UGC NET PUBLIC FINANCE MATERIAL
PUBLIC FINANCE
Compared to the Private finance where people like us spending and making money
individually for their own purposes, Public Finance means the financing by the government
which includes Public Revenue, Public Expenditure, etc..
Important Principles under Public Finance are:
1) Public Revenue
2) Public Expenditure
3) Public Debt
4) Financial Administration
- Budget, Economic Survey
- Finance Commission
TYPES OF GOODS
Public goods:
The public good is that good which consumed by one person, doesn’t reduce the quantity
available for others. In simple words, these goods are non-rival in nature.
The benefits derived on consuming the good by one person doesn’t reduce the benefits
derived by others, that is, the same benefits can be obtained by all and thus there is no
mutual interdependence.
Features:-
1) They are Non-Rival in nature
2) They are Non-Excludable, that is, you cannot exclude anybody from consuming those goods.
3) They are indivisible.
4) Marginal cost for providing the good to an additional consumer is zero or near zero.
5) There exists a problem of free riding or externalities in case of public goods.
Private goods:
Private goods are those goods which give utility to the person consuming the commodity,
and benefits derived are denied to others.
It is a good whose price is determined in the market and those who pay for it are allowed to
consume it, thus the principle of excludability comes into picture.
Features:-
1) They are excludable in nature. 2) They have rivalry characteristics.
3) They are divisible in nature. 4) The price charged per unit is the same.
5) The total demand is calculated by horizontally adding the individual demands
6) Marginal Benefit received by A is not equal to Marginal Benefit received by B (MBA ≠ MBB)
It is not necessary that public good is provided by the government only. While private goods
are not necessarily provided by private sector
Merit Goods:
The concept of Merit goods was given by Musgrave. These are the goods whose
consumption should be encouraged. For example, free education, low cost housing, etc.
Also, these are the goods which the individual or the society should have on the basis of
some concept of need, rather than the ability and willingness to pay.
PRINCIPLES OF PUBLIC FINANCE
The principles of Public Finance was given by Prof. Dalton and Prof. Pigou.
The concept is also known as the Principle of Maximum Social Advantage.
The principle states that the revenue collected and spent by the state should be in such a
manner which maximizes the welfare of the people. According to this principle,
Utility Gain = Utility Loss
If Utility Gain = Utility Loss , then this will lead to maximum welfare of the society.
To compute the level of maximum social welfare, Dalton introduced two concepts,
1) Marginal Social Sacrifice (MSS): It is the per unit of taxation leading to marginal disutility
amongst the tax payers. MSS is an upward sloping curve because with every marginal rise in
taxation, the disutility increases more than before.
2) Marginal Social Benefit (MSB): It is the per unit expenditure leading to creation of marginal
utility amongst the beneficiaries. MSB is a downward sloping curve due to the applicability of
diminishing marginal utility.
The state should choose the taxation and expenditure levels in such a way that the surplus of
utility is maximised and the disutility is minimised.
Dalton further proved that maximum social welfare will be where MSS and MSB curves
intersect
The optimum level of expenditure and taxation is at this point MSS = MSB and thus
Marginal disutility = Marginal Utility.
To calculate the optimum level of taxation, Pigou gave the concept of Marginal Net Benefit
(MNB), which is expressed as follows:
Marginal Net Benefit (MNB) = MSB- MSS
According to Pigou, Optimum level of taxation will be the point where MNB = zero. Optimum
point of taxation and expenditure is where benefits = sacrifice
Fundamental Principles to achieve the objective of Maximum Social Advantage
1. Public expenditure should be continued till the point where benefit derived from the last
rupee spent is equal to the sacrifice made by people in raising the last rupee of revenue.
2. The resources should be distributed in such a manner that the marginal return of
satisfaction is the same from each of the resources.
3. The taxes should be charged in such a way that the marginal utility of money paid in
taxation is equal for all the tax payers.
Objective Tests of Social Advantage: By Dalton
1. Political Stability: If taxes are imposed to protect the people from external threat, then it is
productive.
Internal peace Increases confidence among masses Promote welfare
and productive efficiency
2. Improvement in Production: Maximum social advantage can only be realised when
production increases (in terms of quantity and quality).
3. Improvement in Distribution
• Reduce inequality between rich and poor
• Reduce fluctuations between different periods of time.
4. Economic Stability: Less fluctuations in the economy.
5. Full employment: Leads to increase in production and income inequality.
6. Future considerations: Interest of future generations is maintained.
Mrs. Hicks’ Optima of Public Policy
“Production optimum is realised when it becomes impossible, by reallocating factors to
increase the output of one product without diminishing that of another.”
Maximum output would lead to satisfaction of wants.
PUBLIC BUDGETS
A budget is simply a record of any physical activity undertaken by the government. It is a
statement of revenue and expenditures incurred by the state.
The budget has three components:
1. The statement of funds which are required by the government during a period of time.
2. A detailed statement of assets and liabilities held by the government.
3. The income in the form of interest from loans to other government.
Objectives of a Budget
1. It helps in reallocation of resources so that they can be used most productively.
2. The budgets help governments in redistributive activities like reducing inequalities, etc.
through the mode of taxation and expenditure.
3. The budget helps in stabilizing the activities of the government by reducing the
fluctuations in business activities.
4. The budget helps in managing the public enterprises and reduce the loss making units.
Multiple and Unified Budgets:
Under Multiple budgets, the government prepares the budget into two parts in way that
these two parts can be individually assessed.
On the other hand, unified budget is prepared in such a way that the entire budget can be
studied together and the total impact can be assessed.
Conventional and Cash Budget:
In case of conventional budget, the transactions are recorded on accrual basis and the funds
which do not belong to the government are excluded from it.
On the other hand, the cash budget includes all types of funds which pass through the
government, irrespective of whether they belong to the government.
Revenue and Capital Budget:
Revenue budgets include the items which are of recurring nature.
On the other hand, capital budget includes items which bring a change in the assets of the
economy.
In India, Before Independence, James Wilson presented the budget in 1860. After
Independence, 1st Indian to present it was T.T. Krishnamachari.
A budget gives three estimates:
1) Budget Estimates
These estimates need Parliamentary approval. The other Ministries give the information to the
Finance Ministry and then the estimates of expenditure and revenue for the upcoming year
are prepared accordingly.
2) Revised Estimates
These estimates do not need Parliamentary approval. They are prepared for the ongoing
financial year when half year has passed.
3) Actual Estimates
These estimates are prepared when the financial year has ended and reflects the actual
expenditure and revenue taken place
A budget includes three funds:-
1) Consolidated Fund
The fund is basically the Government's account from which the salaries of government
employees is paid, etc. The withdrawal from it requires Parliamentary approval
2) Contingency Fund
These funds can be used only at times of emergencies and hence do not require
Parliamentary approval
3) Public Accounts
This account holds people's provident funds, small savings, etc.
QUESTIONS FOR CLARIFICATION
1. Who amongst the following propounded 'the law of increasing state activities' ?
(a) Dalton (b) peacock-Wiseman
(c) Musgrave (d) Wagner
2. Who amongst the first identified the role of government as allocator, Distributor and stabilizer?
(a) Dalton (b) Musgrave
(b) Pigou (d) J.K. Mehta
3. The principle of ' Maximum social advantage' is concerned with :
(a) taxation only
(b) public expenditure only
(c) public debt policy only
(d) both taxation and public expenditure.
4. Budgetary deficit does not take into account
(a) revenue deficit (b) Capital deficit
(c) BOP deficit (d) non -tax receipts
6. Which of the following is the main objective of taxation?
(a) increase in consumption (b) increase in production
(c) raising public revenue (d) increase in Capital formation
7. Laffer curve is a relationship between which of the following variables?
(a) tax revenue and GDP
(b) tax rate and tax revenue
(c) tax rate and burden of tax
(d) tax revenue and debt redemption
8. Key benefits of GST are:
(a) Promoting cooperative federalism (b) Reducing corruption and leakages
(c) Creating a common market. (d) All of the above.
Answers:-
1) D 2) A 3) D 4) C 5) C 6) B 7) D 8) B
Types of Budget
1. Revenue Budget: This budget accounts for current financial transactions which are recurring in
nature.
Revenue Receipts: Includes Tax receipts, Non-tax receipts.
Revenue Expenditure: Includes Developmental, Non-Developmental expenditure.
Tax Receipts:- Taxes and other proceeds levied by the government
Non-Tax Receipts:- Other revenue receipts by the government
For example, Interest receipts, dividends and profits, external grants
2. Capital Budget: The budget includes creation/addition of capital assets and even
acquisition/disposition of capital assets.
It further includes:
Capital Receipts: Includes market borrowing, loans and recoveries, external assistance,
disinvestment.
Capital Expenditure: It includes developmental expenditures like capital expenditure,
construction of roads, etc. and non-developmental expenditures
like discharging debt, defence, advancing loans, etc.
3. Planned Budget: The budget which is made for a certain time period. In our country, the
five-year plans are considered to be a Planned budget.
Non-plan Budget: The budget which is prepared to take an immediate action, is called a
non-plan budget.
Non-Plan Expenditure has two Components
1) Revenue Expenditure
2) Capital Expenditure
Revenue Expenditure
These expenditures do not result in creation of assets. For example, interest payment, defence
expenditure, subsidies, economic, social services
Capital Expenditure
These expenditures are made to acquire assets like land, machinery, etc.
4. Executive Budget: The budget which is prepared by executive and followed by the
legislative is known as the Executive budget.
Non-Executive budget: The budget which is prepared and followed by the Legislator, is
known as non-executive budget.
Balanced Budget:
If the estimated receipts are equal to the estimated expenditure, then it is considered to be a
balanced budget. Such kind of a budget does not have any impact on the economic activities,
that is, it has a neutral effect.
Surplus Budget:
If estimated receipts are more than the estimated expenditure, then it is known as a surplus
budget. The surplus budget means that the government or the central bank is printing more
money than what is required. Therefore, it has a contractionary effect on the economy.
More money than what is required Fall in the level of economic activity
Decrease in investment Decrease in production and hence decrease in
employment Decrease in income and thereby reducing the consumption
and savings level in the economy.
Deficit Budget:
If estimated receipts are less than the estimated expenditure, then the economy has a deficit
budget. The deficit is then financed by printing more notes. Moreover, it means that the economy
is pumping in more money than what is required.
More money is pumped in the economy Increase in economic activity
Increase in investment, hence rise in employment Rise in income levels leading
to the rise in consumption and savings level.
Techniques of Budgeting
1. Performance Budgeting: This budget was used prior to 1968.
Under this kind of budgeting, the resources were allocated on the basis of performance
depending on:
a. Final outcome of the budget.
b. Strategy adopted while implementing the budget.
c. Activities undertaken as a part of the budget.
2. Programme Budgeting:
It is also known as Programme Planning. It means that out of the available strategies, the
authorities choose the best and the most economical in terms of use of resources, cost, etc.
The major difference between performance budgeting and programme budgeting is that the
latter is more comprehensive as compared to the former. Moreover, programme budgeting is
forward looking while performance budgeting is backward looking, that is, it analyses the
event which have already occurred.
3. Zero Based Budgeting:
It was developed by Peter A. Phyrr in 1969. The budget, by its name, means starting from the
scratch. Under Zero-Based budgeting, each department is required to justify its expenditures
and budget requests from the scratch.
The programmes are regularly evaluated and justification is given to continue the
programme.
Mr. Jimmy Carter, while he was the Governor of Georgia, first tried this kind of a budget in
1973, with necessary modifications. In India, it was applied in 1987.
The features of Zero-Based Budgeting are as follows:
1. The programmes are evaluated at various levels of resource allocation and its
performance is measured.
2. Objectives are to be formulated by each agency.
3. Each agency’s activities are to be converted into decision packages which reveal
their true performance.
4. Top-down budgeting:
It originated in U.S. in 1981. Under this, one authority sets limit for all the departments and
then each department is responsible to undertake the activities to achieve their goals.
Concept of Deficits
1. Revenue Deficit: Revenue Expenditure – Revenue Receipts
- It is the amount by which expenditure on revenue account exceeds the receipt.
2. Capital Deficit: Capital Expenditure – Capital Receipts
- It is the amount by which expenditure on capital account exceeds the receipts
3. Budget Deficit: Capital Deficit + Revenue Deficit
- It is financed through borrowings of 91 day ad-hoc T-Bills and drawing down of
cash balances.
4. Fiscal Deficit: Budget Deficit + Sale of public assets + borrowings and liabilities of
government
5. Primary Deficit: Fiscal Deficit – Net Interest payments
6. Net Fiscal Deficit: Fiscal Deficit – Loans and Advances
7. Net Primary Deficit: Net Fiscal Deficit – Net Interest payments
8. Monetized deficit: Increase in net RBI credit to the Government. It reflects the level of RBI’s
credit to centre’s borrowing programme and is usually determined by
increase in reserve or high powered money.
9. Effective Revenue Deficit: Revenue deficit – Grants for creation of Capital Assets
- It was introduced in Budget 2011-12
10. Public Sector Borrowing Requirements (PSBR):
Also known as Public Sector Net Cash Requirements. It is the net claim on all government
entities. It is a comprehensive measure including all government entities/bodies that show the
net claim on the use of resources by the public sector.
11. Structural Deficit: It is the PSBR adjusted for occasional measures for reducing deficits and
increasing resources/increasing revenue.
12. Operational Deficit: It is the PSBR adjusted for inflationary/price changes.
PUBLIC EXPENDITURE
Public Expenditure refers to the expenses incurred by the public authorities for the social and
economic welfare of the citizens.
Theories of Public Expenditure
1. Wagner’s Law of Increasing State Activities:
The Wagner’s law came into writing in 1880. His period of study was 1835-1917. According to
his study, as public expenditure increases, role of the public sector also increases.
Due to these governmental activities, its role becomes more important as compared to the
private sector.
Thus Income elasticity of government services is greater than 1, implying that the level of
government services changes more than the level of output in the economy.
In short, during the process of economic development, the government expenditure increases
more than proportionally as compared to the per-capita community output.
Moreover, Government’s role, both intensively and extensively, increases over a period of
time.
2. Peacock-Wiseman Hypothesis:
The theory originated in 1890s in their work ‚Growth of Public Expenditure in U.K.‛. Peacock-
Wiseman notes the behaviour of public expenditure.
They said that the public expenditure does not increase in a smooth manner but in a jerky,
step-like fashion.
They talked about three effects:
1. Displacement effect: According to this, any kind of social disturbance leads to rise in
expenditure and taxation. It is simply the movement from previous level of expenditure and
taxation to a new and higher level.
2. Inspection effect: Government increases expenditure due to involvement in other activities,
that is, government will find new areas to operate. Also, it is sometimes considered to be a
situation of inadequate revenue as against the required public expenditure.
3. Concentration effect: Tendency of Central government activities increases at a faster rate than
the state government or local bodies.
3. Colin-Clark Hypothesis:
The hypothesis tells the optimum level of public expenditure. According to this theory, if
government expenditure is more than 25% of the total economic activity, then it leads to
inflation.
Expenditure and taxes increase Decrease in production Increase in
Demand Increase in price
Pigou’s Ability to Pay:
Goods and services provided should be charged a fees to cover the cost of production.
Conditions when public expenditure can be larger:
• Greater the aggregate income
• New opportunities for expenditures by the government, and no private sector is
available.
• Greater the concentration of income with few rich.
Voluntary Exchange Theory: By in 1919.
Price mechanism of public goods does not exist because they are jointly consumed.
If such goods are supplied; all members will consume it, irrespective of who pays for it and
who not.
Samuelson Theory
Public goods are provided collectively and can’t be provided by private entrepreneurs.
Applies market principle to determine the optimal provision of financing of public goods.
Johansen’s Theory:
Intends to apply fiscal theory to partial problems and specific issues.
Canons of Public Expenditure: given by Findlay Shirras
1. Canon of Benefit: Public expenditure should be for the maximum number of people. The
public expenditure should be made in such a manner that it satisfies the
public interests in the best possible manner.
2. Canon of Economy: There should not be over-spending or waste of resources. In other words,
the expenditure should not involve the resource use more than what is
required. Also, there should be no corruption in the economy.
3. Canon of Sanction: The public expenditure can be done only up to a certain limit without
sanction from the higher authorities. Beyond that, it should be
compulsory to take the permission from the authorities.
4. Canon of Surplus: Spending should be done so that the surplus is maintained. Enough
money should be there to repay loans or interests. The budget should be
in balance or surplus but a strict no to the deficit budget.
Classification of Expenditure
1. Productive and Unproductive Expenditure: Productive expenditures are those which are
made to create or maintain the social overheads. On the other hand, the unproductive
expenditures are those like on defence, administration, etc. which do not have any effect on the
production capacity of the economy.
2. Transfer and Non-transfer Expenditure: Transfer payments are unilateral payments and does
not involve receipt of goods and services in return. For example, old age pensions, maternity
benefits, etc. Non transfer expenditures is a bilateral payment and involves exchange of goods
and services.
3. Revenue and Capital Expenditure: Revenue expenditure does not lead to creation of assets
and are recurring in nature. On the other hand, capital expenditure leads to the creation of assets
in the economy.
Effects of Public Expenditure
1. Distribution effects: The public expenditure reduces inequalities by providing public goods or
services which are common to all, irrespective of their income levels. In other words, the
government should follow a progressive expenditure system.
2. Effect on production: The public expenditure has a positive impact on the production levels
because workers will be able to save more, hence demand more and thus increase the production
activities in the economy.
3. Growth effects: When the public expenditure increases, the demand for goods increase and
hence economic activities also increase.
4. Stability: Public expenditure level is changed according to the state of the economy and hence
bringing about stability. At times of inflation, the expenditure decreases and during recessionary
times, expenditure increases.
QUESTIONS FOR CLARIFICATIONS
1. In India the fiscal year is
A) From January 1 to December 31 B) From March 1 to February 28
C) From June 1 to May 31 D) From April 1 to March 31
2. Zero base budgeting was first adopted by
A) France B) England
C) USA D) Germany
3. Which one of the following is a feature of ‘club good?’
A) The exclusion principle is possible
B) It is shared by public
C) It is an intermediate between public good and private good
D) All the above
4. Budget deficit may be defined as
A) Revenue expenditure minus revenue receipts
B) Total expenditure minus total receipts
C) Total expenditure minus total receipts minus capital receipts
D) Fiscal deficit minus interest payments
5. The type of note issue system followed in India is
A) Maximum fiduciary system B) Minimum reserve system
C) Proportional Fiduciary system D) Fixed fiduciary system
Answers:-
1) D 2) C 3) D 4) B 5) B
PUBLIC REVENUE
Public Revenue is the income received by the government through its sources. It includes taxation
policies, fees and fines, interest from loans given to other economies, etc.
Sources of Public Revenue are:
1. Taxes:
These are the compulsory payments which are collected to do something for the common
interest of the people. There is no relation between tax payment and benefit received after
paying the taxes.
2. Non-Tax Revenue:
This includes: 1. Interest receipt on loans.
2. Revenues from government activities like railways, PSUs, etc.
3. Receipts of currency notes, coinage and mint.
4. Administration revenue including fees, fines, etc...
Impact of Tax: It is the immediate/original/Primary burden of tax. The person who pays the
tax in the first incidence, experiences an ‚Impact of Tax‛.
Incidence of Tax: It is the final resting point of tax. It is the person who faces the final burden
of tax.
Shifting of Tax: It implies transferring the burden of tax from one person to another. It can
be either forward or backward.
Direct Tax:
Direct Tax is directly imposed on the income levels. For example, Income tax, Corporation tax,
Property tax, Wealth tax, Gift tax.
For a Direct Tax, the impact and incidence of a tax will be borne by the same person
Indirect Tax:
These are the taxes which affect the incomes of the people through their consumption
activities. For example, Sales tax, Excise duty, Custom duty, VAT, Entertainment tax, Service tax.
Indirect Taxes are those taxes in which the incidence of tax can be shifted to another.
Difference Between Direct Taxes and Indirect Taxes
Ad-Valorem Taxes:
These are the taxes which are termed usually as the proportion of the price of the commodity.
These are the taxes imposed on the value of the property/good.
Specific tax:
If the tax is levied on the per unit of the commodity produced or sold, it
Corporation tax: It is the tax imposed on the profits of a company.
Expenditure tax: It is the tax imposed on the expenditure undertaken by the corporation.
Death Duty: It can either be in the form of estate duty or inheritance tax or succession duty. It is
imposed on the property inherited after the death of the person.
Gift tax: It is a tax on gifts of a certain value
Capital-gains tax: It is imposed on the net gains realised on the sale of property at a higher price
than what was paid for it.
Custom duty: It is the tax imposed on imports and exports of commodities.
Excise duty: It is the tax on production and sales.
Sales Tax: It is the tax on sales of a commodity.
Service tax: It is the tax on services availed by the consumer.
Fringe Benefit tax: It is the tax to be paid by the employers for benefits given to the employees
collectively.
Canons of taxation: given by Adam Smith.
1. Canon of Equality: The canon of equality aims to provide economic justice to all. It means that
the burden is equally shared, that is, rich should be charged with more amount of taxes and poor
with less. As a result, it would progressively bring equality in the economy.
2. Canon of Economy: It means that the resources collected through the tax should be minimum.
3. Canon of Certainty: It specifies when/who will pay taxes. The contributor should be clear of all
the information regarding the time of payment, amount to be paid, etc.
4. Canon of Convenience: It means that people should not face inconvenience while paying
taxes. The time and mode of payment should be convenient for the tax payer.
Theories of Taxes
Physiocratic Theory: It is the earliest theory. According to this, land is the only factor which will
generate surplus. Tax should be imposed only on land.
Financial Theory: According to this theory, taxes imposed should maximise revenue
regardless of whether it is too burdensome on the poor. The theory
being too regressive, was its major flaw.
Cost of Service Theory: Taxes are paid as per the cost of service provided by the
Government, that is, more cost implies more tax.
Benefit Principle: It is also known as ‘Contractual Theory’ and is given by Lindahl.
According to this theory, there is a contractual relationship between the government and the
people. Government acts as a commercial enterprise and there is a quid-pro-quo setup that
is, favour in return of a favour. Government acts as a supplier of public goods and services
and the taxes should be charged in proportion of the benefits derived or received.
According to this theory, both tax payers will jointly contribute towards the public revenue to
cover the cost of goods provided.
Lindahl’s theory provides solution to three problems which are:
1. The decision regarding the extent of state activity, its expenditure and taxation
levels, which are discussed in the theory.
2. Allocation of public expenditure on various goods and services.
3. Deciding upon the tax burden to be shared by all tax payers in the economy.
Ability to Pay Theory:
The theory was given by Seligman and other contributors were Pigou, Edgeworth, Kaldor.
The focus of this theory was on equality, that is, taxes charged were according to the ‘ability
to pay’ of the tax payer. Thus, for richer class, the marginal utility of money (MUM) is less, thus
they have a higher capacity to pay more.
Factors which affect taxes are as follows:
• Income • Property
• Consumption Expenditure • Size of the family
Sacrifice Principle: It is based on the psychological reaction which varies from person to person.
1) Equal absolute sacrifice:
It is most regressive. According to this, the absolute income after paying tax should be the
same for all.
(Income – Tax)A = (Income – Tax)B
2) Equal Proportional Sacrifice:
It is less regressive as compared to the Equal absolute sacrifice. According to this, the sacrifice
should be proportional to their total income.
3) Equal Marginal Sacrifice/ Least aggregate sacrifice:
It is the most progressive form of taxation. According to this, the marginal sacrifice for each
tax payer should be the same.
Modern Views on Taxation
The concept was given by Musgrave. He considered the distributional side, that is, incidence
is the change in the distribution of income available for private use because of policies of
taxation and expenditure.
He mentioned three effects:
1. Available resources for public and private expenditure changes.
2. Output can be affected.
3. Change in the distribution of income.
Measure of Incidence
The concept was given by Musgrave through Lorenz Curve.
It is the ration between Coefficient of equality after budgetary change and coefficient of
equality before budgetary change
Tax Ratio
Tax Ratio = 𝐑𝐞𝐯𝐞𝐧𝐮𝐞 𝐟𝐫𝐨𝐦 𝐭𝐚𝐱𝐞𝐬 / 𝐓𝐨𝐭𝐚𝐥 𝐍𝐚𝐭𝐢𝐨𝐧𝐚𝐥 𝐈𝐧𝐜𝐨𝐦𝐞
Tax Ratio depends upon:
1. Developing (low)/Developed (high) nations
2. Per capita income
3. Standard of living
Tax Buoyancy
Tax buoyancy = 𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐭𝐚𝐱 𝐢𝐧𝐜𝐨𝐦𝐞/𝐫𝐞𝐯𝐞𝐧𝐮𝐞 /𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐭𝐚𝐱 𝐛𝐚𝐬𝐞
Tax buoyancy reflects how income is increasing from taxation due to increase or expansion in
tax base.
Tax income can be increased using the following measures:
1. Increase in tax rate 2. Widen tax coverage 3. Expansion of tax base
Elasticity of Taxation
It is the change in revenue due to change in income.
Elasticity of Taxation = 𝑷𝒆𝒓𝒄𝒆𝒏𝒕 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒂𝒙 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 / 𝑷𝒆𝒓𝒄𝒆𝒏𝒕 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒊𝒏𝒄𝒐𝒎𝒆
Laffer Curve
Laffer curve is the curve depicting the relationship between tax rates and tax revenues.
The shape of Laffer Curve is Inverted U which indicates that initially tax revenue will increase
as the tax rate increase, and if tax rate past a certain limit, the tax revenue will decrease and
even results in zero tax revenues.
Taxable Capacity
Taxable capacity is the amount of money that can be raised through taxation without causing
burden. It is also known as the degree of taxation or squeezability.
Absolute Taxable Capacity: It is the amount which is actually raised from the people in the state
Relative Taxable Capacity: It is the taxable capacity of one nation compared to the other. It is
used for comparison purposes.
Determinants of Taxable capacity are:
1. National Income: Higher the national income, higher is the taxable capacity.
2. Size and Growth rate of population: More the growth rate of population, lesser will be the
taxable capacity.
3. Income distribution: If there is unequal distribution, then more taxes can be raised.
4. Pattern of taxation: If single tax system is adopted in the economy, then there will be less
taxable capacity. On the other hand, if the economy adopts multiple tax system, then the taxable
capacity is more.
5. Economic conditions: At times of Boom, the taxable capacity is high and at times of
depression, the taxable capacity is low.
6. Stability of Income: If the income is stable, more will be the taxable capacity and vice-versa.
7. Psychology of the tax payers: If tax payers feel that by paying taxes they will be benefitted
then the taxable capacity is high.
8. Nature of public expenditure: More productive the public expenditure, more is the taxable
capacity and vice-versa
The taxable capacity can be measured by following methods:
1. Personal aggregate income method: It is the sum total of personal income of individual.
Higher the sum of personal income, more is the taxable
capacity.
2. Production method: It is the net production of different sectors and judge the taxable
capacity.
Effects of Taxation
1. Effect of Taxation on Production:
Dalton discussed the effect of taxation in the following ways:
a. Effect on the ability to work, save and invest: Taxation reduces the consumption and saving
capacities of the individuals. Therefore, taxation alters the capacity to save and invest in a
negative way.
b. Effect on the desire to work and save: Taxation affects the desire to work and save in a
negative way. However, it is not true for all taxes.
2. Effect on Industries: Big industry houses may not have a severe effect of taxation but the
infant industries do suffer from high rates of taxes charged on them.
3. Effect of Tax on Distribution: It can be discussed in two ways:
a. Nature of tax:
By nature of tax we mean whether the taxes are progressive or regressive in nature.
• Effect of regressive taxes:
Regressive taxes increase the inequalities because poor are relatively charged with more taxes as
compared to the rich.
• Effect of progressive taxes:
Progressive taxes decrease the inequalities because taxes charged are more on rich as
compared to the poor.
• Effect of proportional taxes:
There won’t be any change in the level of inequalities.
b. Kinds of Tax:
• Indirect Taxes:
Effect of indirect taxes are more on the poor, hence increasing inequalities.
• Direct taxes:
Direct taxes are based on the principle of progression and hence reduce inequalities
4. Effect of taxation on Employment:
Taxes reduce income Decrease in purchasing power Fall in
Aggregate Demand Reduced employment levels.
5. Effect of Taxation and Inflation on the economy:
Inflation Tax reduces the purchasing power Low consumption and
low demand for goods and services
QUESTIONS FOR CLARIFICATION
1. The part of public finance which deals with the study of methods and causes of public
borrowings.
A) Public expenditure B) Public debt
C) Public revenue D) None of these
2. -------------------- is established by a government agency or business for the purpose of
reducing debt by repaying or purchasing outstanding loans and securities held against the entity.
A) Capital levy B) Surplus revenue
C) Sinking fund D) Annuities
3. According to Arthur Laffer, when rate of tax is 100%, the tax revenue will be
A) 0 B) 25% C) 50% D) 100%
4. VAT is imposed
A) Directly on consumers B) On final stage of production
C) On first stage of production D) On all stages between production and final sale
5. Which of the following has made recommendations in respect of centre-state
financial relation in India?
A) Sarkaria Commission B) Kelkar Commission
C) Rekhi Committee D) Chelliah Committee
Answers:-
1) B 2) C 3) A 4) D 5) B
PUBLIC DEBT
Why Public Debt
1. Public Debt is used to finance public expenditure when revenue is not enough.
2. Public Debt is also taken to create social overhead capital.
3. It can be beneficial in expanding the education and health services in an economy.
4. It is used to finance the development plans.
Internal Vs External Debt
Internal Debt: It means raising money from within the country. The effect of internal debt simply
leads to the redistribution of money within the economy. There is no extreme impact.
External Debt: It is to be paid back in foreign currency hence it is more harmful for the economy.
It is usually voluntary in nature.
Productive Vs Unproductive Debt
Productive Debt: The debt is taken for financing the productive motives and therefore it is self-
liquidating. According to Dalton, productive debts are those which are fully covered by assets of
equal or greater value.
Unproductive debt: The debt is unproductive in nature and are not necessarily self- liquidating.
Unproductive debt doesn’t lead to rise in growth rate in future. Therefore, it is more harmful for
the economy.
Short, Medium and Long term Debt
Short term Debt: It matures within 3 to 9 months. The rate of interest is low on such debt.
In India, the most common example of short term debt is the treasury bills (91 days, 182 days, 364
days).
Medium term Debt: Debt taken up to five years. They are usually taken from the market.
Long term Debt: Debt taken for ten or more years. Rate of interest is very high on long term
debt. These type of loans are usually taken to undertake developmental activities
Redeemable Vs Irredeemable Debt
Redeemable Debt: It is the debt which the government promises to pay off at some future pre-
decided date. Under this, interest and principle amount both are paid.
Irredeemable Debt: It is also known as “Perpetual Debt”. There is no pre-decided maturity date
for irredeemable debt. Under this regular interest payments are made but doesn’t guarantee
about the principle amount.
Effects of Public Debt
1. On consumption: The consumption is curtailed and hence has harmful consequences like
deterring growth of the economy, etc. It is because people buy securities from their personal
disposable income which reduces the consumption.
2. On Investment: Public debt leaves less finance for appropriate amount of investment activity
to take place. If the government borrows from the central bank of the economy, then the public
debt would not have any effect on the investment levels in the economy. However, if debt is
borrowed from individuals or investment houses, it reduces the investment
3. On distribution: Inequalities increase due to public debt. It leads to unjustified transfers and
government’s liquidity increases. For example, if public debt is taken for importing luxuries in the
economy (which poor cannot afford); it will only lead to rise in inequalities.
4. On Private Sector: If the government uses the public debt to purchase goods from the private
sector, it will lead to rise in demand and hence boost the economy.
Public Debt Management
Public Debt Management means managing the debt and repayment of loans in such a way that
such debt should not affect the economic situation of the country in an adverse manner.
Its principles are: 1. Cost of debt servicing should be minimum.
2. Bonds/securities should be on attractive terms.
3. Public debt servicing should be in sync with monetary and fiscal policy.
4. The debt should be repaid as soon as possible.
5. Period of maturity should be wisely chosen.
Remedies to Manage Public Debt in India
1. Reduction in primary deficit:
The reduction in primary debt should be done in two steps:
1. Slow down the growth rate of debt ratio.
2. Revenue generation should be increased so that the public debt should only be taken
for productive purposes.
2. Reduction in Growth of Current Expenditure:
R.J. Chelliah suggested the following changes in expenditure policy:
1. Reduction in expenditure on the government’s staff.
2. Reduction in subsidies.
3. Liquidation of public debt
4. Reduction in subsidy to public enterprises.
5. Reduction in government civilian employment.
FISCAL FEDERALISM
Fiscal Federalism implies the division of public sector functions and finances among different
layers or tiers of the government and no layer is completely sovereign.
One way of fiscal federalism is that all matters of regional nature should be given to the
regional/state government.
Fiscal federalism leads to better fiscal discipline and efficiency and avoids double taxation.
Principles of Federal Finance
1. Independence and Responsibility
2. Adequacy and Elasticity
3. Administrative Economy and Efficiency
4. Integration and Co-ordination
5. Accountability
Forms of Inter-Governmental transfers
1. Supplementary levies:
Principle levy by the Central authority and over and above that the state also levies a
supplementary tax.
2. Grants-in-aid:
Grants given from the centre to the states should be able to fill the gap between revenue and
expenditure of the states to reduce inter-state disparities and to bring about balanced
development.
On the basis of tax collection, there exist three Lists
1. Union List: Powers of Union government/ tax levied by the Centre.
2. State Lists: Powers of the state government/tax levied by the state.
3. Concurrent Lists: Powers with both Centre and states, that is, taxes which are levied by both
centre and states. For example, Education is a part of the concurrent list.
There are 12 items of taxation under the Union Lists, however revenue from these items do
not go to the Union alone.
Taxes under the Union list are divided into four categories:
1. Taxes levied and collected by the Union and the proceeds of which are retained by the
Union.
• Custom Duty
• Corporation Tax
• Tax on Capital value of assets except agricultural land
2. Taxes levied and collected by the Union and the proceeds of which are shared with the
states in a prescribed manner.
• Taxes on Income other than agricultural income.
• Duties on tobacco and other goods manufactured in India except liquor and narcotics.
• Excise duties
3. Taxes levied and collected by Union, the proceeds of which go wholly to states
• Terminal Tax, Taxes on railway freight
• Succession and Estate duty one property except agricultural land.
• Taxes on transactions and stock exchanges and futures market.
• Taxes on the sale and purchase of newspapers and advertisements therein.
4. Taxes levied by Union but collected and appropriated by States
• Stamp duty
• Excise duty on medical and toilet preparation (all items containing alcohol).
List I of the Seventh Schedule of the Constitution is the Union List which contains
following items.
1. Income tax, other than agricultural income.
2. Custom duties.
3. Excise duties except on liquor, alcohol, opium, narcotics.
4. Corporation tax
5. Taxes on Capital value of assets exclusive of agricultural land of individuals and
companies.
6. Terminal taxes on goods and passengers carried by railway, sea, air.
7. Estate duty on property except agricultural land.
8. Succession duty on property other than agricultural land.
9. Taxes other than stamp duties or transactions in stock and futures market.
10. Rates of stamp duty on financial documents.
11. Taxes on sale and purchase of newspapers and advertisements therein.
12. Taxes on sale and purchase of trade in the course of inter-state trade.
List II of the Seventh Schedule gives State Tax
1. Land Revenue
2. Taxes on agricultural income
3. Succession and Estate duty duties with respect to agricultural land
4. Taxes on entry of goods into a local area. 5. Taxes on land and buildings
6. Taxes on mineral rights
7. Excise duties on Alcoholic, liquor goods for human consumption, Opium, narcotics
8. Tax on consumption and sale of electricity
9. Tax on sale and purchase of goods other than newspapers
10. Tax on motor vehicles, animals and boats 11. Toll taxes
12. Taxes on luxuries including betting, etc. 13. Capitation fee
14. Tax on advertisement other than those in newspapers
15. Stamp duties except those on financial documents.
16. Taxes on goods and passengers carried by board or inland water ways.
17. Taxes on professions , trades, callings and employment.
Problems in fiscal federalism can be due to following reasons:
1. Horizontal Imbalance: When equals are not treated equally, it leads to horizontal imbalance.
2. Vertical Imbalance: When non-equals are treated equally, it leads to vertical imbalance.
Problems in Fiscal Federalism are as follows:
1. Over dependency of states on centre.
2. State’s taxes are not as buoyant and elastic as compared to the centre’s taxes.
3. Discrimination in giving grants-in-aid.
4. Centre can borrow unlimited amount from RBI unlike the states.
5. Appointment of Finance Commission members is biased towards the centre.
QUESTIONS FOR CLARIFICATIONS
1. If the supply of the commodity is perfectly inelastic and the demand is relatively elastic, the
burden of the tax will be -------------
A) Upon the buyer
B) Upon the seller
C) Equally divided between buyers and sellers
D) In higher proportion upon the sellers than upon the buyers.
2. The modern theory of tax shifting was advanced by
A) Mansfield and Canard B) Hobson and Stein
C) Mrs. Ursula Hicks and Prof Cannon D) E.R.A. Seligman and F.Y. Edgeworth
3. Penalties imposed by the courts for the failure of individuals to appear in courts to complete
contracts as stipulated.
A) Fees B) Escheats C) Fines D) None of these
4. Free riding means
A) There is incentive to pay for public goods because people can be excluded from consumption
B) There is no incentive to pay for public goods because people cannot be excluded from
consumption
C) There is incentive to pay for private goods because people can be excluded from consumption
D) There is no incentive to pay for private goods because people can be excluded from
consumption
5. Revenue which is derived by the State from eminent domain, penal power and taxing power.
A) Gratuitous Revenue B) Contractual Revenue
C) Compulsory Revenue D) None of these
Answers:-
1) B 2) D 3) D 4) B 5) C
DEFICIT FINANCING
Filling the gap (deliberately created) between public revenue and expenditure.
Objectives:-
1. Meeting financial needs at times of war.
2. Mobilisation of surplus, idle and unutilised resources.
3. Financing plans for economic development.
4. Instrument for economic policy for removing conditions of depression and increasing
output and employment.
PUMP PRIMING
• Used as a tool for fiscal policy.
• This means one-shot hike in public expenditure.
• Govt. will use this when economic activity in private sectors is slow.
The effect of Pump Priming is follows:
Public expenditure increases Increase in purchasing power Increase in earnings of different
sections of people Increase in consumption Increase in production
FISCAL POLICY
It is the policy of government regarding public revenue, public expenditure, etc...
Fiscal policy in any economy focuses on the following aspects:
1. Taxes
2. Expenditure
3. Borrowings
4. Management of Public Debt
Different Views on Fiscal Policies
Classicals
They believed in the principles of Fiscal Neutrality or Sound Finance or Balanced Budget.
Classicals Never advocated Fiscal policy.
They believed that the government is at its best when it’s activities are minimum, both in
terms of taxation (relative income distribution is not affected) and expenditure (spend least
possible amount).
According to them, balanced budget is a good indicator because they were against taxation
and expenditure.
They were of the view that borrowings should be restricted and they were more in favour of
productive expenditure.
The major drawback of the Classical view was that the balanced budget cannot have neutral
effects. It can either have contractionary or expansionary effects.
A.K. Hansen’s View:
The argued for reduction of government spending to a certain limit.
Taxes should leave the product and factor prices undisturbed.
P.A. Samuelson’s View:
Taxes should be on current consumption so that savings and investments are encouraged.
Balanced budget at low level of expenditure.
Public debt is evil and should be avoided.
Nation’s budget should be administered like private budget.
Tax systems should not cause distribution changes.
Keynes’ View on Fiscal Policy
Fiscal Policy should include:
• Progressive taxation because of redistribution effects.
• Increased public spending on purchase of goods and services, subsidies.
• Deficit financing
Compensatory Fiscal Policy
This kind of a policy was more associated to Great Depression of 1930s.
According to this theory, fiscal policy will compensate for the changes in economic
conditions, that is, inflation/deflation.
Functional Finance
The concept was given by A.P. Lerner, Keynes, Myrdal.
According to this view, the government has an important and a positive role towards the
economy.
The focus is on taxes without considering their revenue aspect, that is, to increase or decrease
the purchasing power with people.
FINANCE COMMISSION IN INDIA
Functions:
1. Distribution of Income tax and other taxes.
2. Percent of net proceeds of taxes which may be divided between the Union and States.
3. Distribution of Grants-in-aid among states, Grants-in-aid for tribal areas.
4. Special grants for any particular state.
Members: Chairman of the Finance Commission + four members
Article 280 of the Indian Constitution explains about the Finance Commission India
Finance Commission has been appointed for 5 years.
Main Purpose: Decides the share of taxes between Centre and States
14th Finance Commissioner: Y V Reddy (2015-20)
15th Finance Commissioner: N K Singh (2020-25)- Present
15th Finance Commission
The 15th Finance Commission (Chair: Mr N. K. Singh) was required to submit two
reports. The first report, consisting of recommendations for the financial year 2020-21, was
tabled in Parliament on February 1, 2020. The final report with recommendations for the
2021-26 period will be submitted by October 30, 2020.
Key Recommendations from First Report
1. Devolution of taxes to states: The share of states in the centre’s taxes is recommended to
be decreased from 42% during the 2015-20 period to 41% for 2020-21. The 1% decrease is
to provide for the newly formed union territories of Jammu and Kashmir, and Ladakh from the
resources of the central government.
2. Financing of security-related expenditure: The ToR of the Commission required it to
examine whether a separate funding mechanism for defence and internal security should be
set up and if so, how it can be operationalised. In this regard, the Commission intends to
constitute an expert group comprising representatives of the Ministries of Defence, Home
Affairs, and Finance.
3. Criteria for Devolution
4. Grants-in-aid
In 2020-21, the following grants will be provided to states: (i) revenue deficit grants, (ii) grants to
local bodies, and (iii) disaster management grants. The Commission has also proposed a
framework for sector-specific and performance-based grants. State-specific grants will be
provided in the final report.
5. Recommendations on fiscal roadmap
Fiscal deficit and debt levels: The Commission noted that recommending a credible fiscal
and debt trajectory roadmap remains problematic due to uncertainty around the economy. It
recommended that both central and state governments should focus on debt consolidation
and comply with the fiscal deficit and debt levels as per their respective Fiscal Responsibility
and Budget Management (FRBM) Acts.
Off-budget borrowings: The Commission observed that financing capital expenditure
through off-budget borrowings detracts from compliance with the FRBM Act. It
recommended that both the central and state governments should make full disclosure of
extra-budgetary borrowings.
Statutory framework for public financial management: The Commission recommended
forming an expert group to draft legislation to provide for a statutory framework for sound
public financial management system
Tax capacity: India’s tax capacity has largely remained unchanged since the early 1990s. In
contrast, tax revenue has been rising in other emerging markets. The Commission recommended:
(i) broadening the tax base, (ii) streamlining tax rates, (iii) and increasing capacity and expertise of
tax administration in all tiers of the government
GST implementation: The Commission highlighted some challenges with the implementation of
the Goods and Services Tax (GST). These include: (i) large shortfall in collections as compared to
original forecast, (ii) high volatility in collections, (iii) accumulation of large integrated GST credit,
(iv) glitches in invoice and input tax matching, and (v) delay in refunds.
FISCAL RESPONSIBILITY AND BUDGET MANAGEMENT (FRBM)
FRBM Bill was introduced in December, 2000 to set numerical targets for various fiscal
indicators.
Revised Bill was introduced in April 2003 and became an Act in August, 2003.
Objectives of FRBM Act are:
1) Reduction in fiscal deficit
2) Adopt prudent debt management
3) Generation of revenue surplus
The FRBM Act made it mandatory for the government to place the following along with the
Union Budget documents in Parliament annually:
1. Medium Term Fiscal Policy Statement
2. Macroeconomic Framework Statement
3. Fiscal Policy Strategy Statement
Several years have passed since the FRBM Act was enacted, but the Government of India has
not been able to achieve targets set under it. The Act has been amended several times.
In 2013, the government introduced a change and introduced the concept of effective
revenue deficit. This implies that effective revenue deficit would be equal to revenue deficit
minus grants to states for the creation of capital assets.
In 2016, a committee under N K Singh was set up to suggest changes to the Act. According
to the government, the targets set under FRBM Act previously were too rigid.
N K Singh Committee's recommendations were as follows:
Targets: The committee suggested using debt as the primary target for fiscal policy and
that the target must be achieved by 2023.
Fiscal Council: The committee proposed to create an autonomous Fiscal Council with a
chairperson and two members appointed by the Centre (not employees of the
government at the time of appointment)
Deviations: The committee suggested that the grounds for the government to deviate from
the FRBM Act targets should be clearly specified
Borrowings: According to the suggestions of the committee, the government must not
borrow from the RBI, except when...
- the Centre has to meet a temporary shortfall in receipts
- RBI subscribes to government securities to finance any deviations
- RBI purchases government securities from the secondary market
The rules were amended in 2018, and most recently to the setting of a target of 3.1% for
March 2023.
The NK Singh committee (set up in 2016) recommended that the government should target a
fiscal deficit of 3% of the GDP in years up to March 31, 2020 cut it to 2.8% in 2020-21 and
to 2.5% by 2023.
QUESTIONS FOR CLARIFICATION
1. If 'lump-sum' tax is imposed on a commodity, then -
(a) Complete shifting is possible. (b) partial shifting is possible.
(c) Shifting is not possible. (d) shifting is possible.
2. If the demand of income is inelastic
(a) the rate of tax be increased (b) rate of tax be reduced
(c) tax be not levied (d) tax be levied in small quantity
3. (A) Tax evasion is not illegal.
(R) The impact is borne by the person on whom it is Frist imposed.
(a) (A) and (R) both are correct and (R) is a explanation of(A)
(b) (A) and (R) both are correct but (R) did not explain (A)
(C) (A) is correct but (R) is false
(d) (R) is correct but (A) is false
4. Which one of the following is not the example of the attain the objective of redistribution of
income and wealth?
(a) Free medical aid to poor
(b) Subsidised food stuff
(c) provision of public toilets
(d) provision of money for private parks.
5. Efficiency requires that the production of pure public goods be undertaken to the point where?
(a) the sum of the marginal private benefits is exactly equal to the marginal social cost of
production.
(b) the marginal private benefits is exactly equal to the marginal social cost of production
(c) the marginal social cost exceeds the sum of the marginal private benefits
(d) None of the above
6. A ‘Transfer Income’ is an–
(a) Income which is not produced by any production process
(b) Income taken away from one person and given over to another
(c) Unearned income
(d) Earned income
7. Which one of the following canons of public expenditure is not given by Findley Shiras?
(a) canon of benefit (b) canon of surplus
(c) canon of elasticity (d) canon of economy
Answers:-
1) C 2) A 3) D 4) D 5) A 6) A 7) C
