UNIT – 1: FISCAL FUNCTIONS:

AN OVERVIEW, CENTRE AND STATE FINANCE

Introduction
The governments of all nations have important economic functions even where
markets constitute the basic resource allocation mechanism.
The primary goal of the state is to promote the general welfare of the society.
What governments do, or do not do, will obviously have an important impact on
the economic performance of an economy and the quality of life of its citizens.

As we know, Macroeconomics is the study of the economy as a whole.

There are three main macroeconomic goals for any nation:

1) The first is economic growth: If the real gross domestic product grows at a
faster rate than population, then people can enjoy higher standard of living.

2) The second goal is high levels of employment: This will ensure higher income
and higher output. When unemployment occurs, it harms not only the
unemployed, but the society as a whole because there is loss of output that
could have been produced

3) The third macroeconomic goal is stable price levels: Inflation reduces real
incomes and purchasing power of some people, and disproportionately affects
lower income families.
On the contrary, deflation signals a downturn in economic activity which may
cause recession or even depression and large scale unemployment. By ensuring
stable prices, an economy can avoid prolonged inflation and deflation and
achieve high levels of economic activity and employment.

The purpose of this lesson is to examine the economic functions of the govt. and
to understand why the government should invariably perform them.
 THE ROLE OF GOVERNMENT IN AN ECONOMIC SYSTEM

We shall first consider why an ‘economic system’ should be in place?

The basic economic problem of scarcity arises from the fact that wants are
unlimited and the resources available to any society are limited.
Consequently an economy cannot produce all economic goods and services that
its members desire to have.
Therefore, an economic system by which a society (households, businesses,
and government) makes decisions about allocating resources to produce
products and about distributing those products should exist to answer the basic
questions such as:
What, How and for Whom to produce and how much resources should be
set apart to ensure growth of productive capacity?

There are three alternative Economic systems:

1) Market or Capitalism
2) Government or Socialism
3) Mixed
Each with different degrees of state intervention in economic activities.
Adam Smith is often described as a bold advocate of free markets and minimal
governmental activity. However, Smith saw an important resource allocation role
for the government when he underlined the role of government in:
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7
National Defence Establishing a system of
to protect the nation Justice to provide
from external internal law and order
violence and invasion and to protect property.

Establishment and maintenance of highly beneficial public institutions and

public works such as roads, bridges, canals, harbours, and postal system that
profit-seeking individuals may not be able to efficiently build and operate.

Since the 1930s, more specifically, as a consequence of the great depression,

the state’s role in the economy has been distinctly gaining in importance, and
therefore, the traditional functions of the state have been supplemented with
what is referred to as economic functions (also called fiscal functions or public
-

finance function)

Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959),
introduced the three-branch taxonomy of the role of government in a market
economy. Musgrave believed that the functions of the government are to be
separated into three, namely,
(a) Resource allocation (to ensure efficiency),- Microeconomic functions
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(b) Income redistribution (to guarantee fairness), Microeconomic functions

(c) Macroeconmic stabilization (to ensure price stability) - Macroeconomic

The National budget, in general, reflects the economic policy of a government and the
government exercises its economic functions partly through the budget -
 THE ALLOCATION FUNCTION

Resource allocation refers to the way in which the available resources or

factors of production are allocated among the various uses to which they might
be put. It determines how much of the various kinds of goods and services will
actually be produced in an economy.
Resource allocation is a critical problem because the resources of a society are
limited in supply, whereas the wants of the members of the society are unlimited.
In addition, any given resource can have many alternative uses.

One of the most important functions of an economic system is the optimal or

efficient allocation of scarce resources so that the available resources are put to
their best use and no wastages are there. Economic efficiency indicates a
situation in which all resources are allocated to serve each person in the best way
possible, minimising waste and inefficiency.
↓ *

Private sector resource allocation State allocation

is characterized by market supply is accomplished through the revenue
and demand and price and expenditure activities of
mechanism as determined by governmental budgeting. In the real
consumer sovereignty and producer world, resource allocation is determined
profit motives by both market and the government.
↓
A market economy is subject to serious malfunctioning in several basic respects.
While private goods will be sufficiently provided by the market, public goods and
merit goods will not be produced in sufficient quantities by the market.
why do markets generate misallocation of resources?
What is Allocative efficiency?
Allocative efficiency is concerned with utilizing limited resources to produce
goods and services that would maximize value to the society. Allocative efficiency
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achieves the largest possible output of goods and services from the existing stock
of resources and technology.

Efficient allocation of available resources in an economy is assumed to take place

only when the markets are perfectly competitive and economic agents make
rational choices and decisions. In reality, markets are never perfectly competitive.
Market failures which hinder efficient allocation of resources occur mainly due to
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the following reasons:

1) Imperfect competition and presence of monopoly power in different degrees

leading to under-production and higher prices than would exist under conditions
of competition. Markets may fail to control the abuses of monopoly power.
2) Markets typically fail to provide collective public goods such as defence which
are, by their very nature, consumed in common by all people.
3) Incomplete markets; markets may fail to produce the right quantity merit
goods, such as education and healthcare
4) Common property resources (e.g. environment) are overused and exhausted in
individual pursuit of self-interest.
5) Externalities which arise when the production and consumption of a good or
service affect third parties (e.g. pollution).
6) Factor immobility which causes unemployment and inefficiency.
7) Imperfect information because it may not be in the interests of one party to
provide full information to the other party, and
8) Inequalities in the distribution of income and wealth
According to Musgrave, the state is the instrument by which the needs and
concerns of the citizens are fulfilled. Therefore, Public finance is connected with
economic mechanisms that should ideally lead to the effective and optimal
allocation of limited resources.

In the absence of appropriate government intervention,

market failures may occur and the resources are likely
to be misallocated with too much production of certain
goods or too little production of certain other goods.

The allocation responsibility of the governments involves suitable corrective

action when private markets fail to provide the right and desirable combination
of goods and services. Briefly put, market failures provide the rationale for
government’s allocative function.

Few of many examples of government intervention in resource allocation:

1) Government can provide us with goods and services that we cannot produce
on our own or buy at a price from the market. For example, the government
establishes property rights and makes the necessary arrangements for enforcing
contracts through provision of law enforcement and courts.
2) When externalities are involved in the production and consumption of goods
and services, prices do not reflect the true costs and benefits and government
intervenes with appropriate corrective measures.
3) Merit goods which are greatly beneficial to the society are by and large
provided by the government.

These interventions do not imply that markets are replaced by government action. In
its allocation role, the government acts as a complement rather than as a
substitute to the market system in an economy.
The resource allocation role of government’s policy focuses on the potential for
the government to improve economic performance through its expenditure and
tax policies. The allocative function in budgeting determines:

(a) who and what will be taxed

(b) how much and on what the government revenue will be spent
(c) the process by which the total resources of the economy are
divided among various uses
(d) the optimum mix of various social goods (both public goods and merit goods).
(e) the level of involvement of the public sector in the national economy
(f) the reallocation of society’s resources from private use to public use.

A variety of allocation instruments are available by which governments can

influence resource allocation in the economy. For example:

a) The government may directly produce an economic good (for example,

electricity and public transportation services)
b) The government may use the price mechanism (i.e altering the market prices
determined by demand and supply through taxes and subsidies) to influence
private allocation by policies that change the behaviour of consumers and
producers. In other words, the government may direct resource allocation
through incentives and disincentives (for example, tax concessions and subsidies
may be given for the production of goods that promote social welfare and higher
taxes may be imposed on goods such as cigarettes and alcohol so that their
prices are higher)
c) The government may influence allocation through legislation and force. For
example, ban of single use plastic goods.
d) The competition policies, merger policies etc. affect the structure of industry
and commerce (for example, the Competition Act in India promotes competition
and prevents anti-competitive activities)
e) Government’s ’ regulatory activities such as licensing, controls, minimum
wages, and directives on location of industry influence resource allocation.
f) government sets legal and administrative frameworks, and
h) governments may adopt any combination of possible remedies
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THE REDISTRIBUTION FUNCTION

Socialist ideology which emphasized equality created strong pressure on the

redistributive role of governments. The distribution responsibility of the
government arises from the fact that, left to the market, the distribution of
income and wealth among individuals in the society is likely to be skewed and
therefore, the government has to intervene to ensure a more socially optimal and
egalitarian distribution.

The distributive function of budget is related to the basic question of ‘for whom’
should an economy produce goods and services. Governments can redistribute
income and wealth either through the expenditure side or through the revenue
side of the budget
Expenditure
Revenue Governments may provide
Redistribution is done free or subsidised education,
through progressive healthcare, housing, food and
basic goods etc. to deserving
taxation
people
Effective demand is determined by the level of income of the households and
this, in turn determines the distribution of real output among people. Therefore,
the distribution function also relates to the manner in which the effective
demand over the economic goods is divided among the various individual and
family spending units of the society.

The distribution function of the government Aims at:

• Redistribution of income to achieve an equitable
distribution of societal output among households
ensuring increased overall social welfare.
• Advancing the well-being of those members of
the society who suffer from deprivations of different types
• Providing equality of income, wealth and opportunities
• Providing security (in terms of fulfillment of basic needs) for people who have
hardships, and ensuring that everyone enjoys a minimum standard of living

A few examples of the redistribution function (or market intervention for socio-
economic reasons) performed by governments are:

• Taxation policies of the government whereby progressive taxation of the rich is

combined with provision of subsidy to the poor households
• Proceeds from progressive taxes used for financing public services, especially
those that benefit low-income households (for example, supply of essential food
grains at highly subsidized prices to BPL households)
• Employment reservations and preferences to protect certain segments of the
population, minimum wages and minimum support prices for farmers for their
output
• Unemployment benefits and transfer payments to provide support to the
underprivileged, dependent, physically handicapped, the older citizens and the
unemployed.
• Families below the poverty line are provided with monetary aid and aid in kind
• Regulation of manufacture and sale of certain products to ensure the health
and well-being of consumers, and
• Special schemes for backward regions and for the vulnerable sections of the
population.

Conflict between Equity & Efficiency

Governments’ redistribution policies which interfere with producer choices or
consumer choices are likely to have efficiency costs or deadweight losses.
For example, greater equity can be achieved through high rates of taxes on the
rich; but high rates of taxes could also act as a disincentive to entrepreneurship
and work, and discourage people from making savings and investments and
taking risks. This in turn will have negative consequences for economic output,
productivity and growth of the economy. Consequently, the potential tax
revenue may be reduced in future and the scope for government’s welfare
activities would get seriously limited.

As such, an optimal budgetary policy towards any distributional change should

reconcile the conflicting goals of efficiency and equity by exercising an
appropriate trade-off between them. In other words, redistribution measures
should be accomplished with minimal efficiency costs by carefully balancing
equity and efficiency objectives.
 STABILIZATION FUNCTION

Macroeconomic stability is said to exist when:

• an economy's output matches its production capacity,
• the economy's total spending matches its total outputAs
AD
Equilibrium
• the economy's labour resources are fully employed, and
• Inflation is low and stable.

Rationale for STABILIZATION Function:

The theoretical rationale for the stabilization function of the government is
derived from the Keynesian proposition that a market economy does not
automatically generate full employment and price stability and therefore, the
governments should pursue deliberate stabilization policies.

The market mechanism is limited in its capacity to prevent or to resolve the

disruptions caused by the fluctuations in economic activity. The government and
the country’s central bank promote full employment and price stability through
prudent fiscal policy and monetary policy. -RBI
Govt

In the absence of appropriate corrective intervention by government, the

instabilities that occur in the economy in the form of recessions, inflation etc.
may be prolonged for longer periods causing enormous hardships to people,
especially the poorer sections of the society. It is also possible that a
situation of stagflation (a state of affairs in which inflation and unemployment
exist side by side) may set in and make the problem more complex.

The stabilization issue also becomes more complex due to ‘contagion effect’
whereby the increased international interdependence and financial integration
causes forces of instability to get easily transmitted from one country to other
countries.
 -
Demand Inflation
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Supply ↑

Expansion
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Contraction
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Inflation ·
Demand
Inflation
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Cost Pull Inflation-
Price
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Final
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Demand
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Unemployment
Demand
Int Rated
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Investment

Int Rate
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Money Supply Investment
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Expenditure Demand
: Taxes ↑
DemandHo
The stabilization function is concerned with the performance of the aggregate
economy in terms of:
• labour employment and capital utilization,
• overall output and income,
• general price levels,
• balance of international payments, and
• the rate of economic growth.

Government’s stabilization intervention may be through monetary policy as

well as fiscal policy.
Monetary policy : Controlling the size of money supply and interest rate
in the economy which in turn would affect consumption, investment and prices.
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Fiscal Policy : Attempts to direct the actions of individuals and organizations

by means of its expenditure and taxation decisions
Government expenditure injects more money into the economy and
↑

stimulates demand.
On the other hand, taxes reduce the disposable income of people and
therefore, reduce effective demand.

Expansionary fiscal policy: adopted to alleviate recession

During recession, in order to ensure income protection, the government
increases its expenditure or cuts down taxes or adopts a combination of both so
that aggregate demand is kept stable or even boosted up with more money put
into the hands of the people
and> Supply
Contractionary fiscal policy : resorted to for controlling high inflation.
To control high inflation the government cuts down its expenditure or raises
taxes.
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To Boost demand
Taxes Expenditured
 ▪

The nature of the budget (surplus or deficit) also has important implications on
a country’s economic activity. Expansion
.

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Deficit budgets ( Expenditure > Revenue) are expected to stimulate economic
activity Re > Exp - Contractionary
Surplus budgets tend to slow down economic activity.

There is often a conflict between the different goals and functions of

budgetary policy. Effective policy design to meet the diverse goals of
government is very difficult to conceive and to implement.
The challenge before any government is how to design its budgetary policy so
that the pursuit of one goal does not jeopardize the other.
* A
 ~

Centre & State Finance

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Fiscal federalism, a term introduced by Richard Musgrave, deals with the division
of governmental functions and financial relations among the different levels of
government.
Fundamentally, federalism is an institutional arrangement to accommodate two
sets of government — one at the national level and the other at the regional level.
Each government is autonomous in its own sphere.
Independently
As per Musgrave:
Economic Stabilization and Income Redistribution: Responsibility of Central govt
Allocation of resources : Responsibility of the state and local governments.

India is a federation of 28 states and 8 union territories.

An independent judiciary is established to resolve disputes between the central
government and the states on issues related to division of power.

The Constitution of India has provided for the division of powers between the
central and then state governments. Article 246 of the Constitution demarcates
the powers of the union and the state by classifying their powers into three lists:

a) Union list - contains items on which the union parliament alone can legislate
b) State list - items on which the state legislative assemblies alone can legislate
c) Concurrent list - on which both the parliament and the legislative assemblies
State
can legislate. UNION

In the event of conflicting legislation in concurrent list, the law passed by

the centre prevails.
Fundamental matter in a Federation - Allocation of revenue and expenditure
responsibilities to different levels of governments.
Sources of revenue for both the centre and states are clearly demarcated with
regard to the financial relationship and the responsibilities between them.

Taxes levied by Centre & State:

The central government has greater revenue raising powers.
The union government can levy taxes such as :
a) tax on income, other than agricultural income,
b) customs and export duties,
c) excise duties on certain goods, >
-
Terminal -

d) corporation tax, Wealth Tax TDX

e) tax on capital value of assets excluding agricultural land,
f) security transaction tax,
g) central GST,
h) union excise duty, taxes other than stamp duties etc.

The state governments can levy taxes on:

a) agricultural income,
b) lands and buildings,
c) mineral rights,
d) electricity,
e) vehicles,
f) tolls,
g) professions,
h) collect land revenue and
I) impose excise duties on certain items.
The property of the union is exempt from state taxation.
The property and income of the states are not liable to be taxed by the
centre.
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A significant element of fiscal federalism is inter-governmental transfers and

revenue-sharing to fulfill diverse national objectives. There is substantial
dependence of states on the union for securing necessary revenues.
Articles 268 to 281 of the constitution contain specific provisions in respect of
distribution of finances among states.

Distribution of revenue between the union and states is based on the

constitutional provisions as follows:

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Discutionary
Article 280 provides for an institutional mechanism, namely the Finance
Commission, to facilitate such transfers.

Finance Commission is a constitutionally mandated body that is at the centre of

-
fiscal federalism. It is responsible for evaluating the state of finances of the
union and state governments, recommending the sharing of taxes between them
and laying down the principles determining the distribution of these taxes
-

among states

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Vertical
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States
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28 state
Horizontal

Functions of Finance Commission:

(a) The distribution between the union and the states of the net proceeds of
taxes which are to be divided between them and the allocation between the
states of the respective shares of such proceeds.
(b) Determination of principles and quantum of grants-in-aid to states which are
in need of such assistance. Increase
(c) To make recommendations to the President on measures needed to augment
the consolidated fund of a state to supplement the resources of the panchayats
and municipalities in the state on the basis of the recommendations made by the
Finance Commission of the state. -

(d) Any other matter referred to the Commission by the President in the
interests of sound finance.

While recommending transfers, the Finance Commission considers issues related

to:
Vertical equity- deciding about the share of all states in the revenue collected by
centre and
Horizontal equity- allocation among states their share of central revenue.

The Finance Commission broadly assesses the overall gross tax revenues of the
union; cesses, surcharges and non-tax revenue are netted out from gross tax
revenue to arrive at the net divisible pool (NDP).
NET Divisible Pool : Gross Tax Revenue of Union - cess - surcharge - Non tax
revenue Finance
Considering the needs of the central and the state governments, the Commission
determines what percentage out of the net divisible pool should be assigned to
the state governments. The balance remains with the central government.

Grosstax
Revenue -
Cess -

Surcharge
-
Non Tax Revenue
Total
 The Fifteenth Finance Commission was constituted on 27, November 2017
The commission recommended the share of states in the central taxes (vertical
&

devolution) for the 2021-26 to be 41%, which is the same as that for 2020-21.
This is less than the-
=
42% share recommended by the 14th Finance Commission
for 2015-20. The adjustment of 1% is to provide for the newly formed union
territories of Jammu and Kashmir, and Ladakh from the resources of the centre.

The criteria for distribution of central taxes among states for 2021-26 period are
same as that for 2020-21. They are:

(a) Income Distance i.e the distance of a state’s income from the state with the
highest income.
(b) Area
(c) Population (2011)
(d) Demographic performance (to reward efforts made by states in controlling
their population)
(e) Forest and ecology:
(f) Tax and fiscal efforts:

A
60 =
 ▪
👉 📝

GST
The introduction of GST- on 1 July 2017
Significantly changed the state
-
>
of affairs of financial relations between the
centre and states.
-

The GST subsumes the majority of indirect taxes – excise, services tax, sales
tax, octroi (entry tax). The GST has made India’s indirect tax regime unitary in
nature.
Types of Taxes:
SGST - levied and collected by state
↓
~

-
Intra. state
CGST - levied and collected by centre Inter-state
IGST - administered and collected by central government.
-

Applied on inter-state movement of goods and services and on imports and

exports. IGST is simply a combination of SGST and CGST, kept in a separate
account, and distributed between the union and states after settlement of input ~

tax credit
-
and verification of the destination of the goods and services.

With many taxes subsumed under it, GST accounts for 35 per cent of the
gross tax revenue of the union and around 44 per cent of own tax revenue of the
states.

As per the supreme court verdict in May 2022, the Union and state legislatures
have “equal, simultaneous and unique powers “to make laws on Goods and
Services Tax (GST) and the recommendations of the GST Council are not binding
on them

States Slac

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 ▪

Specific Ren
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Concept of GST Cess:

The GST system replaced the then prevailing production-based taxation
system with a consumption based one.
Since the manufacturing states had apprehension about loss of revenue, it was
decided to provide compensation to states for loss of revenue arising on
account of implementation of the Goods and Services Tax for a period of five
years from the date of its implementation.
For providing compensation to states, a cess is levied on some luxury goods
and demerit goods and the proceeds are credited to the compensation fund.
GST compensation was extended beyond five years to enable states to tide
over the pandemic induced economic slowdown.
During the five-year transition period, the top five GST compensation-
receiving states were Maharashtra, Karnataka, Gujarat, Tamil Nadu, and Punjab.
The total amount of compensation released to the states and union territories
during the year 2022-23 is Rs. 1,15,662 crore

In so far as expenditure decentralization is concerned:

The Central Government is entrusted with the responsibilities of nationally
important areas like defence, foreign affairs, foreign trade and exchange
management, money and banking, cross-state transport and communication.
-

The State governments are entrusted with the responsibility of facilitating

agriculture and industry, providing social sector services such as health and
education, police protection, state roads and infrastructure.

The Local self governments such as municipalities and panchayats are

entrusted with the responsibility of providing public utility services such as water
supply and sanitation, local roads, electricity etc.
 ▪

Borrowings
Borrowing by the government of India and borrowing by states are defined under
Article 292 and 293 of Constitution of India.

Borrowing by Centre: The centre may borrow within the limits fixed by
parliament by law upon the security of the Consolidated Fund of India or give
guarantees within such limits, if any.

Borrowing by State: The state governments may borrow within the territory
of India upon the security of the Consolidated Fund of the State within such
limits, if any, as may from time to time be fixed by the Legislature of such state
by law, or give guarantees within such limits.

The centre may give loans to the states within limits fixed under article 292
and give guarantees in respect of loans raised by the states.

States need to obtain the centre’s consent in order to borrow in case the state
is indebted to the centre over a previous loan.