Public Finance

ARULMIGU PALANIANDAVAR ARTS COLLEGE FOR WOMEN,

PALANI
Pg department of economics

Learning resources

PUBLIC FINANCE

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CONTENTS PAGE NO.

UNIT I MEANING AND SCOPE OF PUBLIC FINANCE 3

UNIT II PUBLIC EXPENDITURE,PUBLIC REVENUE 13

AND FEDERAL FINANCE

UNIT III PUBLIC DEBT 43

UNIT IV TAX , SHIFTING AND INCIDANCE OF TAX 54

UNIT V BUDGET AND FISCAL POLICY 79

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UNIT I

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MEANING AND SCOPE OF PUBLIC FINANCE Public Finance
Public finance is a field of economics concerned with how a government raises
money, how that money is spent and the effects of these activities on the economy and
society. It studies how governments at all levels—national, state and local—provide the
public with desired services and how they secure the financial resources to pay for these
services.

Public finance deals with the finances of public bodies – national, State or Local
– for the performance of their functions. The performance of these functions leads to
expenditure. The expenditure is incurred from funds raised through taxes, fees, sale of goods
and services and loans. The different sources constitute the revenue of the public authorities.
Public finance studies the manner in which revenue is raised; the expenditure is incurred
upon different items etc. Thus, public finance deals with the income and expenditure of
public authorities and principles, problems and policies relating to these matters. We can
analyse some important definitions of public finance given by some leading authorities in
public finance.

Economists Publication Definition

For all States – whether crude or highly developed – some
Charles F. Public provisions of the kind are necessary and there for supply and
Bastable Finance – application of state resources constitute the subject matter of
1892 a study which is best
entitled in English as Public Finance
Principles of One of those subjects which lies on the border line between
Dalton Public Finance- Economics and Politics. It is concerned with the income and
1922 expenditure of public authorities and with the adjustment of
one to the other
Harold Groves ----- A field of enquiry that treats the income and
out goes of governments –federal, state, and local
PE. Taylor The Economics Public Finance is the fiscal science, its policies
of are fiscal policies, its problems are
public finance fiscal problems
Mrs. Ursula Public Finance The main content of Public Finance consists of the
Hicks examination and appraisal of the methods by which
governing bodies provide for the collective satisfaction of
wants and secure the necessary funds to carry out this
purpose
CS Shoup ----- The discipline of Public Finance describes and analyses the
government services, subsidies and welfare payments and
methods by which the expenditure to these ends are covered
through taxation, borrowing, foreign aid and creation of new
money.

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According to Professor Hugh Dalton,the term ‗Public authorities‘ refers to the

Government or State at all levels –National, State, and Local.

Harold Groves‘ definition outlines the types of governments whose finances are
studied in Public finance.

According to Taylor, public finance studies the manner in which the state through
its organ, the government, raises and spends the resources required. Public Finance is thus
concerned with the operation and policies of the fisc - The State treasury.

The definition of public Finance by [Link] Hicks highlights the satisfaction of

collective wants which in turn leads to the need to secure necessary resources.

The definition of CS Shoup enlarges the scope of Public Finance for modern
governments to include different types of expenditure and different sources of revenue.

All the definitions stated above illustrate the scope of Public Finance. From these
definitions, we can conclude that Public Finance is an enquiry into the facts, techniques,
principles, theories, rules and policies which shape, direct, influence and govern the use of
scarce resources, with alternative uses, of the government.

IMPORTANCE OF PUBLIC FINANCE

1) Provision of public goods: -For providing public goods like roads, military
services and street lights etc. public finance is needed. Business firms will have no
incentive to produce such goods, as they get no payment from private individuals.
2) Public finance enables governments to tackle or offset undesirable side effects of
a market economy. The side effects are called spill overs or externalities. For
example, pollution. The governments can introduce recycling programmes to
lessen pollution or they can make laws to restrict pollution or impose pollution
charges or taxes on activities that bring about pollution.

3) Public finance helps governments to redistribute income. To reduce the inequality

in the economy, the governments can impose taxes on the richer people and
provide goods and services for the needy ones.

4) Public finance provides many a programme for moderating the incomes of the rich
and the poor. Such programmes include social security, welfare and other social
programmes.

5) The acceptance of the principle of welfare state, the role of public finance has been
increasing. Modern governments are no more police states as the classical
economists viewed.

6) As the scope of state participation in the economic activity is widening, the

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scope of public finance has also been increasing. Generation of employment

opportunities, control of economic fluctuations like boom and depression,
maintaining economic stability etc. are some of the thrust areas of the governments
through fiscal operations.

SUBJECT MATTERS OF PUBLIC FINANCE (OR) SCOPE OF PUBLIC FINANCE

The subject matters of Public Finance can be broadly classified in to five categories
–a) Public revenue b) Public expenditure c) Public debt d) Financial administration e)
Economic stabilization and f) Federal Finance.

Public Revenue:
The income of the states is referred to as Public Revenue. In this branch, we study
the various ways of raising revenue by the public bodies. We also study the principles and
effects of taxation and how the burden of taxation is shared among the various classes of
society etc.

Public Expenditure

It deals with the principles and problems relating to the allocation of public
spending. We study the fundamental principles governing the flow of public funds in to
different channels, classification and justification of public expenditure; expenditure
policies of governments and the measures adopted for welfare state etc.
Public Debt
The governments borrow when its revenue falls short of its expenditure. Public
debts is a study of various principles and methods of raising debts and their economic
effects. It also deals with the methods of repayments and managements of public debts.

Financial Administration
It deals with the methods of Budget preparation, various types of Budgets, war
Finance, Development Finance etc. Thus, financial administration refers to the mechanism
by which the financial functions are carried on. In other words, financial administration
studies the organizing and disbursing of the finances of the State.

Economic stabilization and Growth

The use of Public revenue and Public expenditure to secure stability in levels of
prices by controlling inflationary as well as deflationary pressures is studied. Similarly the
income and expenditure policies adopted by the government so as to attain full
employment, optimum use of resources, equitable distribution of income etc. are also
studied.

Major Fiscal Functions

According to Professor Musgrave there are three major fiscal or budgetary functions
of the governments. They are a) Allocation functions b) Distribution functions and c)
Stabilization functions.
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The Allocation Function

There are certain cases in which the wants of all individuals cannot be satisfied
through market mechanism. In such cases the public sector or the governments have to
provide goods and services. The allocation branch of public finance deals with the
provision of social goods. Social goods are those goods and services produced to satisfy
collective wants. Collective wants are those wants which are demanded by all members of
the community in equal or more or less equal amounts. The allocation branch explains the
process by which the resources in use are divided between private goods and social goods
by which the mix of social good is chosen.
The Distribution Function
The very important feature of a market economy is the disparity in the distribution
of income and wealth. The distribution function of public finance deals with the adjustment
of the distribution of wealth and income to ensure ―fair or just‖ state of distribution. That is,
the distribution function of public finance deals with the determination of taxes and transfer
payments policies of the governments.
The Stabilization Function
The stabilization function explains the macroeconomic aspect of budgetary policy.
In other words, the stabilization function deals with the use of budgetary policy as a means
of maintaining high employment, a reasonable degree of price stability and an appropriate
rate of economic growth, with allowances for effects on trade and balance of payments. The
major instruments of stabilization policy are monetary policy and fiscal policy. This
function is otherwise known as compensatory finance.

FUNCTIONS OF PUBLIC AUTHORITY

A modern state performs a wide variety of functions. The following are some of the
important functions of a state.

1. Maintenance of internal peace and order:

It is the most important primary function of the State. The government had to
maintain a large police department to ensure internal peace in the country.

2. Defence :

Defence is also a primary function of the State. Every government must maintain a
large army to ensure defence of the country. In fact, it functions under a separate ministry.
(Ministry of Defence). Nearly 40 to 70 percent of our national income is spent on defence.

3. Justice:

Judiciary plays a very important role in the settlement of disputes between persons,
states and governments. It is one of the three major items of expenditure for a government.

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Judiciary is an independent body. It functions along with executive and legislature.

4. Regulation and control of economic enterprises:

Every government regulates and controls economic enterprises. Examples are

coinage, weights and measures, regulation of business practices, state ownership and
operation of certain enterprises.

5. Promotion of social welfare :

Promotion of social welfare is a very important activity of the State. It is important

for social and cultural advancement of the people.

EXAMPLE: Education, Social Relief, Social Insurance, Health Control, Family

Planning and other activities.

6. Conservation of Natural Resources:

Conservation of natural resources is an important activity of a State. Forests, mines,

rivers, seas etc., are some of the examples of natural resources. These resources have to be
preserved. Every state is spending a large share of its income for the conservation of natural
resources.

7. Promotion of State unity:

Every State must remain as a united one. Divisions and sub-divisions of a country
should be discouraged. A unified State is possible by having effective means of
transportation and communication. Therefore every state concentrates on the development of
the means of transportation and communication.

8. Administration:

Administration of a State is the most important and the most difficult activity of a
State. Government departments are established and government officers are appointed by the
State. They must be paid their salaries and allowances. Apart from this, expenses on
stationary and other items are incurred. This administration is largely responsible for internal
law and order and other establishing cordial foreign relations.

9. Financial system:

The management of finances of a State is also an important function of a State. The

Governments revenues and expenditures should be carefully planned by the government. An
unscrupulous government will face disastrous failures.

10. Religion:

Very occasionally certain governments perform religious functions also.

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FEDERAL FINANCE
Under federal finance we study the principles and policies governing the
distribution of functions and funds among the public authorities in a federal set up. In a
federal set up there are different levels of governments-centre, state and local.

PUBLIC FINANCE AND PRIVATE FINANCE

The understanding and the study of public finance is facilitated by a comparison of

the public or government finance with private or individual finance. Such a comparison
will help us to know how the aims and objectives and methods of public Finance operation
are similar or differed from the financial operations of the individual.

Similarities

1. Both the State as well as individual aim at the satisfaction of human wants through
their financial operations. The individuals spend their income to satisfy their personal
wants whereas the state spends for the satisfaction of communal or social wants.
2. Both the States and Individual at times have to depend on borrowing, when their
expenditures are greater than incomes
3. Both Public Finance and Private Finance have income and expenditure. The ultimate
aim of both is to balance their income and expenditure.

4. For both kinds of finances, the guiding principle is rationality. Rationality is in the
sense that maximization of personal benefits and social benefits through
corresponding expenditure.

5. Both are concerned with the problem of economic choice, that is, they try to satisfy
unlimited ends with scarce resources having alternative uses.

Dissimilarities

1. The private individual has to adjust his expenditure to his income. i.e., his
expenditure is being determined by his income. But on the other hand the
government first determines its expenditure and then the ways and means to raise the
necessary revenue to meet the expenditure.

2. The government has large sources of revenue than private individuals. Thus at the
time of financial difficulties the state can raise internal loans from its citizens as well
as external loans from foreign countries. In the case of private individual, all
borrowings are external in nature.

3. The state, when hard pressed, can resort to printing of currency, as an additional
source of revenue. In fact, during emergencies like war, it meets its increased
financial obligations by printing new currency. But an individual cannot raise income
by creating money.

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4. The state prepares its budget or estimates its income and expenditure annually. But
there is no such limitation for an individual. It may be for weekly, monthly, or
annually.

5. A surplus budget is always good for a private individual. But surplus budgets may
not be good for the government. It implies two things. a) The government is levying
more taxes on the people than is necessary and b) the government is not spending as
much as the welfare of the people as it should.

6. The individual and state also differ in their motives regarding expenditure. The
individuals hanker after profit. Their business operations are guided by private profit
motive. But the states expenditure is guided by the welfare motive.

7. The private individual spends his income on various items in such a manner as to
secure equi-marginal utilities from them. The government on the contrary does not
give as much importance to this law as a private individual does. Modern
government sometimes incur cretin types of expenditure from which there do not
derive any advantage but they do incur this expenditure to satisfy cretin sections of
the community.
8. Individuals always seek quick returns they save only a small amount for future and
spend more to satisfy their current needs. Individual tend to think more on present as
they are dead in the long run. Similarly they seldom spend if it does not yield any
money income. On the other hand, State has a long term perspective of its
expenditure. It does not care only for immediate benefit. State spends on projects
having long gestation period. The burden of taxation is borne by the present
generation in the interest of long run welfare of the community. Similarly sometimes
government may have to spend on schemes which may not yield any money income
at all (e.g. Public Health).

6. An individual‘s spending policy has very little impact on the society as a whole. But
the state can change the nature of an economy through its fiscal policies.

7. The pattern of expenditure in the case of private finance is often influence by

customs, habits social status etc. The pattern of government expenditures is guided
by the general economic policy followed by the government.

8. Private Finance is always a secret affair. Individual need not reveal their financial
transactions to anyone except for filing tax returns. But Public Finance is an open
affair. Government budget is widely discussed in the parliament and out sides. Public
accountability is an important feature of public finance.

9. Individuals can plan to postpone their private expenditure. But the state cannot afford
to put off vital expenditure like defence, famine relief etc. Findlay Shiraz says that
compulsory character is an important future of public finance.

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THE PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE

One of the important principles of public finance is the so – called Principle of
Maximum Social Advantage explained by Professor Hugh Dalton. Just like an individual
seeks to maximize his satisfaction or welfare by the use of his resources, the state ought to
maximize social advantage or benefit from the resources at its command.
The principles of maximum social advantage are applied to determine whether the
tax or the expenditure has proved to be of the optimum benefit. Hence, the principle is
called the principle of public finance. According to Dalton, ―This (Principle) lies at the very
root of public finance‖
He again says ―The best system of public finance is that which secures the
maximum social advantage from the operations which it conducts.‖ It may be also called
the principle of maximum social benefit. A.C. Pigou has called it the principle of maximum
aggregate welfare.
Public expenditure creates utility for those people on whom the amount is spent.
When the volume of expenditure is small with a slighter increase in it, the additional utility
is very high. As the total public expenditure goes on increasing in course of time, the law of
diminishing marginal utility operates. People derive less of satisfaction from additional unit
of public expenditure as the government spends more and more. That is, after a stage, every
increase in public expenditure creates less and less benefit for the people. Taxation, on the
other hand, imposes burden on the people. So, when the volume of taxation becomes high,
every further increase in taxation increases the burden of it more and more. People under go
greater scarifies for every additional unit of taxation. The best policy of the government is
to balance both sides of fiscal operations by comparing ―the burden of tax‖ and ―the
benefits of public expenditure‖. The State should balance the social burden of taxation and
social benefits of Public expenditure in order to have maximum social advantage.
Attainment of maximum social advantage requires that;

a) Both public expenditure and taxation should be carried out up to certain limits
and no more.
b) Public expenditure should be utilized among the various uses in an optimum
manner, and
c) The different sources of taxation should be so tapped that the aggregate scarifies
entailed is the minimum.
Assumptions of the Principle
 The public revenue consists of only taxes (and not of gifts, loans, fees etc.) and the
state has no surplus or deficit budgets.
 Public expenditure is subject to diminishing marginal social benefits and the
taxes are subject to increasing marginal cost or disutility.

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According to Dalton, maximum social advantage is at a point where the Marginal

Social Sacrifice (MSS) of taxation and Marginal Social Benefit (MSB) are equal. The point
of equality between MSS and MSB is referred to as the point of maximum social advantage
or least aggregate social sacrifice.
Musgrave calls Dalton‘s principle as ―Maximum Welfare Principle of Budget
Determination.‖ He puts that the optimum size of the budget is determined at point where
Net Social Benefit (NSB) of fiscal operations to the society becomes zero. The NSB is the
difference between MSB and MSS. (NSB=MSB-MSS). Musgrave presented Dalton‘s
principle of MSA with some slight differences.
Diagrammatic Representation

The curves MSS and MSB show the marginal social scarifies of taxation and
marginal social benefit of public expenditure respectively. MSS curve slopes up words
since taxation increases marginal social sacrifices. MSB curves slopes down wards showing
that public benefit goes on declining with every increase in public expenditure. The ideal
point of financial operations is where the governments collect OM taxation from the
society and uses it for public expenditure. At this point , MSS is exactly equal to MSB
(Point E) at OM 1 , MSS is M1 F1 which is less than MSB (M1 , E1) thus depicting a loss
of welfare to the society (E1 F1). Similarly, the government is collecting OM2 taxation to
finance larger public expenditure; The MSS is higher than MSB by E2 F2. So the ideal
level of taxation and expenditure is at OM. According to Dalton ―Public expenditure in
every direction, should be carried just so far that the advantage to the community of a
further small increase in any direction is just counter balanced by the disadvantage of a
corresponding increase in taxation or in receipts from any other source of public income.
This gives the ideal public expenditure and income‖.

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UNIT-II

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 PUBLIC EXPENDITURE Public Finance
MEANING

Public Expenditure is the expenditure of the public authorities. It is the expenditure

incurred by the government – central, state or local. It is generally incurred for the
satisfaction of collective needs of the citizens or for promoting the economic and social
welfare of the people. The advantages of public expenditure were not fully appreciated by
the traditional economists. They considered market mechanism as a better method whereby
the working of the economy could be guided and the allocation of the resources could be
decided.

PRIVATE AND PUBLIC EXPENDITURE

Private finance starts with a given income as the frame work within which
expenditure must be planned. But Public finance starts with a given expenditure plan and the
public authorities must adjust their income to match their expenditure.

Similarities :

Following are the similarities between private expenditure and public expenditure.

1. Neither private units nor public authorities would like to waste their expenditure
without any corresponding revenue.

2. Both try to achieve their objectives with minimum possible expenditure.

3. There is an element of flexibility in both private expenditure and public expenditure.

4. Both take a collective view of income, expenditure and the possibilities of

adjustments in each. An individual will consider the possibilities of shifting his total
time between an effort to earn and leisure. But a public authority will consider the
cost of earning more and spending more.

5. Both individual units and public authorities have more than one way of raising
additional income.

6. There are problems of overall efficient and integrated management of finances in

both private and public expenditures.

7. There are different levels at which solutions will be found in both private and public
expenditures.

Thus, private expenditure and public expenditure are similar to each other in their
overall and complex ramifications.

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Dissimilarities :

Following are the differences between private expenditure and public expenditure.

1. The private expenditure is determined by income of the individual whereas the

public expenditure determines the income of the public authority.

2. The private expenditure is optional whereas the public expenditure is compulsory.

3. An individual, while spending money, aims at striking a profit – oriented budget

whereas the public authority does not aim at this.

4. An individual, while spending money, calculates the amount of benefit accruing to

him due to that expenditure. But a public authority does not make any such
calculation.

5. An individual calculates short - run benefits out of his expenditure whereas a public
authority calculates only the long - run benefits out of its expenditure.

CLASSIFICATION OF PUBLIC EXPENDITURE

Meaning:

Classification of public expenditure refers to a systematic and orderly arrangement of

various kinds of public expenditure on the basis of some scientific or economic
consideration.

Need for classification:

Classification of public expenditure is important for the following reasons.

(i) To study the nature and effects of each kind of public expenditure

(ii) To compare the effects of one public expenditure with that of another

(iii) To study the relative importance of public expenditure under different heads

(iv) To examine and evaluate the effects and efficacy of the various matters in
which the funds have been allocated and

(v) To determine the most appropriate expenditure policy of the government.

VARIOUS CLASSIFICATIONS

Different economists have given different classifications of public expenditure on the

basis of different scientific or economic considerations. There are numerous classifications.
The following are some of them.
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1. Accounting classification:

Accounting classification is perhaps the oldest classification. It is through this

classification that the executive maintains the effective control and check over public
expenditure and possible leakages and wastages, divisions and misappropriations. This
classification may be made on the basis of either departments or heads of expenditure.

This classification is good for auditing purposes and also safeguarding against
misappropriations.

2. Classifications on the basis of benefits conferred on the public:

German writer Cohn and American writer Plehn have classified public expenditure
on the basis of benefits conferred on the public.

(i) Public expenditure that confers a special benefit to certain individuals: eg, poor
relief, rehabilitation of refugees, etc.

(ii) Public expenditure that confers a common benefit on the entire community ; eg,
defence, general administration education, etc.

(iii) Public expenditure that confers a special benefit on certain individuals and at the
same time a common benefit on the rest or the community; eg administration of
justice.

(iv) Public expenditure that confers a special benefit on particular groups; eg, subsidy
granted to particular industries.

This classification is over lapping. All expenditure is incurred in the interest of the
public as a whole. Hence this is not a good and representative classification.

3. Nicholson‟s Classification:

F. S. Nicholson has classified public expenditure on the basis of amount of revenue

obtained by the state in return for the services which it rendered.

i) Expenditure without direct return of revenue of revenue ; eg poor relief, war

expenditure, etc.,

ii) Expenditure without direct return, but with indirect benefit to revenue; eg.
Education.

iii) Expenditure with partial direct return on revenue; eg. Education, for which fees
are charged, subsidised railway services, etc.

iv) Expenditure with full return of revenue or profit eg. Post and telegraphs, gas
services, industries, etc.,

This classification is also overlapping. Hence this is not a good and representative
classification.

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4. Adam Smith‟s Classification:

Adam Smith, in his ―Wealth of Nations‖ in which he includes a memorable chapter

on ―The Expenses of the Sovereign or Commonwealth‖ divides the duties of a government
into three – (a) defending the society from the violence and injustice of other independent
societies (b) securing internal justice between citizens and (c) erecting and maintaining
public institution and works.

Based on this classified of functions of a public authority, he classifies public

expenditure into the following three categories.

i) Protective functions – defence, police, courts, etc.,

ii) Commercial functions – bounties, industrial exhibitions, etc.,

iii) Development functions – education, roads, rivers, irrigations, recreation,

collection of statistics etc.,

5. Hick‟s Classification:

Following Adam Smith, Mrs. Ursula K . Hicks has also adopted a detailed
classification of public expenditure. She classifies public expenditure into the following four
categories.

(i) Defence expenditure eg. –capital equipment, factories, payment of wages and
pensions for army personnel etc.,

(ii) Civil or administrative expenditure – eg. Police, law and order, courts and
justice etc.,

(iii) Expenditure for economic ends – eg. Provision of subsidies and benefit to
industries.

(iv) Expenditure for social ends – eg. education, public health, social insurance
schemes etc.,

6. Rocher‟s Classification:

Rocher‟s has classified public expenditure into three categories - necessary, useful
and superfluous or ornamental. Necessary expenditure is that expenditure which the state
has necessarily to incur and which cannot be delayed or postponed. Useful expenditure
which the state has to incur, but which can be delayed or postponed. Superfluous or
ornamental expenditure which the state may or may not incur.

This classification has many overlaps. A necessary expenditure is useful and an

unnecessary expenditure is also useful.

It is wrong to assume that the state has to incur superfluous expenditure in it.
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7. Shirra‟s classification:

According to Prof. G. Findlay Shirras, a public authority performs two types of

functions - primary and second function, and hence, the expenditure of the public authority is
of two kinds – primary expenditure and secondary expenditure.

Primary functions are those functions which are performed by the government.
These functions are intended for uplifting the standard of living of the people and protecting
the people from foreign aggression. The primary functions are generally grouped under four
main heads – (i) defence, (ii) law and order, (iii) civil administration and (iv) debt services,

Secondary functions are those functions which are performed by the government.
These functions are performed by the public authority for providing social welfare measures
and other things. These functions are intended to raise the socio – economic welfare of the
people. The secondary functions are grouped under many heads. (i) social services, (ii)
education, (iii) public health, (iv) poor relief, (v) unemployment insurance,
(vi) famine relief and (vii) other services.

8. Mehta‟s classification:

According to Prof. J.K. Mehta, public expenditure is of two kinds–constant

expenditure and variable expenditure

―Constant expenditure is that the amount of which does not depend upon the extent
of the use by the people in whose interest it is incurred, make of the services that are
furnished by it.‖ Eg. Defence expenditure, street lights, lights poles at aerodromes, etc.,

―Variable expenditure likewise is that which increase with every increase in the use
of public services by this people for whose benefit it is incurred.‖ Eg, postal services,
railway services, education, etc.,

9. Economic classification:

Public expenditure may also be classified into two kinds-revenue expenditure and
capital expenditure. This classification is known as economic classification. This was
introduced in India since 1957-58.

10. Classification on the basis of productivity of public expenditure:

Public expenditure is classified into productive and unproductive expenditure. This

classification is made on the basis of productivity of public expenditure. Productivity
expenditure includes all kinds of investment expenditure and expenditure on education,
public health and social welfare schemes. Unproductive expenditure includes all kinds of
consumption expenditure and expenditure on wars.

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Public expenditure may also by classified into two categories –(a) Public expenditure
intended to preserve the country against external aggression and internal chaos and (b)
public expenditure intended to improve the quality of the social welfare of the community.
This classification is not a very important one.

EFFECTS OF PUBLIC EXPENDITURE

Introduction:

For a long time it was thought that public expenditure was a waste. Adam Smith and
his followers held that money in the hands of the public should be more useful than in those
of the state. But modern economists have developed the idea that public expenditure should
be used, as a deliberate investment to influence the level of economic activity. The effects of
public expenditure can be discussed under two heads namely,

a. Effects on Production.

b. Effects on Distribution.

a. EFFECTS OF PUBLIC EXPENDITURE ON PRODUCTION :

The expenditure on development is meant to promote production and employment in

the country. The enormous expansion in expenditure has been to increase the demand for
goods and services and thus to boost production.

Prof. Dalton has discussed three important effects of public expenditure on

production, viz

i. Efficiency Effect.

ii. Incentive Effect.

iii. Allocative Effect.

i. Efficiency Effect :

Public Expenditure can increase the ability of the people to work, save and invest. If
public expenditure increase the efficiency of the people to work will promote production and
national income. Public expenditure incurred on subsidised food, cheap housing facilities,
free education can be of great help in improving the physical and mental improvement of the
people. These public goods and services may be provided to those in the poor areas. General
education improves the general abilities of the people and technical education improves the
technical efficiency of the people. Thus public expenditure can promote ability to work ,save
and invest and promote production, employment and national income.

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ii. Incentive Effect :

Public expenditure can promote the incentive to work, save and invest. Some public
expenditure promote the desire to work and save. For example, old age pension,
unemployment allowances, provident fund, etc., have adverse effects on the precautionary
motive of the people to work and save. On the other hand bonus in government enterprises,
incentives in factories, developmental projects, etc., can increase the incentive effect of the
people.

iii. Allocative Effects :

Public expenditure helps production through the allocation of resources. Allocation

of resources is made between different uses and regions.

 Public expenditure causes diversion of economic resources from one use to another.
For example, the resources from private use to public use can be generated.

 Public expenditure can increase the productive power of the community. Public
expenditure can create economic overheads like roads, railways, irrigation projects,
etc.,

 Public expenditure can exploit the utilised and unutilised resources. In that way, a
country can invest on a large number of key and basic industries like iron and steel,
chemicals and fertilisers. The resources can be transferred from less productive use
to more productive use. The long term efficiency of the people depends upon the
desirable infrastructure facilities.

 Public expenditure promotes the future needs of the society. A better allocation of
resources between the present and future can be made through public expenditure.

Finally public expenditure can divert the resources between the different regions in
such a way that the country is able to achieve the balanced regional development. The
regional imbalances can be very much reduced.

b. EFFECTS OF PUBLIC EXPENDITURE ON DISTRIBUTION

A modern state is interested in reducing the inequalities of income and wealth. Public
expenditure can be used as an important instrument for reducing the inequalities. According
to Dalton, ―That system of public expenditure is the best which has the strongest tendency to
reduce the inequality of income.‖ Public expenditure can supply social goods and services
free or below cost and hence affect the distribution of income in a socially desirable way.
Social security measures like free medical aid, free education, unemployment allowance to
the poor, etc., will obviously benefit the poor than the rich and bring about changes in
distribution of income and wealth.
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Expenditure on roads, electrification, water supply, police, defence and courts do not
affect the distribution of income and wealth.

According to Dalton, public expenditure can be classified into three types as follows:

(i) Regressive Expenditure :

Under this type the benefits from public expenditure will go to the upper income
groups rather than the lower income groups. The government increases inequalities. For
example, interest on public debt or subsidy on private saving is regressive in nature.

(ii) Proportional Expenditure :

In this form of expenditure, neither the inequalities increase nor decrease. Everybody
is proportionately benefited according to the income. For example, a fixed house rent
allowance of 10% of the salary to all the government servants is an example of proportional
expenditure.

(iii) Progressive Expenditure :

Expenditure is progressive when the proportional addition is made by the

government grant is larger. For example, the houses built for low income group are an
example for progressive expenditure. In this category free education, subsidised housing,
free medical care, fair price shop are provided for the public.

The present day policy of the government is to increase development expenditure

and reduce non – development expenditure.

CAUSES FOR THE GROWTH OF PUBLIC EXPENDITURE

One of the most important features of the present century is the phenomenal growth
of public expenditure. Some of the main causes of public expenditure growth are:
1. Income Elasticity and Increase in Per Capita Income 2. Welfare State Ideology and
Wagner‘s Law 3. Effects of War and the Need for Defence 4. Resource Mobilizations and
Ability to Finance 5. Inflation 6. The Role of Democracy and Socialism 7. The Urbanisation
Effect 8. The Rural Development Effect 9. The Population Effect 10. The Growth of
Transport and Communication 11. The Planning Effect.

1. Income Elasticity and Increase in Per Capita Income:

According to Musgrave, a rising share of public expenditure in national income is

associated with a rise in per capita income. Thus, an increase in per capita income over a
period of time may cause a relative rise in public expenditure. This is because the demand for
public goods tends to expand with the rise in per capita income. Usually, it rises faster

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than the latter. Hence, the income elasticity of public expenditure (IEPE) for the U.S.A. was
4.8 for the period 1890-1963 and 4.5 for the U.K. in 1890-1955.

2. Welfare State :

The modern State is a welfare state. It aims at promoting the economic, political, and
social well-being of its citizens. It makes every effort to improve the living standard of the
common people. For this purpose, it has to undertake several functions and services never
visualized before.

The 19th century state was a „police state‟ while, in 20th and 21st centuries modern
state is a „welfare state‟. Even in a capitalist framework, socialistic principles are not
altogether discarded. Since socialistic principles are respected here, modern governments
have come out openly for socio-economic uplift of the masses.

Various socio-economic programmes are undertaken to promote people‘s welfare.

Modern governments spend huge money for the purpose of economic development. It plays
an active role in the production of goods and services. Such investment is financed by the
government.

Besides development activities, welfare activities have grown tremendously. It spends

money for providing various social security benefits. Social sectors like health, education,
etc., receive a special treatment under the government investment. It builds up not only social
infrastructure but also economic infrastructure in the form of transport, electricity, etc.

Provision of all these require huge finance. Since a heavy sum is required for
financing these activities, modern governments are the only providers of money. However,
various welfare activities of the government are largely shaped and influenced by the political
leaders (Ministers, MPs, and MLAs to have a political mileage, as well as by the bureaucrats
(MPLAD).

3. Effects of War and the Need for Defence:

The tremendous growth in public expenditure may also be attributed to wars and
threats of war in modern times. In the Second World War, countries like England incurred
heavy war expenditures, amounting to £ 15 million per day. Wars and threats of war and the
consequent defence needs compel governments to spend more and more on the production of
war goods.

Due to the invention of nuclear weapons, there is always the danger of foreign
aggression. International political situation is uncertain and insecure. Modern States are
already facing a cold war. As such, every nation has to prepare itself for strong defence.

The defence expenditure is thus continuously rising. It contains expenditure on war

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materials, maintenance and growth of armed forces, naval and air wings, expenses on the
development of military art and practice, pensions to retired war personnel, interests on war
debt, cost of rehabilitation, etc.

4. Resource Mobilisation and Ability to Finance:

When the government innovates more and more methods of taxation and resource
mobilisation, its ability to finance public expenditure increases and the size of public
expenditure grows. Public sector outlays could be increased by more taxation yields, public
debt, foreign aid and deficit financing.

5. Inflation:

With the rising prices, the government has to keep on increasing public expenditure to
carry out its functions and maintain the supply of public goods whole. During inflation, the
government has to pay additional Dearness Allowance (DA) to its employees which
obviously call for an extra burden on public expenditure.

6. The Role of Democracy and Socialism:

The recent growth of democracy and socialism everywhere in the world has caused public
expenditure to increase very much. A democratic structure of government is inevitably more
expensive than a totalitarian government. In India, democracy has certainly become a costly
affair. Expenditure on elections and bye-elections is increasing.

The number of ministries and executive offices has also been increasing. Further, the
ruling party has to fulfill its promises and launch upon new policies and programmes to
achieve socialist objectives, in order to create a favourable image in the public. This also
requires increasing State expenses in order to provide new amenities and opportunities to the
people at large.

7. The Urbanisation Effect:

The spread of urbanisation is an important factor leading to the relative growth of

public expenditure in modern times. With the growth of urban areas, there has been an
increasing tendency of expenditure on civil administration.

Expenses on water supply, electricity, provision of transport, maintenance of roads,

schools and colleges, traffic controls, public health, parks and libraries, playgrounds, etc.
have increased enormously these days. Likewise, the expenditure on courts, prisons etc. is
increasing, especially in the urban sector.

8. The Rural Development Effect:

In an underdeveloped country, the government has also to spend more and more for
rural development. It has to undertake schemes like community development projects and
other social measures.
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9. The Population Effect:

A high growth of population naturally calls for increase in the expenses as all State
functions are to be performed more extensively. Rising population also poses various
problems in poor countries.

The State will have the added responsibility of solving such problems as food,
unemployment, housing and sanitation. Further, overpopulated countries like India will have
to check the population growth. The State has, therefore, to spend more and more on family
planning campaigns every year.

10. The Growth of Transport and Communication:

With the expansion of trade and commerce, the State has to provide and maintain a
quick and efficient transport system. Transport being a public utility, the State has to provide
it cheaply also. Hence, railway and passenger transport is nationalized.

Government has, therefore, to run transport services even at a loss. This obviously
calls for a high expenditure for maintenance and expansion. Further, the government in a poor
country has to spend a lot on constructing new railway lines, new roads, national highways,
bridges and even canals to connect the different areas with a smooth transport system as a
precondition of growth.

11. The Planning Effect:

In a less developed economy, the government adopts economic planning for the
development of the country. In a planned economy, thus, when the public sector is expanding
its role, public expenditure obviously shows an increasing trend.

12. Rise in price level:

Rises in prices have considerably enhanced public expenditure in recent years. Higher
prices mean higher spending on the part of the govt. on items like payment of salaries,
purchase of goods and services and so on.

13. Expansion public sector:

Counties aiming at socialistic pattern of society have to give more importance to public
sector. Consequent development of public sector enhances public expenditure.

14. Public debt:

Along with debt rises the problem like payment of interest and repayment of the
principal amount. This results in an increase in public expenditure.

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15. Grants and loans to state governments and UTs:

It is an important feature of public expenditure of the central government of India.

The government provides assistance in the forms of grants-in-aid and loans to the states and
to the UTs.

16. Poverty alleviation programs:

As poverty ratio is high, huge amount of expenditure is required for implementing

alleviation programmes.

CONTROL OF PUBLIC EXPENDITURE IN INDIA

Public expenditure refers to the expenditure of the government. Therefore it cannot

go without any check. It has to be controlled because of the involvement of public money.
There are three important methods of financial control in India.

I. Administrative Control:

The internal control is exercised by Financial Ministry. The Finance Ministry,

exercises control through control of estimates, power of sanctioning expenditure and internal
audit.

After the budget is passed by the Parliament, the Finance Ministry distributes the
grants to the spending departments. There are financial rules which have to be strictly
followed.

II. Audit Control:

It is the purpose of auditing to check irregularities of expenditure and accounting.

For these, it is essential that the auditing authority should be independent of all the
authorities. The Comptroller and Auditor General looks into the audits of all the
Government accounts in the country. He audits the accounts of the State Governments also.

An independent audit is necessary for protecting the state against misappropriation of

funds. The audit must be truly independent to discharge its functions efficiently and
effectively. In India, the independence of audit is complete and fully guaranteed through the
constitution. The Comptroller and Audit General is discharging his duties as the guardian of
public funds.

DUTIES AND POWERS OF AUDITOR GENERAL

 He audits and reports on all expenditure from the revenues of the Central and
State Governments.

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 He audits and reports all transactions of the Central and States relating Finance
to debt,
deposits, sinking funds, advances, etc.,

 He is responsible for keeping accounts for the centre except those relating to
defence and railways.

 He prepares each year‘s accounts showing the annual receipts and

disbursements.

III. Parliamentary Control:

The Parliament has a right to look into the expenditure. There are three important
Committees in the Parliament.

a. Committee of Public Undertakings:

It consists of 15 members from the Lok Sabha and from the Rajya Sabha. The
speaker of the Lok Sabha nominates the Chairman of the committee from among the
members of the Lok Sabha.

The Committee evaluates the performance of public undertakings in all aspects. The
management finance and the progress of the public undertakings are examined by this body.
Later on it will submit a report to the government.

b. Public Accounts Committee :

This Committee is constituted by Parliament for the purpose of scrutinising the

report of the Comptroller and Auditor General. This committee consists of more than 20
elected members of the house. The chairman of the committee is appointed by the Speaker.
This Committee is above party politics. It examines the content of public expenditure in the
past. It can summon the representations of the various departments and also the officers for
any misappropriation.

c. Estimates Committee :

This Committee consists of 30 members including a Chairman appointed by the

speaker. The Finance Minister is not the member of the committee. The Following are the
important functions of the committee.

 To report the economic improvements in organizations and administrative reforms

which are necessary.

 To suggest alternative policies in order to bring about Efficiency and economy in

administration.

 Examines whether money is allotted within the limits of the policies.

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 To suggest the form in which the estimates shall be presented to the Parliament.

Conclusion :

Thus Public expenditure is not left to the free hand. Since public expenditure is made
from public revenue, all efforts are made in all the countries to have a watch over public
expenditure. In a parliamentary democracy like India, the legislature is supreme and the
legislature in India has full control over public expenditure. Parliament is the true custodian
of the public funds.

PUBLIC REVENUE
Public Revenue refers to the revenue of a public authority – Central, State and Local
Governments.

The term „Public revenue‟ may be defined both in a narrow and a broad sense.

In the narrow sense of the term, it includes income from taxes, prices of goods and
services supplied by public enterprises, revenues from administrative activities such as fees,
fines, etc., and gifts and grants. The incomes from the above sources are described as public
revenue. In the narrow sense, it includes only those receipts which increase the assets of the
public authorities without increasing its liability.

In the broad sense of the term, it includes all „incomings‟. It includes, besides public
revenue, many other sources of income like public borrowings, issue of paper money, etc.
Thus, the term, in its broad sense, includes all kinds of incomes. It is generally described as
―public receipt‖. Thus,

Public Revenue = Taxes + Income from sale of public assets + Administrative revenues
+ Gifts and grants.

Public Receipt= Public Revenue + Public Borrowing + Repayment of loan + Issue of

paper currency.

Public Revenue constitutes an important branch of Public Finance.

SOURCES OF PUBLIC REVENUE

The various sources of public income may be grouped into four categories – tax
revenues, commercial revenues, administrative revenues and grants and gift.

1. Taxes

Meaning and Definition :

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Taxes form the most important part of the revenues of any State.―A tax is a compulsory
contribution of wealth of person or body of persons for the services of public powers‖ (Bastable).

―Taxes are compulsory contributions to public authorities to meet the general expenses
of Government which have been incurred for public good and without reference to special
benefits‖ (Findlay Shirras).

Characteristics of a Tax :

A tax possesses the following three important characteristics.

 A tax is a compulsory contribution from the citizen to the public authority. Refusal on
the part of the tax payer to a particular tax to the public authority is liable for punishment by
the court of law.

 A tax imposes a personal obligation on the tax payer. The tax payer has the obligation
to show of all his incomes to the government and pay the eligible amount of tax to the
government. He should not hide the particulars of his income and evade payment of tax.

 The tax revenues are spent for the general and common benefit.

2. Fees

A fee is a charge imposed on the occasion of a special service, the service incidentally
in connection with some comprehensive function, according to [Link].

Prof. Seligman defines a fee as a ―payment to defray the cost of each recurring service
undertaken by the government, primarily in the public interest but conferring a measurable
special advantage on the fee payer.

In simple terms, it is a charge made by the State for a service which is for the general
good but which also confers a special benefit to the fee payer.

Examples :-

 Court Fees,

 Registration fees for legal documents, Gun license fees,

 Contract fees for marriages, mortgages deeds, etc., Fees paid into the postal dept,

 Copy right of books, Issue of passports,

 State inspection of weights and measure, etc.,

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3. Licenses

Sometimes, licenses are granted to individuals to do something. As a matter of fact,

there is very little difference between a fee and a license. Very often, a license is included
under the head of ―fees‖.

4. Fines and Forfeitures

Fines and forfeitures are more or less similar to each other. Fines are penalties levied
for the breach of rules and regulations laid down by the government. They are meant to
deter people from doing something forbidden by law. Forfeitures are penalties imposed on
people for failing to fulfill certain duties. Failures to appear before courts, to complete
contracts as stipulated etc., are examples of forfeitures.

5. Escheats

When owners of estates expire without legal heir or will, those estates will belong to
the Government. The values of these estates are known as escheats.

6. Special Assessments

A special assessment is a levy to defray the cost of a particular improvement, and is

theoretically in proportion to but never excess of, the resulting benefit accruing to the
property against which it is levied, according to Prof. Shultz. In simple terms, when the
value of the property of people living in an area may rise as a result of some project or
improvement undertaken by the Government, like undertaking of an irrigation project or
construction of roads, is quite reasonable that the cost of such project is distributed in part or
in whole among the property owners. These special assessments are usually levied by the
local authorities, but Central and State Governments also make use of them.

Professor Seligman points out that the special assessment has certain characteristics.

 There is an element of special purpose.

 The special benefit to the individuals is measurable.

 These assessments are not progressive, but proportional to the benefits

conferred.

 They are only for special improvements.

 They are to defray the cost of specific project concerned.

 They represent the exercise of the taxing power.

 They are a compulsory payment.

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 They are capable of apportionment.

7. Receipts from public property

Income from the sale or lease of public property like lands, buildings, mines, forests,
etc., constitutes one of the items of public revenue.

8. Receipts from public enterprises

The Government receives profit from public enterprises like railways, post-office, the
central bank, tolls, electricity department, etc. Public enterprises are commercial as well as
quasi-commercial enterprises. Commercial enterprises are those whose sole aim is profit-
maximization eg. French Tobacco Monopoly. In these enterprises, the prices charged are
usually higher than what the prices would be under competition. Quasi-commercial
enterprises are those whose motive is also service or convenience of the people eg. hospital.
In these enterprises, prices may or may not be charged. Of course, incidentally such services
bring profits to the public authority.

9. Public Borrowings

Public borrowings refer to the proceeds of loans floated by the governments. Generally
the Governments borrow from their own citizens, banks in their countries, foreign countries,
and international financial institutions like the I. M. F and the I. B. R. D, etc., Voluntary
public loans from its own citizens are also accounted for under this category.

10. Receipts from the use of the printing press

Receipts from the use of the printing press by the use of paper money for the purpose of
meeting public expenditure are classified under this heading. The issue of token coins also
yields a profit to the Government. Even inflation can be included in this category as a source
of income to the Government.

11. Grants and Gifts

Grants are usually made by one government to another for the performance of a certain
specified function in a specified manner. Grants-in-aid are given by the Central Government
to the State Government and local bodies, and by the State Governments to the local bodies.

Gifts are voluntary contributions by private donors to the Government generally for
some specified purpose, especially in periods of war, famines, floods, etc.,

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CLASSIFICATION OF PUBLIC REVENUE

Different economists have classified the sources of public revenue differently. The
object of classification is to know the similarities and differences between the various
sources of public revenue, to analyse the effects and incidence of various taxes.

1. Adam Smith‟s classification:

Adam smith divided public revenue into two-revenue from the people and revenue from
state property. Revenue from the people refers to the revenue obtained through taxation
while revenue from state property includes profits of public sector enterprises.

2. Bastable‟s classification:

Bastable also classified public revenue into two parts.

a) Income received by the government from its various functions. e.g., fees and
prices.

b) Income received by the government in the capacity of ―state‖ e.g., taxes and
levies.

This classification is also narrow and limited like that given by Adam Smith because it
is not possible to classify fee, gifts, fines and special assessments into separate groups.

3. Adam‟s classification :

Prof. Adam has divided public revenue into three groups.

a) Direct revenue : It refers to the revenue obtained directly from the state owned
property. It includes revenue from public land, rail, roads, high ways post and telegraph etc.,

b) Derivative revenue : Incomes derived from the citizens of the state are included
under this category. Taxes, fees, fines, penalties, etc., fall under this category.

c) Anticipatory revenue : It refers to the anticipated income of the government

obtained through sale of treasury bills, floating new loans, etc.,

This classification is also defective in the sense that it include both commercial and
administrative revenues which are fundamentally different in nature.

4. Seligman‟s classification :

Seligman has divided public revenue into three parts.

a) Gratuitous revenue : It refers to the revenue obtained by the government free of

cost. This includes gifts, donations, etc.,

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b) Contractual revenue : This revenue is derived by the state as a result of the

contracts between the public and the government. Income from land, mines, public
enterprises fall under this category.

c) Compulsory revenue : This category is divided into eminent domain, penal

power and taxing power. The state exercises its power of eminent domain when it
expropriates the property of its citizens. The state exercises its penal power by imposing
fines and penalties. The state may tax the citizens through its taxing power.

5. Lutz‟s classification :

Lutz has classified public revenue into six categories.

a) Commercial revenue

b) Administration revenue

c) Taxation

d) Public debt

e) Subventions and grants

f) Book keeping revenues or transfers

The last three are not included in public revenue today.

6. Prof. Shirras‟s classification:

Prof. Shirras classified public revenue into two categories namely tax and non-tax
revenue.

a) Tax Revenue : It is an important source of revenue and it includes fees and special
assessments. It is called as ―revenue from the people‖ by Adam Smith and as ―derivative
revenue‖ by Adam. A special assessment is defined as a ―a compulsory contribution levied
in proportion to the special benefits derived, to defray the cost of a specific improvement to
property undertaken in the public interest‖. Fees refer to revenue obtained from monopoly
enterprises.

b) Non-Tax Revenue : It includes revenue from public undertakings, like railways,

irrigation, post and telegraph, telephone etc., revenue from social services like education and
hospital fee; revenue from loans; and miscellaneous items like military receipts, exchange
and receipts in aid of superannuation.

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7. Taylor‟s classification :

The most logical and scientifically based classification of public revenue is provided
by Taylor. He has divided public revenue into four groups.

a) Grants and gifts.

b) Administrative revenue

c) Commercial revenues

d) Taxes

a) Grants and gifts:

Grants and gifts are the financial assistance given by one government to another to
perform a specified function. Education and health grants are given by the Centre to the
State. The state governments need not repay it. ―Gifts are voluntary contributions from non-
governmental donors for specified purposes‖. Grants and gifts are voluntary in nature and
there is absence of quid pro quo.

b) Administrative Revenue:

It includes fees, licences, fines, forfeiture, escheats and special assessments. There is
no close relationship between the amount of assessment and value of the benefit or cost
incurred. It arises from the administrative function of the government and therefore, it is
called as administrative revenue.

c) Commercial Revenue:

It refers to the revenue obtained from the prices of government produced

commodities. There is a direct receipt of a good in return for payment. It includes payments
for postage, toll, prices for liquor etc.,

d) Taxes:

Taxes are compulsory contributions made by the public to the government. There is
no direct quid pro quo.

Taylor‟s classification is sound and scientific and therefore, considered to be more

logical and useful.

8. Economic classification:

Since all these classifications are not suitable for making economic interpretations,
comparative study of income and expenditure and for analysing various aspects, an
economic classification of the budgetary transactions was adopted in India in 1957-58. This
classification divides income and expenditure into Revenue Account and Capital Account.

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Revenue account includes tax revenue and non-tax revenue. Market borrowings,
external assistance, small savings, provident funds are all included in Capital Account.

This classification is satisfactory as there is no over-lapping. It is useful for making

economic interpretations.

FEDERAL FINANCE
PRINCIPLES OF FEDERAL FINANCE

Prof .B.P. Adarkar, mentioned three principles of federal finance in his book
―Problems of Federal Finance‖. These and other principles which are obeyed to achieve the
above objectives are analyzed below:

1. Principles of independence and responsibility

Related to this prof. B.P. Adarakar says first that federal and state both the
government should be given all arrangements to do financial management through which
they can not experience any obstacle to fulfil their social and economic objectives. This
means that central and state government should possess their private and independent
finance resources, which should be sufficient to complete their works. In other words it can
be said that central and state government should be independent of the financial matter in
this fields. Except this, every government should take responsibility of imposing tax,
collection of debt and increasing sources of income so that they can smoothly run the
development works of his area.

2. Principle of adequacy and elasticity

In regard of federal finance system Prof. B.P. Adarkar gives more importance to the
principle of Adequacy and elasticity. According to this principle state and central
government should have finance resources in adequate manner. So that government of every
level can easily fulfill its responsibility. In other words, this means that every government
should possess sufficient resources of income which can help them to fulfill their work and
duties which are assigned to them. According to the Australia‘s high court former judge Sir
John Lothem, ―If one federal system wants to exist as a full independent government then
state should have adequate resources to fulfill their responsibilities.‖

3. Principle of administrative economy

Prof. B.P. Aderkar have force third principle which is a principle of administrative
economy according to them it is necessary for federal state and for their financial matter‘s
success that in the arrangement of financial resources the cost should be minimum and there
should be no tax evasion or diplomacy in it. While dividing the resources it should be seen
that which resources can be prepared better by the central or state government, Corruption

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and forceful entry should be popped and every resources must be used for the increase
in income. Except this, taxes should be applied in the manner so that it will not affect
industries and business infect it increases employment and tax evasion lowers down. Prof.
Seligman said while talking about the principle of administrative economy, ―No matter the
planning is more useful, but if its administration is not correct then it will surely become
unsuccessful.‖
4. Principle of uniformity

In the federal system, uniformity means to give equal part of tax to every
government that work which is essential for every state, to tolerate its burden, all the states
government give equal part of tax to the central government on the basis of equality or
apply equal tax rate on the citizens of the states through central government which
imposing taxes every citizen should be treated in an equal manner which doing public
expenditure, central government should also behave equali with all the citizen. But this
equality is not possible in fiscal policy as the sources of every level and their expenditure is
not same. Resource and needs of every state is different. Yes, it may possible that while
giving taxes every citizen of one state should not be given special facilities or discount as
compared to another state.

5. Principle of equity

The principle of equity is an important principle in taxation, which Adam Smith

stated. To implement this principle in federal finance system is an important things, because
according to this principle the distribution of resources in federal and states create the state
of inequality which can spoil the whole structure. There can be difference in level of
economic development of different states of a federal, but if taxation is done according to
this principle then the burden of taxes in different states will be different. Because, marginal
sacrifice will be different in different states. The marginal sacrifice of taxpayers of rich
states will be less in comparison to those states which are relatively poor, Therefore, the
need arises that taxes of central and state government must be coordinated in such a way
that marginal sacrifice must be equal or approximately equal due to both type of taxes on
every taxpayer, whether they live in any state. In means that taxes of center and state
governments must be included in such a way, by which the burden of taxes must be equal
or approximately equal on every citizen.

6. Principle of integration and coordination

A federal finance arrangement should be like that every unit coordinated with one
another and no a unit separate from whole arrangement. It is necessary for an efficient
system. Regarding this one more thing is there that principle of integration and coordination
is not limited only for taxes. Coordination of Budget, Assets, expenditure and other related
activities must be there between union and state.

7. Principle of accountability
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Federal finance system and democracy are like sisters in a federal government. Every
government is responsible for applying taxes and giving accounts to his MLAs, this means
about imposing by the government taxes or expenditure and MLAs have the right to take
accounts. But, government has to take care of other government that what impact they have
on them.
8. Principle of fiscal access

Central and state government should not be any restriction from increasing their
sources of income as they have to fulfill their increasing needs. This means that with the
increasing of government responsibility, their sources should also be increased.

9. Principle of transfer of resources.

This principle means that the state which is rich, their income should be given to the
poor states so that every person of every state can lead a minimum life standard. Its objective
is that person of a country should lead a life standard which is below of it. This means that
no person can get lower life standard below the national standard. Dr. B.R. Mishra had
written in his book ‗Indian federal finance that the division of resources between central and
state should be based on the principle of ‗National minimum, this can be possible by the
income transfer of rich states to the poor ones. The main objective of this transfer is to lower
down the inequality because economic inequality is not beneficial to the national welfare.
Activities of the Revenue can lessen down the inequality.

10. Re-allocation of resources

Every state should division their resources in a type so that centre and state can get
enough money and can complete their objectives efficiently. But this kind of division is not
simple. There is no solid point on the basis which can say that the division is favorable. A
line between state and central government resources is not easy to draw.

When the decision takes place between centre and state then there are some
resources on which central government have the rights and some resources are given to the
state and some are given to both of them. These kinds of resources lie in concurrent list. In
concurrent areas disputes occur which solved according to the constitution. Generally, right
is given to the central government that it limits the tax, its procedure and arrangement and
which the state that in government have to follow.

In this way, it is clear that in relation to the concurrent list central government forms
a structure and under this, state government makes rules and applies taxes. One thing has to
clear that with the time situation also changes and because of this no definite division can
take place. So the solution of the division of resources cannot be limited to one changing
situation can be re-divided. In the end, it can only that the division of the resources should be
done in such a way from which maximum use of resources and can also increase the
economic development rate and can lower down the income inequality.
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STATES FINANCE

An important feature of a federal government is that in this division of power

between state and central takes place, their work is also divided some work are under
concurrent list like economic and social planning, Trade and industrial right, workers
welfare in which their working planning is also included like – price control, education,
irrigation and electricity, etc.

These taxes on which states have right are—Land Revenue, Tax on Agriculture, Tax
on house and resources and on opium, alcohol and on production of alcoholic medicines and
Indian Bhaang. In the British period Land administration was given the name of Land
settlement and this was fixed after the survey and division of Business. Those who earn same
income and are under the category of Direct taxes they should be confirmed first the source
and form of their money.

Types of Division

Tax jurisdiction is clearly divided between central and state government. It has been
done in this way to try to stop duplication and expiration for this tax was calculated and after
that they were given to central and state governments. If any tax is left then it will be paid to
the central government. Generally, these taxes which are of international level comes under
legislative authority of central government and those which are of local level, come under
legislative authority of states.

Functions and resources

One of the important factors of central government is that function and resources are
divided between states and central government. That is why in Indian constitution some
works are given to the state. The main aim of this division is to do the work independently
without any struggle. In this way it is clear that centre government should be given sufficient
resources. It is also essential that state should not be dependent on centre for its income and
also centre should not interfere in states autonomy. So now we understand the functions and
resources which are given to the states by the Constitution, to work independently and how
far they are successful and what problems are they facing.

Functions

Discussions on Power and Resources are already took place but to clarify them more,
here a brief description is given .

Functions of the central Government Work which are under centre are: Defence,
foreign matters, trade, Railway, Currency, Post offices, and Telegraph, Regulations of
international trade and Business, Regulations of international rivers and project progress,
insurance, nuclear power, elections and audited account.

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Functions of state Government The responsibilities which are under state

government are: establishment of law and order, water, Police, administration of justice,
public health, Hospitals, Production of alcohol products, construction and sales, education,
Agriculture and its related problems large and small scale industries like Handicraft etc.
Forest and responsibility of social welfare and its laws.
Concurrent functions

Some subjects are under concurrent list like-economic and social planning; Business
and industrial Rights, Labour controversy and Welfare and work of workers are also
included. Price control, education, irrigation and electricity etc. Some of the other works are
also included in this list like to make law on any subject which is also a part of parliament.
This means the topics which are covered in this list are the responsibility of both centre and
state.

But behaviourly it is seen that mostly central government takes charge or give grants
for these topics, but the responsibility of their control and progress is on the state government
union taxes

The heads of union list are divided in five categories

1) Completely central head included customs duties, Corporation tax, tax on assets
except individuals and Companies and Agricultural land According to the Article 271
surcharge of income tax is also a completely central head.

2) Except Agriculture income, taxes on other income. Centre imposed taxes and also
collects them but it has to give apart of income tax to the states as per the finance
commission recommendations

3) Except Alcohol and Drugs other taxes are collected by the federal excise duty and also
collects them. But if parliament wants then it can distribute some part to the states.

4) There are also taxes which are collected by the union government and completely
distributed by the parliament among and taxes like excise duty, terminal tax on
products which comes or goes through Air and water ways, Train fare, Sale and
purchase of newspapers and on international trade.

5) These taxes which are imposed by the centre but collected by the state and state itself
keep them like cheques, stamped duty and alcohol used cosmetics excise duty.

States taxes

On those taxes which have legislative power of states and have the right to collect
taxes they are Land Revenue, Agriculture tax estate duty of Agricultural land, Tax on opium
Indian Bhaang and Alcoholic medicines and products and Excise duty on Investment except

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this Tax on Consumer goods on local place, Tax on electricity consumption and Sales
Tax, Tax on Vehicles, Animals and on Boats, Except newspaper Tax on other
advertisements, on Roads or travelers, goods of internal water ways, Terminal Tax, Stamped
duty and Tax on Employment, Capitation Tax, Tax on luxurious and entertainment items.
States are also assessed stamped duty and Registration fee.
Land revenue

From the olden times Land Revenue is one of the important sources of income of the
state. In this way in states taxes it is considered as the oldest tax. When it was applied from
then onwards system of Land Revenue and debit tax had a huge difference while calculating
them between states. But then also it is one of the important taxes of states as it is one of the
important taxes so it creates an impact on different times.

Different System of Settlement In the British time different Systems of settlement

were popular in India which were (1) Permanent settlement – in which the interest rate fixed
of Land Revenue. (2) temporary settlement – In this interest rate of land Revenue was fixed
for a time period. This can be further divided into three parts (a) Zamindari system – In which
interest rate was fixed by the Zamindars. (b) mahalwadi system – In this interest rate of land
revenue of a village or palace was different for the whole rural community.(c) raiyatwadi
system – In this land revenue was fixed according to the land size.

Federal Finance

Federal finance refers to the system of assigning the source of revenue to the Central
as well as State Governments for the efficient discharge of their respective functions i.e.
clear-cut division is made regarding the allocation of resources of revenue between the
central and state authorities.

1. Division of Powers: In our Constitution, there is a clear division of powers so that

none violates its limits and tries to encroach upon the functions of the other and
functions within own sphere of responsibilities. There are three lists enumerated in
the Seventh Schedule of constitution. They are: the Union list, the State list and
the Concurrent List.

2. The Union List consists of 100 subjects of national importance such as Defence,
Railways, Post and Telegraph, etc.

3. The State List consists of 61 subjects of local interest such as Public Health, Police
etc.

4. The Concurrent List has 52 subjects important to both the Union and the State,
such as Electricity, Trade Union, Economic and Social Planning, etc.

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CENTRAL STATE FINANCIAL RELATIONSHIP

(I) Union Sources

1. Corporation tax

2. Currency, coinage and legal tender, foreign exchange.

3. Duties of customs including export duties.

4. Duties of excise on tobacco and certain goods manufactured or produced in India.

5. Estate duty in respect of property other than agricultural land.

6. Fees in respect of any of the matters in the Union List, but not including any fees
taken in any Court.

7. Foreign Loans.

8. Lotteries organized by the Government of India or the Government of a State.

9. Post Office Savings Bank.

10. Posts and Telegraphs, telephones, wireless, Broadcasting and other forms of
communication.

11. Property of the Union.

12. Public Debt of the Union.

13. Railways.

14. Rates of stamp duty in respect of Bills of Exchange, Cheques, Promissory Notes,
etc.

15. Reserve Bank of India.

16. Taxes on income other than agricultural income.

17. Taxes on the capital value of the assets, exclusive of agricultural land of individuals
and companies.

18. Taxes other than stamp duties on transactions in stock exchanges and future
markets.

19. Taxes on the sale or purchase of newspapers and on advertisements published

therein.

20. Terminal taxes on goods or passengers, carried by railways, sea or air.

(II) State Sources

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1. Capitation tax

2. Duties in respect of succession to agricultural land.

3. Duties of excise on certain goods produced or manufactured in the State, such as

alcoholic liquids, opium, etc.

4. Estate duty in respect of agricultural land.

5. Fees in respect of any of the matters in the State List, but not including fees taken in
any Court.

6. Land Revenue.

7. Rates of stamp duty in respect of documents other than those specified in the Union
List.

8. Taxes on agricultural income.

9. Taxes on land and buildings.

10. Taxes on mineral rights, subject to limitations impose by Parliament relating to

mineral development.

11. Taxes on the consumption or sale of electricity.

12. Taxes on the entry of goods into a local area for consumption, use or sale therein.

13. Taxes on the sale and purchase of goods other than newspapers.

14. Taxes on the advertisements other than those published in newspapers.

15. Taxes on goods and passengers carried by road or on inland waterways.

16. Taxes on vehicles.

17. Taxes on animals and boats.

18. Taxes on professions, trades, callings and employments.

19. Taxes on luxuries, including taxes on entertainments, amusements, betting and

gambling.

20. Tolls.

(III) Taxes Levied and Collected by the union but Assigned to the States (Art.269)

1. Duties in respet of succession to property other than agricultural land.

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2. Estate duty in respect of property other than agricultural land.

3. Taxes on railway fares and freights.

4. Taxes other than stamp duties on transactions in stock exchanges and future
markets.
5. Taxes on the sale or purchase of newspapers and on advertisements published
therein

6. Terminal taxes on goods or passengers carried by railways, sea or air.

7. Taxes on the sale or purchase of goods other than newspapers where such sale or
purchase taxes place in the course of inter-State trade or commerce.

(IV) Duties levied by the Union but collected and Appropriated by the states (Art.268)

Stamp duties and duties of excise on medicinal and toilet preparation (those
mentioned in the Union List) shall be levied by the Government of India but shall be
collected.

1. In the case where such duties are leviable within any Union territory, by the
Government of India.

2. In other cases, by the States within which such duties are respectively leviable.

3. Taxes which are Levied and Collected by the Union but which may be Distributed
between the Union and the States (Arts.270 and 272)

4. Taxes on income other than agricultural income.

5. Union duties of excise other than such duties of excise on medicinal and toilet
preparations as are mentioned in the Union List and collected by the Government of
India.

6. ―Taxes on income‖ does not include corporation tax. The distribution of income-tax
proceeds between the Union and the States is made on the recommendations of the
Finance Commission.

FINANCE COMMISSION

What is the Finance Commission?

Finance Commission is a constitutional body, that determines the method and formula
for distributing the tax proceeds between the Centre and states, and among the states.

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The Finance Commission also decides the share of taxes and grants to be given to the
local bodies in states. This part of tax proceeds is called Finance Commission Grants, which is
a part of the Union budget.

The Finance Commission has a chairman and four members appointed by

the President of India.
15th Finance Commission: Recommendations

The Fifteenth Finance Commission (XV-FC or 15-FC) is an Indian Finance

Commission constituted in November 2017 and is to give recommendations for devolution of
taxes and other fiscal matters for five fiscal years, commencing 2020-04-01. The commission's
chairman is Nand Kishore Singh, with its full-time members being Ajay Narayan Jha, Ashok
Lahiri and Anoop Singh. In addition, the commission also has a part- time member in Ramesh
Chand. Shaktikanta Das served as a member of the commission from November 2017 to
December 2018.

Know the recommendations of the 15th Finance Commission.

The Finance Commission (FC) is constituted by the President of India every fifth year
under Article 280 of the Constitution.

The Fifteenth Finance Commission (XV-FC) was constituted in November 2017 to give
recommendations for vertical and horizontal devolution of taxes for five fiscal years,
commencing 1 April 2020.

15th Finance Commission

The 15th Finance Commission was constituted by the President of India in November
2017, under the chairmanship of NK Singh. Its recommendations will cover a period of five
years from April 2020 to March 2025.

Terms of Reference of XV-FC

XV- FC is mandated to give recommendations regarding

 The distribution between the Union and the States of the net proceeds of taxes which are to
be divided between them.

 The allocation between the States of the respective shares of such proceeds.

 The principles which should govern the grants in aid of the revenues of the States out of
the Consolidated Fund of India.

 The measures needed to augment the Consolidated Fund of a State to supplement the
resources of the Panchayats and Municipalities in the State based on the recommendations

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made by the Finance Commission of the State.

The Commission shall review the current fiscal status of the Union and the States, and
recommend a fiscal consolidation roadmap. The Commission may also examine whether
revenue deficit grants be provided at all.
While making the recommendations, the XV-FC may consider

 Resources of Central and State governments and their potential and fiscal capacity.

 Demand on the resources of respective governments.

 Impact of the enhanced devolution following 14th FC on the fiscal situation.

 Impact of GST and compensation for the losses in revenues for 5 years.

The Commission may consider proposing performance-based incentives to the

States based on

 Efforts made in expansion and deepening of tax net under GST.

 Efforts and progress made in moving towards the replacement rate of population growth.

 Achievements in the implementation of flagship schemes of Government of India,

disaster-resilient infrastructure, and sustainable development goals.

 Progress made in increasing capital expenditure, eliminating losses of the power sector,
and improving the quality of such expenditure in generating future income streams.

 Progress made in increasing tax/non-tax revenues.

 Promoting savings by the adoption of Direct Benefit Transfers and Public Finance
Management System.

 Promoting digital economy and removing layers between the government and the
beneficiaries.

 Progress made in promoting ease of doing business and promoting labour-intensive

growth.

 Provision of grants in aid to local bodies for basic services and implementation of a
performance grant system in improving the delivery of services.

 Control or lack of it in incurring expenditure on populist measures.

 Progress made in sanitation, solid waste management and bringing in a behavioural

change to end open defecation.

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The Commission shall use the population data of 2011 while making its
recommendations.

The Commission may review the present arrangements on financing Disaster Management
initiatives regarding the funds constituted under the Disaster Management Act, 2005.
Controversies associated with the 15th Finance Commission

The Terms of Reference (ToR) of the 15th Finance Commission were opposed by some
States. The main apprehensions were:

 Progressive states would lose heavily if the population-based on the 2011 census was
considered for the devolution of central funds.

 States that have performed well on population control would be penalized.

 Previous FCs used 1971 Census numbers while the 14th commission had given weight to
both the 1971 (17.5%) and 2011 (10%) censuses.

 Some states have a higher potential in expanding the GST tax base while others do not.
Hence the performance on this parameter cannot be a basis for fund devolution.

 Many states run social sector schemes which are welfare-oriented. If these schemes are
considered populist, these States will be penalized.

 States are already under the burden of GST and devolution based on the 2011 Census will
further constrain the fund position of the States.

 States resent a devolution criterion that considers the implementation of Central schemes,
as tax devolution is their constitutional right and not a largesse of the Central government.

 Since revenue deficit grants are proposed to be re-looked, there may be a reduction in the
fiscal autonomy of the States and conditions for borrowing from external sources will also
be reviewed.

These apprehensions were addressed by the Centre which said that there is no regional
bias and that poorer States rely more on Centre‘s revenue than developed ones. Regarding the
shift to Census 2011 numbers, it was mentioned that efforts made towards reducing population
growth rate towards replacement rate were also included which balances the equation.

REPORT OF THE 15TH FINANCE COMMISSION FOR FY 2020-21

 The Finance Commission is a constitutional body formed by the President of India to

give suggestions on centre-state financial relations. 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

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 February 1, 2020. The final report with recommendations for the 2021- 26 period will
be submitted by October 30, 2020.

Key recommendations in the first report (2020-21 period) include:

 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. The individual
shares of states from the divisible pool of central taxes is provided in Table 3 in the
annexure.

Criteria for devolution

Table 1 below shows the criteria used by the Commission to determine each state‘s
share in central taxes, and the weight assigned to each criterion. We explain some of the
indicators below.

Criteria for devolution (2020-21)

14th FC 15th FC
Criteria
2015-20 2020-21
Income Distance 50.0 45.0

Population (1971) 17.5 -

Population (2011) 10.0 15.0

Area 15.0 15.0

Forest Cover 7.5 -

Forest and Ecology - 10.0

Demographic Performance - 12.5

Tax Effort - 2.5

Total 100 100

Sources: Report for the year 2020-21, 15th Finance Commission; PRS.

 Income distance: Income distance is the distance of the state‘s income from the state
with the highest income. The income of a state has been computed as average per capita
GSDP during the three-year period between 2015-16 and 2017-18. States with lower
per capita income would be given a higher share to maintain equity among states.

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 Demographic performance: The Terms of Reference (ToR) of the Commission

required it to use the population data of 2011 while making recommendations.
Accordingly, the Commission used only 2011 population data for its
recommendations.
 The Demographic Performance criterion has been introduced to reward efforts made by
states in controlling their population. It will be computed by using the reciprocal of the
total fertility ratio of each state, scaled by 1971 population data. States with a lower
fertility ratio will be scored higher on this criterion. The total fertility ratio in a specific
year is defined as the total number of children that would be born to each woman if she
were to live to the end of her child-bearing years and give birth to children in alignment
with the prevailing age-specific fertility rates.

 Forest and ecology: This criterion has been arrived at by calculating the share of dense
forest of each state in the aggregate dense forest of all the states.

 Tax effort: This criterion has been used to reward states with higher tax collection
efficiency. It has been computed as the ratio of the average per capita own tax revenue
and the average per capita state GDP during the three-year period between 2014-15 and
2016-17.

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.

 Revenue deficit grants: In 2020-21, 14 states are estimated to have an aggregate

revenue deficit of Rs 74,340 crore post-devolution. The Commission recommended
revenue deficit grants for these states (see Table 4 in the annexure).

 Special grants: In case of three states, the sum of devolution and revenue deficit grants
is estimated to decline in 2020-21 as compared to 2019-20. These states are Karnataka,
Mizoram, and Telangana. The Commission has recommended special grants to these
states aggregating to Rs 6,764 crore.

 Sector-specific grants: The Commission has recommended a grant of Rs 7,375 crore

for nutrition in 2020-21. Sector-specific grants for the following sectors will be
provided in the final report: (i) nutrition, (ii) health, (iii) pre-primary education, (iv)
judiciary, (v) rural connectivity, (vi) railways, (vii) police training, and (viii) housing.

 Performance-based grants: Guidelines for performance-based grants include: (i)

implementation of agricultural reforms, (ii) development of aspirational districts and
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 blocks, (iii) power sector reforms, (iv) enhancing trade including exports, (v) incentives
for education, and (vi) promotion of domestic and international tourism. The grant
amount will be provided in the final report.

 Grants to local bodies: The total grants to local bodies for 2020-21 has been fixed at
Rs 90,000 crore, of which Rs 60,750 crore is recommended for rural local bodies
(67.5%) and Rs 29,250 crore for urban local bodies (32.5%). This allocation is 4.31%
of the divisible pool. This is an increase over the grants for local bodies in 2019-20,
which amounted to 3.54% of the divisible pool (Rs 87,352 crore). The grants will be
divided between states based on population and area in the ratio 90:10. The grants will
be made available to all three tiers of Panchayat- village, block, and district.

 Disaster risk management: The Commission recommended setting up National and

State Disaster Management Funds (NDMF and SDMF) for the promotion of local- level
mitigation activities. The Commission has recommended retaining the existing cost-
sharing patterns between the centre and states to fund the SDMF (new) and the SDRF
(existing). The cost-sharing pattern between centre and states is (i) 75:25 for all states,
and (ii) 90:10 for north-eastern and Himalayan states.

For 2020-21, State Disaster Risk Management Funds have been allocated Rs 28,983
crore, out of which the share of the union is Rs 22,184 crore. The National Disaster Risk
Management Funds has been allocated Rs 12,390 crore.

Grants for disaster risk management (In Rs crore)

Funding Windows National corpus States‟ corpus

Mitigation (20%) 2,478 5,797

Response (80%) 9,912 23,186

(i) Response and Relief (40%) 4,956 11,593

(ii) Recovery and Reconstruction (30%) 3,717 8,695

(iii) Capacity Building (10%) 1,239 2,998

Total 12,390 28,983

Sources: Report for the year 2020-21, 15th Finance Commission; PRS.

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
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 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. The outstanding extra-budgetary liabilities
should be clearly identified and eliminated in a time-bound manner.

 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. It observed that an
overarching legal fiscal framework is required which will provide for budgeting,
accounting, and audit standards to be followed at all levels of government.

 Tax capacity: In 2018-19, the tax revenue of state governments and central government
together stood at around 17.5% of GDP. The Commission noted that tax revenue is far
below the estimated tax capacity of the country. Further, 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. The Commission observed that the continuing
dependence of states on compensation from the central government (21 states out of 29
states in 2018-19) for making up for the shortfall in revenue is a concern. It suggested
that the structural implications of GST for low consumption states need to be
considered

Other recommendations

 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. The Commission noted that the Ministry of
Defence proposed following measures for this purpose: (i) setting up of a non-lapsable
fund, (ii) levy of a cess, (iii) monetisation of surplus land and other assets, (iv) tax-free

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 defence bonds, and (v) utilising proceeds of disinvestment of defence public sector
undertakings. The expert group is expected to examine these proposals or alternative
funding mechanisms.
Share of states in the centre‟s taxes

Devolution for
14th Finance Commission 15th Finance Commission
FY 2020-2021
State
Share out of Share in Share out of Share in
(In Rs crore)
42% divisible pool 41% divisible pool

Andhra Pradesh 1.81 4.31 1.69 4.11 35,156

Arunachal
0.58 1.38 0.72 1.76 15,051
Pradesh

Assam 1.39 3.31 1.28 3.13 26,776

Bihar 4.06 9.67 4.13 10.06 86,039

Chhattisgarh 1.29 3.07 1.4 3.42 29,230

Goa 0.16 0.38 0.16 0.39 3,301

Gujarat 1.3 3.1 1.39 3.4 29,059

Haryana 0.46 1.1 0.44 1.08 9,253

Himachal
0.3 0.71 0.33 0.8 6,833
Pradesh

Jammu and
0.78 1.86 - - -
Kashmir

Jharkhand 1.32 3.14 1.36 3.31 28,332

Karnataka 1.98 4.71 1.49 3.65 31,180

Kerala 1.05 2.5 0.8 1.94 16,616

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Madhya Pradesh 3.17 7.55 3.23 7.89 67,439

Maharashtra 2.32 5.52 2.52 6.14 52,465

Manipur 0.26 0.62 0.29 0.72 6,140

Meghalaya 0.27 0.64 0.31 0.77 6,542

Mizoram 0.19 0.45 0.21 0.51 4,327

Nagaland 0.21 0.5 0.23 0.57 4,900

Odisha 1.95 4.64 1.9 4.63 39,586

Punjab 0.66 1.57 0.73 1.79 15,291

Rajasthan 2.31 5.5 2.45 5.98 51,131

Sikkim 0.15 0.36 0.16 0.39 3,318

Tamil Nadu 1.69 4.02 1.72 4.19 35,823

Telangana 1.02 2.43 0.87 2.13 18,241

Tripura 0.27 0.64 0.29 0.71 6,063

Uttar Pradesh 7.54 17.95 7.35 17.93 1,53,342

Uttarakhand 0.44 1.05 0.45 1.1 9,441

West Bengal 3.08 7.33 3.08 7.52 64,301

Total 42 100 41 100 8,55,176

Sources: Reports of 14th and 15th Finance Commission; PRS.

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Some of the grants-in-aid for FY 2020-21 (in Rs crore)

State‟s share State‟s share

Grants to Grants to
Revenue in grants for in grants for
State rural local urban local
deficit grants rural local urban local
bodies bodies
bodies bodies

Andhra Pradesh 5,897 2,625 4.32 1264 4.32

Arunachal
- 231 0.38 111 0.38
Pradesh

Assam 7,579 1,604 2.64 772 2.64

Bihar - 5,018 8.26 2,416 8.26

Chhattisgarh - 1,454 2.39 700 2.39

Goa - 75 0.12 36 0.12

Gujarat - 3,195 5.26 1538 5.26

Haryana - 1,264 2.08 609 2.08

Himachal Pradesh 11,431 429 0.71 207 0.71

Jharkhand - 1,689 2.78 813 2.78

Karnataka - 3,217 5.29 1549 5.29

Kerala 15,323 1,628 2.68 784 2.68

Madhya Pradesh - 3,984 6.56 1,918 6.56

Maharashtra - 5,827 9.59 2,806 9.59

Manipur 2,824 177 0.29 85 0.29

Meghalaya 491 182 0.3 88 0.3

Mizoram 1,422 93 0.15 45 0.15

Nagaland 3,917 125 0.21 60 0.21

Odisha - 2,258 3.72 1087 3.72

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Punjab 7,659 1,388 2.29 668 2.29

Rajasthan - 3,862 6.36 1,859 6.36

Sikkim 448 42 0.07 20 0.07

Tamil Nadu 4,025 3,607 5.94 1737 5.94

Telangana - 1,847 3.04 889 3.04

Tripura 3,236 191 0.31 92 0.31

Uttar Pradesh - 9,752 16.05 4,695 16.05

Uttarakhand 5,076 574 0.95 278 0.95

West Bengal 5,013 4,412 7.26 2,124 7.26

Total
74,341 60,750 100 29,250 100

Sources: Report for the year 2020-21, 15th Finance Commission; PRS.

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UNIT – III

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PUBLIC DEBT
The term ―Public Debt‖ refers to the total amount of debt owned by the public
authority including the Central Government, State Government and local governments to
their own citizens or to the foreigners in their individual or corporate capacity. Thus, all kinds
of obligations of a public authority (including the currency obligations) are included in the
public debt. The Government may borrow from Banks, business organisations, business
houses and individuals. The borrowing of the Government may be internal or external.

CLASSIFICATION OF PUBLIC DEBT

I. Internal debt and External debt:

Internal debt refers to the public loans floated within the country. External debt refers
to the borrowing from foreign countries. It is believed that an external loan is a burden
because the country has to pay to the other country. Again there is a special problem in the
case of external loans that both the principal and interest have to be made in the currency of
the lending countries. This leads to the problem of transfer of commodities and services from
the borrowing country to the lending country. It also increases the problem of adverse
balance of payments. However foreign loan should not be coincide a burden provided they
are used for useful purposes.

II. Productive and Unproductive Debt:

Productive debt is used for productive purposes such as the construction of railways,
irrigation and power project. It also includes the establishment of heavy industries like Iron
and steel, cement and fertilizers. Unproductive debt is used for war and relief. In the
unproductive debt the economy is not getting any return.

III. Redeemable and Irredeemable Debt:

Redeemable loans are those loans the governments promise to pay off at some future
date. These loans have to be repaid at some future date. On the other hand for those loans for
which no promise is made regarding the repayment are known as irredeemable loans.

When a loan is redeemable the government has to make some arrangement for its
repayment. It has to find out the ways and means of repaying the debt. In the case of
irredeemable loans the government has to pay only the interest regularly.

IV. Funded and Unfunded Debt :

Funded debts are long term debt the payment of those may be made at least after a year

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or may not be made at all. In other words funded debts are those that are redeemable after a
year or not redeemable at all. Unfunded debts are those that are paid off within a year. Bonds
are unfunded debts. It should be noted that in the case of funded debts the government has
the obligation to pay a fixed amount of interest to the creditor subject to the option of the
government. The creditor has no right to anything except the interest.

V. Voluntary and Compulsory Loans:

Generally government debt is of a voluntary nature. The government invites the

individuals and institutions to purchase the government bonds. But compulsory loans are not
common in modern times. The government may have to exercise this pressure for getting
loans during an emergency like war and also during the period of high inflation.

CAUSES OF PUBLIC DEBT

First of all, when the income of the Government was not sufficient it is forced to borrow
internally and externally,

Secondly in a depression when private demand is insufficient the Government may borrow
the idle savings of the people and spend them to increase the effective demand and thereby
create additional income and employment in the country,

Thirdly a modern state is a welfare state and as such it has to spend more and more of the
people. This also increases the size of public debt,

Fourthly most of the countries in the world are planned economics. As a result the
Government has to spend more money through borrowing.

Fifthly modern wars and defence expenditure have also increased public debt. Many
economists like Keynes have advocated increased public expenditure financed through
borrowing and not through taxation. While taxation reduces incomes and demand, public debt
has no such effect.

Sixthly borrowing is done in order to control inflation. The excess money can be collected
through public borrowing.

Seventhly borrowing is also undertaken for financing public enterprises

THE BURDEN OF PUBLIC DEBT

The burden of public debt refers to the sacrifice it will impose on the community through a
raise in taxation for the payment of interest. The burden of public debt may be direct and
indirect. Direct money burden is measured by the extent of money involved and the raise in

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taxation needed. Direct real burden is equal to the loss of economic welfare (Sacrifice of
goods and services made by the tax payers ) on account of the direct money burden of
increased taxation. Indirect burden of public debt refers to the extent of adverse effect of
increased taxation on the level of production.

Burden of Internal Debt

As far as the burden of internal debt is concerned there may be no direct burden on the
community as a whole because the payment of interest and the increased taxation to meet the
burden of debt involved a transfer of purchasing power from one group of persons to another.
In fact when the creditors and the tax payers are the same there not be any net burden of the
community. On the other hand if the creditors and the tax payers belong to different income
groups, the changes in the distribution of income among the different sections of the
community take place.

While estimating the burden of public debt the purpose of loan should be considered. If a
loan is utilised for productive purposes, it can be paid out of the profits of investments. On the
other hand if a loan is made to finance a war it may be a dead weight in the domestic
economic set up.
It can be concluded that internal debt impose burden upon the community as a whole and
the belief that the internal debt not impose any burden on the community is theoretically
incorrect and practically unrealistic.

Burden of External Debt

The nature of external debt is different from that of internal debt. The burden of external
debt is greater than the internal debt because in case of internal debt interest charges and the
repayment of principle within the country whereas external debt involves the payment of one
country to other country. Again there is also the direct real burden because the country that is
paying to foreign country loses some of the goods and services it can consume. The money
burden may be realised by payment of taxes from the rich people.

The direct real burden of external debt also depends upon the purpose for which the debt
is incurred. If external debt is incurred to meet war expenditure it may be called dead weight
debt. On the other hand if an external debt is incurred for a productive purpose like importing
machinery, raw material and technical know-how it is known as productive debt. Thus we
conclude an external debt is not a burden provided it is used for productive purpose. If it is
used for unproductive purpose like war it is known as an unproductive debt.

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REDEMPTION OF PUBLIC DEBT OR

METHODS OF REPAYMENT
Redemption means repayment of public debt. Repayment has the following advantages.

o First of all it saves the Government from bankruptcy,

o Secondly it discourages extravagant expenditure of the Government,
o Thirdly it maintains the confidence of the lenders,
o Fourthly it saves the future generation from the burden of debt.

METHODS OF REPAYMENT

1) REPUDIATION:

It means refusal to pay a debt by governments. This method was followed by

the USA after the civil war and by the USSR after the 1917 Revolution. This method is
undesirable and has not been used recently anywhere in the world. Repudiation shakes
the confidence of the people in public debt and many provoke retaliation from creditor
countries. But in modern democratic days this method is not possible because contracts
have to be accepted and respected. If one country repudiates an external debt other
countries will not have trade relationship with that country.

2) REFUNDING:

Refunding is the process of replacing maturing securities with new securities. In

some cases the bonds may be redeemed before the maturing date when the government
intends to rearrange the maturity of outstanding debts or when current rate of interest is low.

Generally, short-term borrowings are made in anticipation of tax collections for

meeting current expenditure. However, excessive burden of new expenditure does not
permit the retirement of the debt by means of revenue newly raised or by means of long
term borrowing. Thus, there is necessity of refunding the loans by old lenders and renewing
the loans at lower rate of interest for future period. The drawback of this method is that
government is tempted to postpone its obligation of debt redemption. This leads to a
continuous increase in the burden of public debt in future.

3) CONVERSION OF LOANS:

It is a special type of refunding. Conversion of existing securities into new securities

before maturity. It is generally resorted to reduce the burden of debt by converting high
interest loans into low interest loans. According to Professor Dalton, the conversion does
not reduce the burden of public debt on the state; because a reduction in interest rates
reduces the ability of the creditors to pay taxes which may mean a loss of income to the
governments there by reducing its capacity to repay loans.

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4) ACTUAL REPAYMENT :

a) Sinking Fund: Sinking fund is a special fund created for the repayment of public
debt. There is a theoretical justification for creating this fund because it imposes a
requirement on the government to pay the old debts regularly. According to this method,
the government sets aside a certain amount out of the budget every year for this fund. The
balances in the funds are also invested and the interest accruing on them is also credited in
the fund.

Sinking fund is of two types: (i) certain sinking fund here, the governments
credit a fixed sum of money annually. (ii) Uncertain sinking fund the amount is credited
when government secures a surplus in the budget. The one danger of this method is that
the government may not wait till the end of the period of maturity and utilize the fund for
some other purpose than the one for which the fund was created originally.

The practice of sinking fund inspires confidence among the lenders and the
enhancement of the creditworthiness of governments.

b) Capital levy:

Capital levy is a special type of “once for all” tax on capital imposed to
repay war debts. All capital goods are taxed above a minimum level of assets possessed by
residents of the country. Simply, capital levy refers to a very heavy tax on property and
wealth. This tax was levied immediately after the First World War. This method has been
advocated by economists like David Ricardo, Pigou and Dalton. Professor Dalton has
suggested that capital levy as a method of debt redemption with least real burden on the
society. It is useful on account of its deflationary character.

c) Surplus budget:

Quite often, surplus budget may be used to clear public debt. But in recent times
due to the ever increasing public expenditure, surplus budget is a rare phenomenon.

d) Terminal Annuities :
A government may issue terminal annuity, a part of its matures every year according to a
serial order decided every year. In this method, the loan is repaid annually and hence the
burden of the state is also very much reduced.

e) Buying up of Loans: Governments redeems debt through buying up loans from

the market.

OBJECTIVES OF PUBLIC DEBT

The following are the reasons why a public authority might incur public debt.
a. Revenue :
The modern governments have expanded their activities in recent years. This has
necessitated increase in public expenditure. In such circumstances government expenditure
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far exceeds government revenue.

b. National Emergencies:
National emergencies such as natural calamities, floods, droughts and famines,
earthquakes or outbreak of war, etc., may arise. Government spending under such situations
become both urgent and imperative. Such situations cause a sudden spurt in government
expenditure.
c. Welfare State :
Modern governments are called welfare states. They undertake a number of functions
for promoting the welfare of the people. Old - age pensions, retirement benefits, pensions,
disabled benefits, unemployment insurance, etc., are the welfare measures of modern
governments. Hence, they have to necessarily borrow.

d. Revival of Economic Activity :

Depression is characterized by falling prices, decreasing profits and incomes, and

slackening of business activity. Fall in prices and consequently profits, compel the
businessmen and entrepreneurs to close down their business or cut short their scale of business
activity. The increased expenditure, financed by borrowed money, increases income, effective
demand, investment, employment, production and national income and thereby brings about
recovery in the economic activity.

e. Control of Inflation:
In modern days, inflation occurs too frequently. Inflation refers to a situation in which
too much money chasing too few goods or the volume of money far exceeds the volume of
goods and services. It introduces the spirit of gambling. It pauperises the middle class and
destroys the very foundation of the economy. It is a specie of taxation, cruellest of all and an
open robbery.

To control inflation, money supply should be reduced through increased public

borrowing. The government by raising public debt can withdraw a large volume of money
from circulation and thus, it may check rising prices. But modern economists prefer taxation to
public borrowing, as an anti-inflationary measure because money received through public
borrowing increases the liability of the government for its repayment.

f. Economic Development :
An underdeveloped economy is characterised by low capital formation, high
unemployment percentage, low productivity and low national income. Therefore the
government of an underdeveloped country has to play an active role in the economic
development of the country. Most of these countries have adopted economic planning as a
means to economic development. Government‟s economic activity is therefore, extended to
the development of agriculture, industry, mining, electricity, transport and the provision of
other economic infrastructural facilities.
g. Financing Public Enterprises :
Government are running certain commercial enterprises. These are generally
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productive ones and hence, should be run efficiently. Therefore, the governments
borrow for financing such commercial enterprises.

h. Expansion of Education and Health Services :

Education, public health, etc., are important for the nation as a whole. They improve
the efficiency of the people and hence, the general social well-being. Government may
borrow for financing such services. That is they are not productive in terms of money.

i. Financing War:
Defense is of paramount importance in modern days. The modern age is the age of
atomic warfare and increasing international tensions. Hence every country increases its
expenditure on defense services and up-to-date equipments to protect itself from foreign
aggression. But income through taxation alone is not sufficient and hence, the government is
forced to borrow internally as well as externally for the purpose of financing war.

EFFECTS OF PUBLIC DEBT

The following are the important effects of public debt:

1. EFFECTS ON CONSUMPTION:

Individuals, financial institutions, commercial banks and the central Bank of the
country are the important internal sources of debt for the public authorities. Public debt from
all these internal sources affects consumption pattern and expenditure directly or indirectly.
Public debt from internal sources results in a transfer of purchasing power and hence, the real
resources from the general public authorities. This curbs consumption and has an anti-
inflationary effect on the economy.

If people purchases bonds out of their present savings, the public debt affects directly
the consumption pattern and expenditure of the people. Here, public debt affects consumption
in the same way as taxation.

If, on the other hand, people purchase bonds out of their past savings or out of idle
savings, the public debt does not affect private consumption directly. In this case, public debt
affects private consumption only indirectly. The indirect effect of public debt is as follows:
The past savings, whether idle or active, comes through commercial banks. This reduces the
cash balances with the banks and hence, the credit creation power of the banks. The reduction
in money supply adversely affects consumption of the people.

2. EFFECTS ON PRIVATE INVESTMENT:

When people purchase bonds out of their present savings, it curbs private
consumption, lowers price level, creates deflationary tendencies in the economy and

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ultimately hinders private capital investment.

If, however, people purchase bonds out of their past savings, it does not affect the
present consumption expenditure in any way and therefore the present private investment will
not at all be affected.
3. EFFECTS ON LIQUIDITY :

Public debt is represented by bonds. Bonds are highly negotiable. They can be easily
converted into cash. Thus public debt is responsible for the existence of highly negotiable and
highly liquid form of assets.

4. EFFECTS ON PUBLIC INVESTMENT :

The effects of public debt on investment are not very clear. Two apparently contradictory
effects can be visualised.

Huge public debt may be followed by high taxation rates in order to service the debts.
Heavy taxation to service public debt may generate fear and uncertainty in the minds of the
investors. It will have adverse effects on the willingness of the people to work, save and
invest. Consequently investment will decline.

Huge public debt may be followed by a very low rate of interest in order to keep the
interest obligations of the government at the lowest amount possible. Therefore borrowing
and investment will be encouraged.

5. EFFECTS ON COST OF PRODUCTION :

The effect of public debt on cost of production depends mainly on how the borrowed
fund is utilised by the public authority.

The cost of production of a commodity generally depends on the price of raw materials
and other factors of production. If for example the state utilise the borrowed funds to supply
raw materials to the producers at reasonable rates or to provide transport and training
facilities or to promote industrial research or to give subsidies to private enterprises, the cost
of production will be low.

6. EFFECTS ON RESOURCES ALLOCATION AND NATIONAL INCOME :

If the borrowed fund is used for productive purposes, it increases production and national
income. The cumulative multiplier effect results in further increase in investment,
employment, production and rise in the level of national income.

If the borrowed fund is not used for productive purpose, production decreases and
national income falls cumulatively.

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PUBLIC DEBT IN INDIA

Public debt is an important source of Governments revenue. India‟s public debt has
increased from the introduction of economic planning in 1950. The public debt in India is
undertaken for the following reasons.
 For promoting economic development we have been borrowing both internally and
externally.
 Public debt is also incurred due to the increased defence expenditure. Though we
follow a policy of non- alignment, it is necessary to build a sound military and
unclear- liase.
 The social and cultural development expenditure has increased plans after plan in
order to build a sound education, and health. The population of India is increasing at
the rate of 2.4% per annum. Hence they have to increase our investment in education
and society.
 All the state Governments have to spend more on education, security and health in
their respective states. They are forced to demand more and more of shares from the
Central Government. The increase in debt charges is also another important reason for
the growth of public debt by 20 times.
 Rise in the price level on inflation in India is also an important reason for the growth
of public debt in India. Inflation affect both the private and also public sectors.
 The creation of more and more of administrative posts in India is also an important
cause in the growth of public debt in India. As a result our public debt has to be
increased year after year due to the growth of administrative expenditure.
 The pay-scales and allowances have increased in modern days due to the rise in
prices. As a result the public debt has also increased in India.
 Deficit budgets are also responsible both at the centre and the states for the growth of
public debt in India.

BENEFITS OF PUBLIC DEBT IN INDIA

Public debt in India has benefited the economy in the following ways.

 It has helped in the development of Indian economy. All the sectors of the economy
are being developed with the help of public debt.
 The national income of India has increased as the result of the policy of public debt.
 Public debt has also increased the employment opportunities in India.
 Through the expansion of social services, public debt has improved the human
resources in the country.
 Public debt has provided an opportunity for the people to invest in government
securities. Thus savings are promoted.
 The Indian army has been modernised with the help of public debt.

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PROBLEMS OF PUBLIC DEBT IN INDIA

 The greatest problem of public debt is the problem of repayment. Year after year our
public debt is increasing. Debt charges are also increasing. Therefore we must find
out ways and means for the repayment of public debt in India.
 When public debt increases, public expenditure is also increasing. The government
should not spend extravagantly.
 The resources raised by public debt should not be wasted and there should be well
invested in definite projects.
 Many people have criticised that India has been mortgaged to foreign countries. The
recent IMF loan of Rs. 5000 cores is criticised by a number of people. India has to
pay Rs 72 lakhs per day by way of interest and repayment.
 To some extent, foreign loans even affect our economic freedom.
 Some times to relieve the foreign debt, heavy tax is imposed.
 The adverse balance of payments in India is also due to our heavy public debt.

Market loans, floating debt, special floating loans, etc., constitute the internal debt of
India externally we borrow from the countries as well as international financial institutions
like the IMF, IBRD etc., Both internal and external loans have also grown in magnitude. This
is because we are not able to rise the resources through taxation only. Again loans
are expected mop-up the excessive purchasing power from the people. The ratio of internal
public debt to national income in India is not high compared to the ratio in most of the
countries in the world.

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UNIT – IV

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TAXES

Meaning and Definition:

Taxes form the most important part of the revenues of any State.

―A tax is a compulsory contribution of wealth of person or body of persons for the

services of public powers‖ (Bastable).

―Taxes are compulsory contributions to public authorities to meet the general expenses
of Government which have been incurred for public good and without reference to special
benefits‖ (Findlay Shirras).
Characteristics of a Tax :

A tax possesses the following three important characteristics.

 A tax is a compulsory contribution from the citizen to the public authority.

Refusal on the part of the tax payer to a particular tax to the public authority is
liable for punishment by the court of law.
 A tax imposes a personal obligation on the tax payer. The tax payer has the
obligation to show of all his incomes to the government and pay the eligible
amount of tax to the government. He should not hide the particulars of his income
and evade payment of tax.
 The tax revenues are spent for the general and common benefit.
CANONS OF TAXATION

Canons of taxation refer to the administrative aspect of the tax. They relate to the
rate, amount method of levy, and collection of a tax. In other words, the qualities or
attributes of a good tax are called canons of taxation. It was none other than Adam Smith
who gave first a detailed and comprehensive statement of the principles of taxation.
According to Findlay Shirras, ―No genius, however, has succeeded in condensing the
principles into such clear and simple canons as has Adam Smith.‖
Adam Smith has given the following four canons of taxation.

1) Canon of Equity

2) Canon of Economy

3) Canon of Certainty and

4) Canon of Convenience. (2 Es& 2Cs).

CANON OF EQUITY

Canon of equity or equality is the most important and basic Canon of taxation. It is

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based on the principle of social justice and ability to pay. Tax burden should be equally
distributed among the tax payers according to their ability to pay. That is, the rich people
should bear a heavy burden and the poor a less burden. Hence, the tax system should be
progressive. According to Adam Smith, “The subject of every state ought to contribute
towards the support of the government, as nearly as possible, in proportion to their
respective abilities, that is, in proportion to the revenue which they respectively enjoy
under the protection of the state.”

CANON OF ECONOMY

Canon of economy explains that taxes should be collected at minimum cost. The tax
laws and procedures should be simple. The administrative machinery should not be elaborate
and costly. According to Adam Smith, “Every tax ought to be so contrived as little to
take out and to keep out of the pockets of the people as possible over and above what it
brings in to public treasury of the state.”
Adam Smith argued that lack of economy would result when:

1) Tax administration is costly on account of complicated taxes.

2) Taxes are unduly heavy which would discourage investment, so that the income
level reduces, hence the relative tax yields.
3) Taxes are having elaborate and complicated administrative supervision and
4) Taxes are unproductive in yielding sufficient revenue.

CANON OF CERTAINTY

Taxation must have an element of certainty. That is, there must be certainty about the
tax which an individual has to pay. Things like the time of payment, the manner of payment,
and the quantity to be paid etc. should be plain and clear to the tax payer. It should not be
arbitrary. 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 to be clear and plain to the contributor and to every other
person.”

CANON OF CONVENIENCE

It explains that a tax should be levied in such manneror in such a time that it is
convenient for the tax payer to pay it. In the words of Adam Smith, “Every tax ought to be
levied at the time or in the manner in which it is most likely to be convenient for the
contributor to pay it.”

OTHER CANONS OF TAXATION

Besides the four canons put forward by Adam Smith, there are some other canons
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given by writers like Charles [Link]. They are canon of productivity, canon of elasticity
or flexibility, canon of simplicity, canon of diversity, canon of co- ordination etc.

CANON OF PRODUCTIVITY

Tax should be productive of large revenue. According to this canon it is desirable to

have a few taxes yielding large revenue rather than having a large number of taxes yielding
small [Link] also implies that instead of imposing large number of unproductive taxes, it
is advisable to have a few productive taxes.

CANON OF ELASTICITY

It means that taxation should be flexible or elastic. That is, it should be capable of
increasing or decreasing the tax revenue depending on the need of the government. In other
words, the tax revenue may increase automatically whenever needed by an upward revision
of tax rates or by extension of its coverage.

CANON OF DIVERSITY

This implies that there should be a number of different taxes in the country. This
will make every citizen of a country to pay something to the national exchequer. As the
number of taxes increases it will increase the administrative costs, reducing the revenue.
Hence, too many taxes are to be avoided.

CANON OF SIMPLICITY

This canon implies that the tax should be simple to understand even to a layman. It
should be free from all ambiguities and provisions to avoid differences in interpretation and
legal disputes.

CANON OF CO-ORDINATION

There should be co-ordination among different layers of governments in imposing

taxes. Especially, in a federal country like India there should be co- ordination among the
central, state and local governments regarding taxes, since each of these is having legal
right to impose taxes.

CLASSIFICATION TAX

Taxes are classified on different bases. Different bases adopted by the economists to
classify taxes are the forms, nature, aims and methods of taxation. The various taxes may
be classified under following major heads.

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CLASSIFICATION OF
TAXES

Progressive,
Proportional,
Direct Taxes and Regressive Single and Specific and ad
Indirect Taxes and multiple valorem taxes
taxation
Degressive
Taxes

A) DIRECT TAXES AND INDIRECT TAXES

According to Dalton „ A direct Tax is really paid by a person on whom it is legally

imposed, while an indirect tax is imposed on one person, but paid partially or wholly
by another, owing to consequential change in the terms of some contract or bargaining
between them.‟

According to J S Mill, „A direct tax is one, demanded from the very person who is
intended or desired should pay it. Indirect taxes are those which are demanded from
the one person in the expectation and intention that we shall identify him at the
expenses of another‟.
According to Prest, “The distinction between direct and indirect taxes is more commonly
drawn by reference to the basis of assessment rather than the point of assessment.”
Professor Antonio defines direct taxes as, “Direct taxes strikes a citizen’s
income at the moment of its production.”

In the words of Gladstone, “The direct and indirect taxes are like two attractive sisters
between whom an exchequer should be perfectly impartial.”

According to P.E. Taylor, an authority on public finance, distinguished direct taxes and
indirect taxes as follows,‖ The terms direct and indirect taxes are finally distinguishable
in meaning only in terms of shift ability. Direct taxes are not shifted while indirect
taxes are.”

From the above we can reach in a conclusion that direct taxes are those which are paid
by persons on whom these are imposed and the real burden is also borne by them. The
burden of such taxes cannot be transferred or shifted to some other persons. That is, in

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the case of direct taxes both impact and incidence fall upon the same person.

Indirect taxes are imposed on one person but are paid either partly or wholly by
another. The person who pays the tax in the first instance, transfers its burden on the
shoulders of another person. In other words, an in the case of indirect tax, the impact and
incidence of the tax fall on different persons.

Examples of direct taxes are income tax, wealth tax, corporation tax, gift tax etc. And
examples of Indirect taxes are Sales tax, excise duty, VAT etc.

Merits of Direct Taxes:

Following are the main merits of direct taxes.

1) Equity: direct taxes such as income taxes, taxes on property, capital gain taxes etc.
are progressive in their nature. That is, higher incomes are taxed heavily and lower
incomes are taxed lightly. Hence, direct taxes are based on ability to pay of the tax
payer and they ensure the canon of equity.

2) Economy: The administrative cost of collecting the direct taxes is low. The tax
payers directly pay the tax to the state. So there is not much waste of resources and
time. That is, direct taxes satisfy the canon of economy.

3) Certainty: Another merit of direct tax is that it is certain. The tax payers know how
much tax is to be paid, on what basis tax is paid to the government etc.
Thus, the tax payer is able to make adequate provision the payment of tax in
advance. The government can also plan development activities since they can
estimate the amount of revenue they receives in the form of taxes.

4) Elasticity and revenue generation: the yield from direct taxes increases as the
country economically advances. The government gets more revenue through direct
taxes automatically at higher rates.

5) Distributive justice: Since direct taxes are progressive in rates, tax rate increases as
the income of individuals rises. The tax burden will heavily be on the richer sections
of the society. The increased revenue through taxes is allocated for providing
subsidized food, clothing and housing to the poor and needy people. This will bring
about distributive justice in the country.

6) Civic consciousness: Direct taxes create civic consciousness among the tax payers.
The tax payers will be vigilant in the utilization of the tax revenue and will see
whether the resources are efficiently used and wastage is avoided.

7) Absence of leakages: since there is direct payment of taxes by tax payers to the
government, there is no room for any wastage. The whole amount of direct taxes
such as income taxes, property taxes, and taxes on capital gains etc., reaches the
treasury without any middlemen.
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Demerits of Direct Taxes

The important demerits of the direct taxes are explained below.

1) Uncertainty: The precise degree on needed progression cannot be estimated on

account of the difficulties of measuring the ability to pay and the subjective nature of
the marginal utility of income.

2) Unpopularity: the direct taxes are directly imposed on individuals. They have to
bear both the impact and incidence of these taxes. Thus they experience their pinch
directly. Consequently, direct taxes are not as popular as indirect taxes.

3) Violation of the principle of equity: the burden of direct taxes falls almost
exclusively on the richer sections of the society while the poorer section are totally
exempted from these taxes. This is unjustified and improper because the burden of
state expenditure should be borne by individuals at all levels of society according to
their ability to pay.

4) Large scale evasion: direct tax is based on honesty. The tax is not evaded only when
the tax payer is honest. It is a fact that the people in the higher income groups do not
reveal their full income. It is remarked that ―direct taxes are a premium on honesty.‖
Merits of Indirect Taxes

The following are the important merits of indirect taxes.

1) Convenience: Indirect taxes are more convenient to pay. It is paid at the time of
purchase of a commodity. Hence, the tax payer does not feel the burden of tax. The
tax is hidden in the price of the commodity bought. It is paid in small amount. The
government can also collect it conveniently.

2) Indirect taxes lead to social welfare: indirect taxes on narcotics and intoxicants
reduce the consumption of them which are harmful to health. Reduction in the
consumption of such goods will indirectly increase the welfare of the people.

3) Indirect taxes are justified: indirect taxes are justifiable and equitable. They are
paid by all the individuals and when they purchase goods and services.

4) Indirect taxes help production and investment: Another advantage of indirect

taxes is that they perform as powerful tool in moulding the production and
investment activities of the economy.

5) No evasion: Indirect taxes are generally difficult to be evaded as they are included in
the price of the commodity. A person can evade an indirect tax only when he decides
not to purchase the taxed commodity.

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6) Highly revenue yielding in developing countries: direct taxes do not yield much
income in developing countries, as the income of the people is very less. Since
indirect taxes cover a large number of essential commodities to be consumed by both
the rich and the poor in the country, large revenue could be collected.

Demerits of Indirect Taxes

1) Indirect taxes promote inequality: Indirect taxes are generally imposed on the
consumption goods. The poor people have to pay as much by way of indirect taxes
on commodities as the rich people. This is unjust and equitable. They are regressive
in nature which will promote economic inequality in society by imposing larger
burden of taxes on the poor people.

2) Uneconomical: Indirect taxes involve high costs of collecting them. To raise desired
levels of public revenue, taxes should be collected from millions of people.

3) Element of uncertainty: Indirect taxes are extremely uncertain. The revenue

accrued to the government from indirect taxes cannot be estimated accurately. As
soon as the tax is imposed, the price of the commodity is raised. This will in turn
reduce the demand for the commodity. It cannot be estimated with certainty as to
what extent the demand falls.
4) Lack of civic consciousness: Indirect taxes do not create civicconsciousness as the
tax payers in most cases do not feel the burden of the tax they pay.
5) Indirect taxes promote inflation: another demerit of indirect taxes is that it
promotes inflationary tendency in the economy, as they would increase the prices of
the taxed goods.
6) Discourage saving: Indirect taxes discourage savings because they are included in
the prices of commodities. Therefore, people have to spend more on the purchase of
commodities. This will reduces the disposable income of the people and hence the
savings.

B) PROGRESSIVE, PROPORTIONAL, REGRESSIVE AND DEGRESSIVE TAXES

A tax may be progressive, proportional, regressive or degressive according to the
relationship between tax rate structure and tax revenue.
Progressive Tax:

A progressive tax is that in which the rate of the tax depends on change in income.
That is, the rate of tax increases with the increase in the income. The higher the level of
income, the higher the tax will be and vice- versa. (Table-1)

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 Table1. Progressive Tax Rates Public Finance
Taxable income Tax Rate% Amount of tax
3000 10 300
4000 15 600
5000 20 1000
6000 25 1500

Proportional Taxes

A proportional tax is one in which the rate of tax remains the same irrespective of the
level of income. Here, the same percentage of tax is levied on all income groups. The tax
amount is simply calculated by multiplying the tax base with the tax rate. This is illustrated
in Table 2.
Table-2 Proportional Tax Rates

Tax Base Tax Rate Amount of

% tax
1000 10 100

2000 10 200

3000 10 300

Regressive Taxes
In regressive taxation, the higher the income of the tax payer, the smaller is the
proportion of income he contributes to the government in the form of taxes. That is, in the
regressive taxation, the tax rate declines as income increases. This type of taxation is against
the objective of welfare state in modern time. (Table 3)

Table [Link] Tax Rates

Tax Base in Rs. Tax Rate % Amount of tax in Rs.

1000 10 100

2000 8 160

3000 6 180

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Degressive Taxes

Under this tax system, the tax is mildly progressive up to a certain limit. After that
the tax may be charged at a flat rate. In other words, degressive tax system is a mixture of
proportional as well as progressive tax system. In this, the higher income group people have
to make little sacrifice in comparison with lower income group. (Table 4)

Table 4. Degressive Tax Rates

Tax Base in Rs. Tax Rate % Amount of Tax in Rs.

1000 10 100

2000 12 240

3000 13 390

4000 13 520

C) SINGLE AND MULTIPLE TAXATION

Single tax refers to a system in which the taxes are levied only on one item or head
of tax. It is only one kind of tax. It implies a tax on one thing. That is, one class of things or
one class of people. This type of tax was advocated by economists from 17th to 19th
century. Such a tax is collected at regular intervals, may be monthly or annually or any
other shorter or longer duration. A single tax may be progressive, proportional or
regressive.
First of all, the physiocrats during the 17th and 18th century strongly advocated a
single tax on land, for according to them agriculture was the only productive sector yielding
surplus. Issac Sherman proposed a single tax on all real estates—on land— because it was
convenient in administration and payments. Henry George also advocated a single tax on
land mainly because he thought that it was not possible to shift the tax.

Merits of Single tax System

1) It is a very simple tax as it simplifies the work of the government.

2) It is less costly as lesser amount is spent to collect the revenue.

3) It is based social justice.

4) It does not discriminate against any particular work or industry.

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Demerits

1) It cannot bring adequate revenue to meet the needs of the modern

governments.
2) Single tax system violates the principle of ability to pay.

3) The burden of taxation is not equally distributed.

4) The tax system is not effective during the period of emergency or crisis.

5) Tax evasion is much possible.

6) It lacks elasticity.

MULTIPLE TAXATION

The multiple taxes imply that there should be all types of taxes so that every citizen
can contribute to the state revenue. Similarly, modern economy has to fulfil many objectives
like those of economic growth, equitable distribution of income and wealth, economic
stability, full employment and so on. Since no single tax can realise all these objectives
simultaneously, a multiple tax system is preferred. But at the same time, too many taxes will
yield only a small amount of revenue. The cost of collection will be very high. According to
Dalton, ―It is better to rely on few substantial taxes for the bulk of revenue.‖ Thus, the
burden of taxation should be widely distributed. Multiple tax system is a mixture of
proportional, progressive, direct and indirect taxes.
Merits

1) It leads to equitable distribution of tax burden as it includes proportional,

progressive, direct, and indirect taxes.

2) Tax evasion is very difficult under this system.

3) It is more flexible than single tax system.

4) It is based on the principle of equity.

5) It enhances the income of the governments.

Demerits

1) It is more complicated than single tax system.

2) Too much multiplicity leads to inconvenience to both the taxing authority and the
tax payer.

3) It is not based on the principle of ability to pay.

4) It checks the productive process of the economy.

D) SPECIFIC AND AD VALOREM TAXES

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According to the assessment, taxes on commodities can be divided in to two

types—Specific tax and Ad Valorem tax.
SPECIFIC TAX
Taxes which are based on specific qualities or attributes of goods are called Specific
tax. This tax is imposed on commodities according to their weights, size or volume. It is a
per unit tax on commodity. For example, specific excise duty may be levied on the cloth in
the length units and tax on sugar is based according to the units of weight.

Advantages

1) It is quite easy to calculate and administer.

2) The collection of the tax is very convenient.

3) It does not add to inflation, since it is fixed in amount.

4) It confirms to the canon of certainty.

5) It is difficult to evade as the tax is imposed on the basis of weight, size or

measure.
Disadvantages

1) It is regressive in nature. It falls heavily on the cheaper varieties of products which

the lower income groups consume.

2) It is less equitable as compared to the ad valorem tax.

3) They are less productive and less elastic.

4) They are also less economical during the period of inflation.

AD VALOREM TAX

When a tax is imposed on a commodity on the basis of its value, it is called ad

valorem tax. This type of tax is levied after assessing the value of the taxable possession of
a person. For example, several imported articles are taxed in terms of value and they have
nothing to do with the weight, length, and size of the commodity.
Advantages

1) It imposes greater burden on the rich section of the society.

2) It is more equitable as it is imposed on the value of goods and thus the canon of
ability to pay is fulfilled.

3) It is highly productive and elastic.

4) It is economical.

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Disadvantages

1. It is quite difficult to administer as it is difficult to assess the value of commodities.

2. It increases inflationary pressures when there is rise in price level

3. There is wide scope for tax evasion as people may show smaller value of a
particular commodity only for the sake of saving the tax amount.
MAJOR TAXES IN INDIA

The taxes of the government may be classified into three categories: 1) Taxes on
income and expenditure 2) Taxes on properties and capital and 3) Taxes on commodities.
First two types of taxes are direct taxes and the third type of taxes is indirect taxes.
INCOME TAX

Income tax has become the most important type of direct tax in India. The period of
assessment of income tax is one year. Money income is taken as the basis of income tax in
almost all countries of the world. In India income tax was introduced in 1860 by Sir James
Wilson to meet the heavy expenses incurred during the Sepoy Mutiny of 1857. Though it
was introduced to meet only the temporary needs of the government, it became a permanent
feature of our tax system due to its revenue yield. In 1939, the rate structure was designed o
n a slab System.

After Independence, the government appointed Income Tax Investigation

Commission in 1947, to investigate all matters relating to taxation of income so as prevent
its evasion and avoidance. The Commission recommended in its report in 1948 that all loop
holes in income tax system was to be plugged. The Income Tax (Amendment) Act, 1953
incorporated a number of recommendations of the commission. The Income Tax Act,
1961,as amended from time to time through Annual Finance Acts, is the basis of Income
Tax in India.
A notable feature of income taxation in India is that the whole proceeds of income
tax do not go to the central government. According to the recommendations of various
Finance Commissions, a large share of the total proceeds is distributed among state
governments.

Merits of Income Tax

1) Income tax is based on the principle of ability to pay.

2) It is one of the most important instruments for reducing inequalities in the

distribution of income, because it can be made easily progressive.
3) Income tax is one of the important tools for maintaining price stability.

4) It cannot be easily evaded.

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5) A tax on income prevents the consumption of least useful items.

6) It conforms to the canons of productivity and elasticity.

Demerits

1) The main drawback of income tax is that it will tend to reduce the ability and
willingness to work, save and invest.

2) Direct taxes are inconvenient because complete records and files are to be
maintained up to date by each individual tax payer.

3) There is great scope for tax evasion by concealing actual income.

4) As the poor section of the community remains untouched under income tax, it fails
to achieve the objective of creating civic consciousness among the people.

COPORATION TAX
A corporation tax is a tax on net income of business corporations or companies. In
India, it was introduced after the First World War and since then it has become an integral
part of Indian tax structure. This tax is paid by companies and is distinct from the taxes paid
by shareholders on their dividends. That is, corporation tax is paid out of the taxable profits
(net profit) after meeting all costs i.e., interest charges, wages and depreciation costs etc.
earned by the corporation during an assessment year and the remaining is distributed among
the shareholders in the form of [Link] main feature of Corporation tax is that the
entire proceeds of this form the revenue of the Union Government and no share is divided
among states.

Advantages of corporation tax

1) Since the governments confer special benefits upon the companies and
corporations like perpetual legal existence, limited liability and easy capital issue,
they are liable to be taxed.

2) The income of the corporations constitutes an important source of accumulation of

ideal income and wealth, thus it is appropriate to tax such income and wealth in
order to ensure equity in the economy.

3) The undistributed income of the corporations is mainly used as reserves or for

expansion of the company. All these will enhance the capital gains, which are to be
taxed.
4) It is not only that the corporations have independent ability to pay, but also that
their incomes are earned from supplying services. Hence, corporation incomes
should be more heavily taxed than the personal incomes.

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Disadvantages

1) It is argued that the imposition of a corporate income tax and a personal

income tax will bring about a double taxation. This is because of the fact that
shareholders of corporations are also subjected to personal income tax.

2) It discourages investment in risky enterprises.

3) The burden of such a tax falls entirely upon the ordinary shareholders and not
on the preference shareholders.

4) The tax does not facilitate equitable distribution of income.

5) The ultimate burden of corporation tax is to be borne by the consumers. The

corporation will deem the tax as cost of production and will include this in the
prices. Hence, the final burden is rested on the consumers.

GIFT TAX

The Gift tax was also introduced in April 1958 on the recommendation of Professor
Nicholas Kaldor. It covered the Gifts made by individuals, Hindu Undivided Families,
companies, firms and association of persons. Initially, it was levied on the donor and not on
the donee. All gifts made by a donorduring a particular year where liable for Gift tax.
However, the liability of paying the tax was shifted from the donor to the done who receives
the gift under the new Gift Tax Act of 1990. Thus the Gift tax was made donee-based. The
reason for the major change in the taxation on the Gifts is that the mechanism of Gifts was
used to split up capital and launder black money. The Gift tax was also abolished in October,
1998.

EXPENDITURE TAX

Expenditure tax is a tax on expenditure. It is levied when the income is spent. In India
it was first imposed in 1958 following to the recommendations of Professor. Nicholas
Kaldor. He had suggested the imposition ofthis tax to prevent the possibility of tax evasion
and to discourage superfluous consumption. According to Kaldor the major advantages of
expenditure tax are the following

a. It is more easily definable than income tax.

b. Expenditure is better index of taxable capacity.

The expenditure tax was abolished in 1962. It was again introduced in 1964 and was
abolished in 1966. In 1987, it was again introduced under the Expenditure Tax Act,1987.

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COMMODITY TAXATION IN INDIA

The Central Government of India levies two types of commodity taxes –Excise
Duty and Customs Duty.
UNION EXCISE DUTY
The Constitution of India, under Articles 269 (taxes levied and collected by the
Union and assigned to States) and 270 (Taxes levied and collected by the Union and
distributed between Union and States), has made a provision for levying Union Excise
Duties on all commodities produced anywhere in India except alcoholic liquors and opium,
narcotics and narcotic drugs (these are within the jurisdiction of the State governments.)
There are three types of excise duties which are imposed by the governments. They are: a)
Basic Excise Duties b) Earmarked cesses and c) Additional Excise Duties

Basic Excise Duties are levied and collected by the Union Government. The
proceeds are shared with the state governments under Article 272 of the Indian
Constitution.
Earmarked cesses are levied under Special Act and are earmarked for special
purposes. The entire proceeds of earmarked cesses are assigned to the Union Government.
Additional Duties of Excise Act, 1975 provides for the levy and collection of
additional duties on sugar, tobacco, cotton fabrics, woollen fabrics and man-made fabrics.
These are in addition to the basic duties. The entire proceeds of these duties, excluding
those attributable to the Union Territories, are distributed among the states on the basis of
recommendations of the Finance Commission. These duties are levied in lieu of sales tax.
CANONS OF EXCISE DUTIES

Indian Fiscal Commission, 1921-22 had laid down the following canons of excise
duties:

1) Excise duties should ordinarily be confined to industries

which are concentrated in large factories or small areas.

2) The duties are imposed for the purpose of checking the consumption of injurious
articles and especially on luxuries coming under this category.

3) Otherwise they should be imposed for revenue purpose only.

4) While permissible on commodities of general consumption, they should not

press too heavily on the poorer class.

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ARGUMENTS IN FAVOUR OF EXCISE DUTIES

1) The burden of excise duty is not troublesome. The excise duties are paid in small
instalments along with prices by the consumers at convenient times. So the burden
is not felt by the consumers.

2) It helps in discriminating the rich and the poor in the society, if excise duties are
levied on luxuries.

3) It checks detrimental consumption. The imposition of excise duties on injurious

commodities may reduce the consumption.

4) The duties are productive and elastic.

5) The indigenous industries contribute to the public exchequer, since the excise
duties are imposed on indigenous industries.
ARGUMENTS AGAINST EXCISE DUTIES

1) Equity considerations: Excise duties do not provide any exemption or deduction to

individuals as in the case of other taxes. Thus, the distribution of burden of excise
duties is very often, though not always, regressive in nature.
2) Distortions of Resources Allocations: There may be distortions in the allocation of
resources as the excise duties tend to cause distortions in consumer preferences on
account of changes in relative prices of goods and services.

3) Inflationary Potential: The excise duties have a great inflationary potential. The
prices of goods will tend to rise as the burden of excise duties is shifted to the
wholesalers, retailers, and ultimately to the consumers by the manufacturers. The
manufacturers will include the excise duties in the cost of production and will
meet this by increasing the prices for the products.

4) Conflict between Equity and Elasticity: For raising more revenue the excise duties
may be elastic. In order to get more revenue by way of excise duties, the demand
for the taxed commodities is relatively inelastic. Otherwise, the demand will be
contracted and consequently the revenue to the governments will also decline.
Generally, the demand is inelastic for such commodities which are necessaries of
life and are chiefly consumed by the poorer sections of the society. Thus, the
excise duties violate the principle of equity for the sake of raising revenue to the
states.

5) Excess Burden: The excise duties put an excess burden on the community through
a loss of consumer‘s satisfaction due to higher prices and reduced availability of
goods coupled with misallocation of resources.

CUSTOM DUTIES
Taxes on international trade, particularly known as custom duties, are levied and

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collected by the Central Government and entirely owned by it as per Constitutional

provision. Custom duties usually take the form of import duties and export duties. That is,
custom duties are levied on goods imported to India (import duties) from foreign countries
and goods exported from India (export duties) to foreign countries.
Custom duties applies on goods like any other tax – they are applied like ad– valorem
or specific. These types of taxes are progressive which are based on ad-valorem and specific
taxes are known as special taxes which applies according to the number, size and weight of
the goods. Custom duties are of two types (i) Import duty and (ii) export duty. It is not
definite to say that on which sector the burden of this tax lies. Actual situation is that the
burden of custom duties on import duty and on flexibility of demand and supply.
Export duty: Goods which are sent to foreign countries from India, export duty
applies on that. This is not only the main source of government – income infact it has some
important economic effects like export duty on raw materials will lead to the availability of
the cheap raw materials to the industries. On the annual budget export duty also announces.
Import duty: The aim of import duty is to discourage these items which affect the
county‘s production. With this government also gets income. In India it is applied according
to the Indian Tariff Regulation, 1934. Rates of 1934 first and second list it is applies
differently on various items. Like any other Interest rate improvement had also done in the
of custom duty. In 1985 policy to control the import dependence on tariff increased in 1991.
Chelyah committee suggested that on ready goods tax should be applied. In the next years
also improvement in custom duties continued. In 2002-03 in budget announcement was
made that in the year 2004-05 the rate will be of two basic levels on raw materials and
intermediate it will be 10 % and 20 % on ready goods. Because of this in 2002-03 rate will
be decreased to 3% from 35%.

Objectives of Custom Duties

1) For raising revenue: custom duties are one of the important sources of revenue. For
this aim, it is better to levy on goods which are largely imported rather than those
which are produced at home.

2) For protecting domestic industries: Tariffs or duties may be imposed for protecting
domestic industries. Protection is justified on the basis of infant industry argument.
Infant industries may not be able to compete with well- developed industries.
Therefore, it is argued that infant industries are to be protected till they become strong
and can stand on their own legs.
3) For attaining equal status: to ensure an equal status to domestic industries and
foreign industries, a countervailing duty is advocated. The imposition of an excise
duty on the domestic goods will raise the price of domestic goods. This will be
advantageous for the foreign goods and harmful for the indigenous goods. For
attaining an equal status for both goods, a countervailing duty on

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imported goods, which is equal to the excise duty in amount, is to be imposed.

4) For achieving Price stability: price stability is obtained by imposing import and
export duties. A reduction in import duties may increase imports bringing about a
fall in prices. Similarly, an exemption of export duties will be enlarging exports
which will in turn raise prices.

TAXES ON CAPITAL TRANSACTIONS AND PROPERTY

The important taxes in this group are: (i) Estate duty (ii) Wealth tax (iii) Gift tax
and (iv) Capital gains tax

ESTATE DUTY
Article 269 of the Indian constitution provides for the imposition and collection of
the estate duty in respect of property other than agricultural land, by the Centre. The whole
proceeds of this duty except those which are attributable to the Union Territories are
assigned to the States with in which this duty is liveable and distributed among them in
accordance with the law made by the Parliament, on the recommendations of the Finance
Commission.

An estate duty is levied when any movable and immovable property or interest there
in passes or is deemed to pass at death of its owner. The tax is payable by legal heirs on the
estate of a deceased person inherited by them. It is also known as death duty or inheritance
tax or succession tax. This tax came in to force with effect from October 15,1953 and was
abolished from the middle of March 1985.

WEALTH TAX

Wealth tax is a tax which is levied on the net wealth of individual. It is also known
as a tax on capital or property taxation. Wealth tax is different from income tax which is a
tax on income and paid out of income. Wealth is a stock variable whereas income is flow
variable. This tax was imposed on the recommendation of Professor NicholasKaldor in
1957. He justified the imposition of an annual tax on wealth on the ground of equity,
economic effect and administrative efficiency.

Not all wealth holders where taxed. Wealth below rupees 2.5 lakh was exempted.
Initially the tax rate was very high (15%). Consequently it led to wide scale evasion and
avoidance. Subsequently the rate was reduced to a very moderate level ranging from 0.5
% to 2%. In 1992-93 the finance minister withdrew the wealth tax on productive assets
such as guest houses, residential houses, jewellery etc. With effect from April 1993,wealth
tax is chargeable in respect of the net wealth exceeding RS 15 lakh at 1% only. As a
consequence of these changes, the revenue from this tax has gone down considerably.
Recently the wealth tax has been recommended to be abolished.

SALES TAX
Under the Indian government Regulation Act. 1935, states were assigned the Sales Tax.

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Indian Constitution also gives the rights to the states that they can impose tax on any -
newspaper and also collects them. According to Article 286 states are abide for the following
tax.
1. Selling and purchasing of goods of out of the boundary of India.
2. Selling of goods those given to other states for its use.
3. International Business and trade related selling except this if parliament wanted to
impose tax. which term as essential, it has to take permission of the President. For this in
1952 essential Good Act was passed.
Forms of sales tax :
Sales tax is of many types like General Sales Tax and selected Sales tax, multipoint and
single point Sales tax.
1. General sales tax and selective sales tax: When in sales tax law selected items are
kept then it is known as selective sales tax. In other words when selective sales tax applies on
selected items then it is known as Selective Sales Tax. This type of tax is imposed on high
prices and luxurious goods. In opposite of this when law imposes tax and leave some goods
then it is called General Sales Tax. In this way when the collection of tax is based on some
sales then it is General Sales Tax.
2. multi-Point and single-Point sales tax: General Tax is of two types Multi Point and
Single Point Sales Tax. Multi point is a sales tax and also known as one of the parts of single
point sales tax.
under single Point sales tax: Special money add to the good which sold to the consumer
this sales tax is collected on one level it is collected on that level which the producer sold to
wholesaler or on that level also when retailer sold to consumer this single point sales tax
imposed on producer these people gives sales tax to the government and taken back from the
consumer in this way those traders who purchase goods from the producer they are not
eligible for sales tax but have to give those prices in which sales tax is includes.
Multi Point sales tax: Tax applies on goods of all levels at one point it is applied when
producer sold his books to the whole seller and secondly when whole seller sold it to the
trader and in the end it is applied when retailer sold it to the consumer. The rate of this tax is
low and taken by the consumer.
SALES TAX IN UNDER DEVELOPED COUNTRIES
In under developed countries, on one hand states needs financial settlement for their
resources and on the other hand most of the population is poor and also the scope of taxes is
limited. In this condition sales tax which is an indirect tax is helpful for the state government
sales tax is generally included in the price of a goods and it is -to the principle of colvert
scratch duck wings in this way so that it makes less noise. If sales tax is applies on luxurious
items then it will indirectly encourages saving as the increasing price makes it demand down.
In this way this tax lessen propensity to consume and also encourages

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savings. So sales tax is one of an important source of revenue especially in under developed
countries.
Effects on Production
Now, we will discuss that what are the effects of sales tax on production; means-
(a) On ability to do work
(b) On ability to save and invest
(c) On desire to work and save
(a) effect on the ability to Work: decreases when it affects negatively on the work of
a person. So poor class always against it. In this way if sales tax applies on those things which
are consumed by the poor class then it will affect their work and capacity. So sales tax has
negative effects. But it general consuming goods will be tax free or used by the rich class like
luxurious items then it will not affect negatively. This encourages saving. So it is necessary to
make general consumption goods tax free or to apply low interest rate and the burden of sales
tax must be on such goods which are generally used by rich category, such as the goods of
luxuries then there is no possibility of adverse effect of sale tax on production. Not only this, it
can also encourage more savings. Therefore, it is necessary that the goods of general
consumption must be either kept tax-free or taxes must be imposed on them at lower rates and
taxes must be imposed at higher rates at the goods of luxuries.
(b) effect on ability to save: As far as the question arise of capacity this is less than all
the taxes. But there is a different intake of those people who don‘t have excess income from
which they can do there saving. This type of income and burden lies on the poor class which
have no extra means of savings. So sales tax lies on those sectors which don‘t have the capacity
of savings. But being a sales tax it is included in the price of a thing, so this discourages both
consumption and saving. But if its rates become low than savings can be increased and also if it
applies on luxurious items then it will not create serious effects.
(c) effect on Desire to work and save: As far as the question arise of the work of the
people and wish to save, discussion of goods taxes have been already done. But those people
who have to earn for their dependents should do saving but become helpless with the increasing
burden of the taxes. In this situation applying sales tax discourages savings as these types of
people are more concern for their future and earning.
Effect on Distribution
Sales tax imposes on those items which are purchased by the poor class of the society in
this way its nature become regressive. In this situation it increases the inequity between
income and money distribution. But to remove this defect it can be applied on selected and
luxurious items but in that condition it will not remain the source of Revenue. One of the
fundamental defects of sales tax is that it is not related to the consumer‘s capacity. Rich and
the poor pay this on the same rates. Not only this there is no discount for domestic situations
and in this way it lies burden on the same income group which have large quantity dependents.
In this way, general sales tax is of regressive nature one thing is there that production increase

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and money distribution are parts of economic welfare. Here, this is

mentionable that production growth and best distribution of money are undivided friends of
economic welfare. So sales tax should be applied in a manner with which countries production
increases. In the end it can only be said that in the form of revenue source sales tax performed
better and also gives resources in some states it is one of the big and in some is the biggest
sources.

SHIFTING AND INCIDENCE OF TAXATION

The burden of a tax does not always lie on the person from whom it is collected. In
many cases other people also bear the burden. There are three concepts involved in the
process of taxing.

First of all, a tax may be imposed on a person,

Secondly it may be transferred by him to a second person,
Thirdly it may be ultimately borne by the second person or transferred to others by
whom it is finally consumed.

IMPACT OF TAX
The person who originally pays the tax and does not bear its ultimate burden bears
the impact of the tax. The impact of tax is on the person who pays the money in the first
instance.

Shifting of a tax refers to the process by which the money burden of a tax is
transferred from one person to the another.

Incidence of a tax refers to the money burden of a tax on the person who ultimately
bears it. In other word when a tax finally come to rest on the ultimate tax payer it is known
as the incidence of a tax. The incidence of a tax remains upon the person who cannot shift
its burden to any other person. In short these are three different conception namely the
impact, the shifting and the incidence of the tax which correspond respectively to the
imposition the transfer and the setting or coming to the rest of the tax. The impact is the
initial phenomenon, the shifting is the intermediate process and incidence is the result.
DIFFERENCE BETWEEN IMPACT AND INCIDENCE
There are certain important differences between incidence and impact. The impact
refers to the initial burden of the tax while incidence refers to the ultimate burden of the tax.

Impact is felt by the tax payer at the point of imposition while incidence in felt by the tax
payer at the point of settlement or rest of the tax.

Impact of a tax can be shifted but the incidence of tax cannot be shifted.

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IMPORTANCE OF INCIDENCE OF TAX

The concept of incidence of taxation is important in the theory of public finance
because the burden of taxation can be easily assessed with this concept. The government
should know on whom a tax burden is falling. Then only it can levy a new tax. After knowing
incidence the government is in a position to determine the just and fair distribution of taxes.

FACTORS AFFECTING THE INCIDENCE OF A TAX

The following are the important factors which affect the incidence of a tax.
1. Price :
Price acts a medium of shifting. Tax shifting takes place when the imposition of tax
results in price changes. The shifting and incidence will depend upon the conditions which
brought about changes in demand and supply after the imposition of the tax. The shifting of
the incidence may be forward or backward. The shifting is done by raising the prices so that
the incidence would ultimately fall upon the buyers. The extent to which it can be shifted
forwarded will depend upon the extent to which price can be raised.

2. Nature of Demand :
The nature of demand is also an important factor affecting the incidence of a tax. The
nature of demand for different goods is different because the elasticity demand for different
goods is different. Hence the demand for necessaries is inelastic while the demand for
luxuries is elastic. Therefore the relative incidence of a tax on different goods would be
different. The burden of tax is divided almost equally between buyers and sellers in the case
business which is not easily shifted to the consumers.

3. Nature of Supply :
The nature of supply depends upon certain conditions. Those industries which have a
large fixed and immobile capital do not have a very inelastic supply. When the supply is
inelastic the burden of tax is not easily shifted.

4. Effects of period on Shifting :

The shorter the period of time the lesser is the scope of adjusting the supply. The
supply of a commodity cannot be increased in the short period. But in the long period the
supply of the commodity will be relatively elastic because it is easy to change the
capacity of a plant.

5. Area :
The size of the area in which a tax is applicable is also important in its shifting. It may
be very difficult to shift a purely local tax if it is heavy. On the other hand a light local tax
can be easily shifted.

6. General Business Conditions :

During prosperous times taxes can be easily shifted while during depression taxes
cannot be easily shifted. The demand for the commodity is highly elastic and the supply is
inelastic.

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INCIDENCE OF SPECIFIC TAXES

There are two types of tax on income namely taxes on the net income of the individual
and taxes on net incomes of business firms.

A) TAXES ON NET INDIVIDUAL INCOME

A tax imposed upon individual is net income is not generally shifted. Personal incomes
are generally received through wages, interest and rent. The shifting is difficult the case of a
tax on income because of the following reasons.

 The scope of progressive income taxes is limited.

 The burden of taxes falls upon the surplus income.
 Market forces generally remain and favourable to shifting.

In general the burden of taxes on net individual income cannot be shifted.

B) TAXES ON NET INCOMES OF THE BUSINESS FIRMS

A tax on a income of a firm can be shifted to the buyers of the product of the firm.
Hence again it depends upon the elasticity of demand and supply. If, forward shifting is not
possible. On the other hand if the supply is highly elastic and the demand is inelastic,
forward shifting is possible.

C) TAX ON PURE PROFIT

It cannot be shifted because such a tax does not affect the price level.
In the short period the incidence of tax on the profit of the firm will remain upon its
numbers. On the other hand in the long run a competitive industry may be in a position to
shift the income tax burden to the buyers. The firm with enjoy the marginal profits will
leave the industry and the supply position would be affected. Hence the price of the
commodity may be raised. Therefore a part of the tax burden may be shifted forward.

D) INCIDENCE OF SALES TAX AND EXCISE DUTIES

The sales tax is imposed at the time of a sale of a commodity and the excise duties
impose when the commodity is a product. Such a tax is called commodity taxation. The
incidence of such a tax will depend upon the elasticity of demand and supply. If the
elasticity of demand is equal to the elasticity of supply, the tax burden would be equally
divided between buyers and sellers. Hence the price will raise by half the amount of tax. If
the demand is inelastic and supply is elastic the raise in price will be more than the amount
of tax and vice-versa. Generally sales and excise taxes are shifted forward through backward
shifting of taxes is possible. There are some other factors also deciding the incidence of such
taxes. They are listed below.

 During prosperity shifting of taxes is easier.

 If a taxed product has an untaxed substitute forward shifting would be
difficult.
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 When people are accustomed to certain goods the forward shifting of taxes is
easy.

E) INCIDENCE OF CUSTOMS DUTIES

Import and export duties are known as custom duties. The incidence of import and
export duties is determined by the elasticity of demand of the commodities to each country. For
example if the demand for India‟s product to American is inelastic then the major part of
export duty will be upon the buyers in America. On the other hand if the demand for
America‟s product in India is inelastic, then the major part of export duty will be upon the
consumers in India. Let us suppose there are two countries America and Britan and understand
the incidence of imports and exports duties.

FACTORS DETERMINING THE INCIDENCE OF EXPORT DUTIES:

1. If the commodity is produced in America and necessary in Britan the burden of a

export duty will fall upon the consumer of Britan.
2. If America has a monopoly power in the production of the commodity then the export
duty will be upon the people of Britan.
3. If the supply of a commodity to any country is elastic the burden of export duties will be
largely upon the importing country.

FACTORS DETERMINING THE INCIDENCE OF IMPORT DUTIES:

1. If the America is monopolist then the import duty will be on America if the demand for
the product is elastic. On the other hand if the demand for the product in Britan is
inelastic then Britan will have to bear the import duty.
2. If a country imports the major portion of the total world supply of a commodity, the
burden of import duty will depend upon the foreign country.
3. If a commodity is facing completion in the foreign market the burden of import duty
may be partly upon the exporting country and partly upon the importing country.

Thus the incidence and shifting of taxation differ from tax to tax and time to time.
Hence the incidence and impact are not always uniform.

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UNIT – V

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BUDGET

The term budget has been derived from a French word ‗bougette‘ which means a
leather bag or purse. The term ‘budget‘ is commonly understood as a document presented by
a government containing an estimate of proposed expenditure for a given period and
proposed means of financing them for the approval of legislation. As per Article 112 of
Indian Constitution the Government has to present in the Parliament an annual financial
statement showing estimates of revenue and expenditure. This is called the Annual Financial
Statement or Budget. Hence, government budget is a schedule of all revenues and
expenditures that the Government expects to receive and plan to spend during the following
year. A Budget includes a) financial actions of the previous year b) budget and revised
estimates of the current year and c) the budget estimates for the following year. For example,
in the budget 2013-14 there will be the actual estimates of 2011-12, the budget estimates and
revised estimates for the year 2012-13 and the budget estimates for the year 2013-14.

The budget is presented in the parliament by the Union Finance Minister. Similarly,
the State Governments have also to present the budget in the State Legislatures as per Article
202 of the Indian Constitution.
Definitions of Budget
―It is a document containing a preliminary approved plan of public revenue and
expenditure.‖ Prof. Rene Stourn.

―A budget is at once a report on estimates and proposals, that it is the instrument by

which all the processes of financial administration are correlated and coordinated.‖ Bastables.

―A budget is a pre-determined statement of management policy during a given period

which provides a standard for comparison with the results actually achieved.‖ Crown and
Howard.

B.E Buck defines budget as, ―(a) finance plan, (b) a procedure formulating,
authorizing, executing and controlling this plan and (c) some government authority
responsible for each successive step in this procedure.‖

Government Accounts

Consolidated Fund: - All sums of money, all revenues of the governments, the loans raised by
it, receipts by way of repayment of

Loans constitute the consolidated fund. All expenditures are also incurred out of this
fund. No amount can be withdrawn from this fund without the sanction of the parliament.
[Article 266 (1)]

The Contingency fund:- The fund is placed at disposal of the President to enable

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the government to meet the unforeseen emergencies. Prior sanction of the parliament is not
required to spend from the fund.[Article 267]

Public Account:-Certain transactions are not included in the contingency fund. They
include transactions relating to provident funds, small savings collections, other deposits etc.
The money thus received is kept in public account. This money does not belong to the
government. It has to be paid back to the persons and authorities who have deposited it.
Hence, parliamentary approval is not required for payments.[Article 266(2)]

Features of Budget

1. It is a statement of expected revenue and proposed expenditure.

2. It is sanctioned by some authority.

3. It is periodicity, generally annual and

4. It prescribes the manner in which revenue is collected and expenditure is incurred.

5. Budget is prepared on cash basis.

6. Rule of lapse- All unutilized funds within the year ‗lapse‘ at the end of the financial
year.

7. Realistic Estimation.

8. Budget is on Gross/ Net basis.

9. Form of Estimate is to Correspond to Accounts.

10. Estimates to be on Departmental Basis.

Objectives of a Budget

Budget is an important tool of financial administration and an effective means of

enforcing fiscal policies. The main objectives of a budget are the following.
 Re-allocation of resources
 Re-distribution of resources
 Stabilization of resources
 Sources of information to the public of the past, present and future activities,
plans and programmes of the relevant governments.
 Tool of government policy
 To estimate income and expenditure
 An instrument of fiscal policies
 Basis of public welfare
 To ensure financial and legal accountability

 To serve as a tool of management for controlling administrative efficiency.

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OBJECTIVES OF BUDGETING
Planning :
The process of budgeting begins with the establishment of specific targets of
performance and is followed by executing plans to achieve such desired goals and from time
to time comparing actual results with the target goals. These targets include both the overall
business targets as well as the specific targets for the individual units within the business.
Establishing specific targets for future operations is part of the planning function of
management, while executing actions to meet the goals is the directing function of
management. It may be explained as
 Budget plans are made in synchronisation with the overall objectives of the
organisation, keeping mission and corporate strategy into account. Individual plans at unit
level should be in consonance with organisational plan.
 Budgets reflect plans and that planning should have taken place before budgets
are prepared.
 Budgets plans are quantified and responsibility is assigned to the persons who
are responsible for execution of plan.
 Using the budget to communicate these expectations throughout the
organisation has helped many a companies to reduce expenses during a severe business
recession.
 Planning not only motivates employees to attain goals but also improves overall
decision making. During the planning phase of the budget process, all viewpoints are
considered, options identified, and cost reduction opportunities assessed. This process may
reveal opportunities or threats that were not known prior to the budget planning process.

Directing and Coordinating :

 Once the budget plans are in place, they can be used to direct and
coordinate operations in order to achieve the stated targets.
 A business, however, is much more complex and requires more formal
direction and coordination.
 The budget is one way to direct and coordinate business activities and units
to achieve stated targets of performance.
 The budgetary units of an organisation are called responsibility centers.
Each responsibility center is led by a manager who has the authority over and responsibility
for the unit‘s performance.
 Objectives and degree of performance expected from a responsibility
centres are communicated rapidly.

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Controlling :
 As time passes, the actual performance of an operation can be compared
against the planned targets. This provides prompt feedback to employees about their
performance. If necessary, employees can use such feedback to adjust their activities in the
future.
 Feedback received in the form of budget report from the responsibility
centre. This report is helpful to know the performance of the concerned unit.
 Any unexpected changes into the conditions which were prevailing at the
time of preparing budget are taken into account and budgets are revised to show true
performance yardstick.
 Comparing actual results to the plan also helps prevent unplanned
expenditures. The budget encourages employees to establish their spending priorities.
The main objective of Budgeting is to help in achieving the overall objective of the
organization.

COMPONENTS OF A BUDGET
The government budget is divided into Revenue Budget and Capital
Budget.
Revenue Budget or Revenue Account is related to current financial
transactions of the government which are of recurring in nature. Revenue Budget consists of
the revenue receipts of the government and the expenditure is met from this revenues.
Revenue Account deals with Taxes, duties, fees, fines and penalties, revenue from
Government estates, receipts from Government commercial concerns and other
miscellaneous items, and the expenditure there from.
Revenue Receipts include receipts from taxation, profits of enterprise, other
non- tax receipts like administrative revenue (fees, fines, special assessment etc.), gifts
grants etc. Revenue expenditure includes interest-payments, defense expenditure, major
subsidies, pensions etc.
The Capital Account is related to the acquisition and disposal of capital assets.
Capital budget is a statement of estimated capital receipts and payments of the government
over fiscal year. It consists of capital receipts and capital expenditure. The capital account
deals with expenditure usually met from borrowed funds with the object of increasing
concrete assets of a material character or of reducing recurring liabilities such as
construction of buildings, irrigation projects etc.
Capital Receipts include a) Borrowings b) Recovery of loans and advancesc)
Disinvestments and d) Small savings.
Capital Expenditure includes a) Developmental Outlay b) Non-developmental outlay
c) Loans and advances and d) Discharge of debts.

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TYPES OF BUDGETS

Based on the balancing of revenue and expenditure, budgets are divided into
Balanced Budget and Unbalanced Budget.
Balanced Budget: - A balanced budget is that over a period of time, revenue does not
fall short of expenditure. i.e., revenue is equal to expenditure (Revenue= Expenditure).
Unbalanced Budget

The Budget imbalance may be due to an excess of expenditure over income or an

excess of income over expenditure. In other words, budget may either be surplus or deficit.
A budget is said to be surplus when public revenue exceeds public outlay (R>E.)
A deficit budget means a budget when expenditure exceeds revenue (R<E.)

BUDGETARY PROCEDURE IN INDIA

The Constitution of every country lays down a specific procedure in this regard and
the budget is framed and passed. In the Parliament in accordance with that specified
procedure. However this procedure is almost similar in almost all the countries of the world.
The budgetary procedure can be divided into the following five stages :

1. Preparation of the Budget

2. Presentation of the Budget

3. General discussion

4. Voting and

5. Execution of the Budget

1. PREPARATION OF THE BUDGET :

The Finance Department supplies Administrative Ministries and Heads of

Departments with Skeleton forms. The Administrative Ministries and Heads of Departments
are expected to prepare the estimates of expenditure in these forms.

The prescribed form has four different columns :

a) Actual of the previous year

b) Sanctioned estimates for the current year
c) Revised estimates for the current year and
d) Budget estimates for the next year.
The ministries, after examining these estimates pass them on to the Ministry of
Finance.

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2. PRESENTATION OF THE BUDGET :

After the budget is prepared, the Finance Minister obtains the concurrence of the
cabinet with regard to the tax proposals and estimates of expenditure. After this is over, the
Finance Minister presents the budget in the legislature for approval.
The Finance Minister presents the budget in the Parliament usually on the last day of
February. Exactly at the appointed hour, the Finance Minister, accompanied by minister of
Parliamentary Affairs, enters the house, makes a speech and presents the budget. That day is
known as budget day and his speech the budget speech. The budget speech is a very important
document. It gives a bird‟s eye-view of the economic conditions of the country and the
reasons for the financial proposals of the government. Thus the budget is presented in the Lok
Sabha. Then, the budget is also presented in the Rajya Sabha by a junior minister in the
Ministry of Finance.

3. GENERAL DISCUSSION :
There will be no discussion on the budget in the budget day. The time and day for
discussion are fixed by the speaker. Then there is a general discussion on the budget. The
discussion generally lasts for three or four days. The general discussion takes place in both the
houses.

The general discussion is an important stage in budgeting procedure. All items of

expenditure, votable and non-votable, are subject to discussion. During the general discussion,
the members are free to express their appreciation or apprehensions about the tax proposals on
any item of the budget. Thus, the members of the legislature have the opportunity of placing
the grievances of the tax payers before the House during the course of general discussion.

4. VOTING :
After the general discussion is over, the demands of various ministries are put to vote
one after another. The demands of various ministries for grant are called votable expenditures.
The demand of each ministry is introduced by the Minister-in-charge of the respective
ministry or by somebody else on his behalf. The Lok Sabha examines the demand thoroughly
and much time is devoted for discussion. A maximum time limit is also fixed to be two or
three days for each particular demand. After discussion, the demand is voted and it becomes a
grant.

There are certain items which are a charge on the Consolidated Fund of India and
are, therefore non-votable items. Non-votable items include

 Salary and allowances of the President of India

 Salary and allowances of the Judges of the Supreme Court
 Salary and allowances of the Comptroller and Auditor-General of India
 Public debt charges including repayment of public debt
 Salary and allowances of the Chairman and Deputy Chairman of Rajya Sabha

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 Salary and allowances of the Speaker and Deputy Speaker of the Lok Sabha and
 Any expenditure required to satisfy any judgment, degree or award of any court or
arbitration or tribunal
After the demands have been voted, a Finance Bill is prepared and brought before the
House for approval as per the proposals and estimates given in the budget. When the Finance
Bill is passed, an Appropriation Bill is presented to accord legality to the voted Demand-
Grants and to authorise the government to incur expenditure from the Consolidated Fund of
India. Thus, after passing of the Finance Bill and Appropriation Bill by the Parliament, the
budget is sent to the President of India who normally gives his assent. After the President
assent is given, the budget is sent to the Government for execution.

5. EXECUTION OF THE BUDGET :

The execution of the budget is the responsibility of the government. It is the last and
also the most important step in budgeting. The budget should be executed with a high degree
of integrity and efficiency, otherwise, it will fail to accomplish its objectives.

The execution of the budget consists of three aspects :

 Distribution of grants to different Administrative Machineries and Departments

 Collection of revenues and
 Proper custody of the collected funds.

Proper distribution of grants or funds :

The distribution of grants is done by the controlling officers. The distribution plan is
sent to the Accountant-General who, in turn, communicates the distribution plan of grants to
treasuries so that they may have a control over expenditure.

Collection of revenue :
Collection of revenue is also an important step in the execution of the budget. It
involves two kinds of operation – (a) Assessment of revenue and (B) Collection of revenue.
The Central Board of Direct Taxes and the Central Board of Excise and customs are
responsible for assessment, supervision of collection and adjudication of revenue disputes.

Custody of collected funds :

After collection of revenue, proper custody of government funds is the most important
step. There is a District Treasury in each district. Each treasury has under it one or more Sub-
Treasuries. Receipts and disbursements of money take place daily in treasuries and sub-
treasuries on behalf of the Central and State governments. The accounts, thus received from
the various treasuries and sub-treasuries are complied and consolidated by the Accountant-
General on monthly and annual basis.

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BUDGETARY CONTROL

Meaning

CIMA has defined the terms ‗budgetary control‘ as ―Budgetary control is the
establishment of budgets relating to the responsibilities of executives of a policy and the
continuous comparison of the actual with the budgeted results, either to secure by individual
action the objective of the policy or to provide a basis for its revision. ―It is the system of
management control and accounting in which all the operations are forecasted and planned in
advance to the extent possible and the actual results compared with the forecasted and planned
ones.
Budgetary Control Involves :
1. Establishment of budgets
2. Continuous comparison of actual with budgets for achievement of targets
3. Revision of budgets after considering changed circumstances
4. Placing the responsibility for failure to achieve the budget targets.

The salient features of such a system are the following:

1. Determining the objectives to be achieved, over the budget period, and the policy or
policies that might be adopted for the achievement of these ends.
2. Determining the variety of activities that should be undertaken for the achievement of
the objectives.
3. Drawing up a plan or a scheme of operation in respect of each class of activity, in
physical as well as monetary terms for the full budget period and its parts.
4. Laying out a system of comparison of actual performance by each person, section or
department with the relevant budget and determination of causes for the discrepancies,
if any.
5. Ensuring that corrective action will be taken where the plan is not being achieved and,
if that be not possible, for the revision of the plan.
In brief, it is a system to assist management in the allocation of responsibility and
authority, to provide it with aid for making, estimating and planning for the future and to
facilitate the analysis of the variation between estimated and actual performance.
In order that budgetary control may function effectively, it is necessary that the
concern should develop proper basis of measurement or standards with which to evaluate the
efficiency of operations, i.e., it should have in operation a system of standard costing.
Beside this, the organisation of the concern should be so integrated that all lines
of authority and responsibility are laid, allocated and defined. This is essential since the
system of budgetary control postulates separation of functions and division of
responsibilities and thus requires that the organisation shall be planned in such a manner that
everyone, from the Managing Director down to the Shop Foreman, will have his

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duties properly defined.

Objectives of Budgetary Control System
1. Portraying with precision the overall aims of the business and determining targets of
performance for each section or department of the business.
2. Laying down the responsibilities of each of the executives and other personnelso that
everyone knows what is expected of him and how he will be judged. Budgetary control is
one of the few ways in which an objective assessment of executives or department is
possible.
3. Providing a basis for the comparison of actual performance with the predetermined
targets and investigation of deviation, if any, of actual performance and expenses from
the budgeted figures. This naturally helps in adopting corrective measures.

4. Ensuring the best use of all available resources to maximise profit or production,
subject to the limiting factors. Since budgets cannot be properly drawn up without
considering all aspects usually there is good co-ordination when a system of budgetary
control operates.
5. Co-ordinating the various activities of the business, and centralising control and yet
enabling management to decentralise responsibility and delegate authority in the
overall interest of the business.
6. Engendering a spirit of careful forethought, assessment of what is possible and an
attempt at it. It leads to dynamism without recklessness. Of course, much depends on
the objectives of the firm and the vigour of its management.
7. Providing a basis for revision of current and future policies.
8. Drawing up long range plans with a fair measure of accuracy.
9. Providing a yardstick against which actual results can be compared.

WORKING OF A BUDGETARY CONTROL SYSTEM

The responsibility for successfully introducing and implementing a Budgetary Control
System rests with the Budget Committee acting through the Budget Officer. The Budget
Committee would be composed of all functional heads and a member from the Board to
preside over and guide the deliberations.
The main responsibilities of the Budget Officer are:
1. to assist in the preparation of the various budgets by coordinating the work of the
accounts department which is normally responsible to compile the budgets—with the
relevant functional departments like Sales, Production, Plant maintenance etc.;
2. to forward the budget to the individuals who are responsible to adhere to them, and to
guide them in overcoming any practical difficulties in its working;
3. to prepare the periodical budget reports for circulation to the individuals concerned;
4. to follow-up action to be taken on the budget reports;

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5. to prepare an overall budget working report for discussion at the Budget Committee
meetings and to ensure follow-up on the lines of action suggested by the Committee;
6. to prepare periodical reports for the Board meeting. Comparing the budgeted Profit
and Loss Account and the Balance Sheet with the actual results attained. It is
necessary that every budget should be thoroughly discussed with the functional head before it
is finalized. It is the duty of the Budget Officer to see that the periodical budget reports are
supplied to the recipients at frequent intervals as far as possible.
The efficiency of the Budget Officer, and through him of the Budget Committee, will
be judged more by the smooth working of the system and the agreement between the actual
figures and the budgeted figures.
Budgets are primarily an incentive and a challenge for better performance; it is up to
the Budget Officer to see that attention of the different functional heads is drawn to it to face
the challenge in a successful manner.
Advantages of Budgetary Control System

Description
The use of budgetary control system enables the management
Efficiency of a business concern to conduct its business activities in the efficient
manner.
It is a powerful instrument used by business houses for the
Control on control of their expenditure. It in fact provide1`s a yardstick for
expenditure measuring and evaluating the performance of individuals and their
departments.
Finding It reveals the deviations to management, from the budgeted
deviations figures after making a comparison with actual figures.

Effective Effective utilisation of various resources like—men, material,

utilisation of machinery and money—is made possible, as the production is
resources planned after taking them into account.
Revision of plans It helps in the review of current trends and framing of future
policies.
Implementation It creates suitable conditions for the implementation of
of Standard standard costing system in a business organisation.
Costing system
Budgets are studied by outside fund providers also such as
Cost banking and financial institutions, realising that management
Consciousness encourages cost consciousness and maximum utilisation of available
resources.
Management which have developed a well ordered
Credit Rating budget plans and which operate accordingly, receive greater favour
from credit agencies.

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Limitations of Budgetary Control System

Points Description
Budgets are based on series of estimates which are based on the
Based on Estimates conditions prevailed or expected at the time budget is established.
It requires revision in plan if conditions change.
Budgets cannot be executed automatically. Some preliminary
steps are required to be accomplished before budgets are
Time factor [Link] requires proper attention and time of management.
Management must not expect too much during the development
period.
Staff co-operation is usually not available during budgetary
control exercise. In a decentralised organisation each unit has its
Co-operation own objective and these units enjoy some degree of discretion. In
Required this type of organisation structure coordination among different
units are required. The success of the budgetary control depends
upon willing co-operation and teamwork,
Its implementation is quite expensive. For successful
implementation of the budgetary control proper organisation
Expensive structure with responsibility is prerequisite. Budgeting process
start from the collection of requirements to budget and
performance analysis. It consumes valuable resources for these
purpose, hence, it is an expensive process.
Not a substitute for Budget is only a managerial tool and must be applied
management correctly for management to get benefited. Budgets are not a
substitute for management.
Budgets are considered as rigid document. But in reality, an
organisation is exposed to various uncertain internal and external
Rigid document factors. Budget should be flexible enough to incorporate
ongoing developments in the internal and external factors affecting
the very purpose of the budget.

Components of Budgetary Control System

The policy of a business for a defined period is represented by the master budget the
details of which are given in a number of individual budgets called functional budgets. These
functional budgets are broadly grouped under the following heads:
1. Physical budgets : Those budgets which contain information in terms of physical
units about sales, production etc. for example, quantity of sales, quantity of production,
inventories, and manpower budgets are physical budgets.

2. Cost budgets : Budgets which provides cost information in respect of manufacturing,

selling, administration etc. for example, manufacturing costs, selling costs, administration

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cost, and research and development cost budgets are cost budgets.
3. Profit budgets : A budget which enables in the ascertainment of profit, for example,
sales budget, profit and loss budget, etc.
4. Financial budgets : A budget which facilitates in ascertaining the financial position
of a concern, for example, cash budgets, capital expenditure budget, budgeted balance sheet
etc.
DEFICIT FINANCING IN INDIA
The fiscal policy plays a very important role in any economy. Through its fiscal policy,
the government creates and sustains the public economy consisting of the provision of public
services and public investment. It is also an important instrument for the reallocation of
resources according to national priorities, redistribution, promotion of private savings and
investments, and the maintenance of stability. If the fiscal policy is not managed in a prudent
way then it can create a fiscal mess. A fiscal imbalance needs to be rectified immediately
through corrective measures because a large fiscal deficit is unsustainable.
Up to the mid-1980s in India fiscal imbalance was seen in terms of the overall budget
deficit measured by the gap between the expenditure and the receipts under the revenue and
capital accounts have been taken together. This gap was actually filled up by deficit
financing.

What is deficit financing?

In India, it is defined as ―borrowings from the Reserve Bank of India against the issue
of Treasury Bills and running down of accumulated cash balances‖. When the government
borrows from the Reserve Bank of India, it merely transfers its securities to the Bank. On the
basis of these securities the bank issues more currency and puts them into circulation on behalf
of the government. This amounts to the creation of money. Nowadays most governments
both in the developed and developing world are having deficit budgets and these deficits
are often financed through borrowing. Hence the fiscal deficit is the ideal indicator of
deficit financing. In India, the size of fiscal deficit is the leading deficit indicator in the
budget. It is estimated to be 3.9 % of the GDP (2015-16 budget estimates). Deficit
financing is very useful in developing countries like India because of revenue scarcity
and development expenditure needs.

Various indicators of deficit in the budget are:

Deficit financing is the budgetary situation where expenditure is higher than the
revenue. It is a practice adopted for financing the excess expenditure with outside resources.
The expenditure revenue gap is financed by either printing of currency or through
borrowing
1. Budget deficit = total expenditure – total receipts
2. Revenue deficit = revenue expenditure – revenue receipts
3. Fiscal Deficit = total expenditure – total receipts except borrowings

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4. Primary Deficit = Fiscal deficit- interest payments

5. Effective revenue Deficit-= Revenue Deficit – grants for the creation of
capital assets
6. Monetized Fiscal Deficit = that part of the fiscal deficit covered by borrowing
from the RBI

Simply budget deficit is printing money to finance a part of the budget. In India,
there is no budget deficit at present. Hence one there is no budget deficit entry in
Government‘s budget. Another absent deficit identity is monetized fiscal deficit. This is
borrowing by the government from RBI to finance the budget. Such a borrowing practice
is not adopted in India from 1997 onwards. Hence the monetized fiscal deficit is also not
there.
The leading deficit indicator and also the best one to measure the health of
the budget in the Indian context is fiscal deficit. The fiscal deficit represents
borrowing by the government. This borrowing is made by the government mostly
from the domestic financial market by issuing bonds or treasury bills

The root factor that cause deficit in the budget is the revenue deficit. Revenue deficit
is the difference between revenue receipts and revenue expenditure in an accounting sense
In recent years, government is following another deficit term called effective revenue
deficit. Actually, revenue expenditure indicates expenditure to finance day to day
functions of the government. They are not productive. But according to the government
some revenue expenditure creates assets and hence is productive. This revenue
expenditure which creates assets is deducted to get Effective Revenue Deficit.
The last type of deficit is Primary Deficit that shows the difference between
fiscal deficit and interest payments.

Underlying Rationale for Deficit Financing

In a developing country sometimes the government fails to mobilise adequate

resources. In this situation, the option of deficit financing is required to meet fiscal deficit
targets. If the option of deficit financing is not utilized the government ends up compromising
on growth targets. A developing country has to make a decision by choosing between two
difficult choices viz. a lower growth rate and an inflationary price rise. It is held that out of the
two options, the price rise is a lesser evil and has to be preferred to a lower growth rate.
The recourse to deficit financing is taken largely because the government fails to
mobilise enough resources from other options. Additionally, it also occurs because of the
rapidly growing expenditures. At times the government has also failed to curb expenditure on
unproductive non-developmental activities as it has lacked fiscal prudence.

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What are the consequences of Deficit Financing?

Deficit financing can have a useful role during the phase of depression in a developed
economy. During this phase, the level of expenditure falls down to a very low level and the
banks and the general public are in no mood to undertake the risk of investment. They prefer
to accumulate idle cash balances instead. The machinery and the capital equipment are all
present there but the incentive to produce is lacking due to a deficiency in aggregate demand.
It is in this scenario that the government pumps in additional purchasing power in the
economy through deficit financing the level of effective demand is likely to increase.
Capital accumulation in developing countries through deficit financing is likely to
generate inflation because in these countries ―the propensity to consume is high, there are
many market imperfections, there is little excess capacity in plant and equipment, and the
elasticities of food supplies are low‖.
As a consequence of deficit financing, the demand for food items is likely to be
pushed up to a far higher level as compared to their supply resulting in an inflationary spiral in
their prices. It is being held by economists that even if deficit financing tends to be
inflationary it carries no danger as long as the inflationary pressures are mild.

Inter-linkage between Deficit financing and inflation

Deficit financing is inherently inflationary. Deficit financing increases aggregate

expenditure which logically enhances aggregate demand. Consequently, the danger of
inflation is always there. At times deficit financing has also resulted in hyper-inflation.
However, the critical variable is the nature of deficit financing which has a bearing on
whether deficit financing is inflationary or not. If the deficit financing is unproductive in
character (for example, war expenditure made through deficit financing) it is definitely going
to be inflationary. However, the net consequence is different if a developmental expenditure is
made via the instrumentality of deficit financing. In this case, deficit financing may not be
inflationary although it results in an actual increase in money supply.
It is being held that ―Deficit financing, undertaken for the purpose of building up
useful capital during a short period of time, is likely to improve productivity and ultimately
increase the elasticity of supply curves.‖ In this case, the productivity is raised which acts as
an antidote against price inflation.
The most crucial thing about deficit financing is that it produces an economic
surplus during the process of development. By economic logic, the multiplier effects of deficit
financing will be larger if total output exceeds the volume of money supply. Consequently, the
inflationary effect will be neutralized.
Deficit financing helps in meeting the liquidity requirements of the growing
economies. Actually, a mild dose of inflation following deficit financing is helpful to the
whole process of development. Deficit financing is not anti-developmental if the resultant
inflationary spiral is only moderate. However, in most cases, deficit financing causes inflation
and economic instability. It is very inflation-prone compared to other sources of financing.

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Some amount of inflation is bound to happen under the following circumstances:

(a) If the economy is fully employed, the raised level of money supply enhances
aggregate money income via multiplier effect. Since no excess capacity in the economy is
there such increased money income leads to a raised level of aggregate expenditure.
Consequently, it incentivizes inflationary rise in prices. Deficit financing immediately
releases monetary resources leading to excessive monetary aggregate demand creating
demand-pull inflation.
(b) It is held that the method of deficit financing is actually a vicious circle. It is very
difficult to escape from the vicious circle of deficit financing once this popular method of
financing is adopted. The inflationary impact becomes stronger once persistent deficit
financing is adopted.
Once the prices zoom up and the government fails to stabilize the price level, rising
prices lead to an increased cost which forces the government to mobilize additional revenues
through deficit financing. This surely threatens price stability. Thus a vicious circle of rising
price level and increased cost sets in. On the whole, deficit financing has the potential to
create demand- pull and cost-push inflationary scenarios.

Pros and Cons of Deficit Financing

Deficit financing happens to be a very popular method, especially in developing

countries. Its popularity is due to the following reasons:
It is beneficial:
 There has been a huge expansion in governmental activities. It has forced
governments to mobilize resources from different sources. As a source of finance, tax-
revenue is highly inelastic in poor countries. Also, governments in these countries are under
political compulsion not to impose newer taxes. If they do so they may lose political support
of the electorate. Additionally, public borrowing is also insufficient to meet the expenses of
the state. In this scenario, deficit financing does not give any trouble either to the taxpayers or
to the lenders who lend their surplus money to the government. Hence, this instrumentality of
deficit financing is most popular to meet developmental expenditure. Deficit financing does
not take away any money from the pocket of anybody and yet provides massive resources to
be utilized for further development.
 In India, deficit financing is associated with the creation of additional money
by borrowing from the Reserve Bank of India. Interest payments to the RBI against this
borrowing come back to the Government of India in the form of profit. Thus, this borrowing
or printing of new currency is virtually a cost-free method. In sharp contrast to this,
borrowing involves payment of interest cost to the lenders.
 Financial resources that a government can mobilize through deficit financing are
certain and the exact figures are known before. The financial strength of the government is
determinable if deficit financing is made.

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
 Deficit financing is an inflationary method of financing. However, the rise in prices
must be a short run phenomenon. In any case, a mild dose of inflation is necessary for
economic development. If inflation is kept within a reasonable limit, deficit financing ends
up promoting economic development. Consequently, it neutralizes the disadvantages of
price rise.
 Deficit financing has certain multiplier effects on the economy. This method
encourages the government to utilize unemployed and underemployed resources. This
results in more incomes and actually ends up promoting employment in the economy.
Disadvantages
It is equally important to understand and critically analyse the disadvantages of deficit
financing. The negative effects of deficit financing are:
 It is actually a self-defeating method of financing. This is so because it always leads to
an inflationary rise in prices and proves to be a vicious cycle as some countries go for
persistent deficit financing.
 Deficit financing-induced inflation helps to produce classes and businessmen to
flourish. However, fixed-income earners suffer very much during inflation. This increases
the gap between the two classes. Consequently, income inequality increases.
 Another significant negative fallout of deficit financing is that it creates significant
distortion in investment pattern. Actually, the investors have a higher profit motive. So, they
tend to invest their resources in quick profit-yielding industries. However, investment in
such industries is not beneficial in the interest of a country‘s long-term economic
development.
 Deficit financing may not produce beneficial results in the creation of employment
opportunities. Generally, additional employment opportunities are not created in poor
resource-deficient countries. This happens because these countries lack raw materials and
types of machinery even if adequate finance is made available via the instrumentality of
deficit financing.
 Under inflationary conditions, the value of money goes down. In this scenario, the
purchasing power of money declines. Consequently, a country experiences a flight of capital
abroad for safe returns. This leads to a scarcity of capital.
 This deficit financing method causes a larger volume of the deficit in a country‘s
balance of payments scenario. This happens because after an inflationary rise in prices there
is a decline in exports while import bill keeps on rising. In this scenario, resources get
transferred from export industries to import- competing industries.

Conclusion
Despite the perils associated with deficit financing, it is quite inevitable that the
governments in poor and developing countries will employ this method of financing. It is a
necessary evil. It is almost like a double-edged sword. Its success is actually premised upon
the way in which it is used. It can be very successful if robust anti-inflationary measures are
employed to combat inflation. The key challenge lies in keeping the inflation within a
reasonable limit. Most of the woes related to deficit financing can be neutralized
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if inflation is kept within a reasonable limit.

It is quite interesting that deficit financing itself needs to be kept within the safe limit
if we want to keep inflation within a safe limit. However, it is difficult to define a safe limit for
the same. Given the fact that deficit financing is unavoidable, it must be exercised with due
prudence and caution. There are contextual and differential needs of the economy and hence
its use cannot be discouraged. However, it must be acknowledged that the risky option of
deficit financing must be utilized in a limited way.

FISCAL POLICY IN INDIA

According to Mrs. Hicks, fiscal policy is ―concerned with the manner in which the
different elements of public finance are primarily concerned with carrying out their own
duties may collectively be geared to forward the aims of economic policy‖. Fiscal policy
refers to the taxation, expenditure and deficit financing policy of a government. The various
fiscal instruments should try to achieve the desired goals laid down by the economic policy
from time to time.

The classical economists laid down the following principles as sound fiscal policy.
 A government should tax the least and spend the least.
 Taxation should be minimum because it would affect production adversely.
 Public expenditure is unproductive.
 Balanced budget should be followed :

Modern economists have rejected the classical approach to public finance. Modern
economists headed by Keynes believe in the concept of functional finance.

FUNCTIONAL FINANCE
This idea was stated by Keynes and developed by A. P. Lerner. According to Lerner,
the fiscal measures should be judged only by their effects. The way in which fiscal measures
work in the economy is called functional finance. Budget is an instrument for achieving and
maintaining full employment with stability. Judging a fiscal policy by it effects in an
economy is called functional finance. According to the concept of functional finance, the
operations of public finance must eliminate the basic causes of inflation and deflation.
However, functional finance is more concerned with the developed countries than with the
developing countries.

FISCAL POLICY IN DEVELOPING COUNTRIES :

The following are the objectives of fiscal policy in developing countries like India.
1. MOBILISATION OF RESOURCES :

The developing economics need more and more of resources for the purpose of
economic growth.

Prof. R. N. Tirpathy has suggested the following methods to raise the incremental
saving ratio :
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 Direct physical control.

 Increase in the rates of existing taxes.
 Imposition of new taxes.
 Surplus from public enterprises.
 Public borrowing of a non-inflationary nature.
 Deficit financing.

2. PROMOTION OF ECONOMIC GROWTH :

Economic growth refers to an increase in real per capita income. Public expenditure
can promote the social and economic overheads. These investments will enlarge the
economies of large scale production, extend the market, raise the productivity and reduce the
cost of production. The government can also undertake investment in industries.
Industrialisation will promote the rate of economic growth. At the same time agriculture can
be modernised. A balanced growth of agriculture and industry can ultimately bring about
economic growth.

3. INCREASE OF EMPLOYMENT OPPORTUNITIES :

The government can provide employment opportunities through public works
programmes. In fact, even developed economies use this type of public works. This type of
work is known as pump-priming. Provision of social and economic overheads will mitigate
unemployment.
4. ECONOMIC STABILITY :
A developing economy has to protect itself from the cyclical fluctuations. Cyclical
fluctuations due to international factors would affect the stability. Export and import duties
can be used for this purpose.

5. REDUCTION OF INEQUALITIES :
Fiscal policy can also achieve an egalitarian society by reducing the inequalities of
income and wealth. Progressive taxation of the rich and government investments for
improving the economic position of the poor can be followed.

Nurkse pointed out that, ―not a change inter-personal income distribution but an increase
in the proportion of national income devoted to capital formation is the primary aim of
public finance in the context of economic development.

CONCLUSION :
Besides the above objectives fiscal policy should aim at achieving a diversified and
self-reliant economy. All the objectives should be well balanced.

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