Faculty of commerce and modern management

Department of Accounting
Semester: Five
Subject:- Public Finance

COIRSE OUTLINES

1. NATURE AND SCOPE OF PUBLIC FINANCE

2. PUBLIC EXPENDITURE

3. PUBLIC REVENUE

4. KINDS OF TAX

5. INCIDENCE AND SHIFTING

6. TAXABLE CAPACITY

7. PUBLIC DEBT

8. FINANCIAL ADMINSTRATION

0
 Chapter 1 NATURE AND SCOPE OF PUBLIC FINANCE

INTRODUCTION/MEANING

The financing of Government is a matter of universal concern. Governments, all over the world
have started number of public projects, such as social security, protection and other services of
public utilities like electricity, water supply, railways, heavy electrical, atomic energy, etc. To
provide social amenities in the form of education, health and sanitation facilities and public
utilities, the Government requires adequate revenue. The total expenditures and revenues of a
Government are much larger than the revenues and expenditures of a single man within the
country.
Public Finance deals with the income and expenditure of public authorities. It deals with the
financial operations or finances of the Government - Central, State and Local Government raises
revenues from various tax sources and non-tax sources, such as revenue from general,
administrative and economic services, borrowings from individuals, corporations and friendly
foreign countries. The Government raises revenue from internal as well as external sources to
incur huge expenditure on various functions the Government has to perform. The important ones
being; maintenance of law and order, defense, socio-economic development, etc. Public Finance
is thus concerned with the use and accomplishment of essential monetary resources of the
Government. In fact, Public Finance deals with how and through what different sources the
Government gets income, how it spends it and how it controls and administers its incomes and
expenditures. These two activities, i.e. raising of revenue through taxation and other sources, and
spending it on various services plus borrowings from internal as well as external sources,
together constitute “Public Finance.” We, therefore, can say that Public Finance includes (1)
public revenue, (2) public expenditure, and (3) public debt and financial administration.

DEFINITIONS OF PUBLIC FINANCE

According to Hugh Dalton’s definition, “Public finance is concerned with the income and
expenditure of public authorities and with the adjustment of one to another”.

In the words of Bastable, “Public Finance deals with expenditure and income of public
authorities of the State and their relation as also with the financial administration and

1
 control.” Above definitions of public finance point out that the scope of Public Finance has been
enlarged by the modern economists. But in whatever words one may define, it frames the
definition, it seems that there is no considerable difference between the sum and substance of
these various definitions. All of them say that it is a study of income and expenditure of the
Central, State and Local Governments. Government performs many functions which the
individual cannot or do not perform. Therefore, raising of funds for the expenditure and their
disbursement constitutes the subject of Public Finance.
SCOPE OF PUBLIC FINANCE

Now, the next question which needs consideration is what is that we study in Public Finance?
What are the various branches of the study of Public Finance?
The above definitions throw light on the subject-matter of Public Finance. The contents of the
science of Pubic Finance are divided into five categories of financial activities of the Government:
1. Public Revenue,

2. Public Expenditure,

3. Public Debt,

4. Financial Administration and Control;

1. Public Revenue

Revenue includes all incomes irrespective of the source they are obtained from. Thus, in the
wider sense, we can include taxes as well as borrowings under public revenue. But in the interest
of the clarity, we study such incomes separately. Hence, in public, revenue, we include only
those incomes which do not carry with them the obligation of repayment for the State. Thus,
public revenue implies raising income, by way of taxation.
2. Public Expenditure

Expenditure is the end and aim of the collection of revenues. In public expenditure, we are
concerned with the principles and problems relating to the expenditure of public funds. We study
the fundamental doctrine that governs the distribution of the expenditure among various heads. As
public expenditure is an important component of Public Finance, therefore we also study various
effects of public expenditure on total employment, total income, aggregate investment, output,
distribution and general price level etc.

2
Through public expenditure, the Government contributes to the financial flows of the economy
and conditions the demand and supply patterns. Public expenditure is also used as a tool for
implementing welfare, growth, stabilization and other policies, by the Government.
3. Public Debt

A public authority can obtain income through loans and public borrowings. The loans raised in
a particular year constitute receipts for that year. It is an income of a capital nature, while the
provision for repayment of the capital sum for the year constitutes expenditure of a capital
nature.
The study of public debt also includes:

(i) Methods and objectives of public borrowings;

(ii) Management of public debt; and

(iii) Burden of public debt - internal and external.

Methods of public debt are an important instruments of not only raising funds but also for
meeting increasing Government expenditure, for securing economic stability, increasing
public borrowings during the periods of inflation and liquidation of public debt during the
period of depression, borrowings from the people during inflation and borrowings from banks
during depression and so on. 4. Financial Administration

It examines the mechanism by which, revenue, expenditure and debt are carried on. Therefore,
under financial administration, we are concerned with the machinery of the Government that is
in charge of performing various financial functions of the State.
Thus financial administration and control include the following:

1. Study of budgets and their procedure.

2. Budget as an instrument of securing certain objectives, such as promotion of

employment, economic growth with stability, welfare of the weaker sections,
infrastructural development for promoting private investments, etc.
3. Financial and physical controls through different fiscal tools for controlling private
expenditure in the economy to avoid the effects in inflation, deflation, recession, etc.

3
Significance of Public Finance

Public Finance occupies great significance in an underdeveloped or developing country.

According to R.J. Chelliah, “Public Finance has a positive and significant role in the context of
economic development.”
The importance of public finance in an underdeveloped / developing country may be
summarized as under.
1. Capital Formation

Since the economic development of the country depends on the rate of capital formation, the
first and the foremost aim of Public Finance is to promote capital formation. In a developing
country, the Government’s economic policy should concentrate on production and fiscal
policy should act as a tool of capital formation. For rapid capital formation, the Government
should incur expenditure on the establishment of basic and heavy industries, infrastructure
development, such as power projects, transport sector, means of communication, etc.
2. Economic Stabilization

Economic stabilization is yet another economically significant responsibility of the

Government. The problem arises whenever there is economic instability such as inflation,
deflation and recession. Public Finance (revenue and expenditure process of the Government)
may be, therefore, used to secure economic stability or to remove economic fluctuations in the
economy.
3. Full Employment

Public Finance also plays an important role in increasing employment.In an

underdeveloped/developing country, major problem faced by the people is the problem of
unemployment. This problem leads to low standard of liy.ing, poverty, backwardness,
ignorance and above all starvation. It is the function of public finance to provide employment
opportunities. Therefore, expenditure should be incurred by the Government for increasing
employment and for achieving full employment. To generate employment, public expenditure
should be incurred on setting up new industries, encouraging small-scale and cottage
industries through financial subsidies, expenditure on training schemes, etc.
4. Balanced Regional Development

For the economic development of a country, balanced regional development is very essential.
4
Balanced regional development is possible by developing backward areas instead of urban
areas. To encourage this diversion, the Government should provide fiscal or tax concessions in
the form of 5-year tax holiday, communication facilities should also be provided. If the private
industries fail to divert to backward regions, should be taxed heavily.
5. Reduction in Economic Inequalities

One of the major problems of underdeveloped countries is the unequal distribution of income
and wealth. There is a gap between the rich and the poor. Public finance has an important role
to play in this context. To bring about equitable distribution of income and wealth, the
Government should follow the system of Progressive Taxation. In other words, the
Government should impose heavy taxes on the richer section of society, and the amount
realized from the rich should then be spent on the poor by way of providing them social
amenities such as free education, medical facilities, public utilities like roads, water facility,
recreation facilities, etc.
6. Mobilization of Resources

Mobilization of resources is another important role of Public Finance. The Government can
mobilize or raise resources by imposing taxes on the people and industries, by encouraging
savings through various saving schemes, surplus of public enterprises and borrowing and
making them available for investment for the rapid economic development of the
underdeveloped country.
7. Optimum Utilization of Resources

Optimum utilization of scarce resources is very essential for the economic development of the
underdeveloped countries. In a developing country like India, we find that there is
nonutilization or destruction of scarce resources. The solution of this problem lies in the
optimum utilization of available resources by means of adopting planned monetary and Public
Finance policies. The State can direct the flow of consumption, production and distribution in
the right direction by adopting balanced budgetary policy.

5
 Differences or Dissimilarities between public and private finance

The following are the main points of differences or dissimilarities between public and private
finance:
1. Adjustment between Income and Expenditure – An individual determines his expenditure
on the basis of his income. He prepares his family budget on his expected income during the
month. On the other hand, the government first estimates about its expenditure and then finds
out means to raise the necessary income. As pointed out by Bastable, 'The individual says, I
can spend so much', the Finance Minister says, 'I have to raise so much'
2. Elasticity of Finance – Public Finance is more elastic than private finance. There is not
much scope for changes in private finance while drastic changes can be made in government
finance. For example, a private individual cannot affect any special increase in his income.
As against this the government can increase its income by imposing fresh taxes on the
people.
3. Differences in Objectives – There are a fundamental difference in the objective of private
and public finance. The motive of private expenditure is personal benefit whereas the
objective of public expenditure is social benefit. An individual always tries to save and a firm
to earn profit. But there are no such considerations on the part of the government, except the
public welfare. However, there are some public enterprises which are run on profits that are
utilized for public welfare.
4. Nature of Expenditure – There are differences in the nature of expenditure between the
two" An Individual's expenditure is governed by his habits, customs, fashions etc on the other
hand. The government expenditure depends on its economic and social policies, like
removing unemployment and poverty, reducing income inequalities, providing' infrastructure
facilities, etc
5. Compulsion – There is compulsion in public finance. People have to pay taxes. If they do
not pay, they are punished by fine and imprisonment. BA an individual or firm cannot force
anybody to pay him money. He can file a suit in the court. But even then he may not receive
his money back. The same is the case with loans. The government can force the people to
lend it during war or emergency. But a individual cannot compel any person to lend him
money.

6
6. Law of Equi-marginal Utility – The private individual spends his me on various items in
such a manner as to secure equal marginal utilities from them. It is only by equalizing the
various marginal utilities that he can secure maximum utility out of his expenditure. The
government on the contrary, does not give as much importance to this law as a private
individual does.
Modern governments sometimes incur certain types of expenditure from which they do not
derive any advantage, but they only incur this expenditure to satisfy certain sections of the
community
7. Present Vs Future – An individual is more concerned with his present needs and tries to
satisfy them. Life being uncertain and short, he has his immediate gain or profit in view. On
the other hand, government is a permanent organization. Only the ruling party changes it is
concerned not only with the welfare of present generation but also I with future generations.
It therefore, undertakes and spends on those activities which also benefit future generations
8. Nature of the Budget – A surplus budget is always good for a private individual. Bin a
surplus budget may not be good for the government. It implies two things: (i) The
government is levying more taxes on the people than is necessary, (ii) The government is not
spending as much on the welfare of the public as it should. Keynes supported a deficit budget
to meet the situation created by depression. Further, the government budget is passed by the
parliament. But the budget of an individual or firm is a private affair without any controlling
authority.
9. Nature of Borrowing – In the case of an individual, there can no internal borrowing". An
individual cannot borrow from himself. He can borrow only from an external agency. The
State, however, can borrow both from internal as well as external sources. It borrows not only
from its own citizens, but also from foreigners.

CHAPTER TWO PUBLIC EXPENDITURE

Meaning and Definition

Public expenditure refers to Government expenditure i.e. Government spending. It is incurred by

Central, State and Local governments of a country. Public Expenditure is incurred by public
authorities - Central, State and local Governments - either for the satisfaction of collective needs
of the citizens or for promoting their economic and social welfare.

7
 Public expenditure can be defined as, "The expenditure incurred by public authorities like
central, state and local governments to satisfy the collective social wants of the people is
known as public expenditure."

Classification of public expenditure refers to the systematic arrangement of different items on

which the government incurs expenditure.

CURRENT AND CAPITAL EXPENDITURE

Classification of Public expenditure refers to the systematic arrangement of different items on

which the government incurs expenditure. Technically, in the structure of a budget, most
Governments classify public expenditure into two:
(i) Current expenditure, and

(ii) Capital expenditure.

All sorts of administrative and defense expenditure and debt services are called current
expenditure. They are also referred to as non-developmental expenditure. They are intended for
continuing the existing flow of goods and services and maintaining the capital of the country
intact. On the other hand, capital expenditures contribute to increased productive capacity of the
nation and therefore, are known as development expenditure. Expenditures on construction of
dams, public works, state enterprises, agricultural and industrial development etc., are instances
of capital expenditure.

1. Revenue and Capital Expenditure:

(A) Revenue Expenditures are recurrent or consumption expenditures incurred on public
administration, defense forces, public health and education, maintenance of government
machinery, subsidies and interest payments. These expenditures are recurrent in nature and they
do not create any capital assets. Revenue expenditure is classified into development and non-
development expenditure
i) Development Expenditure: The part of revenue expenditure that directly or indirectly
contributes to the development of the country is known as development revenue expenditure. It
8
includes expenditures on the maintenance and functioning of social and community services and
physical infrastructure. For example, maintenance of education and public health infrastructure like
schools, hospitals, irrigation facilities, electricity boards etc.
ii) Non-Development Expenditure: The part of revenue expenditure that may not directly
contribute to economic development is known as non-development revenue expenditure. They
include expenditures on the maintenance of defense establishments, administrative expenditure,
interest payments, payment of old age pension etc.

(B) Capital Expenditures are incurred on building durable assets, like highways, multipurpose
dams, irrigation projects, buying machinery and equipment. They are a non-recurring type of
expenditure in the form of capital investments. Such expenditures are expected to improve the
productive capacity of the economy.
i) Not all capital expenditures are productive. Non-development capital expenditure on
defense establishment which does not have any direct impact on economic development but is
necessary for the security of the nation.
ii) Capital expenditures on social infrastructure like government schools, hospitals, primary
health centers may not generate revenue and therefore cannot be termed productive in that sense,
but they indirectly contribute to improving productivity.

2. Productive and Unproductive Expenditure

(a) Productive Expenditure: Expenditure on infrastructure development, public enterprises or
development of agriculture increase productive capacity in the economy and bring income to the
government through tax and non-tax revenues. Thus they are classified as productive expenditure.
(b) Unproductive Expenditure: Expenditures in the nature of consumption, such as defense,
interest payments, expenditure on law and order, public administration do not create any
productive asset which can bring income or returns to the government. Such expenses are classified
as unproductive expenditures.

3. Non-Transfer and Transfer Expenditure:

(a) Non-transfer Expenditures: Are incurred for buying or using goods and services. These
include expenditure on defense, education, public health etc. Investment expenditures on capital
assets are also non-transfer expenditures as the government gets capital goods and assets in return
9
for them. (b) Transfer Expenditures: Refer to those expenditures against which there is no
corresponding transfer of real resources i.e. goods or services. These include expenditures incurred
on old age pension, unemployment allowance, sickness benefits, interest payments on public debt
and subsidies.

4. Plan and Non-Plan Expenditure:

(a) Plan Expenditures: Refer to the spending of the annual funds allocated by the Central
government for development schemes outlined in the ongoing Five Year Plan. For example:
Industrial Development, Agricultural Development, Infrastructure, Education & Health etc. (b)
Non-Plan Expenditures: Include all those expenditures of the government that are not included in
the ongoing Five-Year Plan. They include both development and non-development expenditure.
Part of the expenditure is obligatory in nature e.g. interest payments, pensions etc. and a part is
essential obligation e.g. defense and internal security.

5. Dalton’s Classification: Economist Hugh Dalton has provided the following comprehensive
classification of public expenditure:
i) Expenditures on political executives i.e. maintenance of ceremonial heads of state, like the
President.
ii) Administrative expenditure to maintain the general administration of the country, like
government departments and offices. iii) Security expenditures to maintain armed forces and the
police forces.
iv) Expenditures on administration of justice include maintenance of courts, judges, public
prosecutors.
v) Developmental expenditures to promote growth and development of the economy, like
expenditure on infrastructure, irrigation etc.
vi) Social expenditures on public health, community welfare, social security etc.
vii) Public debt charges include payment of interest and repayment of principal amount.

OBJECTIVES OF PUBLIC EXPENDITURE

Dr. Dalton divided the aims of public expenditure into two parts:

(i) Security of life against the external aggression and internal disorder and injustice.
10
 (ii) Development or upgradation of social life in the community.

REASONS FOR GROWING EXPENDITURE

A mass of factors have caused the rising trend of public expenditure in modern times. We may
enlist a few of them below:
1. Welfare State: The modern state is a welfare state. It aims at promoting the economic,
political and social well - being of citizens. It has to spend increasing amounts on such
items as social insurance, unemployment relief, free medical aid, free education, child
welfare, women welfare, labour welfare, concessional rates of water supply, food stuff,
electricity, etc., to improve the economic and social welfare of the country. As a result,
the public expenditure is bound to increase.
2. Defense: Due to the invention of nuclear weapons there is always a 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 a strong defense.
The defense expenditure in the form of expenditure on war materials, maintenance and
growth of armed forces, pension to retired war personnel etc., are perpetually rising.
3. Population Growth: It is an admitted fact that the population is increasing rapidly. As a
result, the Government has to incur greater expenditure to meet the requirements of the
Increasing population. Rising population also poses problems in poor countries. The
States have added responsibility by solving such problems as food, unemployment,
housing and sanitation. The States have to spend more and more on family planning
campaigns every year.

4. 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. The Government has to spend a lot
on constructing new railway lines, good roads, new roads, highways, bridges and even
canals to connect different areas with a smooth transport system as a prepcondition of
growth.

5. Urbanization Effect: The spread of urbanization is an important factor leading to

relative growth of public expenditure in modem times. Urbanization is responsible for
11
 the increase in expenditure on water supply, electricity, construction and maintenance of
hospitals, roads, schools and colleges, play-grounds, provision of transport, parks,
libraries, sanitation, community halls, street lights etc.
6. Growth of Democracy: Growth of democracy and socialism has been responsible for
the increasing tendency of public expenditure to a great extent. In a democracy, to
achieve the goodwill of the public, the ruling party has to incur heavy expenditure on
providing variety of services and facilities to the public. Expenditure on elections and by-
elections is increasing every year. Number of ministries and executive offices has also
been increased. As a result of this the public expenditure increases rapidly.
7. Rising Trend of Prices: Public expenditure is also increasing in every country due to
rising trend of prices. The reason is that the Government has to buy goods and services
from the market at higher price The Government has also to increase the salaries,
dearness allowance etc., of Government employees leading to a rapid increase in
Government expenditure.
8. Increase in the Activities of the State: In recent years’ activities of the State,
particularly in the social and economic fields, such as education, public health, public
recreation, public works, commerce and industry, five-year plant, etc., have increased
tremendously.
9. The Planning Effects: 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, the public expenditure shows an increasing trend.
Huge sums are also spent by the Government on formulating and implementing plans.

10. 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 social measures. The Government also incurs
expenditure on imparting training to personnel for implementing rural development
programmes.
11. General Expenditure and Internal Security: Internal situation of a country is
becoming uncertain and insecure day by day. Government has been constantly facing

12
 communal and political riots. Hence, to check and control these troubles, the
Government has to spend more on the maintenance of law and order. Moreover, the
Government is bound to spend huge amounts, as in a free country it is essential that the
just demands of the public are duly considered.

CANONS OF PUBLIC EXPENDITURE

In economic, literature, the expression “Canons of public expenditure” it used for the
fundamental rules or principles governing the spending policy of the Government. The following
canons of public expenditure have been laid down by Prof. Findlay Shirras:
1. Canon of Benefit: This canon suggests that every public spending must ultimately he
used for the cause of social benefit i.e. for the general well-being of the common people.
In other words, the State spending should confer benefits on the entire community at
large than on an individual group or section. It means public funds should be spent in
such directions which pursue common interest and promote general welfare.
2. Canon of Economy: It implies that public expenditure should be incurred carefully and
economically. Economy here means that wasteful and extravagant expenditure should be
avoided at all levels. Public expenditure must be productive and efficient. Hence, it must
be incurred only on very essential items of common benefit - without duplication in a
way that involves minimum Cost. An efficient system of financial administration is
therefore, very essential in any country.
3. Canon of Sanction: This canon suggests that no public spending should be made without
the approval of proper authority. Only obtaining prior sanction is not sufficient. It must
be properly inspected and examined whether the sanctioned amount of money is being
spent properly on sanctioned items or not. As a rule, therefore, money must be spent on
the purpose for which it is sanctioned by the highest authority and accounts properly
audited.
4. Canon of Surplus: This canon suggests that saving is a virtue even for the Government,
so an ideal budget is one which contains an element of surplus by keeping public
expenditure below public revenue. In other words, public authorities should aim at
surplus of income over expenditure and they should avoid deficits. Frequent and huge
deficits lead

13
 to uncontrollable financial situation with dire consequences of inflation. Therefore, every
Government should attempt to balance its income and expenditure.

5. Canon of Elasticity: This canon requires that the expenditure policy of the State should
be such that changes must be possible in the expenses according to the changes in
requirements and circumstances. In other words, there should be scope for changes in
public expenditure according to the to the equipment’s of the country.
6. Canon of Productivity: This canon or principle implies that the expenditure policy of
the Government should be such that would encourage production in a country. That
means a large part of public expenditure must be allocated for development purposes.
7. Canon of Equity: One of the foremost aims of public expenditure is also to ensure the
just and equitable distribution of income by conferring benefits on the poorer section of
the community. This canon of equitable distribution is more significant for the countries
where the gap between the highest income and the lowest income groups is very wide.
Underdeveloped countries like India, have given this aim a significant and particular
importance in the economic activities of the State and in their fiscal policies.

Theories of Public Expenditure

In ancient times, classical economists have not paid much attention to frame any theory regarding
the increase of public expenditure. They regarded it as an administrative institution which only
concerned with performing certain functions. The states have to do very little with the provision
of public services, but in 20th century concept of government have changed altogether. The
modern State is termed as ‘Welfare State’ in which the Government has enormous functions to
perform. For the first time, Adolph Wagner, a fiscal theorist propounded an empirical theory to
effect the Govt. inequitably grows larger.
The various theories regarding increasing public expenditure can be classified into two parts as: (a)
Pure theories of public expenditure (b) General theories of public expenditure 1)
Pure theories

The pure theories regarding increasing public expenditure can be further classified into four parts,

but most important are these: - A. Pigou’s Ability to Pay

14
Pigou’s Ability to Pay Theory—Prof. Pigou gave a most comprehensive treatment to ability to pay
theory in the determination of optimum level of public expenditure. According to Pigou, “Goods
and services which are provided by government departments and can be sold for fees so arranged
as to cover cost of production pose no problem. The amount of resources which should be devoted
to these purposes is determined automatically by public demand but fees can cover neither bulk of
nontransfer expenditure of government such as defense, civil administration and so forth nor
transfer expenditure. So, there is no automatic machinery to determine how far expenditure shall be
carried; and some other method has to be employed” He further opined that bulk of current transfer
expenditure debt services, as pensions, old age pensions is regulated by practically irrevocable
contracts. But large parts of non-transfer expenditure are optional. The optional parts of public
outlay transfer as well as non-transfer need to be “regulated with some reference to the burden
involved in raising funds to finance them”. And he propounds the principle of balance based on the
concept of margin. The optimum amount of government expenditure is determined at the point at
which the satisfaction obtained from the last rupee spent is equal to the satisfaction lost in respect
of the last rupee. Pigou states the conditions when government expenditure could be larger as
under: i. the greater is the aggregate income of the community, the larger will optimum amount of
the government expenditure is. ii. Suppose new opportunities for expenditure by government are
opened up but their corresponding opportunities for private expenditure. In this, case the balance
between marginal been expenditure and marginal disutility of revenue will be struck at a higher
point. iii. Given aggregate income and population, greater the concentration of income in the hands
of rich persons, the higher the optimum level of public expenditure. It is for the simple reason that
the tax scheme can be so framed so as to arise given revenue with marginal sacrifice.

B. benefit principle/Analysis:

The benefit principle is a concept in the theory of taxation from public finance. It bases taxes to
pay for public-goods expenditures on a politically-revealed willingness to pay for benefits
received. The principle is sometimes likened to the function of prices in allocating private goods.
In its use for assessing the efficiency of taxes and appraising fiscal policy, the benefit approach was
initially developed by Knut Wicksell (1896) and Erik Lindahl (1919), two economists of the
Stockholm School. Wicksell's near-unanimity formulation of the principle was premised on a just
income distribution. The approach was extended in the work of Paul Samuelson, Richard

15
Musgrave, and others. It has also been applied to such subjects as tax progressivity, corporation
taxes, and taxes on property or wealth. The unanimity-rule aspect of Wicksell's approach in linking
taxes and expenditures is cited as a point of departure for the study of constitutional economics in
the work of James Buchanan.

The benefit principle takes a market-oriented approach to taxation. The objective is to accurately
determine the optimal amount of revenue that should be spent on public goods.

• More equitable/fair because taxpayers, like consumers, would "pay for what they get"
• Taxes are more similar to prices that people would pay for government services
• Consumer sovereignty - specific rather than general...charges are more direct...so the
preferences of taxpayers, rather than government planners, are given more weight
• More efficient allocation of limited resources...it is less likely that funds will be overinvested in
low priority programs.
• There's no such thing as a free lunch - taxpayers would have a better understanding of the costs
of public goods

C. Samulson Theory

The Samuelson condition, authored by Paul Samuelson, in the theory of public goods in
economics, is a condition for the efficient provision of public goods. When satisfied, the
Samuelson condition implies that further substituting public for private goods (or vice versa) would
result in a decrease of social utility.

The Samuelson condition can be re-written as:

MB=MC

where MB is the marginal benefit to each person of consuming one more unit of the public good,
and MC is the marginal cost of providing that good. In other words, the public good should be
provided as long as the overall benefits to consumers from that good are at least as great as the cost
of providing it. (Remember that public goods are non-rival, so can be enjoyed by many consumers
simultaneously).

Each individual consumer's marginal benefit, MB, represents his or her demand for the public
good, or willingness to pay. The sums of the marginal benefits represent the aggregate willingness

16
to pay or aggregate demand. The marginal cost is, under competitive market conditions, the supply
for public goods.

Hence the Samuelson condition can be thought of as a generalization of supply and demand
concepts from private to public goods.

2) General theories of public expenditure

There are two theories that explain increase in public expenditure namely: -
A. Wagner’s law of increased public expenditure
B. Wiseman and Peacock Hypothesis.
1) Wagner’s law of increased public expenditure
Adolph Wagner (1835-1917) was a German economist who based his law on historical facts
prevailing in Germany.
According to him, there has been an inherent tendency for the activities of different layers of
government to increase both intensively and extensively.
Increase in public expenditure is at higher rate than economic growth. He attributed increase in
public expenditure to the following-:
1) Expansion of the traditional function of the state e.g defense, maintenance of law and
order, provision of social overheads, maintenance of the state. e.t.c
2) Increased awareness of government responsibility to the society rather than in traditional
role eg giving pension to it retiring workers, provision of public goods, social welfare
activities, culture enrichment etc.
3) The need to provide and expand the sphere of public goods was being increasingly
recognized.
NB However there are other factors that tend to increase public expenditure that he left out.

2) Wiseman and Peacock Hypothesis

Wiseman and peacock did their study of public expenditure behavior in UK for the period 1890-
1955. The main thesis for the two is that public expenditure doesn’t increase in a smooth and
continuous manner but in fort of step like fashion.

17
According to the 2, at times, some social or other disturbances take place creating a need for
increased public expenditure which the existing public revenue cannot meet.
Due to the deficit budget as a result of the increased expenditure, the government and its people
review the position and the need to find a solution of the important problem that has come up and
agree to undertake adjustment to finance the increased expenditure. E.g. they can agree to
increase taxes or public borrowing.
The time when the government and the people are deliberating on what to do to finance the
expenditure, is known as the ‘inspection effect.’
The movement from the older level of expenditure and taxation to a new and a higher level is
referred to as the displacement effect.
At a new tax tolerance level, (i.e. new expenditure level), people are now ready to tolerate a greater
burden of taxation and as a result, the general level of expenditure and revenue goes up. This way,
the public expenditure and revenue get stabilized at a new level until another disturbance occurs to
cause a displacement effect.
 There are various theories of public expenditure which includes: -
1) The doctrine of Laissez faire
2) Individual choice theory
3) The authoritarian conception/ the organic theory
4) Optimum level of public expenditure theory
5) The ballot box theory
6) The positive theory of government expenditure
1) The doctrine of Laissez faire
This one is based on the principle of minimum state intervention in the working of the economy.
‘Governments are always and without exemption the greatest spendthrifts of society,’ according
to Adam Smith, because, they spend other people’s money. Adam Smith believed that individual
people acting in self-interest will promote public good under the guidance of the ‘invisible hand’.
The implication of this theory was a low level of public expenditure and taxation but the need for
some increase in public expenditure was conceded.
2) Individual choice theory
Emphasis in theoretical discussion of public finance shifted to the consideration of the basis on
which collective decision in the public sector should be made. Writers such as Ferra (1850)
advocated individual choice as the basis of social choice and of collective decision making. The
18
problem of this approach was the aggregation of individual preferences and of relating them to
policies.

3) The authoritarian conception/organic theory

The organic theory avoided this difficulty, since it was based on the assumption that the decisions
were made by ruling group.

4) Optimum level of expenditure theory

Having accepted the need for some public expenditure, economists turned their attention to the
question of what was its desired level. This theory is associated with W. Stanley Jevons (1835-
1882), an English Economist. The theory postulates that, as a person’s consumption increases, each
additional (marginal unit) of a good consumed gives lower satisfaction (utility) than the one before.
Thus the consumer experiences diminishing utility.
The theory is based on the relationship between the satisfaction derived from the consumption of
goods and services provided by that state and the sacrifice involved in paying taxes to finance
public expenditure.
The marginal theory sheds some light on how people behave. We may not go round calculating
our diminishing marginal utility of each good we consume. Nevertheless, all of us are aware that
there is some point at which the burden of taxation appears greater than the various state benefits
are worth to us. We may not be able to put a figure on that point and it may not be the same for all
people, but we may prefer to go without some public goods and services rather than pay more in
taxation to finance the increase of public expenditure.
The optimum level of public expenditure can be defined as the point at which the benefit to all
individuals from additional expenditure is equal to the additional sacrifice by those involved in
paying more tax.

5) The ballot box theory

In a democratic society, people have the opportunity to decide how much they wish to provide for
themselves and how much they want the state to provide for them. Their individual preferences

19
can be expressed by putting on vote in the ballot box at the next election for a political party
whose manifesto most closely reflects their views. It is the majority vote, which is the aggregate
of individual preferences that gives the government the mandate to carry out its policies.

The problem however is that at a general election, people vote on a number of issues and for a
manifesto package’ containing various proposals.
Consequently, elections have no opportunity to express the views on a particular issue or measure.
Also not all of the proposals in a manifesto may be equally acceptable to them.

6) The positive theory of public expenditure

This theory has been advanced by present day writers such as A. Down, J. Buchaman and G.
Tullock. It could perhaps be described as the ‘clinging to power theory, since it is based on the
assumption that, in a democratic society, governments seek to maximize their lifespan while voters
seek to maximize the benefits they receive from the government. An increase in public expenditure
is popular with voters if they do not pay taxes to finance it.

Effects of Public Expenditure

1. Effects on Production
The effect of public expenditure on production can be examined with reference to its effects on
ability & willingness to work, save & invest and on diversion of resources.

1. Ability to work, save and invest : Socially desirable public expenditure increases
community's productive capacity. Expenditure on education, health, communication,
increases people's productivity at work and therefore their incomes. With rise in income
savings also increase and this in turn has a beneficial effect on investment and capital
formation.

2. Willingness to work, save and invest : Public expenditure, sometimes, brings adverse
effects on people's willingness to work and save. Government expenditure on social
security facilities may bring such unfavourable effects. For e.g. Government spends a
considerable portion of its income towards provision of social security benefits such as
20
 unemployment allowances old age pension, insurance benefits, sickness benefit, medical
benefit, etc. Such benefits reduce the desire to work. In other words they act as
disincentive
to work.

3. Effect on allocation of resources among different industries & trade: Many a times
the government expenditure proves to be an effective instrument to encourage investment
on a particular industry. For e.g. If government decides to promote exports, it provides
benefits like subsidies, tax benefits to attract investment towards such industry. Similarly
government can also promote a particular region by providing various incentives for
those who make investment in that region.

2. Effects on Distribution

The primary aim of the government is to maximise social benefit through public expenditure.
The objective of maximum social welfare can be achieved only when the inequality of income
is removed or minimised. Government expenditure is very useful to fulfill this goal.
Government collects excess income of the rich through income tax and sales tax on luxuries.
The funds thus mobilised are directed towards welfare programmes to promote the standard of
poor and weaker section. Thus public expenditure helps to achieve the objective of equal
distribution of income. Expenditure on social security & subsidies to poor are aimed at
increasing their real income & purchasing power. Public expenditure on education,
communication, health has a positive impact on productivity of the weaker section of society,
thereby increasing their income earning capacity.

3. Effects on Consumption

Public expenditure enables redistribution of income in favour of poor. It improves the capacity
of the poor to consume. Thus public expenditure promotes consumption and thereby other
economic activities. The government expenditure on welfare programmes like free education,
health care and housing certainly improves the standard of the poor people. It also promotes
their capacity to consume and save.
21
4. Effects on Economic Stability

Economic instability takes the form of depression, recession and inflation. Public expenditure
is used as a mechanism to control instability. The modern economist Keynes advocated public
expenditure as a better device to raise effective demand & to get out of depression. Public
expenditure is also useful in controlling inflation & deflation. Expansion of Public expenditure
during deflation & reduction of public expenditure during inflation control money supply &
bring price stability.

5. Effects on Economic Growth

The goals of planning are effectively realised only through government expenditure. The
government allocates funds for the growth of various sectors like agriculture, industry,
transport, communications, education, energy, health, exports, imports, with a view to achieve
impressive growth.
Government expenditure has been very helpful in maintaining balanced economic growth.
Government takes keen interest to allocate more resources for development of backward
regions.
Such efforts reduce regional inequality and promotes balanced economic growth.

22
 CHAPTER 3

Public Revenue

MEANING

Public revenue, like public expenditure, is very necessary for the government to perform its
various functions for the welfare of the society. Public revenue holds the same position in the
study of public finance, which production holds in the study of economics. The necessity of
raising the public revenue follows from the necessity of incurring public expenditure. As the
modern government has to perform several functions for the welfare of the people and as these
functions require huge amount of expenditure which can be financed only through public
revenue.
Dalton has defined “Public Revenue” in a broad and a narrow sense. In the wider sense, it
includes all the income and receipts which the Government happens to get during any period of
time. Public income/revenue includes income from taxes, prices of goods and services supplied
by public enterprises, revenue from administrative activities, such as fees, fines etc., and gifts
and grants, while public receipts include all the incomes of the government which it may have
received during a given period of time.
In the narrower sense, it includes only those sources f income of the government which are
described as “revenue resources.
SOURCES OF PUBLIC REVENUES

Public revenue is raised from two sources.

They are: (1) Tax and (2) Non-tax.
These receipts are divided into tax-revenue and non-tax revenue.

Tax-revenue is divided into three sections:

(a) Taxes on income and expenditure

This section covers corporation tax, income tax, expenditure tax and similar other taxes, if any.

(b) Taxes on property and capital transactions

This section includes wealth tax, gift tax and others, such as land revenue and stamps and
registration fees with respect to union territories without legislatures.

23
 (c) Taxes on commodities and services

This section includes custom duty, namely, import duties and export duties, union excise duties,
and other miscellaneous receipts like the following: certain taxes which the Central Government
levies and tax on foreign travel etc.
The non-tax revenue is similarly divided into three sections
(a) Interest Receipts, Dividends and Profits: This section includes apart from interest
receipts, loans by the Central Government, dividends and profits from public sector
undertakings and contribution from railways and posts and telegraph and also includes
surplus profits of the Reserve Bank of India transferred to the Government.
(b) Other Non-Tax Revenue: This section covers revenue from various Government
activities and services such as administrative services, public service commission, police
jails, agriculture and allied services, industry and minerals, water and power development
services, and disposal, public works, education, housing, information and publicity,
broadcasting, grants-in-aid and contributions, etc

MEANING OF TAX

A tax is a compulsory levy and those who are taxed have to pay the sums irrespective of
corresponding return of services or goods by the Government. It is not a price paid by the tax-
payer for any definite service rendered or a commodity supplied by the Government. The tax-
payers do get many benefits from the Government but no tax-payer has a right to any benefit
from the public expenditure on the ground that he is paying a tax. The benefits of public
expenditure may go to anyone irrespective of the taxes paid. Therefore, we may say that taxes
are compulsory payments to Government without expectation of direct return or benefit to the
tax-payer.
Prof. Seliginan defined a tax as, “a compulsory Contribution from the person to the Government
to defray the expenses incurred in the common interest of all, without reference to special
benefits conferred.”
Bastable defined a tax as a compulsory contribution of the wealth of a person or body of persons
for the services of public power.

24
CHARACTERISTICS OF A GOOD TAX SYSTEM

 Tax is a Compulsory Contribution

 The Assesse will be Required to Pay Tax if It is Due from Him

 Taxes are Levied by the Government

 Common Benefits to All

 No Direct Benefit

 Certain Taxes Levied for Specified Objectives

 Attitude of the Tax – Payers

 Good Tax System should be in Harmony with National Objectives  Tax – System

Recognizes Basic Rights of Tax-Payers

Tax Concepts

1. THE BASE OF A TAX

It refers to the assessed value of a set of assets, investments or income streams that is subject to
taxation, or the assessed value of a single asset that is subject to taxation. The base of a tax is the
legal description of the object with reference to which the tax applies. Every tax has a base. For
example, the base of income-tax is the money income of assessee, the base of an excise duty is
the volume of production or packing or processing of a specific good – within the enterprise, the
base of customs duty is the value of import or export of goods. The base of each tax has to be
defined legally for the purpose of determining the tax liability of an individual tax-payer. Each
tax payer is considered a legal entity for this purpose. Accordingly, an individual legal entity
may be subjected to more than one tax. Every tax base may have a time-dimension also. For
instance, income-tax is usually on annual basis.
2. BUOYANCY OF A TAX

It refers to a measure of how rapidly the actual revenue from a tax rises (including that due to
any change in the tax law) as the tax base rises. Buoyancy of a tax indicates the factors
responsible for an increase in the yield of a tax - over time. If a tax revenue increases with the
25
growth of its base, hut without an upward revision of the tax rates (without an increase in the rate
of tax), then the tax is said to he buoyant. It has an inherent tendency to yield more tax revenue
with the growth of the base. For example, if 10% increase in sales tax collection is owing to 10%
increase if the volume of sales and not due to an increase in tax rates, it is termed as the measure
of buoyancy i.e. 10% buoyancy.

Similarly, if yield from income-tax increases as national income increases with given rates of
income-tax, it would be termed a buoyant tax. Another example is that of excise duties. Excise
duties are imposed on production of specified goods. If new items are not brought under these
duties and the rates of existing duties remain unchanged, but the revenue from excise duties
increases with an increase in the production of excisable items, we have a case of buoyancy 0f
excise duties.

3. ELASTICITY OF A TAX

Refers to the change of the real revenue from a tax with respect to the real tax base, for a given
tax law. Elasticity of tax is related to the rate of tax and yield of a tax. If the yield of a tax
increases or decreases owing to reduction or increase in tax rates, we call it elasticity of a tax.
The yield of a tax may also go up on account of extension of its coverage or a revision of its
rates. Such a characteristic of a tax is referred to as its elasticity. In other words, the elasticity of
a tax refers to the steps taken by authorities in increasing its yield through an extension of its
coverage or revision of its rates.

CANONS OF TAXATION

Adam Smith has enumerated the following four canons of taxation; they are:

1. Canon of Equality

This canon proclaims that a good tax is that which is based on the principle of equality. In other
words, subjects of every state ought to contribute towards the support of the government, as
nearly as possible, in proportion of their respective abilities, that is, in proportion to the reserve
which they respectively enjoy under the protection of the State. It implies what the income which
a person enjoys under the protection of the State, should be taxed on the proportional rate of

26
taxation. But modern economists do not agree with Adam Smith. They advocate progressive
taxation to observe the canon of equality. In other words, they advocate progression should be
the basis for imposing taxes.

2. Canon of Certainty

The canon of certainty implies that the tax-payer should be well informed about the time, amount
and the method of tax payment. According to Adam Smith, “the tax, which each individual is
bound to pay, ought to be certain and not arbitrary. The time of payment the manner of payment
the quantity to be paid, ought all to be clear and plain to the contributor and to every other
person.” Adam Smith was also of the view that the government must also be certain of the
amount which it derives from a particular tax. Thus this canon is equally important both for the
individual and the state.

3. Canon of Convenience
The third canon of Adam Smith is that of convenience. According to Adam Smith, “every tax
ought to be so levied at the time or in the manner in which it is most likely to be convenient for
the contributor to pay it.” In other words, taxes should be imposed in such a manner and at the
time which is most convenient for the tax-payer, i.e., the best time for the collection of land
revenue is the time of harvest. Similarly, taxes on rent of houses should be collected when it is
most convenient for the Contributor to pay.

4. Canon of Economy

The fourth canon is the Canon of economy. This Canon implies that the administrative cost of
tax collection should be minimum i.e., the difference between the money, which comes out of the
pockets of people and that which is deposited in the public treasury, should be as small as
possible Administrative cost of tax collection should be minimum because levying of a tax may
require a great number of officers, whose salaries may eat up the greater part of the produce of
the tax, and whose pre-requisites may impose another additional tax upon the people. Hence, the
administrative cost should be minimum.
These are the four canons enumerated by Adam Smith.

27
OTHER CANONS

In addition to the above four canons given by Adam Smith, the following other canons have been
advanced by Bastable and other economists

5. Canon of Productivity

The Canon of productivity advocated by Bastable implies that taxes should be productive The
Productivity of a tax may be observed in two ways. In the first place, a tax should yield a
satisfactory amount for the maintenance of a government. In other words, the tax should be such
that it procures a considerable amount of revenue for the expenditure of the governemt,
Secondly, the taxes should not obstruct and discourage production in the short as well as in the
long run.
6. Canon of Elasticity

Bastable also laid stress on the principle of elasticity. The canon of elasticity implies that yields
of taxes should be increased or decreased according to the needs of the government. The
government may need funds to face natural calamities and other unforeseen contingencies. It
may need funds to finance a war or for development purposes. The government resources can be
raised quickly only when the system is elastic.

7. Canon of Diversity

The canon of diversity put forward by Bastable implies that the tax system should be diverse in
nature. In other words, in a tax system, there should he all types of taxes so that everyone may be
called upon to contribute something towards the revenues of the state. Thus, the governments
should adopt multiple tax system.

8. Canon of Simplicity

The canon of simplicity implies that a tax should easily be understood by the tax-payer, i.e., its
nature its aims, time, of payment, method and basis of estimation should be easily followed by
each tax-payer. In other words, the tax imposed on the tax-payers should be so simple that they
are able to guess easily the aim of its imposition and they are not confronted with accounting,
administrative or any other difficulties.

28
 9. Canon of Expediency

This canon implies that the possibilities of imposing tax should be taken into account from
different angles, that is, its reaction upon the tax-payers. Sometimes it is seen that tax may be
desirable and may be productive and may have most of the characteristics of a good tax, yet the
government may not find it expedient to impose it, for example, progressive agricultural income
tax, but it has not been imposed. So far in the manner it should have been imposed.

10. Canon of Co-ordination

In democratic countries, taxes are imposed by central, state and local governments. It is,
therefore, very much desirable that there must be co-ordination between different taxes that are
imposed by different taxation authorities. In other words, interest of the tax-payers and the
government should be taken into consideration.

APPROACHES OF TAXATION

1. COST OF SERVICE APPROACH

This is one of the oldest principles, advocated for the distribution of the tax burden. According to
this theory, the basis of taxation should be the cost incurred by the Government on different
services for the benefit of the individual tax-payers. Each tax-payer has to pay the tax equal to
the cost of service to him. It means, the higher the cost, the higher should be the tax rate and
viceversa. In other words, according to this theory, the citizens are not entitled to any benefits
from the state and if they do receive any, they must pay the cost thereof. The government acts
like a producer of a commodity who charges the price from his customers equal to the amount of
cost of production of the commodity. By adopting this approach, the government gives up its
basic protective and welfare functions. It’s only job is to recover the cost of service. The state is
not concerned with the problems of income distribution. No effort is made by the government to
improve income distribution or no notice is taken of the policy of levying taxes according to the
cost of service principle. This deteriorates the income distribution further. If this approach is
adopted, quite a few sources of public revenue will be ruled out like taxes on capital gains,
unearned increments, gifts, expenditure, excise duties and sales tax etc. Welfare activities
including all sorts of relief activities will also be ruled out.

29
LIMITATIONS

This principle is also full of many conceptual difficulties:

1. This principle cannot be accepted as the basis of taxation because it is very difficult to
estimate the cost of service to every individual. For e.g., the government can estimate
total expenditure on the defense of the country, but it is difficult to estimate the
expenditure incurred by the government on the defense of a particular individual.
2. Secondly, the basis of cost service principle is not fair in a welfare state. If cost is taken
as the basis of taxation, the government may not perform various functions which may be
very much desirable for the welfare of the country as a whole e.g., relief in times of
drought, flood and earthquake, free education and free medical facilities etc. Hence, the
cost of service principle cannot be accepted as the basis of taxation.
3. Thirdly, in many cases, it is not possible to have a conceptual clarity of the cost
measures.
4. This principle is not in accordance with the character of a tax. A tax is compulsory
payment and there is no special benefit in return of the payment of a tax. But according to
this theory, the payment of a tax is in return of the cost of service.
5. Lastly, the cost of government services to individuals is fixed arbitrarily, which may not
be justified.

2. EXPEDIENCY APPROACH

Generally, every government imposes tax to fulfill its normal social obligations in the form of
defense, maintenance of law and order and socio-economic development. Normally, the tax
policy is governed by the principles of equity, economic stability and economic growth, but in
actual practice, the tax policy is determined by the pressures which are exerted on the
government by different pressure groups in society. In practice, every legislature and every
authority is pressurized by various economic, social and political groups to orient its taxation
policy in certain directions. Every group would try to resist a change that goes against its
interests. The authorities, in many cases, have to adopt certain policies simply because there are
pressures to that effect. The authorities have too many times, reshape the tax structure depending
upon the changing political strength of different economic groups. It is also clear that while
choosing and imposing a tax, the authorities would be making a great blunder if they lose sight
of the administrative feasibility, the cost of collection, and so on.

30
Therefore, when the government bows before the pressures of various pressure groups and
formulates its tax policy accordingly, we call it the expediency approach.

E.g. Liberalization of import and export policy has been effected recently by the central
government under the pressure from the World Bank and multinational corporations. At present
the government has allowed the import of such commodities which are not in the interest of the
country as they may pose serious problems and competition to the local industry. Similarly, the
government has been pressurized to reduce duty on exports to foreign countries. Such policies
formulated by the government under expediency more often hit the interests of society.
This approach is criticized on the ground that to build up an entire tax system solely on the
considerations of expediency, must be full of pitfalls. In certain cases, such a tax policy may be
able to yield certain good results like contributing to the equality of income distribution, or
reducing regional disparities but such results would be purely accidental and not the fruits of any
thoughtful efforts or plan.

A taxation system has a role to play in helping the economy. It should be based on equity and
should contribute towards augmenting welfare in general. But when the tax system ignores
certain factors like economic growth, equity, economic stability etc., it is not likely to be helpful
to the economy. On the contrary, it will positively be harmful. It will on many occasions be an
establishing factor and would increase inequalities and socio-economic injustice.

3. SOCIO-POLITICAL APPROACH

In contrast to the expediency approach, Adolph Wagner advocated an approach in which social
and political objectives are the deciding factors for the distribution of tax burden. Wagner, like
most Germans of those days, did not believe in individualist approach to a problem. He wanted
that each economic problem should be looked in its social and political context. Accordingly, a
tax system should not be designed to serve the needs of the individual members of the society.
But it should be designed for the welfare of the society as a whole. He was in favor of using
taxation for reduction in income inequalities and he advocated that all small incomes should be
exempted from taxation. In other words, the tax structure should aim at achieving social
objectives. He advocated that the government should follow the policy of progressive taxation.

31
 Wagner’s ideas, though much criticized at that time, are now the hall-mark of modern state’s
fiscal policies. Taxation in a modern state is generally designed to curb inequalities. Progressive
Taxation is the rule rather than the exception.

Adolph Wagner, also advocated that the government should formulate a tax policy to achieve
political objectives in the form of protecting the fundamental rights of the people. He advocated
that the government should provide protection to the life and property of the people by way of
incurring expenditure on defense and maintenance of law and order. In the modern context, we
may accept Wagner’s stand by including other economic and social objectives of the society in
which taxation could be a helpful tool. Taxation could curb cyclical fluctuations, unemployment,
production of undesirable goods and services, monopolistic and restrictive trade practices and
hoarding etc. Through taxation, government could also bring balanced growth between different
regions. That way, the socio-political approach is far more meritorious than the expediency
approach.
Both the expediency Approach and socio-political Approach have their merits, but they cannot
be advocated as the basic policies in a tax system. Equity should be ‘the main criterion of every
tax system, without it, not only the tax system loses its fairness, it also becomes a source of
social, economic and political unrest as well.

Socio-Political Approach, though having the merit of equity, suffers from short-comings also.
This concept is more of academic nature than of much practical relevance. This is proved by the
fact that in spite of the fact that the government follows the policy of progressive taxation, the gap
between the rich and the poor has been increasing at a very fast rate.
This policy has encouraged lot of tax evasion either on account of loopholes or by adopting such
methods that lead to tax evasion. The problem of taxation has led to the operation of a parallel
economy which is causing inflation in economy.

2. BENEFIT RECEIVED APPROACH / PRINCIPLE

Benefit received approach was accepted by the political theorists of the 17 th century. Taxation in
those times was considered as a price for the services rendered by the state. The entire
philosophy was based on the contract theory of the state. According to this approach the state

32
provides goods and services to the members of the society and they contribute to the cost of these
supplies in proportion to the benefits received. It is an exchange relationship.

According to this principles, the burden of ‘taxation should be divided among the people in
proportion to the benefits received from the state. The persons receiving equal benefits from the
state should pay equal amount as taxes and those who receive, greater benefits should pay more
as taxes than those getting less benefits.

The benefit theory, therefore, demands that on the ground of equity, the people should be taxed
according to the benefits (Protection, hospitals, education, roads, irrigation etc.) they receive
from the government and that the division or apportionment of taxes be in proportion, to the
benefits received by each individual or group of individuals. Larger the benefits received, larger
should be the amount of tax on the beneficiary concerned.

The benefit approach is, in fact, a combination of t principles: 1.

the cost of service principles, and

2. the value of service principle.

According to the former, the taxes should be divided in proportion to the cost of services
rendered by the state.
According to the value of service principle, every individual should contribute in proportion to
the value of the services he has received from the government.
In fact, both the principles come to the same conclusion that the cost of services rendered by the
government should be recovered from individuals in proportion to the benefit received by each
of them. These views were held by German Writers like Grotuis and Pufend. These views were
supported by Hobbes and Locke. Laker, these were accepted in the 18 th century by the celebrated
Writers like Hume and Rousseau. These views were accepted by Bentham also.

CRITICISM

This principle has the following drawbacks:

1. It is very difficult to estimate the benefit that an individual receives from the expenditure of
the government, e.g., how much benefit an individual receives from the army, police and

33
 education institutions, cannot be exactly estimated. And therefore the burden of taxation may
not be equitable. Hence, this theory may he rejected.
2. If the basis of taxation is benefit, then the poor will have to pay higher taxes than rich
because the poor derives greater benefits than rich from the expenditure of the government,
e.g., the poor may be more benefitted by the provision of free medical service and free
education. And, therefore, on this grol.thd also, this theory cannot be accepted as the basis of
taxation.

Rich people have more capacity to pay taxes than poor; but according to this principle the per
capita tax burden upon the rich and the poor is the same. This means regressive taxation. It is,
therefore, clear that the benefit principle cannot ensure just distribution of burden of taxation
among different sections of society. The principle is also not conducive to general welfare
which requires redistribution of income in favour of the poorer sections through public
welfare programs and services for their benefit.
3. A general objection to the whole approach is that this principle is not based on the concept of
equity in taxation. Taxes are not progressive in nature.

5. ABILITY TO PAY APPROACH

Ability to pay is interpreted as the money income of the assesse. It is the most generally accepted
theory. According to this theory each person should contribute to the income of the state in
proportion to his ability to pay. Ability is the “ideal ethical basis of taxation.”1 Every tax-payer
should feel that he has made equal sacrifice in the payment of tax. The concept of ability to pay
depends upon the bold concept of equity in taxation. Equity implies just tax payment. When the
assessee is required to pay tax according to his ability to pay, it may be called equity in tax
payment. As Dalton puts it, “the burden of taxation should be so distributed that the direct real
burden on all tax-payers is equal.”

According to Seligman, “the basic point of the ability to pay principle is that the burden of
society should be shared amongst the members of the society so as to conform to the principle of
justice and equity.”

34
The ability to pay principle accepts the idea that tax is a compulsory payment to the government
without any direct benefit. This approach considers revenue and public expenditure as two
distinct
entities. Public expenditures are for the “common good” and Cannot be individually evaluated.
The ability to pay principle points out that this collective expenditure should be distributed on the
basis of “ability to pay” of the people and not on the basis of any benefits received.

According to this approach, a citizen has to pay taxes because he can, and his relative share in the
total tax burden is to be determined by his relative paying capacity.
It was J.S. Mill who advocated the cause of the principle of ability to pay. He sharply rejected the
benefit approach, based on the concept of protection of life and property. He concluded that
application of benefit rule would lead to regressive taxation, as poor are more in need of
protection.
A quite different principle of taxation is thus needed.

This new principle i.e. the principle of ability to pay is based on the dictum that all should be
treated equally under law. Equality in taxation means equality in sacrifice which may be stated as
the concept of equal sacrifice.

JUSTIFICATION TO ABILITY THEORY

The supporters of the ability theory have justified it on three grounds:

Firstly, it has been justified on psychological effects of tax payments upon individual tax-payer.
Psychologically every tax-payer should feel that he has made equal sacrifice in the payment of a
tax. Equality of sacrifice means that all the tax-payers should feel the same pinch by paying the
last rupee as tax.

Secondly, it has been justified in terms of diminishing marginal utility of income. As income
increases, marginal utility of additional unit of income decreases and vice-versa. The tax-burden
should be more on rich than on poor.

Thirdly1 ability is known as the faculty interpretation. The faculty is represented by the income,
property and wealth on an individual.
35
INDEX OF ABILITY TO PAY

The theory of ability to pay, however, involves the fundamental problems as to how to measure
the ability to pay of a person. There are two approaches which have so far been advanced for this
purpose - the objective approach and the subjective approach. In the objective approach1 the
faculty theory has been evolved to measure ability to pay. In the subjective approach the sacrifice
has been evolved to measure ability to pay.

The two approaches to measure the ability to pay are:

1. Objective Approach

In view of the practical difficulties of sacrifice theories or subjective approach some writers,
especially American have presented an objective approach to measure the ability to pay. Prof.
Seligman has used the ‘faculty’ to indicate ability in the objective sense. Thus, it is also known
as faculty theory of ability to pay.
The indices of ability to pay are as follows:

(i) Property

Property or Accumulated wealth was considered as the index of ability to pay. It was considered
that property in the form of land, buildings1 gold1 golden ornaments, etc., was a measure of a
man’s financial ability. Property gives security and insurance against risks. A person with
property has a better ability to pay a tax than a person having no or very little property. Thus it
was argued that taxation should be imposed on the basis of the extent of property possessed by
the people. A person having larger wealth or property should be made to contribute more.

Though property is an important source of income, yet, it cannot be considered as the primary
test of ability because of the following reasons. “Firstly, property is an important source of
income, but all property do not yield income” Secondly, the income from property is not
continuous. Thirdly, income from property may vary on account of its nature, location, use etc., a
house in a village may not yield anything, but it may be a good source of income in a town.
Fourthly, property is taxed on its capital value, but if it does not yield income, the taxation may
36
be unjust. Hence, it can be said that property may not be regarded as a primary test of ability to
pay.

(ii) Income

Income is one of the most accepted indices of ability to pay. Under this index, persons with
higher incomes share a larger money burden of tax and lower incomes are taxed at lower rates.
People with equal incomes are taxed at equal rates.

According to Adam Smith, “The subject of every state ought to contribute towards the support of
the government in proportion to their respective abilities.” Only net income should be taxed.
Gross income cannot be treated as an index of ability to pay. Secondly, it is necessary to classify
income into - (i) earned income and (ii) unearned income. Income earned from work is treated
as earned income and that from capital gains from sale of shares, security and buildings etc.,
interest on savings and rent from immovable property, windfall, gains from gambling, races,
lottery, etc. is treated as unearned income. It is argued that unearned income should be taxed
heavily as compared with earned income, because unearned income discourages willingness to
work (iii) Size of the Family

While determining the tax paying ability of a person, the size of the family - should also he taken
into account. A larger size of the family with a given income may have smaller tax paying ability
than of a similar size family, e.g., a bachelor possesses the higher tax paying ability than a
married Couple having four children while other things being the same. Though, the size of the
family can be taken into account while determining the tax ability of an individual, but it cannot
be taken as the primary measure of the tax paying ability. (iv) Consumption

Another objective index of ability to pay is the consumption expenditure of the members of the
society. Sometimes, it is noticed that taxation on the basis of property and income is not
equitable and can be manipulated to evade by the tax-payers in many ways. Hence Prof. Fisher
and Prof. Nicholas Kaldor advocated taxation on expenditures. Firstly, consumption implies
withdrawal of resources from the economy. A man’s capacity to pay taxes, therefore, depends
upon to what extent he withdraws resources to satisfy his consumption needs.
Secondly, a person spending large amounts to meet consumption (luxuries) has a greater ability
to bear the burden of taxation.

37
It is therefore, argued that persons with a higher consumption expenditure should contribute a
larger share of total tax amount.
Thirdly, there has been a large scale evasion of taxes on income because of the concealment of
income by the taxpayers. Since consumption of items especially consumption of items of luxury
cannot be concealed, it is stressed that the consumption expenditure should be used as an index
of ability to pay taxes.

Fourthly, it is difficult to locate the different sources of income of an individual. Therefore, his
ability to pay cannot exactly he measured since the expenditure on consumption can be located
without much difficulty, it would truly represent a man’s capacity to spend and hence his ability
to pay taxes.

In spite of the fact that expenditure on consumption can be located to determine a person’s ability
to pay, yet is suffers from various limitations:
(i) If the consumption expenditure of a person is taken as an index of his ability to pay, then
those who save and invest will escape the tax burden. This is against the Canon of equity.
(ii) Lack of records of the consumption expenditure also creates a major difficulty in locating
a person’s consumption expenditure for taxation purposes.
(iii)Since different persons have different standards of living, it will not be proper to tax
higher consumption expenditure of the people with higher standard of living.

In the end we may conclude by saying that the consumption expenditure like property cannot be
a satisfactory index of ability to pay. It is only the income which is by far the most important
determinant of a person’s ability to pay. Income taxation is the most important source of revenue
to the governmen5 of developed countries. Property taxation is used as an additional source.
India depends largely on commodity taxation.

SUBJECTIVE APPROACH

The subjective approach is based on the psychological mental reactions of the taxpayers. In this
approach we estimate the burden felt by the tax-payer or sacrifice undergone by him. Each tax-
payer should make equal sacrifice, if tax burden is to be justly distributed.

38
According to John Stuart Mill, “The just distribution of tax share prevails when all individuals
incur equal sacrifice while contributing to the common good.
Here equal sacrifice refers to the sacrifice in terms of utility of income sacrificed by individuals
in contributing to the common good.”

Conen Stuart and Edgeworth have advanced three concepts of equal sacrifice, viz.:

1. Equal Absolute Sacrifice

2. Equal Proportional Sacrifice

3. Equal Marginal Sacrifice.

1. Equal Absolute Sacrifice
Under the concept of equal absolute sacrifice, each tax-payer should make equal absolute
sacrifice, i.e. the total disutility of a tax should be equal for all tax-payers. In other words all
should be treated equally under law as well as in all affairs of government. According to J.S.
Mill, equity in taxation means equality in sacrifice. When the total tax payable by tax-payers is
equally divided among them without regard to their money income, it may be stated as the
application of the principle of Equal Absolute Sacrifice. In this case the total sacrifice in the form
of payment of tax is equally divided among the tax-payers without regard to their ability to pay.
This may prove to be highly regressive in nature as the quantum of sacrifice on the part of the
assessees with lower money income may be the highest. Hence, most economists have strongly
rejected the concept.

2. Equal Proportional Sacrifice

According to this concept also, no one is exempt from sharing the tax burden. In other words,
each tax payer should sacrifice the same proportion of total utility or satisfaction derived from
his total income.
When the tax burden is distributed among the tax-payers in proportion to their money income, we
call it equal proportional sacrifice. In this case, the sacrifice of the poorer section of society is
quite higher because marginal utility of money is quite higher to them as compared to the richer
section of the society. Thus, according to the principle of proportional sacrifice, the direct real
burden on every taxpayer would be proportionate to the economic welfare which he derives from
the income.
39
Hence, this concept cannot be considered as a system of just tax payment by the government.

3. Equal Marginal Sacrifice

Edgeworth and later Pigou concluded that least aggregate sacrifice is the superior principle of tax
distribution not because it is equitable, but because it is derived directly from the basic utilitarian
principle of maximum happiness. According to this concept, the tax burden is so distributed
among different categories of tax-payers that the marginal sacrifice of all the tax-payers is equal.
In other words, everyone, whether rich or poor should feel the same pinch by paying the last
shilling as tax. This implies that the tax payers should pay tax according to their money income,
i.e. the rich should pay the tax at a much higher rate than poor.

According to Edgeworth, marginal sacrifice and not the total sacrifice of the different tax-payers
should be the same so that aggregate sacrifice for the community as a whole is the least. In other
words, the welfare to all would he maximum. To put it in the words of Prof. Pigou, Thus the
distribution of taxation required to conform to the principle of least aggregate sacrifice is that
which makes the marginal - not the total - sacrifice borne by all the members of the community
equal.” The object of the state is to maximize the economic welfare. Taxation creates disutility to
the tax-payers. Hence, taxes should be distributed in accordance with the principle of least
aggregate sacrifice, i.e., the marginal sacrifice imposed by way of taxation on each tax-payer is
equal. In this approach the emphasis is on the welfare of the community. Musgrave and others
consider it as the “ultimate principle of taxation.” Thus this approach leads to progressive
taxation.

On the basis of the above analysis, we may conclude by saying that with the exception of equal
marginal sacrifice, the case of progression and the degree thereof is quite inconclusive It means,
it is not clear whether progressive distribution of taxation s possible or not. For instance, equal
absolute sacrifice points out nothing more than the fact that, tax liabilities should rise with the
rise in income, under equal proportional sacrifice, it is not clear, what formulation may lead to
equal proportional sacrifice, since the precise shape of the marginal utility is not given.

40
EFFECTS OF TAXATION

Introduction

Taxation is only a small element in the structure of rules and conventions which constitute the
framework of the modern economic system. Effects of taxation can he clearly apprehended only
as phases of the broad budgetary implications for modifying this framework in such a manner as
to make the system more-efficient and more secure.

Taxes have micro and macroeconomic effects in a modern economy. The economic effects of
taxation may be good as well as bad. Due to heavy imposition of tax, the ability of the tax-payer
to work may be affected adversely or he may be reluctant to work more since his additional
income is taxed. This is turn, may affect production adversely.

There are also direct and indirect effects on the distribution of income. Taxation also affects the
allocation of resources and may change the composition and direction of production and income
of the community. Such changes caused by different taxes have far-reaching effects on the
economic welfare of the society. Therefore, the government should not keep only the revenue
consideration in mind but the economic effects of taxation should also be considered. To put it in
the words of Dalton, “the best system of taxation from the economic point of view is that which
has the best, or the least bad economic effects.”

Effects of taxation may be analyzed under the following heads:

(1) Effects of Taxation on Production

(2) Effects of Taxation on Distribution

(3) Effects of Taxation on Stabilization.

1. Effects of Taxation on Production

The effects of taxation on production may be viewed through:

(1) Effects on the ability to work, save and invest;

(2) Effects on the will to work, save and invest;

41
 (3) Effects on the composition and pattern of production.

(A) Effects on Ability to Work

Ability to work depends on the health and efficiency possessed by the people. Health is related to
the level of consumption which is determined by the money income of the assessee. Imposition
of higher tax reduces the purchasing power of the tax payer and his ability to obtain the
necessaries, comforts and luxuries of life. This effect is most strongly felt by the poorer people.
When the tax burden falls upon the poor, it curbs the consumption of necessaries and comforts
which lowers the standard of living and thus efficiency and ability to work of poor people is
adversely affected by taxation. For the rich1 however, the ability to work is not so much affected
by taxation because taxation on rich may only curb his luxurious consumption and this may not
affect his efficiency and ability to work. Therefore, heavy taxation on the poorer section of the
community has been strongly objected by most of the economists. Therefore, to maintain the
health efficiency and ability to work .of the people, system of progressive taxation should be
duly implemented by the government. In other words, taxes on low incomes and on those articles
which are largely consumed by less well to do sections of the community should be avoided in
the interest of production. This will keep the health and efficiency intact without additional work
load on them.

(B) Ability to Save

Capacity of the people to save depends on the tax policy followed by the government. Ability to
save is adversely affected by taxation as taxes fall on income and savings depend on income
When income is reduced by taxation, savings automatically decline Ability to save is affected
adversely in the case of those who have a higher marginal propensity to save. It is the rich who
possesses a high marginal propensity to save since their incomes exceed their expenditure. Taxes
falling on the poor have no effect on their ability to save as they have no margin to save out of
their low incomes. Since the rich are accustomed to a very high level of living, they maintain
their expenditure and pay taxes out of their savings. Hence their ability to save is greatly
reduced. This
affects investment and capital formation in the economy. Therefore, to maintain

42
the capacity of the people to save the government should provide tax incentives to the rich and
spend the tax income on the poor to enhance their ability to save.

(C) Ability to Invest

Ability to invest depends on the resources available for investment i.e. savings. It is clear from
the above discussion that savings are reduced by taxation. When ability to save is adversely
affected by high taxes, ability to invest of those who take investment decisions is automatically
reduced. These are the people having a high entrepreneurial ability. Such people generally the
people in the higher income group.

The government has to play a major role in exploiting the capacity to invest of the tax-payer by
adopting an appropriate tax policy. The government should exempt earnings from investment to
encourage savings and capital formation.

(B) Effects of Taxation on the Will to Work, Save and Invest

(1) Effects on the Will to Work

Will of the people to work depends on the nature of taxes. Each individual tax has its specific
effects. However, some taxes by their very nature have the least or no bad effect on the
willingness to work e.g., estate duty excess profit tax etc. Likewise, reasonable rates of income-
tax, sales tax etc., have no bad effects on the desire of the people to work hard. Conversely,
unduly high rates of income-tax, wealth tax and commodity taxes adversely affects the desire of
the people to work hard.

(2) Will to Save

Will of the people to save depends on the volume of income, volume of tax and the tax policy
pursued by the government. If a tax payee has limited income and is hardly sufficient to meet his
day to day requirements it will be difficult for him to save anything. Some people save for their
old age and many times they save to improve their social prestige. So in order to enhance the will
of the people to save, the government should provide tax incentives to the people.

43
(3) Will to Invest

Will of the people to invest depends on savings. If savings are taxed, nothing will be left with the
people for investment purposes.
To enhance the will of the people to invest, the government should devise such a tax policy
which provides tax incentives to those who divert their savings towards investment. Investment
also depends on the treatment of income from investment - under tax laws. If earnings are
exempted from tax net, people will divert most of their savings towards investment.

People will also save and invest if they have full knowledge about the avenues available for
investment and the tax incentives associated with each of these channels of investment.

(C) Effects on the Composition and Pattern of Production

The effects of taxation on the composition and pattern of production depends upon allocation of
resources. When higher taxes are imposed on some industries, resources will shift from the high
taxed industries to low taxed industries. Likewise, when a tax rebate is offered, it will encourage
allocation of resources in favour of developing industries.

Similarly, there will be reallocation of resources from high taxed regions to the low taxed
regions.

High rate of tax on goods of harmful consumption has a beneficial impact as the production of
these goods will be diverted to low-taxed essential goods.

Taxes, may thus change the pattern of production in an economy. A high tax on the production of
luxuries may improve the production of necessaries. Some taxes, however, have no effect on
diversion of resources, e.g., taxes on windfall gains, high land values, monopoly profits and non-
differential taxes such as income tax, etc. have no effect on the composition or pattern of
production.

44
EFFECTS OF TAXATION ON DISTREBUTION

There are two aspects of an economy:

I. Income Generation

II. Income Distribution.

Income generated in society if not distributed properly will create inequality in the distribution of
income and wealth. It will give rise to the creation of two classes i.e. the class of the rich and the
class of the poor. The gap between rich and poor will lead to class conflict which may prove
disastrous to the society. Every government in the world tries to bridge this gap by imposing
higher taxes on the richer section of society and the proceeds realized from such taxes are
distributed among the poorer section of society by way of providing social amenities to them.
In other words, equitable distribution is the main goal of the modem economy. Taxes serve as a
means of reducing inequalities by taking away the excessive capacity to pay of the richer section
of society. According to Dalton, “Other things being equal, one tax-system is preferable to
another if it has a stronger tendency to check inequality.
The effects of taxation on the distribution of income and wealth among different sections of the
society, however, depends upon the following two factors:
(1) Nature of Taxes and Tax Rates; and

(2) Kinds of Taxes.

By nature, taxation may be proportional, progressive or regressive. The nature of taxation also
implies as how the burden of taxation is distributed among different sections of the community.
A tax is called as proportional, if all the tax-payers pay the same proportion of their income as
tax. A tax is said to be progressive, if larger is the tax-payer’s income, the greater is the
proportion that he pays as tax. A tax is regressive, if larger is the tax payee’s income, the smaller
is the proportion, which he pays as tax.
(i) Effects of Regressive Taxation on Distribution
If regressive taxation is fo1loed, the inequalities may increase in the distribution of income and
wealth, as the burden of taxation will fall more heavily on the poor than on the rich. A toll-tax is
regressive as the amount of the tax is the same for the rich and the poor, while the utility of

45
money, which is paid in tax, is greater for the poor than for the rich. A regressive tax, thus, tends
to widen the gap of inequality.

(ii) Effects of Proportional Taxation on Distribution

Under proportional taxation, inequalities would continue as before, if the income remains the
same. But, however, if the income changes in unequal proportions, the inequalities in income
will increase. For instance, if A’s income is Rs. 500 and B’s income is Rs. 1,000 and both are
taxed at the rate of 10%, the net income of A and B, after tax payment, would be Rs. 450 and Rs.
900 respectively. The burden of taxation fall heavily on A than on B. Hence, the burden of
taxation is higher on the poor than on the rich.

(iii) Effects of Progressive Taxation on Distribution

Under the progressive system of taxation, inequalities would be reduced, because a higher
proportion of the income and the wealth of the rich would be taken away by taxes than that of
poor. Hence, a sharply tends to reduce inequalities in the distribution of income and wealth.
Sharper the progression, greater is the tendency to reduce inequalities. Obviously, progressive
system is desirable in order to bring about a more equitable distribution of wealth.

However, the tax system should be based on the principle ability to pay. The higher the income
of a person, the greater would be his ability to pay taxes and vice-versa. People who get unearned
income should be taxed at higher rate than poor because of their greater capacity to pay taxes.
The progressive tax system may be designed in such a way that it may not have adverse effects
on production. In other words, tax system should be progressive to the highest income group, the
middle income groups should be subjected to lower tax rates and the lower income groups should
be exempted from taxation.

1. Tax Rates

While fixing the rates of taxes, progression should be kept in mind. Higher taxes should be
imposed on the richer section of society and revenue realized from the rich should be utilized for
the benefit of the poorer section of society by way of providing social amenities to them. In other
words, taxes should be progressive because sharper the progression, greater is the tendency to
reduce inequalities.
46
2. Kinds of Taxes

Whether the effect of taxation is progressive, proportional or regressive in nature, depends upon
the kinds of taxes. There are two kinds of taxes:
(a) Direct Taxes

(b) Indirect Taxes

(a) Indirect Taxes and Distribution

The burden of indirect taxes, like taxes on commodities is regressive in nature. The commodities
on which indirect taxes are imposed are widely consumed by the poor and they have to spend
larger proportion of their income on such goods than rich. That is, propensity to consume is
higher for the poor than that of rich. Hence, the burden of indirect taxes, like the tax on foodstuff,
raw tobacco, cheap alcohol etc., falls more heavily upon the poor than upon the rich. However,
the indirect taxes may be made progressive if the necessities are exempted from taxation and
luxuries are subjected to higher rates of taxation so that the tax rates would be higher for the high
priced goods. But it should be noted that purchase of luxury goods is optional, hence the rich can
avoid the payment of these taxes by not purchasing such goods or by contracting their demand to
some extent. Therefore, indirect or commodity taxes in general are and regressive in nature.
Hence inequalities of income and wealth cannot be reduced by these taxes.

(b) Direct Taxes and Distribution

To bring about equitable distribution of income and wealth, all taxes which fall heavily or
exclusively upon the richer section of society can have favourable distributional effects. All
direct taxes which are based on the principle of progression and ability to pay may have desirable
distributional effects.

The most important taxes, which can be made progressive are income tax, property-tax and
inheritance tax.

(i) Income-Tax Distribution

47
An income-tax may be made progressive by subjecting larger incomes to high rates of taxation
than smaller incomes. This will not only achieve equity in taxation but will also reduce the
inequalities of income. Additional taxes like super tax along with general progressive tax should
also be imposed on very high income. Secondly, the exemption should be granted to the incomes
below a certain level, i.e., the income below a certain level should not be taxed at all. And
finally, unearned income may be taxed at higher rate than the income earned by means of hard
work.

(ii) Property-Tax and Distribution

A property-tax or a net annual wealth-tax if progressive in nature, will tend to reduce the amount
of property in the hands of property owners. The greater the amount of property or net wealth,
the higher would be the burden of tax. Hence, a progressive property-tax may have favourable
distributional effects. Secondly, income from property should be taxed at higher rate than income
earned by means of hard work. Hence, it may be concluded that progressive property- taxation
generally helps in bringing about equitable distribution of wealth and income in the society.

(iii) Inheritance – Tax and Distribution

A progressive inheritance - tax and death-duty may bring about equitable distribution of wealth
and income. It may be made progressive by imposing tax on the amounts inherited by different
individuals on the occasion of death. Mill’s proposal was to fix up a sum, beyond which no
individual could be allowed to inherit. It would be desirable, from the point of view of
distribution, to graduate an inheritance tax, not also according to the amounts received by
inheritance, but also according to the amount of wealth possessed by them.

It should, however, be noted that direct taxes may be helpful in reducing inequalities of income
and wealth, only when they are progressive in nature. Thus, it can be concluded, that direct taxes
are helpful in making the distribution of income and wealth equitable, if they are steeply
graduated.

48
EFFECTS OF TAXATION ON STABILISATION

Economic stability may be judged by the behaviour of prices. This does not mean that prices
should remain static. Conversely there should be a normal rise in price because a normal rise in
price is a sign of healthy economy. Problem, however, arises whenever there are price
fluctuations. These price fluctuations may be known as abnormal economic situations prevailing
in the country. Economic stability also implies stability in the economic activity, output and
employment. It also refers to the avoidance of inflationary and deflationary conditions.

Every government tries to overcome these problems through fiscal measures which is the safest
and the durable course adopted by any government to control such situations.There may be three
abnormal economic situations:-
(1) Inflation

(2) Deflation

(1) Taxation and Inflation

As regards inflation and deflation, taxes can play an important role as they can reduce or
stimulate consumption.
Inflation may be defined as a Situation in which prices continue to rise. Inflation maybe either:-

(i) Demand Pull, or

(ii) Cost Push.

Demand pull inflation is caused by rising demand - owing to higher capacity to pay of the
people. In comparison to the capacity to pay of the people, supply of goods and services fails to
keep pace with it. In other words, prices rise because the money supply far exceeds the
availability of goods and services in the market., Since people have more money to offer for
goods which are in short supply, prices continue to rise.
Taxation, if applied properly, may take away the excessive capacity to pay of the people. The
aim of taxation in times of inflation should be to reduce the purchasing power in the hands of the
people. Thus a rise in the rates of existing taxes and the imposition of new taxes would check
consumption, decrease the level of effective demand and therefore, help in bringing up stability
49
in prices. To increase the rate of saving and investment and thus, to increase production, certain
tax exemptions and tax concessions should be given and savings utilized for the payment of
insurance premium may be exempted from the taxation.

(ii) Cost-Push inflation is caused on account of rising cost of production which erodes the value
of money. In this situation capacity of the people t buy continues to go down, with the result that
the demand also continues to fall. Cost-Push inflation may be checked by keeping the cost of
production in control. To keep the cost of production in control, certain tax exemptions and
concessions should be granted to the producers. Savings may also be exempted from taxation to
encourage production.

(2) Taxation and Deflation

Deflation is a situation of falling prices. In such a situation people’s capacity to pay continues to
fall with the result that demand for goods also comes down. With the continuous fall in demand,
most of the manufacturing enterprises are unable to stand as the prices prevailing in the market
may even be lower than the cost of production. Most of the enterprises, under this state decides
to close down their business. To check this situation, the government should devise a tax policy
which will reduce the tax liability of the people so that they have the needed capacity to buy
goods and services in the market.
CHAPTER 4 KINDS OF TAXES DIRECT TAXES: MEANING
According to Dalton, direct taxes are those taxes which are paid entirely by those persons on
whom they are imposed. In other words, the immediate money burden is upon the man who pays
the tax to the authority. Direct taxes are those taxes which cannot be shifted to others. To
quote of J.S. Mill, “A direct tax is demanded from the very persons who, it is intended or desired,
should pay it.” Thus if a tax is intended to be paid by the persons on whom it is imposed, it is a
direct tax. Bastable, however, puts that taxes which are levied on permanent and recurring
occasions are direct.
While imposing taxes, point of assessment should also be considered.

50
AR. Prest, an authority on Public Finance, defines direct taxes as those taxes which are based on
the receipts of income. Thus income-tax, tax on profits, capital gains tax, property or wealth-tax
are direct taxes.
Thus, considering all those things, Prof. Shirras was of the view that those taxes which are levied
immediately on the property and income of persons are called direct taxes.
A tax system is composed of both direct and indirect taxes. Since effects of direct and indirect
taxes on production, distribution and consumption are separate and distinct, it is necessary to
examine their merits and demerits.

MERITS OF DIRECT TAXES

1. Equitable: Direct taxes such as income-tax, taxes on property, capital gins tax, etc. are
just and equitable because they are based on the principle of progression. Higher incomes
are taxed more heavily and lower incomes slightly. The larger the income the higher is
the rate of tax and vice-versa. Direct taxes are taxed according to the “ability to pay” of
the taxpayers. Ability to pay is interpreted as the money income of the assessee. It means,
any person having a flow of income is expected to pay tax. Taxes at high rate are paid by
the richer section of society and lower are paid by the poorer section of society.
2. Certainty: Direct taxes satisfy the canon of certainty. Direct taxes involve certainty
about the rates of taxes, such as income-tax, which are widely publicised. In other words,
the taxpayer is certain as to how much he is expected to pay, and similarly the State is
certain as to how much it has to receive income from direct taxes. There is also certainty
about the time of payment and manner of payment. Therefore, tax-payers can plan their
own budgets and other economic activities in advance because they know with certainty
their tax liabilities.
3. Reduce Inequalities: As stated above, direct taxes are progressive in nature, and
therefore, rich people are subjected to higher rates of taxation, while poor people are
exempted from direct tax obligations. Rates of taxes increase as the levels of income of
persons rise. As they fall heavily on the rich, they take away a large part of their income
by way of income and property taxes. The revenue so collected is used for providing
social amenities like, food, clothing and housing facilities to the poor people. The real

51
 income of the poor rises and that of the rich falls. Hence, direct taxes help to reduce
inequalities in incomes and wealth.
4. Elasticity: Direct taxes also satisfy the canon of elasticity. Elasticity in direct taxes
implies that more revenue is collected by the Government by simply raising the rates of
taxation. In other words, revenue of the Government may be increased by increasing the
incomes of the people. Therefore, the income of the Government from direct taxes may
increase with the increase in the incomes of the people.
5. Civic Consciousness: Direct taxes inculcate the spirit of civic responsibility amongst the
tax-payers. Since, direct taxes are certain the tax-payers feel the pinch of such payment
and are, therefore, alert and take keen interest in the method of public expenditure,
whether the revenue raised is properly utilized or not. In other words, people try to be
vigilant about how much tax revenue is being raised by the Government and to what uses
it is being put. Tax-payers become conscious of their rights and obligations. In a
democratic country, this civic consciousness checks the wastage in the public
expenditure.
6. Adverse Effects of Direct Taxes can be Avoided: One of the merits of direct taxes is
that their rats can be modified in time to avoid their adverse effects on willingness and
ability to work, save and invest. In other words, reasonable rates of income-tax, property-
tax, etc. may avoid adverse effects of direct taxes on tax-payers. Exemptions and
concessions may also avoid their adverse effects on production.

DEMERITS FO DIRECT TAXES

However, direct taxes are not free from certain disadvantages. They are criticized on the
following grounds:
1. Unpopular: Direct taxes are unpopular because they are required to be paid in one lump
sum which is inconvenient to the tax-payer. Direct taxes are generally not shifted,
therefore, they are painful to the tax-payer. Hence, such taxes are unpopular and are
generally opposed by the tax-payers as they have to be borne by the assessee themselves.

2. Inconvenience: Direct taxes are inconvenient in nature, because tax-payer has to submit
the statement of his total income along with the source of income from which it is

52
 derived. Moreover, direct taxes are paid in lump sum which causes inconvenience to
the taxpayers. Hence, these taxes are said to be inconvenient to the tax-payers.

3. Possibility of Evasion: A direct tax is said to be a tax on honesty, but it can be evaded
through fraudulent practices. As stated above, direct taxes are certain and tax-payers
know the rate of tax they have to pay. therefore, awareness of tax liability tempts the
taxpayer to evade tax. It is a fact that the people in the higher income groups do not
reveal their full income. They do not hesitate to fill up false returns, concealing a
considerable part of their incomes. Black money is generated on a large scale and a
parallel economy is established which is injurious to economic development. Hence, it is
found that direct tax can wholly or partly be evaded, if the tax-payer decides to become
dishonest.

4. Arbitrary: Direct taxes are found to be arbitrary because there is no logical or scientific
principle to determine the degree of progression in taxation. Rates of income-tax and
other direct taxes are determined according to the whims of taxation authorities. They
are likely to underestimate or overestimate the taxable capacity of the people.
5. Adverse effects of Direct Taxes on Will to Work and Save: Will of the people to work
depends on the nature of tax. Certain taxes by nature like, excess profit tax etc., do not
have any bad effect on the will of the people to work and in turn save. Conversely, if the
higher taxes are imposed on the income of the assessor’s, will of the people to work hard
and save may adversely be affected. This may prove to be injurious to the economy.

INDIRECT TAXES – MEANING

Indirect tax is a tax the burden of which may not necessarily be borne by the assessee. Indirect
taxes can be shifted or passed on to other persons. Indirect taxes are taxes on commodities.
These are custom duties, excise duties, sales tax, etc. According to John Stuart Mill, “Indirect
taxes are those which are demanded from one person in the expectation and intention that he
shall indemnify himself at the expense of another”. Thus, if it is intended that the amount of tax
should be collected from other persons by those on whom it is imposed, such a tax is an indirect
tax.

53
From the point of view of assessment, indirect taxes are imposed when the income is spent i.e. on
goods purchased. According to Bastable, taxes levied on occasional and particular events are
indirect. Thus, according to Prof. Shirras, taxes which affect the income and property of persons
through their consumption may be called as indirect taxes. In a sense, indirect taxes are taxes on
expenditure.
In the end we may say that due to lack of any precise definition, all taxes on commodities and
services other than personal services are treated as indirect taxes.

MERITS OF INDIRECT TAXES

Indirect taxes have the following merits:

1. Convenient: Indirect taxes are convenient to pay. They are paid in small amounts
instead of in one lump sum. They are generally included in the price of a commodity and
hence the burden of these taxes is not felt very much by the tax-payers. They are
convenient from the point of view of the Government also. These are collected only when
the income of the person is spent, and spending is spread over a long time. Thus indirect
taxes are convenient and less unpopular.
2. No Evasion: There is always a tendency to avoid or evade taxes. Indirect taxes are
generally difficult to be evaded as they are included in the price of a commodity. A
person can evade an indirect tax only if he decides not to purchase the taxed commodity.

3. Elastic: Indirect taxes can be elastic, i.e., the revenue from indirect taxes can be
increased. Revenue may be increased if the tax is imposed on those articles, the demand
for which is inelastic. In other words, if taxes are imposed on articles of common
consumption, revenue may be increased.

4. Wide Coverage: Through indirect taxes, every member of the community can be taxed,
so that everyone may provide something to the Government to finance the services of
public utilities. In other words, through indirect taxes, everyone contributes towards
social benefit.

5. Can be Progressive: Indirect taxes can be made progressive by imposing heavy taxes on
luxuries and exempting articles of common consumption from the tax net.

54
 6. Economy: Indirect taxes, such as sales tax, are collected by traders, manufacturers and
seller from individual buyers and then paid in lump sum to the tax authorities. Thus,
there is economy in the collection of indirect taxes.

DEMERITS OF INDIRECT TAXES

1. Regressive: Indirect taxes are regressive in nature, as they fall more heavily upon the
poor than upon the rich. The Government in order to increase its revenues, imposes
heavy taxes on the articles of common consumption, the demand for which is inelastic.
The real burden on the poor is more, since their incomes are low.
2. Administrative Cost: The administrative cost of collection of such taxes is generally
heavy as they have to be collected from large number of people in small amounts. It is
necessary to check records of manufacturers and sellers. It is also necessary to prevent
smuggling of goods. Large number of inspectors have to be maintained. Thus, the cost of
collection tends to be very high in the case of indirect taxes.

3. Discourage Savings: Indirect taxes discourage savings because they are included in the
price of a commodity and people have to spend more on essential commodities. Hence,
they discourage savings.

4. Uncertainty: The income from indirect taxes is said to be uncertain, because the taxing
authority cannot accurately estimate the total yield from different taxes on account of
the fact that the demand for different goods is influenced by so many factors like
elasticity of demand. If the demand for these is elastic, the income may be less and vice-
versa.

5. No Civic Consciousness: Indirect taxes are collected through middlemen like traders,
and hence they have no direct impact. Unlike direct taxes, indirect taxes are collected in
small amounts, hence, they are not felt very much by the tax payer and does not arouse
civic consciousness.

6. Adverse Effects on Efficiency: When indirect taxes, such as excise duties and sales tax,
are levied on essential goods, their consumption by workers is reduced and so too their
efficiency. Therefore, productivity of workers is reduced.
55
7. Creation on Inflation: Another major evil of indirect taxes is that these taxes generate
inflation in the economy. Prices of taxed goods keep on rising without any reduction in
the purchasing power in the economy.

Price inflation caused by indirect taxes increases the cost of input and output. Increase in
production costs pushes the prices of goods further, which in turn, increases the wages of the
workers. This hampers both the welfare of the people and economic growth. Thus, cost-push
inflation results from indirect taxes.

COMPARISON BETWEEN DIRECT AND INDIRECT TAXES

Following Musgrave and other modern economists, we may compared between direct and
indirect taxes in view of the allocative effect, administrative costs and distributive effects as
follows:

1. Allocative Effects: It has been observed that the allocative effects of direct taxes are
superior to those of indirect taxes. If a particular amount is raised through a direct tax like
income-tax, it would imply a lesser burden than the same amount raised through an
indirect tax like excise duty. In other words, if a given amount is to be collected through
taxes, the burden of the tax or the sacrifice involved would be greater in case of indirect
taxes than direct taxes. This is because an indirect taxes puts an excess burden because it
is concluded in the price of a commodity and the amount of indirect tax depends on
changes in prices. Thus an indirect tax has a greater adverse effect on the allocation of
resources than a direct tax.
2. Administrative Aspect: A comparison between direct and indirect taxes can be made
from the point of view of administrative cost and efficiency. In India, majority of people
are exempted from income-tax because, of extremely low level of incomes. Hence, it is
not possible to approach each individual through direct taxes because of their
administrative cost. Hence, from the point of view of administrative cost, direct taxes are
considered superior to that of indirect taxes.

56
But from efficiency and productivity point of view, indirect taxes are better. Indirect taxes are
included in the price of a commodity so that cannot be so easily evaded. Indirect taxes can be
evaded only of a person decides not to purchase a commodity. They are more productive as
India, depends on indirect taxes for its revenues.

On administrative ground, it is found that indirect taxes are equally levied on every person, they
are collected in small amounts and their cost of collection is constant over time. Thus, indirect
taxes are administratively easy to manage.

3. Distributive Effects: Direct and indirect taxes may be compared on the basis of
distribution effects. Direct taxes are regarded as superior to indirect taxes as an
instrument of fiscal policy to reduce inequalities. Direct taxes reduce inequalities of
income and wealth, as they are progressive in nature. Rich are subjected to higher rates of
taxation and poor are exempted from tax obligations. Hence, they fall more heavily on
the rich than on the poor. On the other hand, indirect taxes are included in the price of a
commodity, so they cannot be evaded. Secondly, articles of common consumption are
subjected to higher rates of taxation, hence they are generally regressive in nature as the
burden of indirect taxation falls more heavily on the poor than on the rich. Therefore,
indirect taxes are generally not suitable from the point of view of removing inequalities
of income and wealth But, this is not always true. Even indirect taxes can be made
progressive if necessities are exempted from taxation and luxuries are subjected to heavy
rates of taxation so that the tax rates would be higher for the high priced goods or for
goods of superior quality. Such taxation would be progressive in nature as these goods
are purchased mainly by rich people.

It is, therefore, concluded that both direct and indirect type of taxes have their own merits and
none can be regarded as inferior to the other. Both are mutually complimentary to each other,
therefore, both types must be appropriately adjusted in a rational tax system.

57
ROLE OF INDIRECT TAXES IN AN UNDERDEVELOPED ECONOMY

Developing countries have the basic problem of rapid rise in capital formation. Hence, savings
and investment should be promoted. Taxes can be used for the mobilization of resources. Under
economic planning of a mixed economy, Government assumes the role of entrepreneur. Hence,
through taxes more and more resources should be mobilized by the Government to undertake
public sector investments. For the mobilization of resources, indirect taxes play an important
role.

The role of indirect taxes in the process of economic development may be discussed under the
following heads:
1. Diversion of Resources / Diversion Effect

Every society needs sufficient resources to accelerate the pace of economic development. Since,
the volume of resources is limited, it enjoins on the Government to formulate such a fiscal policy
which seeks to divert resources from those areas and activities which are of lesser importance to
those which are of greater importance to the health of the economy.
The diversion of resources is possible in two important areas:
(A) Diversion of Resources from Consumption Goods Industries to Production Goods
Sector/Industries
Since the availability of resources is limited, there is a need for the encouragement of
infrastructural faculties like coal, power and production goods industries like iron and steel,
engineering, heavy chemicals etc. The Government should provide lots of incentives for the
establishment of industrial unit in the production goods sector and discourage consumption
goods sector by not offering incentives to consumer goods sector like textiles, T.V. sets, motor
cycles, motor cars etc. In other words, to encourage entrepreneurs to make investment in
production goods sector, the Government should grant tax incentives to them in the form of
granting 5 year tax holiday, supplying raw material and other inputs at cheaper rates, reducing
the rates of sales tax, custom duties etc. These incentives would encourage entrepreneurs to
divert their capital towards production goods sector.

58
(B) Diversion of Resources from Imported Goods to Domestically Produced Goods

In order to encourage local industries, the Government is expected to follow a policy which seeks
to discourage imported goods and encourage locally produced goods.
Two types of fiscal policies may he followed by the Government to discourage imported goods.
Imported goods should be discouraged and locally produced goods should encouraged by-
(i) making foreign goods costlier in the domestic market by way of imposing import duties,
and

(ii) making local goods cheaper in the local market by way of providing subsidy to local
industries.
By doing so, there would be diversion of funds from imports to domestically produced goods.

(2) Role of Indirect Taxes in Raising Revenue/Revenue Effect

Government needs revenue for socio-economic development apart from fulfilling other
obligations in the form of defense and maintenance of law and order.

In other words, in order to raise the level of economic development, more resources may be
needed by the Government. Since people may resent the payment of direct taxes like income-tax
at high rate, it can impose indirect taxes to raise revenue specially on the richer section of
society. Thus, the volume of revenue may go up many times if the Government follows a rational
indirect tax policy. In other words, more resources may be generated through indirect taxes if
luxury items, mainly purchased by rich, are subjected to higher rates of taxation and articles of
common consumption or necessities generally consumed by poor also, are exempted from tax
obligations.

(3) Role of Indirect Taxes in Checking Price Behaviour / Price Effect

Price stability is related to the manner in which price behaves in an economy. Prices should not
be stagnant. Normal rise in price is a sign of healthy economy. Problem, however, arises,
whenever there are price fluctuations. Price fluctuations may be called abnormal price behaviour.
There may be three state of abnormal price behaviour.
59
 (a) Inflation,

(b) Deflation,

(c) Recession.

Inflation is a situation of rising prices. Prices rises as the money supply increases more than the
availability of resources.

The Government controls inflation by way of imposing higher dose of taxation. By doing so, the
Government withdraws the capacity to pay of the people so that the price of the goods does not
rise out of production.
Deflation is a situation of falling prices. Prices fall because of the lack of money supply. The
result is, demand also falls.
In times of deflation, the Government may follow the policy of lowering the tax rates so that
people may have the requisite capacity to pay. This would create demand for the products which
would provide sustenance to sellers, producers and economy as a whole.

Recession is a situation in which the prices continue to rise inspite of the continuously falling
demand. Under recession, the price could be kept under control through proper tax policy. Since
under recession, inspite of fall in demand, the price continues to rise, to sustain demand, it
becomes essential to bring down the price.

This is only possible if cost of production is kept under control. For this purpose, the producer’s
nay be extended fiscal support by way of reduction in the rates of custom duties, sales tax and
other indirect taxes.

(4) Role of Indirect-taxes in the Distribution of Income / Distribution Effect:

The process of economic growth depends on two factors:

(1) Income Generation;

(2) Income Distribution.

60
We have discussed income generation through diversion of capital and generation of revenues
through fiscal measures apart from stabilizing prices.
The income so generated from the diversion of resources from the consumption goods industries
to production goods industries, from the diversion of resources from imported goods to
domestically produced goods, by formulating a rational indirect-tax policy and by checking
abnormal price behaviour, if not distributed properly among the factors. capital and labour and
different sections of society, it may lead to economic tension and conflict between different
sections of society.
To ward off such a situation, the Government should follow the policy of progressive taxation to
withdraw excessive capacity to pay of the richer section of society and pass on the same to the
poorer section of society. The method adopted by the Government should be to make more and
mare expenditure on providing social amenities to the poor like health, sanitation, education,
utilities and recreation. By doing so, the gap between the rich and the poor may be bridged. We
find that theory and practice of tax structure and policy can be at variance from each other, and
quite often tax proposals1 which theoretically are quite sound and desirable, may have to be left
out from practical point of view.

However, to the extent possible, the authorities must see to it that the taxes are designed in such a
way as to reduce their ill-effects to the minimum and strengthen their good effects to the
maximum. It is in the light of these observations, that we find it necessary to study some general
classifications of the possible taxes and their relative merits and demerits.

Taxes can be classified on the basis of form, nature, aim and methods of taxation. The following
classifications are commonly found in the modern tax system:
1. Proportional and Progressive tax System.

2. Single and Multiple tax system.

(1) Proportional Vs Progressive Taxation

A tax is called as proportional, if all the tax-payers pay the same proportion of their income (or
property) as tax.

61
ARGUMENTS IN FAVOUR OF PROPORTIONAL TAXATION

1. Relative Position Not Affected: According to classical economists, the objective of

taxation should not be to alter the relative position of the tax-payers. Hence, they
advocated proportional taxation, as it does not affect the relative position of the tax-
payers - as percentage of tax is the same on all the tax-payers.
2. Uniform Tax Rates: Proportional taxes are simple and uniform. Tax rates are the
same for the rich as well as for the poor. Since the tax rate is uniform for all the
taxpayers, taxation is not very much opposed by them. Taxpayers do not feel the
pinch of paying proportional taxes.
3. Certainty: Proportional taxation satisfies the canon of certainty. As the tax rates are
same for all the tax-payers, the amount of proportional taxes can be estimated and
calculated easily by the Government. Therefore, proportional taxation also satisfies
the canon of simplicity and has been regarded as better than progressive taxation.
4. Wi11ingnes to Work and Save Not Affected: The proportional taxation has been
supported on the ground that the willingness to work more and save more of the tax-
payers is not adversely affected by the proportional taxation because the rate of taxes
remains constant. Therefore, they are generally not opposed by the taxpayers.
5. Equitable: Proportional taxes are just and equitable because the money burden
increases in the same proportion as the income increases. Therefore, the taxpayers do
not feel the pinch of paying proportional taxes.
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, i.e. in proportion
to the’ revenue which they respectively enjoy under the protection of the State.
Up to the end of the nineteenth century, the essentially unanimous opinion of writers on the
subject supported the view that fairness or justice in taxation calls for taxation at proportional
rates.
OBJECTIVES OF PROPORTIONAL TAXATION

On the other hand, the supporters of progressive taxation and the critics of proportional taxation
argue that-
1. Not Just and Equitable: A system of proportional, according to some critics, is not just
and equitable. According to them, proportional taxation would not lead to equitable and
62
 just distribution of the burden of taxation, as it falls more heavily on small incomes than
on high incomes. Hence, the sacrifice involved in paying of a tax, proportion to the
income, is greater for the poor than for the rich as the marginal utility is greater for the
poor than for the rich. Justice requires that the sacrifice made by each tax-payer in paying
a tax should be equal. Therefore, the rich should be taxed at higher rate than the poor.
2. Inadequate Resources: A system of proportional taxation means that the tax rates for
the rich and the poor are the same. Hence, the State cannot obtain from the richer section
of society as much as they can give. Therefore, in modern times, with the increasing
financial needs of the Government, such a system may fail to provide adequate resources
to the Government.
3. Not Elastic: The proportional tax system cannot be elastic. In other words revenue
from proportional tax system cannot be increased as the financial needs of a Government
are not fixed, they may change from time to time and is often required to have more
funds. In a proportional tax-system, the burden of taxes fall more heavily on the poor
than on the rich, as the rates of taxes are the same. If the tax rate for the smaller income
group is already heavy and that it cannot be raised anymore, the resources of the
Government cannot be increased. This implies that the tax rate for the higher income
groups also cannot be raised, as under the proportional tax system all should be taxed at
the same rate. Hence, the Government may not be able to increase its revenue in times of
emergency. Therefore, the system is not elastic.
Hence, the proportional tax system suffers from the effect of inequitable distribution of the
burden of taxation, lack of elasticity and inadequacy of funds for the increasing needs of the
modern Government.
(2) Progressive Taxation

A tax is said to be progressive, if larger the tax-payer’s income (or property), the greater is the
proportion that he pays as tax. A sharply progressive tax system tends to reduce inequalities in
the distribution of income and wealth, and, sharper the progression, the stronger is the tendency
to reduce inequalities.

63
ARGUMENTS IN FAVOUR OF PROGRESSIVE TAXATION

The principle of progression in-taxation has been accepted. This principle has been favoured by
different writers on a number of grounds, some of which are as follows:-
1. Just and Equitable: Progressive taxation is just and equitable on the ground that it
secures equality in sacrifice. In other words, under the system of progressive taxation
inequalities would be reduced because a higher proportion of the income and wealth of
the rich would be taken away by way of taxes than that of poor. Hence, a sharply
progressive tax system tends to reduce inequalities in the distribution of income and
wealth and, the sharper the progression, the stronger is the tendency to reduce
inequalities. Obviously, progressive taxation is desirable in order to bring about a more
equitable distribution of wealth as it is based on the principle of ability to pay.
2. Reduces Inequalities: Progressive taxation reduces inequalities of income and wealth by
taking away the excessive capacity to pay. In a progressive tax system, rich are subjected
to higher rates of taxation and poor are either subjected to lower rates of taxation or
exempted from tax obligations. Professor Kaldor has also emphasized the role of
progressive taxation to reduce the inequalities of income.
3. Economical: Progressive taxes have also been justified on the ground that they are
economical, as the cost of collection does not rise with the increase in the rates of taxes.
4. Elastic: Progressive taxes are elastic in nature. Revenue from progressive taxes can be
increased by increasing the rates of taxes i.e. the public revenue can be increased at any
time by increasing the rates of taxes and vice- verse.
5. Curbs Inflationary Trends: Progressive taxation may be helpful in curbing the
inflationary trends as it reduces consumption demand and the resources thus mobilized
may be directed towards productive investment which may increase the supply of
commodities. Hence, inflationary trend may be curbed, growth and economic stability
may be achieved.
OBJECTIONS TO PROGRESSIVE TAXATION

The following objections have been advanced against the policy of progressive taxation:-

1. Arbitrary: Progressive taxation is arbitrary. It is not bound by rules. In other words,

there is no guiding principle according to which tax rates are determined. The

64
 Government, in order to increase its revenue, arbitrarily increases the rates of taxes and
vice-versa.
2. Discourages Capital Formation: Secondly, it has been argued that progressive taxation
may adversely affect production and discourage the growth of industry. Mill pointed out
that, “to tax the higher incomes at higher percentage than smaller, is to lay a tax on
industry and economy. This may hamper the formation of capital and the growth of
industry.
3. Encourage Evasion: Progressive taxation encourages evasion also. As rich are subjected
to higher rates of taxation, assessees submit false returns of their income and wealth.
Hence, in case of progressive taxation, the motives for evasion would be stronger and the
means of prevention less effective than in case of a proportional tax. However, this
objection may be removed through an efficient and strong tax collecting machinery.

SINGLE VS MULTIPLE TAXATION SINGLE TAX SYSTEM

Meaning

A single tax means only one kind of tax. It does not mean tax on only one person. In other words,
a tax on one thing i.e. on one class of things or one class of people. Such a tax is collected not
only once but regularly every month, or every year, at intervals of shorter or longer durations. It
may also imply a tax on all classes of things or on all expenditure or on all income. But in all
such cases, it is after- all only one thing that is taxed. A single tax may be proportional,
progressive or regressive or it may be a fixed amount. A single tax was advocated by some
people in the 17th and 18th centuries. In the 18th century some people in England wanted a single
tax on houses.
They wanted to have a simple uncomplicated system which would be able to tax all the people.
In the 19th century, many people on the continent of Europe advocated a single tax on income.
Everybody has income and so everybody would have to pay this tax. Economists in France
advocated a single stamp tax. There were some who wanted a single tax on capital. Those who
have capital must pay the tax and those who have no capital, need not be taxed.
However, Physiocrats advocated a single tax on land. They believed that agriculture was the only
productive industry and so it was only agriculturists who had the capacity to pay taxes. In this
way they justified a single tax on land. Mr. Issac Sherman, a diffusionist, wanted that everybody
65
should pay taxes. He believed that all taxes are shifted or re-shifted and all the taxes could be
diffused equitably. Thus, he advocated a single tax on land unlike Physiocrats, who believed that
only agriculturists could pay taxes. On the other hand the modern economists do not consider the
proposals of single tax on the ground that revenue from single tax may be insufficient.
MERITS OF A SINGLE TAX

1. Simple: The greatest merit of a single tax lies in its simplicity. Since, there is only one
tax, it simplifies the work of the Government. A multiple tax system complicates the
work of the Government. A multiple tax system complicates the work in every respect in
collecting revenue and its effect on production and distribution. Thus in a single tax
system, collection of revenue would be greatly simplified and it would be much less
costly, if all the taxes are replaced by only one tax.
2. Equitable: Single tax like income tax is just and equitable because it is based on the
principle of equity in taxation. Higher taxes are imposed on the income of the rich and
lower taxes are imposed on the income of the poor. Income below the exemption limit is
exempted from taxation.
DEMERITS OF A SINGLE TAX

1. Insufficient Revenue: From the point of view of revenue, the single tax may not be
sufficient for the Government. The financial needs of the Government are not fixed and
sometimes, the needs of the Government suddenly increases which cannot he met by the
yield of a single tax. The yield of a single tax does not increase as rapidly as the yield
from the multiple tax system.
2. Regressive: Single tax is opposed on the ground that, it is regressive in nature as it
cannot be imposed in proportion to the ability to pay of the tax-payer. For instance, if a
tax is imposed on houses, land, or any other such things, it is very difficult to make its
burden on everybody in proportion to his ability. Here it has been pointed out that, if the
tax is on income it can be made very equitable. But Income-tax can be evaded especially
by rich people and hence tax may not achieve the objective of equitable distribution of
income and ability
MULTIPLE TAX SYSTEM MODERN VIEWS

Modern economists have laid great stress on the diversity of taxation. In other words, there
should he all types of taxes, direct and indirect, so that every class of citizen may be called upon
66
to contribute something towards the State revenue. Hence, a multiple tax system is preferable to
a single tax system, but too great a multiplicity is not desirable, as it may go against the canon of
economy and productivity. If there are large number of taxes, each one of them may yield only a
small amount of revenue and the cost of collection would be high. Thus, Dalton suggested that,
every Government should rely on few substantial taxes, rather than on many. Dalton was of the
opinion that too much multiplicity of taxes may spoil the efficiency of the administrative system,
hence it is essential to have a limited number of taxes to maintain the efficiency of the
administration.

Thus, the burden of taxation should be widely distributed on the entire economy without causing
much harm to anyone. Hence, it is concluded that the tax system should be based on the principle
of multiple taxation without sacrificing the character of productivity and economy.
MERITS OF MULTIPLE TAXATION

Following arguments have been advanced in favour of multiple taxation:

1. Just and Equitable: Multiple taxes are just and equitable because they are based on the
principle of ability to pay. All the tax-payer pay taxes according to their money income.
Rich pay taxes at high rates and poor are exempted from taxation. The burden of taxation is
equitably distributed on all the sections of society. In other words, the sacrifice of the
society is equal.
2. No Evasion: Multiple taxes cannot easily be evaded. If a person evades a tax on one
account, he pays the tax on another account because of the multiplicity of taxes. Direct tax
like incometax can be evaded but it is not possible to evade commodity taxation because the
tax is included in the price of a commodity. Hence, tax evasion is not easy under multiple
tax system.
3. Sufficient Revenue: As a number of taxes are imposed in a multiple tax system, therefore
all the people pay, more or less, all the taxes. Hence, the Government is able to collect
sufficient revenue to meet the growing needs of the society.
4. Wide Coverage: Through multiple taxes, every member of the community can be taxed, so
that everyone may provide something to the Government to finance the services of public
utilities. In other words, through multiple taxes, everyone contributes towards social benefit.

67
 Therefore, by adopting multiple tax system, the tax structure becomes broad based covering
almost every sector and person in the country.
5. Satisfies All the Canons: Multiple tax system satisfies most of the canons of taxation such
as equity, diversity, productivity, flexibility etc.

DEMERITS OF MULTIPLE TAX SYSTEM

1. Unpopular: Multiple tax system is unpopular amongst the tax-payers as it is composed of
all types of taxes, direct taxes as well as indirect taxes. Direct taxes are generally not
shiftable, therefore, they are painful to the tax-payer. On the other hand, indirect taxes are
included in the price of a commodity, therefore, they cannot be evaded. Hence, multiple tax
system is unpopular and opposed to the tax-payers.
2. Inconvenient: Too much multiplicity of taxes, may lead to inconvenience to both the taxing
authority and the tax-payer as well as to the general public.
3. Affects Economy and Productivity: Excessive taxation in the name of multiple taxation
must he avoided, for though, multiple tax system is generally preferable to a single tax-
system, too much multiplicity is not desirable, since it may sacrifice the canon of economy,
productivity and convenience.
4. Administrative Cost: The administrative cost of collection of such taxes is generally heavy
as they have to be collected from large number of people. It is necessary to check records of
manufacturers and sellers. It is also necessary to prevent smuggling of goods. Large
numbers of officers have to b appointed to collect revenue. Salaries have to be given to the
officers. Salaries of the officers eat up the greater part of the produce of tax. The
Government has to impose additional taxes on the people.
CHAPTER 5 INCIDENCE AND SHIFTING

MEANING

When a tax is imposed on some person, it is quite possible that it may be transferred by him to a
second person, and this tax may be ultimately borne by this second person or transferred to
others by whom it is finally borne. Thus, a person who originally pays the tax may not be
actually bearing its money burden as such. The problem is, therefore, to determine who bears the
tax ultimately. This is known as incidence of taxation. In other words, incidence of a tax is upon
that person who cannot shift it further. Incidence of a tax relates to money burden of a tax on a

68
person who ultimately bears it. In other words, when the money burden of a tax finally settles or
comes o rest on the ultimate tax payer, we may call it the incidence of tax.

The concept of “incidence” of taxation has been variously described by different economists.
Dalton, for instance, considers incidence as the direct money burden of tax on the person who
ultimately pays it. Incidence, thus, rests on the person who cannot shift the money burden of the
tax to any other person. For example, when a sales-tax is imposed on Bata Shoes, the Company’s
shop recovers it from the buyers, so the incidence of this tax lies on the buyers since they
ultimately bear its money burden. Thus, according to Dalton, the incidence of tax refers to the
direct money burden of tax, i.e., the actual initial payment of tax which may either fall upon a
person on whom it is initially imposed.
According to Philip Talyor, “Incidence is the locus of direct burden of a tax.”

According to Seligman, “the incidence is upon him who bears the ultimate direct money burden
of tax.”
DISTINCTION BETWEEN IMPACT AND INCIDENCE

The impact refers to the initial burden of tax while incidence refers to the ultimate burden of
the tax. Impact is felt by the tax-payer at the point of imposition of the tax, while the incidence is
felt by the tax-payer at the point of settlement or rest of the tax. For example, if an excise duty of
Sh. 2,000/- per T.V. set is imposed on the manufacturer of colour T.V. sets, then the impact of
the tax falls on him. This is the immediate money burden of the tax on the manufacturer who
must arrange to pay it to the Government even before the goods are actually sold.
However, the incidence of the tax levied on the manufacturer may fall on the buyers of the colour
T.V. sets.
Thus, impact of the tax is always on the person who is responsible by law to pay the tax amount
to the Government treasury, in the first instance. Incidence may fall on somebody from whom
the manufacturer ultimately recovers the amount, provided he shifts the tax.

SHIFTING - MEANING

Shifting of a tax refers to the process by which the money burden of a tax is transferred from
one person to another. Whenever, there is shifting of taxation, the tax may be shifted forward or

69
backward. Thus, a producer upon whom a lax has been imposed, may shift it to the consumer, or
a seller may shift it to the purchaser. The tax is shifted forward or backward to the consumer or
the purchaser, respectively. On the other hand, the tax may be imposed in first instance on the
consumer or purchaser, he may shift it to the producer or the seller respectively. In this case, tax
is shifted backward. When the tax is shifted from the seller to an immediate purchaser, who then
sells it to another person, and so on until the tax finally settles on the ultimate purchaser or
consumer, it may be called forward shifting.

In other words, the person upon whom the tax is imposed not necessarily bear the burden of tax.
In this case, the assessee is given the right to pass on the tax burden to the buyer of goods. Thus,
the process of passing on the tax burden to the buyer of goods by the seller of goods is known as
shifting of tax.

Shifting can occur only in connection with the price transaction. Price is the only vehicle through
which a tax can be shifted. As Seligman points out, shifting of a tax is primarily a function of
price.
Thus, shifting -is common is commodity taxation.

If a tax is shifted, the price of the taxed commodity increases. For example, if a tax is imposed on
the manufacturers of T.V., the manufacturers, if they are successful, collect the tax by adding it to
the price, charged to dealers, who in turn, if they are fortunate, add the tax to the retail price.
TYPES OF TAX SHIFTING

Tax shifting may be of two types:

(1) Forward Shifting

(2) Backward Shifting.

(I) Forward Shifting

A tax is said to have shifted forward if- price of the commodity which constitutes the medium for
shifting the money burden of tax is increased. Under complete shifting, the price will be higher
by the full amount of tax. In forward shifting of a commodity taxation, the money burden of a

70
tax is transferred from the producer or seller to the consumer or buyer when the tax is initially
imposed on the producer. Thus, forward shifting is possible with regard to all indirect taxes
which are generally passed partly or shortly to the buyer of goods.

(2) Backward Shifting

Backward shifting refers to the process by which the money burden of a commodity tax is
shifted from the consumer or buyer to the producer or seller, if the tax is initially imposed on
the consumer. In other words, it is a typical situation in which the tax burden is shifted
backward, i.e. from the buyer of good to the seller of goods under the following conditions:

(1) Backward shifting is applicable in the case of property-tax only.

(2) Backward shifting is effected when the buyer of property shifts the entire tax burden to
the seller of property.
(3) The shifting is done by buyer of property by way of capitalizing the value of tax by the
life of the property and deducting it out of the total value of the property.

Whether tax is shifted forward or backward, depends on the relative strength of resistance to
transfer the burden. Commodities having inelastic demand will have less resistance to forward
shifting while commodities having relatively elastic demand would have greater resistance to
forward than backward shifting.

FACTORS OF TAX SHIFTING

The current condition of the market is an important determinant of the direction and extent of
shifting. There are two set of factors which influence tax shifting:
(1) Internal Factors

(2) External Factors.

(1) Internal Factors

Internal factors implies the market conditions which are reflected in the form of (i) elasticity of
demand, and (ii) elasticity of supply.

71
 (i) Elasticity of demand means changes in the level of demand due to price variation. If with
the slight rise in price, a considerable fall in demand is obtained, we call it highly elastic
demand or elasticity is greater than one, i.e., e>1. When with the moderate rise in price,
there is moderate fall in demand, we call it moderately elastic demand or elasticity equal to
one e=I. In the case. of the rise in price, if there is no shortfall in demand, we call it
inelastic demand or elasticity is less than one, i.e., e>1.Shifting is possible if the demand is
inelastic
(ii) Elasticity of Supply

Another component of market condition is elasticity of supply. When supply changes with the
change in the price, the supply is said to be highly elastic. The more elastic the supply of the
commodity, the more will be the incidence of the tax upon the buyer. And, the less elastic the
supply of a commodity, the greater will be the incidence of the tax upon the seller. If the supply
of a commodity is perfectly elastic, the entire tax burden is shifted to the buyers. With the
imposition of a tax, the cost ol production will rise, hence, the• prie will rise, which may affect
the demand of the commodity and bring loss to the seller. Therefore, the seller would curtail the
supply of the commodity, increase the price of the commodity by the amount of tax and will shift
the entire burden of the tax upon the buyers. If it is perfectly inelastic, the entire tax burden will
be on the seller. If the supply of a commodity is more elastic, a greater part of the tax burden will
be upon the buyer and vice-versa.
EXTERNAL FACTORS

Following factors also affect shiftability:

(1) Public Policy

Public Policy of the Government resists shiftability. Such policies may pertain to the price of the
product. If the Government wants that the business enterprise should not raise the price of the
product in the event of shifting the tax burden forward, or in other words, if the Government
wants that the seller should charge the pre-tax price even after the imposition of tax, then in
that situation, the seller/producer/business enterprise should bear the burden himself or itself.
Therefore, we may say that the Government policy to ask the sellers to charge pre-tax price
offers maximum resistance to shiftability.

72
 (2) Advertised Prices

Advertised prices can have real effect upon the shiftability of a tax. As per the policy of the
Government, prices of the products should be displayed at the counter so that the customers
become used to the advertised price. In other words, advertised price would psychologically
prepare the customers in the event of shiftability.
The display of prices at the counter will show separately the actual price of the product and the
value of tax. The entire goodwill of the seller, revolves around the advertised price. If the seller,
after the imposition of tax changes the price, he may lose all the customers. Under this
circumstance, the seller instead of shifting the tax burden forward, should bear the tax burden
himself. In other words, advertised price also resists shiftability.

(3) Customary Price

Customary price means one price charged by the seller year after year. The existence of
customary prices in the market militates against forward shifting to the consumer. For
example, “25 cents strap” charged by the seller every year is known as the customary price. Any
rise in price owing to the shifting of tax, will put an end to the years of valuable goodwill of the
seller within no time. This is particularly true in cases where the price has traditionally been a
small, round sum. If the seller increases the price of the product, all his customers will withdraw
from him. Under such a circumstance, the seller should take a decision of not shifting the tax
burden forward if the tax is imposed on him.
(4) Geographical Coverage

Narrow distance between the markets offers maximum resistance to shiftability. The
geographical coverage of the tax law can be an important determinant of shiftability. If a local
area is covered by a tax on goods, it is difficult to shift it, because, if the prices of such goods
rise, local people will buy them from neighboring areas which are not covered by such taxes. In
other words, if the seller, having a shop in one market, raises the price of a product and if the
same product is available at a lower price in the neighboring market, the customers, may, in such
a circumstance, purchase the commodity from the neighboring market at a lower price.
Therefore, we may say that geographical coverage offers maximum resistance to shiftability.

73
 (5) Substitute

It will be difficult to shift the tax burden in the case of a commodity which has an effective
substitute. If the price of the main commodity rises owing to the shiftability of a tax burden
forward, the customers will withdraw from the consumption of the main commodity to the
consumption o the substitute. In such a case, the seller, instead of shifting the tax burden
forward, should bear the tax burden himself. Therefore, the substitute can be an important
determinant of shiftability.

(6) Market Structure

Shifting of a tax also depends upon the market structure. Shifting of a tax is easier in the case of
a monopoly market for a product. In the case of a perfectly competitive market for goods, taxes
cannot be shifted. In case of monopolistic competition, shifting will be determined by the extent
of elasticity of demand for the goods. Greater the elasticity of demand for the goods taxed, the
lesser is the shifting of the tax to the consumer and vice-versa.

(7) Size of the Taxed Area

The size of the taxed area will always affect shiftability of a tax on the production or sale of a
commodity. When the goods can be brought in near-by untaxed markets, an attempt at
forward shifting will meet vigorous resistance caused by the availability of untaxed competing
goods.

(8) General Business Conditions

Buying and selling prices and costs are affected by general business conditions, along with tax
shifting. In periods of rising prices and prosperity, it is easier for most enterprises to sell at prices
equal to or greater than costs than it is during falling prices and depression. Tax can, therefore,
be shifted more easily during prosperity than during depression. New taxes which are imposed
at a time of business crises or depression are especially difficult to shift.

74
THEORIES OF SHIFTING

There are quite a few theories and ideas as to who finally pays the tax or on whom the final
incidence of a tax rests. Theories of tax shifting were advocated by Adam Smith, David Richardo
and others. There are three prominent approaches which we shall consider one by one.

(1) The Concentration Theory

This theory was developed by Physiocrats in the 18 th Century. Physiocrats and others have
advanced the theory that all taxes ultimately concentrate on a particular object. The French
economists believed that the tax levied on anything is ultimately shifted to landlords. They
reasoned that agriculture was the only occupation which created surplus over and above the cost
of production. According to them all other occupations, such as trade and commerce did not
yield any surplus. Wages were at the subsistence level and could not be taxed. Industry was not
in a position to generate surplus. This left land rents as the sole taxable surplus. Physiocrats,
therefore, strongly advocated that the Government should concentrate on a single tax on
economic rent earned by landlords from the agricultural occupation. They also argued that the
existing diversity of taxes should be abolished. This would simplify taxation, reduce the
excessive cost of tax collection and lessen the tax charges upon the land owners.

CRITICISM
The theory advocated by Physiocrats has been condemned by Adam Smith and modern
economists too. This theory is criticized on the ground that agriculture is not the only occupation
yielding economic surplus, that is rent. Modern economists are of the view that other occupations
are also productive and yield surplus over and above their cost of production and a single tax on
land is not suitable in modern welfare societies. The burden of taxation should be distribution in
equitable manner on the community as a whole and not on a particular section of the community.
Hence, it is wrong to assume that many tax is ultimately shifted to and concentrated in agriculture.

75
2. The Diffusion Theory

This theory was advanced by French writers like Mansfield and Carard. Diffusion theory is just
the opposite of concentration theory. It negates the basic assumptions of the concentration theory
which may be stated as follows:

The tax burden instead of concentrating on the land owning lass having surplus gets diffused
over different sections of society. In other words, the diffusion theory asserted that all taxes are
diffused among the members of a community. According to this theory, the individuals from
whom the tax is collected do not ultimately bear the whole burden but shift it on to the other
classes, so that it is diffused all over the society.

However, for some time, a tax may stick at a place where it is imposed, but it is shifted again and
again till its burden spreads over the entire society.

According to Canard, the French economist, the buyer of a commodity is also the seller of
something else, and as seller, he passes a part of the tax paid by him to the buyer of his goods.
This buyer, being the seller of some other goods, passes on a part of the tax again to his buyers,
and in this way, a tax imposed on labour or business gets diffused over the whole community
through such shifting and reshifting.
The supporters of the diffusion theory are of the opinion that it is immaterial as to where a tax is
imposed. It is soon partially shifted and reshifted till its entire burden is spread over the various
factors in more or less equitable way. Since surplus exists in different classes of society, the tax
imposed gets diffused among different sections of society. It keeps on shifting from one person
to another till it gets diffused on the entire social system.

CRITICISM

1. The theory is shallow and misleading as there is no diffusion of tax in the real sense, This
theory avoids the question of justice in taxation. In other words, this theory is not based
on the principle of ability to pay. It is not progressive in nature. More often the tax

76
 imposed on one section is passed on to the other section, i.e. the poor section which does
not have either the ability or the mechanism to shift the tax burden.
2. This theory violates the principles of equity in taxation. Equity in taxation implies that
the sacrifice of the community should he equal. All the tax-payers should feel the same
pinch by paying the last rupee as tax. But since the poorer section of society is supposed
to pay higher tax, there is the virtual sacrifice of the equity principle.
3. This theory ignores the fact that this diffusion does not take place automatically. Unless,
the price vehicle exists, the tax burden cannot be diffused.

3. Demand and Supply Theory/Modern Theory

This is the most acceptable approach is explaining the incidence of tax. Tax incidence can be
shifted only through sale/purchase transactions and only through, price revision. A price revision
is determined by demand and supply elasticities. Similarly, tax shifting and sharing of the
incidence will be determined by the demand and supply elasticities. The more elastic the
demand, the more will be the incidence of tax upon the seller. In other words, if the demand of
a commodity is perfectly elastic, the entire tax burden will be upon the seller, because an
increase in the price due to tax will make the demand of the commodity zero. If the demand for
the commodity is perfectly inelastic, the entire tax burden will be passed on to buyers because an
increase in price due to tax will not affect the demand.

CHAPTER 6 TAXABLE CAPACITY MEANING & DEFINITION

Taxable capacity refers to the maximum capacity that a country can contribute by way of
taxation both in ordinary and extra-ordinary circumstances or is the maximum capacity or ability
to pay taxes. Capacity of people to pay taxes depend upon the per-capita income which in turn
depends upon the national income generated from agricultural sector, industrial sector and
tertiary sector.

According to Prof. Musgrave, the term taxable capacity refers to the sacrifice the community is
able to sustain. Prof. Musgrave also defined the concept of taxable capacity in a different context

77
that arises in determining regional contribution to Federa finances, or the ‘fair’ contribution of
various countries to an international organization.
As Levis Kimmal, an economist observes, the concept of taxable capacity has been subject to
varied and frequently loose interpretations. Dr. Dalton observes, “Taxable capacity is a common
phrase but a dim and confused concept.” Let us examine a few definitions of taxable capacity.
Joshiah Stamp, defines taxable capacity as under:
“Taxable capacity is the maximum amount which the citizen can pay to the public
authorities without having a really unhappy and downtrodden existence and without
dislocating the economic organization too much.”
He further defines that limit of absolute taxable capacity as the difference total production and
total consumption.
Taxable capacity = Total production - Total consumption.

According to him, absolute taxable capacity is total production minus the amount required to
maintain the population at subsistence level. Further according to him, there are two checks
which determine the level of absolute taxable capacity viz. (1) Check to production, (2) Check to
the maximum revenue due to the imposition of higher tax rates. Any taxation that leads to a
reduction in production and/or reduction in revenue/tax shows that the taxable capacity of the
community is exceeded.

In short, taxable capacity of the people will increase if there is equity in taxation. So taxable
capacity stands for the maximum amount which the people can contribute by way of taxes and
the maximum amount which the state can get from the community by way of taxes without
causing any unpleasant effects.

ABSOLUTE TAXABLE CAPACITY

Absolute taxable capacity refers to the maximum amount of tax that can be collected from a
community without causing any unpleasant effects or which can be raised from the whole
community.

78
RELATIVE TAXABLE CAPACITY

Relative taxable capacity can be defined as the ratio of the taxable capacity of one group of
people to that of the other groups or sections and/or it refers to the proportion in which two or
more nations or states in a federalism should contribute to the nation. For example: the rich can
bear more tax burden (i.e. their taxable capacity is more) as compared to that of poor. If two
separate communities have to meet some common expenditure, it can be in proportion to their
relative taxable capacity. This principle is commonly applied in federal system of govt., in which
different states are expected to contribute to the common expenditure of the country. The relative
taxable capacity of a community will depend upon such factors as the share of national income,
the pattern of distribution of income, the size of population, the rate of growth of income taken
together with rate of increase in population, and so on.
To give an international example, America should contribute heavily to the common
international expenditure of the United Nations Organization in comparison to a poor country
like India. The Indian tax authorities should tax heavily those people who live in skyscrapers and
palatial buildings in comparison to those who live in low cost houses.

Of these two concepts, absolute taxable capacity may seem more precise and theoretically ‘nice’
but it has no practical validity since it involves measurements. If we apply the concept of taxable
capacity in India, the vast masses of Indians will be exempt from paying any tax to the govt.
amount by applying the concept of relative taxable capacity, it is possible that the vast majority
will have to bear larger and larger tax burden. Thus the concept of relative taxable capacity has
more usefulness.

FACTORS DETERMINING TAXABLE CAPACITY

The surplus or difference between the total quantity of production and the minimum of
consumption required to produce that volume of production is not and cannot be an absolutely
fixed figure. It depends upon certain factors such as-

1. National Income and Wealth

Taxable capacity of a nation obviously depends upon its income and wealth. In fact, taxable
capacity is a function of national income. The national income of a country is a single major
determinant of taxable capacity. As the national income increases, its taxable capacity also
79
expands. However, the extent of taxable capacity is determined by three aspects of national
income, viz.
(a) Its size,

(b) Its distribution, and

(c) It’s spending.

(a) Size of National Income: If the volume of national income is large, the capacity to pay
taxes is also large. The taxable capacities of rich countries with a very large national
income is very big. Whereas that of poor countries like India, it is very small. America can
collect a large amount by way of income taxation, and spend a substantial part of it on
welfare measures.
(b) Distribution of National Income: People play a vital role in deciding the taxable capacity
of a country. Greater the inequalities in income distribution, greater is the taxable capacity:
it will be easy for the govt. to raise the bulk of its revenue from the richer section of the
community. If the distribution of national income and wealth is equitable the taxable
capacity will be low. This is so, because the ability to pay taxes on the part of the richer
classes is much greater than that of not so rich people. It should also be noted that if
distribution of income and wealth is more equitable the govt. may not require to raise huge
amount of revenue, because no public expenditure is needed to remove inequalities of
income.

(c) Country’s Expenditure Pattern: It also informs whether the taxable capacity is great or
small. Where a large part of the national income is spent on luxury and superfluous
consumption, the taxable capacity is great. However, if the masses spend a large part of
their income on essential goods, the taxable capacity is low as there is little surplus that is
left alter spending the income on essential goods. The former is the case of rich countries
and the latter that of poor countries.

2. Size of Population

Taxable capacity of a country depends on the size of its population and its growth. Firstly, a large
population reduces the capacity. In this case, the gap between income and consumption tends to
be small. Given the total income, a small size of population shows a greater taxable capacity.
80
Secondly, the rate of population growth also affects the taxable capacity. A rapidly rising
populations if unaccompanied by a rising income, reduces the taxable capacity.

3. People’s Standard of Living

Existing standard of living determines the taxable capacity, because the latter is the difference
between total production and aggregate consumption. Higher capacity to pay, higher per capita
income and improvement in the volume of consumption expenditure are only possible in the long
period. Only the higher income group can have a higher standard of living. The people having
higher standard of living will have a higher capacity to pay taxes and vice-versa.

4. Nature of Public Expenditure

The taxable capacity of a country is also influenced by the nature of public expenditure. If
revenues collected by way of taxation are spent on the social and economic overheads or on the
economic development of the people, i.e. on the development of agriculture, industry and trade,
which increases income and production of the country, the taxable capacity will increase.

If the public expenditure is increased for the payment of external debt, this will reduce the net
income of debtor and in turn reduces the taxable capacity. On the other hand, if the money is
applied in paying interest on internal debt or in repaying internal debts, the taxable capacity will
be greater, because taxes are returned to the citizens. It will increase the income and tax paying
capacity of the people which is possible only in the long period.

5. Psychology of the Tax Payer

The psychology of the tax payer has much to do with the extent of taxable capacity. People are
often willing to bear heavier taxation on patriotic or sentimental grounds. They may easily pay
indirect taxes distributed over every day of the year than a direct tax levied in lump-sum once a
year. Heavier taxation may make some men industrious, enterprising and wealthy while others
may become indolent and dispirited.

81
 6. Pace of Economic Growth

The pace of economic growth also determines the extent of taxable capacity. This is particularly
true in the case of developing countries. As the rate of economic growth increases, the taxable
capacity also expands.

7. Trade Cycle Phases

Taxable capacity is commensurate with the phases of a trade cycle. During the period of
prosperity, taxable capacity is very high as people’s incomes are rising fast.

During periods of recession and depression, the incomes of the people are fast falling and
unemployment is rising. The taxable capacity during such periods is very low and the
government’s tax revenue collection becomes small.
8. Political Conditions

Political conditions also determine the taxable capacity. A stable govt. and peaceful conditions
have a favourable effect on the taxable capacity of a country. A truly representative govt.
receives the backing of the people, and the tax collection on a large scale becomes easy. Tax
yield is low where the govt. is unstable or where the govt. is undemocratic.

9. Tax Structure

The type of system also determines the taxable capacity. The taxable capacity is greater where
multiple tax system is adopted. Taxable capacity is greatly reduced if there is a single tax system.
The taxable capacity increases where new sources of taxes are tapped. A progressive tax system
yields large revenue. However, if income taxes are highly regressive. they may adversely affect
the ability and willingness to work, save and invest- and hence taxable capacity will fail.
Expenditure tax will increase the taxable capacity. A properly framed tax system will increase
the taxable capacity.

10. Stability of Income

The taxable capacity is higher in those countries where income is stable. Income of the people is
more stable in industrially developed countries than in agricultural countries. It should be noted
that agriculture and industry both are inter-dependent, but agriculture is more easily influenced

82
by some exogenous factors, such as, failure of monsoons, which in turn affects the income of
agriculturists and revenues of the government.

11. Administrative Efficiency

Taxable capacity is also influenced by the efficiency of administration. If tax collecting

machinery is efficient and the tax obligations are uniformly enforced, the tax evasions may be
reduced. This may encourage people to pay their obligations. Taxable capacity may reduce
because of unpopular policies and ineffective administrative machinery.

12. Other Factors

Besides the above factors fiscal, monetary and income policies of the govt. also affect the taxable
capacity. Favourable balance of payments of a country increases its taxable capacity. Inflow of
foreign capital, technological progress, modernization of production pattern and rationalisation of
manufacturing methods-these and many such other factors increase the taxable capacity of any
country.
USEFULNESS OF THE CONCEPT

Economists are not agreed on the importance of the concept of taxable capacity. Some writers are
of the opinion that the concept cannot be properly defined or measured and that it would be
better to attach more importance to the tax structure of a country rather than the aggregate level
of tax burden. In these days of international political conflicts and of competitive economic
development, it is important to devise a tax structure which will bring in the necessary revenues
with the minimum of adverse economic and political consequences. From this point of view the
concept of taxable capacity came to have no importance at all.
However, there are other economists who attach sufficient importance to this concept.

The knowledge of the taxable capacity of the community is bound to be of great use to the govt.
in many ways and under different circumstances. In the first. place, such information will be
useful for mobilization of economic resources, for purpose of economic planning. Secondly,
during periods of war it is essential for the government to know the maximum amount which
the people can contribute for the prosecution of the war. Thirdly, even in normal times a
knowledge of the limits of taxable capacity will prevent a govt. from imposing unnecessary
taxes which may prove harmful than productive and which may result in disinterest among

83
peop1e Lastly, the concept is of value in federal finance. In federal finance the comparison has
to be made between the different contributors in order to allocate the burden of taxation.

The knowledge of relative taxable capacity is still more important. It will enable the state to
decide progression in taxation, and thus, obtain the maximum revenue from different income
groups in the community. It enables to achieve the objective of equity in taxation and for
reducing the glaring inequalities of income and wealth. It also helps in locating weaker sections
of the community and thereby devising an effective mistaken-expenditure policy.

OPTIMAL TAXATION

Optimal taxation may be defined as a tax system which establishes relationship between equity
and efficiency in taxation. Equity implies justice in taxation. In other words, when the tax
system is based on the principle of equal marginal sacrifice, we may call it equity in taxation It
means that the entire tax burden should be so distributed among people having different capacity
to pay that the last shilling so paid as a tax by the tax-payers belonging to different income
groups bear equal amount of sacrifice. In other words, when everyone whether rich or poor feels
the same pinch by paying the last rupee as tax, we may call equity in taxation. It means rich
should pay higher taxes than the poor.
Efficiency in taxation implies minimum of wastage of time and effort of the Government and the
tax-payers.
Efficiency in taxation implies minimum of wastage in realizing the tax revenue. In other words,
efficiency in taxation is related to the expenditure the Government incurs in collecting taxes and
the Post incurred by the tax payers in the payment of taxes.
CRITERIA OF OPTIMALITY OF TAXATION

The optimality of taxation is related to the following criteria:

(1) Reduction in Resource Cost

The first criterion of optimality of taxation is the minimization of resource cost. A tax-payer and
the Government incurs cost in terms of time and effort. Time and effort involves money which is
a resource for further generation of income. Unfortunately, the cost to the taxpayers is usually
ignored by the authorities while deciding on alternative tax measures. Optimality requires
84
reduction in time and effort on the part of the tax-payers and reduction in administrative cost
incurred by the Governments. To optimize revenue, the Government should simplify the tax
structure so that the incidence of wastage in terms of time and effort is eliminated or reduced
to the minimum.

(2) Equity in Taxation

The second criterion may be a measure of justice or equity. When all the tax-payers pay tax
according to their ability to pay, we may call equity in taxation. Optimality of taxation requires
that the principle of ability to pay or equity in taxation should be based on the principle of
equality in taxation. In other words, there should be equality in sacrifice. The entire tax burden
should be so distributed among people having different ability to pay, that the last shilling so
paid as tax by the tax-payers have equal amount of sacrifice. In other words, equity in taxation
implies that all the tax-payers, whether rich or poor, should feel the same pinch by paying the last
rupee as tax. Rich should pay tax at high rates, according to their ability to pay and poor should
pay tax according to their money income.

(3) Economic Efficiency

The third criterion of optimality of taxation can be derived in terms of economic efficiency.
Economic efficiency depends on (i) proper location pattern of industries, (ii) proper production
pattern, and (iii) elimination of social losses. (i) Proper Location Pattern

Optimum revenue depends on the proper location of industries. Industries should be located at
places which are ideally suitable for production. If industries are not located at places which are
best suited to their location, entire income generation will be lower. Optimality of taxation
requires that the Government should provide tax incentives to those who establish their
industries at proper places and the Government should impose taxes on those entrepreneurs
who establish their factories at those places which are not suitable for production.

(ii) Proper Production Pattern

For the establishment of new industrial units, capital and labour are needed. In our country,
capital is available in short supply in as much as the same manner as the professionally and
technically qualified personnel. The industrial enterprises like the consumer goods industries
which give quick returns attract maximum capital. As a result of this, vital sectors of industry,
85
like production goods sector suffers for want of adequate capital. Therefore, to optimize its
income, the Government should impose heavy taxes on consumer goods sector to encourage
the supply of capital towards production goods sector i.e. basic and heavy industries, which
play a pivotal role in the industrial development of the country.

(iii) Minimum Social Losses

Many business enterprises cause incalculable damage to ecology and environment. The
destruction of flora and fauna owing to the establishment of business enterprises causes
ecological imbalance in the form of destruction of natural resources like forests and minerals.
Big industries enterprises also cause the problem of over-crowding, accidents and unemployment
due to modern technology used by enterprises. To optimize its income, the Government should
impose taxes on industrial enterprises to reduce destruction of natural resources..

OTHER FACTORS OF OPTIMALITY OF TAXATION

(b) The composition and rate schedules of direct taxes,

(c) The composition and rate schedules of indirect taxation.

A. The Composition and Rate Schedule of Direct Taxes

Direct tax is a tax the burden of which falls directly on the assessee. Direct taxes are income-tax,
wealth or property – tax etc. These taxes cannot be shifted forward. They have to be borne by
those assesses on whom the burden of such taxes fall.

Optimal taxation requires that more and more people belonging to high income group should be
brought under the tax net. In other words, direct taxes should be such that they give maximum
revenue to the Government and minimum sacrifice on the part of the people. In other words,
direct taxes should be progressive in nature. Rich should pay higher taxes according to their
money income and poor should pay lower taxes according to their money income.

Optimum revenue also depends upon rates of direct taxes. To optimize tax revenue, the
Government should design tax rates in such a manner that they discourage tax evasion and
avoidance. In other words, rates of direct taxes like income-tax, ‘property-tax should not be very

86
high, because high rates of taxes create a psychological barrier and undermines the capacity and
will to save and invest. Prevalence of high tax rates makes the tax evasion profitable and
attractive inspite of the attendant risks. Hence, tax rates should be reasonable.

CHAPTER 7 PUBLIC DEBT

Introduction

Public borrowing or public debt is a debt or loan taken by the Government from its own people
as well as form foreign countries or both. Borrowing may be short-term as well as long-term.
The Government may borrow from banks, business organizations, business houses, individuals
and foreign countries. As mentioned in the “Encyclopedia Britannica”, Public debt refers to
“Obligations of Governments, particularly those evidenced by securities to pay certain sums to
the holders at some future date.” Government needs to borrow when current revenue falls short
of public expenditure since current public revenue is usually insufficient to meet the current and
development expenditure of the modern Government, the Government has no alternative except
to borrow money.

The instruments of public borrowing in the form of various types of Government bonds and
securities. A Government bond or a Government security paper is a form of a written promise to
pay, made by the Government to the lender of the capital. The proceeds from public borrowing
constitute the revenue of a capital nature, while the provision for their repayment, and servicing
should be regarded as an expenditure of a capital nature in any budget. The payment of interest
on loans borrowed is, however, a charge on the revenue account of the budget. There is
difference between public revenue and public debt. While differentiating public revenue and
public debt, Prof. J.K. Mehta remarked, ‘Public revenue consists of the money that the
Government is not obliged to return to the very individuals from whom it is obtained, public
debt, on the other hand, carries with it the obligation on the part of the Government to pay money
back to the individuals from whom it has been obtained.’

CLASSIFICATION / FORMS OF PUBUC DEBT

There are various categories of public debts. Major forms of public debt are:-

87
 1. Internal and External Debt
Public loans floated within the country are called internal debt. In other words, when the
Government borrows from its citizens, it is called internal debt. Internal debt is in the form of
market borrowings or market loans raised in the open market. It also includes special securities
issued to the Reserve Bank, and other loans.
External debt, on the other hand, is always in terms of foreign currency. External debt is in the
form of borrowing from abroad. The Government borrows from friendly foreign countries or
from international financial institutions such as International Monetary Fund, World Bank, etc.
External debt leads to a transfer of wealth from the lender nation to the borrower nation.

2. Productive and Unproductive Debt

Public debt may be productive or unproductive depending on the use of public loans. Productive
debts are those which are used for those projects which yield income to the Government. Thus,
when the Government borrows for developmental expenditure, the debt is productive. For
instance, public debts may be raised for construction of railways, irrigation and power projects
etc. The income derived from these projects may be used for the payment of interest on the debts
so borrowed.
On the contrary, when the Government borrows for non – developmental purposes such as war
finance or extravagancy in public administration, the debt becomes unproductive. Such debts do
not provide any income to the Government.

3. Compulsory and Voluntary Debt

When the Government borrows from public by using forceful methods, i.e. by virtue of its
sovereign powers, we may call it compulsory debt, for instance, the loans raised during an
emergency such as war or meeting inflation. On the other hand, when the Government borrows
money from the public, individuals and institutions by issuing securities like bonds etc., it is
called voluntary debt. In other words, when the people, on their own volition, invest money in
securities issued by the Government for monetary purposes, we may call it voluntary debt.

88
4. Redeemable and Irredeemable Debt

Redeemable loans are those loans which the government promises to pay off at some future date.
For redeemable debts, the Government has to make some arrangement for their repayment.
Whereas those loans for which no such promise is made are called irredeemable loans. In other
words, irredeemable debts are those- which are raised without any intention to repay the same,
though the Government continues to pay interest on such debts. These loans may also be known
as perpetual debts.

5. Funded and Unfunded Debt

Funded debt is a long-term debt, exceeding the duration of at least a year. Funded debt may be
for a specified period of time, to be paid at the will of the Government These are permanent
debts in the sense that new securities are issued every time the debt matures. Thus the permanent
debt covers loans raised in the open market by sale of securities or otherwise.

On the contrary, unfunded or floating debt is a relatively short-period debt, meant to meet current
need. They are generally redeemable within a year. Small savings of the people, provident fund
deposits etc. fall under this category.

6. Marketable and Non – Marketable Debt

Generally, securities issued by the Government at the time of borrowing are bought and sold in
the open market. These are called marketable public debt. For example, treasury bills and
promissory notes.

Certain forms of public debt, such as savings under various saving schemes, postal savings,
national defense certificates etc., are not marketable. In other words, they cannot be bought and
sold in the open market. These are non-marketable loans.

SOURCES OF PUBLIC DEBT

Every Government has two major sources of borrowings:- (i) Internal, and (ii) External.
internally, the Government can borrow from individuals, financial institutions, commercial
89
banks, non-banking institutions and central bank. Externally, the Government borrows from
individuals and banks, international institutions and foreign friendly countries.

The sources of raising public debt are:-

(1) Internal Sources

Internal sources of raising public debt are:-

(i) Borrowings from Individuals

Public debt borrowed from individuals is in the form of bonds, debentures or loan. They carry
fixed rate of interest and are repayable on due dates by the Government to the individuals from
whom it borrows.
(ii) Borrowings from Commercial Banks

Public debts are also raised by the Government from commercial banks in the form of loans.
Commercial banks can subscribe to Government loans through creation of credit.
(iii) Borrowings from Non-Banking Financial Institutions

Public debt is also raised by the Government from non- banking financial institutions such as
insurance companies, trusts, mutual saving banks etc. in the form of Government bonds. (iv)
Borrowings from Central Bank

The Central Bank of a country is also an important subscriber to the Government loans. Central
Bank purchases bonds of both the Central Government as well as State Governments.

(2) External Sources

To finance various services, the Government also resort to external borrowings. External sources
of borrowings include foreign individuals and foreign banks, international institutions and
foreign Governments. International financial institutions which lend money are International
Monetary Fund i.e. IMF, World Bank, Agricultural Development and Asian Development Bank
etc. Public debt is also raised by the Government from external sources for overcoming
temporary balance of payment difficulties and for development purposes.

90
Besides, the Government of India has also made borrowings in the form of (a) loans, (b) cash
grants, (c) commodity grants, and (d) special credits, from friendly countries like Canada,
Denmark, France, Japan, Sweden, U.S.A., U.K. and Soviet Russia.

COMPARISON BETWEEN PUBUC AND PRIVATE DEBT

There are similarities and dissimilarities between private debt and public debt.

SIMILARITIES

1. Both private and public debt involve the diversion of funds from one USC to another.

2. Government (public) as well as private individuals debt to meet their immediate and
temporary requirements.
3. Both have to pay interest on loan.

4. Both these debts are used either for investment or consumption.

5. The capacity of both to borrow depends more or less upon the capacity to repay loans.

DISSIMILARITIES

1. Firstly, funds borrowed by the State are to be spent for the benefit of the community. The
proceeds of private loans are used for the benefit of the individual borrower only.
2. The Government can borrow from internal as well as external sources. But a private
individual can borrow from external sources only.
3. For the repayment of debt to the public, the Government takes fresh debt from the public.
On the other hand, the individual has to repay the debt from his own earnings.
4. The rate of interest on public debt is generally lower than that of private loans.

5. Public debt produces a deep impact on production of wealth in the country. On the
contrary, the private debt produces no such impact.
6. Under public debt, the creditor can realize his money by selling the Government
securities in the open market before the due date. On the contrary, it is not possible in the
case of a private debt.

91
EFFECTS OF PUBLIC DEBT

The public debt of a country affects its economy in two ways. It has its, ‘revenue effects’ as well
as ‘expenditure effects’. In the first place, raising of money by a specific loan makes the people
change their budgets. Though, it ‘may not affect the consumption expenditure directly as the
taxation does, because people use their past or present saving to buy the public securities. But, in
some cases they may increase their savings and cut down their current expenditure to buy the
Loan (securities). Obviously, public debts affect consumption expenditure. This is, therefore; the
first effect of public debts.
Secondly, the benefit, conferred upon the people by the expenditure o(the money raised through
public loans, is another effect of public, debt. These benefits may not always be different from
the benefit that expenditure of tax income may confer, provided that the same use is made of
borrowed money as is made of tax revenue.. But except in rare cases, borrowed money is always
used in different ways to that of tax revenue. However, this difference is not always very radical.
For instance, tax revenue may be used to pay the salaries of teachers while borrowed money may
be utilized for the construction of school building. The effects of spending, of the proceeds of
taxation and of borrowing are the same. But in some cases, the difference in clear-cut. The
borrowed funds are used to finance expenditure of capital nature, such .as for the construction of
plants for generating the atomic energy, whereas the tax proceeds are used to finance current
revenue expenditure, the effects of the former expenditure are different to that of latter, Let us
now discuss the effects of public debt on consumption, production, distribution and on private
sector.
BURDEN OF PUBLIC DEBT

The burden of public debt refers to the sacrifice it will impose and have effects on the
community through an increase in taxation, necessitated at the time of repayment and for paying
the annual interests on the government loans.
The Concepts of the Burden of Public Debt

The concept of the burden of public debt is an extremely vague term. However, a distinction is
made between financial burden or primary burden and real burden or secondary burden. When a
debt is incurred by the government, the level of taxation in the economy has to be increased in
order to meet the interest charges so long as the debt continues to exist. To the extent of the
increase in the tax level, the income of the people is transferred to the government. The
92
consequent loss in the income of the people may be called as the financial burden of public debt.
To put it in the words of David M.C. Wright, “The financial burden of the national debt is to be
measured by the effects of the interest charges and the taxes levied to meet them. The relation
which the taxes or interest bear to the national money income is the question of primary
importance.
The higher level of taxation caused by the rising public debt may have son repercussions on the
economy in the farm of adverse effects on the capacity and willingness to work on the capacity
and willingness to save. These effects may be called real burden or secondary burden of public
debt. In this context, Prof. A.P. Lerner also observed, “An increase in national debt can make the
owner of the Government Bonds less willing to work, once the reason to put away (money) for
the rainy day is weakened ………. because there is more put away (money) already for a rainy
day. The concept of burden of the public debt has also been explained in terms of direct and
indirect burden of public debt. Direct money burden is measured by the extent of money
payment involved and the rise in taxation needed. Direct real burden is equal to the loss of
economic welfare, (i.e., 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, however, refers to the
extent to adverse effects of increased taxation on the level of production.
Again, the concept of burden is sometimes explained in terms of the notion of abstinence or
paincost doctrine and opportunity cost. When a loan is raised by the government, resources are
transferred from private hands to government and. those who contribute to government loans
abstain from consuming current income and undergo the pain of abstinence which may be called
a burden caused by the incurring of public debt. On the basis of the principle of opportunity cost,
it is said that the public debt entails a burden because, when a loan is raised by government,
people are prevented from putting their resources into other purposes, the marginal productivity
of which might be more.

However, the concept of burden based on the notion of abstinence and opportunity cost is not
quite acceptable, if people contribute to the public loans voluntarily. When people voluntarily
lend to the government, it means that by investing in the government securities they are moving
to a preferred position on the utility surface.
In estimating the burden of public debt, It should be taken into account, whether the debt is
productive or unproductive, and whether it is internal or external besides the price level in the

93
economy If price level falls, the value of money rises and vice versa Hence, if the price level
falls real burden of interest increases and vice versa.

Estimation of Burden of Public Debt

There are various ways of estimating the comparative burden of public debt. However, the
conclusion is that, all things considered, not one method alone should be adopted, but a
combination of the various methods Probably the most useful methods are (1) the ratio of
national debt to national wealth and income, and (2) the percentage of expenditure on the debt
services to total ordinary expenditure. A combination of these two methods has been considered
useful for estimating the relative burden of public debt.

LOANS VERSUS TAXES

Sometimes, the government faces the problem whether a certain expenditure should be met out
by raising taxes or by raising loans. Heavy taxation as well as reckless borrowing may ruin the
financial structure and may bring misfortunes to the community as a whole. Let us now know
what should be the general principle of raising revenue.
The general principle followed in financing public expenditure is that the normal or ordinary and
recurrent expenditure should be financed out of taxes, while non-recurrent and productive
expenditures should be met out of loans1. This general principle has now been analyzed from
different angles.

The government should raise as much taxation annually as the nation can bear, to defray
extraordinary or abnormal expenditure, as far as possible from this source. The great advantage
of a tax, as compared with a loan, is that. the former never leaves any charge behind it in the
form of repayment of principal to disturb subsequent budgets. Hence, Mr. M.C. Kenna,
Chancellor of the British Exchequer, said that even in the war, taxation should meet ordinary or
normal expenditure plus the charges for interest on debt. Therefore, taxation should be preferred
to loans, if commerce and industry are not prejudicially affected by the increased taxation.
Loans, on the other hand, are necessary to avoid too rapid an increase of taxation. Some system
of taxation may easily be adjusted to meet the increasing expenditure than others. In an
unsatisfactory tax system, it is almost impossible to increase taxation. Hence, in abnormal times
borrowing of the money may become important to the State, but this should be the last method to
finance public expenditure.
94
Difference between Taxes and Loans

1. Taxation is a burden on the current income, while borrowing implies the curtailment of
future power of spending.
2. Taxes come from the annual incomes and involve curtailment of present enjoyments,
while a loan comes from savings and reduces the available funds for production in private
sector.
3. A tax is compulsory contribution, while a loan is generally voluntary. The pressure of a
tax is immediate, while that of a loan is imposed on future.
4. The burden of heavy taxation may not be equitable, but the burden of loans is diffused
over a long period.
5. The taxes exercise a solitary and wholesome check on the tendency of an individual to go
for extravagant expenditure; while loans may give an expectation of increased income in
future; this expectation of an increased income in future may make an individual
extravagant in present.
This does not mean that loan finance should out rightly be rejected. In fact, taxation and loans can
and should be judiciously combined. A good tax system should possess consider elasticity, and,
therefore, it is very much desirable that increase in revenue should be raised through taxation. But
when a limit of increased taxation is reached, the device of loan to finance public expenditure
may be used.
The rules to finance an abnormal outlay for non-economic purposes may be summarised as
below
1. As far as feasible and practicable current expenditure should be met out of the annual receipts
and witl1 the increase in expenditure, taxation should also increase.
2. When there is non-recurring expense of a large amount, it should be financed through
borrowing. This will avoid a serious disturbance of the existing tax system.
3. When the abnormal expenditure is expected to last for a number of years, tax structure should
be adjusted to meet it.
4. This principle will not work where (i) an equitable distribution of the increased taxation
cannot be secured, or (ii) the productiveness of various taxes would have to exceed, or (iii)
heavy taxation would be politically inexpedient. In any of the last three cases taxation has to
be supplemented by loans.

95
Role of Taxes and Loans in Financing Development Plans

Most of the under-developed countries face the problem of financing their development plans.
The problem is whether the development plans should be financed through taxation or loans.
Under-developed countries are subject to acute poverty, the per capita income is very low, the
distribution of wealth is inequitable. The standard of living of the people is also low, and the
taxable capacity of the people is also low, and hence, the scope of additional taxation for
financing development plans is limited. In such a situation, heavy taxation would hamper the
very purpose of development as it will curb the consumption and discourage productive
incentives. Moreover, the expenditure on these projects is so heavy that it cannot be met by
taxation. Hence, loans should be raised from internal as well as external sources for financing the
development projects. It is important to raise loans from external sources as the internal lending
capacity of under-developed countries is poor.
The financing of development projects through loans is also justified because these projects are
productive, and their benefits would be enjoyed by the future generation. Hence, the burden
should also fall on them. The loans can be repaid when these projects start production. However,
long term loans should be preferred because short term loans are nothing but postponement of
taxation for a short period.
Though, theoretically it may be correct to finance development projects through loans but
practically it is unwise to depend entirely on loans. The budget surplus should also be used to
finance such investments. The Five-Year Plans of India make provision of this course also, other
countries have also used budget surpluses for this purpose. And most economists believed that
economies of different countries would suffer greatly economic reconstruction were not financed
through budget surpluses. Moreover, inflationary conditions can be checked to an appropriate
degree through surplus budgeting, generally found during the development period, because of
heavy investment. Thus, the development programme should be financed both by taxes and
loans. Loans have, of course, an important place in the development finance, but a part of the
development programme should be financed through budgetary surpluses. It will not cause a
greater real burden on the current consumption on the community than would be imposed by an
equal amount of public borrowing
CHAPTER 8 FINANCIAL ADMINISTRATION

96
Meaning of; Financial Administration

Financial administration refers to the management of the finance of the public authority or
Government. It includes the study of budget, its preparation, methods of administration of public
revenue with regard to the custody of public funds, manner of spending money and keeping of
financial records, etc. As a matter of fact, every act of Government in respect of management,
and its finances are included in the study of financial administration. To put it in the words of
Prof.
M.S. Kenderic, “The financial administration refers to the financial management of government,
including the preparation of the budget, method of administering the various revenue resources,
the custody of public funds, procedures in expending money, keeping of financial records and
the like. These functions are important to the effective conduct of the operating of pub1ic
Finance.”3

A sound financial policy implemented through sound financial system is sure to produce best
results. Even the best financial policies and plans will come to naught, if financial administration
is weak or inefficient. Thus Prof. W.F. Willoughby said that “Of the several factors entering into
the problem of efficient Government none is of greater importance than that of financial
administration.”4 It means that, an efficient and sound system of financial administration is
essential for the successful implementation of financial as well as socio-econornic policies of
Government.

However, Prof. Marshall, Edward Dimock and Gladys Diniock defined financial administration
as, “Financial administration consists of a series of steps whereby funds are made available to
certain official under procedures which will ensure their lawful and efficient use. The main
ingredients are budgeting, accounting, auditing, and purchases and supply.” To understand
clearly the meaning of financial administration, let us now define the main ingredients of
financial administration.

(a) Meaning of Budget: The word Budget is derived from the French word, “Bougettee”
which means a. bag or a wallet. Prof. Edward Dimock and Gladys Dimock defined as “A
budget is a balanced estimate of expenditures and receipts for a given period of time. In
97
 the hands of the administration, the budget is a record of past performance, a method of
current control, and a projection of future plans.”5 In government, the funds come largely
from taxes and also from borrowings and earnings of public enterprises ‘and are made
available by the legislature through specific appropriations to particular agencies and
programs.

(b) Accounting: The basis of all financial administration is Accounting. Accounting is the
art by which the financial effects of executive action are recorded assembled and
ultimately summarized in the form of financial reports A harmonious relationship
between budget and accounts is a pre-requisite to current comparison between goals as
set up in ‘he budgets, and accomplishment as reflected in the reports and financial
statements prepared from accounts.

(c) Auditing: Auditing is closely related to accounting. It is the investigation of report and
the fidelity, legality and efficiency of all financial transactions. Auditing consists of both
internal auditing for control purposes within a department and external auditing by an
independent body reporting to a higher authority.

(d) Purchase and Supply: Finally, as the name implies, purchasing is the acquisition of the
property and materials needed in administration. Purchasing is a report of a large
category called supply, which also covers specification, traffic management, inspection,
property identification, storage and issue and property utilization. Principles of Financial
Administration

In a federation, there are two or three layers of government - Federal, State and Local. It means
that the financial administration is also decentralized ma federation. There is one federal
financial administration for the individual states and local bodies financial administration for
their respective jurisdiction. There is one budget of the Federal Government, and one budget
each for every State. In a federal set-up, there is a multi-unit budget system. Under such a
system, need arises for co-operation and coordination between different layers of financial
98
 administration for effective implementation of the financial policies. There also arises need for
standardizing the various procedures of financial administration, like form and classification of
budgets. It will help in presenting the finance of the country as a whole in a systematic way.

Guiding Principles of Financial Administration

In most Federal Constitutions, there are’ three fundamental provisions in the field of financial
administration which safeguard the interest of the taxpayers. These principles guide the
operations of financial administration.
1. No tax shall be levied or collected unless it is approved by the representatives of the people.
In the Constitution of India, it has been mentioned as, “No tax shall be levied or
collected except by authority of law.”
2. No expenditure out of public revenue is incurred unless it is sanctioned by the Parliament.
In the Constitution of India, it has been mentioned as, “No money out of the
Consolidated Fund of India or the Consolidated Fund of a State shall be appropriated
except in accordance with the law and for the purpose and the manner as passed by
Legislature.

3. The executive spends the money exactly in the manner as passed by the Parliament. In order to
check the abuses of power on the part of the executive, the Auditor-General audits the accounts
of the Government to place before the Legislature a report to show that the executive has spent
the money for the purposes for which the Parliament has sanctioned. Thus, the provision for
the appointment of Comptroller and Auditor-General is laid down in the Constitution of India
to achieve the above objective.
AGENCIES INVOLVED IN THE ADMINISTRATION OF FINANCES.

Generally, the following agencies are involved in the financial administration of a Government:

1. The Executive,

2. The Legislature,

3. The Finance Department of Finance Ministry,

4. The Audit Department,

5. Parliamentary Committees.
99
 1. The Executive

The financial initiative lies with the Executive. No tax can be imposed or expenditure sanctioned
unless asked for by the Executive Government. The Parliament cannot act in these matters
suomotto. The Executive alone has the right to draw up and present a budget (plan for raising
revenue by means of taxes, etc., and expenditure). Any member can propose any thing, but not on
money. The Finance Minister alone can propose to tax the people. It is a major constitutional
principle.
Since, the Government receives administrative reports, it is the only authority which has an
accurate picture of the needs of the various services and of the amount of revenue likely to be
available. The Ministers alone are in a position to assess accurately the cost of running the public
services and the Finance Department is equipped to make a synthesis of these expenditures and
try to strike a balance between its expenditure and the revenue totals, “Hence, the responsibility
for preparing the budget lies upon the Executive.” To put in the words of Prof. H.M. G rove, “The
Executive is in the best position to view the financial problem as a whole and to assume the
responsibilities for the success and failure of a financial programme.” 9 In India, Executive refers
to the Government. Since, we are dealing with the principles of financial administration of the
Government, here Executive refers to the Central Government. Hence, the responsibility for

preparing the Union Budget lies upon the Central Government. As the Finance Ministry is
responsible for the administration of the finances of the Central Government, it gives the final
shape to the budget and presents it to the Legislative (Parliament) for approval. Besides, the
entire Executive performs the policy making function concerning finances, and it tries to get the
approval of the Legislature (Parliament).
2. The Legislature

Under the parliamentary democratic system, the Legislature is the Parliament. As a

representative body of the people, it has to safeguard the rights and interest of the taxpayers in
the fields of financial administration. To safeguard the interest of the taxpayers, the following
provisions are made in the Constitution.

(a) Parliamentary Control Over Taxation: Article 265 of the Indian Constitution provides that
“No tax shall be levied or collected except by authority of law,” The Government has to

100
 present all tax proposals before Parliament in the form of a Bill, to be passed into law, and
unless an Act is passed authorizing the levy of any tax, no tax can be levied. The
U.S.A. Constitution in its Article I, states that “The Congress shall have power to levy and
collect taxes”. Thus, no tax can be imposed except with the authority of the Legislature. In
other words, the power of taxation under democratic form of the government always vests with
the Legislative. It is a check of the Parliament upon the taxing powers of the Government so as
to safeguard the interest of the taxpayers.
(b) Parliamentary Control Over Public Expenditure: Article 266 of the Indian Constitution
provides that “All revenues received, all loans by the Union or State shall be paid into the
Consolidated Fund of the Union or State, as the case may be, and that no money can be
withdrawn out of the Fund except in accordance with the law and for the purpose and in the
manner provided for in the Constitution”. “No expenditure can be incurred except without the
sanction of the Legislature.” Thus, it is a check of the Parliament upon the expending power of
the Government so as to protect the interest of the taxpayers.

(c) Parliament’s Enforcement of Financial Accountability: The Government is bound to spend

the moneys granted by Parliament for no purpose other than those for which they were
sanctioned by Parliament. This control is exercised through the Comptroller and Auditor-
General of India. The Comptroller and Auditor-General audits the account of the Government.
His reports are scrutinized by the Public Accounts Committee of the Parliament and laid before
the House. This provision checks the Government not to use the allotted funds for the purpose
other than those for which they were sanctioned by Parliament.
It is, thus, obvious that the Parliament is supreme in financial matters also as it is in other
matters.
3. The Finance Ministry

The Finance Ministry is the pivot on which the financial administration of the country rests.
Though, the entire Executive or Government is responsible for preparing the Budget, but in
reality it is the Finance Ministry which prepares the Budget, while the other departments of the
Ministry only help the Finance Ministry. It is the Finance Ministry which frames financial rules
about the preparation and execution of the Budget. It also frames rules about the form and-
methods of keeping accounts. It is a big organization which is split up into 4 Departments, viz.,

101
(1) Department of Economic Affairs, (2) Department of Revenue and Insurance, (3) Department
of Expenditure, and 4) Department of Co-ordination.

4. Auditing and Accounting

Auditing
Importance and Objective: Audit, like the Judiciary, the Executive and the Legislature, is one
of the most important ingredients of democracy, since it is one of the important instruments of
Parliamentary control over the finances of the country. Its primary purpose is to ensure that in
the process of expending government funds all canons of financial propriety have been observed
; that the rules and regulations which govern expenditure are adhered to ; that the expenditure is
incurred by the authority which has been empowered to incur it; and that it has been incurred for
the purpose for which it has been appropriated by the Parliament. Thus, “Audit supplies an
essential link between the Executive and the Parliament and is helpful in interpreting the action
in so far as they have a financial bearing, of the former on the latter.”10

Meaning: Auditing has been defined as “a systematic examination of the books and records of a
business or other organisation in order to ascertain or verify, and to report upon, the facts
regarding its financial operations and the result thereof.” 11 Auditing of the government
transactions is “the process of ascertaining whether the administration has spent or is spending its
funds in accordance with the terms of the legislative institution which appropriated the money.” 12
The main objective of the government audit, “is to fix the accountability of the officers of the
government, for any illegal, improper or incorrect payments made resulting from any false,
inaccurate or misleading certifications made by them”13.

Why Independent audit: An Independent audit protects the State against misappropriation of
funds and check frauds and unauthorized expenditure. The function of the auditor is to check the
actual figures and satisfy himself about the legal sanction of each item of expenditure. He reveals
dishonesty, carelessness and misappropriation of funds, if any. The auditor does not make
enquiry into the policy of the Executive, as sanctioned by the legislature, but he only sees that
sanction has been faithfully carried out .and no misuse of funds has been made under that
authority.

102
5. Accounting

With Respect to Keeping of Accounts: Proper maintenance of accounts of the Public and their
audit by an agency independent of the Executive control are essentials for an efficient
administration of public finances. Accounting has been defined as the “art of recording,
classifying, and summarizing transactions, wholly or in part of a financial nature in terms of
money, and interpreting the results thereof.” In fact, accounting means, maintaining a proper
record of the finances of the organization. “Through a proper system of accounting, wrongful use
of funds can be prevented. Accounting has to ensure that funds have been legally used for the
purpose for which the Parliament sanctioned it. The responsibility for the maintenance of proper
accounts of the Government of India lies with the Comptroller and Auditor-General.

The Auditor-General has the following duties and powers with regard to the maintenance of the
accounts of the Government of India14.

6. Parliamentary Committee

Finally, there are two Committees of the Legislature, commonly known as the Estimates
Committee and Public Accounts Committee which exercise financial control on behalf of the
Legislature. The Estimates Committee suggests economies in expenditure in various
Departments of the Government, and the Public Accounts Committee examines the appropriation
of accounts in the light of the audit report of the Comptroller and Auditor General, draws the
attention of the Legislature to financial irregularities, which might have occurred and makes
suggestions for preventing them in future.

Besides, there is another Parliamentary Committee through which the Parliament controls the
finances of Public Enterprises. This Committee is known as Parliamentary Committee on Public
Undertakings. It was constituted on May 1, 1964. It examines the reports and accounts of such
public undertakings as have been specially allotted to the Committee for this purpose.

The above-mentioned agencies are employed for financial control and administration in the
Government. The purpose of financial control is to secure honesty and economy in expenditure.

103
Government money is provided by taxpayers. These agencies have to see that the taxpayers’
money is rightly and properly utilized. Public money is a trust, and Financial Administration of
the country should see that a pound is not spent where a penny would have been sufficient, and
even that penny is spent not for the personal gain of any individual, but for the good of the
society as a whole. Thus, efficient Financial Administration is a necessity for every country.
Conclusion: In administration of finances, Legislature plays the Central role. All other agencies
of Financial Administration act on behalf of the Legislature, and are responsible to the legislature
for all their activities. The Control of Legislature over the Finances and Financial Administration
of the country is direct and all-pervasive. Responsibility for the sound administration of finances
of the country lies with the legislature. It lays down conditions wider which money can be spent,
and it finally judges whether the Executive has fulfilled those conditions or not.

BUDGET AND CONTROL OF PUBLIC EXPENDITURE

Sound financial administration needs sound budgetary procedure. It means that budgeting and
budgetary procedure is the most important constituent of the financial administration. It involves
four different operations given and discussed in detail hereunder:
(1) Preparation of the Budget,

(2) Enactment of the Budget.

(3) Execution of the Budget, and

(4) Parliamentary control over finance.

1. PREPARATION OF THE BUDGET

In India, the budget is the annual financial statement of accounts for the preceding and current
year, and the estimates of the revenue and expenditure of the coming year. The Finance Ministry
is responsible for framing the budget of the Union Government However, the Ministry of
Finance is helped in this task by Administrative Ministries and Departments, Audit Departments,
Planning Commission Central Board of Direct Taxes and Central Board of Excise and Customs
The general rule is that he who spends the money must also prepare estimates in advance.
104
Hence, preliminary estimates are prepared by the disbursing officers.

Administrative Ministries and Heads of the Departments are supplied with skeleton forms on
which they are asked to prepare the estimates The departmental officials prepare the estimates
for the coming financial year on the basis of the revised estimates of current year The prescribed
form has four different columns, i.e (i) Actuals of the previous year, (ii) Sanctioned estimates for
the current year, (iii) The revised estimates for the current year, and (iv) Budget estimates for the
next year Thus estimates are preparing’ on the prescribed form and in the prescribed manner
These estimates are then consolidated by the Head of each department These estimates are then
consolidated by the Ministries concerned and passed on the Finance Ministry for scrutiny The
Finance Ministry consolidates all these estimates and prepares the budget for presentation to the
Parliament.

Under the Constitution, Budget has to distinguish expenditure on revenue account from other
expenditure Government Budget, therefore, comprises (i) Revenue Budget and (ii) Capital
Budget.

2. ENACTMENT OF THE BUDGET

The Central Government could raise revenue and incur expenditure only on the approval of
Financial Budget by the Lok Sabha and Rajya Sabha. Similarly, the States could raise revenue
and incur expenditure with the approval of their budgets by the Vidhan Sabha and Vidhan
Parishad both. The Budget has to be passed by the Vidhan Sabha only in those States where there
is no
Vidhan. Parishad. The cardinal principle of parliamentary system of democracy is that “No
taxation can be levied and no expenditure can be incurred without prior approval of parliament.”

Thus, a budget is an instrument of parliamentary control over the financial activities of

government. It indicates how resources are to be raised, and how they are to be directed into
different channels by the Government. In fact, it represents the fiscal policy of the Government.
It indicates how public revenue, and expenditure would affect the level of national income,
employment, production and the distribution of incomes and wealth among different sections of

105
the community. Hence, the study of budget is of vital importance and is a matter of general
concern.

Budget in Parliament undergoes the following Stages:

(a) Presentation of Budget in Parliament:

In his Inaugural speech to the Budget session of the Parliament (both Lok Sabha and Rajya
Sabha) the President makes a reference that the Annual Financial Statement will be presented in
the House. The Finance Minister presents the budget in Parliament usually on the last day of
February, except in election years or due to any other unavoidable reasons. Exactly at the
appointed hour, the Finance Minister enters the House with the Minister of Parliamentary Affairs
and makes a speech in the Lok Sabha at the time of presentation of the Budget. The day of the
presentation of the
Budget is called the “Budget day”.

The Budget. speech is a very important document. It gives a detailed review of the economic
conditions of the country and reasons for the financial proposals of the Government in the
country are also given. Besides, the fiscal, monetary and financial trends at home and abroad are
reviewed in the budget speech. The reasons for the surplus or deficit in the budget are mentioned
in the Budget speech. The Budget speech is classified in two parts. In the first part of Part A, the
Finance Minister reviews in a general way the outturn of the previous and current years and
reveals the estimated expenditure for the next year as well as the budgetary gap at the existing
rates of taxation, if it exists, and then discloses in the second part of Part B, the money required
for the next financial year and his tax proposals for raising the money, and points out the reasons
for the uncovered budget deficit, if it exists even after his tax proposals. The Budget is laid
before the Rajya Sabha at the end of his Budget speech in Lok Sabha by a Minister of State in
the Ministry of Finance.

(b) General Discussion

There is no discussion on the budget on the day it is presented to the Lok Sabha. The time and
day for its discussion are fixed by the Speaker in consultation with the Leader of the House.

106
After the budget has been presented to the Lok Sabha a general discussion takes place in both the
Houses. It should, however, be noted that no item of expenditure is exempted from general
discussion. Expenditure charged upon the Consolidated Fund of India or the expenditure, which
is not subjected to vote of the House, is equally open for discussion. However, the details of the
budget are not discussed when the General Discussion of the Budget is going on. The scope of
the discussion at this stage is confined to the general examination of the budget, i.e., the proper
distribution of resources, the policy of taxation as well as the volume of surplus or deficit. Thus,
the general discussion is confined upon matters relating to fiscal policy including a review and
criticism of the administration of the Government and its departments. The members of the
Legislature, thus, have the opportunity of placing the grievances of the taxpayers before the
House. (c) Consolidated Fund

There is a Consolidated Fund at the Centre and similarly in each State. All revenue received by
the Government, loans raised by it, and also its receipts from recoveries of loans granted by it are
credited to the Consolidated Fund. All expenditure of Government is incurred from the
Consolidated Fund and no amount can be withdrawn from the Fund without authorization from
Parliament. Thus, all receipts are credited to the Fund and all authorized expenditure is incurred
from it.
(d) Contingency Fund

Occasions may arise when Government may have to meet urgent unforeseen expenditure
pending authorization from Parliament. The Contingency Fund is an imprest, placed at the
disposal of the President to incur such expenditure. Parliamentary approval for such expenditure
and for withdrawal of an equivalent amount from the Consolidated Fund is subsequently
obtained and the amount spent from the Contingency Fund is recovered from the Fund. (e)
Votable and Non-votable Expenditure

Some items of expenditure are charged as Non-votable while others are Votable. Votable
Expenditure refers to the demands of various ministries for grants. The demand of each Ministry
is introduced by the Minister-in-charge of the respective Ministry or by some body else on his
behalf. A demand becomes a grant when it is voted. After the general discussion of the budget,
the Lok Sabha proceeds to examine the estimates or the demands for grants Ministry wise. It
examines the demands thoroughly and much of the time is taken in the discussion of the
demands or estimates. A maximum time limit is also fixed for discussion for a particular
107
demand. Generally, the speaker allots two or three days for discussion and voting of demand for
a Ministry. However, amendment motions can be moved to reduce any grant, but no amendment
can be made on such motions. It should, however, be noted that the demands for grants are voted
only in the Lok Sabha at the Cente and the Vidhan Sabha in each State respectively.

(f) Non-votable items

The items which are charged as Non-votable are as follows:

1. The salary and allowances of the President and other expenditure relating to his office.

2. Salaries and allowances of the Chairman of Rajya Sabha and the Speaker and Deputy
Speaker of the Lok Sabha.
3. The debt charges of the Government of India.

4. Salaries and pensions of the Judges of the Supreme Court.

5. Salaries, allowances and pension of the Comptroller and Auditor General of India.

6. Any sum required to satisfy any Judgment decree or award of any court/arbitral tribunal.

7. Any other expenditure declared by the Constitution or by Parliament by law to be

charged. (g) Passing of the Appropriation Bill

In the Constitution of India, it has ‘been laid down that no money can be appropriated out of the
Consolidated Fund, “except in accordance with the law.” Hence, the Appropriation Bill has to be
passed otherwise the Government is not legally authorized to utilize any amount out of the
Consolidated Fund. The Appropriation Bill includes all the grants for the year whether votable or
non-votable. It is moved when the demands for grants have been voted by the House. It is also
known as Money Bill. Thus, the Appropriation Bill is moved to seek the power to withdraw from
the Consolidated Fund the amounts voted by the Parliament and the amount required to meet the
expenditure charged on the Consolidated Fund, i.e., the amount required to n the Non-votable
expenditure. It, thus, gives the legal effect to the demands which have been voted by the House.
Here, it also becomes obvious, as to how the Parliament controls public expenditure. In other
words, it is one of the ways in which Parliament controls public expenditure.

108
(h) The Passage of Financial Bill

It should, however, be noted here that the Appropriation only authorizes the Government to
appropriate money from the Consolidated Fund, but the problem of collecting the required money
is not solved. It has been laid down in our Constitution that “no tax shall be levied and collected
except by authority of law” Thus, to solve this problem a Finance Bill is placed before the House.
The Bill when passed becomes the Act, which authorizes the Government to collect the required
money through taxation or the provisions that have been made in the Budget. This Bill embodies
the proposals of Government to levy new taxes, modification in the existing tax structure or
continuance of the existing tax structure beyond the period approved by Parliament. In other
words, this Bill embodies taxation proposals for the coming financial year and it Includes all the
existing taxation schemes, with or without modifications as proposed by the Government to the
Parliament, It authorizes the Government to collect the required money through taxation or
through the provisions that have been made in the Budget.

The Budget is said to be passed when the Appropriation Bill (l1oney Bull and the Finance Bill
are passed. However, every aspect of these Bills are fully discussed in parliament before they are
passed. When the Budget has been passed in both the Houses it then goes to the President for
assent. Generally, the President gives his assent because of his very limited powers.

3. EXECUTION OF THE BUDGET

The responsibility to execute the Budget. lies upon the Government. It is expected from the
Government that is will execute the Budget with a high degree of integrity and efficiency “If this
is not done, the budget will fail in a large measure to accomplish its purpose, which is to produce
stability in government finance by making both ends meet”15.
Thus, the execution of the budget has three aspects – (a) distribution of grants to different
administrative ministries or departments, (b) collection of revenue, and (c) proper custody of the
collected funds.
References

Tyagi B.P (2009-10), Public finance5th ed, jay Prakash nath &Co, Meerut (U.P), India.

109
Alika Gupta (2001), Public Finance and Tax Planning,1 st ed, Anmol Publication Pvt Ltd,
New Delhi.
Bhatia H.L (2003) Modern Public finance, New Delhi

Bahemuka K.P (2001), Income Tax in Uganda, Fountain Publishers.

110