Economics Paper IV – Public Finance (English Version)-munotes

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1Chapter 1: Introduction
Module 1
1 INTRODUCTION
Unit Structure
1.0 Objectives
1.1 Meaning and Scope of Public Finance
1.2 Public Finance Versus Private Finance
1.3 Market Failure
1.4 Public Goals and Private Goals
1.5 Externality
1.6 Efficiency versus equity
1.7 Questions
1.8 Reference
1.0 Objective s
• To know the scope of public finance
• To understand difference between Public finance and Private finance
• To know difference between efficiency and equity
• To understand the concept of market failure
• To understand the concept of market failure
• To know the term externality
• To know the term public goods and private goods
1.1 Meaning and scope of Public finance
Classical and n eo-classical economists discussed public finance in the context of
money raising and money spending activities of the government. In Public finance
we study the finances of the government . Thus public finance deals with the
questions of how the government raises its resources to meet its ever - rising
expenditure .
One of the first books exclusively written on the subject was by Bastabls in 1892.
Accord ing to Bastabls ," Public Finance deals with expenditure and income of
public authorities of the state and their mutual relation as also with the financial
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1.1.1 Definition of Public Finance
1. Huge Dalton : According to Dalton , “Public finance is concerned with the
income and expenditure of public authorities and the adjustment of one with
the other ”.
2. Otto Eckstein : According to Otto Eckstein , “Public finance is the study of
the effects of the budget on the economy , particu larly the effects on growth
, stability, equity and efficiency”.
3. Richard Musgrave : According to Richard Musgrave , “Public finance is
concerned with the complex of problems that centre around the revenue -
expenditure process of government”.
It also deals wih fiscal policies which ought to be adopted to achieve certain
objectives such as price stability , economic gro wth, more equal distribution of
income. As per the thinkers view the role of public finances changes from time to
time. Classical economist believe that government should play minimum role i.e
less intervention of government is the thought of classical and neo-classical
economist. Whereas Keynesian i.e John Maynard Keynes in his famous book "The
General Theory of Employment , Interest and Money " which was published in
1936, have mentioned that the state means government plays significant role
importance is given to government activity. According to J.M.Keynes , government plays a vital role in maintaining or stabilising the volatility of Economic Activity.And also to improve the Aggregate demand level in the economy which
was experienced by the U.S economy d uring great depression. Thus it is considered
as functional finance and important concept associates with public finances are (a)
Fiscal policy (b) Budgetary policy.
1.1.2 Scope of Public Finance
According to the traditional explanation of public finance, it relates to
financing of state activities. In a narrow sense, Public finance is the function
or activities /role of government at National state and local levels. According
to classical view government play minimum role. They are believer of
Laissez faire policy. Government play role of basic Law and Order, Defence
and Justice . Other than these important activity government does not
intervene. Importance of role of government realised during depression
period of 1929. It is great economist Abba P. lerner who coined the term
Functional finance . Later on J.M.Keynes popularised this term functional
finance by proving through the incidence which took place during 1929 -30
great depression of U.S.Economy . With the help of government intervention
it become easy to get recover by raising government expenditure and reducing taxation. This activity helps to improve Aggregate output. munotes.in

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3Chapter 1: Introduction
Prof. Dalton categorises the scope of public finance into focus areas which includes
public Revenue, Public Expenditure , Public Debt or Public Borrowing and
financial administration.
1) Public Revenue :
Primary scope of public finance is Public Revenue. The main sources of
income for the government like taxes, fe es, fines, special assessment and
commercial revenues, from pub lic undertakings. Here in scope of Public
Revenue the concept of canon of taxation, different types of taxation, merit
and demerits of taxation and different types of tax rates need to be studied.
2) Public Expenditure :
One of other important instrument of public finance is public expenditure.
Public expenditure important for implementing various policies of the
government with respect to welfare , growth, stabilization and so, on. Here
again it is more relevant to study canon, classification and effects of public
expenditure.
3) Public Debt/ Public Borrowings:
When public expenditure exceeds Public Revenue it leads to Burden on
economy and thus Public Debt takes place in the economy. Here we will learn
different types of P ublic Debt Internal and External public debt and its impact
on economy.
4) Financial Administration :
The scope of financial administration various financial process and operations of Public Revenue,Public expenditure and Public Debt. It administers collect ion, custody and disbursement of public money. It covers
the preparation of the budget, the execution of the budget and also auditing
the finances of the state.
1.2 Public Finance VS Private Finance
1) Meaning :
Public finance is concerned with the revenue / incomes and expenditure
borrowings etc of the economy or government Private finance is the study of income and expenditure, borrowing etc of individuals household and business firms.
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2) Adjustment :
Public Finance - Government adjust the income ac cording to the size of
expenditure on different segments
Private Finance - Individuals adjust their spending as per their Income
3) Objective :
Public Finance - aim to offer the maximum social advantage to society
Private Finance - aims to fulfill private interests
4) Nature of budget :
Public Finance - the government prefers a deficit budget.
Private Finance - a individual attempts to maintain a surplus budget
5) Financial transaction :
Public Finance - Transaction s are open and know to all
Private Finance – Transactions are kept secret .
6) Determination of expenditure :
Public Finance - Government first determines the volume and different ways
of its expenditure .
Private Finance – An individual considers his In come and then determines
the volume of expenditure
7) Right to print currency :
Public Finance - The government can print notes through Reserve Bank of
India
Private Finance - Private Individual does not enjoy right to print currency
8) Effect on economy :
Public Finance - has tremendous impact on the economy of country .
Private Finance - has marginal effect on the economy of a country.
1.3 Market failure
● Market :
Market is a place where buyers and sellers come in close contact with each
other. Either directly or indirectly. In economics we study different forms of munotes.in

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5Chapter 1: Introduction
market, perfect market and imperfect market. Perfectly competitive market
is form of perfect market an d other market such as monopoly, oligopoly ,
monopolistic competitive market , oligopsony and monopsony are also
special form of imperfectly competitive market sellers have an objective of
maximising profit whereas buyers opine to maximise utility. An idea l market
is the market where both are equally satisfied which generally we find in
perfectly competitive market.
● Market failure :
Generally market failure occurs when quantity demanded by consumer does
not get equated or supplied by producer. On the other hand when resources
are misallocated or allocated inefficiently.
According to Michael Todoro market failure is a “phenomenon that results
from the existence of market imperfections that weaken the functioning of a
free market economy i.e it fails to real ise its theoretical beneficial results. ”
1.4 Public goods and Private goods
1.4.1 Public goods:
Public goods are those goods which satisfy collective wants or social wants in
general. Public goods are those goods and services which are jointly and equally
consumed by many people at the same time and its consumption by one person
does not alter its availability for another person. The examples of public goods and
services are public roads street lights, defence and education services.
According to J. Sloman , public goods refers to “a good or service which has the
features of non -rivalry and non -excludability and as a results would not be provided
by the free market “.
Features of public goods:
1) Non - Rivalrous: It refers to the fact that no one has an exclusive right over
the consumption of the goods. It can be consumed by any number of people
simultaneously , without diminishing the amount available to be consumed by others. A good is nonrival in consumption because one person’s enjoyment of the goods does not reduce anyone’s else’s enjoyment of them.
2) Non- excludable: it is simply if one person consumes the good it is become
impossible to prevent other from consuming it. A good is not excludable
because of inability to keep people, specifically non -payers from consuming
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3) These goods are of collective consumption
4) Public goods may not be produced through the free market pricing mechanism.
5) Public goods are indivisible
6) Public good is always joint and equal. Thus public goods are produced and
supplied by the society to meet its collective wants for increasing social
welfare.
7) Public goods create externalities or divergences between social and private
benefits.
Common examples of public goods are street lighting , national and domest ic
security, national public parks and beaches, public welfare programmes , education,
roads , research and development and a clean environment. In these cases
consumption by one does not impose an opportunity cost or other and non -payers
can not be exclud ed from consumption. In all such examples market fails to
efficiently allocate the production, consumption or provision of the goods.
1.4.2 Private goods :
Just inverse to what public goods private goods and services satisfy individual
wants and have the characteristics of rivalry and exclusiveness. These goods can
be produced by the free markets pricing mechanism. Private goods are rival in
consumption their consumption by a person reduces the amount available to others.
All those who have to enjoy or ful fill the utility have to pay for it. And those who
do not show interest to pay will not be able to get benefit of that. Private goods are
subject to the principle of exclusion. Eg . food, clothing, shelter, transportation and
communication etc.
Character istic of private goods
1) Private goods are rivalrous in consumption
2) These goods are subject to the exclusion principle
3) These goods satisfy individual wants.
4) These can be produced through free market pricing mechanism.
5) Private goods are divisible into so far as their use is concerned
6) Marginal cost of providing a private good to an extra consumer is always
positive.
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1.5 Externality:
An externality is interpreted as spill over effect or third -party effect. These are two
different possibility of externality (a) positive externality (b) negative externality.
Externality arises when a person engages in an activity which directly or indirectly
influences positively or negatively and do not get any compe nsation for that effect.
The third parties can be an individual, an organisation or it can be community as
well who get indirect benefit or suffer as a result of consumers and producers
attempting to pursue their own self - interest.
Examples of externality can be interpreted in both form. It can be in the form of
consumption and production as well.
1) Consumption externality : suppose a person wants privacy thus he builds a
high fence which may obstruct the sunshine to his neighbours house.
2) Production external ity : it exist when production activity of firm directly
affects the production activity of another firm. Example when firm X
discharges effluents into a river, which may increase the cost of production
of firm Y downstream. Two types of externality
(a) Negat ive externality : when third party adversely get affected it is
termed as negative externality. Negative externality leads markets to
produce a larger quantity than is socially desirable. Eg . when the firms
do not pay for the pollution their cost would be low and they would
produce more.
(b) Positive externalities : when third party get benefited with any
activity. Example: If an entrepreneur stage a firework show, people can
watch the show from their windows or backyards. Positive externalities
leads markets to produce a smaller quantities than is socially desirable.
The main problem with externality in production and consumption is
that their cost or benefits are not reflected in the market price. The
externality make it impossible for the market to reach a p areto
optimum.
1.6 Efficiency versus equity
• Efficiency It is concerned with the optimal production and allocation of
resources given existing factors of production.
For eg. producing at lower cost, efficiency in an economy means “that society is
getting the maximum benefits from the scarce resources” under ideal conditions
markets ensures that the economy is pareto efficient. There are two different types
of efficienc y 1) productive efficiency 2) allocative efficiency. munotes.in

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● Equity - Equity is concerned with the relative income how resources are
distributed throughout society.
There are two types of equity discussed here
1) Horizontal equity
2) vertical equity
Economic effic iency is measured by the quantity and variety of goods and
services that its members produce, consume and distribute out of their
limited available resources. The most efficient market is one where, it is
possible to decide what combination of goods and s ervices people want and
delivering that combination. It is more efficient when market is able to
produce at low cost and sell it out at lowest possible price. The ideal efficient
outcome of market is referred to as pareto optimal. When it is not possible t o
make at least one person better off without making one or more persons worse
off.
● Productive and allocative efficiency :
It involves minimization of cost for producing a given level of output or
producing maximum possible output of various goods from a given amount
of outlay or cost incurred on productive resources. And hence on the basis of
there it is expected that free ma rket mechanism can achieve best possible
resource allocation and produce optimum output also it is possible to reach
pareto optimum in a free market through efficient resource allocation and
production
The concept of production and allocation efficiency can be explain with the
help of suitable diagram of pareto optimality.
Figure No. 1.1 Pareto Optimality

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Fig 1.1 curve LP is the production possibility curve. The point m,n,g are the points
where the maximum (optimum) output of goods X and Y can be produced. Any
point inside this curve let say R brings out inefficient production. Any movement
from R towards L P curve will bring about more efficiency. For e.g if it move from
R to G we increase the production of X from OX to OX 1, without decreasing output
of Y similarly if we move from R to M we produce more of Y from OY to OY 1,
without reducing quantity of x so these shifting from R to M from R to G all these
are productive efficiency.
մ Productive efficiency : It will be achieve on any point on the PPC curve (
PPC - production possibility curve ) productive efficiency is possible at level
where maximum output is gained at minimum cost which is possible at level
where marginal product of each pair of factors is mad e equal to the ratio of
their prices. When we apply this condition to an industry productive
efficiency can be obtained when marginal cost of producing the last unit of
output of a firm must be same for each firm in any industry.
մ Allocative efficiency : It implies that the pattern of products produced should
correspond to the desired pattern of consumption of the people. Allocative
efficiency is achieved when the resources are allocated to the production of
various goods that it results in maximum possible satisfaction of the people.
When it is impossible to change the allocation of resources in such a way as
to make a person better off without making another person worse off.
In fig 1.1 allocative efficiency concerns the choice among alternative points on the
PPC, that is between M,N,G. Among these point only one point at a given time is
allocatively efficient while others are inefficient.
An economy reaches the point of allocative efficiency when, for each goods
produced, its marginal cost is equal to its price.
1.7 Questions
Q1. What do you understand by the concept Public Finance ?
Q2. Explain scope and subject matter of Public Finance.
Q3. Explain the concept of market failure.
Q4. Distinguish between public goods and private goods
Q5. What do you understand by the term externality ?
Q6. Explain the concept of Efficiency and Equity. munotes.in

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1.8 Reference
1) J.Hindriks, G, Myles (2006), Intermediate public economics MIT press.
2) Harvey Rosen, (2005), Public Finance, seventh edition, McGraw Hill
publication
3) Chauhan, M.S, Public Finance issue and problems, Global publication (New
Delhi)
4) Musgrave , Richard A, Public Finance in theory and practice , Tata MCGraw
- Hill publishing company lim ited (New Delhi) 5th ed.

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11Chapter 2: Sound Finance and Functional Finance
Module 1
2 SOUND FINANCE AND FUNCTIONAL FINANCE
Unit Structure
2.0 Objective
2.1 Principles of sound finance
2.2 Principles of Functional finance
2.3 Function of the Government
2.3.1 Allocation
2.3.2 Distribution
2.3.3 Stabilization
2.3.4 Growth
2.4 Questions
2.5 Reference
2.0 Objective
• To understand the principle of sound finance and functional finance
• To know various functions government
• To understand the concept of stabilization
• To know growth function of Government
2.1 Principle of Sound Finance
Most of the classical and Neo classical economist such as Adam Smith, David
Ricardo, J.B say, John stewart mill and Thomas Malthus are follower of sound
finance. Prior to 1930 classical economist has an assumption that the less the
intervention of government in economic activity better the life of people. So their
should be Laissez faire capitalism, which is a system where economic transaction
are largely between private owners of factors of production and such transactions
are free from government restrictions taxation and subsidies. Classi cal’s were
against unwanted intervention of government, According to them due to too much
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to provide welfare to the people but that is also at the cost of people. If suppose
Govt provide any program like survey Siksha Abhiyan, Indradha - nush yojna, Atal
pension yojna etc then ultimately it shoots the expense of the government and to
run such expenditure government charges additional taxes to earn public revenue.
At last Governme nt intervenue and provide welfare at the cost of tax on masses.
Classical and Neo classical opines that due to such circumstances as it is mentioned
above the role of the government was expected to be restricted to traditional areas
like defence, law and o rder, justice, provision of civic amenities and therefore most
government expenditure was expected to be restricted to these areas.
Hence they believe that government’s budget should be small and budget should
be balance. These multiple beliefs of less in tervention of government, with balance
budget are some key opinions which form the basis of the principle of the sound
finance by classical and Neo classical economist.
Ɣ The following are some of the key features of sound finance:
a) Say‘s law : Classical eco nomist interpreted the basic theory based on
the assumption of supply create its own demand and because one
person expenditure become another persons income hence, aggregate
demand will always be equal to aggregate demand which forms the
base of sound fina nce.
b) Full Employment : As classical economist are in favour of AD= AS,
so there is less possibility of wastage or we can say no overproduction
& underproduction. And because they are believer of free market
mechanism so in expectation of maximum profitabi lity they will be
optimally using all resources. So full employment occur and only
voluntary and frictional unemployment may exist.
c) Invisible hand : Adam Smith has given this concept which is applica ble in case of sound finance simply because private owner s of
factors of production will always achieve maximum level of efficiency
in their use of resources to get maximum of profitability. Thus private
self interest will result in collective social goods.
d) Taxation: Taxation lends to sacrifice. Taxation are al ways burdensome
to tax prayers. There is no quid pro quo. So the amount of taxation should be minimum higher the progreeive taxation slower the economic growth thus classical economist believe that taxes are
harmful they adversely affect the willingness an d ability to work save
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e) Public expenditure: Classical school of economist believe that government spending should be minimum. It should be on traditional
area like defence, law and order justice and civic amenities. It is believe
that the size of budget is small and that too for these traditional
function. Because if government tries to go for more welfare expenditure then ultimately they will ask for more taxes to run addition expenditure. Thus classical economist support sound financing recommends least is the best which means less the expenditure by the
government better the economic condition.
f) Balanced budget: Classical economist believe that budget should
always in balance. Since in classical thought Private Owners are in
pursuance of maximising profit by optimally utilising resources. So
very less scope of wastage. As full employment prevail, thus AD=AS.
Expenditure incurred by the government would not increase total
demand for factors of production as there is already full employment.
Except war time rest period budget in balance.
g) Market eff iciency: It is assumed that free market mechanism prevails
in the economy with Laissez faire policy. If any disequilibrium takes
place leading to market failure. With the help of invisible hand it is self
correcting byself.
h) Ricardian equivalence theorem: This is one of famous and fundamental theorem by classical economist. Proving that Budget
deficit are uneconomical, harmful and socially undesirable. According
to theorem, deficit will not boost the economy. To meet deficit
ultimately they need to raise rev enue by raising tax. And general
masses need to sacrifice their consumption due to tax payment. So
indirectly it is loss of welfare.
2.2 Principle of Functional Finance:
Year 1920 of Europe and 1930, of united states was great depressionary period. It
was that time realised that market can fail and do not always correct themselves ,
leading to tough time for people. Thus most Laissez faire capitalism transform
themselves into welfare state. The role of government increased, government
activities expanded from only tradition area to other activities also. Example,
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other programme. Government started using fiscal policy to avoid another
depression, control inflation and keep aggr egate demand high. Thus fiscal policy
used contra -cyclical measure. Such type of fiscal policy to bring about desired
changes in the economy is known as functional finance and main advocate of this
type of fiscal policy was John maynard keynes. Sound finan cing system of classical
economist were challenged by John maynard keynes, A.C pigou, edgeworth and
most significantly , Abba P. Lerner. The term ‘functional finance’ is given by Abba
P. Lerner.
The following are some feature of functional finance.
a) Market failure: modern economist believe that market cannot be perfect , it
can fail also. They are not capable always to do sel f correction and adjust.
Market failure can also lead to severe depression or it may also influence
through hyper - inflation. Example of 1930 united states great depression
brought the powerful economy at downtrend. And various other factors
causing volat ility and unstable economic situation of economy.
b) Importance of fiscal policy: modern economist believe that important or
main aim of public finance is to maintain balance situation in the economy
not only public revenue. And to maintain stability use of instrument like
public expenditure, tax, public debt are adopted. Basically budget are
considered as an instrument of economic change.
c) Aggregate demand: aggregate demand consist of consumption demand,
investment demand, government demand and foreingn demand. AD= C+I+G+(X -M). Classical economist believed that ‘supply creates its own demand’ whereas modern economist particularly keynesian economist believe demand is the base and with the help of his study and book on general
theory of employment interest and money which was published in 1936 tried
to prove that if the economy is facing depression. Then with the help of increase in aggregate demand economy will be able to recover and slowly will be able to overcome from such recessionary situation. During 193 0’s it was applied and economy was really able to overcome from such circumstances.
d) Budget : modern economist believe that with the help of its instrument like
public expenditure, public borrowing and public revenue will be able to
maintain full employment in the economy. Modern economist rejected the
ideology of balance budget of classical economist. Modern economist believe
that Deficit budget is applied during to overcome from the problem of
recession and vice versa to release economy from inflation surp lus budget
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expenditure and vice verse during inflation raising of taxes and reduction of
expenditure.
e) Income redistribution : modern economist believe that fiscal policy can
provid e social justice through better Income distribution as well as benefit
economic growth through higher investment. Government will charge heavy
tax to rich section of society and provide welfare by redistributing the tax
revenue in the form of public welfar e expenditure to poor section of
economy. By this way Average propensity to consume(APC) will increase
and govt bring about equality in the economy.
f) Welfare capitalism: Karl marx had predicted that, due to the inherent crisis,
the capitalist system will co llapse and make new way and more equal system.
Keynesian through fiscal measure tried to prevent capitalist system in a better
way by increasing aggregate demand in the economy. Thus the economy was
able to prevent from collapse level.
g) Social objectives: social objectives are the key focus of functional finance.
The basic objective of taxation is to redistribute income to provide welfare in
the form of reducing poverty, reduction in unemployment providing better
measure of improved standard of living, good and quality education etc.
Thus functional finance proved to be more effective to eradicate the basic problems
faced by the economy. Through the concept of functional finance has been
criticised by many economist. But most of the countries dir ectly or indirectly using
functional finance to overcome from disequilibrium in the economy.
2.3 Function of the Government:
Basic objective of government into perform key function in the economy.
a) Allocation function
b) Distribution function
c) Stabilization function
d) Growth function
a) Allocation function: 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?
Allocation of resources depends upon the collection o f taxes and size and
composition of government expenditure. Government can use taxation and
subsidies to indirectly influence resource allocation. Example - Tax
incentives given to S.E.Z units to encourage investors to direct resources to
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b) Distribution function: The national Income should be properly distributed
so that the fruit of development are fairly shared by all people. Equality in
Income, wealth and opportunities must form an integral part of economic
development and social advanc e. Fiscal policy can influence spending in two
ways.
1) The direct changes in total spending brought about by the government
increasing or decreasing its own expenditure.
2) Increasing or reducing private spending by varying its own tax revenue.
Thus redistributing Income in favour of poor section of society by collecting
tax revenue from rich class.
c) Stabilisation function: Stabilisation function is another important fun ction
of fiscal policy, especially in developed economies that experience business
cycle. Business cycle is inclusive of various type of phases. Eg Prosperity,
Peak, Recession, Depression, trough, recovery, … and cycle move recur
again and again leading t o influence economic variables like, income,
employment, output , saving and investment. Fiscal policy is meant to counter
these fluctuations. This is known as counter - cyclical fiscal policy. To curtail
down the effect of fluctuation contra cyclical fiscal policy is used.
Thus during the period of recession government by increasing public
expenditure and reducing taxation i.e by adopting deficit budget can stabilise
the fluctuation and contrary to that during inflation using of surplus budget
i.e raisin g taxes and reducing public expenditure and bring out stability in the
economy.
d) Growth function: For accelerating the rate of growth, allocation of higher
proportion of the fully employed resources is needed. Such activities increase
the productive cap acity of the economy. Hence fiscal policy is used through
its tax instrument to encourage investment and discourage consumption so
that production may increase. It is also require to increase capital formation
that is possible through reducing tax on perso nal Income. Through various
programme and projects government can provide social and economic
overheads and depending upon the availability for example developing
country like India we have excess of labour as compare to capital. Government should involve labour more by establishing labour based projects. munotes.in

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2.4 Questions
Q1. What do you understand by the concept of allocation function of government?
Q2. Explain principle of sound finance and functional finance.
Q3. Describe Distribution function of Government.
Q4. Explain various functions of Government.
2.5 Reference
1) Musgrave , Richard A, Public Finance in Theory and Practice, Tata MCGraw.
Hill Publishing Company Limited (New Delhi) 5th edition.
2) Harvey Rosen (2005) Public Finance, Seventh Edition, MCGraw Hill Publication.

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Module 2
3 FISCAL POLICY: BUDGET AND TAXATION -I
Unit Structure
3.0 Objective
3.1 Dalton version of the Law of maximum social advantage
3.2 Musgrave’s approach
3.3 Application of principle of maximum social advantage
3.4 Limitations of principles of maximum social advantage
3.5 Role of government
3.6 Questions
3.7 References
3.0 Objective
• To understand Dalton and Musgrave version of maximum social advantage
• To know role of government in modern economy.
• To know application of principle of maximum social advantage
• To understand limitations of maximum social advantage
3.1 Introduction
One of the fundamental principles of public finance is known as the principal law
of maximum social advantage. Classical economist where against of too much
intervention of government. According to classical view if government has to
provide welfare to the people, then they collect tax. Budgetary activities of the
government result in transfer of purchasing power with in society. Taxation causes
transfer of purchasing powe r from taxpayers to government. Example, Let's
say, when person A pays tax, his/ her purchasing power reduces up to the amount
paid in the form of tax to the government. This amount goes to the government
so purchasing power transferred to government with such collected tax revenue
government provides welfare i.e. public expenditure takes place to the people as
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19Chapter 3: Fiscal Policy: Budget and Taxation-I
According to J.B. Say, (French classical economist ), “The very best of all plans of
finance is to spend little and the b est of all taxes is that which is least in amount.”
Thus, it is crucial to manage the taxes and expenditure and its effect on economic
activity.
3.2 Dalton’s version of the Law of Maximum Social Advantage:
The principle of maximum social advantage was prop ounded by British economist
Hugh Dalton.
According to Hugh Dalton, “Public Finance is concerned with income and
expenditure of public authorities and with the adjustment of one with the other.”
According to Hugh Dalton, “The best system of public finance i s that which secures
the maximum social advantage from the operations which it conducts.”
The principle of maximum social advantage is based on following assumptions:
1. Taxes collected by public authorities leads to sacrifice and all public expenditure provi de benefits.
2. Public revenue collected by government is the only source of income to the
public authorities that is government no other source other than tax is available
to government.
3. It is assumed that government has only balanced budget.
4. Public expenditure based on diminishing marginal social benefit
5. Public revenue through tax are subject to increasing marginal social sacrifice.
The application of maximum social advantage(MSA) is based on the fact that
marginal social sacrifice equal to margin al social benefit. Where to achieve such
objective marginal utility concept has been utilised. And at such equilibrium level
of MSB=MSS it is assumed that maximum welfare is achieved.
The principle of maximum social advantage interprets Public Finance resu lting to
economic welfare. Welfare will be achieved at that level where by benefit derived
by marginal utility of expenditure is equal to marginal disability of sacrifice causing
due to taxation.
The Law of maximum social advantage can better way explain ed with the help of
concepts like marginal social sacrifice and marginal social benefit.

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1. Marginal social sacrifice: (MSS)
Figure No. 3.1: Increasing Marginal Social Sacrifice

It is necessary to understand MSS. Marginal social sacrifice refers to that
amount of social sacrifice undergone by public due to the imposition of an
additional unit of tax. If government raises Tax amount which brings public
revenue to public authority. But as government charges higher tax more the
sacrifice that taxpayer has to face, Does we can say there is direct
relationship between taxation and sacrifice.
The relationship can be explained with the help of diagram in the given
figure 3.1. On x -axis units of tax in terms of rupees is measured and on y -
axis marginal social benefit has been given. When the Tax amount is OM 1,
the sacrifice level is OS 1 and when tax increases from OM 1 to OM 2,
sacrif ice level also increases from OS 1 to OS 2 likewise. Tax increases OM 2
to OM 3 and sacrifice increases from OS 2 to OS 3 and thus the joining curve
of such combination given upward sloping MSS curve. Showing that as
there is direct relation upward toward right slope of MSS curve represents
higher the tax more the sacrifice involved to taxpayers and vice versa.
2. Marginal social benefit :
Imposition of taxes on people puts burden or increases sacrifice. Whereas
public expenditure which is carried out by the government benefit to people.
Government provide welfare by doing public expenditure on defence,
education, health, infrastructure etc.
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21Chapter 3: Fiscal Policy: Budget and Taxation-I
The benefit conferred on the society, by an additional unit of public
expenditure is known as Marginal Social Bene fit (MSB). As we are aware
about the term diminishing marginal utility, as the marginal utility from a
commodity to a consumer declines as more and more units of commodity are
made available to him, the social benefit from each additional unit of public
expenditure declines as more and more units of public expenditure are spent.
The term maximum social benefit (MSB) can be explained with the help of
following diagram:
Figure No. 3. 2: Diminishing Marginal Social Benefit curve

On x -axis units of public expenditure is measured on y axis marginal social
benefit. When public expenditure is OM 1, MSB is OB 1 and when public
expenditure rises to OM 2, MSB falls to OB 2 and also with the further
increase in OM 2 to OM 3 , MSB falls from OB 2 to OB 3.
In the beginning, the units of public expenditure are spent on the most
essential social activities. Subsequent doses of public expenditure are spent
on less and less important social activities. As a result, The curve of
marginal social benefit slopes downward from left to right as it is shown in
figure 3.2
3. Maximum social advantage:
The point of maximum social advantage:
Social advantage is maximized at the point where marginal social sacrifice
cuts the marginal social benefits curve. I.e. when MSS = MSB which is
achieved at point P in the fig. 3.3.

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Figure No. 3. 3: Maximum Social Advantage

The marginal disutility or social sacrifice is equal to the marginal utility or
social benefits at this point. Beyond this point, the marginal disutility or
social sacrifice will be higher and marginal utility or social benefit will be
lower. At point P social adva ntage is maximum. If we go through point P 1,
At this point marginal social benefit is on P 1Q1 which is greater than
marginal social sacrifice S1Q1. Since MSB> MSS it become more relevant to that government should expand the level of taxation and public expenditure Which will raise the Net Social Advantage.
Net Social Advantage (NSA)= MSB - MSS.
This process of increasing taxation and public expenditure will goes on in
continuation to the levels of taxation and public expenditure are towards the
left of point P.
On the contrary to this any point (P 2) forward to OQ level of units the MSS
i.e. S 2Q2 > P 2Q2, MSB Therefore beyond the point P 1 any further expansion
in the level of taxation and public expenditure may bring down the social
advantage. This occurs due to the fact that each subsequent unit of
additional taxation will increase the marginal disutility or social sacrifice
which will be more than marginal utilit y or social benefit.
Thus this will be optimal level where the net social advantage is zero. I,e
MSB=MSS , In the figure at point P. Which yields maximum social
advantage.
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23Chapter 3: Fiscal Policy: Budget and Taxation-I
3.3 : Musgrave’s Approach:
The principle of maximum social advantage is explained b y economist Richard
Musgrave who termed it as maximum welfare principle of budget determination.
According to Musgrave, Dalton has proposed two principles of budget policy.
1. Resources should be distributed among different direction in such a way as
to equalise the marginal returns of satisfaction for each type of Expenditure.
2. public expenditure should be pushed to the point where the satisfaction
gained from the last rupee spent is equal to satisfaction lost from the last
rupee taken in Taxes.
Hence the size of the budget is determined in such a way which will bring
maximum welfare to the society. This can be explain with the help of following
figure 3.4.
Figure No. 3. 4: Gains ans Losses from Budget operation

In the given figure 3.4 the size of budget ( level of taxation and public expenditure) is represented on x -axis. On the positive part of y axis MSB is
measured and on the negative part of y axis MSS is measured. The curve EE in the
first quadrant, repr esents the MSB e of successive units of money spent as public
expenditure, allocates optimally between different public uses. The reason behind
downward slope from left to right of EE curve at first quadrant is that as public
expenditure increases, MSB declines.
On the contrary curve TT on the fourth quadrant, represents the marginal social
sacrifice (MSS). As taxation increases the sacrifice involved will also increase. Hence curve TT Slopes downward from the left to right at fourth
quadrant indicate higher tax result to more sacrifice.
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The curve NN represents the marginal net benefit MNB which derived from the
successive addition to public budget. MNB can be estimated by deducting MSS
from MSB i.e. MNB = MSB - MSS. The vertical difference among EE curve and
TT curve measure MNB at different size of budget. in the above diagram in figure
3.4 the optimum size of budget is determined at OM, where the difference between
MSB and MSS is Nil i.e. zero. Since MSB and MSS are measured in opposite
direction, the MNB curve NN cuts the x -axis At point M where MNB is zero (MSB -
MSS=0). Any movement from optimal level M will ultimately push the economy
to reach the optimal position.
Example - At point M 1, MSB will be greater than MSS and MNB is positive.
Hence it will be beneficial at this situation to increase the size of budget as long as
MNB is positive. Ultimately there is a tendency to further move from M 1 to M. and
on the contrary to it, if the budget exceeds from M to M 2 then MSS> MSB and
MNB is negative. Which make it sensible to government to cut down size of
budget and shift from M 2 to M.
Hence from this it is clear that, according to Musgrave, the optimum size 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 at this point MSB= MSS.
3.4 Application of Principle of Maximum Social Advantage :
Though the law of MSA has been criticized by many economist as purely
theoretical and has no practical application. But Dalitan has provided certain relevance to the government of this principle which are as follows :
1. Helps to improve in income distribution
An improvement in the distribution of national income covers both efficiency
and equality dimensions with the help of public finance equity can be
maintained as rich people have less utility for money. Thus with the
application of progressive taxation More tax is levied on high income group
based on the principle of ability to pay for it. And collected public
revenue will be redistributed for the poor people in the form of more public
expenditure on social welfare activity.
2. Protecting and defence preservi ng society / community:
Ultimate objective of all public finance is protecting the country defence from
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25Chapter 3: Fiscal Policy: Budget and Taxation-I
3. Helps to improve production capacity:
This is applicable to how far government operations promote production of
goods and services. the application of tax and public expenditure policies
should be such that production increases up to optimal level.
4. Helpful to stabilize the economy:
Fluctuations on income and employment influence economic activity negatively. Business cycle needs to stabilize with the help of public policies.
So during recession low tax and more expenditure and during inflation vice -
versa and stabilize economy.
5. Full employment and economic growth:
Full employment is the level where all the resources are optimally utilised.
Fiscal policy is helpful in achievement of this objective and ultimately to
enhance and leading to economic development.
3.5 Limitations of the Principle of Maximum Social Advant age
1. Unrealistic assumptions “The principle of maximum social advantage is
based on unrealistic assumptions of the term MSB and MSS. It means
government expenditure always benefit and taxation is always burdensome.
But the fact is that tax on demerit goods may be beneficial. Eg. Tax on
alcohol, cigarette etc.
2. Conceptual differences : In case of direct tax specially taxes are paid by
individual. No shifting of tax is tax. Thus it become micro concept. Where
is public finance is for the Welfare of entire society. Public expenditure gives
rise to public goods that are jointly consumed b y all in a community. The
benefits are at micro level. Thus for some criteria use of both micro and
macro terms are not acceptable.
3. Economic Conditions are not static: Economic conditions are continuously
keep on changing. Thus it's difficult to determi ne the maximum social
advantage level. During some unforeseen situation government has to
undergo with the major adjustment of increase in public expenditure as well
as increasing public revenues to reach the level of required to maintain
economic conditio ns.
4. Absence of divisibility : In order to maintain marginal benefit from public
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26PUBLIC FINANCE
resources are required to be divided into small units. But due to lack of
divisibility it is not possible practically.
5. Difficult to measure : the principle of maximum social advantage is based
on marginal utility concept which itself is criticized by many economist and
the Cardinal measurement of utility concept is unaccepted by most of The
Economist. The ma rginal benefit of public expenditure and the marginal disutility on sacrifice of public revenue are concepts, the objective measurement of which is extremely difficult.
6. Difficult to estimate large budget size: The public authorities are not capable
of esti mating the marginal benefit and marginal sacrifices. It is almost
impossible to apply practically size of budget that will maximize the Welfare
of the community
3.6 Role of Government in Modern E conomy
One of the basic differences of Fiscal economy with rest of the economy is
existence or relevance of intervention of government. Government plays key role in
modern economic activity. Most important function of public expe nditure and
Public revenue (Taxation) influence National Income, output, consumption,
production and various other economic variables. Economic activities are largely
market based influenced activity. It is not very confirm that market will always be
in favorable situation. Sometime due to some factor discrepancy arise which leads
to market failure. Now it become very crucial to prevent economy from mar ket
failure. Hence we introduce government here to prevent economy from mar ket
failure. Though classical economist were against with the intervention of
government, but for some important function like defence, law and order, justice
they also agreed the fact that to run these function government intervention is
needed. Presence of political and social ideologies can be realized with the help of
presence of government. Government play vital role in correcting market failure
and also bring about economic stability which is needed for economic efficiency.
Government pursue social values of equity by altering market outcomes.
Modern Economy felt need of government to stabilize the economy. The task of
price stability and full employment is not so easy. But it is the Keynesian who for
the first time during 1930s promoted the influential role of government by way of
adjustment in its budget by its weapon i.e public expenditure and taxation and
maintaining aggregate demand which ultimately affect employment and output.
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27Chapter 3: Fiscal Policy: Budget and Taxation-I
Two important Principle of Fiscal Policy are given below:
1. Imposition of taxes reduces purchasing power of people because disposable
income of people falls due to which the aggregate demand also reduces.
2. Public expenditure helps to boost the economic condition by way of
increasing effective demand.
This principle is strongly applicable depending upon the form of phas es of business
cycle. During prosperity which may bring inflationary situation in economy by way
of raising tax and reducing public spending which will normalize the aggregate
demand.
On the contrary during the period of slowdown of economy or recession to
overcome f rom this problem the reduction in taxation and raising public
expenditure will bring out stability and aggregate demand also increase which
improves the possibility of recovery from depression level.
Important objective of fiscal policy are optimum allocation of resources, full
employment, economic stability, increase in rate of investment and capital
formation etc. According to J.M Keynes the primary objective of f iscal policy that
is government in modern economy is to maintain aggregate demand by way of
adjustment in consumption, investment, government expenditure and net foreign
demand as all these variables are inter related.
Disposable income, public and private investment, government expenditure and net
foreign income these all are interrelated economic variables. Interrelationship
between them can be shown as follows:
AD = C+ I + G + (X – M)
Where,
AD = Aggregate demand C = Consumption demand I = Investment demand
G = Government Demand
X = Export
M = Import
In the short run,
C = f(Yd) and M = f(Y) Yd = Y – tY + TR Where,
Y = gross income
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TR = Transfer payments (e.g. pension, subsidies, unemployment benefits)
Aggregate demand highly get influence by fiscal policy. Consumption increases by
reducing taxes and reduction in consumption by raising taxes which bring down the
disposable income. Investment can be raised through tax exemption as well as
subsidies to producers. Import also get affected by fiscal policy import can be raised
by providing subsidies and can be reduced by import duties. Similarly export can
be promoted by tax incentives to export.
It become important to take be very careful while taking decision regarding any
fiscal policy change. Let say if government increases government expenditure and
reduces tax in order to raise aggregate expe nditure and boost GDP in short run.
Leading to increase in fiscal deficit causing inflation, because of which money
supply increase and government have to meet this burden by heavy borrowings.
Government borrowing also put burden of increasing interest burden. All these burden will slowdown the economic growth in the long period of time.
Thus the role of government is crucial in modern economy in overall functioning
of economic variable but need to take care while taking decision.
3.7 Questions:
Q1. Explain Daltons version of the Law of Maximum Social Advantage.
Q2. Describe Musgrave’s Approach of Maximum Social Advantage.
Q3. Explain importance of Maximum So cial Advantage.
Q4. What are the Limitations of Maximum Social Advantage?
Q5. Explain Role of Government in determination of economic activity.
3.8 . Refe rences:
H.L, B. (n .d.). PUBLIC FI NANCE. NEW DELHI: VIKAS PUBLISHING HOU SE
PVT. LTD. J.HINDRIKS, G. (2006). INTERMEDIATE PUBLIC ECO NOMICS.
MIT PRESS.
MUSGRAVE, R. A. (n.d.). PUBLIC F INANCE IN THEORY AND PRACTICE,
(5TH ed.). NEW DELHI: TATA MCGR AW - HILL PUBLIS HING CO MPANY
LIMITED.
T.N., H. (2010). PUBLIC FINANCE. NEW DELHI: ANE BOOKS PVT. LTD.
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29Chapter 4: Fiscal Policy: Budget and Taxation-II
Module 2
4 FISCAL POLICY: BUDGET AND TAXATION -II
Unit Structure
4.0 Objective
4.1 Introduction
4.2 Types of Public Budget
4.3 Structure of Public Budget
4.4 Role of Taxation
4.5 Merits and Demerits of Direct and Indirect tax policy
4.6 Features of Good tax system
4.7 Concept of Impact, Incidence and shifting of taxation
4.8 Elasticity and Determination of tax Burden
4.9 Questions
4.10 References
4.0 Objective
• To know different types of Public Budget
• To Understand Structure of Public Budget
• To Know Features of Good Tax System
• To understand the concept of Impact, Incidence and Shifting of Taxation
• To Understand different types of elasticity and incidence of tax burden on buyer
and seller
4.1 Introduction :
The public budget is represented as a financial plan of a government. It is a
systematic record of income and expenditure and related programmes and policies
related with it. The term budget is derived from Fr ench word “B ougette” which
means bag containing financial statement of country consisting of various sources
of public revenue to the government and expenditure plan for the year. According
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together estimates of anticipated re venues and proposed expenditure employing the
schedule of activities to be undertaken as a means of financing these
activities”.Public budget is an annual statement of the fiscal policies with
corresponding financial plans prepared by the government of country. There is
three different possibility of bu dget. When public revenue is greater than
expenditure surplus budget takes place, public revenue less than expenditure
causing deficit in the budget and optimal budget level is one when, public revenue
is just equal to expenditure.
Objec tives of Public Budget:
As per classical view budget was just a statement consisting of only balanced
condition of income and expenditure of economy. But as per welfare e conomist it
is more wider than mere a statement of income and expenditure. According
to modern economy budget is an instrument of fiscal policy through which
government can achieve multiple objectives depending upon the requirements.
The obj ectives of public budget are as follows:
1. Allocation of Resources: This is fundamental objective of any public budget.
As resource are limited so to optimally utilize such resources government
tries to divert available resources at required productive purpose.
2. Reduction of Poverty and Income Inequalities: one of the major challenges
in front of developing nation is the gap between the rich and poor, widening
the problem of inequality. But on the basis of ability to pay principle
gove rnment will be charging tax to the rich as they are able to pay and from
colle cted revenue government provides welfare program and project. Boost
the standard of living which reduces the gap between rich and poor
3. Economic Growth: Public Budget helps to promote the GDP of the
economy. Government plan various policy considering the factors required
to have ec onomic growth. Mobilizing saving, increase in productive
investment and also mobilizing resources for capital formation and encourage
investment.
4. Economic Stability: Most volatile factors are cyclical fluctuation of trade
cycle. Inflation and recession are the critical situation for economy which
causes unstable economy. So to bring back the stability in economy again
government uses its fiscal instrument of tax and expenditure. Hence during
inflation government increases tax rate and reduces public expenditure vice
versa during recession economy is slow down thus to improve the economic
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31Chapter 4: Fiscal Policy: Budget and Taxation-II
By doing so demand increases leading to increase multiplier effe ct increase
in employment.
5. Management of Public Enter prises: Public entreprises are own ed managed
and controlled by public authority i.e government. Public enterprise have
multiple responsibility of providing basic necessary goods at subsidized rate
example are food, health, education and medical facilities. When the
resources fa ll short of fund to achieve to fulfil these objectives then
government choose to disinvest in its budget.
6. Employment Gen eration: Government in its budget tries to include various
programe related to employment generating scheme. Example MGNREGA,
and also tries to promote industries by focusing more on MSME.
4.2 Types of Public Bu dget:
1. Traditional budget: this is most common budget, where changes over the
past years are taken in to consideration. Increm ental approach is implemented
in traditional approach. Hence previous years progr ammes and projects are
continued and funded.
2. Zero based Bu dget: In Zero based Budget all item is included rather than
only changes. The process of zero-based budgeting starts from a "zero base,"
and every function within an organization is analyzed for its needs and costs.
Zero-based budgeting is a more granular process that aims to identify and
justify expenditures.
3. Balanced Bu dget: When public revenue is equal to public expenditure it is
consider as balanced budget. Classical economist believes in balance budget,
when there is full employment. Aggregate supply and aggregate demand are
in equilibrium at full employment, due to which income is equal to
expenditure. Hence ultimately budget is in balance.
4. Unbalanced bu dget: on the contrary to balanced budget unbalanced budget
is the budget which is due to disequilibrium in public revenue and public
expenditure by the government. The examples of unbalanced budget are
surplus budget and deficit budget. In case of surplus budget of government
Public revenue > Public expenditure, vice versa deficit budget is the budget
where public revenue fall short of public expenditure i.e public revenue <
public expenditure.
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5. Performance Bu dget: performance budget is based on the functions and
activity involve in an economy and efficient utilization of resources to
achieve the ultimate goal of economy. It is one that reflects both the input of
resources and the output of services for each unit of an organization.
Performance budget inclusive of three aspects which are understanding of
final outcome, the tools and strategies adopted to reach to those final
outcomes and the specific activities that are to be carr ied out to ensure those
outcomes.
6. Programme Budget: A program budget is a budget formed specifically for
a project or program. This type of budget includes expenses and revenues
related to one specific project. No revenues or expenses of any other projects
are mixed with this particular project. Government has to work on multiple
task and responsibilities. So, they divide these functions into specific
programmes, ac tivities and projects. Depending upon the size and
requirement and also the urgency of the programme f und is allocated.
7. Unified Bu dget: A unified budget is a form of federal government budget in
which receipts and expenditures from central resources and the Social
Security Trust Fund are me rged. The change to a unified budget resulted in a
single mea sure of the fiscal status of the government, based on the sum of all
government activity. This is one of the most inclusive me asure of the
government’s annual finances.
8. Multiple Bud get: multiple budget is subdivided in various parts in such
pattern that each and every part highlights the specialised functions of the
government showing their budget.it is in practice in India as well. Indian
government announces Railway budget and the Union Budget disjointedly.
9. Legislative Budget: A legislative Budget is prepared by the various
committees appointed by the legislature from among its members. Elected
representative of government are key participant of it. The power of
enactment, ame nd and repealing of laws are in their hands.
10. Executive budget: An executive budget, on the other hand, is the one which
is prepared by the executive branch of the government. The responsibility of
implementation of budget is in the hands of executive authority of budget.
11. Revenue Bu dget: Revenue budget includes those items which is in rec urring
form which repeats again and again. There are two components of revenue
budget those are re venue receipt and revenue expenditure. Re venue recei pts
are sources of recurring form of revenues to the government example – (a)
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33Chapter 4: Fiscal Policy: Budget and Taxation-II
tax (ii) indirect tax. On the contrary to this Revenue expenditure are basically
to run the recurring form of spending which government has to bear. S uch
expenses generally done from re venue received by the government either
directly or indirectly. Higher the need of maintenance of public service of
public welfare more will be requirement of revenue expenditure in the list of
budget.
12. Capital Budget: Like revenue budget capital budget also has two
components those are (a) ca pital receipts (b) capital expenditure. Capital
budget is non-recurring, both receipt and expenditure of capital is in decades
or once or twice of life of asset but does not repeat again and again. Example
of Capital expenditure are disinvestment, borrowing, loans from public or
foreign governments, Reserve Bank of India, etc and capital expenditure are
like expenditure on development of machinery, health facilities, etc.
4.3 St ructure of Public Budget:
There are three tier system of government as per the constitution of India. Those
are ce ntral government which is also called as union government, state government
and Local government (like Municipal corporation, Municipal committee, Zila
Parishad etc.). All these three governments have their own system of preparation of
budget. Structure of budget for all these gov ernment is almost similar, but the
sources of revenue and the spending are different to each of them. The budget
framed by central government is formed by taking in to consideration the welfare
of entire nation. Which is called as central budget or Union Budget. Budget formed by particular state for the development or promotion of that particular state it is
called as state budget. Example budget formed by Maharashtra government, this
budget is formed by considering for
the growth and development of Maharashtra sou rces of revenue will be from
Maharashtra and spending will also be for the welfare of Maharashtra only. As
central government and state government cannot reach at all remote and interior
part of the economy. Then it became responsibility of local government to improve
the condition of local area by forming the optimum Budget as per the need and
requirement, such budget is called as Municipal Budget.
Here the core study is of Central Budget. Central Government is constitutionally
required to present annual financial statement before both the houses of Par liament.
This statement is conventionally called Government Budget. Accordingly in India
every year c entral Budget for the coming finance year is presented by the Union
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of February. Year 2020 -21 is intertwined in three major themes, those are
Aspirational India, Economic Development and a Caring Society. The dream of
Prime Minister ‘Sabka Saath, Sabka Vikas,
Sabka Vishwas’ which a ddress the aspirations of India. Union Budget gives item
wise details of the government receipts and expenditure for three consecutive years
those are Actuals for the preceding year, Budget estimates for the current year.
Revised estimates for the current year and budget estimate for the coming year.
Structure/Components of Government Budget are c lassified in two important
component i.e revenue and capital which is furth er classified in revenue rec eipt and
revenue expenditure and capital receipt capital expenditure.
Revenue Budget : Revenue budget includes recurring form of sources of income
to the government which will be part of revenue receipt.
Example: Revenue from direct taxes and indirect taxes are tax revenue Sources .
Fees, fines, penalty, administrative fees, grants etc. are Non – Tax Re venue sources.
On the contrary to which revenue expenditure are those expenses where
government is liable to pay for it. The funding of which government do from the
amount received through revenue receipt.
Example: Defence expenditure, interest payment, Major Subsidies. Capital Budget:
Just like Revenue Budget capital budget also have two components capital receipt
and capital expenditure, the only difference is that it is non - recurring does not
repeat again and again. Capital receipts are the sources of income to the government
which they earn not in recurring form.
Example of Capital Receipt are Disinvestment, recovery of loan, Borrowings and
other liabilities.
Capital expenditure are those expenses which is born by government for creat ion
of assets and investment.
Following flow chart is representing components or structure of Budg et:





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35Chapter 4: Fiscal Policy: Budget and Taxation-II
Figure No. 4.1

4.4 Role of Taxation:
Government has to perform va rious function for the welfare of economy, thus they
need funding for expenses to run the economy. The amount which is collected by
the people of country following canon or principle are known as public revenue.
Revenue can be collected in two different ways. Firstly through taxation and Non
– Tax revenue. Tax revenue is most popular source of revenue to the government.
According to Dalton, “a tax is a compulsory contribution imposed by a public
authority, irrespective of the exact amount of service re ndered to the tax payers in
return and not imposed as a penalty for any legal offence. He further stated that “ a
tax, by definition is a payment in return for which no direct and specific and specific
quid – pro – quo is rendered to the tax payer.”
Taxation is of two different types : (a) Direct Tax
(b) Indirect Tax
Features of Taxation:
1. People who are liable to pay tax can not refuse to pay it to the gove rnment,
thus tax can not be avoided it is compulsory payment.
2. It is not necessary that if tax is paid by person in return that person will get
benefit of that with equal proportion. So there is no quid – pro – quo.
3. There is no give and take relationship.
4. No one get pleasure by paying tax because it reduces disposable income thus
it involves sacrifice.
Taxation plays vital role in following ways:
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1. Helpful in at taining the obj ective of revenue: revenue is must for
government to run the expenses of the economy. In modern world it is also
used as an instrument to frame policy.
2. Reduces income inequlity:Taxation also helpful in achieving equality in two
different income gro up i.e the gap between rich and poor can be era dicated.
3. Full employment : taxation helps in achieving objective of full employment.
With the help of use of taxation disposable income get influence hence also
affecting demand. A reasonable rate of taxation will increase the disposable
income which will increase demand for goods and services. Effect of
increase in demand will also be on investment positively and multiplier effe ct
is on income a nd employment.
4. Price Stability: Due to some uninvited circumstances disequilibrium exist in
economy. Taxation plays vital role in bringing back to equality level to the
economy and thus stabilise the economy. During the period of inflation by
raising tax rate inflationary effect can be absorbed. And just opposite to that
during recession to bring back to stable economy the technique of reducing
tax rate is applied.
5. Economic Development :Economic development is continuous long term
process, for which huge capital formation is required. In less developed
countries due to lack of finance there is shortage of resources to form capital.
Optimum taxation policy helps to allocate the resources for productive
purposes. Productive utilisation of resources increases investment level
which increases income and employment in multiplier form.
6. Reducing the imbalance in Balance of Payment: Balance of Payment is
double column entry of countries receipts and payment record. It consist of
current and capital account. Generally less developed countries face the
disequilibrium in balance of payment i.e they have import > export. But
balance of payme nt should to be in balance for which taxation plays very
crucial role. By imposing taxes like custom duties import can be reduced, and
the objective of Balance of payment can be achieved.
4.5 Merits and Demerits of Direct and Indirect Tax:
4.5.1 Direct Tax: Direct tax is one of the sources of tax revenue to the government.
Direct taxes are borne by the individual or organisation on whom it imposed. Such
type of taxes can not be shifted on other. Impa ct and incidence of tax is on the same
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with increase in increase in income of person rate of tax also increases. Hence direct
taxes are usef ul in bringing equality in nation. More taxes levied on high income
group and revenue collected from that used to redistribute to poor section of
economy.
Example of Direct Tax: Income Tax, Wealth tax, gift tax, corporate tax etc.
Merits of Direct Tax:
1. Certain: Direct tax are ce rtain on the basis of various aspects i.e the am ount
of tax, the time pe riod, the procedure and the ma nner of tax payment.
2. Economical: Direct tax follows the canon of economy. The cost incurred to
collect direct tax is low. It get collected directly from the source of salaried
people in case of direct tax.
3. Elastic: Direct taxes are flexible, it satifies the canon of elasticity.
Depending upon the need and requirement of country government do changes
in tax rate. During boom period to prote ct the economy from problem of
inflationary situation tax rate increased by the government. And just contrary
to that during recession to improve the economic condition government
reduces tax rate.
4. Civic Consciousness: in democratic country like India, direct tax create civic
consciousness in the mind of tax payer. The tax which is paid by them is their
hard earned money so they are c oncern about its uses, they show interest on
where the government is spending their money.
They feel responsibility towards the growth, welfare and development of
economy.
5. Equi ty: Direct taxes are based on the most important canon of taxation i.e
ability to pay. The tax burden is distributed throughout economy(people and
institution) in equitable manner. Direct tax are progressive in nature whi ch
support to reduce inequality in rich and poor class of economy.
6. Simple: Direct taxes are simple and easy to understand.
Demerits of Direct Tax:
1. Arbitrary and possibility of injustice: Direct taxes are levied on the basis
of the recommendations of the tax authority. There is involvement of many
other factors also which may lead to error in the process. Some time in some
cases it become difficult to identify the true income of person and the source
of it. So the ability to pay principle does not prevail successfully. Hence
burden of tax does not get distributed equally leading to arbitrage and
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2. Inconvenient: Direct tax are inconvenient basically to less educated because
of its formality. The procedure of return filling is not so convenient to tax
payers.
3. Unpopular: Direct taxes a re not so popular as it discourages the disposable
income of person. Biggest factor responsible for unpopularity of direct tax is
that it cannot be shifted, the burden and pain of tax is on tax payer itself.
4. Do not cover large pop ulation: In less developed country maximum
population belong to low income(poor),they are exempted from payme nt of
taxes.
5. Tax Evasion: Direct tax involve sacrifice thus tax payers try to evade
themselves from paying taxes. So possibility of cheating is more in such type
of taxes.
4.5.2 Indirect Tax: Indirect tax is another impo rtant source of revenue to the
government. Indirect taxes a re imposed on goods and services and thus it is also
called as commodity tax. Indirect taxes are regressive in nature. Whether the person
is rich or poor, but if person wants to get the benefit of it then liability of paying tax
is born on them. Due to its policy in case of poor people basically due to imposition
of tax on commodity it become mo re expensive for them and their purchasing
power re duces, thus it is regressive in nature. One can shift the burden of tax.
Generally tax is impose on manufacturer and finally they forward the burden of tax
partially or fully on consumer. I mpact and incidence are not compulsory to be on
same person. There is quid – pro – quo in most of the cases.
Example of Indirect taxes are – GST, Custom duty, union excise duty etc.
Goods and Service tax – GST is one of the most popular example of indirect tax
which has changed the economic structure of economy. Goods and services Tax
(GST) was launched in India on 1st July 2017, which is more comprehensive, Multi
stage, destination based tax that is levied on every value addition. There are total
of 5, GST tax rates those are 0%, 5%, 12%, 18% and 28%.
Merits of Indirect Tax:
1. More Convenient to Pay : Unlike direct tax, indirect taxes are more
convenient as tax is included in the price of pro duct so people don’t feel
like burden of tax. The other reason for convenience is that one can pay
in instalment in small amount. It is also convenient to the government as
well because tax is collected in lumpsum form manufacturer or the
importers.
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39Chapter 4: Fiscal Policy: Budget and Taxation-II
2. Elastic: Indirect tax on some commodity fulfils the principle of elasticity.
Government can raise revenue by imposing such taxes on inelastic demand.
Butneed to consider the situation of poor people before imposing such taxes
on necessary goods.
3. Wide Coverage: indirect tax collected by the government covers large
number of population. Beca use it is levied on all section of society. It is not
imposed on selected class like in direct tax poor section of society as per the
policy they are exempted due to ability to pay principle.
4. Control over consumption of demerit Good s: Demerit goods like Alcohol,
Cigarette, opium, ganja etc are harmful and not accepted by society. So by
imposing heavy indirect tax like excise duty on production of such goods and
even consumption also can be controlled. Producer will try to transfer the
burden of tax on the consumer by raising price of such goods. And due to
high price of such commodity and lack of ability to buy they will not consume
it.
5. Tax Evasion is Difficult: Scope of tax evasion in case of indirect tax is less.
Tax evasion is illegal practice where people try to avoid the tax liable to pay.
Demerits of Indirect Tax:
1. Regressive Character: one of the biggest drawback of indirect tax is that it
is regressive which is unjust for poor section of the economy. Commodity tax
affect more to poor, due to imposition of tax on basic necessity price of such
commodity increases. Rich person don’t mind to pay small addition in the
price but poor suffer more because their ability to pay is less.
2. Uneconomical: The administrative cost of collecting tax is expensive. They
have to appoint inspectors to check and supervise the accounts, stocks of
producers, wholesalers and retailers whether they are paying tax or not.
3. Uncer tainty: Revenue which government has to earn through indirect tax is
totally uncertain. Because once price increased due to imposition of tax there
is possibility of reduction in demand for such goods. Thus government cannot
predict exact amount of revenue collection from indirect tax.
4. Inflationary: Indirect tax has its direct negative eff ect on economic
condition, it increase the price of goods and services. Which influence other
factor in spiral and disturb the whole economy.
5. Adverse effect on production and e mployment: Due to impositions of
various duties on production become costly and producer may get discourage
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4.6 Features of Goods Tax System:
A tax system is considered as good tax system only when it fulfils the desired
principle which is also called as Canons of taxation. Tax involve sacrifice, tax
payer never find pleasure to pay tax. Hence the revenue which is collected through
tax should be used in optimum and productive way. Because it is someone’s hard
money. Adam Smith, father of economics supported effective use of taxation by
introducing four canons of taxation which he believe that good tax must follow.
Canons of taxation by Adam Smith are
(1) Equality
(2) Certainty
(3) C onvenience
(4) Economy.
Adam S mith was more concerned with how the wealth of nations or productivity
can be raised. According to him one of the most important objective is that
government should be able to raise sufficient revenue to run the expense of
Defence, Law and Order, Justice etc. Later on, with further development of
economy and prom otion of welfare economy there were addition in the canons of
economy with the help of many other economist.
Following Canons are required to fulfil to be consider as good tax:
1. Canon of Eq uality: Most effective canon of taxation is canon of equality.
According to Adam Smith canon of equality means every person shou ld pay
to the government as per their ability to pay. Thus people belong to high
income group i.e rich will pay more tax and poor will have to pay less based
on the ability to pay principle. There are two aspects of ability to pay
principle.
(a) Horizontal Equity – It means those who have same income will pay
same am ount of tax with no discrimination among them.
(b) Vertical Equity - People with different income group will be paying
as per their ability. Various tax rates should be levied on people with
different levels of income. Rich people have to pay more as they are at
top level and bottom class i.e poor due to less ability will be paying less.
A good tax system must be able to ensure both these aspect of ability to pay
principle , i.e horizontal and vertical equity.
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2. Canon of Certainty: According to Adam Smith “The Tax which each
individual is bound to pay ought to be certain and not arbitrary. The time of
payment, the manner of payment, the quantity to be paid ought all to be clear
and plain to the contributor and to every other person”. As per the study of
Adam S mith uncertainty leads to corruption. Canon of certainty in relation to
taxation a good tax system system, “individual should be secure against
unpredictable taxes levied on their wages or other income. The law should be
clear and specific; tax colle ction should have little discretion about how much
to assess tax payers, for this is a very great power and subject to abuse.” The
certainty aspect include (a) c ertainty of incidence (b) Certainty of liability (c)
Certainty of revenue. Canon of certainty in taxation is also useful to the
government in assessing the tax income which is relevant for budget
formulating.
3. Canon of Convenience: According to Adam smith the third Canon of
taxation i.e Canon of Convenience is also very important aspect to fulfil to
consider tax as a good tax. He represents that the sum, time and manner of
payment of a tax should not only be certain but the time and manner of its
payment should also be convenient to the contributor.
Example: If a land revenue is collected at the time of harvest, it will be
convenient since at this time farm ers reap their crop and obtain income.
Another example of convenience with respect to India, income tax in India is
levied on the basis of income received rather than income accrued during a
year.
4. Canon of E conomy: Tax imposition and tax collection these are two different
concepts. Collection of tax includes cost, since such cost do not add any
productivity to the nation. These addition cost to the nation should be
minimised. According to Adam Smith, there is lack of economy when,
(a) Tax administration is costly on account of complicated taxes.
(b) Taxes are unduly heavy which would discourage investment, so that the
general level of income re duces and hence the relative tax yields.
(c) Tax collection machinery is elaborated and administrative expenses are
high.
(d) Taxes are unproductive in yielding sufficient revenue.
Thus more the complexity in procedure and formalities higher will be cost of
collection. Hence tax should be simple and tax laws should not be subject to
different interpretation.
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utilised and should yield something in return. Thus canon of productivity in
taxation means that tax system should be able to bring enough revenue for
the treasury. It is more relevant to Indian economy so that country can provide
more welfare and leads to developmental activities. On the contrary to this if
the tax system do not get success to yield enough resources, the government
will resort to deficit financing which is harmful for economic activity.
6. Canon of Elasticity: According to the Canon of elasticity of the taxation
system me ans changes in tax revenue as per the changing state of the
economy, as national income increases due to economic growth government
revenue from tax source should also increase. Progressive form of tax on
income and wealth leads to elasticity to the tax system.
Example: More indirect tax on luxury goods having high income elasticity of
demand also makes the tax system elastic.
7. Canon of Simplicity: Tax system should be simple. The mode of payment,
way of calculation and various other procedure need to be simple, so that it is
understandable to tax payer. And tax payer do not find difficulty in paying
tax.
8. Canon of Flexibility: It means absence of rigidity. Taxation system need to
be flexible as per the need and requirement of economy.
9. Canon of Coordination: As Indian government has three tier federal
government system. These are Central government, State Government and
Local Government. Some power is shared among different level of
government. The tax authority from different level of government need to
coordinate among themselves then only it will be considered as good tax.
10. Canon of Diversity: It indicates that there should be multiple tax system
rather than single. The single tax system may not be able to fulfil the
requirement of the economy i.e shortage of revenue may arise. Whereas
multiple tax system helps to collect revenue from multiple sources and large
number of populations contributing to pay taxes. Hence the burden of tax is
not on limited number of mem bers of economy. It has wider coverage.
4.7 Concept of Impact, Incidence and Shifting of Taxation:
4.7.1 Impact of Taxation:
Impact of taxation is the immediate burden of tax on the tax payer. Its initial stage
of tax burden on the person who is liable to pay. The impact of tax is the first point
of contact. The impact of tax is on the person on whom it is imposed
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43Chapter 4: Fiscal Policy: Budget and Taxation-II
imposition of the tax.
4.7.2 Incidence of Taxation: Incidence of tax is the final resting point at which the
ultimate burden of tax gets settled. It is economic term to find the ultimate source
on whom finally tax get settled.
Example: Person A is producer of commodity X let assume that due to new
government policy he has to bear additional cost of GST for his product. Then the
impact of tax is on person A, but he may forward the tax burden by raising the price
of his product exactly equals to the am ount of GST which he has to
pay it to the government. Hence it become very clear that the incidence of tax is
on Buyer of commodity X. thus incidence of tax is the final resting point who finally
pay the tax.
According to Dalton: incidence of taxation is classified further in two f orm –
(i) Real Burden: The sacrifice incurred in payment of tax is the real burden on
tax payer.
(ii) Money Burden: The money burden or the amount which is imposed on the
tax payer.
The other classification of incidence of taxation by Mrs. Urusula Hic ks are
(i) Formal Incidence – The tax authority collect tax revenue, the direct money
burden of such tax is formal incidence of taxation.
(ii) Effective Incidence – Due to imposition of taxation the entire economy
activity get affected. Thus overall economic effe ct of tax is called as effective
incidence.
Table No. 4.1: Distinguish between Impact and Incidence of Taxation SR. IMPACT INCIDENCE NO. 1. Impact refers to initial burden of Incidence refers to ultimate burden of tax tax 2. Impact is at the point of imposition Incidence occurs at the point of settlement. 3. The impact of a tax falls upon the person from whom the tax is collected The incidence rests on the person who pays it eventually. 4. Impact may be shifted Incidence cannot 5. Example – Direct Tax i.e Income tax in which impact and incidence is on same person Example – Indirect Tax i.e GST in which impact and incidence are not on same person munotes.in

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4.7.3 Shifting of taxation:
Shifting of taxation relates to transferring the money burden of tax on someone else.
The objective behind shifting of taxation is to escape self from payment of taxation.
Tax shifting is the intermediate process of between the impact and incidence of
taxation. Commodity taxation is the source where shifting of taxation is possible.
The price is the medium through which the shifting of taxation can be done. Due to
shifting of taxation the price of the pro duct increases the buyer has born the burden
of shifting of tax, or the other possibility is that if the price re mains same the quality
of quantity get affected. There are different types of shifting of taxation.
1. Forward S hifting: This is most common tendency of shifting of taxation.
Here the burden of tax is forwarded further. Example – Tax levied by the
government leads to addition in the cost of production to the producer. Then
Producer shift the money burden of tax on to the buyer by raising the price of
its product.
2. Backward Shifting: backward shifting is the process where the impact and
incidence of tax is not on the buyer i.e the price do not get change. Perhaps
the producer shift the money burden of tax backward by reducing the wages
of workers on by bargain to reduce the cost of raw material to the seller of
raw ma terial.
3. Combination Shifting: By name itself we can understand that here
combination of both forward and backward shifting takes place. Producer
tries to shift forward partial burden of tax on buyer by raising price partially
and partially shift backward on factors of production like workers by reducing
wages or deteriorating the quality of input.
4. Single point and Multi –Point Shifting –
Single point shifting of taxation is at single sour ce i.e when the burden of tax
is shifted from producer to the consumer it is called as single point shifting.
Multi point shifting - It is the shifting of tax burden at various level. First
level is government when they impose tax on producer, for example excise
duty on production of commodity. Producer forward the addition cost of such
tax burden to the retailer and finally retailer forward it to the buyer who is the
ultimate tax payer.
4.8 Elasticity and determination of tax burden.
According to Dalton, the incidence of commodity taxation is shared between
buyers and sellers in the ratio of the elasticity of supply of the taxed commodity to
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45Chapter 4: Fiscal Policy: Budget and Taxation-IIாೞா೏= ூ௡௖௜ௗ௘௡௖௘௢௡஻௨௬௘௥௦ூ௡௖௜ௗ௘௡௖௘ ௢௡ௌ௘௟௟௘௥
4.8.1 Elasticity of Demand:
Dalton put down two propositions with regard to the general principle of incidence
of commodity taxation.
1) Other things remain the same, the more elastic the demand for the taxed
commodity, the more will be the incidence of the tax upon the seller.
2) Other things remains same, the more elastic the supply of the taxed commodity, the more will be the incidence of the tax upon the buyer.
On the basis of these proposition the tax incidence differ on elasticities of Demand
and Supply.
პ(ODVWLFLW\RIGHPDQG
Ed = ௣௥௢௣௢௥௧௜௢௡௔௧௘௖௛௔௡௚௘௜௡ௗ௘௠௔௡ௗ
௣௥௢௣௢௥௧௜௢௡௔௧௘௖௛௔௡௚௘௜௡௣௥௜௖௘
Given Elasticity of supply we will explain different types of elasticity of demand
and tax incidence
1) Perfectly Elastic Demand:
Given supply elasticity, when demand is perfectly elastic. The entire tax
burden is on the seller. On x -axis output is mentioned on Y axis price.
Figure No. 4. 2


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46PUBLIC FINANCE
In fig 4.2 DD is Demand curve Horizontal showing perfectly elastic demand
SS is original supply curve. Equilibrium is at E. Due to imposition of tax SS
curve shift upward at S’S’ the vertical gap between the two supply curve is
tax amount equilibrium changes from E to E 1 But price remains same at OP.
The tax amount in fig 4.2 is TE 1PN which lie below the price charged. Thus
the entire burden of tax burden (i.e incidence ) is borne by the seller.
2) Perfectly inelastic demand:
Figure No. 4. 3

Figure 2.2 represent per fectly inelastic demand. Supply curve is SS demand
curve is vertical i.e DD the price is OP. Now due to imposition of tax the new
supply curve is SS’ the gap between SS and S’S’ is tax amount EE’ here we
can see that the price rise from OP to OP’ due to t ax. Thus we can understand
with this, that in case of perfectly inelastic demand the entire tax burden in
borne by buyer.
3) Relatively Elastic Demand:
Figure No. 4. 4

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47Chapter 4: Fiscal Policy: Budget and Taxation-II
Fig 4.4, Demand curve is flatter indicating more elasticity tax amount is E’T
PP’E’A > PABT out of which area upto PP’E’A is born by buyer and PABT
is born by seller. So we can say that in Relatively elastic demand, more
burden of tax is on seller and the small er burden falls on buyer.
4) Relatively inelastic demand:
Figure No. 4. 5

Fig 4.5 is the case where we have steeper demand curve which is due to
Relatively inelastic demand situation. Here tax amount is E’T. out of which
WKHEX\HUKDVWRSD\PRUHWD[DVFRPSDUHWRVHOOHUƑ33¶(¶$!3%$7+HUH
PP’E’A is the amount born by buyer and PAB T is born by seller. In this case
seller is able to shift maximum burden of tax on buyer and only partial tax by
seller.
5) Unitary elastic demand :
Fig 4.6 represent that the tax amount E’T is equally shared among both of
WKHPLHEX\HUDVZHOODVVHOOHUƑ 33¶(¶$ Ƒ3$%76R
Figure No. 4. 6

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48PUBLIC FINANCE
Thus the money burden of tax will be divided equally between the buyer and the
seller.
4.8.2 Elasticity of supply:
ܧ௦= ௣௥௢௣௢௥௧௜௢௡௔௧௘ ௖௛௔௡௚௘௜௡௦௨௣௣௟௬
௣௥௢௣௢௥௧௜௢௡௔௧௘ ௖௛௔௡௚௘௜௡௣௥௜௖௘
Elasticity of supply also influence to a greater extent in determining incidence of a
tax. Sellers can affect the market by changing supply and h ence the price. To what
extent price change that can be determined by elasticity of supply. Here we assume
that demand elasticity is constant. More precisely we can say that given the
elasticity of demand, higher the elasticity of supply greater will be th e burden on
the buyer. Different types of elasticity of supply and tax incidence.
1) Perfectly elastic supply:
Figure No. 4. 7

In fig 4.7 (A) SS in perfectly elastic supply curve keeping elasticity of
demand constant equilibrium is at point E and AS tax imposed supply curve
S’S’ shift upward horizontally. New equilibrium is at E’. The tax amount is
the distance between old supply curve and new su pply curve E’T. as here the
price before tax was OP and after imposition of tax, the price rises to OP’.
Thus it indicates that entire burden of tax is on buyer.
2) Perfectly inelastic supply :
Here in case of perfectly inelastic supply, the supply cu rve is vertical and the
seller is not able to shift the burden of tax on anyone else. Thus fig 4.8 shows
that entire burden of tax is borne by seller himself.
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49Chapter 4: Fiscal Policy: Budget and Taxation-II
Figure No. 4. 8

3) Relatively more elastic supply:
In figure 4.9 the supply curve is flatter showing more elasticity tax amount is
E’T of which greater portion of tax burden fall on buyer and smaller
proportion of tax on seller. Buyer has to bear (E’A) and seller (AT).
Figure No. 4. 9

4) Relatively inelastic supply:
Figure 4.10 represents relatively inelastic supply situation where the supply
curve is steeper. Tax amount is ET where greater proportion of tax burden is
on seller smaller proportion of tax incidence is on buyer. Area PP’E’A is
borne by buyer and area PBAT is borne by seller.
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Figure No. 4. 10

5) Unitary elastic supply:
Like fig 4.6 in this case also tax is divided equally among buyer and seller.
Hence we conclude that greater the elasticity of demand, lesser will be the
possibility of the seller is to shift the incidence of tan on buyer. On the
contrary to it higher the elasticity of supply, the greater is the possibility of
the seller to shift the tax on the buyers.
4.9 Questions
Q1. Explain different types of Public Budget.
Q2. Describe in detail the role of Government in economic welfare.
Q3. Distinguish between impact and incidence of taxation.
Q4. Explain incidence of tax burden on b uyer and seller with the help of
suitable diagrams.
Q5. What are the features of good taxation ?
Q6. Distinguish between direct tax and indirect ta x.
4.10 References
• Musgrave Richard A. Public Finance in Theory and Practice, Tata Mc Graw
Hill Publishing Company Ltd, New Del hi, 5th edition.
• Chauhan M. S., Public Finances, Issues and Problems, Global Publication,
New Delhi
™™™
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51Chapter 5: Fiscal Policy: Public Expenditure
Module 3
5 FISCAL POLICY: PUBLIC EXPENDITURE

Unit Structure:
5.0 Objectives
5.1 Introduction
5.2 Meaning of Public Expenditure
5.3 Importance of Public Expenditure
5.4 Canons of Public Expenditure
5.5 Effects of Public Expenditure
5.6 Classification of Public E xpenditure
5.7 Dalton’s Classification of Public Expenditure
5.8 Wagner’s Law of Public Expenditure
5.9 Public Expenditure as an Instrument of Fiscal Policy
5.10 Conclusion
5.11 Questions
5.12 References
5.0 Objective
• To understand the concept of Public Expenditure.
• To familiar students with the Canons and Classification of Public expenditure.
• To enable the learners to grasp fully the theoretical rationale behind Wagner’s
law of Public expenditure .
• To explain the students public expenditure as an instrument of Fiscal pol icy.
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5.1 Introduction
The 19th century State was mainly a police State, but the 20th Century State is a
Welfare State whose main objective is to promote the economic, political and social
well-being of citizens. Government spend money to create and maintain full
employment, development programmes, education [free] and on social security
measures. Expenditure on national defence generally accounts for half of the total
expenditure. Larger the country, greater the percentage of revenue allotted to
national defence. The continuous process of urbanization brings an expansion in
expenditure on the protection of life and prosperity, and on public health,
educations and other functions like hospitals, playgrounds, organized recreations,
water, sewerage growt h of network of roads, railways and provision of welfare and
assistance.
The great depression of 1929 -33 demonstrated the need for government to interfere
and participate in economic activity and new functions. The government took
various measures for the active encouragement of industry, agriculture, labour full employment, promoting public welfare, and control over all sectors of the economy.
The other causes for the growth of public expenditure includes, rise of democracy,
rise in price levels, increase in public debt followed by increased interest rates,
growth of the spirit of economic nationalism and desire for self -sufficiency, etc.
In the previous chapters on public finance, we have examined budget and taxation
as an important aspect of public financ e. Classical economists have been interested
in the problems of taxation for a long time. Modern economists believe that the
question of public expenditure is not less important than that of taxation. In fact,
public expenditure is another very important s ide of public finance. In this chapter,
we shall examine public expenditure as an important area of public finance.
5.2 Meaning Of Public Expenditure
Public expenditure refers to expenditure of the government. i.e. government
spending for public welfare. It is incurred by Central, State and Local governments
of a country. Public expenditure can be defined as , “The expenditure incurred by
public authori ties like central, state and local governments to satisfy the collective
social wants of people is known as public expenditure.”
Public expenditure is important branch of public finance. It is not nearly a financial
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53Chapter 5: Fiscal Policy: Public Expenditure
which governs the least”. It means the role of government in the economy should
be minimum. The classical economist were the followers of laissez faire policy.
(i.e. no government intervention.)
New approach to public fi nance however evolved in the 1930s, since the Keynesian revolution in economic thought. Modern economists believe that public expenditure has a positive role to play, to achieve definite ends. Its goal is to
promote maximum social welfare. Today the state is recognized as a welfare state,
therefore it has to perform many other functions.
In modern era, public expenditure has the following objectives; -
1. To make provision of social wants in order to maximize social and economic
welfare.
2. To make provision of op timum level of investment in order to maintain full
level of employment and economic growth.
3. To make provision of infrastructure by improving capital formation.
4. To provide equal distribution of income and wealth.
5. To maintain national security.
6. Maintenance of law and order and internal security.
5.3 Importance of Public Expenditure
Public expenditure plays a significant role in the development process of a country
in the following ways: -
1. By building economic overheads.
2. To buy balanced regional development.
3. By augmenting the developm ent of agriculture and industry.
4. By exploit ation and development of mineral resources , coal and oil .
5. By rural electrification Programme which can bring rural development.
5.4 Principles / Canons of Public Expenditures
The principles of public expenditure are certain guidelines for the public authorities
in spending government money. They are also known as canons of expenditure.
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1. Principle of Maximum Social Advantage
The objective behind this principle is that public money should be spent for
general cause and must promote social welfare. It should not be spent for the
benefit of a particular group of society. Public expenditure should result in
increased production, elimi nation of inequality and promotion of welfare of all. It should secure internal peace and also protection from external aggression.
2. Canon of Economy
The authorities are expected to follow utmost economy in its expenditure.
Public money should not be m isused and not result in any wastage. Whenever
money is raised by taxation , public expenditure in return should bring
maximum benefit. It should not produce unfavorable effect on production.
Canon of economy does not mean niggardliness or miserliness. It s imply
means the prevention of extravagance and waste of all kinds.
3. Canon of Sanction
Without the sanction of the public authority, no money should be spent. At
the same time, the amount of money must be spent for the purpose for which
it was sanctioned.
This will ensure that:
• waste and extravagance are avoided,
• there is proper audit done compulsorily,
• there is control and legislative supervision over public expenditure,
• It is seen whether the expenditure has fulfilled the objective.
In the a bsence of proper sanction, there may be misuse and misappropriation
of public funds. The Public Accounts Committee established by every
legislature sees that these objectives are achieved.
4. Canon of Elasticity
This implies that there should be scope fo r varying the expenditure according
to need or circumstances. There should not be any rigidity in public
expenditure.
5. Canon of Surplus
To greater extent, the government expenditure should lead to increased
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55Chapter 5: Fiscal Policy: Public Expenditure
revenue of the State. Deficit is permitted only for a short duration. In times
of crisis, government is allowed to have deficit budget. The deficit must be
made good after the normalcy returns.
Finally, public expenditure shoul d promote economic growth, stability and
social justice. Public expenditure should be directed to achieve economic and
social objectives of the country.
5.5 Effects of Public Expenditure
Public expenditure is beneficial since it influences the economy in many directions.
The effects of public expenditure are always beneficial. It increases the capacity of
the people to produce output efficiently. It influences the production not only
directly but also indirectly. It increases the community’s pro ductive power. It
promotes social and economic equality and finally increases income, employment
and welfare.
1. Effects on production
Expenditure on defence becomes productive and it becomes a protective
expenditure. Development of infrastructures facilitates production and thereby helps to increase national income and in turn per capita income.
Expenditures on social services like free education, health and medical aid,
which increase the capacity of the people to work and save and productive
power.
2. Effects on distribution
Public expenditure is an ideal medium to remove economic inequalities in
society. The government should tax more the rich. The amount so collected
should be spent on free education, medical aid, cheap food, subsidized
houses, old age pension, etc. This process of public expenditure will bring
about redistribution of national income in favour of the poor.
3. Effects on income and employment
Public expenditure affects the level of income and employment in the country
by removing the widespread unemployment. Investing more on public works
like roads, hydro -electric generating works, etc. will create a multiplier effect
on the economy and thereby increases the income and employment. This
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Thus, public expenditure plays a vital role in the economic development of a
country. It also creates necessary environment for the expansion of private
enterprise and initiat ive.
5.6 Classification of Public Expenditure
Different economists have classified Public Expenditure into different forms. Prof.
Adam Smith has classified public expenditure on the basis of functions performed
by the government. They are defence expenditu re, commercial expenditure and
development expenditure. Classification of public expenditure refers to the systematic arrangement of different items on which the government incurs expenditure.
Public expenditure has been classified into various categories . Firstly, Government
expenditure has been classified into revenue expen diture and capital expenditure.
Revenue expenditure is a current or consumption expenditure incurred on civil
administration (i.e., police, jails and judiciary), defence forces, publi c health and
education.
This revenue expenditure is of recurrent type which is incurred year after year. On
the other hand, capital expenditure is incurred on building durable assets. It is a
non-recurring type of expenditure. Expenditure incurred on build ing multipurpose
river projects, highways, steel plants etc., and buying machinery and equipment is
regarded as capital expenditure.
Transfer Payments and Expenditure on Goods and Services. Another useful
classifica tion of public expenditure divides it into transfer payments and non -
transfer payments. Transfer payments refer to those kinds of expenditure against
which there is no corresponding transfer of real resources (i.e., goods and services)
to the Government.
1. Revenue and Capital Expenditure:
(A) Revenue Expenditures are recurrent or consumption expenditures incurred on public administration, defence forces, public health and education, maintenance of government machinery, subsidies and interest
payments. These expenditur es are recurrent in nature and they do not create
any capital assets. Revenue expenditure is classified into development and
non-development expenditure
i) Development Expenditure: The part of revenue expenditure that
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57Chapter 5: Fiscal Policy: Public Expenditure
on the maintenance and functioning of social and community services
and physical infrastructure. For example, maintenance of education and
public health infrastructure like schools, hospitals, irrigation facilities,
electricity boards etc.
ii) Non-Development Expenditure: The part of revenue expenditure that
may not directly contribute to economic development is known as non -
development revenue expenditu re. They include expenditures on the
maintenance of defence establishments, administrative expenditure,
interest payments, payment of old age pension etc.
(B) Capital Expenditures are incurred on building durable assets, like
highways, multipurpose dams, irrigation projects, buying machinery and
equipment. They are a non -recurring type of expenditure in the form of capital investments. Such expenditures are expected to improve the productive capacity of the economy.
i) Not all capital expenditures are productive. Non-development
capital expenditure on defence establishment which does not have any direct impact on economic development but is necessary for the security of the nation.
ii) Capital expenditures on social infrastructure like government schools, hospitals, primary health centers may not generate revenue and
therefore cannot be termed productive in that sense, but they indirectly
contribute to improving productivity.
2. Productive and Unproductive Expenditure
(a) Productive Expenditure: Expenditure on infrastructure development,
public enterprises or development of agriculture increase productive
capacity in the economy and bring income to the government through
tax and non -tax revenues. Thus they are classified as productive
expenditure.
(b) 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 gov ernment. Such expenses
are classified as unproductive expenditures.
3. Non-Transfer and Transfer Expenditure:
(a) Non-transfer Expenditures: Are incurred for buying or using goods
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health etc. Investment expenditures on capital assets are also non -
transfer expenditures as the government gets capital goods and assets
in return for them.
(b) Transfer Expenditures: Refer to those expenditures against which
there is no corresponding transfer of real resources i.e. goods or
services. These include expenditures incurred on old age pension,
unemployment allowance, sickness benefits, interest payments on
public debt and subsidies.
4. Plan and Non -Plan Expenditure:
(a) Plan Expenditures: Refer to the spending of the annual funds
allocated by the Central government for development schemes outlined
in the ongoing Five Year Plan. For example: Industrial Development,
Agric ultural Development, Infrastructure, Education & Health etc.
(b) Non-Plan Expenditures: Include all those expenditures of the government that are not included in the ongoing Five -Year Plan. They
include both development and non -development expenditure. Pa rt of
the expenditure is obligatory in nature e.g. interest payments, pensions
etc. and a part is essential obligation e.g. defence and internal security.
5.7 Dalton’s Classification of Public Expenditure
Economist Hugh Dalton has provided the following c omprehensive classification
of public expenditure:
i. Expenditures on political executives i.e. maintenance of ceremonial heads of
state, like the President.
ii. Administrative expenditure to maintain the general administration of the
country, like government de partments and offices.
iii. Security expenditures to maintain armed forces and the police forces.
iv. Expenditures on administration of justice include maintenance of courts,
judges, public prosecutors.
v. Developmental expenditures to promote growth and development of the
economy, like expenditure on infrastructure, irrigation etc.
vi. Social expenditures on public health, community welfare, social security etc.
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5.8 Wagner ’s Law of Increasing State Activity
First, there is Wagner’s Law of Increasing State Activity. According to Wagner, a German economist, there are inherent tendencies for the activities of the Government to increase both extensively and intensively. In other words, ac cording
to this law as an economy develops over time, the activities or functions of the
Government increase.
With the development of the economy, the Government undertakes new functions,
activities, and old functions are p erformed more thoroughly. The expansion in the
Government functions and activities leads to the increase in public expenditure.
Though Wanger based his law on the historical evidence drawn from economic
growth of Germany, this applies equally to other coun tries, both developed and
developing ones.
The size of public expenditure has been rising in developed countries since early
twentieth century and in developing countries since the middle of twentieth
century. This is because governmental functions have in creased. This increase has
far reaching impact on economic growth and development through production,
distribution, consumption, saving and investment. Wagner’s Law and Wiseman -
Peacock Hypothesis have explained increase in public expenditure . According to
Wagner public expenditure in any economy increases because of an increase in the
role of government.
The government in every economy is performing the following fundamental duties.
1) The government is involved in the production of materialistic goods.
2) The government plays an important role in maintaining internal and external
security.
3) The government also provides social justice through court i.e. maintaining
law and order.
In the process of performing its duties the public expenditure increas es. In India,
there has been spectacular rise in public expenditure since 1950 -51. The ratio of
public expenditure to GDP rose steadily until 1990 -91. From 9.1 percent of GDP
in 1950 -51, the ratio rose to 28.5 per cent of the GDP in 1990 -91. From 1990 -91 to
1995 -96, there was a decline in this ratio. Since then, this trend has reversed and
the public expenditure GDP ratio has been rising.
Total Public Expenditure (Revenue and Capital) since 1990 -91

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5.8.1 The following are the causes of growth of public expenditure in India:
1. Defence: One of the major contributors to rising public expenditure in India
is the growing defence expenditure. Defence expenditure has increased from
Rs.3,600 crore in 1980 -81 to Rs.86,879 crore in 2009 -10.
2. Population: In 1951, India’s population was 36 crore. It rose to 102.9 crore
in 2001. This massive growth in population has made it necessary for the government to spend ever increasing amounts on education, health, infras tructure, subsidies and development programmes.
3. Rise in National Income: Rise in public expenditure is directly related to
rise in national income and per capita income. This is because, as income
rises beyond subsistence level, and the basic necessities of people are
satisfied, demand for public goods like education, communica tion,
transportation, health care etc. tend to increase. Thus, governments are
expected to spend more on such goods.
4. Urbanization : With economic development and industrialization, urbanization has taken place. In 1951, the percentage of urban populati on was
17 percent, whereas in 2001 it was around 28 percent. With urbanization,
public expenditure or urban infrastructure has increased.
5. Subsidies: The government gives subsidies to different sectors in order to
make essential goods and services affo rdable to the poor. In India Central
Government subsidies have increased from Rs.9,581 crore in 1990 -91 to
Rs.1,06,004crore in 2009 -10.
6. Development Programmes: The government of India has always been
committed to planned development. This requires heav y investments in
various physical and social infrastructure projects. The Government’s Plan
expenditure was Rs.3,25,149crore in 2009 -10.
7. Poverty Alleviation and Employment Generation: As part of the planned
programme, the government has launched sever al programmes to directly
attack the problems of poverty and unemployment. These require continuous
ongoing expenditure for their implementation.
8. Servicing of Public Debt: Most plan capital expenditures in India have been
financed through public debt from various sources. There has been a continuous growth in the total outstanding debt of the government. In India,
interest payment is the single largest item of expenditure. It has increased
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9. Administrative Machinery: Indian government’s administrative machinery
is vast and has expanded many times over the years. Maintenance of various
ministries, departments and offices, payment of salaries to a large staff has
increased administrative exp enditure over the years.
10. Judiciary and Internal Security: India has a strong and extensive judicial
system that is designed to protect the rights of its citizens. Huge expenditure
has to be incurred for the maintenance of courts and jails, salaries of the
judges and other staff, as well as police forces involved in maintaining
internal law and order.
11. Democracy: India is the world’s largest democracy, Periodic elections and maintenance of the political representatives have increased public expenditure to a great extent over the years.
5.9 Public Expenditure as an Instrument of Fiscal Policy
Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions, including
aggregate demand for goods and services, employment, inflation, and economic
growth. Fiscal policy refers to the use of gover nment spending and tax policies to
influence economic conditions. Fiscal policy is largely based on ideas from John
Maynard Keynes, who argued governments could stabilize the business cycle and
regulate economic output. During a recession, the government may employ expansionary fiscal policy by lowering tax rates to increase aggregate demand and
fuel economic growth. In the face of mounting inflation and other expansionary
symptoms, a government may pursue contractionary fiscal policy.
Public expenditures a re income generating and include all types of government
expenditure such as capital expenditure on public works, relief expenditures,
subsidy payment of various types, transfer payments and other social security
benefits. Government expenditure is an impo rtant instrument of fiscal policy.
It includes governments expenditure towards consumption, investment and transfer payments. Government expenditures includes:_
1. expenditures to meet the day to day running of the government.
2. to capital expenditures which are in the form of investment made by the
government in capital equipment and infrastructure.
3. transfer payments that is government spending which does not contribute to
the GDP because income is only transfer from one grou p of people to another
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Government may spend money on performance of its large and ever growing
functions and also for deliberately bringing is stabilization during recession. It may
initiate a fresh wave of public work such as construction of roads, irrigation
facilities, sanitary works, ports, electrification of new areas etc. Government
expenditure involved employment of labour as well as purchase of multitude of
goods and services. These expenditures di rectly generate income to labour and
supplier of materials and services. Apart from direct effects, there is also indirect
effect in the form of working of multiplier. The income generated are spent on
purchase of consumer goods. The extent of spending by people depends on the on
their marginal propensity to consume (MPC). There is generally surplus capacity
in consumer goods industries during recession and an increase in demand for
various goods leads to expansion in production in those industries as well. Additionally, a program of public investment will strengthen the general conference of the businessperson and consequently their willingness to invest .
Primary employment in public works programs will induce secondary and tertiary
employment and before lo ng the economy is put on the expansion track.
A distinction is made between the two concepts of public spending . During
depression , namely the concept of ‘pump priming ’ and the concept of ‘compensatory spending ’. Pump priming involves a one -shot injection of the
government expenditure into a depressed economy with the aim of boosting
business confidence and encouraging larger private investment. I t is a temporary
fiscal stimulus in order to set of f the multiplier process . The argument is that with
the temporary injection of purchasing power into the economy through the rise in
government spending financed by borrowing rather than taxes, It is possible for
government to bring about permanent recover y from a slum p. Pump priming was
widely used by the governments in the post -war era in order to maintain full
employment .
However , it become discredited later when it fails to halt rising unemployment and
was held responsible for inflation . Compensatory spending is said to be resorte d
when the government spending is deliberately carried out with obvious intention to
compensate the deficiency in private investment . Public expenditure is also used as
a policy instrument to reduce the severity of inflation and to bring down the prices .
This is done by reducing government expenditure when there is a fear of
inflation ary rise in prices . Reduced incomes on account of decrease public spending
helps to eliminate excess aggregate demand.
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5.10 Conclusion
Public expenditure is necessary to address the diverse social, economic and
regulatory requirements of an economy. The links between public expenditure and
economic growth are well recognized. Public expenditure also contributes towards
economic growth and social development through mul tiple channels; for instance,
investments in agricultural and industrial infrastructure creates backward and
forward links and leads to employment opportunities. Similarly, investments in
health and education can lead to higher labour productivity and cont ribute towards
economic growth. While public expenditure is expected to generate significant
growth -multiplier effects, there are several constraints when deciding upon the magnitude of public expenditure. The effectiveness of public expenditure is particu larly sensitive to the composition of expenditure allocations and the state of
the fiscal environment.
5.11 Questions
Q1. What is Public expenditure? Explain its objectives and importance.
Q2. What are the Canons of Public expenditure?
Q3. Explain in detail, the Classification of Public expenditure.
Q4. What are the causes of rising public expenditure in modern era?
Q5. What are the effects of public expenditure on production and distribution in
the economy?
Q6. How does the public expend iture used as an effective instrument of Fiscal
policy.
5.12 References
1. J. Hindriks, G. Myles, (2006), Intermediate Public Economics, MIT Press.
2. Harvey Rosen, (2005), Public Finance, Seventh Edition, McGraw Hill
Publications.
3. Kaushik Basu and Maertens (ed), (2013), The New Oxford Companion to
Economics in India, Oxford University Press.
4. Sury M.M., (1990), Government Budgeting in India, Commonwealth Publishers.
5. Bhatia H.L., (2012), Public Finance, Vikas Publications.
6. Report of the Fourteenth Finance Commission, Government of India.
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Module 3
6 FISCAL POLICY: PUBLIC DEBT
Unit Structure:
6.0 Objectives
6.1 Introduction
6.2 Meaning of Public debt
6.3 Classification of Public Debt
6.4 Burden of Public Debt
6.4.1 Burden of Internal Debt
6.4.2 Burden of External Debt
6.5 Meaning and Framework of Public Debt M anagement
6.5.1 Importance of Public Debt Management
6.5.2 Framework for Public Debt Management
6.6 Effects of Public Debt
6.7 Methods of Redemption / Repayment of Public Debt
6.8 Concepts of Deficits
6.9 Conclusion
6.10 Questions
6.11 References
l.0 Objective
• To understand the concept of Public Debt.
• To familiar students with the meaning, importance and types of Public Debt.
• To enable the learners to grasp fully the burden of public debt.
• To understand the principles of management of public debt.
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6.1 Introduction
In the previous chapter, we have seen that taxation is one of the sources through
which the government of a country collects revenue and public expenditure is that
which the government spends for the progress of the economy. This implies that
revenue is one side and expenditure (spending) is another side o f the budget.
Nowadays, the fiscal operation of the government has increased to such an extent
that the current revenues from taxation fall short of the total expenditure. The
deficit is bridged by up in two ways:
1. By borrowing from the public
2. By printing n ew currency called Deficit financing.
Public debt is the total amount borrowed by the government of a country. So, why
is public debt significant? Let’s take a closer look. In the Indian context, public
debt includes the total liabilities of the Union gove rnment that have to be paid from
the Consolidated Fund of India. Sometimes, the term is also used to refer to the
overall liabilities of the central and state governments. However, the Union
government clearly distinguishes its debt liabilities from those of the states. It calls
overall liabilities of both the Union government and states as General Government
Debt (GGD) or Consolidated General Government Debt.
Since the Union government relies heavily on market borrowing to meet its
operational and developm ental expenditure, the study of public debt becomes key
to understand the financial health of the government. The study of public debt
involves the study of various factors such as debt -to-GDP ratio, and sustainability
and sources of government debt. The f act that almost a fourth of the government
expenditure goes into interest payment explains the magnitude of the liabilities of
the Union government.
In this chapter, we will examine the various aspects of government borrowing and
its management.
6.2 Meanin g of Public Debt
Modern governments need to borrow from different sources when current revenue
falls short of public expenditures. Thus, public debt refers to loans incurred by the
government to finance its activities when other sources of public income fail to
meet the requirements. In this wider sense, the proceeds of such public borrowing
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However, since debt has to be repaid along with interest from whom it is borrowed,
it does not constitute income. Rather, it constitu tes public expenditure. Public debt
is incurred when the government floats loans and borrows either internally or
externally from banks, individuals or countries or international loan -giving
institutions.
What is true about public borrowing is that, like t axes, public borrowing is not a
compulsory source of public income. The word ‘compulsion’ is not applied to
public borrowing except in certain exceptional cases of borrowing.
The State generally borrows from the people to meet three kinds of
expenditure:
(a) to meet budget deficit,
(b) to meet the expenses of war and other extraordinary situations and
(c) to finance development activity.
(a) Public Debt to Meet Budget Deficit:
It is not always proper to effect a change in the tax system whenever the
public expenditure exceeds the public revenue. It is to be seen whether the
transaction is casual or regular. If the budget deficit is casual, then it is proper
to raise loans to meet the deficit. But if the deficit happens to be a regular
feature every year, then the proper course for the State would be to raise
further revenue by taxation or reduce its expenditure.
(b) Public Debt to Meet Emergencies like War:
In many countries, the existing public debt is, to a great extent, on account of
war expenses. Especially after World War II, this type of public debt had
considerably increased. A large portion of public debt in India has been
incurred to defray the expenses of the last war.
(c) Public Debt for Development Purposes:
During British r ule in India public debt had to be raised to construct railways,
irrigation projects and other works. In the post -independence era, the
government borrows from the public to meet the costs of development work
under the Five Year Plans and other projects. A s a result the volume of public
debt is increasing day by day.
6.3 Classification of Public Debt
The structure of public debt is not uniform in any country on account of factors
such as categories of markets in which loans are floated, the conditions for
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In view of these differences in criteria, public debt is classified into various
categories:
i. Internal and external debt
ii. Short term and long term loans
iii. Funded and unfunded debt
iv. Voluntary and compulsory loans
v. Redeemable and irredeemable debt
vi. Productive or reproductive and unpro ductive debt/deadweight debt
i. Internal and External Debt:
Sums owed to the citiz ens and institutions are called internal debt and sums
owed to foreigners comprise the external debt. Internal debt refers to the
government loans floated in the capital markets within the country. Such debt
is subscribed by individuals and institutions of the country.
On the other hand, if a public loan is floated in the foreign capital markets,
i.e., outside the country, by the government from foreign nationals, foreign
governments, international financial institutions, it is called external debt.
ii. Short term and Long Term Loans:
Loans are classified according to the duration of loans taken. Most government debt is held in short term interest -bearing securities, such as
Treasury Bills or Ways and Means Advances (WMA). Maturity period of
Treasury bill is usually 90 days.
Government borrows money for such period from the central bank of the
country to cover temporary deficits in the budget. Only for long term loans,
government comes to the public. For development purposes, long period
loans are raised by the government usually for a period exceeding five years
or more.
iii. Funded and Unfunded or Floating Debt:
Funded debt is the loan repayable after a long period of time, usually more
than a year. Thus, funded debt is long term debt. Further, since f or the
repayment of such debt government maintains a separate fund, the debt is
called funded debt. Floating or unfunded loans are those which are repayable
within a short period, usually less than a year.
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revenue, it is referred to as a floating debt. Thus, unfunded debt is a short
term debt.
iv. Voluntary and Compulsory Loans:
A democratic government raises loans for the nationals on a voluntary basis.
Thus, loans given to the government by the people on their own will and
ability are called voluntary loans. Normally, public debt, by nature, is
voluntary. But during emergencies (e.g., war, natural calamities, etc.,)
government may force the nationals to lend it. Such loans are called forced
or compulsory loans.
v. Redeemable and Irredeemable Debt:
Redeemable public debt refers to that debt whic h the government promises
to pay off at some future date. After the maturity period, the government pays
the amount to the lenders. Thus, redeemable loans are called terminable
loans.
In the case of irredeemable debt, government does not make any promise
about the payment of the principal amount, although interest is paid regularly
to the lenders. For the most obvious reasons, redeemable public debt is
preferred. If irredeemable loans are taken by the government, the society will
have to face the consequen ce of burden of perpetual debt.
vi. Productive (or Reproductive) and Unproductive (or Deadweight) Debt:
On the criteria of purposes of loans, public debt may be classified as
productive or reproductive and unproductive or deadweight debt. Public debt
is productive when it is used in income -earning enterprises. Or productive
debt refers to that loan which is raised by the government for increasing the
productive power of the economy.
A productive debt creates sufficient assets by which it is eventually re paid. If
loans taken by the government are spent on the building of railways,
development of mines and industries, irrigation works, education, etc.,
income of the government will increase ultimately.
Productive loans thus add to the total productive capac ity of the country.
In the words of Findlay Shirras: “Productive or reproductive loans which are
fully covered by assets of equal or greater value, the source of the interest is
the income from the ownership of these as railways and irrigation works.”
Public debt is unproductive when it is spent on purposes, which do not yield any
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for financing war may be regarded as unproductive loans. Instead of creating any
productive assets in the economy, unproductive loans do not add to the productive
capacity of the economy. That is why unproductive debts are called dead weight
debts.
6.4 The Burden of Public Debt
When a country borrows money from other countries (or foreigners) an external
debt is created. It owes its all to others. When a country borrows money from others
it has to pay interest on such debt along with the principal. This payment is to be
made in foreign exchange (or in gold). If the debtor nation doe s not have sufficient
stock of foreign exchange (accumulated in the past) it will be forced to export its
goods to the creditor nation. To be able to export goods a debtor nation has to
generate sufficient exportable surplus by curtailing its domestic cons umption.
Thus an external debt reduces society’s consumption possibilities since it involves
a net subtraction from the resources available to people in the debtor nation to meet
their current consumption needs. In the 1990s, many developing countries such as
Poland, Brazil, and Mexico faced severe economic hardships after incurring large
external debt. They were forced to curtail domestic consumption to be able to
generate export surplus (i.e., export more than they imported) in order to service
their exte rnal debts, i.e., to pay the interest and principal on their past borrowings.
The burden of external debt is measured by the debt -service ratio which returns to
a country’s repayment obli gations of principal and interest for a particular year on
its exter nal debt as a percentage of its exports of goods and services (i.e., its current
receipt) in that year. In India it was 24% in 1999. An external debt imposes a burden
on society because it represents a reduction in the consumption possibilities of a
nation . It causes an inward shift of the society’s pro duction possibilities curve.
THREE PROBLEMS
When we shift attention from external to internal debt we observe that the story is
different.
It creates three problems:
(1) Distorting effects on incentives due to extra tax burden,
(2) Diversion of society’s limited capital from the productive private sector to
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Public debt is one of the sources of deficit financing. When the govern ment
expenditure exceeds its revenue it borrows either from people within the country
or from external sources. Since it is a income with liability government has to repay
in future course of time. Repayment of both internal and external debts impose
burde n on the community.
6.4.1 Burden of Internal Debt:
Internal public debts are raised and repaid within the country. Therefore, they have
no direct money burden. The repayment of such debts results in transfer of
purchasing power from one group of people to anot her. The government taxes some
people to repay the interest and the principal to the creditors. Such debts give rise
to real burden.
1. Direct Real Burden: Transfer of purchasing power will take place as the
government imposes tax to repay the internal debts. When purchasing power
is transferred from the tax payers to the public creditors, it will influence the
distribution of income in the country. While, re paying debt, if tax burden falls
more heavily on the poor then inequality of income distribution will increase.
If the debt is repaid by imposing heavy taxes on the higher income groups,
then the direct real burden will be less. In most cases, repayment of internal
debt is more likely to transfer purchasing power from the poor to the rich.
This is the direct real burden of such debts.
2. Indirect Real Burden: High rates of taxation generally have a negative
effect on people’s ability and willingness to wo rk, save and invest. This in
turn will affect productivity, production and investment in the economy.
3. Burden on Future Generations :It is usually the older generation who
subscribe to government bonds and securities with their accumulated wealth.
But the debts are repaid through taxes which are paid by the younger working
population. Thus there is also transfer of purchasing power from the active to
the passive population.
4. Effect on Private Investments: In order to borrow on a large scale, the
government offers high rates of interest. Most people believe that government
securities and small savings are a safe place to park their money in. Therefore,
a large chunk of domestic savings are directed towards p ublic debt. This
reduces funds available for the private sector and adversely affects the growth
of this sector.
5. Effects on Capital Expenditure: In most developing countries, including
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is considered unproductive. As government’s debts become larger, the
interest burden also increases. A very large portion of government revenue is
then spent on paying interests. Thus the government is unable to make
adequate capital expendit ure on development of infrastructure.
6. Inflation: If indirect taxes are raised in order to repay internal debts, then
inflation may take place. Inflation will reduce the real income or purchasing
power of the poor. Therefore, though internal debts do n ot have direct money
burden, they result in making some people better off than others through
transfer of resources between them.
6.4.2 Burden of External Debt:
During a given period, the direct money burden of external debt is the interest
payment as well as the principal repayment (i.e., debt servicing) to external
creditors. The direct real burden of such external borrowing is measured by the
sacrifice of goods and services which these payments involve to the members of
the debtor country. External debt are raised from foreign countries. When such
debts are raised they result in inflow of capital into the borrowing country. But
when these debts need to be repaid it results in outflow of money in the form of
interest and principal.
External debts create the following money and real burden:
1. Direct Money Burden: It is equal to the sum of money payments for
principal and interest made to the creditor country.
2. Direct Real Burden: It is measured in terms of loss of welfare suffered by
the people of the debtor country due to the repayment of debt. It will vary
according to the proportion in which various members of the community
contribute to the repayment in the form of higher taxes.
3. Indirect Money Burden and Indirect Real Burden: This may be measured
in terms of effects on production and allocation of resources. To repay public
debt, the government may increase taxes to reduce public expenditure. These
will cause reduction in production and consumption in the economy. This is
termed as indirect money and real burden of external debt.
4. Burden of Unproductive Foreign Debt: If foreign debts are taken for
unproductive purposes then the burden of repayment will be very high on the
community.
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5. Foreign Currency Burden: Repayment of external debts has to be made in
foreign currency. Foreign exchange reserves can be increased by increasing
exports and controlling imports. Therefore the government may give a lot of
incentives to the export sector. This will divert resources from other s ectors
and result in unbalanced development. Besides, if import of essential items
is controlled to increase foreign exchange reserves, it may have an adverse
effect on development of the nation.
6. Domination by Creditor Country: Heavy dependence on one or more powerful creditor country may result in the debtor country being economically and politically dominated by the creditor countries.
6.5 The Meaning And Frame Work Of Public Debt Management
Public debt management is the process of establishing and e xecuting a strategy for
managing the government’s debt in order to raise the required amount of funding,
achieve its risk and cost objectives, and to meet any other debt management goals
of the government, such as developing and maintaining an efficient ma rket for
government securities. The governments should try to ensure that the level and rate
of growth of their public debt is sustainable, and can be serviced under a wide range of circumstances while meeting cost and risk objectives. Debt mangers of gove rnment debt should ensure that there is a strategy to reduce excessive levels of
debt.
6.5.1 Importance of Public Debt Management:
1. A good public debt management can help reduce borrowing cost in many
ways.
2. A carefully balanced composition of se curities can contain financial risk,
which are difficult to manage in countries having few alternative source of
finance.
3. Good public debt management can also help to develop the domestic
financial market. A well-developed domestic financial market can facilitate
economic development, and make the economy more resilient to external
shocks, such as capital outflows.
4. The economies with well-regulated and sound bond markets are less affected
by shocks / crises or recovered faster.

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6.5.2 Framework for Public Debt Management:
The IMF and World Bank have prepared the following framework for public
debt management.
1. Debt Management Objectives and Co -ordination:
The main objective of debt management is to ensure financing needs and
payment obligations are met at the lowest possible cost. To achieve the
objectives, debt managers, fiscal policy advisors, and central bankers should
share an understanding of the objectives of debt management, fiscal, and
monetary policies. Since their different policy instruments are inter -
dependent, there should be better co -ordination between the above agencies.
2. Transparency and Accountability: The allocation of responsi bilities
among the Ministry of Finance, Central bank and debt agency should be
disclosed. It is also important to provide information about the past, current
and projected fiscal activity and consolidated financial position of the
government.
3. Institutiona l Framework: There should be legal frameworks which clarify the authority to borrow, and issued new debt, invest, and undertake transactions on behalf of the government. Organizational framework should
be specified and the roles are to be specified.
4. Debt Strategy and Risk Management: An effective debt strategy should be
implemented. Risks in the portfolio should be mitigated by modifying the
debt structure.
5. Efficient Market for Government Securities: An important instrument of
public debt management is to ensure that the policies and operations are
consistent with an efficient market for government securities. It is necessary
to achieve a board investor base, with due regard to cost and risk, and need
to treat investors equitably. The debt managers, centra l banks, ministry of
finance should work closely with market participants and regulators for the
development of efficient market.
Broad Principles of Debt Management:
Important principles of debt management are:
(i) Low interest cost of servicing debt: Interest cost of servicing a debt should
be kept as minimum as possible.
(ii) Satisfy the needs of investors: The public debt should be structured in such
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(iii) Co-ordinat ion between public debt, fiscal and monetary policies: Since
the public debt, fiscal and monetary policies have common objective of
stabilization of the level of economic activity, they should work in unison.
(iv) Funding of short -term debt into long -term debt: If possible, the government should try to convert short -term debt into long -term debt. The
funding operations should be undertaken in such a manner that they do not
lead to undue rise in the long -term interest rates.
6.6 Effects of Public Debt
A peculiar profile of public borrowing is its voluntary nature, as con trasted to the
compulsory features of taxation. When the govern ment offers its securities to the
public, persons are free to purchase them.If they subscribe government bonds, they
suffer no net dimi nution in their wealth, as occurs when they pay taxes. In exchange
for liquid cash, they receive bonds or other securities which bear interest and which
will ultimately be paid off.
The government in turn receives money for meeting its expendi ture, but incurs a
liability for the payment of interest and the repayment of principal in the future.
The economic effects of a government programme financed by borrowing are
different from the effect of a similar programme financed by taxation. This is p artly
because the lending of money to the gov ernment is purely voluntary and partly
because the making of such loans does not reduce the personal wealth of the lenders
but merely changes its form.
A major consequence of these types of fund mobi lization i s that borrowing, on the
whole, is likely to have a less contractionary effect upon aggregate demand, than
raising an equiva lent amount by way of taxation.
Hence , a programme of expenditure financed by borrowing is likely to have a
greater net expansionar y effect upon the economy than a programme of the same
magnitude financed by taxation.
1. Effect of Borrowing upon Consumption:
In the case of borrowing, curtailment of consumption spending is likely to be
slight, except in wartime borrowing programmes in which substantial pressure is applied to individuals to reduce consumption and buy bonds.
Hence compared with taxation, public debt do not have any serious effect on the level of current consumption. In the case of individuals, their munotes.in

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consump tion pattern is set by their current income. Loans are advanced out
of saving, whereas taxes are paid out of income.
Under certain conditions, there is greater possibility of an increase in the
spending on consumption, due to government borrowing. The bon d holders
regard their bonds as wealth and a source of income.
Moreover, by holding government bond, their li quidity position is not very
much effected because bonds can be converted into cash at any time. Hence
there will be a tendency to increase spend ing on consumption.
2. Effect of Borrowing on Saving and Investment :
The floating of public debt influences saving and investment through the
interest rate mechanism. Floating of public debt will raise the rate of interest.
Since savings are interest ela stic, creation of public debt will raise savings.
Investment expenditure of the bond holders are influenced through the claim
effect on investment. That is through increase or decrease in interest rate.
When bonds are issued, the ratio of money supply to debt supply will be
reduced and as a result rate of interest will increase.
As a result the effect of public debt will be, reduced investment expenditure.
On the other hand when bonds are purchased by the government from the
open market, or when governmen t repay public debt, the ratio of money
supply to debt supply increases and the rate of interest declines.
This will lead to an increase in investment. The overall effect on the economy
depends largely on the way in which the investment is made in the pu blic
sector, compared with what could have been achieved in the private sector.
The effect of public debt on investment also depends on the method of raising
loans. Suppose if the government borrows from commercial banks and
central bank of a country, it will increase the money supply or purchasing
power and hence the funds available for investment will not be reduced.
However, if the government bonds are subscribed by the public and financial
institutions, out of funds meant for investment, then automati cally investment
expenditure will be curtailed.
3. Effect of Borrowing on Production:
In general, government borrowing results in enhancing the productive capacity of the economy. If the borrowed money is used by the government
to finance developmental p rojects, it will generate in come and employment
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Such investments strengthen the capital base of the economy and help to
increase the production of goods and services. Moreover, the government
will be able to re pay the debt and interest ch arges in future without much
difficulty.
Whereas, if the public purchases government bonds, by selling their shares
or debentures, invested in private industrial concerns, it will create an adverse
effect on private investment. However, when the borrowed money, as stated
above is used for highly productive activities, overall production is not
affected badly. Likewise, if the public subscribe government bonds by
withdrawing their bank de posits, it will adversely affect the lending capacity
of commercial b anks and thereby private investment activities.
However, if public debt is purchased by the individuals, utilizing their idle
funds, it will not adversely affect private investment. Whereas borrowing
resorted to meeting current expenditure or for financing a war, would result
in the diversion of resources from productive activities to wasteful ex -
penditure flows.
4. Effect of Public Debt on Distribution:
Borrowing leads to transfer of resources from one section of the community
to another section . If this transfer takes place from the rich to the poor, the
inequality in the distribution of income and wealth would be reduced and as
a result the economic welfare of the com munity will be enhanced.
On the other hand if the transfer of wealth takes p lace from the poor to the
rich, the disparity in the income distribution will be aggravated.
Usually, government bonds are subscribed by the richer income group.
Whereas, the burden of taxation imposed for financing debt service and
repayment of public debt, falls on the poor section. There fore generally
public debt has a tendency to increase economic in equality. Whereas suppose
the public debt is mobilized through the small savings of lower income group.
Correspondingly debts are serviced and r epaid through taxation imposed on
the richer income group. Then public debt will not result in increased income
inequality. Hence, loan finance can be used as a means to redistribute income
between different segments of the society.
5. Other Effects of Public Debt:
(a) Public debts in the form of government bonds are negotiable credit instruments. They are highly liquid form of assets. The investors can freely
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Moreover, as far as financial insti tutions are concerned, it adds to the liquidity
position of these institutions, because of its transparency in convertibility.
(b) During times of inflation, when the government borrows from the people, the
purchasing power in the hands of the public will be reduced. As a result
inflationary pressure in the economy will be reduced.
On the contrary, during depression, when the borrowed funds are utilized for
development projects, it will generate additional purchasing power, employment and income. Hence, dur ing depression, public debt can be
utilized as an effective instru ment to curb deflationary fluctuations in
economic activity.
Hence, in modern times, public debt is used as an important instrument to
bring about economic stability in the economy. In fact, one of the major
objectives of government borrowing today is to strengthen the economy by
freeing it from the evils of depres sions and also to build up the economy and
stable economic growth. Owing to this reason, rapid increase in public debt
need not be viewed with concern.
6.7 Methods of Redemption / Repayment of Public Debt
Redemption of debt refers to the repayment of a public loan. Although public debt
should be paid, debt redemption is desirable too. In order to save the gover nment
from bank ruptcy and to raise the confidence of lenders, the government has to
redeem its debts from time to time.
Sometimes, the government may resort to an extreme step, such as repudiation of
debt. This extreme step is, of course, violation of the contract. Use of repudiation
of debt by the government is economically unsound.
Here, instead of concentrating on the repudiation of debt, we discuss below
other important methods for the retirement or redemption of public debt:
i. Refunding:
Refunding of debt implies issue of new bonds and securities for raising new
loans in order to pay off the matured loans (i.e., old debts).
When the government uses this method of refunding, there is no liquidation
of the money burden of public debt. Instead, the debt servicing (i.e.,
repayment of the interest along with the principal) burden gets accumulated
on account of postponement of the debt - repayment to save future debt.
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By debt conversion, we mean reduction of interest burden by converting old
but high interest -bearing loans into new but low interest -bearing loans. This
method tends to reduce the burden of interest on the taxpayers. As the
government is enabled to reduce the burden of debt which falls, it is not
required to raise huge revenue through taxes to service the debt.
Instead, the government can cut down the tax liability and provide relief to
the taxpayers in the event of a reduction in the rate of interest payable on
public debt. It is assumed that since most taxpayers are poor people while
lenders are rich people, such conversion of public debt results in a less
unequal distribution of income.
iii. Sinking Fund:
One of the best methods of redemption of public debt is sinking fu nd. It is
the fund into which certain portion of revenue is put every year in such a way
that it would be sufficient to pay off the debt from the fund at the time of
maturity. In general, there are, in fact, two ways of crediting a portion of
revenue to th is fund.
The usual procedure is to deposit a certain (fixed) percentage of its annual
income to the fund. Another procedure is to raise a new loan and credit the
proceeds to the sinking fund. However, there are some reservations against
the second method.
Dalton has opined that it is in the Tightness of things to accumulate sinking
fund out of the current revenue of the government, not out of new loans.
Although convenient, it is one of the slowest methods of redemption of debt.
That is why economists oft en recommend capital levy as a form of debt
repudiation .
iv. Capital Levy:
In times of war or emergencies, most governments follow the practice of
raising money necessary for the redemption of the public debt by imposing a
special tax on capital.
A capi tal levy is just like a wealth tax in as much as it is imposed on capital
assets. This method has certain decisive advantages. Firstly, it enables a
government to repay its (emergency) debt by collecting additional tax
revenues from the rich people (i.e., people who have huge properties).
This then reduces consumption spending of these people and the severity of
inflation is weakened. Secondly, progressive levy on capital helps to reduce
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too. Firstly, it hampers capital formation. Secondly, during normal time this
method is not suggested.
v. Terminal Annuity:
It is something similar to sinking fund. Under this method, the government
pays off its debt on the basis of terminal ann uity. By using this method, the
government pays off the debt in equal annual instalments.
This method enables government to reduce the burden of debt annually and
at the time of maturity it is fully paid off. It is the method of redeeming debts
in instalm ents since the government is not required to make one huge lump
sum payment.
vi. Budget Surplus:
By making a surplus budget, the government can pay off its debt to the
people. As a general rule, the government makes use of the budgetary surplus
to buy ba ck from the market its own bonds and securities. This method is of
little use since modern governments resort to deficit budget. A surplus budget
is usually not made.
vii. Additional Taxation:
Sometimes, the government imposes additional taxes on people to pay
interest on public debt. By levying new taxes —both direct and indirect — the
government can collect the necessary revenue so as to be able to pay off its
old debt. Although an easier means of repudiation, this method has certain
advantages since taxe s have large distortionary effects.
viii. Compulsory Reduction in the Rate of Interest:
The government may pass an ordinance to reduce the rate of interest payable
on its debt. This happens when the government suffers from financial crisis
and when there is a huge deficit in its budget.
There are so many instances of such statutory reductions in the rate of
interest. However, such practice is not followed under normal situations.
Instead, the government is forced to adopt this method of debt repayment
when situation so demands.
6.8 Concepts of Deficit
Budget is a financial statement of the government dealing with the public revenue
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a significant role in process of economic development. When the total revenue is
more than th e total expenditure it is called surplus budget. When total revenue is
equal to the total expenditure it is called balanced budget. If the total expenditure
exceeds the total revenue it is called a deficit budget. In most of the developing
countries and un der developed countries there is always deficit budget and it has
become a permanent feature.
Budgetary deficit is a multi -dimensional concept. It is quite easy to say that a
budgetary deficit is simply the excess of public expenditure over public revenue .
However, in practice, the concept admits of many variations, and yields widely
divergent measures of budgetary deficit.
The existence of such a large number of measures is explained by the fact that each
measure has analytical and policy relevance, and t here is no single measure which
may be universally preferred over all others for all time to come.
The choice of the correct measure would depend upon the purpose of analysis. A
brief description of the various concepts of budgetary deficit is as follows.
1. Revenue Deficit:
The excess of expenditure on revenue account over receipts on revenue
account measures revenue deficit. Receipts on revenue account include both
tax and non -tax revenue and also grants. Tax revenue is net of States’ share
as al so net of assignment of Union Terri Tory taxes to local bodies. The non -
tax re venue includes interest receipts, dividends and profits, and non -tax
receipts of Union Territory’s Grants include grants from abroad also.
Expenditure on revenue account includes bot h Plan and Non -Plan
components. Thus, the Plan component includes Central Plan and Central
Assistance for States and Union Territory Plans.
Non- Plan expenditure includes interest payments, defence expenditure on
revenue account, subsidies, debt -relief to farmers, postal services, police,
pensions, other general services, social services, economic services, non -plan
revenue grants to States and Union Territories, expenditure of Union
Territories with legislature, and grants to foreign governments.
Revenue deficit means dissaving’s on government account and the use of the
savings of other sectors of the economy to finance a part of the consumption
expenditure of the government.
An important objective of fiscal policy should be to ensure surplus in the
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2. Budgetary deficit: Budgetary deficit denotes the difference between all
receipts and expenditure of the government, both revenue and capital. It
implies that government incurs more expenditure that its normal receipt from
revenue and capital goods. Budget deficit is financed either by drawing down
cash balances with the central bank or by borrowing from central bank
against treasury bills. This is called deficit financing. As deficit financing
results in creation of new money, it may lead to inflation.
3. Capital Deficit:
The excess of capital disbursements over capital receipts measures the capital
deficit.
Capital Deficit = Expenditure on Capital Acc ount – Capital Receipts
Plan capital disbursements include those on Central Plan and Assistance for
States and Union Territories. Non -Plan Capital disbursements include defence expenditure on Capital account, other non -plan capital outlay, loans
to public enterprises, States and Union Territory Governments, foreign
governments and others; and non -plan capital expenditure of Union Territories without legislature. The items of capital receipts include recoveries of loans extended by the centre itself, but on ly net receipts of loans
raised by it.
It may be noted that receipts on account of sale of 91 days treasury bills and
drawing down of cash balances do not form a part of capital receipts.
However, net receipts on account of sale of 182 days and 364 days t reasury
bills and sales proceeds of government assets are included in capital receipts.
4. Fiscal Deficit:
Fiscal deficit is the difference between revenue receipts plus certain non -debt
capital receipts and the total expenditure including loans net of repayments.
Fiscal Deficit = Total Expenditure – (Revenue Receipts + Non -debt
Capital Receipts)
In short, fiscal deficit indicates the total borrowing requirements of the
government from all sources. This may also be called Gross Fiscal Deficit
(GFD). It measures that portion of government expenditure, which is
financed by borrowing and drawing down of cash balances.
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It should be noted that in India, borrowings are net amounts (that is, gross
borrowings less repayments). Similarly, loans extended by Gove rnment of India are included on the expenditure side of capital account while ‘recoveries’ are included on the receipts side. Therefore, the amount of loans
and advances by Government of India is also reduced.
It is often stated that fiscal deficit measur es an addition to the liabilities of
Government of India. In 2008 -09, fiscal deficit was at a figure of Rs. 3,
26,515 crore (RE) which is 6.1 per cent of Gross Domestic Product.
Fiscal deficit was of the order of 4 per cent of gross domestic product (GDP )
at the beginning of 1980s, and was estimated at more than 8 per cent in 1990 -
91. The growing fiscal deficit had to be met by borrowing which led to a
mammoth internal debt of the government.
The servicing of this debt has become a serious problem. Publi c debt in India
is mostly subscribed to by commercial banks and financial institutions. A
judicious macro -management of the economy requires a progressive reduction in the fiscal deficit and revenue deficit of the government.
5. Primary Deficit:
It is si mply fiscal deficit minus interest payments. In the 2008 -09 budget,
primary deficit was shown at a figure of Rs. 1, 33,821 crore (Revised
estimates). This measure is also referred to as Gross Primary Deficit (GPD).
Measures of deficit described above (exce pt capital deficit) include payments
and receipts of interest. These transactions, however, reflect a consequence
of past actions of the government, namely, loans taken and given in years
prior to the one under consideration.
Exclusion of interest transac tions would, therefore, enable us to see the way
the government is currently conducting its financial affairs. Accordingly,
Primary deficit is defined as Fiscal Deficit less net interest payments, (that is
less interest payments plus interest receipts).
Net primary deficit is obtained by subtracting ‘Loans and Advances’ from
net fiscal deficit. It is also equal to Fiscal Deficit less interest payments plus
interest receipts less loans and advances.
The primary deficit which was 4.3 per cent of GDP during 1990 -91 came
down to 1.5 per cent of GDP during 1997 -98 and in the revised estimates for
the year 2008 -09 it was 2.5 per cent of GDP.
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Besides ways and means advances, the Reserve Bank of India also supports
the government’s borrowin g programme. Monetised deficit indicates the
level of support extended by the Reserve Bank of India to the government’s
borrowing programme.
Monetised deficit is defined as net increase in net Reserve Bank of India
credit to central government. The ration ale for this measure of deficit flows from the inflationary impact which a budgetary deficit exerts on the economy.
Since borrowings from Reserve Bank of India directly add to money supply,
this measure is termed monetised deficit. It is obvious that mone tised deficit
is only a part of fiscal deficit.
6.9 Conclusion
Public debt is the total amount, including total liabilities, borrowed by the
government to meet its development budget. It has to be paid from the Consolidated
Fund of India. The term is also used to refer to overall liabilities of central and state
governments, but the Union government clearly distinguishes its debt liabilities
from the states’. The central government broadly classifies its liabilities into two
categories — debt contracted against the Consolidated Fund of India, and public
account.
Over the years, the Union government has followed a considered strategy to reduce
its dependence on foreign loans in its overall loan mix. Internal debt constitutes
over 93 per cent of the overall public debt. Internal loans that make up for the bulk
of public debt are further divided into two broad categories – marketable and non -
marketable debt.
The sources of public debt are dated government securities (G -Secs), treasury bills,
extern al assistance, and short -term borrowings.
In the long run, public debt that's too large is like driving with the emergency brake
on. Investors drive up interest rates in return for the increased risk of default. That
makes the components of economic expansion, such as housing, business growth,
and auto loans, more expensive. To avoid this burden, governments need to
carefully find that sweet spot of public debt. It must be large enough to drive
economic growth but small enough to keep interes t rates low.
Fiscal improvement can be achieved only through effective performance and good
governance by the central, state and local governments. Indian public finance must
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manage ment in terms of long term perspective. Though the FRBM Act talks about
Medium Term Fiscal Policy statement, it is yet to be developed. A long term
approach is a must.
6.10 Questions
Q1. What is Public Debt? What are the different types of public debts?
Q2. What are the different types of burdens of public debt? Explain in detail.
Q3. What is the internal burden of public debt?
Q4. What is external burden of public debt?
Q5. Explain the framework for the management of public debt.
Q6. What is budget? What a re the different components of a Budget?
Q7. Explain the different concepts of Deficits.
6.11 References
1. J. Hindriks, G. Myles, (2006), Intermediate Public Economics, MIT Press.
2. Harvey Rosen, (2005), Public Finance, Seventh Edition, McGraw Hill
Publications.
3. KaushikBasu and Maertens (ed), (2013), The New Oxford Companion to
Economics in India, Oxford University Press.
4. Sury M.M., (1990), Government Budgeting in India, Commonwealth Publishers.
5. Bhatia H.L., (2012), Public Finance, Vikas Publications.
6. Report of the Fourteenth Finance Commission, Government of India.
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Module 4
7 INDIAN PUBLIC FINANCE – I
Unit Structure:
7.0 Objectives
7.1 Introduction
7.2 Budget of the Government of India
7.3 Sources of Public Revenue (Tax, Non -tax)
7.4 Introduction to GST
7.5 Components of Public Expenditure
7.6 Summary
7.7 Questions
7.0 Objectives
• To study the budget of Government of India.
• To understand the concept s of public expenditure and components of public
expenditure.
• To understand the concept of public receipts and the sources of public
receipts.
• To study about the introduction to Goods and Services Tax (GST).
7.1 Introduction
Public finance is branch of economics which deals with the government revenue
and expenditure that means public finance studies what are ways of government
revenue and government outlay or expenditure. In the other words public finance
is the study of role of government in the economy. Government intervene in
econ omy for adjustments according to need of the economy through public finance
or public policy.
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Definitions of public finance
According to Adam Smith, “The investment into the nature and principles of state
expenditure and state revenue is called public finance".
According to Dalton, “Public finance is one of those subjects which lie on the
borderline between economics and politics. It is concerned with the income and
expenditure to the public authorities and with the adjustment of one to the other”.
Accordingly, effects of taxation, Governme nt expenditure, public borrowing and
deficit financing on the economy constitutes the subject matter of public finance.
According to F. E. Taylor, “Public finance deals with the finance of the public as
organized group under the institution of the governm ent. It therefore, deals only
with the finance of the government. The finance of the government includes the
raising and disbursement of government funds. Public finance concerned with the
operation of the fiscal science, its policies are fiscal policies, its problems are fiscal
problems. Thus, “Public Finance is the part of political economy which discusses
the way in which government obtains revenue and manages them”.
According to Findlay Sirras and C. F. Bastable , “Public finance is the science
which is concerned with the matter in which public authorities
Obtain their income and spend it.”
Thus , Public finance is nothing but the study of government revenue or income and
expenditure. That means how government collect income from the various economic ac tivity via taxation and non - taxation policy and same as with how the
government expenditure occurs.
7.2 Budget of the Government of India
The financial operations of the government comprising public revenue, public
expenditure and public borrowing for a year are estimated. ‘The statement with
estimates of planned expenditure and the expected revenues from taxes and other
sources is called as budget.’ In other words, ‘an annual financial statement of
anticipated revenues and planned expendi ture of the government is called as
budget.’
Thus, budget deals with how the government raises its resources to meet its ever -
increasing expenditure. In this sense, a budget may be considered a description of
both the fiscal policies and the financial plan s of the government. Budget is an
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Types of Budget:
There are three types of budget.
1. Balanced budget:
‘When the expected total revenues of the government are equal to its total
expenditure during a given year is called as balanced budget.’ The classical
economists have advocated laisez faire policy, they believed that the
government should follow sound finance and balanced budget.
2. Surplus budget:
‘When the expected total revenue exceeds the total expenditure of the
government during a given year is called as surplus budget.’
3. Deficit budget:
‘When the total planned expenditure exceeds expected total revenues of the
government during a given year is called as deficit budget.’ With the
emergence of Welfare State and massive increase in public expenditure,
balanced or surplus budget has become a rare phenomenon. However,
modern economists advocate deficit budget. Because they believe that the
government should spend more than its income to maximize welfare of the
people.
Components of Budget:
The budget of a government is generally divided into two accounts, namely (1) The
Revenue Account or Revenue Budget, and (2) The Capital Account or Capital
Budget.
1) The Revenue Account or Budget:
The Revenue Account shows both revenue receipts and revenue expenditure.
Revenue receipts are divided between tax revenue and non -tax revenue. The
two components of tax revenue are
1) Revenue from direct taxes, particularly tax on personal income and
corporate tax, and
2) Revenue from indirect taxes like the excise duties and customs duties
are most notable.
Non-tax revenue includes fees, fines and penalties, interest receipts and
surplus or profits from pub lic enterprises and gift and grants. Revenue
expenditure is usually divided into developmental and non -developmental
expenditure. Revenue expenditure of the government of India is defence
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2) Capital Account or Budget : -
The Capital Account shows capital receipts and capital expenditure. Capital
receipts include market borrowings, small savings, provident funds, special
deposits, recoveries of loans, external loans and recei pts from disinvestment.
Capital expenditure includes repayment of debts and expenditure incurred on
creation of capital assets. Capital expenditure is also two types, development
expenditure and non -development expenditure.
Key Point of Budget of India (2020 -21)
While presenting the union budget in the parliament on February 1st 2020, Finance
Minister Nirmala Sitharaman said, “In May 2019, Prime Minister Narendra Modi
received a massive mandate to form the government again. People of India have
unequivocally given their janaadesh for not just political stability, but have also
reposed their faith in our economic policy. This is a budget to boost their income
and enhance their purchasing power.”
The key highlights of the Full Union Budget 2020 -21 from Finance Minister
Nirmala Sitharaman’s speech are as follows -
DEFENCE
• The defence budget was increased to Rs. 3.37 lakh crore for 2020 -21 against
last year’s Rs. 3.18 lakh crore.
• Rs 1.13 lakh crore has been set aside out of the total allocation for cap ital
outlay to purchase new weapons, aircraft, warships and other military
hardware.
• The revenue expenditure has been pegged at Rs 2.09 lakh crore which
includes expenses on payment of salaries and maintenance of establishments.
INCOME TAX
• Upto Rs 5 lakh: No tax
• Rs 5-7.5 lakh income: reduced to 10 from 20%
• Rs 7.5 lakh to 10 lakh: reduced to 15 from 20%
• Rs 10 -12.5 lakh: reduced to 20% from 30%
• Rs 12.5 -15 lakh: reduced to 25% from 30%
• Rs 15 lakh: 30% (No change)
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• Around 70 of more than 100 income tax deductions and exemptions have
been removed, to simplify tax system and lower tax rates
• To boost start -ups, tax burden on employees due to tax on Employee Stock
Options to be deferred by five years or till they leave the company or when
they sell, whichever is earliest
• Option to be provided to cooperative societies to be taxed at 22% plus 10%
surcharge and 4% cess, with no exemptions or deduction s. To also be
exempted from Minimum Alternative Tax.
• Under Vivad Se Vishwas Scheme, taxpayer to pay only amount of disputed
tax, will get complete waiver on interest and penalty, if scheme is availed by
March 31, 2020.
• Aadhaar based verification of taxpayers is being introduced. A system to be
launched soon, for instant online allotment of PAN on the basis of Aadhaar,
without the need for filling any application form .
• Total allocation for Swachh Bharat is around Rs. 12,300 crore for this year.
• Central government’s debt has come down to 48.7% in March, 2019 from
52.2% in March, 2014.
GDP
• GDP growth for the year 2020 -21 is estimated at nominal 10%
• Receipts for 2020 -21 is estimated at 22.46 lakh crore rupees
• Expenditure at is 30.42 lakh crore rupees
• Revised expenditure estimate is at Rs. 26.99 Lakh Cr for FY 21
• Estimate Fiscal deficit is at 3.8% vs target of 3.3% of GDP
• Corporate tax is at 15% lowest in the world
• Turnover threshold for audit is raised to Rs. 5 Crore from Rs. 1 Crore
SPORTS BUDGET
• The government allocated Rs. 2826.92 cro re to the sports budget for the next
financial year.
• The government gave a substantial hike of Rs 291.42 crore to its flagship
Khelo India programme for development of sports at the grassroot and youth
level.
• The highest reduction was for National Sports F ederations with Rs. 245.00
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• Incentives for sportsperson has been proposed to be slashed from Rs. 111
crore to Rs. 70 crore. The budget for National Sports Development Fund will
also be reduced to Rs. 50.00 from the earlier Rs. 77.15 crore.
• The government also reduced the allocation to Sports Authority of India from
the revised Rs. 615 crore to Rs. 500 crore.
• National Welfare Fund for Sports persons will continue to get the same
amount of Rs. 2 crore as earlier, while, at Rs. 50 crore, there was also no
change in the allocation for the enhancement of sports facilities in Jammu
and Kashmir.
• Laxmi Bai National Institute of Physical Education will, however, gets Rs.
55 crore, Rs. 5 crore more than the last b udget.
AGRICULTURE
• Finance Minister listed 16 -point action plan for farmers, towards the goal of
doubling farmers income by 2022
• Agricultural credit target has been set at Rs. 15 lakh crore. NABARD
Refinancing Scheme to be further expanded.
• Will encourage state governments who implement following model laws:
Model Agricultural Land Leasing Act of 2016; Model Agricultural Produce
and Livestock Marketing Act of 2017; Model Agricultural Produce and
Livestock Contract Farming and Services Promotion and Facilita tion Act of
2018
• Pradhan Mantri Kisan Urja Suraksha evem Utthan Mahabhiyan (PM KUSUM) to be expanded to provide 20 lakh farmers in setting up standalone
solar pumps
• 2.83 lakh crore rupees allocated for agriculture and allied activities, irrigation
and rura l development
• Encourage balanced use of all fertilizers, a necessary step to change the
incentive regime which encourages excessive use of chemical fertilizers
• Village Storage Scheme run by SHGs, will provide holding capacity for
farmers, women in villages can regain their status as Dhaanya Lakshmi
• Krishi UDAN will be launched by the Ministry of Civil Aviation on
international and national routes, improving value realization in North East
and tribal districts
• Milk processing capacity to be doubled by 2025
• Indian Railways will set up Kisan Rail through PPP arrangement, for
transportation of perishable goods
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EDUCATION
• A medical college to be attached to a district hospital in PPP mode, viability
gap funding to be set up for setting up such medical colleges.
• Rs. 3,000 crore for skill development.
• IND-SAT exam to be held in African and Asian countries, for bench -marking
foreign candidates who wish to study in India.
• Degree -level full -fledg ed online education program to be offered by institutes
in top 100 in National Institutional Ranking Framework.
• Government announces Rs 99,300 crore outlay for education sector in 2020 -
21.
• New Education Policy to be announced soon.
• Urban local bodies across the country to provide internships for young
engineers for a period of up to one year.
• 8,000 crore rupees over five years to be provided for quantum technologies
and applications.
G-20 PRESIDENCY
• Finance minister Nirmala Sitharaman on Saturday said India will host the G -
20 Presidency in 2022 and Rs. 100 crore has been allocated for this purpose.
• During this meeting, India would be able to drive the global economic and
development agenda, the finance minister said while presenting the Budget
for 2020 -21 in Parliament.
• India would be able to drive considerably the global economic and development agenda during this presidency, she said.
• The G20 (or Group of Twenty) is an international forum for the governments
and central bank governors from 19 countries and the European Union.
HEALTH
• The Budget provides an additional Rs. 69,000 crore for the health sector and
proposes to expand Jan Aushadhi Kendras in all districts of the country to
provide medicines at affordable rates.
• Nominal health cess on import of medical equipment to be introduced, to
encourage domestic industry and generate resources for health services.

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FINANCE
• Deposit Insurance Coverage to be increased from 1 lakh rupees to 5 lakh
rupees.
• We wish to enshrine in the statute a taxpayers' charter. I would like to reassure
taxpayers that we remain committed to taking measures to eliminate tax
harassment.
• To achieve higher export credit, a new scheme being launched which
provides higher insurance cover, reduced premium for small ex porters and
simplified procedure for claim settlements.
• Rs. 27,300 crore rupees for development of industry and commerce.
• Investment Clearance Cell to set up through a portal, will provide end -to-end
facilitation, support and information on land banks.
• Ame ndments to be made to enable NBFCs to extend invoice financing to
MSMEs.
• Government proposes to sell a part of its holding in LIC by initial public
offer.
ENERGY
• Rs. 22,000 crore rupees to be provided to power and renewable energy sector
in 2020 -21.
INFRASTRUCTURE
• 100 more airports to be developed by 2024 to support the UDAN scheme.
• 1.7 lakh crore rupees to be provided for transport infrastructure in the coming
financial year.
• More Tejas -type trains to connect iconic destinations.
• Accelerated development of highways will be undertaken. Delhi -Mumbai
expressway and two other projects to be completed by 2023. Monetization of
12 lots of highway bundles of over 6,000km before 2024
• National Logistics Policy will soon be rele ased, creating single window e -
logistics market.
• Project Preparation Facility to be set up for preparation of infrastructure
projects, actively involving young engineers and management graduates.
• Fibre to Home connections under Bharat Net will be provided to 1 lakh gram
panchayats this year itself, 6,000 crore rupees provided for Bharat Net.
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WOMEN & NUTRITION
• Gross Enrolment Ratio is now higher for girls than for boys at all levels under
'Beti Bachao Beti Padhao'.
• Rs. 28,600 crore rupees provided for programmes which are specific to
women.
• Rs. 35,600 crore rupees for nutrition -related programmes in 2020 -21.
• Over 6 lakh anganwadi workers have been equipped with smartphones to
upload the nut rition status of 10 crore households.
OTHER SECTORS
• 85,000 crore rupees for Scheduled Castes and Other Backward Classes in
2020 -21.
• 53,700 crore rupees for Scheduled Tribes.
• Enhanced allocation of 9,500 crore rupees for Senior citizens and Divyangs.
• Five a rchaeological sites to be developed as iconic sites.
• Rs. 2,500 crore rupees to be allocated for tourism promotion, in 2020 -21.
• Rs. 3,150 crore rupees to be provided for culture ministry in 2020 -21.
• Parameters and incentives to be provided to states who take measures for
cleaner air in cities above 1 million population - 4,400 crore rupees allocated
for this.
• India will host G20 Presidency in 2022, 100 crore rupees to be allocated for
making preparations for this historic occasion, where India will drive global
economic agenda .
7.3 Sources of Public Revenue
The income of the government from all possible sources is called as public revenue.
Different economists have offered different classification of public revenue. Among them the classification offered by Adam Smith, Seligmen and Bastable are
well known. Based on some classifications the various sources of public revenue
are divided into two groups - A) Tax Revenue and B) Non-tax Revenue.
A) Tax Revenue :
The revenue from taxes is ca lled tax revenue. Tax is the most important source of
revenue to the government. ‘A tax is a compulsory contribution made by the
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Tax is required to meet its general expenses incurred in the common interest of all.
These expenses are incurred with any corresponding benefits to the taxpayers.
There are two types of taxes - i) Direct taxes and ii) Indirect taxes. Personal income
tax, corporate tax, capital gain tax, wealth tax, gi ft tax etc. are called direct taxes.
Sales tax, excise duty, custom duty etc., are called indirect taxes. Taxation has been
considered to be an important source of raising revenue. However, at present, it is
also used as a means to achieve various objectiv es of society. The important
characteristics are -
1. Tax is a compulsory payment; every citizen is legally bound to pay.
2. If any person does not pay the tax, he can be punished by the government.
3. There is no direct quid - pro- quo between taxpayers and the government.
4. Tax is imposed on income, goods, and services.
Progressive taxes help to reduce the inequality of income and wealth. Taxation
affects production, consumption and distribution. It can be used as an effective
instrument to achieve price s tability.
B) Non -tax Revenue: The revenue obtained by the government from sources other
than tax is called as non - tax revenue. They may be classified as -
1. Administrative Revenue
2. Profit of Public Enterprises and
3. Gifts and Grants.
1. Administrative Revenue: - Government gets revenue from the public for
administrative work in the form of fees, fines and penalties, special assessment.
i) Fees : - Fee is the government for providing certain services to the
people for e.g. court fee, license fee etc, and charges Fees. Generally,
fees are charged to recover the cost of services. Those citizens who
make use of certain special services by the government pay fee. There
is always a definite relationship between the fee paid and the benefits
received by the cit izens. However, there is no relationship between tax
paid and benefits received by the taxpayers. Unlike tax, there is no
compulsion in case of fee. Fees are an important source of non -tax
revenue to the government.
ii) Fines and penalties : - Fines and penalties are levied on offenders of
laws as a punishment. The main objective of the government is not to
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insignifica nt source of revenue. Fines and penalties are arbitrarily
determined. They are not related to government activities. Like taxe s,
fines are compulsory payment without quid -pro-quo. They are no t
expected to be a major source of revenue to the government.
iii) Special assessment : - A special type of compulsory contribution mad e
by the citizens of a parti cular locality in exchange for certain special
facilities give n to them by the authorities is known as special assessment . For example, if the municipal corporation in a city builds
‘pucca ’ road or makes arrangement for the supp ly of electricity and
water in pa rticular locality, the value of property in that locality will
inevitably go up. Therefore, the municipal corporation can levy a
special tax on the residents in proportion to the increase in the va lue of
the property, to co ver a part of the cost of facilities. Th ere is quid -pro-
quo between the special taxpayer and the local public authority.
2) Profits of public enterprises : - Almost all countries have public enterprise
involved in commercial a ctivities. The profits of these enterprises are an
important s ource of non -tax revenue to the government. The revenue collected in the form of profits is largely influenced by the manner in whic h
the government determines the prices of goods and services i t sells. When
state has an absolute monopoly high prices are charged. There is quid -pro-
quo.
3) Gifts and grants : -Gifts are voluntary contributions made by individuals or
NGOs to the governme nt. This is done for a specific purpose such as relief
fund, wa r fund, draught fund, earthquake fund etc. The volume of gifts is
normally small.
Grant refers to the funds pro vided by the central government or a state
government for undert aking special activities. State governments also provide grants t o the local gov ernment to carry out their functions. Grant
from foreign count ries is known as foreign aid. Developing countries receive
military aid, food aid, economic and technical aid etc. from devel oped
countries. Such grants are normally conditio gnal. They constitut e
insignificant source of revenue to the government. In short, mai nly tax and
non-tax sources are ways and means of government revenue.


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7.4 Introduction to GST
Goods and Service Tax (GST) is a n indirect tax, which is levied only on the value
added at each s tage of supply chain comprising of manufacture, sale and consumption of taxable goods or services.
The GST provides for a compre hensive and continuous chain of tax credits
beginning from the manufacture or production of goods or provision of service up
to the reta iler or consumer to ensure that (a) There is no cascading effect by le vying
tax on tax at each stage; and (b) The tax is levied only on t he value added at each
stage of supply.
At eac h stage of supply, a supplier of goods or service or both can avail input credit
for the ta x paid on the purchase of goods or services or both and set off this credit
against the GST payable on the supply of goods and serv ices or both made by him
to the next stage. GST makes no differ ence between goods and services and both
are treated at par and taxed at a single rate.
It is only the final consume r, who bears the GST charged by the last supplier in the
supply chain, w ith set -off benefits at all the previou s stages.
India has a dual GST model, with identical tax rate applied by the Central
Government called Central GST (CGST) and State GST (SGST). For inter -state
transac tions, Integrated GST (IGST) is levied, which is equal to CGST= SGST.
NEED FOR GST
India had a multi -tier indirect tax regime comprising of -
• overlapping taxes
• levied by different authorities
• at different levels
• Denied credit or set off for the taxes paid at the previous stages.
Credit for the VAT paid on the inputs was denied to the manufacturer and the
service provider and credit for the excise duty or the service tax paid was denied to
the seller only because the excise duty and the service tax were the central taxes,
but the VAT was a state tax.
These taxes were not mutually exclus ive. For instance, intrastate sale of excise -
paid manufactured goods attracted VAT on the gross value of the goods, which
included the basic value, the excise duty charged by manufacturer and the profit by
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As a result, the indirect - tax structure w as a complex cobweb of rules and
regulations in different parts of the country having cascading tax effect. There was
no credit at all for local taxes like entry tax and octroi imposing hindrance in smooth
movements of goods across the country besides crea ting scope for arbitrage of rates
at different places, interstate smuggling and grey markets for goods and services.
India needed a uniform tax regime with lower rates and stringent implementation.
The flaws in the indirect tax structure created the need f or a broad - based uniform,
integrated central tax with lower tax rates, efficient implementation and free credit
across the board for various taxes paid and reduce the cascading effect of multiple
taxes, which subsumes all the taxes levied on the sale of g oods or provision of
services by both the centre and the states and provide a larger pull for set off of
taxes. These reasons may be summed up as under: -
a. Integration of different taxes such as excise, VAT, luxury tax, entertainment
tax, Octroi and CST so as to avoid multiple taxation of a transaction as both
goods and services.
b. Replacement of multiple tax levies by a uniform tax regime in respect of
goods and services both.
c. Abatement of the cascading tax burden of tax on tax at different levels.
d. Introduction of an indirect, comprehensive, broad based consumption tax for
any product or service throughout India
e. Provision for a continuous chain of credits from the original producer or
service provider to the retailer or end consumer for taxes paid at earlier stages
i.e. input credit to ensure the removal of cascading effect of multiple taxes.
f. Imposition of tax only on the value added at every stage in the supply chain
instead of tax on origin or manufacture of goods.
g. Setting up an eff icient tax regime free of corruption and bureaucratic red -tape
to enable simplified tax compliance.
h. Creation of a national market for goods and services.
i. Safeguarding the interests of the states by opting for a dual model GST with
inbuilt provisions for CGST, SGST, UGST and IGST.
Principles of subsuming taxes
Accordingly several taxes were subsumed or absorbed in the GST, based on the
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b. Such ta xes were part of the supply chain i.e. manufacturer, service provider
or retailer or consumer ;
c. The taxes resulted in free flow of tax credits in intra and inter - State levels;
and
d. The taxes which were not specifically unrelated to supply of goods or
services, e.g. stamp duty, municipal taxes etc. were not subsumed in GST.
e. The subsuming of the taxes maintained revenue neutrality and fairness
between the central and the states.
Taxes subsumed or absorbed in GST
Based on the above principles, foll owing taxes have been subsumed in GST:
A. Central Taxes
(a) Central Excise Duty (CENVAT)
(b) Additional Excise Duties
(c) Excise Duty under the Medicinal &Toiletries Preparations (Excise
Duties) Act 1955
(d) Service Tax
(e) Additional Customs Duty, commonly known as Countervailing Duty
(CVD)
(f) Special Additional Duty of Customs – 4% (SAD)
(g) Surcharges and Cesses levied by Centre wherever they are in the nature
of taxes on goods or services e.g. cess on rubber, tea, coffee, national
calami ty contingent duty etc.
(h) Central Sales Tax phased out
B. State / Local Taxes
(a) VAT / Sales tax
(b) Entertainment tax except levied by the local bodies
(c) Luxury tax
(d) Taxes on lottery, betting and gambling
(e) State cesses and surcharges rela ting to supply of goods and services
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C. Taxes not subsumed in GST
(a) Basic Customs Duty levied on Import of goods into India.
(b) Exports Duty imposed on export of goods are not available in India in
abundance,
(c) Road and Passenger tax ,
(d) Toll tax
(e) Property tax
(f) Stamp duty
(g) Electricity duty
D. Treatment of Specific goods
a) The Alcoholic Liquor for Human Consumption
Under Article 366, clause 12A, the supply of the alcoholic liquor for human
consumption is outside the ambit of GST. The States will continue to impose
tax on it. Moreover, CST on inter -state sales of alcohol products would also
continue.
b) Tobacco Products
Tobacco and tobacco products being “Sin’ goo ds will be subjected to GST
subject to a separate excise duty by the Centre.
c) Petroleum, Crude, High Speed Diesel (HSD), Motor Spirit, Natural Gas
and Aviation Turbine Fuel (ATF)
The states will continue to levy VAT on intra -state sales of petroleum
products. Inter -state sales would continue to attract Central Sales Tax (CST).
However, these products may be transitioned into the GST regime on a future
date to be notified by the GST Council. Moreover, these products are also
subject to levy of excise duty imposed by the Centre in addition to the VAT
or GST.
d) Newspapers and newspaper advertisements
While there is no GST on newspaper, GST, advertisements are subject to levy
of GST.
4. DUAL GST MODEL
GST is a uniform destination -based tax a pplicable on all transactions
involving supply of goods or services, or both, for a consideration subject to
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Kashmir. India has followed Canada and Brazil and adopted the dual GST
model , while most of the countries have a single GST model.
Under the dual GST model, both the Centre and the states/UT may
concurrently levy GST on intra -State taxable supply of goods or services or
both. Accordingly, the dual model of GST adopted in India comprises of the
following components in respect of intra -state supply of goods or services or
both : -
Type of GST Levied and collected by
a) The Central Goods and Service Tax (CGST) Centre under the CGST
Act, 2017 passed by the parliament,
b) (i) The State Goods and Service Tax (SGST)
The states under the respective SGST Acts passed by the
legislature of the concerned states and the union territories with
their own legislatures viz. Delhi and Puducherry,
(ii) The Union Territories State Goods and Service Tax (UTGST)
The Union territories without State legislatures viz. Andaman
and Nicobar Islands,
Lakshadweep, Dadra and Nagar Haveli, Daman and Diu and
Chandigarh under the provisions of UTGST Act, 2017 passed by
the parliament.
c. Integrate State Goods and Service Tax (IGST) Centre under the IGST
Act, 2017 passed by the parliament in respect of inter -state supplies.
By and large, CGST and SGST/UTGST rates are equal and IGST is
almost equal to the sum total of CGST and SGST/UTGST.
Hence, it can be said that GST in respect of intra -state supplies is equally
shared by the concerned state and the Centre.
For instance, If CGST rate in case of intra state supply of goods or service or
both, is 12%, then 6% will be the CGST and 6% will b e the SGST/UTGST.
IGST will be levied at 12% on inter -state supplies.
Further, the SGST acts of the states/UT, UTGST Act, 2017 and IGST Act,
state are by and large uniform in respect of the basic features of the tax,
chargeability, taxable event, taxable person, classification and valuation of
goods and services, procedure for collection and levy of tax etc. to keep the
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5. GOODS AND SERVICES TAX NETWORK (GSTN)
GST regime is technology based. It seeks to avoid personal interface with
taxpayers and insists on online compliance. With this objective, Goods and
Service Network (GSTN) was incorporated as a special purpose vehicle as a
non –profit company under section 8 of the Companies Act, 2013 with an
initial equity capital of Rs. 10 crore; 24.5% contributed by the Centre, 24.5%
by all States including Delhi and Puducherry, and the balance 51% equity by
non-Government financial institutions.
Objects
The company set up a single portal www.gst.gov. in with the objects:
(a) to provide IT infrastructure and all GST related services to the Central
and the State Governments, taxpayers and other stakeholders for
implementation of the Goods and Services Tax (GST); and
(b) to establish a uniform interface linkage for the taxpayer and a common
and shared IT infrastructure between the Centre, Union Territories and
States.
The portal is accessible over Internet by taxpayers and tax professionals
like chartered accountants, tax advocates, banks, accounting, tax authorit ies and other stakeholders and intranet by tax officials etc.
Functions of the GSTN
GSTN provides to the taxpayers three front -end services, viz. registration,
payment and return through GST common portal. Its main functions are as
under: -
a) To facilitate registration of the taxpayer. GSTN takes help of IT, ITeS,
and financial technology companies called GST Suvidha providers
(GSP), who provide mechanism to receive GST returns from the
taxpayers and forward the returns to Central and State authorities;
b) To develop applications to be used by taxpayers for interacting with the
GSTN and facilitate the taxpayers in uploading invoices as well as
filing of returns and act as a single stop shop for GST related services
with the help of GSPs;
c) To customize products that address the needs of different segment of
users. GSPs may take the help of Application Service Providers (ASPs)
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e) To ma tch payment of tax by the tax payers with the banking network;
f) To generate MIS reports from the information furnished by the
taxpayers in the GST returns information and provide such reports to
the Centre and States;
g) To analyse and provide analysis of taxpayers' profile;
h) To match reversal and reclaim of input tax credit and
i) To ensure data privacy and protection along with developing data
retrieval and audit trails and other value added service.
7.5 Components of Public Expenditure
Public exp enditure is the most important part of the public finance. Public
expenditure refers to the expenditure incurred by public authorities for the benefit
of society as a whole. There are different views regarding public expenditure. The
classical definition of public expenditure indicates that, government should play
limited role like protection and maintaining law and order. On the other hand,
Keynes stated that, that system of public expenditure is the best which is highest in
amount. It means government should spend more than its income to maximize the
welfare of the society. Modern state is a welfare state economy in which
government has to play different role and perform a number of functions. Hence
public expenditure has increased enormously to promote maximum social welfare.
The public expenditure is defined as, ‘that expenditure which is incurred by the
public authorities like, central, state and local government bodies to satisfy
collective social wants of the people.’ The expenditure incu rred by the government
on defense, administration, maintenance of law and order, economic development,
welfare activities etc. is called as public expenditure.
In modern welfare state, the functions of the state have been enlarged and the
importance of pub lic expenditure has increased.
The government has to spend a lot for achieving various socioeconomic and
political objectives. Public expenditure is an effective measure to achieve certain
objectives.
1. Price stability
2. Full employment
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5. Creation of social goods
6. Provision of education and health
7. Development of transport and communication.
8. Protection from external aggression etc.
9. Promotion of economic stability
10. Elimination of socio -economic inequalities etc.
The components of public expenditure as follows.
1. Revenue Expenditure: Revenue expenditure refers to those items of current
expenditure which reduce the usable funds of the government without
reducing any debt liability. Such expenditure does not result in creation of
assets. Revenue expenditure is incurred towards purposes like running of
government departments, provision of various services, interest payments on
government loans, subsidies etc.
2. Capi tal expenditure: Capital expenditure refers to expenditure incurred by
the central government on acquisition of assets like land, building, machinery
and equipment, investment on shares, loans granted to state and union
territories, government companies, c orporations etc.
3. Development expenditure: It refers to expenditure incurred by the government on programmes related to the growth and development activities
of the government. It includes expenditure on education, health, industry,
road, channels, rur al developments, water works and power generation etc.
4. Plan expenditure: It refers to expenditure incurred by the government towards its planned development programmes. Both consumption and investment expenditure made by the government will be included under plan
expenditure. Expenditure on power communication, industry, agricu lture and
health are the different types of expenditure falling under plan expenditure.
5. Non development expenditure: It refers to expenditure incurred on the non development activities of the government. It includes activities like maintenance of law and order, defence, tax collections, payment of interest
and loan, payment of old age pension etc.
6. Non-plan expenditure: It refers to expenditure made beyond the preview of
the plan development activities of the government. It includes expenditure on
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7.6 Summary
Public expenditure is the most important part of the public finance. Public
expenditure refers to the expenditure incurred by public authorities for the benefit
of society as a whole. There are different views regarding public expenditure. The
classical definition of public expenditure indicates that, government should play
limited role like protection and maintaining law and order. On the other hand,
Keynes stated that, that system of public expenditure is the best which is highest in
amount. It means government should spend more than its income to maximize the
welfare of the society.
Modern state is a welfare state economy in which government has to play different
role and p erform a number of functions. Hence public expenditure has increased
enormously to promote maximum social welfare.
7.7 Questions
Q1. Explain the types and components of budget.
Q2. What is the meaning of public finance? What are the sources of public revenue?
Q3. Writhe about Goods and Services Tax (GST).
Q4. Explain the components of public expenditure.
Q5. Explain the key points of budget of India (2020 -21)
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Module 4
8 INDIAN PUBLIC FINANCE – II
Unit Structure:
8.0 Objectives
8.1 Introduction
8.2 Sources of Public Borrowing Debt
8.3 Deficits
8.4 Appraisal of Fiscal Responsibility and Budget Management (FRBM) Act
8.5 Fiscal Federalism
8.6 Fourteenth Finance Commission Recommendations
8.7 Summary
8.8 Questions
8.0 Objectives
• To know the different sources of public borrowing and debt liabilities.
• To study the various concepts of deficits.
• To know more about Fiscal Responsibilities (FRBM) act.
• To know the concept of Financial Commission and study the recommendations of Fourteenth Finance Commission.
• To study in detail about fiscal federalism
8.1 Introduction
Public finance is one of the i mportant branches of economics. It is the study of the
financial operations of the central and state government. According to H. Dalton,
‘Public finance is the study of income and expenditure of public authorities.’ Public
finance broadly implies the vario us activities undertaken by the public authorities
regarding - raising resources of funds, their proper utilization and achieving various
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equitable distribution of income etc. The subject matter of public finance includes
public revenue, public expenditure, and public debt.
In developed countries, public finance is used to maintain economic stability
through the control of inflation and recession. In developing countries, the ro le of
public finance is different from that in developed countries. In such countries,
public expenditure is directed towards economic development and public revenue,
as a source of financing the development activities.
8.2 Public Borrowing / Debt
Public debt is a source to collect income by states. Public borrowing or debt is the
debt the state collects from the citizens of other countries. When government
borrow, then it gives the birth to public debt. Government can take debt from banks,
business or org anizations, business houses and the person. Government can take
the debt from inside the country and from outside the country, or from both the
sides.
According to Dalton, “Public debt is a way of collecting income from public
officers”.
According to Prof . J.K. Mehta, “Public debt is comparatively modern incident and it would come in practical form with the development of democratic governments”.
According to Adam Smith, “Public debts create the conditions of war and extra
expenditure”.
Classification of Public Borrowing / Debt
Debt has been divided on the bases of use, target, time limit and terms of payment
by the economists . The different types of public debt are as fo llows –
1. Internal and External Debt
Internal Debt: Internal debt is a public debt taken from the country inside,
but the external debt is a debt taken from foreign governments. In Dalton's
words, “A debt is internal if given by those people or organizat ions living in
that area that is controlled by the local officer of taking debt. ”
External Debt: “A debt is external, if it is given by those people and
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2. Productive and Unproductive Debt
This classification of debt is depend on the use of public debt. Debts can be
used for the production works and unproductive debt.
Productive deb t: Productive debts are those debts which are used in those
plans which provide the income, like railway, plans of electricity and the
plans of irrigation. The income got from these plans can be used to the
payment of yearly interest and for the payment of Principle.
Unproductive debt: - Unproductive debts are those debts which used in that
plans, no income is provided, for example, war.
3. Funded and Non -Funded Debt
Government debt can also be divided in the form of funded and non -funded
debt.
Funded debts: - Funded debts are long term debts. Payment of these debts
can be done with in one year or it can be possible, not to give any promise
regarding this in other words funded debts are those debts, in which the
payments are given with in, one year.
Unfunded debts: - Treasury bonds are unfunded debts, because these debts
are given fo r three or six months and their time period is not more than one
year. Even then, this is clear that in the condition of funded debts, government
is responsible to pay the regular payment of interest to the debt payer; yes,
their basic money payment is tot ally left on the government.
4. With Rate of Interest and without Rate of Interest
Debt with Rate of Interest: - On loans with rate of interest, government
gives interest on a fixed rate to the loan taker after a fixed time period.
Debt without Rate of Interest: - debt without rate of interest, loans
government don’t have to pay any interest.
5. Purchasable and Non –Purchasable Debt
Purchasable debts: - it includes government securities; whose sale and
purchase is not possible independently.
Non-purchasable debts: - In opposite, those securities are included in non -
purchasable debts, whose sale and purchase is not possible in the open market
and can only give back to the government on a fixed rate.
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Total Debt: - On a fixe d time, whatever debts governments have, the total of
all is called total debt.
Net Debt: - If government collects any fund to pay back the debts, then the
amount of that fund subtracted from the total debt and whatever left is called
net debt.
7. Short Term and Long Term Debt
Short Term Debt: - When government takes debt for a short period, then
this is called short term debt. These debts are paid back in the time period
with in a year that is to be taken to complete the tenure of debts.
Long Term Debt : - When governments take debt for a very long period then
this is called long term debit. The time of giving it back is not fixed. At that
time the debt is paid back, the debt giver got regular interest.

8.3 Deficits
Budget deficits represent excess of all expenditure by the government over its
receipts from revenue and capital accounts. This means, the government spends
more than it collects through taxes and non -tax receipts. It may be noted that the
deficit may occur either in the revenue ac count or capital account or in both.
Thus , budget deficit can be obtained as
Budget Deficit = Total Expenditure – Total Revenue.
This deficit may be financed by withdrawing cash balance of the government with
the RBI or by borrowing from the public to fil l up the gap between current income
and expenses. Further, a budget deficit may also be financed through the creation
of new money. In other words, the government may cover the deficit by borrowing
from the central bank of the country.
The various concepts of deficit used in budget in modern world are as follows.
1) Revenue Deficit:
The deficit in revenue account of the budget is called as revenue deficit. It
takes place when revenue expenditure is more than revenue receipts. It refers
to the excess of re venue expenditure over the revenue receipts of the
government. Revenue receipts come from direct, indirect taxes, and other
sources like fees, fines, surplus of public enterprises. Revenue expenditures
are made on civil administration, law and order, justice, defence, interest
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Revenue Deficit = Revenue Expenditure > Revenue Receipts
Revenue deficit reflects the inability of the government to finance current
expenses through tax and non -tax rev enues. It should be noted that most of
the expenditure on revenue account represents collective consumption of the
society. It thus does not create income -earning assets. Prudent fiscal management requires that receipts on revenue account should be more th an
the expenditure on revenue account. When there is a deficit in revenue
account, the borrowed funds from capital account are used to meet a part of
the consumption expenditure of the government.
2. Budgetary Deficit: -
It is defined as excess of total budgetary expenditure over total budgetary
receipts (both revenue and capital account) of the government. The budgetary
deficit in India is met by either withdrawing cash balance kept with the RBI
or by net addition to the Treasury bill issued by the centr al government. It is
only a partial measure of budgetary imbalances, as it does not reflect the total
indebtedness of the government.
Budgetary Deficit = Total Expenditure > Total Revenue
3. Fiscal Deficit: -
The fiscal deficit is an internationally used concept. It is an important and
complete measure of deficit. Fiscal deficit is the excess of total expenditure
(both revenue and capital account) over revenue receipt and non -borrowing
types of capital receipts like
proceeds from disi nvestment of public enterprises. It shows the total resource
gap in the financial operation of the government. It is a comprehensive
measure of budgetary imbalance as it fully reflects the total indebtness of the
government.
Fiscal Deficit = Revenue Expen diture + Capital Expenditure > Revenue
Receipts + Non Borrowing Capital Receipts
The government in two ways can meet fiscal deficit firstly, by borrowing –
both internal and external market borrowing secondly, by borrowing from the
Central Bank against its own securities. When the government borrows from
the Central Bank, new money or currency is created. This is called monetizing the deficit because it leads to the creation of reserve money of
high-powered money. Monetizing fiscal deficit is called deficit financing in
India. In other words, Fiscal deficit is the excess of total expenditure,
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4. Primary Deficit: -
Primary deficit is obtained by deducting interest payment from fiscal deficit.
It is a measure of budget deficit, which indicates the real position of the
government finance. If the interest payments on past borrowings are high the
fiscal deficit is high.
Hence, fiscal deficit may be high and primary def icit may be low. If public
debt is reduced b mobilizing resources and curtailing public expenditure, then
fiscal deficit would be reduced.
Primary Deficit = Fiscal Deficit – Interest Payment
5. Monetized Deficit: -
It refers to the increase in net RBI cr edit to the government. It is the sum of
net increase in holding of Treasury bill of central bank and its contribution to
the market borrowing of the government.
It gives rise to the expansion of new money of currency is called Monetizing
the deficit. Hen ce it leads to the creation of reserve money or high powered
money by the RBI. When the government is monetizing the fiscal deficit, it
shows the extent of
deficit financing in India. Thus monetized deficit is responsible for directly
raising the general price level.
To conclude, the fiscal imbalance was attributed to a number of factors such
as rapid increase in government spending, inadequate rise in revenue receipts,
excessive borrowing, unproductive use of the resources etc. In fact, the large
and increasing fiscal imbalance affected adversely the economy in terms of
deficits because of balance of payments, large inflationary rise in the general
price level, and cut in capital expenditure.
8.4 Fiscal Responsibilities Budget Management (FRBM) Act
The fiscal situation in India was deteriorated throughout 1980’s and reached to a
peak level of crisis in the year1990 -91. The fiscal deficit in 1990 -91 was 6.6 percent
of GDP while revenue deficit was as high as 3.3 percent of GDP. The primary
deficit was 2.8 percent in the same period. The situation did not improve
significantly. This further indicates deterioration in fiscal situation due to rise in
burden of interest payments. This was one of the factors responsible for the BOP
crisis in 1990 -91. But by the time the stock of government liabilities had become
very large. It was affecting government functioning. Therefore, the central munotes.in

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government appointed a committee on Fiscal Responsibility Legislation on Jan. 17,
2000 to look into various aspects of fiscal system and recommended a draft
legislation on fiscal responsibility of the government. To ensure fiscal discipline
the central government according introduced ‘fiscal responsibility and budget
management bill’ in the parliament in December 2000 with the primary objective
of reducing the central government’s deficits and debts. Later on it became an act.
The fiscal responsibility and budget management act was passed and came into
force on 5 July 2004.
Objectives of the FRBM Act 2003
1. To set the limits on g overnment borrowing, under a time bound programme.
2. Achieve zero revenue deficit, to achieve sufficient revenue surplus and bring
down fiscal deficits.
3. Make government responsible to ensure long -term macroeconomic stability.
4. To make government responsible to reduce burden of debt repayment on
future generations and to adopt prudent debt management.
5. Improve the transparency in fiscal operations of the government.
Main Features of FRBM Act 2003 and FRBM Rules 2004:
1. Reduction in Revenue Deficit: - The FRBM rules states that, the central
government must take appropriate measures to reduce revenue deficit by 0.5
percent of GDP or more at the end of each financial year beginning with
2004 -05. The FRBM Act further Stipulates that, reve nue deficit should be
reduced to zero within a period of 5 years ending with 31st March 2009.
2. Reduction in Fiscal Deficit: - The FRBM Rules states that, the central
government should take appropriate measures to reduce fiscal deficit but 0.3
percent of GDP or more at the end of each financial year beginning with
2004 -05. The Act further states that fiscal deficit should be reduced to 3
percent of GDP by the end of 2008 -09.
3. Borrowing from the RBI: - The FRBM Rules states that, the central
government sh ould not borrow directly from the RBI with effect from 1st
March 2006 except by way of advances to meet temporary shortage of cash.
The RBI should not subscribe to the issue of government securities from
2006 -07.
4. Additional Liabilities: - The FRBM Rules states that, the central government
should limit the additional liabilities to 9 percent of the GDP in 1004 -05 and
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5. Relaxation of Deficit Reduction Targets: - The FRBM Act states that, the
revenue and fiscal deficit may be more than the specified targets in the rules,
but only on ground of national security, national calamities, or other
exceptional cases relaxation from deficit reduction targets may be granted to
the central government.
5. Quarterly Reviews : - The FRBM Act states that, the Finance Minister
should take quarterly review of receipts and expenditure, and should place
the outcome report of review before the parliament. He must present a
statement in the parliament by explaining the reasons for changes in FRBM
Act targets. Similarly, government should announce the corrective measures
to be taken to overcome these changes.
6. Fiscal Transparency : - The FRBM Ac t clearly stated two important
measures to ensure greater transparency in fiscal operation of the government. They are
I) The central government should minimize secrecy in preparation of
annual budget.
II) The central government should disclose the information relating to the
significant changes in accounting standards, policies and practices as
well as revenue arrears, guarantees and assets by 2006 -07.
7. Government Guarantees: - The Act states that, the central government
should not provide guarant ee to loans borrowed by the state governments and
public sector undertakings in excess of 0.5 percent of GDP in any financial
year beginning with 2004 -05.
8. Placing Reports: - The Act further states that, the government should present
three reports before the parliament every financial year.
• Macroeconomic Framework Statement - This report states what is
the growth rate expected to be achieved and also the macroeconomic
situation in the economy.
• Fiscal Policy Strategy Statement - This report sta tes the policy
measures relating to taxation, expenditure, borrowing, subsidies and
administrative prices.
• Medium term Fiscal Policy Statements - This report states three year
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Evaluation of FRBM Act
The cr itical evaluation of FRBM Act 2003 can be done by analyzing it broadly into
to groups. They are A) Achievements and B) Limitations.
A) Achievements :- The three main achievements of FRBM Act 2003 are as
follows.
1. Reduction in Revenue Deficit :- The first major achievement of the Act is
the reduction in revenue deficit from 3.6 percent of GDP in 2003 -04 to 1.1
percent of GDP in 2007 -08.
2. Reduction in Fiscal Deficit : - The second major achievement is reduction in
fiscal deficit from 4.5 percent of GDP in 2003 -04 to 2.7 percent of GDP in
2007 -08.
3. Reduction in Revenue Expenditure : - The third major achievement is
reduction in revenue expenditure from 3.1 percent of GDP in 2003 -04 to 1.1
percent of GDP in 2007 -08.
B) Limitations ; - Thoug h the government has taken credible efforts to reduce
revenue and fiscal deficits FRBM Act has certain limitations. They are as follows.
1. False expectations of revenue deficit target: - It was expected that the
revenue deficit is to be brought down to z ero. Central government failed to
reduce revenue deficit during the 1990s. The revenue deficit of the government rose from 2.4 percent of GDP in 1996 -97 to 4.1 percent of the
GDP in 223 -04. This is due to a decline in tax -GDP ratio and rise in interest
payment, subsidies, defence expenditure and other non -plan expenditure. If
restrictions are imposed on the government to reduce revenue deficit the real
possibility is that the government may cut down social sector spending
especially on health and education. This will adversely affect large sections
of the population.
2. Low level of capital expenditure :- One of the major limitations of FRBM
Act is the continuous decline in capital expenditure. According to critics to
reduce fiscal deficit the government has reduced capital expenditure from 5.6
percent of GDP in 1990 -91 to 3.02 percent of GDP in 2002 -03. This will
restrict governments’ investment in infrastructure in future which is vital for
rapid economic growth.
3. Neglect of equity and growth: - According to critics one of the major
limitations of the FRBM Act is the bill has not favoured investment in human
resource development and infrastructure because the returns on these do not
contribute directly to government revenue. But these areas are crucial for
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4. Lack of seriousness about financing public expenditure: -
The FRMB Act does not address the problem of financing public expenditure
in a ser ious manner. During 1990s the tax -GDP ratio declined significantly.
Hence there was a need to raise this ratio, but it has not received top priority
under the Act. There is no target under the Act for the tax -GDP ratio. The
problem of financing public expe nditure is callously dealt with by imposing
a restriction on the central government borrowing from the RBI to finance
government expenditure.
5. Flawed assumptions of the FRBM Act : - The FRBM Act is based on the
following assumptions.
i. Lower fiscal def icits lead to higher and more sustained growth.
ii. Larger fiscal deficits necessarily lead to higher inflation.
iii. Larger fiscal deficits increase external vulnerability of the economy.
These assumptions have been rejected by C. P. Chandrashekhar an d
Jayati Ghosh who have given the following arguments.
1. If the deficit is in the form of capital expenditure, it would contribute
to future growth.
2. Fiscal deficit is not the only cause for higher inflation. During the late
1990s, the rate of inflation has fallen even when the fiscal deficit was
as high 5.5 percent of GDP.
3. Higher fiscal deficit need not necessarily cause external crisis.
The external vulnerability depends more on capital and trade account
convertibility. In India, we have managed to build large foreign
exchange reserves, though fiscal deficit has not come down.
In short , the assumptions of the FRBM Act are theoretically incorrect.
6. Neglect of primary deficit : - According to critics the FRBM Act completely
neglected the primary deficit because it did not determine any specific target
for it despite high burden of interest payment on nation.
7. Target for gross fiscal deficit very stringent : - The Act states that gross
fiscal deficit should be reduced to 3 p ercent of GDP up to March 31, 2009.
This means that government borrowings would be restricted to 3 percent of
GDP. According to Dr. Chelliah this target is very stringent. The ratio of
gross fiscal deficit to GDP should be 4 to 5 percent of GDP to boost
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To conclude, the government has introduced several measures of improving
fiscal situation. The Task Force constituted under the chairmanship of Dr.
Vijay Kelkar, submitted its report to the government. It has outlined measure
to increase revenue and reduce revenue expenditure. It has also recommended
raising capital expenditure to induce economic growth. On account of such
reforms, the Task Force has estimated that the tax-GDP ratio can improve
considerably in 2008 -09. At the same time there would be a decline in total
expenditure. As a result, revenue surplus would be 2 percent of GDP while
the fiscal deficit could be brought down to 2.8 percent of GDP.
8.5 Fiscal Feder alism
The f iscal federalism refers to financial relations between the country’s federal
government system and other units of the government. It is a study of how
expenditure and revenue are allocated across the different vertical layers of
government admin istration. Article 246 and Seventh Schedule of the Indian
Constitution distributes powers and allots subjects to Union and states with a
threefold classification type:
a. Union List :
The Union is responsible for functions of national importance, including but
not limited to the communications, constitution, defence, elections, external
affairs and organisation of Supreme Court and High Courts.
b. State List:
States are the responsible f or touching on the life and welfare of the people,
for instance, through public order, police force, agriculture, local
government, public health and water land, etc.
c. Concurrent List:
The Concurrent list includes the administration of justice, economic and
social planning, and more.
According to the lists, the Parliament has reserved exclusive powers to create laws
with regards to anything from Union List. Contrarily, the Legislature of any state
reserves the power to make laws for their respect ive states in relation to anything
from State List. However, for any subject matter that falls within Concurrent List
both, the Parliament and State Legislature can create laws, however, in the event
of any conflict, the law made by the Parliament will pre vail. Residuary functions
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The Union and State lists also include powers of taxation. The main source of
income for the Union are direct taxes, mainly income tax. However, they are also
entitled to collect various other taxes such as customs and corporate tax. States
normally derive their income from indirect taxes, most commonly from sales tax.
Besides this, the State List also includes land revenue, excise on alcoholic liquor,
estate duty, tax on vehicles and more. The Concurrent List does not comprise any
tax power. The distribution of revenues and approaches for determining grants
between the States and Union are legislated by various Articles of the Indian
Constitution.
8.6 Fourteen th Finance Commission
Fourteenth Finance Commission of India was a finance commission which is
constituted on 2nd January, 2013. The chairman of the fourteenth financ e
commission was the former governor of Reserve Bank of India , Y. V. Reddy and
the members were Sushma Nath, M. Govinda Rao, Abhijit Sen, Sudipto Mundle,
and A. N. Jha. The recommendations of the commission entered force on April
2015; they take effect for a five -year period from that date.
The government of India on 24th February, 2015 accepted the recommendations of
the fourteenth finance commission to increase the share of states in central taxes to 42% ,the single largest increase ever recommended. It has recommended distribution of goods to states for local bodies using 2011 populati on data with
weight of 90% & area with weight of 10%.
Major recommendations of Fourteenth Finance Commission (FFC) accepted
by the government
• States’ Share in the net proceeds of Union tax revenues increased to 42%
from 32% earlier. This is the largest eve r jump in percentage of devolution.
In the past, changes have ranged between 1 -2% increase.
• Eight Centrally Sponsored Schemes (CSS) delinked from support from the
Centre. Finance Commission has identified over 30 CSS schemes to be
delinked from Centre’s s upport but all have not yet been delinked considering
the national priorities and legal obligations.
• Sharing pattern under various CSS to undergo a change, with States sharing
higher fiscal responsibility for scheme implementation.
• Distribution of grants to States for local bodies based on 2011 population data
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Other key recommendations of FFC that government will examine
• Revenue compensation to States under GST should be for five years; 100%
in first three years, 75% in fourth year and 50% in fifth year.
• Create an autonomous and independent ‘ GST Compensation Fund’ through
legislative actions to facilitate the compensation process.
• Suggesting a fiscal consolidation roadmap, FFC puts a ceiling on fiscal
deficit at 3% of GDP from 2016 -17 onwards .
• Some flexible provisions for State’s borrowings over and above the annual
limit of fiscal deficit at 3% of GSDP.
• Establish an i ndependent Fiscal Council to undertake ex -ante assessment of
fiscal policy implications of budget proposals and their consistency with
fiscal policy and rules.
• Suitably amend Electricity Act 2003 to facilitate levy of penalties for delays
in payment of su bsidies by the State Governments.
• Have independent regulators for road sector for tariff setting, quality regulation, among other functions.
• Several recommendations made for evaluating government’s ownership,
disinvestment in Central Public Sector Enterp rises.
8.7 Summary
The Finance Commission is Constitutionally mandated body which is at the centre
of fiscal federalism. Finance commission has been Set up under Article 280 of the
Constitution, its core responsibility is to evaluate the state of finances of the Union
and State Governments, recommend the sharing of taxes between them, lay down
the principles determining the distribution of these taxes among States. Its working
is characterised by extensive and intensive consultations with all levels of governments, thus strengthening the principle of cooperative federalism. The first
Finance Commission was set up in 1951 and there have been fifteen so far. Each
of them has faced its own unique set of challenges.
The Fifteenth Finance Commission was constituted on 27 November 2017 against
the backdrop of the abolition of Planning Commission (as also of the distinction
between Plan and non -Plan expenditure) and the introduction of the goods and
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8.8 Questions
Q1. What are the Sources of Public Borrowing and Debt Liabilities?
Q2. What the meaning of deficits? Explain various types of deficit.
Q3. Write about Appraisal of Fiscal Responsibility and Budget Management
(FRBM) Act.
Q4. Explain the concept of fiscal federalism.
Q5. What are the measure recommendations of Fourteenth Finance Commission?
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