenditure. Therefore taxation plays a very important role in modern
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58 consumption in order to make resources available to meet collective needs
of the people and on the other hand, taxation is used to redistribute income
and wealth.
In the growing economies with the huge amount of public expenditure,
there is always the possibility of inflation due to excessive consumption.
In such cases, anti -inflationary taxation is used to reduce propensity to
consume. It is in the form of higher rates of direct and indirect taxes. Anti -
inflationary taxation which re duces consumption is justified if the
resources released from private consumption are used by the government
for welfare activities of the society at large.
The redistributive taxation like progressive direct taxes is designed to
reduce savings, whereas a nti-inflationary taxes are designed to reduce
consumption. When the government uses taxation to reduce savings, the
funds raised from such taxes are the funds which might have been left idle
by the people. But in case of anti - inflationary taxation used to reduce
consumption, the resources raised by the government are the funds that
people would otherwise have used for consumption. Therefore funds
raised through anti -inflationary taxation should be used wisely and
productively.
The general classical view i s that the all taxes are anti -inflationary and all
public expenditures are inflationary in nature. Whereas, Modern
economists believe that neither all taxes are anti -inflationary nor
expenditures are inflationary. The effects of taxation and public
expendi ture depend on the state of the economy. During normal situations,
any tax that reduces consumption and promote investment may be anti -
inflationary.
4.4.2 REDISTRIBUTIVE NATURE OF TAXATION
Classical economists considered taxation as a means to raise reve nue. But
modern economists consider taxation as a tool for redistributing income
and wealth among the various sections of society. Modem economists are
of the opinion that taxation can be used for transferring income and wealth
from the rich to the poor. T his is referred to as redistributive taxation.
Redistributive taxation aimed at reducing savings of the rich and using
these resources raised to increase the consumption of the poor.
Unequal distribution of income and wealth harms the economy in many
ways. It widens the gap between the rich and the poor which is not only
socially undesirable, but is also harmful for the economy’s growth.
Income inequality reduces average propensity to consume and may lead to
depression and unemployment. Therefore, modem eco nomists have
recommended the use of taxation to redistribute income and wealth in a
more socially desirable manner. Most economies use progressive taxation
to redistribute income and wealth. Progressive taxes are generally imposed
in proportion of income a nd wealth. They impose a heavier burden on the
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59 A redistributive fiscal policy includes progressive direct taxation and
public expenditure on social security, job creation and promotion of social
equity. Such expenditure are in the form of old age pensions,
unemployment allowances, free and subsidized housing, education, health
care and food distribution. All these are aimed at reducing people’s cost of
living, increasing their capacity to consume and provide social justice
Redistributiv e taxation increases people’s average propensity to consume.
When income distribution improves due to transfer of income from the
rich to the poor, larger number of people can increase their consumption
levels. It increases aggregate demand and leads to in crease investment and
employment.
However, highly progressive direct taxes have certain limitations. They
result in tax evasion, which gives rise to black money in an economy. At
the same time, such taxes can adversely affect people’s willingness and
ability to work, save and invest. This can also harm economic progress.
Another limitation of redistributive taxation is that often government use
the redistributive fiscal policy to fulfil their political agenda of winning
elections by providing subsidies an d transfers to a very large extent. This
can result in excessive consumption, causing inflation and lowering the
value of money. Such a fiscal policy may result in large deficit and public
borrowing, pushing interest rates upward. High interest and high in flation
will harm growth prospects of the economy.
Developing economies tend to rely on the indirect taxation of domestic
and imported goods and services. Indirect taxes are said to be regressive
because they adversely affect consumption rather than income , and
wealthier people save a higher proportion of their income. In addition,
indirect taxation in developing economies may even increase poverty
depending on the structure of tax rates and the consumption basket of
households at various rungs of the incom e scale. Lowering taxes on goods
such as food that weigh more in the budget of poor people achieves
relatively little redistribution because wealthier people also consume these
goods.
4.5 SUMMARY
1. Incidence if taxation has got a relevance so far as the e ffects of taxation
are concerned. Public finance operations are likely to produce various
effects on the level and pattern of economic activity in country. The
systems of public finance becomes acceptable to the people when public
authorities try their utm ost to promote and maximise the favourable
effects and to check and minimise the adverse effects of Governmental
budgetary operations.
2. The impact of tax is defined as the initial, immediate and legal money
burden of a tax which falls on a person on wh om the tax is levied. The
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60 should pay the tax. The person who is liable to pay the tax to the
Government bears its impact.
3. Incidence of tax refers to the ultimate money burden of a tax. It also
means the final resting point of a tax.
4. Shifting is defined as a process of transfer of money burden of tax from
one person to another person. Shifting of tax takes place only in case of
indirect taxes. The indirect taxes which are also k nown as commodity
taxes like excise duty, sales tax, custom duty, etc. which can only be
shifted to the third party.
5. Impact, shifting and incidence are the interrelated terms which are
related to imposition, transfer and settlement of tax. Initially it is the
impact that occurs first and incidence is the end result. In between these
two lies the phenomenon of shifting of tax.
6. The shifting is of two types viz.
i) Forward shifting and
ii) Backward shifting.

A forward shifting is one in which the tax is shift ed forwardly to the
ultimate users of a commodity through price i.e. the tax gets mixed up
with price and the ultimate user of a commodity has to pay a gross price.
So in case of forward shifting of tax prices is used as a vehicle of tax
shifting.

A backw ard shifting is one in which the tax is shifted backwardly to the
grower of the raw materials.
7. Though raising revenue is the primary objective of taxation, taxes are
considered as instruments of control and regulation with the objective of
influencing t he pattern of consumption, production and distribution i.e.
taxes affect an economy in various ways.
8. Taxes seem to have the greatest anti -inflationary effects. However, the
effectiveness of taxes depend not only on the individual taxes but also on
the o verall tax structure.
9. Taxation plays a very important role in modern economies. Through
taxation, on one hand, the government control private consumption in
order to make resources available to meet collective needs of the people
and on the other hand, taxation is used to redistribute income and wealth.
10. The redistributive taxation like progressive direct taxes is designed to
reduce savings, whereas anti -inflationary taxes are designed to reduce
consumption.
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61 4.6 QUESTIONS
1. Explain the meaning of t he concepts of impact, shifting and incidence
of a tax.
2. Discuss the factors influencing shifting of tax.
3. What are the various economic effects of taxation?
4. Explain anti -inflationary and redistributive nature of taxation.


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62 Module III
5
PUBLIC EXPENDITURE AND PUBLIC
DEBT
Unit Structure
5.0 Objectives
5.1 Introduction
5.2 Classification of Public Expenditure
5.3 Canons of Public Expenditure
5.4 Effects of Public Expenditure
5.5 Adolph Wagner's Law o f Increasing State Activity
5.6 The Peacock -Wiseman Hypothesis
5.7 Causes of Public Expenditure Grwoth
5.8 Significance of Public Expenditure
5.9 Summary
5.10 Questions
5.0 OBJECTIVES
 To understand the meaning of public expenditure
 To study classification of public expenditure
 To study can ons of public expenditure
 To understand the economic effects of public expenditure on
production, consumption, distribution, employment and stabilization
 To study Wagner’s hypothesis and Wiseman Peacock hypothesis
 To understand the causes of increasing pub lic expenditure
 To study the significance of public expenditure

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Public Debt
63 5.1 INTRODUCTION
1. Public Expenditure : Meaning & Definition
Public expenditure refers to Government expenditure i.e. Government
spending. It is incurred by Central, State and Local governments o f a
country. Public expenditure can be defined as, "The expenditure
incurred by public authorities like central, state and local
governments to satisfy the collective social wants of the people is
known as public expenditure."
The Public Expenditure is inc urred on various activities for the welfare of
the people and also for the economic development, especially in
developing countries. In other words The Expenditure incurred by Public
authorities like Central, State and local governments to satisfy the
collective social wants of the people is known as public expenditure .
2. Need / Importance / Significance of Public :
In modern economic activities public expenditure has to play an important
role. It helps to accelerate economic growth and ensure economic
stabil ity. Public Expenditure can promote economic development as
follows :-
1. To promote rapid economic development.
2. To promote trade and commerce.
3. To promote rural development
4. To promote balanced regional growth
5. To develop agricultural and industrial sectors
6. To build socio -economic overheads eg. roadways, railways, power
etc.
7. To exploit and develop mineral resources like coal and oil.
8. To provide collective wants and maximise social welfare.
9. To promote full - employment and maintain price stability.
10. To ensure an equitable distribution of income.
Thus public expenditure has to create and maintain conditions conducive
to economic development. It has to improve the climate for investment. It
should provide incentives to save, invest and innovate.

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64 3. Objectives of Public Expenditure :
The major objectives of public expenditure are
1) Administration of law and order and justice.
2) Maintenance of police force.
3) Maintenance of army and provision for defence goods.
4) Maintenance of diplomats in foreign countries.
5) Public Administr ation.
6) Servicing of public debt.
7) Development of industries.
8) Development of transport and communication.
9) Provision for public health.
10) Creation of social goods.
In a modern welfare state, the importance of public expenditure has
increased. Throughout the 19th Century, most governments followed
laissez faire economic policies & their functions were only restricted to
defending aggression & maintaining law & order. The size of pubic
expenditure was very small. But now the expenditure of governments all
over has significantly increased. In the early 20th Century, John
Maynard Keynes advocated the role of public expenditure in
determination of level of income and its distribution.
In developing countries, public expenditure policy not only accelerates
economic growth & promotes employment opportunities but also plays a
useful role in reducing poverty and inequalities in income distribution.
5.2 CLASSIFICATION OF PUBLIC EXPENDITURE
Classification of Public expenditure refers to the systematic arrangement
of different items on which the government incurs expenditure. Different
economists have looked at public expenditure from different point of
view. The following classification is a based on these different views.
A. Functional Classification :
Some economists classify publ ic expenditure on the basis of functions for
which they are incurred. The government performs various functions
like defence, social welfare, agriculture, infrastructure and industrial
development. The expenditure incurred on such functions fall under t his
classification. These functions are further divided into subsidiary
functions. This kind of classification provides a clear idea about how the
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65 B. Revenue and Capital Expenditure :
Revenue expenditure are current or consumption expe nditures incurred on
civil administration, defence forces, public health and education,
maintenance of government machinery. This type of expenditure is of
recurring type which is incurred year after year.
On the other hand, capital expenditures are incurr ed on building durable
assets, like highways, multipurpose dams, irrigation projects, buying
machinery and equipment. They are non recurring type of expenditures in
the form of capital investments. Such expenditures are expected to
improve the productive c apacity of the economy.
C. Transfer and Non-Transfer Expenditure :
A.C. Pigou , the British economist has classified public
expenditure as :-
1. Transfer expenditure
2. Non-transfer expenditure
1. Transfer Expenditure :-
Transfer expenditure relates to the expenditure against which there is
no corresponding return.
Such expenditure includes public expenditure on :-
1. National Old Age Pension Schemes,
2. Interest payments,
3. Subsidies,
4. Unemployment allowances,
5. Welfare benefits to weaker sections, etc.
By incurring such expendit ure, the government does not get anything in
return, but it adds to the welfare of the people, especially belong to the
weaker sections of the society. Such expenditure basically results in
redistribution of money incomes within the society.
2. Non-Transfer Expenditure :-
The non-transfer expenditure relates to expenditure which results in
creation of income or output. The non-transfer expenditure includes
development as well as non-development expenditure that results in
creation of output directly or indirec tly. Economic infrastructure such as
power, transport, irrigation, etc.
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66 1. Social infrastructure such as education, health and family welfare.
2. Internal law and order and defence.
3. Public administration, etc.
By incurring such expenditure, the government creat es a healthy
conditions or environment for economic activities. Due to economic
growth, the government may be able to generate income in form of duties
and taxes.
D. Productive and Unproductive Expenditure :
This classification was made by Classical economist s on the basis of
creation of productive capacity.
1. Productive Expenditure :-
Expenditure on infrastructure development, public enterprises or
development of agriculture increase productive capacity in the economy
and bring income to the government. Thus they are classified as
productive expenditure.
2. Unproductive Expenditure :-
Expenditures in the nature of consumption such as defence, interest
payments, expenditure on law and order, public administration, do not
create any productive asset which can bring income or returns to the
government. Such expenses are classified as unproductive expenditures.
E. Development and Non-Development Expenditure :
Modern economists have modified this classification into distinction
between development and non-development expend itures.
1. Development Expenditure :-
All expenditures that promote economic growth and development are
termed as development expenditure. These are the same as productive
expenditure.
2. Non-Development Expenditure :-
Unproductive expenditures are termed as non development expenditures.
F. Grants and Purchase Price :
This classification has been suggested by economist Hugh Dalton .
1. Grants :-
Grants are those payments made by a public authority for which their may
not be any quid-pro-quo, i.e., there will be no recei pt of goods or
services. For example, old age pension, unemployment benefits, subsidies,
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67 2. Purchase prices :-
Purchase prices are expenditures for which the government receives goods
and services in re turn. For example, salaries and wages to government
employees and purchase of consumption and capital goods.
G. Classification According to Benefits :
Public expenditure can be classified on the basis of benefits they confer on
different groups of people.
1. Com mon benefits to all : Expenditures that confer common benefits
on all the people. For example, expenditure on education, public
health, transport, defence, law and order, general administration.
2. Special benefits to all : Expenditures that confer special benefits on
all. For example, administration of justice, social security measures,
community welfare.
3. Special benefits to some : Expenditures that confer direct special
benefits on certain people and also add to general welfare. For
example, old age pension, subsidies to weaker section, unemployment
benefits.
H. Hugh Dalton's Classification of Public Expenditure
Hugh Dalton has classified public expenditure as follows :-
1. Expenditures on political executives : i.e. maintenance of ceremonial
heads of state, like the president.
2. Administrative expenditure : to maintain the general administration
of the country, like government departments and offices.
3. Security expenditure : to maintain armed forces and the police forces.
4. Expenditure on administration of justice : include maintenance of
courts, judges, public prosecutors.
5. Developmental expenditures : to promote growth and development
of the economy, like expenditure on infrastructure, irrigation, etc.
6. Social expenditures : on public health, community welfare, social
security, etc.
7. Pubic debt charges : include payment of interest and repayment of
principle amount.


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68 5.3 CANONS OF PUBLIC EXPENDITURE
The expression canon of public expenditure is used for the fundamental
rules or principles governing the spending policy of the government.
Findlay Shirras has suggested Four Canons of Public Expenditure viz.
1) Canon of benefit
2) Canon of economy
3) Canon of Sanction
4) Canon of Surplus.
Other economists have also suggested certain canons such as
5) Canon of economic growth
6) Cano n of productivity
7) Canon of elasticity
8) Canon of equitable distribution
1) Canon of benefit : This canon implies that public expendit ure should
be incurred in a such way that it promotes maximum social advantage.
The ultimate purpose of public expenditure should be social benefit.
Hence public expenditure should be directed to those areas which
maximise the benefits of the society as a whole and not as an individual
group.
2) Canon of economy : Public expenditure should be productive and
efficient. It shou ld be incurred economically avoiding extravagance and
wastes. It should avoid duplication and involve minimum cost. It should
be incurred on essential items of common benefit. It should ensure
optimum utilisation of resources.
3) Canon of sanction: All pub lic expenditures should be incurred after
the approval of a proper authority. This sanction is required for proper
allocation of resources and to avoid the misuse of funds. The expenditures
must be audited to ensure that money is spent for the purpose for which it
is sanctioned.
4) Canon of Surplus: This principle implies that the government should
create a surplus in budget and avoid deficit. An ideal budget is one which
contains a surplus by keeping the public expenditure below public
revenue. This ensure s the credit worthiness of the government.
5) Canon of economic growth: Growth with stability is an important
objective which governs public expenditure. Developed countries can
maintain the present high rate of economic growth and under -developed
countri es can focus on raising the growth rate and attainment of a higher
standard of living through public expenditure.
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69 6) Canon of Productivity : Public expenditure must be productive so that
income and employment can be generated. A large part of public
expen diture should be allocated for developmental purpose.
7) Canon of elasticity : This canon implies that the government spending
policy should be fairly elastic according to the changes in the
circumstances and requirement of the economy.
8) Canon of equitab le distribution: Public expenditure policy of the
government should aim at reducing inequalities of income and wealth in
the economy. Thus the expenditure policy should provide maximum
benefits for the weaker sections of the society.
5.4 EFFEC TS OF PUBLIC EXPENDITURE
A. Effects on Production
The effect of public expenditure on production can be examined with
reference to its effects on ability & willingness to work, save & invest
and on diversion of resources.
1. Ability to work, save and invest : Socially desirable public
expenditure increases community's productive capacity. Expenditure on
education, health, communication, increases people's productivity at work
and therefore their incomes. With rise in income savings also increase
and this in turn has a beneficial effect on investment and capital
formation.
2. Willingness to work, save and invest : Public expenditure,
sometimes, brings adverse effects on people's willingness to work and
save. Government expenditure on social security facilities may bring such
unfavourable effects. For e.g. Government spends a considerable portion
of its income towards provision of social security benefits such as
unemployment allowances old age pension, insurance benefits, sickness
benefit, medical benefit, etc. Such b enefits reduce the desire to work. In
other words they act as disincentive to work.
3. Effect on allocation of resources among different industries
&trade : Many a times the government expenditure proves to be an
effective instrument to encourage investment o n a particular industry. For
e.g. If government decides to promote exports, it provides benefits like
subsidies, tax benefits to attract investment towards such industry.
Similarly government can also promote a particular region by providing
various incent ives for those who make investment in that region.
B. Effects on Distribution
The primary aim of the government is to maximise social benefit through
public expenditure. The objective of maximum social welfare can be
achieved only when the inequality of incom e is removed or minimised.
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70 collects excess income of the rich through income tax and sales tax on
luxuries. The funds thus mobilised are directed towards welfare
programmes to promote t he standard of poor and weaker section. Thus
public expenditure helps to achieve the objective of equal distribution of
income.
Expenditure on social security & subsidies to poor are aimed at increasing
their real income & purchasing power. Public expendit ure on education,
communication, health has a positive impact on productivity of the weaker
section of society, thereby increasing their income earning capacity.
C. Effects on Consumption
Public expenditure enables redistribution of income in favour of poor. It
improves the capacity of the poor to consume. Thus public expenditure
promotes consumption and thereby other economic activities. The
government expenditure on welfare programmes like free education,
health care and housing certainly improves the standa rd of the poor
people. It also promotes their capacity to consume and save.
D. Effects on Economic Stability
Economic instability takes the form of depression, recession and inflation.
Public expenditure is used as a mechanism to control instability. The
mode rn economist Keynes advocated public expenditure as a better
device to raise effective demand & to get out of depression. Public
expenditure is also useful in controlling inflation & deflation. Expansion
of Public expenditure during deflation & reduction o f public expenditure
during inflation control money supply & bring price stability.
E. Effects on Economic Growth
The goals of planning are effectively realized only through government
expenditure. The government allocates funds for the growth of various
sectors like agriculture, industry, transport, communications, education,
energy, health, exports, imports, with a view to achieve impressive
growth.
Government expenditure has been very helpful in maintaining balanced
economic growth. Government takes keen interest to allocate more
resources for development of backward regions. Such efforts reduce
regional inequality and promotes balanced economic growth.
Conclusion
Modern economies have all experienced tremendous growth in public
expenditure. So it is absolut ely necessary for governments to formulate
rational public expenditure policies in order to achieve the desired effects
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71 5.5 ADOLPH WAGNER'S LAW OF INCREASING STATE
ACTIVITY
Adolph Wagner, the German ec onomist made an in depth study relating to
rise in government expenditure in the late 19thcentury. Based on his study,
he propounded a law called "The Law of Increasing State Activity".
Wagner’s law states that "as the economy develops over time, the
activ ities and functions of the government increase". According to Adolph
Wagner, "Comprehensive comparisons of different countries and different
times show that among progressive peoples (societies), with which alone
we are concerned; an increase regularly tak es place in the activity of both
the Central Government and Local Governments, constantly undertake
new functions, while they perform both old and new functions more
efficiently and more completely. In this way economic needs of the people
to an increasing extent and in a more satisfactory fashion, are satisfied
by the Central and Local Governments."
Wagner's Statement Indicates Following Points
1. In Progressive societies, the activities of the central and local
government increase on a regular basis.
2. The increase in government activities is both extensive and
intensive.
3. The governments undertake new functions in the interest of the
society.
4. The old and the new functions are performed more efficiently and
completely than before.
5. The purpose of the government activities is to meet the economic
needs of the people.
6. The expansion & intensification of government function & activities
lead to increase in public expenditure.
7. Though Wagner studied the economic growth of Germany, it applies
to other countries too both developed and developing.
5.6 THE PEACOCK -WISEMAN HYPOTHESIS
Peacock and Wiseman conducted a new study based on Wagner's Law.
They studied the public expenditure from 1891 to 1955 in U.K. They
found out that Wagner's Law is still valid.
Peacock and Wiseman further stated that :-
1. "The rise in public expenditure greatly depends on revenue collection.
Over the years, economic development results in substantial revenue
to the governments, this enabled to increase public expenditure".
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72 2. There exists a big gap bet ween the expectations of the people about
public expenditure and the tolerance level of taxation. Therefore,
governments cannot ignore the demands made by people regarding
various services, especially, when the revenue collection is increasing
at constant rate of taxation.
3. They further stated that during the times of war, the government
further increases the tax rates, and enlarges the tax structure to
generate more funds to meet the increase in defence expenditure. After
the war, the new tax rates and tax structures may remain the same, as
people get used to them. Therefore, the increase in revenue results in
rise in government expenditure.
Wagner's law and Peacock -Wiseman hypothesis emphasize on the fact
that public expenditure has tendency to increase overtime.
5.7 CAUSES OF PUBLIC EXPENDITURE GRWOTH

There has been a persistent and continuous increase in public expenditure
in countries all over the world. The classical ideology of keeping the
government spending at the lowest possible level has lost its appeal in the
modern days. According to Adolf Wagner a German economist, there is a
continuous tendency of the intensive and extensive and increase in the
functions of the government. New functions are continuously being
undertaken and old function are b eing performed more efficiently and on a
large scale.

This observations of Wagner, popularly known as ‘ Wagner’s Law’ is
universally valid. Wagner argued that there exists a direct functional
relationship between the activities of the state and the size o f public
expenditure. Along with the growth of the economy the government
activities grow faster.

Thus Wagner’s law reveals an universally true inductive generalization
about the continuous and substantial growth of public expenditure.
Following factors a re responsible for such tremendous and continuous
increase in spending of modern governments.

1. Acceptance of welfare state: The concept of welfare state has been
accepted by all the governments the world over. The adoption of welfare
state has multiplie d the responsibility of the government. In a welfare state
the role of government has significantly widened. In fact there is hardly
any field of economic activity in which the government is not concerned
directly or indirectly. Huge expenditure has to be incurred by the
government on welfare items like education, public health, social security
measures like old age persons, unemployment allowances, subsidies, etc.
In short the acceptance of welfare state has brought about a change in the
attitude of the go vernment towards Public expenditure which has grown
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73 2. Impact of Great Depression: The great Depression of 1930,has
widened the economic role of the government. In order to rectify the bad
effects of the depression such as unemployment. Investm ent deficiency,
etc. the government has to play an active role in stabilising the economic
activity. Thus to fight the depression government is required to incur huge
expenditure.

3. Defence expenditure : Defence has been a traditional function of the
government. In modern times there is qualitative and quantitative changes
in the expenditure on defence. Such expenditure has to be incurred not
only during war time but also during peace time. All the countries have
always to remain ready for any emergency. Naturally, huge expenditure
becomes inevitable. If the actual war breaks up there is further manifold
increase in this expenditure. Above all modern wars have become a costly
affair. Increasing amounts have to be spent on modern weapons and other
requirem ents. The war arms -race among the countries of the world causes
limitless expansion of expenditure on defence.

4. Democratic Institutions: Democracy is a costly affair as the
government has to spend huge amounts on various institutions to ensure
smooth fu nctioning of the system. There is a chain of such institutions
right from village gram panchayats to the central government at the
national level. Large amount becomes necessary for conducting periodical
elections, allowances of elected representative etc. Further expenditure has
to be incurred on constitutional posts. They acceptance of democracy is
one of the causes of growth of public expenditure.

5. Growing population: A high growth of population naturally calls for
increase in public expenditure as al l state function are to be performed
more extensively. Rising population also poses various problems in poor
countries. The government will have the added responsibility of solving
such problems as food. Unemployment, housing, and sanitation. Further
over-populated countries like India will have to check the population
growth. Therefore the government has to spend more and more on family
planning campaigns every year.

6. Urbanisation : The spread of urbanization is an important factor
leading to the relat ive growth of public expenditure is modern times. With
the growth of urban areas, there has been an increasing tendency of
expenditure on civil administration. Expenses on water supply, electricity,
provision of transport, maintenance of roads schools and colleges, traffic
controls, public health, parks and libraries, playgrounds etc. have
increased enormously in these days. Likewise, the expenditure on courts
prisons etc. is increasing especially in urban areas.

7. Development project: In an underdevelop ed country, the government
has to spend more and more on developmental projects, especially in rural
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74 and other social measures for rural development. Huge investment has to
be incurred on infrastructure and basis industries for rapid economic
development of a country. This has increased the public expenditure.

8. Rising Prices: Inflationary tendencies have become a common feature
of the post world war. The government is required to spen t increasing
amounts on completion of the existing projects and on new ones. During
inflation the government has to play additional D.A.to the employees
which obviously calls for an extra burden on public expenditure. Thus
inflationary price rise is one of the important factors that leads to growth
of public expenditure.

10. Public Borrowing : To finance the development projects the
government has to borrow internally as well as externally. Interest
payment and servicing of these debts along with repayment of the
principle has increasing the expenditure of modern governments
Thus the various factors like extension of traditional functions, acceptance
of new functions and increasing importance of government in economic
activities have caused increase in publ ic expenditure.
5.8 SIGNIFICANCE OF PUBLIC EXPENDITURE
The significance of the public expenditure arises from the fact that those
services are provided by the government which might not otherwise be
provided in significant amount by private expenditure .
In the 1930s, J. M. Keynes emphasized the importance of public
expenditure. The modern state is described as the ‘welfare state’ . As a
result, the Modern governments are undertaking various social and
economic activities.
i. Economic Development:
Public expenditure has the expansionary effect on the growth of national
income, employment opportunities, etc. Economic development also
requires development of economic infrastructures. A developing country
like India must undertake various projects, like road -bridge -dam
construction, power plants, transport and communications, etc.These
social overhead capital or economic infrastructures are of crucial
importance for accelerating the pace of economic development.
ii. Fiscal Policy Instrument:
Public expenditu re is considered as an important tool of fiscal policy. It
creates and increases the scope of employment opportunities during
depression. Thus, public expenditure can prevent periodic cyclical
fluctuations. During depression, it is recommended that there s hould be
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75 jobs and incomes.On the contrary, a cut -back in government’s expenditure
is necessary when the economy faces the problem of inflation.
iii. Redistribution of Income:
Public exp enditure is used as a powerful fiscal instrument to bring about
an equitable distribution of income and wealth. By providing subsidies,
free education and health care facilities to the poor people, government
can improve the economic position of these peop le.
iv. Balanced Regional Growth:
Public expenditure can correct regional disparities. By diverting resources
in backward regions, government can bring about all -round development
there so as to compete with the advanced regions of the country.
Thus, publi c expenditure has both economic and social objectives.
1. Low income support: Public expenditure on free education,
unemployment benefit and free medical facilities etc., increase the
purchasing power of the people and especially of low income groups and
it helps to protect and promote the efficiency of the people and the ability
to work and save. Public expenditure for increasing the salaries and wages
of the people and supply of goods and services at cheaper rate will
increase their purchasing power, standa rd of living, efficiency and their
ability to work and save may increase.
2. Social insurance programs: it has been argued that the social security
measures like old age pension, provident fund benefit, insurance against
sickness and employment at state expen se reduce the desire of a person to
work, save and invest. But practically, it does not adversely affect the
desire to work, save and invest. These measures are socially desirable.
Social security measures should be provided to the extent they do not
disco urage savings and investment. Therefore, public expenditure should
be incurred in such a way so as to provide social security measures to the
maximum extent which the government can afford without directly
affecting saving and investment expenditure.
5.9 SUMMARY
1. Public expenditure can be defined as, "The expenditure incurred by
public authorities like central, state and local governments to satisfy the
collective social wants of the people is known as public expenditure."
2. Classification of Public exp enditure refers to the systematic
arrangement of different items on which the government incurs
expenditure. Different economists have looked at public expenditure
from different point of view.
3. The expression canon of public expenditure is used for the fundamental
rules or principles governing the spending policy of the government. munotes.in

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76 4. Modern economies have all experienced tremendous growth in public
expenditure. So it is absolutely necessary for governments to formulate
rational public expenditure polici es in order to achieve the desired
effects on income, distribution, employment and growth.
5. Wagner’s law states that "as the economy develops over time, the
activities and functions of the government increase".
6. Wagner's law and Peacock -Wiseman hypothe sis emphasize on the fact
that public expenditure has tendency to increase overtime.
7. There has been a persistent and continuous increase in public
expenditure in countries all over the world. The classical ideology of
keeping the government spending at the lowest possible level has lost
its appeal in the modern days. According to Adolf Wagner a German
economist, there is a continuous tendency of the intensive and
extensive and increase in the functions of the government.
8. The significance of the publi c expenditure arises from the fact that those
services are provided by the government which might not otherwise be
provided in significant amount by private expenditure. In the 1930s, J.
M. Keynes emphasized the importance of public expenditure. The
modern state is described as the ‘welfare state’ . As a result, the
Modern governments are undertaking various social and economic
activities.
5.10 QUESTIONS
1. Discuss the meaning and classification of public expenditure.
2. Explain the canons of public expendit ure.
3. Explain the various effects of public expenditure.
4. Explain Wagner’s Law of increasing state activity.
5. Discuss Peacock Wiseman hypothesis of increasing public expenditure.
6. What are the causes of growing public expenditure?
7. Explain the si gnificance of public expenditure in a welfare state.



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77 6
PUBLIC DEBT

Unit Structure
6.0 Objectives
6.1 Introduction
6.2 Public Debt : Meaning
6.3 Classification / Types of Public Debt
6.4 The Burden of Public Debt
6.5 Public Debt and Fiscal Solvency
6.6 Summ ary
6.7 Questions
6.0 OBJECTIVES
 To study the meaning
 To understand the classification / types o f public debt
 To study the concept of burden of public debt
 To study different solutions to manage public debt
 To understand the concept of public debt and fiscal insolvency
6.1 INTRODUCTION
Public debt or public borrowing plays an important role in an econom y
when a country’s expenditure is more than its collection of revenue. In
such a situation government has to borrow to meet its spending
requirement. In this chapter, we will study the meaning of public
borrowing, classification of public debt, effects of public debt in an
economy, and the ways to manage public debt by the government.
6.2 PUBLIC DEBT : MEANING
Public debt or public borrowing is considered to be an important source of
income to the government. If revenue collected through taxes & other
sources is not adequate to cover government expenditure government may
resort to borrowing. Such borrowings become necessary more in times of
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78 Public debt may be raised internally or externally. Internal debt refers to
public debt floated within the country; While external debt refers loans
floated outside the country.
The instrument of public debt take the form of government bonds or
securities of various kinds. Such securities are drawn as a contract
between the government & the lenders. By issuing securities the
government raises a public loan & incurs a liability to repay both the
principal & interest amount as per contract. In India, government issues
treasury bills, post office savings certificates, Natio nal Saving Certificates
as instrument of Public borrowings.
6.3 CLASSIFICATION / TYPES OF PUBLIC DEBT
Government loans are of different kinds, they may differ in respect of time
of repayment, the purpose, conditions of repayment, method of covering
liability. Thus the debt may be classified into following types.
1. Productive and Unproductive debts
A. Productive debt :-
Public debt is said to be productive when it is raised for productive
purposes and is used to add to the productive capacity of the economy.
As Dalt on puts, productive debts are those which are fully covered by
assets of equal or greater value.
If the borrowed money is invested in the construction of railways,
irrigation projects, power generations, etc. It adds to the productive
capacity of the econo my and also provides a continuous flow of income to
the government. The interest and principal amount is generally paid out
of income earned by the government from these projects.
Productive loans are self liquidating. Generally, such loans should be
repai d within the lifetime of property. Thus, such loans does not cause any
net burden on the community.
Unproductive debt :-
Unproductive debts are those which do not add to the productive capacity
of the economy. Unproductive debts are not necessarily self li quidating.
The interest and the principal amount may have to be paid from other
sources of revenue, generally from taxation, and therefore, such debts are
a burden on the community. Public debt used for war, famine relief, social
services, etc. is consider ed as unproductive debt.
However, such expenditures are not always bad because they may lead to
well being of the community. But such loans are a net burden on the
community since they are repaid generally through additional taxes.
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79 2. Voluntary and Compulsory Debt
A. Voluntary debt :-
These loans are provided by the members of the public on voluntary basis.
Most of the loans obtained by the government are voluntary in nature. The
voluntary debt may be obtained in the form of market loans, bonds, etc.
The Governme nt makes an announcement in the media to obtain such
loans. The rate of interest is normally higher than that of compulsory
debt, in order to induce the people to provide loans to the government.
B. Compulsory debt :-
A compulsory debt is a rare phenomenon in modern public finance unless
there are some special circumstances like war or crisis. The rate of
interest on such loans may be low. Considering the compulsion aspect;
these loans are similar to tax, the only difference is that loans are rapid but
tax is not. In India, compulsory deposit scheme is an example of
compulsory debt.
3. Internal and External Debt
A. Internal debt :-
The government borrows funds from internal and external sources.
Internal debt refers to the funds borrowed by the government from variou s
sources within the country. Over the years, the internal debt of the
Central Government of India has increased from Rs.1.54 lakh crore in
1990 -91 to Rs.13.4 lakh crore in 2005 -06.
The various internal sources from which the government borrows include
individuals, banks, business firms, and others. The various instruments of
internal debt include market loans, bonds, treasury bills, ways and means
advances, etc.
Internal debt is repayable only in domestic currency. It imply a
redistribution of income and wealth within the country & therefore it has
no direct money burden.
B. External debt :-
External loans are raised from foreign countries or international
institutions. These loans are repayable in foreign currencies. External
loans help to take up various dev elopmental programmes in developing
and underdeveloped countries. These loans are usually voluntary.
An external loan involves, initially a transfer of resources from foreign
countries to the domestic country but when interest and principal
amount are bein g repaid a transfer of resources takes place in the reverse
direction.
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80 4. Short -Term, Medium -Term & Long -Term Debts
A. Short -Term debt :-
Short term debt matures within a duration of 3 to 9 months. Generally, rate
of interest is low. For instance, in India, Treasury Bills of 91 days and
182 days are examples of short term debts incurred to cover temporary
shortages of funds. The treasury bills of government of India, which
usually have a maturity period of 90 days, are the best examples of short
term loans. Inter est rates are generally low on such loans.
B. Medium -Term debt :-
The Government may borrow funds for medium term needs. These funds
can be used for development and non development activities. The period
of medium term debt is normally for a period above one year and up to 5
years. One of the main forms of medium term debt is by way of market
loans.
C. Long -Term debt :-
Long term debt has a maturity period of ten years or more. Generally the
rate of interest is high. Such loans are raised for developmental
progra mmes and to meet other long term needs of public authorities.
5. Redeemable and Irredeemable Debts
A. Redeemable debt :-
The debt which the government promises to pay off at some future date
are called redeemable debts. Most of the debt is redeemable in nature.
There is certain maturity period of the debt. The government has to make
arrangement to repay the principal & the interest on the due date.
B. Irredeemable debt :-
Such debt has no maturity period. In this case, the government may pay the
interest regularly, but the repayment date of the principal amount is not
fixed. Irredeemable debt is also called as perpetual debt. Normally, the
government does not resort to such borrowings.
6. Funded and Unfunded Debts
A. Funded debt :-
Funded debt is repayable after a long per iod of time. The period may be
30 years or more. Funded debt has an obligation to pay fixed sum of
interest subject to an option to the government to repay the principal. The
government may repay it even before the maturity if market conditions are
favoura ble. Funded debt is Undertaken for meeting more permanent
needs, say building up economic & industrial infrastructure. The
government usually establishes a separate fund to repay this debt. Money
is credited by the government into this fund & debt is repai d on maturity
out of this fund.
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81 B. Unfunded debt :-
Unfunded debts are incurred to meet temporary needs of the governments.
In such debts duration is comparatively short say a year. The rate of
interest on unfunded debt is very low. Unfunded debt has an oblig ation to
pay at due date with interest.
6.4 THE BURDEN OF PUBLIC DEBT
Over the years, the public debt of the India's Central and that of State
government has increased considerably during the planning period. The
Government borrows funds by way of public debt to meet the various
development and non-development expenses.
Table below indicates composition of public debt of the Central Govt. of
India.

Apart from internal debt, there are also internal liabilities of the central
government in the form of small sa vings of the public, provident funds,
reserve funds & deposits of Government department. Both internal and
external debt carry a burden on the economy of nation.
6.4.1 The Burden of Internal Public Debt
1. Internal debt trap
One of the bad effects of internal debt is the interest paid by the
government. Such interest payments increase public expenditure and
may become a cause for fiscal deficit. If internal public debt is not
checked and kept within limits, it may take the country to the worst
position called 'Inter nal Debt Trap'.
2. More burden on poor and weaker sections
Internal debt provides opportunities for the rich and higher middle class to
earn a higher rate of interest from the state on their lending. At the
same time the poor suffer a lot due to the tax burden. The
government levies taxes to repay interest on public debt. But the tax
burden does not necessarily fall on the rich unless it is progressive in
nature. In the case of indirect taxes, the burden is felt more by the poor
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82 3. Increasing interest burden
Public borrowing may become costlier for the government especially
when it resorts to public borrowing by issuing bonds and debentures. Such
bonds and debentures carry a high rate of interest to the extent of 15
percent. Th e impact of such interest payments may develop manifold and
still worsen in the future if the government stick to the same policy of
borrowing in the years to come.
4. Unjustified transfer
The servicing of internal debt involves transfers of income from the
younger to the older generations and from the active to the inactive
enterprises. The government imposes taxes on enterprises and earnings
from productive efforts for the benefit of the idle, inactive, old and
leisurely class of bond holders. Hence work and productive risk taking
efforts are penalised for the benefit of accumulated wealth. This adds to
the net real burden of debts.
5. Indirect real burden
Internal debt involves an additional indirect real burden on the
community. This is because the taxation re quired for servicing the debts
reduces the tax payer's ability to work and save and affects production
adversely. The government may also economise social expenditure
thereby, reducing the economic welfare of the people.
Taxation will reduce the personal efficiency and desire to work. Thus
there would be a net loss in the ability and desire to work. The creditor
class will also not have any incentive to work hard due to the prospect
of receiving interest on bonds. This would further cause a loss to
producti on and increase the indirect burden of debt.
6.4.2 The Burden of External Public Debt
External debt is beneficial in the initial stages as it increases the resources
available to the country. But its repayment & servicing creates a burden
on the debtor country.
1. External debt trap
The external debt creates direct money burden. This is because; it involves
transfer of funds from the debtor country to foreign citizens. The degree of
burden depends upon the interest rate, and the loan amount. The loans are
normally t o be paid in foreign currency. Therefore, the funds are mostly
transferred from export earnings or by raising more funds from foreign
markets. Borrowing by way of additional loans would put extra burden on
the country. The situation may become so worse, th at the country may be
caught in the external debt trap. It may have to borrow from foreign
markets to repay the interest amount and it would be very difficult to
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83 2. Direct real burden
The external debt may also result in direct rea l, burden. The citizens of the
debtor will have to suffer loss of economic welfare to the extent of
repayment of principle amount and interest burden.
The foreign currency earned through exports would have been utilized to
import better goods and technolog y. Which would have increased the
economic welfare of the citizens of the debtor country. But because of
external debt repayment, they have to restrict their welfare which the
imported goods would have provided. In other words, the citizens of
debtor count ry are deprived of imported goods and service to the extent
till the loans and interest amount is repaid.
3. Decline in expenditure to public welfare programmes
When the government spends a significant portion of its resources towards
the payment of foreign debt it reduces the government expenditure to that
extent which otherwise would have been spent for public welfare
programmes.
4. Decline in the value of nation's currency
The repayment of external debt involves an increase in the demand for the
currency of th e creditor country. This will raise the exchange rate of the
creditor country's currency, and aggravate the problem of foreign
exchange crisis.
The creditor country may also be adversely affected if it is induced to
import more from the debtor country. This may hinder the growth of
their domestic industries and cause unemployment.
5. Burden of unproductive foreign debt
The magnitude of external debt burden depends upon whether the debt is
incurred for productive purposes or for unproductive purposes. If it is
incurred for unproductive purposes, it will create a greater burden and
sacrifice on the citizens of the debtor country.
6. Political exploitation
In recent years, it was found that the lending countries who dominate
international organisations like World Ban k & international monetary
fund use the lending opportunity as an instrument to exploit the
borrowing countries economically & politically.
6.4.3 Shifting the Burden of Public Debt
When resources for government expenditure are generated through
taxation, the pre sent generation bears the burden but when resources are
generated through public debt, the future generation pays the interest &
principal and thus bears the burden. Thus in the case of public debt the munotes.in

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84 burden falls on the prosperity. Payment of such projec ts out of taxation
would be unjustified as it would put burden on the present generation
while benefit would accrue to the future generations. In future when the
time for payment of interest & principal comes, the government will have
to tax people to pay money to bond holders. The future tax payers will pay
future bond holders. It would merely imply diversion of funds from one
set of people to another within the country. However, it will involve direct
real burden as the classes of tax payers & bond holder s are likely to be
different. The burden of taxation is likely to be heavy on general mass
while the benefit will accrue to small rich class of bond holders.
Whether the burden of public debt is borne by future generations or not
may also depend upon many factors. The loan raised for productive
purposes may not create burden on future generation since it will create
assets and will add to productive capacity of the economy. This would not
only increase income for present generation but also for the posterit y. If it
is used for unproductive purposes or emergencies like war it will shift
burden on future generation.
Whether the burden will shift or not also depends on whether the present
generation pays off debts by sacrificing current consumption or
investmen t. If it is done by reducing current consumption, future
generation will not bear the burden. But if it is done by reducing
investment the future generation will bear the burden.
If loans are short term it can be repaid by the current generation. This will
not shift the burden. In case of long term loans shifting of burden will
depend upon whether the loan is self liquidating or deadweight. It may be
concluded from the above analysis that shifting of the burden of public
debt from present to future generati ons may be possible, but it depends of
various factors.
6.5 PUBLIC DEBT AND FISCAL SOLVENCY
Public debt is the total amount, including total liabilities, borrowed by the
government to meet its development budget . The term is also used to refer
to overall l iabilities of central and state governments. Fiscal solvency is
the ability of the government to meet its long -term debts and financial
obligations. It is an important measure of financial health of the country. It
demonstrates government’s ability to mana ge its operations into the
foreseeable future. In simple words fiscal solvency refers to the
management of public debt. The objective of the management of public
debt is to adopt such methods of borrowing funds and the repayment of
loans by the government which helps to maintain economic stability i.e., it
should reduce inflationary and deflationary effects upon the economy.
6.5.1 Definition and significance :
The public debt management is concerned with the decisions regarding the
forms of public debt iss ued, terms on which new bonds are sold, maturing munotes.in

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85 debts are redeemed or refunded, the proportion in which the different
forms of public debt should be issued, the pattern of maturities of the debt
and its ownership etc. in short the management of public deb t is concerned
with refunding, floating or retirements of public debts etc.
The management of the public debt is very significant because there can
be important economic effects of the changes in the size of the public debt
on the operation of the economy . The public debt policy, fiscal policy and
the monetary policy are closely connected with each other for the
determination of economic policy.
6.5.2 Principles of public debt management
1. The interest cost of servicing public debt must be minimized: The
interest cost of servicing public debt should be kept minimum because
the government has to impose additional taxes or the rates of existing
taxes are raised for the payment of interest cost. The interest can be
minimized, if the central bank of the country is induced to keep the
interest rate low by means of effective monetary policy.
2. Satisfaction of the needs of investors: Public debt should be managed
in such a way that the needs of the investors with regard to the types of
the government securities and th e terms of issues are satisfied. If the
public debt management fails to satisfy the needs of the investors,
there may be disturbances in the security markets on account of sale of
securities.
3. Funding of short term debt into Long term debt: Public debt
mana gement should help to fund as much of the short term debt into
long term debt as possible. The funding operations must be undertaken
in such a way that there is no undue rise in the long term interest rates.
4. Public debt policy must be coordinated with fis cal and monetary
policy: the coordination is essential to maintain economic stability and
to promote economic growth.
6.5.3 Redemption of public debt :
Redemption means repayment of a loan. All government loans should be
repaid promptly. Advantages of deb t redemption are as follows:
1. It saves the government from bankruptcy.
2. It discourages unnecessary expenditure of the government.
3. It maintains confidence of the investors.
4. It would be easy for the government to raise new loans in future.
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86 6. When the loans are repaid, the resources may be diverted to their other
potential uses.
6.5.4 Methods of repayment:
Following are the various methods of debt repayment.
1. Repudiation: means refusal to pay the debt by the government. It
shakes the confidence of the people and banks in the government. The
government finds it difficult to raise new loans in the near future. In
case external debt, it may create a number of difficulties for the
repudiating country such as economic blockade, mili tary invasion etc.
by the foreign countries.
2. Refunding: When the government sells its bonds to pay its floating
obligations, the debt is said to be refunded. It is process by which
maturing bonds are replaced by the new bonds. The refunding is
undertaken m ainly with a view to meeting maturity requirements.
3. Conversion: conversion of public debt means exchange of new debts
for the old ones. In this method, the debt is actually not repaid but the
form of debt is changed. The process of conversion consists gene rally
in converting or altering a public debt from a higher to a lower rate of
interest.
4. Actual repayment: For actual repayment of loans the following
measures can be adopted:
a) Sinking fund: it is a device which has been developed for the regular
retirement of debt. It is a fund into which a certain amount of revenue
is deposited each year for the repayment of out -standing debt. The
fund is used for the purchase of outstanding debt and the ultimate
retirement of loans as they fall due.
b) Surplus revenues: a p olicy of surplus budget may be followed
annually for clearing of public debt gradually instead of creating a
fund for its repayment on maturity.
c) Terminal annuities: The government may issue terminal annuities, a
part of which matures every year according t o a serial order
announced or decided by lottery system, so that the debt can be
cleared every year and consequently the burden of interest is also
reduced to that extent every year. Thus it is method of repayment of
loan in instalments.
d) Capital levy: refe rs to a very heavy tax on property and wealth. It is a
once for all tax imposed on the capital assets above the certain value.
6.5.5 Repayment of external debt :
The redemption of external debt is possible only through the earning of
foreign exchanges to p ay it. It can be done by creating export surpluses. If munotes.in

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87 foreign loans are invested in those industries, which increase the supply of
those commodities which are exported, the loans may be easily repaid. If,
however loans are utilized for unproductive purpos e, and export surplus
may be possible at the cost of home consumption, and hence the burden of
debt may be very much felt by the people.
6.6 SUMMARY
1. Public debt or public borrowing is considered to be an important source
of income to the government. If revenue collected through taxes &
other sources is not adequate to cover government expenditure
government may resort to borrowing. Such borrowings become
necessary more in times of financial crises & emergencies like war,
droughts, etc.
2. Public debt may be raised internally or externally. Internal debt refers
to public debt floated within the country; while external debt refers
loans floated outside the country.
3. Government loans are of different kinds, they may differ in respect of
time of repayment, the purpose, conditions of repayment, method of
covering liability. Thus the debt may be classified into following types.
 Productive and Unproductive debts
 Voluntary and Compulsory debts
 Internal and external debts
 Short term, Medium term and Long term deb ts
 Redeemable and Irredeemable debts
 Funded and Unfunded debts
4. Over the years, the public debt of the India's Central and that of State
government has increased considerably during the planning period.
The Government borrows funds by way of public debt to meet the
various development and non-development expenses.
5. Both internal and external debt carry a burden on the economy of
nation.
6. The burden of public debt adversely affect the growth and
development of the economy. Therefore there is a need to effectively
manage public debt. Management of public debt involves; repayment
of public debt, controlling the amount of borrowings and productive use
of borrowed funds for development.
7. Public debt is the total amount, including total liabilities, borrow ed by
the government to meet its development budget . Fiscal solvency is the munotes.in

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88 ability of the government to meet its long -term debts and financial
obligations. It is an important measure of financial health of the
country. In simple words fiscal solvency refe rs to the management of
public debt. The objective of the management of public debt is to adopt
such methods of borrowing funds and the repayment of loans by the
government which helps to maintain economic stability i.e., it should
reduce inflationary and deflationary effects upon the economy.
6.7 QUESTIONS
1. Discuss the meaning of public borrowing.
2. Explain various types of Public debt.
3. Differentiate between Internal debt and External debt.
4. Discuss the burden of internal debt and external debt.
5. Explain the concept of shifting of debt burden.
6. Explain the management of public debt in India.



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89 Module IV
7
FISCAL POLICY

Unit structure
7.0 Objectives
7.1 Meaning of fiscal policy
7.2 Functioning of fiscal policy
7.3 Objectives of fiscal Policy
7.4 Constituents
7.5 Limitations
7.6 Classical and Neo Classical View of Fiscal Policy
7.7 Principles of Sound Finance
7.8 Principles of Functional Finance
7.9 Types of Fiscal Policy
7.10 Summary
7.11 Questions
7.0 OBJECTIVES
 To know the meaning of fiscal policy
 To understand how does the fiscal policy works
 To know the objectives of fiscal policy
 To underst ands the different constituents of fiscal policy
 To know the limitations of the policy
 To understand the classical principle of sound finance
 To understand neo classical principle of functional finance
 To know the different types of fiscal policy
 To know l imitations of fiscal policy


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90 7.1 MEANINGOF FISCAL POLICY
Fiscal policy is the part of government policy that deals with raising
revenue through tax and non -tax sources and deciding on the level and
pattern of public expenditure.
Fiscal policy is compose d of several parts. These include, tax policy,
public expenditure policy, investment or disinvestment strategies and
debt or surplus management. Fiscal policy is an important constitution
of the overall economic framework of a country and is a therefore
intimately linked with its general economic policy strategy. In most
modern economics, governments deal with fiscal policy while the central
bank is responsible for monetary policy .
These measures included social security expenditures and following
counter c yclical budgetary policy to keep aggregate demand high .
In developing countries , besides traditional functions, governments also
promote economic development . In developing economies, fiscal policy
is used as an important instrument to bring about creatio n of economic
and social infrastructure, employment generation, poverty reduction
and improvement in income distribution.
7.2 FUNCTIONING OF FISCAL POLICY
According to Keynesian economists, the primary objective of fiscal policy
is to maintain high level o f aggregate demand through variables like
disposable income, public and private investment, consumption
expenditure, net exports and government purchases. A high level of
aggregate demand will result in higher production, employment and
ensure better stand ard of living. A change in any one of the policy
variables affects all other variables as they are all interrelated.
This interrelationship can be explained as follows :
AD = C + I + G + (X – M)
Where, AD = aggregate demand
C = consumption expenditure
I = investment expenditure
X = exports
M = imports
In the short run,
C = f (Y d) and M = f (Y)
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91 Where, Y = gross income
Y d = disposable income (income left with people for spending)
TR = transfer payments (e.g. pension, subsidies, unem ployment benefits)
t = tax rate (direct tax is imposed as a proportion of income Y)
By using fiscal policy measures, the government can influence aggregate
demand (AD) as follows :
(a) C can be increased by reducing t and increasing TR as this will raise
the level of disposable income.
(b) Imposition of import duties will reduce M and subsidies and tax
incentives to exports will increase X.
(c) I can be raised through tax exemptions as well as subsidies to
producers.
(d) G can be increased through government purchases.
All these decisions will increase aggregate demand and national output.
But these decisions will have implications on government’s budget.
Deficits and surplus budgets have their own impact on the economy in the
long run. For example, if the government incre ases G and reduces t in
order to increase AD and achieve higher GDP growth in the short run, it
will run the risk of incurring heavy fiscal deficit. This will cause inflation
as money supply will rise and it will make it necessary for the government
to bor row heavily, increasing interest burden. Resources may have to be
diverted from other public expenditure heads for interest payments. All
these factors will slow down economic growth in the long run. Therefore,
fiscal policy decisions have to be made with utmost care by the
government.
7.3 OBJECTIVES OF FISCAL POLICY
The fiscal policy is formulated with specific objectives in view. The
objective in developed countries is to achieve economic stability and
maintain high aggregate demand .
In developing countr iesthe goal is to achieve economic growth and
development.
Following are some of the objectives of fiscal policy
1. Optimum Allocation of Resources : The most important function of
fiscal policy is to determine how the country’s resources will be
allocated . What should be the share of different sectors of the
economy in terms of resource allocation? This is closely related to the
government’s taxation and expenditure policies. Allocation of
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92 compositio n of government expenditure . The national budget
determines how funds are allocated to different heads of expenses. The
policy of public expenditure is used by the government to directly
undertake resource allocation for different sectors. On the other han d,
the government can use taxation and subsides to indirectly influence
resource allocation. For example, tax incentives given to SEZ units
will encourage investors to direct resources to those units.
2. Full Employment : The importance of fiscal policy as a n economic
tool gained significance during the Great Depression in 1930s when
the developed countries were suffering from unemployment. Thus the
main objective of fiscal policy was defined as achievement of full
employment. For this the fiscal policy shoul d be designed to keep the
level of aggregate demand high. In developing economies government
expenditure on social and economic infrastructure is used to generate
employment opportunities.
3. Economic Stability :Stabilization of the economy is another import ant
function of fiscal policy, especially in developed economies that
experience business cycles. The cycle nature of the market in these
economies causes fluctuations in variables like income, output,
investment and employment causing hardships to the peo ple. When
growth periods end, they are followed by contraction in the form of
recession. Fiscal policy is meant to counter these fluctuations. This
known as counter cyclical fiscal policy . A counter cyclical fiscal
policy is adopted to counter the effects of recession and depression
by following a deficit budget . This brings about an increase in
government expenditure to generate employment and decrease in taxes
to induce consumption and investment. On the other hand, during
inflation, government expenditur e and tax rates are lowered to reduce
aggregate demand and prices. A surplus budget is followed.
4. Increasing the Rate of I nvestment and Capital Formation :In
developing countries the problem of mass and structural
unemployment . Fiscal policy in such countrie s is aimed at increasing
the rate of capital formation through investment. This can be done by
giving tax incentives and subsidies to encourage private sector
investment. Also, in many developing countries the government
directly takes part in capital form ation through investment in social
and economic infrastructure.
5. Encouraging Sociall y Optimum Pattern of Investment :In
developing countries fiscal policy can direct investment in those fields
that are most desirable from social point of view. For example, fiscal
incentive to small scale industries and infrastructure development.
6. Reducing Income Inequalities : Fiscal policy can be effectively used
to manipulate the distribution of national income and resources.
Taxation and public expenditure policies are us ed by the government
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93 burden on the rich than the poor. Public expenditure on social
infrastructure and subsidies on food, housing, health and education
help reduce income inequality.
7. Reducing Unemployment and Underemployment : Public
expenditure can play an important role in this regard. Public works
programmes can be initiated to create employment and to absorb
surplus labour from areas of underemployment especially in
developing countries.
8. Controlling Inflation :Developing countries need to resort to deficit
financing in order to finance their programmes of industrialization and
infrastructure building. This creates inflationary conditions in the
economy as purchasing power is bound to rise w ith deficit financing.
In order to control inflation, the ideal fiscal response would be
reduction of public expenditure . But this is unlikely to take place in
a developing country and hence the fiscal response should be in the
form of encouraging supply o f goods and services though appropriate
incentives. As supply increases, the inflationary pressure is likely to be
on the decline.
7.4 CONSTITUENTS OF FISCAL POLICY
There are four constituents of fiscal policy
1. The Budget : The budget is an estimate of th e government’s
expenditure and revenue for a fiscal year. It is an important instrument
of fiscal policy used by most modern governments to fulfill objectives
of economic growth, reduction of inequalities, generation of
employment and economic stability. T he budget is used to allocate and
divert resources to the desired sectors. A budget is typically comprised
of the revenue and the capital budget. It can be balanced, surplus or
deficit. According to functional finance, the budget can be used to
reduce the effects of business cycle. During recession, a deficit budget
should be followed and during inflation, a surplus budget should be
followed.
2. Taxation : Taxes are the most important sources of revenue to a
government. They are compulsory payments levied on income and
wealth (direct taxes) and on production, sales and movement of
commodities (indirect taxes).
Taxes are not only sources of revenue to the government, but they are
used to reduced income inequality (redistributive taxation) and
maintain price st ability (anti -inflationary taxation). Taxes are levied at
progressive, proportional and regressive rates. Progressive taxes, like
income tax, are based on ability to pay and are used to reduce income
inequality. Indirect taxes are regressive in nature. Tax es have wide
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94 3. Public Expenditure : The public expenditure policy is the end
objective of fiscal policy. Government spending is classified as
revenue and capital spending. The primary obj ective of public
expenditure is generation welfare. Public expenditures are financed
through tax and non -tax sources of revenue as well as public
borrowing.
4. Public Debt . :Most governments finance their expenditure through
borrowings when the tax and other sources of revenue prove to be
inadequate. Public debts are classified on the basis of time period,
productive or unproductive, voluntary or compulsory. One of the most
important classifications of public debt is internal and external. Public
debt cause bu rden of repayment which results in income redistribution.
All the above mentioned constituents of fiscal policy are discussed in
details in different chapters in this book.
7.5 LIMITATIONS OF FISCAL POLICY
The effectiveness of fiscal policy is subject to the following limitations :
1. Practical Difficulties : Theoretically, the outcomes of fiscal policy are
based on certain assumptions. However, real macroeconomic
situations are far more complex. Certain assumptions made in theory
may not be present in reali ty making fiscal policy ineffective. For
example, during inflation, taxes are raised and public expenditure is
lowered. This measures would only be effective in controlling
inflation, if money supply in the economy is not increased by
government’s deficit financing. Also, fiscal policy must be
complementary to monetary policy.
2. Forecasting Difficulties : Reliable forecasting of target variables is a
very important factor in the success of fiscal measures. These variables
include national income, output, pric e level, employment,
consumption and investment. Forecasting is a function of data
collection and analysis which is difficult in developing economies.
Even in developed economies, forecasting has not been foolproof.
3. Multiplier : The efforts of fiscal measu res are transmitted to the
economy through the working of various multipliers like, investment
multiplier, tax multipier. For example, the effect of an induced
government investment on infrastructure will lead to an increase in
income and consumption throu gh the multipier process. The exact
impact of such an investment would depend on the investment
multiplier coefficient. Firstly, it is difficult to estimate the values of the
multiplier coefficients due to leakages and uncertainties. Secondly,
there are ti me lags in the working of the multipliers. It may happen
that by the time the full impact of a fiscal decision is felt on the
economy, economic conditions may have changed in such a way that it
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95 example, the government may decide to increase expenditure in order
to boost economic growth. This can lead to rise in fiscal deficit. By the
time economic growth is revived, the fiscal deficit may have growth so
large as to force the government cut down on capital and revenue
expenditure, once again affecting growth.
4. Time Lags : These lags exist in case of discretionary fiscal policy
which are deliberate measures taken by the government. It takes time
for the government to recognize a problem and th en decide to
implement a suitable policy to address the problem. These are inside
lags. The outside lag is in the form of time taken for the impact of the
policy to be felt. These lags reduce the effectiveness of fiscal policy.
5. Underdeveloped Economies : Fiscal measures, as well as monetary
policy measures, are not very effective in underdeveloped economies
due factors like, low taxable capacity, large unorganized and non -
monetised financial system, low income levels and corruption.
6. Political Influence : W hile monetary policy is under the central
bank’s control, fiscal policy is implemented by the government. The
central bank is an autonomous institution, relatively free from political
influence. This is not true of the fiscal policy. The democratic
governm ents often mix politics with economics in their budget
decisions. This limits the effectiveness of fiscal policy. For example,
during election years, the government may increase subsidies and
other expenditures to gain public support. This can increase fis cal
deficit and cause harm to the economy in the long run. Thus, short run
political gains can compromise log run economic goals of fiscal
policy.
7.6 CLASSICAL AND NEO CLASSICAL VIEW OF
FISCAL POLICY
Fiscal policy deals with government policy in relation to raising revenue
through taxation and other means, and deciding on the level and pattern of
public expenditure. It is composed of tax policy, public expenditure
policy, investment or disinvestment strategies and budget
management .
In recent history, fi scal policy has been a very important component of
government policy. But until the Great Depression of 1929, the
government’s role was concentrated on traditional functions like
provision of defence, law and order and civic amenities. It was believed
that the government need not use fiscal policy to interfere in the market
mechanism, since the market is efficient enough to correct itself, in case it
failed at times. This was known as the principle of sound finance. Most
classical and neo -classical economis ts advocate sound finance policy.
But after the Depression, it was realised that markets can fail and do not
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96 Unemployment and price instability make life difficult for the common
person. Therefore, most laissez faire capitalist economies transformed
themselves into welfare states. In such economies, the role of the
governments expanded to include several non- traditional activities, like
reduction of inequality, provision of social justic e, building economic
infrastructure and most Governments began to use fiscal policy to avoid
another depression, control inflation and keep aggregate demand
high. Therefore, fiscal policy was used as a contra -cyclical measure .
This type of use of fiscal po licy to bring about desired changes in the
economy is known as functional finance. The main advocate of this type
of fiscal policy was John Maynard Keynes.
A major problem of fiscal policy is finding a balance between the short
run stabilization objectives and long run goals of growth and
development. At times, the short run policies adopted to deal with
cyclical fluctuations like inflation and recession may conflict with long
run goals of the economy.
Two conflicting views on how to achieve the goals of f iscal policy are
represented by the following principles :
(a) The Principle of Sound Finance
(b) The Principle of Functional Finance
The discussion below involves the basic economic, political and
sociological basis for arguments for and against sound finance and
functional finance. In the analysis, the classical school includes the
economic thoughts of economists like Adam Smith, David Ricardo, J.B.
Say, John Stuart Mill and Thomas Malthus. The term ‘modern’ used in the
context here refers to denote economists wh o challenged and opposed the
classical principle of sound finance. They include John Maynard Keynes,
A.C. Pigou, Edgeworth and most significantly, Abba P. Lerner.
7.7 PRINCIPLES OF SOUND FINANCE
Prior to 1930s, classical economists did not include fiscal p olicy in 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 s ystem where economic transactions are largely
between private owners of factors of production and such transactions are
free from government restrictions, taxation and subsidies. Laissez faire
policy advocates that there should be only enough government re gulations
to protect property rights of individuals. The market mechanism should be
left free of any government interference.
Such an economic system formed the basis for classical, and later, neo -
classical economic thoughts. In such a system, the role of the government
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97 order, justice, provision of civic amenities and therefore most government
spending was expected to be restricted to these areas. The classical
economists argued that taxation should be restricted to a limit that was
sufficient for the government to raise funds for performing its traditional
functions. The role of the budget and fiscal policy did not extend beyond
raising funds through taxation and spending on tradition al functions. The
primary belief was that the size of the government’s budget should be
small and the budget should balance . These beliefs form the basis of the
principle of sound finance .
The following are some of the features of sound finance :
1. Say’s La w : Like many other classical principles, the principle of
sound finance is also based on Say’s Law, that is, “Supply creates its
own demand.” Since one man’s expenditure is another man’s income,
aggregate demand will always be equal to aggregate supply. T his
belief forms the base of the argument 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 -consumption. In other
words, the econ omy cannot suffer from fluctuations like
unemployment and inflation. Driven by profit motive, the private
sector will ensure optimum use of resources. Therefore, there will be
full employment in the economy. Only voluntary and frictional
unemployment may e xist.
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. The concept of Adam
Smith’s ‘invisible hand’ is used to explain how private self interest
will result in collective social good.
4. Taxation : According to the classical school of thoughts, taxes are
harmful because they adversely affect willingness and ability of work,
save and invest. Taxation was expected to be kept a t 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. Therefore, it was believed that government spending
would not have a ny significant impact on the economy. The classical
school generally viewed the government with suspicion and therefore
any increase in public expenditure during peacetime was not
advocated. Sound finance is based on the belief that government which
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98 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 b y the government would not increase
total demand for factors of production as there is already full
employment. Therefore, there is no justification for the government to
expand its expenditure beyond revenue and incur deficit budget.
Budget should always balance except during waritime when
government will have to expand expenditure to fight war. The state
should not take up business activities as private sector is considered to
be most efficient. Also, there is no justification for large public
expenditure as it is assumed that there is full employment in the
economy.
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 t here 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 bas ed 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 s avings increase, they will not increase
consumption and therefore, increased public expenditure will not be
able to boost demand, production and boost growth.
7.8 PRINCIPLES OF FUNCTIONAL FINANCE
In the 1920s, Europe, and the 1930s, the United States, bega n to
experience depression. During this time, economists, like A.C. Pigou, F.
Knight, and J.M. Keynes, began to question sound finance principles. Low
profit expectations during depression kept investment spending low,
causing unemployment to rise. The eco nomists favoured, at least
temporarily, giving up the sound finance principles and using government
spending to stimulate the economy.
Increased government spending during depression would mean running a
deficit budget. But this was considered necessary a s private investment
was not forthcoming. Increased government expenditure in infrastructure
building, job creation and paying social security would increase income.
This would encourage spending and aggregate demand would rise and
ultimately would help pu ll the economy out of the depression or recession.
It was generally agreed by economists and policy makers that fiscal policy
could be of some use in helping pull an economy out of a severe recession.
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99 policy. This view that fiscal policy can be used to offset undersirable
cyclical fluctuations in output was later termed as ‘functional finance’ by
Abba P. Lerner.
The concept of functional finance has the following features :
1. Market failure : U nlike classical economists, modern economists
believe that markets are not perfect and they can fail. They do not
always correct themselves. Market failures can have severe economic
consequences in the form of depression and hyper -inflation. The Great
depression of 1930s brought the powerful US economy down. In more
recent times, the financial crisis of 2007 -08 in the USA showed that
due to excessive de -regulation, financial markets can fail and become
the cause of a severe and long standing recession. Also , due to
globalization, this recession had affected the economic prospects of
almost every country in the world.
2. Importance of fiscal policy : According to Abba P. Lerner, who
advocated the concept functional finance, fiscal policy is the most
important par t of any economic policy. Taxation, public expenditure
and public debt must be adopted according to the needs of the time.
While classical economists believed that the main aim of public
finance is to raise revenue, modern economists believe that the main
objective of public finance is to correct imbalances in the economy.
They are the most important instruments of promoting economic
stability and progress. Budget must act as an instrument of economic
change.
3. Aggregate demand : While classical economists b elieved that supply
creates its own demand, modern economists, particularly Keynesians,
believed that it is demand that leads to investment. Consumption and
investment can rise or fall together. Aggregate demand consists of
consumption demand, investment d emand, government expenditure
and net foreign income. Modern economists believed that it is
aggregate demand that determine level of national income and
employment. Deficiency in aggregate demand results in
unemployment. Government expenditure needs to be increased during
such times to boost aggregate demand to stimulate the economy.
4. Budget : Modern economists believe that the government, through
public expenditure, taxation, or deficit financing, can maintain full
employment. During recession and depressio n, public expenditure
should be increased and the budget should be expanded to increase
aggregate demand. A deficit budget is perfectly justifiable to pull the
economy out of recession. On the other hand, during inflation, the
government may have a surplus budget by raising taxes to control
consumption. Modern economists have rejected the principle of a
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100 5. Income redistribution : According to modern economists, the
distribution of national income is as important as its size. A mo re even
distribution of income would increase the average propensity to
consume (APC) and increase the level of investment and employment.
A government aiming at full employment should try to redistribute
national income in such a way that the savings neve r exceed current
investment. Re -distribution taxation has been suggested as the best
means for achieving this. This implies imposing high taxes on the rich
and redistributing them to the poor through pension, welfare schemes
and allowances. This will impro ve APC and increase schemes and
allowances. This will improve APC and increase aggregate demand,
boosting investment, employment, production and profits. Thus fiscal
policy can provide social justice through better income distribution as
well as benefit ec onomic growth through higher investment.
6. Welfare capitalism : Karl Marx had predicted that, due to the inherent
crisis, the capitalist system will collapse and make way for a new,
more equal system. The Great Depression was a situation very close to
what Marx had predicted. But it was Keynes who advocated fiscal
measures for regulating capitalism and preventing its collapse. Keynes
gave importance to compensatory actions through fiscal measures for
improving and maintaining the level of effective demand an d thus the
level of economic activity in the country. The concept of functional
finance forms the basis of welfare capitalism that now exists in most of
the advanced economies.
7. Social objectives : Advocates of functional finance believe that public
finance has no function in the interest of the entire society. Taxation,
expenditure, borrowing policy and ownership and operation of public
utilities must be measured on the basis of their effects on the entire
society. Objective of taxation should be to redistri bute income in the
most socially just manner Expenditure on social security, poverty
eradication, medical care and education will always be justified as they
bring in distributive justice. Public expenditure and taxation should
follow the objective of equa lizing marginal social cost and marginal
social benefit. Social objectives are the primary focus of functional
finance.
Though the concept of functional finance has been severely criticized by
conservative economists and politicians, it has had very wide acceptability
in the last few decades in most of the major developed as well as
developing countries. After following functional finance policy for
decades, in 1980s, many advanced countries began to adopt different
versions of laissez faire capitalism by promoting privatization and
reducing public expenditure on welfare measures. This coincided with
globalization of trade and capital movement. There was high degree of
market deregulation. This resulted in unprecedented increase in world
trade and capital m ovement. This also led to high growth in emerging
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101 deregulation resulted in multiple market failures. The USA experienced a
major financial crisis followed by a long recession with high level of
unemployment. The recession in the advanced economies effected the
world economy, including the rapidly growing emerging countries. It
became necessary for the advanced economies to expand their budgets and
increase public expenditure to provide stimul us to their economies, thus
reviving the policy of functional finance. Similarly, the emerging
economies too had to expand their budgets to revive growth.
7.9 TYPES OF FISCAL POLICY
Based on their experiences of following sound and functional finance
polic ies, countries have evolved fiscal policies to suit their own
requirements. Most modern economies follow some version of functional
finance in deciding on their fiscal policy. In most developed economies
the primary objective of fiscal policy is to counter the harmful effects of
economic fluctuations.
Following are some of the types of fiscal policies used :
1. Automatic Stabilisers :
Many developed economies have built -in flexibility in their tax and public
expenditure structure that lead to automatic sta bilization of the economy
during inflation and recession. Due to built -in flexibility automatic
adjustment takes place in government expenditure and tax revenue in
response to changes in the national income.
When the national income rises and the economy experiences prosperity
and inflation takes place. During such times, tax revenue automatically
increases and government expenditure on social security like
unemployment benefits reduces as less people are unemployed. This
keeps effective demand under contr ol and slows down the growth of
aggregate demand preventing inflation .
On the other hand, during recession, public expenditure on
unemployment benefits and other social security measures
automatically go up while tax revenue falls. Due to this the growth o f
aggregate demand increases. Production rises, unemployment falls
and this prevents the economy from going into depression .
These changes in tax revenue and government expenditure take place
automatically due to the built -in flexibility in the fiscal syst em. This
leads to automatic stabilization of the economy.
Automatic stabilizers work only under certain conditions. They will be
ineffective in case of cost push inflation or inflation caused due to deficit
financing. If the economy is affected by externa l factors like worldwide
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102 to developing economies where built -in flexibility in the first system is
very limited.
2. Discretionary Fiscal Policy
In this type of fiscal policy, th e government makes deliberate changes in
its taxation and expenditure policies in order to achieve some targets.
Changes are made in tax rates and structures, size and composition of
public expenditure and debt. changes in tax rates, addition or abolition
of taxes, result in changing the disposable income of people and bring
about the desired changes in aggregate demand.
Discretionary changes in government expenditure take the form of
expansion or reduction in the size of expenditure, changing the
compositi on and sources of financing, changes in transfer payments like
pensions, unemployment benefits etc. surplus or deficit in the budget and
methods of financing deficit. All these changes have an impact on
aggregate demand through consumption and investment e xpenditure .
Discretionary fiscal policy is effective only when it is used for short run
corrections in the economy. For long run structural changes there should
be effective automatic stabilizers. Besides, time lags in recognizing a
particular problem and implementing the discretionary policy measure
reduce the impact of the policy.
3. Contra -cyclical Fiscal Policy or Compensatory Fiscal Policy :
The main objective of contra -cyclical fiscal policy is to achieve economic
stability. The purpose is to counte r the phases of business cycle and
minimize their negative impact on the economy. Such a fiscal policy is
discretionary in nature and consists of deliberate budgetary action taken
to manipulate aggregate demand. The budget is the primary instrument
of comp ensatory fiscal policy.
A. Fiscal policy during Recession and Depression : During recession
and depression the level of aggregate spending is very low. People
reduce their consumption spending and businesses reduce their
investment spending. Many resources re main unutilized as production
levels of goods and services decline. There is under consumption and
unsold inventories are high. The government has to then formulate a
fiscal policy that will bring the economy out of such a situation.
During depression, de ficit budget is followed. The government
increases its expenditure and reduced taxes to encourage spending.
The government can increase spending in the economy either
Indirectly or through direct spending. Taxes are lowered in order to
increase people’s dis posable income and encourage them to spend.
Government can also undertake massive expenditure on public works
programme in order to generate employment and transfer money to the
people. Indirect taxes are also lowered to give benefits to businesses
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103 and employ people. A cut in corporate income tax is also done to
encourage investment.
In public expenditure policy during recession and depression, the
government can use the following;
(i) Pump -priming : The term originated in the United States of America
in 1932. Here the government tries to revive economic activities in
those sectors that are stagnant and their revival is necessary to take the
economy out of recession, for example the banking sector.
Government spending in these sectors should stimulate private
spending by increasing purchasing power of the people. The policy of
pump -priming was used to revive the US economy during the
recession that began in 2008. The Japanse government under Prime
Minister Shinzo Abe has been using this policy to revive the economy
from the two decades of recession.
(ii) Compensatory spending : This kind of spending is adopted to
compensate the decline in private investment during recession and
depression. Such exp enditures are in the form of government
investment in infrastructure building and introducing new social
security measures. Compensatory spending should be carried out only
as long as private sector investment is low and should be withdrawn
once private in vestment picks up to a desired level. The problem with
using such policies is that the governments are not able to time the
beginning of recession and therefore may begin compensatory
spending after recession has become serious. Secondly, expenditure on
public works and infrastructure cannot be withdrawn easily as they
have long gestation period. The programmes often continue even after
the economy has revived. Such expenditure requires the government to
borrow and this increases the debt servicing burden o f the economy.
In view of the limitations of compensatory financing, many
economists argue that the government should spend on social security
measures like unemployment benefits and old age pension to increase
purchasing power and revive the economy thro ugh indirect measures.
In conclusion, we can say that to revive the economy from recession
and depression, the government should follow a deficit budget.
B. Fiscal Policy during Inflation : Inflation causes the value to money
to decline people can buy less wi th their income. During inflation, the
poor suffer the most and hence every government is concerned about
reducing the harmful effects of high rate of inflation. Fiscal policy
during inflation would include policy related to government spending,
taxation a nd public borrowings.
(i) Government expenditure : During inflation, aggregate demand is
high, there is unregulated private spending and the goods and services
available are not sufficient to meet the rising demand. The policy to be
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104 order to reduce purchasing power and bring down the price level.
However, there are certain limitations to this policy. The government
cannot reduce its spending in the short run to tackle inflation. Many
public s pending are medium to long -term commitments and they
cannot be withdrawn at short notice.
(ii) Taxation : Due to the difficulties regarding expenditure reducing
policy, the government usually resorts to raising tax rates and
imposing new taxes to control infla tion. The objective of anti -
inflationary taxation is to reduce aggregate demand and also to control
speculative expenditure, like those on housing, stock market and
commodities markets. However, taxes also cannot be increased
indiscriminately as that will lead to tax evasion and will affect
willingness and ability to work, save and invest.
(iii) Public Borrowings : Along with increased taxation, the government
could follow a policy of increasing public borrowing. The government
can borrow by issuing bonds (long term) and treasury bills (short term)
on a large scale. During inflation, people and the banking system have
excess cash. Therefore, government debt instruments, with attractive
interest rates, become a good source of earning for those who have
excess cas h. The sale of these instruments will absorb the excess
money from the system and help to reduce purchasing power. Massive
public borrowing also raises interest rate and this discourages
borrowing also raises interest rate and this discourages borrowing fr om
banks and encourages savings. All these measures help to reduce the
rising aggregate demand and lower the price level. However, while
following such a policy the government has to keep in mind the fact
that massive increase in public borrowing will incr ease its debt burden
and will enlarge fiscal deficit.
Fiscal policy followed during inflation will result in a surplus budget.
It is generally observed that fiscal policy may not be a very effective in
countering the effects of inflation but it is much mo re effective in
countering the effects of recession and depression. It is clear, that in order
to achieve economic stability and to counter the effects of business cycle,
the government will not be able to maintain balanced budget but will have
to resort t o either deficit or surplus budget.
7.10 SUMMARY
1. Fiscal policy is the part of government policy that deals with raising
revenue through tax and non -tax sources and deciding on the level and
pattern of public expenditure. Fiscal policy is composed of se veral
parts. These include, tax policy, public expenditure policy, investment
or disinvestment strategies and debt or surplus management.
2. According to Keynesian economists, the primary objective of fiscal
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105 like disposable income, public and private investment, consumption
expenditure, net exports and government purchases. A high level of
aggregate demand will result in higher production, employment and
ensure better standard of living. A change in any one of the policy
variables affects all other variables as they are all interrelated.
3. The fiscal policy is formulated with specific objectives in view. The
objective in developed countries is to achieve economic stability and
maintain h igh aggregate demand. In developing countries the goal is to
achieve economic growth and development.
4. A major problem of fiscal policy is finding a balance between the short
run stabilization objectives and long run goals of growth and
development. At t imes, the short run policies adopted to deal with
cyclical fluctuations like inflation and recession may conflict with lon g
run goals of the economy. Two conflicting views on how to achieve
the goals of fiscal policy are represented by the following princi ples :
(a) The Principle of Sound Finance
(b) The Principle of Functional Finance
7.11 QUESTIONS
1. Define fiscal policy. Explain how fiscal policy functions
2. Discuss the objectives of fiscal policy.
3. Discuss the constituents of fiscal policy.
4. What are the limitations of fiscal policy?
5. Discuss the principles of sound finance .
6. Write down the features of functional finance .
7. Explain discretionary and contra cyclical fiscal policy .
8. Write a note on Automatic stabilisers .



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106 8

PUBLIC BUDGET, DEFICIT AND FRBM
ACT 2003

Unit structure
8.0 Objectives
8.1 Meaning and objectives of budget
8.2 Important types of public budget
8.3 Structure of Union Budget
8.4 Types of Deficit
8.5 FRBM ACT 2003
8.6 Classification of government Into Unitary and Federal Governm ents.
8.7 Meaning of Fiscal Federalism
8.8 Meaning of Fiscal decentralization
8.9 Financial relation between center and state
8.10 Summary
8.11 Questions
8.0 OBJECTIVES
 To know the meaning of budget
 To understand the objectives of Budget
 To know different types of Budget
 To und erstands the structure of union budget
 To understand the concept of fiscal responsibility and budget
management
 To know the limitations of the FRBM
 To know broad classification of government
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107  To know the Meanin g of Fiscal decentralization
 To understands the financial relation between center and state
8.1 MEANING AND OBJECTIVES
Meaning of Budget
A budget is a description of the spending and financing plans of an
individual, a company or a government. The governme nt budget shows
the planned expenditure programmes of the government and the expected
revenues from taxes and other sources during a given year. The budget
contains a list of specific programmes like education, defence, welfare,
etc. which give rise to gov ernment spending. It also contains tax sources
like income tax, commodity tax, etc. which give revenues to the
government. The revenue sources differ depending on the level of
government (i.e. central, state and local). Although the central government
collects most of the taxes, states and local governments also have a wide
list of choices with respect to taxing.
When all taxes and other revenues exceed government expenditures for a
given year, there is a budget surplus. When government expenditures
exceed taxes and other revenues, there is a budget deficit. When revenues
and expenditures are equal during a given year, the government has a
balanced budget . Balanced budget is a rare phenomenon.
Fig. 8.1 shows government expenditure and revenue in relation to national
income. Government expenditure is assumed constant and revenue is
assumed to rise with national income. At the point E, budget is balanced.
To the left of E the government budget is in deficit and to the right of E
the budget is in surplus.

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108 When the government incurs a budget deficit, it is financed by borrowing.
The government borrows from the public by issuing government bonds.
This gives rise to government debt or public debt.
Objectives of Public Budget
In a laissez faire economy, with minimal government intervention, the
public budget was considered merely a statement of receipts and
expenditures of the government. The objective of the budget was to ensure
that the government taxed as little as possible and that the revenue was
sufficient to provide essential activities of the government. But as most
laissez faire economies converted into welfare states, the budget was no
longer considered to be a mere statement of receipts and expenditures, but
became an important instrument of fi scal policy through which the
government could fulfill many objectives. The functions and role of the
government expanded to cover a very wide area and the primary objective
of such functions is to promote general welfare of the people.
Some of the object ives of the public budget in any modern economy
are :
1. Allocation of Resources : This is the primary objective of any public
budget. In order to fulfill all the other objectives, the government
needs to first direct the allocation of resources in a desired manner.
Resources are public or privately owned. In order to divert private
resources to desired sectors, the government makes provisions in the
budget that includes; (a) tax concessions; and (b) subsidies. For
example, government may make provisions of bo th (a) and (b) for the
MSME sector in order to encourage investment in this sector as the
sector has large capacity to generate employment. In order to allocate
public sector resources, the government directly invests in public
sector undertakings like the railways, or public enterprises like oil
refineries, fertilizer plants or in transport and other infrastructure.
Resources are also diverted from undesirable sectors by levying higher
indirect taxes and withdrawal of subsidies. All these can be done
throu gh budgetary provisions.
2. Reduction of Poverty and Income Inequalities :The public budget is
an instrument of reducing income inequality through progressive
taxation, provision of social security benefits, subsidies on food,
housing and education, provisio n of merit goods. In most developing
economies, the government directly attacks poverty through poverty
alleviation programmes. The public budget allocates funds for such
expenditures. All these budgetary provisions are absolutely necessary
to redistribute income and wealth and reduce inequality.
3. Economic growth : Growth of the GDP results in more production
and employment generation. Therefore, every nation tries to ensure a
healthy rate of growth of the GDP as well as achieve balanced growth
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109 these objectives. Economic growth can be achieved through (a)
mobilization of savings; (b) investment and capital formation; and (c)
maintaining high level of effective demand. All these can be
influen ced by the budget. Tax incentives given to the people can
encourage them to save. Investments and capital formation are
encouraged through business tax incentives, subsidies and government
infrastructure spending. High level of effective demand is maintain ed
by keeping direct tax rates low, better distribution of income through
progressive taxation and subsidies, and social security expenditure and
following contra -cyclical fiscal policy. All these can influence the
growth rate of the GDP.
4. Economic Stabilit y : Most economies experience fluctuations in the
form of business cycles. Such fluctuations cause inflation recession
and unemployment. To protect the economy from the adverse effects
of the fluctuations and maintain stability in the economy, the budget
can play an important role, particularly in a recession or depression.
During recession, the automatic stabilizer in the fiscal system results in
reeducation in tax collection and increase in social security
expenditure. Besides, the government uses discret ionary fiscal policy,
like spending to create jobs. All these make the budget a deficit
budget. On the other hand a surplus budget is followed during
inflation. However, inflation can be better tackled with monetary
policy than with fiscal policy. In order to ensure long term price
stability, the government makes provisions in the budget to encourage
production, like investment in agriculture through irrigation projects to
increase food production and reduce food prices.
5. Management of Public Enterprises : M any developing economies
have adopted the mixed economy system, where the government
sector and the private sector both produce goods and services for the
market. The objective of setting up public sector enterprises is to
generate jobs, prevent private mo nopolies and provide people with
essential goods and service at low prices. In order to maintain the
public sector, regular budgetary provisions have to be made. Such
provisions include raising taxes to make investments in public sector,
as well as selling off unsustainable public sector enterprises through
the process of disinvestment. All these budgetary provisions have an
impact on the budget deficit and surplus.
6. Employment Generation : The budget is used to directly generate
employment through governme nt programmes, like the MNREGA in
India, or by budgetary support to sectors like MSME and agriculture
that generate large scale employment. Every year the government has
to make budgetary provisions for employment generation programmes.
In developed econom ies, the budget is used to maintain high level of
effective demand in order to maintain high employment level.
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110 8.2 TYPES OF PUBLIC BUDGET
The important types of public budgets are explained below.
1. Balanced and Unbalanced Budget : In a balanced budget the
revenues are equal to expenditures. It has neither a budget deficit nor
budget surplus. In the unbalanced budget, revenues and expenditures
are not equal. When the revenues are greater than expenditure, we
have surplus budget. On the other hand, when expen diture exceed
revenues, there is a deficit budget.
2. Zero based Budget and Traditional Budget : In the traditional
budget changes over the past years are to be justified, based on the
assumption that the baseline is automatically approved. In the
traditiona l budgets, incremental approach is used. Thus the
programmes and projects of previous years are automatically
continued and funded.
In zero based budget, every item of the budget must be approved,
rather than only changes. In zero based budget every item h as to be re -
evaluated thoroughly starting from the zero base. In a zero based
budget all expenses must be justified for each new year. The needs and
costs of every function of the government department are taken into
consideration for the next year’s budge t. It is used when resources are
limited.
3. Performance and ProgrammeBudget : Performance budget takes
into account the end result or the performance of the programme or
activity and thus ensures cost effective and efficient planning. It relies
on three aspe cts, such as, understanding of the final outcome, the
strategies formulated to reach those final outcomes and the specific
activities that are to be carried out to achieve those outcomes. Since it
involves a very detailed and objective analysis, this budge ting process
is very result oriented and its approach. This type of budget is mostly
used by the organizations and ministries involved in the developmental
activities.
Programme budget is somewhat similar to performance budget. But,
the programme budget i s different in considering the programme as a
unit. In this the major functions of the government is divided into
specific programmes, activities and projects. The funds are allocated
according to the achievements expected from each programme over a
specif ic period. The emphasis is on the size of the programme, its
implementation, costs involved and benefits expected from the
programme. Thus this can be narrower than the performance budget.
4. Multiple and Unified Budget : Multiple budget is where the budget is
divided into parts in such a way that each part highlights the
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111 example, the Indian government presented the Railway budget and the
Union budget separately.
Unified budget includes receipts from all sources and outlays for all
programmes of the government. It is the most comprehensive measure
of the government’s annual finances. Unified budget is a single
measure of the fiscal status of the government, based on the sum of all
government acti vities. When many fund groups are consolidated to
display budget totals, interfund transactions are deducted to avoid
double counting. Now the Indian government has merged the railway
budget with the general budget.
5. Legislative and Executive Budget : Legi slative budget is prepared by
the legislature directly or with the help of committees. A legislature
consists of elected representatives of the government. It is a decision
making organization that has the power to enact, amend and repeal
laws. The executi ve budget is prepared by the executive wing of the
government. The executive is responsible to the implementations of
the budget proposals prepared by the legislatures and executives.
6. Revenue Budget and Capital Budget : Budget is also classified into
reven ue and capital budget.
The revenue budget covers those items which are of recurring in
nature. The revenue budget shows both revenue receipts and revenue
expenditures.
Revenue receipts consist of tax revenue and non -tax revenue . The
two components of tax r evenue are (i) revenue from direct taxes, and
(ii) revenue from indirect taxes. Non tax revenue consists of interest
and dividend on investments made by the government, fees, and other
receipts for services rendered by the government.
Revenue expenditure is expenditure on maintaining existing level of
public services. Such expenditures do not create any capital asset but help
to maintain the existing assets. Revenue expenditure should ideally be met
through revenue receipts and not through borrowings.
Capi tal budget consists of capital receipts and capital expenditures .
The capital budget covers those items which are concerned with acquiring
and disposal of capital assets. The purpose of capital expenditure is the
expansion of present level of public servic es.
Capital receipts include funds received by the government in the form of
market borrowings, small savings, provident funds, recovery of loans,
external loans and disinvestment receipts and any other receipts from sale
of government assets.
Capital exp enditure includes repayment of debts and all expenditure
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112 power generation projects, establishment of schools, health care
infrastructure, etc.
8.3 STRUCTURE OF UNION GOVERNMENT BUDGET
OF INDIA
According to Constitution of India, there is a three -tier system of
government, namely, Central (or Union) government, state government
and local government (like Municipal Corporation, ZillaParishad, etc.).
Accordingly, these governments p repare their own respective budgets
(called Union Budget, State Budget and Municipal Budgets) containing
estimates of expected revenue and proposed expenditure.
The basic structure of government budget is almost the same at all levels
of government but it ems of expenditure and sources of revenue differ from
budget to budget. We shall discuss here only the structure of the Central
(Union) government budget briefly.
The Central Government is constitutionally required to lay an annual
financial statement bef ore both the houses of Parliament. This statement is
conventionally called Government Budget. Accordingly, in India, every
year Central (or Union) Budget for the coming financial year is presented
by the Union Finance Minister in the LokSabha normally on t he last
working day of the month of February. (Let us assume Union Budget for
the financial year 2016 -2017 is presented in February 2015).
The Union Budget contains details of government receipts and
expenditure for three consecutive years under the follow ing heads.
1. Actual for the proceeding year (i.e. 2014 -15 in this case).
2. Budget estimate for the current year (i.e. 2015 -16).
3. Revised estimate for the current year (i.e. 2015 -16)
4. Budget estimate for coming year (i.e. 2016 -17).
Union budget is divided into tw o parts, i.e. Revenue budget and Capital
budget. The revenue budget comprises revenue receipts and revenue
expenditure. Capital budget consists of capital receipts and capital
expenditure. The components of Union budget are presented in Chart 8.1
and Tabl e 8.1 [Chart 8.1 and Table 8.1 are self explanatory).




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113
Chart 8.1: Components of Budget

























COMPONENTS OF UNION BUDGET
Revenue Budget Capital Budget
(Important
Componcents)
i) Inter est payments
ii) Majir subsidies
iii) Defence expenditure (Compon ents)
i) Recovery of Loans
ii) Disinvestment
iii) Borrowings
iv) Other Liabilities (like PFs, etc. It is
expenditure
on creation
of assets and
investments. Revenue Expenditure Capital Expenditure Capital Receipts Revenue
Receipts
Tax Revenue Non-Tax Revenue
Direct Tax Indirect Tax
(Important Compone nts)
i) Personal Income Tax
ii) Corporate Tax
iii) Wealth Tax
iv) Minimum Alternative Tax
(Important
Components)
i) Union Excise Duty
ii) Customs Duty
iii) GST (Important Components)
i) Interest receipts
ii) Profits and dividends
iii) Fees and fines
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114 The Union Budget at a glance (without figures) is also given in
Table 8.1
Table 8.1 : Union Budget at a Glance 5
(Rs. Crore)
Actuals for
preceding
year Budget
estimate
for
current
year Revised
estimate
for
current
year Budget
estimate
for
coming
year
2014 -15 2015 -16 2015 -16 2016 -17
1. Revenue receipts
(2+3)
2. Tax revenue (net to
centre)
3. Non tax revenue
4. Capital receipts
(5+6+7)
5. Recoveries of
loans
6. Other receipts
(include
Disinvestments)
7. Borrowings and
Other liabilities
8. Total Receipts
(1+4)
9. Revenue
Expenditure
(Important items)
10. Interest payments
11. Subsidies
12. Defence spending
13. Grants to states for Creation of capital
Assets
14. Capital
Expenditure
15. Total Expenditure
(9+14)

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115 16. Revenue Deficit
(9 – 1)
17. Effective Revenue Deficit (16 – 13)
18. Fiscal Deficit
(15 – (1 + 5 + 6)]
19. Primary Deficit
(18 – 10)

8.4 CONC EPTS OF DEFICIT
When the government expenditure exceeds revenues, the government has
a deficit in the budget. Thus, the budget deficit is the excess of
government expenditures over receipts. The government finances its
deficit mainly by borrowing from the public through selling bonds on
which government promises to pay specified amounts of interest. This
gives rise to public debt. The deficit may also be financed by borrowing
from the Central Bank of the country. This may give rise to increase in the
money supply in the country. Thus, budget deficit causes the aggregate
demand in the economy to rise and even lead to inflation. But deficits need
to be incurred during recession to increase aggregate demand.
The important types of deficits are the following:
1. Revenue Deficit : Revenue deficit arises when revenue expenditure
exceeds revenue receipts. The revenue receipts come from both direct
and indirect taxes as well as from non tax sources like interest received
on loans given, dividend and profits of public e nterprise, fees, etc.
They represent transfer of purchasing power from individuals to
government. The revenue expenditures consists of interest payments
on public debt, civil administration, defence, subsidies on food,
fertilizers, etc. and social services like education, health, etc.
The deficit or surplus in the revenue budget is carried over to the
capital budget. Generally, a prudent public finance management
should give rise to surplus in the revenue budget which could be used
for financing developmen t activities. However, in India for the last
several years, there has been revenue deficit. This implies that for the
last several years part of the government’s consumption expenditure
has been financed by borrowing.
The revenue deficit of the Union Gove rnment of India was
Rs.3,54,015crore or 2.3 percent of GDP in 2016 -17.
2. Budgetary Deficit : It is the difference between all receipts and
expenditures of the government, both revenue and capital. This
difference is met by the net addition to the treasury bi lls issued by the
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116 called deficit financing by the government of India. This deficit adds
to money supply in the economy and, therefore, it can be a major
cause of inflationary rise in prices. This concept is not used by the
government in the recent years.
3. Fiscal Deficit : Fiscal deficit is the excess of total government
expenditure (both revenue and capital) over revenue receipts and non -
borrowing capital receipts, like recovery of loans, sale proceeds from
disinvested government assets. It is the most comprehensive
measurement of the budgetary imbalance. It measures the entire short -
fall in the fiscal operations of the government.
Fiscal Deficit = Total Expenditure – Total Receipts net of bor rowings.
Fiscal deficit is financed by borrowing both internally and externally
and incurring other liabilities like draw -down of cash balances with the
central bank. However, according to the provisions of the Fiscal
Responsibility and Budget Management Act 2003, the RBI is not to
lend to the Government of India by subscribing to primary issues of
the Central Government securities since 2006 -07.
The fiscal deficit of the Union Government of India was
Rs.5,33904crore of 3.5 percent of GDP in 2016 -17.
4. Primary Deficit : The fiscal deficit may be decomposed into primary
deficit and interest payments. The primary deficit is obtained by
deducting interest payments from the fiscal deficit. Thus, primary
deficit is equal to fiscal deficit less interest payments. It indicates the
real position of the government financs it excludes the interest burden
of the loans taken in the past.
Primary deficit = Fiscal deficit – Interest Payments
Primary deficit of the Union Government of India in 2016 -17 was
Rs.41,234Crore or 0.3 percent of GDP.
5. Monetised Deficit : It is the sum of the net increase in holdings of
treasury bills of the RBI and its contributions to the market borrowing
of the government. It shows the increases in net RBI credit to the
government. It creates equiv alent increase is high powered money or
reserve money in the economy and hence leads to rise in money
supply. This concept is also not used by the government in the recent
years.
6. Effective Revenue Deficit : This concept was introduced by the
government in the Budget Proposal for 2011 -12. Effective revenue
deficit is equal to revenue deficit is equal to revenue deficit minus
grants for creation of capital assets. The revenue expenditure of the
centre includes grants given to states for the creation of capita l assets.
Thus, by excluding grants for the creation of capital assets from
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117 Effective revenue deficit of the Union Government of India in 2016 -17
was Rs.1,87175crore or 1.2 percent of GDP.
In the Union Budget Government uses 4 concepts of deficits namely,
revenue deficit, effective revenue deficit, fiscal deficit and primary deficit
(see Table 8.1)
8.5 FRBM ACT 2003
The fiscal situation in India had been under mounting pressure especially
since 1980s, because the finances of the central government as well as
state governments had been in a bad shape. The long term trend in the
government finances indicated that the revenue generation has been lower
than the expenditure requirements, resulting in persistent and huge
revenue deficit as well as fiscal deficit. This resulted in mounting debt
accumulation and rising interest payments leading to fiscal crisis at the
beginning of the nineties.
The fiscal imbalance was related to rising debt servicin g obligations of the
central government. Debt service payments of central government had
risen exorbitantly from about 30 percent of tax revenue in 1980 -85 to
about 70 percent in 2002. As a proportion of total revenue receipts, debt
service had increased f rom about 24 percent in 1980 -85 to about 50
percent in 2002. As a proportion of GDP, debt service payments have
increased from about 2.2 percent in 1980 -85 to about 5 percent in 2004.
Another consequence of rising debt service was that the revenue deficit
had increased from about 17 percent as a proportion of fiscal deficit in
1980 -85 to about 50 percent in 2002. In another words, half of the current
borrowing was going to finance current expenditure. Since current
expenditure yields to economic returns in the future, debt service
payments will continue to rise in future unless a significant correction is
made in this regard.
The presence of fiscal crisis was affecting the objectives of promotion of
capital formation and high sustained economic growth. It was felt
necessary to have a permanent frame work for a rule -based fiscal
discipline. For this purpose the Fiscal Responsibility and Budget
Management (FRBM) Act was passed in 2003.
8.5.1 Fiscal Responsibility and Budget Management (FRBM) Act 2003
The Fis cal Responsibility and Budget Management (FRBM) Bill was
initially introduced in LokSabha in December 2000. This bill was referred
to the Parliamentary Standing Committee on Finance. A revised Bill was
introduced in April 2003. It was passed in LokSabha in May 2003 and in
RajyaSabha in August 2003. After receiving the assent of the President, it
became an Act in August 2003. The Act became effective from July 5,
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118 8.5.2 Major Features of Fiscal Responsibility and Budget
Management Act
The important fea tures of the Act are related to :
 Fiscal Responsibility and Budget Management Rules
 Borrowing from Reserve Bank of India
 Measures for Fiscal Transparency
 Measures to Enforce Compliance of Rules
The above features are explained below –
1. Fiscal Responsibi lity and Budget Management Rules : The
central government has to take appropriate measures to eliminate
the revenue deficit and fiscal deficit and build up adequate revenue
surplus. In particular the Central government has to take the
following measures :
(i) Reduce Revenue deficit by 0.5 percent or more of the GDP at
the end of each financial year beginning with 2004 -05.
(ii) Reduce Fiscal deficit by 0.3 percent or more of the GDP at the
end of each financial year beginning with 2004 -05
(iii)There should be no additiona l liabilities (including external
debt at current exchange rate) in excess of 9 per cent of GDP
for the financial year 2004 -05 and progressive reduction of this
limit by at least one percentage point of GDP in each
subsequent year.
(iv) In the medium term fisca l policy statement fiscal indicators
namely Revenue Deficit, Fiscal Deficit, tax revenue and total
outstanding liabilities as percentage of GDP are to be
projected.
(v) For greater transparency in the budgetary process, FRBM rules
mandate the Central Governmen t to disclose changes, if any, in
accounting standards, policies and practices that have a bearing
on fiscal indicators.
Exceptions : It is accepted that Revenue deficit and Gross fiscal
deficit may exceed the limits on account of unforeseen demands on
the finances of the central government due to national security or
natural calamity. However, such slippage in the targets of revenue
deficit and gross fiscal deficit must be explained to the parliament
as soon as such a slippage occurs.
2. Borrowing from Reser ve Bank : The central government shall not
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119 borrow from the RBI by way of advances to meet temporary
excessof cash disbursement over cash receipts during any financial
year in accordance with the agree ments which may be entered into
by the government with RBI. This essentially means that the RBI
will not be a handmaiden of the finance ministry and it need not
follow an accommodating monetary policy.
Reserve Bank of India is not to subscribe to the prima ry issues of
the Central Government securities from the year 2006 -07.
3. Measures for Fiscal Transparency :
(i) The central government shall take suitable measures to ensure
greater transparency in its fiscal operations and minimize, as
far as practicable, secrec y in the preparation of the annual
budget.
(ii) The central government should disclose significant changes in
the accounting standards, policies and practices affecting or
likely to affect the computation of prescribed fiscal indicators.
4. Measures to Enforce Co mpliance of Rules :
(i) The finance minister shall review, every quarter, the trends in
receipts and expenditure in relation to the budget and place
before both houses of parliament the outcome of such reviews.
(ii) In case of shortfall in revenue or excess of exp enditure over
pre-specified levels during any period in a financial year, the
central government shall proportionately curtail the sums
authorized to be paid.
(iii)The finance minister shall make a statement in both houses of
parliament explaining the following :
(a) Any deviation in meeting the obligations cast on the central
government under this Act; and
(b) The remedial measures the central government proposes to
take.
8.5.3 Limitations of FRBM Act
Although the FRBM Act shows that the government is serious about
reducing fiscal deficit, it has the following limitations.
1. Target regarding Gross Fiscal Deficit very Stringent : The FRBM
Act stipulates that by March 31, 2006, the gross fiscal deficit as a
proportion of GDP must be 2 percent. This, of course, means that th e
government can borrow from the economy only to the extent of 2
percent of GDP, whatever be the level of savings. The question is
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120 developing economy like India that wishes to hasten the process o f its
development. The rear problem that the economy faces is the presence
of large revenue deficits.
2. Possible Neglect of Social Sector Spending : The most significant
portion of spending on the social sector takes place on the revenue
account. Capital ex penditure on this sector is very small. The social
sector spending especially on basic health and basic education
involves important externalities. The presence of such externalities
makes subsidization of social sector spending desirable. The FRBM
Act rul es may lead to neglect of social sector.
3. Need to Increase Revenues : Revenue deficits are determined by the
interplay of expenditures and revenues, both tax and non -tax. Very
often, attention gets focused only on the expenditure side of the
identity to th e neglect of the revenue side. Enough attention is not
given for increasing tax and non tax revenues in the FRBM Act.
4. Zero Primary Deficit : The FRBM Act does not have anything to say
about Primary Deficit (PD) which is defined as the difference between
gross fiscal deficit and Interest Payments. It has been argued that the
interest payments component of government expenditure reflects the
impact of past debts and cannot be reduced. Hence, it makes sense to
focus on only those components of the gross fiscal deficit, which are
amenable to reduction. Consequently, the focus should be on PD and
targets must be set for it. Thus initial target would be to get PD down
to zero, so that current operations of the government would not create
additional debt.
5. Non-cover age of State Governments : The provisions of the FRBM
Act impose restrictions on only the central government but state
governments are out of its scope. But, deficits of state governments are
as much or even a greater problem. Hence it will be necessary tha t
state governments also make similar commitments to pursue fiscal
discipline. Though a few states have enacted fiscal responsibility
legislation, majority of states are yet to follow suit.
6. Neglect of Development Needs : Today, the levels of capital
expen ditures by the government are miserably low in India. These
capital expenditures increase the efficiency and productivity of private
investment and thus contribute to the development process in the
country. If gross fiscal deficit is reduced to 2 percent o f GDP as per
the requirement of FRBM Act, it is the capital expenditure which will
be sacrificed and thus will hinder further development of the country.
8.6 GOVERNMENTS CAN BE CLASSIFIED INTO
UNITARY AND FEDERAL GOVERNMENTS.
(a) Unitary Government : In a unit ary government set -up, all the affairs
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121 or all the governing powers are with the central government, which
may delegate some power to the regional and local authorities. Some
of the examples o f unitary states are the UK, France, Italy and China.
Majority of the countries in the world have unitary form of
government.
(b) Federal Government : In a federal form of government, the affairs
of the country are conducted by the authorities of different le vels
of government. The governing power is shared between the national
or central government and state or provincial governments. Some
of the major countries that follow the federal form of government are
India, the USA, Canada, Germany and Australia. Some of the
advantages of the federal system are, administrative efficiency, sharing
and raising of revenue, protecting cultural and regional identities of
regions. Some of the problems faced by federal governments are
related to maintaining a balance between central and the state
government in sharing administrative power and financial resources.
Sharing of financial resources comes under the concept of fiscal
federalism.
8.7 FISCAL FEDERALISM
Meaning of Fiscal Federalism
It is the study of how expenditures an d revenues are allocated across
different layers of administration i.e. Central government, state and local
governments. It is concerned with understanding which functions and
instruments are best decentralized.
According to Joseph E. Stiglitz, fiscal fed eralism is concerned with the
division of economic responsibilities between the Central (or federal)
government and the states and local governments. Federalism covers
issues that go beyond economics.
Key Issues under Fiscal Federalism
1. Division of Respons ibilities and Resources : The main issues of
fiscal federalism are concerned with the division of responsibilities
and resources between the central government and the states and local
governments. There are two important issues :
(i) Who makes the decisions a bout the programmes? And
(ii) Who pays for the programmes?
In some cases, the central government pays for a programme and gives
broad discretion to the states regarding how to carry out the programme.
In other cases, the central government essentially dictates all the terms and
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122 Just as there is a division of responsibility between the central government
and state and local governments, there is also a division of responsibilities
between the state governments and loc al governments. The division is
complicated one, involving financing, regulation and administration.
According to the traditional theory of fiscal federalism given by R.A.
Musgrave and others, the central government should have the basic
responsibility for the macroeconomic stabilization function and for income
redistribution. In addition to these functions, the central government must
provide certain national public goods like defence that provide services to
the entire population of the country. The state and local governments
should be concerned with the provision of goods and services whose
consumption is limited to their own jurisdictions.
2. Regulation : The constitution restricts the laws that states can pass.
Similarly, state and local governments may al so be subject to the same
pollution and environmental regulations that apply to private firms and
individual. Sometimes the central government has mandated that state
and local governments provide certain service without providing the
requisite funds. All these may give rise to problems in the federation.
3. Incentives for Resource Transfer : Sometimes the central
government imposes its will through eligibility requirements for grants
and loans, etc. This leads to disparity in the allocation of grants to
states . The intention of central government aid to local government is
to encourage local spending on particular public services. The central
government uses this power to transfer resources to enforce national
rules and standards.
4. Tax Expenditures : One of the i mportant ways that the central
government affects state and local expenditures is through the sharing
of central tax revenues with the states. This can provide an incentive
for greater expenditures at the state and local level.
5. National and Local P ublic G oods : One of the important factor
influencing fiscal federalism is difference between national public
goods and local public goods . In the case of national public goods
benefits accrue to everyone in the nation, e.g. national defence. In
contrast, the bene fits of local public goods accrue to the residents of a
particular locality, e.g. traffic lights, fire protection, etc. While some
argue that the central government should provide certain public goods
locally, some argue for assigning greater responsibilit y for the
provision of public goods at the local level.
There is a presumption that the central government should provide
national public goods. The question is whether the provision of local
public goods should be left to state and local governments. It i s argued
that competition among communities will result in local governments
supplying and producing local public goods and services individual
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123 6. Tax Competition : If the local governments use tax incentives to
attract businesses and to increase employment opportunities, gains in
one locality or state are partly at the expense of losses in other
localities or states. But the competition to attract businesses results in
lower taxes for businesses. Thus, at the end businesses are the ultimate
beneficiaries.
7. Tax Subsidies : Tax subsidies lead to increased expenditures on
publicly provided goods and increased capital investment by state and
local governments. At the same time, tax subsidies are an inefficient
way of subsidizing state an d local governments due to following
reasons :
(i) Some of the benefits accrues to wealthy investors rather than to the
communities.
(ii) Some of the benefits is passed on to the businesses and not to the
residents of the communities.
(iii)Tax subsidies discriminate in favour of higher income individuals
who have a strong preference for publicly provided goods.
8. Financial Imbalance : One of the main issue in the federal set -up is
the financial imbalances. Financial imbalance means lack of harmony
between functions and fina ncial resources.
The sources of revenue assigned to the centre and the states should be
adequate to enable them to fulfill the functions allotted to them. It is
very likely that the needs and resources of each government will not be
balanced. Therefore, i t is necessary to evolve mechanisms which can
be used to even out the shortages and surpluses. One such mechanism
is fiscal decentralization.
8.8 FISCAL DECENTRALIZATION
Decentralisation in general, is an ongoing and gradual process whereby,
political, adm inistrative and fiscal powers are transferred from the central
government to the state and local governments. Fiscal decentralization
refers to the transfer of taxing and expenditure powers from the
control of central government to government authorities a t sub -
national levels (state and local governments) . The main purpose of
decentralization is improved administration, better accountability, larger
participation in the democratic process by people and ultimately
generation of economic welfare.
Components of fiscal decentralization are :
1. Expenditure Sharing : The central government in a federal system,
transfers the public expenditure responsibilities to the lower levels of
government. Each state government has unique public expenditure
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124 the state government is responsible for social sector expenditure on
education and health, child and youth welfare, subsidized housing. In
some cases part of the funding for such expenditure may come from
the central government. State governments are also responsible for
building roads and other economic infrastructure that benefit the
people of the state. The maintenance costs of such infrastructures are
generally covered by local taxes, user charges like r oad tolls, fees and
central government grants.
2. Tax Sharing : Some taxes are levied by the central government and
part of the proceeds is transferred to the state governments. Tax -
sharing is advantageous because, when tax is collected by one
authority it b rings in uniformity of tax rate, makes collection easier
and lowers cost of collection. In India, the central government collects
personal and corporate income tax and shares the proceeds with the
state government. The mode of sharing tax differs from coun try to
country. In some countries, the central government collects taxes and
shares the entire proceeds with the state or regional governments after
deducting the cost of collection. In some cases the taxes are shared on
the basis of the states respective contribution to tax generating
activities or the size of population. The mode of tax sharing is
reviewed from time to time and undergoes changes whenever required.
This is necessary for bringing in flexibility in the fiscal
decentralization process. In Ind ia, a Finance Commission is constituted
periodically to examine this.
3. Supplementary Levies : Supplementary levies are imposed over and
above a main tax. Cess and surcharges are examples of such levies.
These are imposed by the central government and procee ds are
distributed to the lower local governments.
4. Local Taxes :These local governments have the power to impose and
collect taxes usually on property, sale of goods and services,
movement of goods, and in some cases even on income. Such powers
are a part of fiscal decentralization. Collection of these taxes provides
greater autonomy to local governments to carry out expenditures to
meet the needs of the local population.
5. User Charges :In many cases, local governments supplement their tax
collection by ch arging user charges and fees from the people for use of
local infrastructure. Examples of these are road tolls, fees for using
public spaces like parks, museums, art galleries etc.
6. Inter -Government Transfers of Grants : Grants in aid are provided
by the ce ntral government to the state governments to meet additional
need for funds for services they have to provide. Grants are classified
as (a) outright or untargeted grants given to bridge the gap between
current revenues and expenditure of the state governme nt and there are
no conditions attached to these grants, and (b) targeted or conditional
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125 education or primary health care Grants are given in order to avoid the
imposition of state tax burden on the people. They are provided to
reduce regional imbalances which are common in developing
economies. Backward and under developed states get a larger share of
grants in order to bring them on par with other states. This benefits the
entire nation. Some states have lower capacity to generate revenue
through taxes due to lower level of economic activities. Such fiscal
gap between different states are sought to be filled through grants.
7. Loans : Loans are necessary to finance large capital expenditure.
Large infrastructure related expenditure cannot be funded through
revenue receipts. The central governments provide loans to the state
government to meet such expenditures either fully or partially. Such
loans are expected to be used for productive purposes s o that they are
self-liquidating, that is, they generate income to repay the loans. The
rates of interest on such loans are usually lower than the market rates.
8.9 CENTRE -STATE FINANCIAL RELATIONS IN
INDIA
The constitution of India has clearly laid down the division of
responsibilities (functions) involving expenditure and division of powers
to raise resources between the centre and the states as also local bodies.
A. Division of Functions
The principle underlying the division of functions assigns countr ywide
tasks to the centre and state/region. Similarly the tasks of local importance
are assigned to municipalities in towns and panchayats in villages.
Central Government Functions : The several functions of the central
government are classified into deve lopmental and non developmental
functions. Developmental functions are the ones which promote growth
and welfare and welfare of the people, for e.g. provision of social and
community services (education, public health, science and technology,
labour and em ployment etc.) economic services (agriculture and allied
services, industry and minerals, transport and communications, foreign
trade etc.); and grants in aid to states for developmental purposes.
Non developmental functions include maintenance of law and order
(police, defence); maintenance of external relations; grants to states for
non developmental purposes.
State Government Functions : The various responsibilities of the states
are also grouped under two categories : developmental and non
development al. Developmental functions include : social and community
services; economic services etc.
Non developmental functions include administrative services, payment of
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126 Justification for the Division
The above mentioned d ivision of functions is justified on the following
grounds:
(i) Defence and communication services are to be provided uniformly
throughout the country and thus should be the responsibility of the
centre.
(ii) Benefits accrue due to economies of scale in the provis ion of these
services due to the large size of the country.
(iii) Critical areas such as foreign investment and foreign trade, which
require a national agenda, are with the centre.
(iv) Further, services which differ from region like agriculture, are
assigned to th e states.
Problems
The existing division of functions has the following problems :
1. There is over lapping of functions in important areas like education
and health.
2. Many of the centrally sponsored schemes do not provide the required
freedom and autonomy to the regions in respect to their designing and
implementation and thus do not benefit the targeted groups.
B. Division of Resource Raising Powers
To meet the expenditures involved in the performance of functions, the
governments at different levels have be en assigned powers to raise
resources.
Receipts of Central Government : There are various sources of receipts
of the central government classified into revenue receipts and capital
receipts. Among the revenue receipts the most important is the tax
revenue . A part of the tax receipts is statutorily transferred to the states as
per the recommendations of the Finance Commission. The various types
of taxes allotted to the centre may be listed under three categories :
 Taxes on income and expenditure, which incl ude income tax,
corporation tax and expenditure tax.
 Taxes on property and capital transactions which cover estate duty,
wealth tax etc.
 Taxes on commodities : A major change in the indirect tax structure
was made with the implementation of The Goods and S ervices Tax
(GST) on 1 July 2017. Since GST is a destination based tax, an end
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127 received by the State in which the goods or services are consumed and
not by the state in which such goods a re manufactured.
(i) Central GST (CGST) is a tax levied on intra -state supplies of
both goods and services by the central government and governed
by the CGST Act.
(ii) State GST (SGST) will also be levied on the same intra -state
supply, but will be governed by the state government. This implies
that both the Central and the State governments will agree on
combining their levies with an appropriate proportion for revenue
sharing between them.
(iii)Integrated GST (IGST) is a tax levied on all inter -state supplies
of goods and services and will be governed by the IGST Act. Tax
will be shared between central and state governments.
Apart from tax revenue there are other sources of revenue receipts. These
include dividends from railways, posts and telegraphs, RBI, public sect or
undertakings and foreign governments.
As regards capital receipts , the government has the legal power to borrow
from the domestic as well as the international markets, as also from world
institutions and foreign governments.
Receipts of Sta te Governme nt: Like those of the Centre, receipts of
states are classified into revenue and capital receipts. The revenue receipts
come mainly from taxes on agricultural income, profession tax, property
and capital transactions like stamp and registration, land reven ue, urban
immovable property tax and surcharge on cash crops. Besides these direct
taxes, states have the power to levy indirect taxes like those on
commodities and services such as GST.
Besides tax revenue, states have other sources of receipts on revenue
account. These are non -tax revenues such as interest receipts, dividends
from state enterprises etc.
Then there are receipts on capital account, which are loans taken from the
market in the form of bonds and securities, and loans, which flow from the
centre.
In addition there are receipts like share in central taxes, grants in aid and
other receipts of funds from the centre for centrally sponsored schemes
(CSS).
Financial Imbalance
Inspite of the clearcut division of the powers and the financial resourc es
between the Centre and states, there is an imbalance in the division of
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128 that while the responsibilities of the states have increased over the years,
their revenue resources have not increased substantially.
Transfer of Resources from Centre to States
The constitution itself has recognized the finance inadequacy of states and,
therefore, the constitution has made a provision for the transfer of
resources from the centre to states. These transfers are of three types :
1. Transfer of a part of tax proceeds from centre to the states. This is
done through the agency of Finance Commission.
2. Transfer in the form of grants and loan from centre to states. These too
are done through the Finance Commission.
3. Transfer in the form of plan assistance for plan projects. This takes
place through the planning commission.
The above scheme of transfer does not solve the problem of financial
imbalance.
C. Finance Commissions
Article 280 of the Constitut ion of India has made provision for the
appointment of a Finance Commission. The Finance Commission
(Miscellaneous Provisions) Act was passed in 1951. According to the
provisions of the Act, the Commission is appointed every five years. It
includes a chair person and four other members.
The functions of the Finance Commissions are :
(a) To recommend the distribution of net tax proceeds and allocation of
shares of such proceeds between the Union and the States.
(b) Grants in aid recommendations for covering the gap between current
revenues and expenditures of the States, and for removal of regional
disparities between the States. The Commission also recommends
special purpose grants to any State.
(c) The Finance Commission may look into and study specific problems
and i ssues in the interest of healthy and sound financial relations
between the Centre and States, on the advice of the President. These
issues include extent of indebtedness of States, debt relief measures
and special expenditures required to be made by States .
So far 14 Finance Commissions have been constituted. The 14th Finance
Commission was constituted in January 2014 under the chairmanship of
Dr. Y.V. Reddy, former governor of the RBI. The Commission submitted
its report to then president Pranab Mukherjee in December 2014. The
Government of India has accepted the recommendations of the
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129 Some of the major recommendations of the 14th Finance Commission that
have been accepted by the Government of India are :
1. State s’ share in the net proceeds of Union tax revenue to be increased
from previous 32% to 42%.
2. Eight Centrally Sponsored Schemes (CSS) delinked from the Centre
support. 30 such CSS have been identified, but have not yet been
delinked from Centre support due t o national priorities and legal
obligations. [CSS are special purpose grants or loans given by Central
Government to State Governments to plan and implement programmes
to help achieve national goals and objectives. Some examples of CSS
are Jawaharlal Nehru National Urban Renewal Mission (JNNURM),
RashtriyaKrishiVikasYojana, SarvaShikshaAbhiyan, National Mission
on AYUSH].
3. States to share higher fiscal responsibility for the existing CSS.
4. Revenue compensation to States under GST should be for five years;
100% in first three years, 75% in fourth year and 50% in the fifth year.
States are expected to have lower tax collection due to imposition of
GST.
5. An autonomous and independent GST Compensation Fund to be
created.
8.10 SUMMARY
1. A budget is a description of the spending and financing plans of an
individual, a company or a government. The government budget
shows the planned expenditure programmes of the government and the
expected revenues from taxes and other sources during a given year.
The budget contains a list of specific programmes like education,
defence, welfare, etc. which give rise to government spending. It also
contains tax sources like income tax, commodity tax, etc. which give
revenues to the government. The revenue sources differ depending on
the level of government (i.e. central, state and local).
2. When all taxes and other revenues exceed government expenditures for
a given year, there is a budget surplus. When government expenditures
exceed taxes and other revenues, there is a budget deficit. When
revenues and expenditures are equal during a given year, the
government has a balanced budget. Balanced budget is a rare
phenomenon.
3. Revenue expenditure is expenditure on maintaining existing level of
public services. Such expenditures do not crea te any capital asset but
help to maintain the existing assets. Revenue expenditure should
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130 4. Capital budget consists of capital receipts and capital expenditures. The
capital budget covers those items which are concerned with acquiring
and disposal of capital assets. The purpose of capital expenditure is the
expansion of present level of public services.
5. Capital receipts include funds received by the government in the form
of market borr owings, small savings, provident funds, recovery of
loans, external loans and disinvestment receipts and any other receipts
from sale of government assets.
6. Capital expenditure includes repayment of debts and all expenditure
incurred on creation of capi tal assets, like roads, railroads, irrigation
and power generation projects, establishment of schools, health care
infrastructure, etc.
7. According to Constitution of India, there is a three -tier system of
government, namely, Central (or Union) governmen t, state
government and local government (like Municipal Corporation,
ZillaParishad, etc.). Accordingly, these governments prepare their own
respective budgets (called Union Budget, State Budget and Municipal
Budgets) containing estimates of expected reven ue and proposed
expenditure.
8. When the government expenditure exceeds revenues, the government
has a deficit in the budget. Thus, the budget deficit is the excess of
government expenditures over receipts. The government finances its
deficit mainly by bo rrowing from the public through selling bonds on
which government promises to pay specified amounts of interest. This
gives rise to public debt. The deficit may also be financed by
borrowing from the Central Bank of the country. This may give rise to
incre ase in the money supply in the country. Thus, budget deficit
causes the aggregate demand in the economy to rise and even lead to
inflation. But deficits need to be incurred during recession to increase
aggregate demand.
9. The Fiscal Responsibility and Bu dget Management (FRBM) Bill was
initially introduced in LokSabha in December 2000. This bill was
referred to the Parliamentary Standing Committee on Finance. A
revised Bill was introduced in April 2003. It was passed in LokSabha
in May 2003 and in RajyaSab ha in August 2003. After receiving the
assent of the President, it became an Act in August 2003. The Act
became effective from July 5, 2004.
10. In a unitary government set -up, all the affairs of the entire country are
conducted by a single government. Mo st or all the governing powers
are with the central government, which may delegate some power to
the regional and local authorities. Some of the examples of unitary
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131 11. In a federal form of government, the affai rs of the country are
conducted by the authorities of different levels of government. The
governing power is shared between the national or central government
and state or provincial governments. Some of the major countries that
follow the federal form of government are India, the USA, Canada,
Germany and Australia.
12. According to Joseph E. Stiglitz, fiscal federalism is concerned with the
division of economic responsibilities between the Central (or federal)
government and the states and local governmen ts. Federalism covers
issues that go beyond economics.
13. The constitution of India has clearly laid down the division of
responsibilities (functions) involving expenditure and division of
powers to raise resources between the centre and the states as al so
local bodies.
8.11 QUESTIONS
1. Discuss the objectives of public budget.
2. What are the different types of public budget?
3. Explain the structure of the Union Government of India’s budget.
4. Discuss the types of deficit.
5. Discuss the features of FRBM Act 2003.
6. What are the limitations of FRBM Act 2003?
7. Explain the concept of fiscal federalism? Write down the key issues
of it.
8. Write note on functions of finance commission.
9. Explain the concept of fiscal decentralization and write down its
components.


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