University of Hargeisa

Faculty of Economics and Faculty of Business Administration

Public Finance

MODULE

Prepared by Mohamed M Egeh,

Faculty of Economics and Faculty of Business

March 2011

Hargeisa

1
 University of Hargeisa
Date: / /

Course Code

Course Title Public Finance

Pre-requisites: Macroeconomics

Instructor’s Name Mohamed Mohamoud

Office

a) Course Description

This course deals with Public Economics or Public Finance; market failure and other justifications for
public finance; public revenue and optimal taxation (tax theories, tax incidence, tax properties, the
role of taxation in developing countries, non-tax revenues); Public expenditure and Fiscal policy,
theory and application (fiscal federalism, public debt, deficit financing, etc.). The course also deals
with Roles of modern state, bureau and bureaucracy, government expenditure analysis and public
choice theory, majority voting and vote trading, and centralization and decentralization.

b) Course Objective

The objective of this is to introduce students with a broad spectrum of public finance aspects such as
the nature and role of government, voting rules and fiscal politics, the revenues and expenditures of
a government, fiscal policies and the implications of fiscal decentralization. The course requires
significant student participation in class during lecture hours.

c) Learning Outcomes:

Upon completion of this course, the students/participants should be able to:

 Express the nature and scope of public finance
 State the role of public finance both in prosperous and developing countries.
 Enumerate the different sources of public income and their sub-categories
 Realize the different principles of taxation including their strength and weaknesses.
As well as you can make a comparison among the different principles
 Compare and contrast between direct and indirect taxes
 Explain the effect of public expenditure both on production and employment
 Explain the role the government budget can play as instrument of economic policy.
 Explain the nature and objectives of public debt

2
  Explain the role of public debt in economic development
 Meaning, objectives, effects and Limits to Deficit Financing

d) Teaching and Learning Patterns

the teaching and learning patterns will be a one based on participatory and discussion. The student
instructor relationship will be a kind of discussion where all students are encouraged to actively
participate the discussion.

e) Course Content (Chapters)

Session Chapter Topic

Week 1 Chapter one 1.1. What is Public Finance?
1.2. Public Finance and private
finance – A comparison
1.3. Role of Public Finance Public
Finance in Advanced Economies
1.3.1. Public Finance and private
finance – A comparison
1.3.2. Public Finance in Developing
Economies

Week 2 Chapter Two SOURCES OF PUBLIC REVENUE

– PROMINENT TAXES
2.1. Sources of Public Income
2.1.1. Income Based on Compulsion
2.1.2. Income by Way of Voluntary
Payment
2.1.3. Sources of Income, Partly
Compulsory and Partly Voluntary
Week 3 2.2. Features of Sound Taxation
2.2.1. Equity in the Distribution of
Tax Burden
2.2.2. Productivity
2.2.3. Rights of Taxpayers
2.2.4. The Tax System and the
Economy

3
 2.3. The Benefit Principle of
Taxation
2.3.1. Merits of Benefit Principle
Week 4 2.3.2. Demerits of Benefit Principle
2.4. Ability Principle of Taxation
2.4.1. Justification of Ability
Approach
2.4.2. Index of Ability to Pay
2.4.3. Ability to Pay and Equality of
Sacrifice
2.4.4. Rate Schedules of Taxation

Week 5 Chapter Three DIRECT AND INDIRECT TAXES

5.1. Direct and Indirect Taxes: A
Comparison
3.1.1. Allocative Aspect
3.1.2. Administrative Aspect
3.1.3. Distributional Aspect
3.2. The Cases of Direct Taxes
Week 6 3.2.1. Merits of Direct Taxation
3.2.2. Demerits of Direct Taxes
3.3. The Case for Indirect taxes
3.3.1. Merits of Indirect Taxation
3.3.2. Demerits of Indirect
Taxation
Week 7 3.4. Superiority of Indirect
Taxes Over Direct Taxes

Week 8 Chapter Four PUBLIC EXPENDITURE

4.1. Causes of Growth in Public
Expenditure
4.2. Public Expenditure: Canons
and Accountability
4.2.1. Canons of Public Expenditure
Week 9 4.2.2. Control and Accountability of
Public Expenditure

4
4.3. Effects of Public Expenditure Week 10
on Production and Distribution
4.3.1. Effects on Production and 4.3.2. Effect of Public Expenditure on
Employment Distribution of Income
4.4. Public Expenditure and
Control of Inflation
4.5. Content of Development
Expenditure

Week 11 Chapter five GOVERNMENT BUDGETING

5.1. Meaning and Purpose of
Government Budget
5.2. Budget Framing
Week 12 5.3. Modern Classification of
Budget
5.4. Budget as an Instrument of
Economic Policy

Week 12 Chapter Six PUBLIC DEBT

6.1. Nature and Kinds of Public Debt
Week 13-14 6.2. Effects of Public Debt
6.3. Public Debt in a Developing
Economy

DEFICIT FINANCING
Week 15 Chapter Seven 7.1. Meaning of Deficit
7.2. Financing Objectives of Deficit
7.3. Financing Effects of Deficit
Week 16 Financing
7.4. Limits to Deficit Financing

f) Assessment Methods
There will be mid and final exams to evaluate the performance of the students. In
addition to, there will be assignments given to the students in the form of term
paper.

g) References
1. Joseph E. Stiglitz, Economics of the Public Sector, Second Edition
2. C.V. Brown and P.M. Jackson Sector Economics, 4th Edition

5
3. J. Hrber, Modern Public Economics
4. Harvey S. Rosen, Public Finance, 4yh Edition, IIRWIN, 1995
5. Richard A. Musgrave, The Theory of Public Finance, McGraw Hill Book Company,
1959

6
 CHAPTER ONE
1.1 WHAT IS PUBLIC FINANCE?
Chapter objectives
This is the first chapter for the course public finance. Thus it will acquaint you with basic
concepts in the subject matter. In this chapter issues like nature of public finance, comparison
between public finance and private finance, and role of public finance will be discussed.
Then after reading this chapter, you will be able to:
 define public finance
 express the nature and scope of public finance
 compare and contrast between public finance and private finance
 State the role of public finance both in prosperous and developing countries.

Public finance is a study of the financial aspects of government. The term has been variously
defined. According to Dalton, “public finance is one of those subjects which lie on the
borderline between economics and politics. It is concerned with the income and expenditure
authorities and with the adjustment of the one to the other.” Harold Groves, an authority on
the subject, defines public finance as: “A field of inquiry that treats of the income and outgo
of governments (federal, state and local). In modern times this includes four major divisions:
public revenue, public expenditure, public debt, and certain problems of the fiscal system as a
whole, such as fiscal administration and fiscal policy.

The subject matter (scope) of public finance consists of the following parts:
1. Public income: this part includes the study of raising public revenues and the
principles of taxation.
2. Public expenditure: this consists of the study of the principles and the effects of public
expenditure.
3. Public debt: this part studies the causes and the methods of public borrowing as well
as public debt management.
4. Financial Administration: this part studies the use of fiscal policy to bring about
economic stability in the country.
5. Economic Stability and Growth.
It should be emphasized here that the above parts are not distinct and separate from one
another but are intimately related to one another.

7
 1.2 Public finance and private finance – A comparison
There are both similarities and differences in governmental financial operations as compared
to the monetary operations of private business.

Similarities:
 Both private finance and public finance have broadly the same objective, viz., the
satisfaction of human wants. While the individual is concerned with the utilization of
labour and capital at his disposal in order to satisfy some of his wants, the state is
concerned with the utilization of labour, capital and other resources to satisfy social
wants.
 Both individuals and governments borrow as and when current incomes are
insufficient to meet current expenditure
 Just as income is not fixed for private business, so also it is not fixed for a government
 Private businesses often increase income by first increasing expenditure; so also a
government may borrow in anticipation of tax receipts; it borrows so as to spend with
the objective of increasing national income from which increased tax income can be
expected.

It may, then, be concluded that public finance is only an extension of private finance and
that the principles and rules which apply to private finance (in maximizing individual
welfare) will also be applicable to public finance (in maximizing social welfare). This
conclusion, however, is not warranted. There may be many similarities between public
finance and private finance but the dissimilarities are all the more sharp and clear.

Dissimilarities
i. Adjustment of Income and Expenditure: It is generally stated that an individual
attempts to adjust his expenditure to his income, that is, he calculates his income first
and then decides his expenditure. The public authorities, on the other hand, first
estimate the various items of expenditure and then devise methods of raising the
necessary amount. This difference in adjustment of income and expenditure arises
because the individual ordinarily knows the size of his income while the government
does not know it.

8
ii. Nature of Resources: The individual has only limited resources at his disposal. His
income will normally come from his current income, saving from the past earnings
and borrowings. However the public authorities can draw upon the entire wealth of
the community, by using force, if necessary. Besides tax revenue, the public
authorities can borrow from the general public and in some cases they can borrow
from foreign countries also. Moreover, under difficult times the government can
resort to the printing of currency notes.

iii. Motive of Expenditure: In the case of an individual, the main consideration in

expenditure is whether it will be profitable and beneficial to him. On the other hand,
the motives of profit and surplus do not influence government departments except
such commercial departments as the railways, posts, telegraphs, etc. The government
has to finance improvements of a general nature and activities for which financial
return is uncertain or long delayed.

iv. Expenditure and Welfare: Every individual attempts to maximize his satisfaction by
distributing his limited income on different goods and services in such a way that
marginal utilities of money spent on all goods would be more or less the same. On the
other hand, the government should spend its income in such a way that the welfare of
the community should be maximized.

v. Provision Made for the Future: The individual hopes to live only for a short period
and he feels the present needs far more urgently; therefore, he goes about satisfying
his present needs and allots only a very small portion of his income for the future
since generally he underestimates the future. The state, on the other hand, is a
permanent organization and is the custodian of not only the present but also the future
generations and, therefore, allots a large portion of its resources for the conservation
as well as the promotion of future interests

vi. Secrecy and Publicity: Private finance is generally shrouded in secrecy for ordinarily
an individual does not like to expose his financial affairs to others. On the other hand,
the government gives the greatest publicity to its budget proposals and, in fact,
publicity strengthens rather than weakens pubic credit.

9
Thus, on important points, private and public finance differ from each other. It is not;
therefore, correct to assume that the principles and rules which govern private finance are
equally applicable to public finance.

1.3 Role of Public Finance

Fiscal policy which consists of the application of taxation, public expenditure and public debt
to realize certain economic objectives is an important instrument for influencing the level of
economic activity. In a sense, the objective of fiscal policy is more or less the same in
developed and developing countries. Walter Heller, for instance, has stated that fiscal policy
aims at promoting investment and economic growth and maintaining economic stability and
reducing inequality of wealth and income. However, as there are basic differences between
advanced and developing countries, the role of fiscal policy differs in these countries too.

1.3.1 Public Finance in Advanced Economies

It is now generally accepted that the main problem of industrial or high income economies is
stability in business conditions and maintaining full employment. Fiscal policy has, thus
come to assume significance as effective means of stabilization and attaining full
employment in advanced economy and, therefore, for high income countries it is not
generally held that no other measure of economic planning is better than adoption of a correct
fiscal policy.

1.3.2 Public Finance in Developing Economies

While the main economic problem of an advanced economy is one of stability, that of a
developing economy is the scarcity of productive resources and rareness of capital formation
and investment. Some fiscal theorists argue that fiscal policy may not be effective in an
underdeveloped economy, since modern economic and financial institutions are not as well
developed. Even then, the fiscal policy has a positive and significant role to play in an
underdeveloped economy.

In the first instance, the state is called upon to play an active and important role in promoting
economic development, especially through control and regulation of economic life; it is
argued that fiscal policy is the most powerful and least undesirable weapon of control which

10
the state can employ to promote economic development. Secondly, capital accumulation is
the key problem of an underdeveloped economy and this can be done through taxation.
Finally fiscal policy has an important role to play under democratic planning; financial plan is
as much important as physical plan and the implementation of the financial plan will
obviously depend upon the use of fiscal measures.

Thus, public finance has great importance which is increasing with every decade.

Questions for Review and Discussion

1) What is public finance?
2) Account for similarities and differences between public finance and private finance.
3) What importance has public finance in developing countries?
4) What is the role of public finance in developed countries?

11
 CHAPTER Tw0
2. SOURCES OF PUBLIC REVENUE – PROMINENT TAXES
Chapter Objectives
This chapter is about public revenue in general and that of taxation in particular. Tax revenue
has occupied the most important place in the revenue system of almost all the governments.
On account of this and other reasons theory of taxation has always occupied an important and
leading position in the discussions of public finance. In this chapter issues like sources of
public income, tax ratio, buoyancy and elasticity of taxation, principles of taxation, rate
schedules of taxation, direct and indirect taxes, impact, shifting and incidence of a tax will be
discussed and analyzed.

Thus, after studding this chapter you will be able to:

 enumerate the different sources of public income and their sub-categories
 Realize the different principles of taxation including their strength and weaknesses.
As well as you can make a comparison among the different principles
 state the rate schedules of taxation, the superiority of one over the other, merits and
demerits of each tax rate schedule

2.1 Sources of Public Income

Broadly speaking, a government gets revenue from three different sources. In the first place,
it gets income from taxes and from other sources in which there is an element of compulsion.
Secondly, the government gets income for services rendered to the public.
These may be fees or prices of services rendered or profits of enterprises, and so on.
Thirdly, there are certain sources of income which may not come under any of the above two
types - they are not compulsory, nor are they voluntary payments. It is interesting to observe
that the distinctions between the various kinds of public income are not clear-cut and they
shade gradually into one another.

2.1.1 Income based on Compulsion

There are four different sources of income for the government which are based on
compulsion. These are:
a) Taxes of various types;
b) Fines for offences committed;

12
 c) Compulsory loans; and
d) Tributes and indemnities arising out of war or from other reasons.

A tax is a compulsory charge imposed by the government, without any reference to the
service rendered to a taxpayer. In other words, a tax is a compulsory contribution for which
there is no direct return or quid pro quo.

It is compulsory in the sense that once it is levied, the person concerned has to pay it and
cannot escape it (though he may try to avoid or evade the tax). Most of the sources of income
of the government these days come from taxes.

Fines or penalties imposed by courts of justice resemble each other since there is compulsion
in both. The distinction between them, however, is one of motive. While taxes are generally
imposed to obtain revenue, fines are imposed as a form of punishment for mistakes
committed or to prevent people from making mistakes in the future. However, fines may be
of the nature of tax. For instance, if a penalty of $ 100 is imposed on a car owner every time
he exceeds a speed limit of, say, 60 kilometers within city limits and if this amount is
regularly collected, it may be regarded as a tax on speed, similar to a tax on petrol. On the
other hand, if the fine is imposed only if there is excessive speed and it is raised for
successive infringements and if finally the driver's license is cancelled for continuous
violation, the fine may be regarded as a penalty for an offence and not a tax on speed.

In the case of customs duties, the concepts of compulsion and penalty gradually merge with
each other. A customs duty may be imposed on an imported article for two reasons:
a) to raise revenue and, accordingly, if a higher rate of customs duty is followed by
increased revenue, the duty is a tax, and
b) if the purpose of raising the rate of a particular duty is to restrict imports or, to
prohibit imports altogether, then a rise in the rate of a particular duty should be
followed by a reduction in imports and in revenue. In this case, the duty is of the
nature of a penalty for imports.

13
 2.1.2 Income by way of Voluntary Payment
There are certain sources of income for public authorities which are mostly of the nature of
prices. These sources are:
a) Income from public property such as lease of lands owned by the government;
b) Receipts from government enterprises which do not have monopoly power or which
do not exercise their monopoly power;
c) Fees for services rendered by the government, such as registration of births and
deaths, etc.; and
d) Receipts from voluntary public loans
In all these cases there is no compulsion involved. The government is providing certain
services and charging certain prices for the same; all those who make use of these services
pay for them. In some cases, the price charged may be much lower than the cost of the
service provided. A good example is the price charged for postcards and letters.

Profits from government enterprises which do not charge monopoly prices are also of a
voluntary type.

2.1.3 Sources of Income, Partly Compulsory and Partly Voluntary

Dr. Dalton mentions four different sources of income which do not fall completely under the
first type or the second type. These sources are partly of the nature of taxes and, therefore,
contain an element of compulsion and partly of the nature of price and, therefore, they are
voluntary in character. These sources are:
a) Income from public enterprises using monopoly power to raise their prices above the
competitive level;
b) Betterment levy and other special assessment:
c) Income from the use of the printing press or through the issue of new paper money to
cover the deficit in public expenditure; and
d) Voluntary gifts

2.2. Features of Sound Taxation

Many modern writers have multiplied the requirements of a sound tax system. This is
understandable since the problem has become extremely complicated. A sound tax system, it
is argued, should be based on the principle of progression, i.e., the rate of taxes should rise

14
with rise in incomes and the tax burdens should be increasingly borne by the richer classes.
Proportional and regressive taxes should be avoided as far as possible. It is further argued that
between direct and indirect taxes, the former should be preferred to the latter since it was
easy to introduce the principle of progression in direct taxes. The tax system should be
diversified instead of being concentrated in one or two taxes, though from certain points of
view, a single tax on income would probably be the best type of tax. At the same time, care
should be taken to avoid multiplicity of taxes. Most economists do not agree these days with
the well known statement of Arthur Young: “If I were to define a good system of taxation, it
should be that of bearing lightly on an infinite number of points, heavily on none.”

A well known modern writer on public finance, Mrs. Hicks, emphasized three characteristics
of a good tax system. First, taxation should be used to finance public services. Secondly, the
general public should be taxed according to their ability to pay which will depend on their
income and family circumstances. Thirdly, taxes should be universal in the sense that persons
in the same financial position should be treated in the same way without any discrimination
whatsoever. Others probably may argue that a good tax system should not hamper the
development of trade and industry; rather it should assist in the economic development of the
country.

In a broad sense, there are four general characteristics for a sound tax system:
a) Equity in the distribution of tax burden;
b) Productivity of the tax system;
c) Appreciation of the rights and problems of the taxpayers; and
d) Adaptability of the tax structure to meet the changing needs of an economy.
We shall describe below these four general features of sound taxation.

2.2.1 Equity in the Distribution of Tax Burden

From the earliest times, equity or justice in taxation has been a universally accepted goal of
taxation. There are two aspects to the problem of equity. The first is the proper treatment of
persons in like circumstances. The rule in this case is “equal treatment of equals”. All those
persons who are placed in similar circumstances should bear the same amount of burden of
taxation. The second aspect of equity in taxation is the desirable relative treatment of persons
in unlike circumstances. That is, those who are better off should pay more taxes and thus

15
should bear a greater burden of taxation. Though there is general agreement on these points,
there is considerable difference of opinion among economists and statesmen on the
realization of equity in practice.

2.2.2 Productivity
The second element of sound tax system is productivity. The basic purpose of taxation is to
get revenue, though it can have both regulatory and non revenue uses. As the needs of the
public authorities increase continually, the tax system should yield increased revenues.
Experience in the last few decades both in advanced as well as developing countries indicates
greater need for resources to meet the demands of expanding public programs. There has
been continuous pressure on the available revenue sources and there is every indication that
this pressure will continue.

Tax productivity does not mean simply revenue returns. Adequacy, regularity and flexibility
are important aspects of tax productivity. A sound tax system should ensure adequate and
regular tax returns to meet the requirements of the economy. The returns should also be
flexible. But productivity is only a relative concept, for there may be times during a
depression when stability of tax revenues will be possible only at the expense of unduly
burdensome effects upon the taxpayer and a heightening of general deflationary effects.

2.2.3 Rights of Taxpayers

A sound tax system will have to safeguard the interests of the taxpayers. In a democratic
setup the rights of taxpayers have to be continuously kept in mind. Besides, the present level
of taxation as well as future prospects necessitate that the interests and rights of taxpayers
should be given adequate recognition. Apart from the inherent rights of the taxpayers who
support government functions, high taxpayer morale is essential for the effective
administration of tax laws. An intelligent concern with the taxpayer‟s problems will require
the public authorities to:
a) Make efforts to broaden his understanding of particular tax measures;
b) reduce to the minimum the inconvenience and interference associated with tax
payment and collection; and
c) Provide for promote and fair treatment of his complaints

16
 2.2.4 The Tax System and the Economy
Fourthly, a sound tax system should be so devised that it should fulfil certain basic
requirements or objectives of an economy. Since 1930‟s special attention has been given to
the problems of controlling economic fluctuations, maintaining full employment, preventing
tendencies towards secular stagnation and controlling inflation during wars or defence
emergencies. While full employment and economic stability are important
objectives of public policy in an advanced economy, economic growth is significant in
backward and underdeveloped economy.

2.3 The Benefit Principle of Taxation

In the benefit principle of taxation, therefore, relationship between tax payer and the
government is seen as one of exchange in which tax is considered as a price to be paid for the
benefit received and, hence, the rules of public household should be more or less like the
rules that govern exchange of goods in the private market. As „quid-pro-quo terms‟ settle the
transactions between buyer and the seller under market mechanism of exchange, so also a tax
is paid against the benefit received from government.

Thus, a tax on petrol, for example, may be paid by motor vehicle owners against the benefit
of motor way road facilities they receive from government.
What it follows is that the optimal supply of social goods should be determined at a point
where it is equal to the amount demanded by the tax payers. Just as a producer under market
competition equalizes the total cost of production with total sale proceeds, so also the
aggregate amount of tax revenue should cover the cost of supplying social goods by the
government.

Again, just as a private buyer pays the price which represents marginal utility of commodity
to him, so also the amount of tax which a person ought to pay should measure the benefit he
receives from social goods and services. Thus, the benefit principle of taxation follows that
larger the benefit, larger should be the contribution of tax payer. This fact, it is important to
note, raises a controversial question as to whether tax should be proportional, progressive or
regressive in character.

17
Cost of service and value of service: The benefit theory of taxation may be interpreted in
two ways, viz., the „cost of service principle‟ and the „value of service principle‟. According
to the former, the contribution of tax payer should be equal to the cost of supplying public
services that benefit him. The principle can be applied to certain areas of public services like
posts and telegraphs, electricity, transport, etc. where the payment is directly linked to
benefits received. But it cannot be applied to those services where the expenses of production
are met from the tax revenues of government. Such public services include those like police,
defence, justice, public parks, etc. where the cost of rendering services to the tax payers
cannot be determined.

In such cases, taxation should be guided by the value of service principle which requires that
the incidence of tax should be in accordance with the worth of public services to the tax
payer. Since the value of service also depends on the cost of producing it, the two principles
are not essentially different from each other. They are rather two ways of expressing the same
benefit approach to taxation.

The benefit theory of taxation is hailed by its exponents on the ground of justice or equity.
Justice demands that a payment should be made only against some benefits received whether
from the public sector or from private sector. Hence, the benefit theory conforms not only to
justice but also to equity so that the tax payers do not have to suffer from a sentiment of
deprivation.

2.3.1 Merits of Benefit Principle

The basic merit of the benefit approach is that it is based on the assumption that the benefits
conferred by public services justify the imposition of taxes to pay for them.

Secondly, the benefit approach combines both the income and expenditure sides of the budget
processes and thus determines simultaneously both the public service as well as tax shares.
Public services involve the withdrawal of funds from private use. The benefits derived from
public services must at least be equal to the losses that result as other wants go unsatisfied. It
is in this sense that the revenue and expenditure should go together. Thirdly, benefit taxation
is applicable to those cases where the benefit received by the individuals can be measured.
Examples are: petrol tax on the users of roads, local property taxes to finance police, fire

18
protection and sewage services and special assessments to finance local public works. In spite
of these merits, the drawbacks of the benefit approach are far too many.

2.3.2 Demerits of Benefit Principle

i. The benefit approach is based on the assumption that varied and complex activities of
government can and should be calculated and assessed against each person on the
basis of the individual benefit derived. This assumption is highly unrealistic and does
not recognize the serious theoretical and practical difficulties.

ii. The benefit approach was developed in earlier days based on the peculiar relationship
between the State and the individual. This relationship was the quid pro quo basis of
exchange or simply price exchange. The government was said to provide certain
services and the individual was expected to pay for them. This was similar to the
satisfaction of private wants. Whatever its validity in the past, such a basis of
exchange does not exist between the State and the individuals with respect to most
public services. These days, the State provides certain services for the general welfare
and not for individual welfare. The State provides, for instance, for national defence,
police, etc. It is easy to calculate the total expenses of the government but it is
difficult to estimate the services which individuals may derive from them.

iii. In recent years, governments have entered into the welfare field attempting to provide
all sorts of services with the object of increasing the welfare of the general mass of the
community. This has rendered impossible any general use of the benefit principle.

iv. As benefits accrue to the community as a whole, taxation also should be taken as a
collective instrument for supporting the services of the government.

v. Benefit approach, if applied blindly, will lead to great injustice rather than bring about
justice in taxation. For instance, the benefit derived by a pensioner is definite and
clear enough but the benefit principle will expect the old-age pensioner to pay it back
to the government treasury by way of taxes. This is what precisely the benefit
approach tells us: everyone should pay to the government according to the benefits
received by him from the government. In the case of the pensioner, as in many similar

19
 cases, the government will take away with one hand what it has given with the other
hand! A far more sensible thing would have been not to have pension scheme at all!!

vi. The benefit approach would mean the per capita burden on the poor as on the rich in
the case of many services. This is so because the rich have very many sources for
making tax payments.

vii. The benefit principle cannot solve the problem of distribution and stabilization which
are important aspects of public economy. For instance, taxation based on benefit
cannot be used to bring about a better distribution of income or to stabilize the
economy.

viii. Finally, the benefit approach can have only a limited application, viz., for
special or direct services made available to individuals on a voluntary basis. In other
words, the government may function as a private or commercial enterprise and in such
a case the benefit approach cannot be applied, for it is unworkable as well as
unacceptable from the point of view of equity.

For centuries, writers and pamphleteers have advocated taxation on the basis of benefit
received. The basic idea was that such a taxation would be just and equitable. Whatever its
merits in the past, this principle is clearly not applicable to taxation as a whole. If used as a
general principle, it will definitely result in inequality and injustice. Besides, the government
may be forced to give up some of the most essential items of expenditure such as on
education and public health. However, the benefit approach may be recommended, though on
a very limited scale, in the financing of roads and streets.

2.4 Ability Principle of Taxation

The ability approach is based on the broad assumption that those who possess income or
wealth should contribute to the support of the government according to their relative abilities.
The obligation to pay the government is taken as a social or collective responsibility, though
“who shall pay and in what amounts” is necessarily an individualized one. Those who have
should pay and those who have not need not.

20
 2.4.1 Justification of Ability Approach
Supporters of the ability approach have sought to justify it on three grounds: First is the
sacrifice interpretation of ability. As Dalton has stated, sacrifice interpretations of ability look
at the psychological effects of tax payments upon individual taxpayers or every group of
taxpayers. What could be more equitable than a situation under which each person's
contribution to the support of the government resulted in equal sacrifice for all?
But since the concept of sacrifice is subjective, there are many different formulations as, for
instance, equality of sacrifice, proportional sacrifice and marginal sacrifice.

Secondly, the ability principle is justified through the principle of diminishing marginal
utility of income. Incomes, it may be noted, are meant to satisfy human wants. All those
wants which are essential for survival and which are most urgent have been classified as
necessities and they have to be satisfied somehow by all. Next in order are those goods and
services which may be termed as conventional necessities which, in turn, are followed by
comforts and luxuries.

As one proceeds from necessities to conventional necessities and then on to comforts and
luxuries, the intensity of desire will go on decreasing and, therefore, the successive
increments of income necessary to satisfy these categories of goods and services will
necessarily give less and less utility. It is, therefore, concluded that tax burdens should be
imposed on high incomes, in which case the burden will not be felt much. At the same time,
the lower income groups who spend their incomes to satisfy their most urgent and essential
wants should be exempted from taxation.

Finally, ability principle is justified on the basis of faculty. Faculty is the capacity of an
individual to produce and consume and this is represented by the income and the accumulated
wealth of the individual. After meeting certain basic needs, the individual is left with certain
resources which reflect a high degree of taxpaying capacity.

A little consideration of the above three points to justify ability-to-pay principle of taxation
will show the weaknesses of each one of them. Sacrifice is subjective and each writer would
interpret it in his own way. Marginal utility of income interpretation of ability has

21
considerable merit but it is also on a subjective plane. Besides, it ignores the use of income
for saving and investment which are important both individually and socially.
Finally, though faculty interpretation of ability is objective, it bristles with many difficulties
when applied in practice.

2.4.2 Index of Ability to Pay

a) Property as the basis. At one time, property or accumulated wealth was considered
as the best index of ability to pay. A family's wellbeing depended upon the
accumulated wealth possessed by it. Wealth was considered a better index of ability
than income because in addition to being a source of income, wealth provided security
and insurance against risk. It is now rightly held that property is unsatisfactory as a
primary test of ability but that it can provide a possible supplementary index of
ability. This is because property as a source of income is subject to a number of
weaknesses:
i. Property is not the main source of income, though it is an important one.
ii. Property may or may not yield an income in any particular year.
iii. The tax on property will fall upon the capital value of the property if, in any year,
there is no income or there is actually a deficit.
In spite of these weaknesses, the ownership of property gives its holder an additional source
of taxpaying capacity which is not reflected by net income.

b) Income as the basis. Income has come to be accepted as an index or criterion of a

person's ability to pay. A family's wellbeing will depend primarily upon the income
received and hence, income after making due allowances for the children in the
family, etc., is generally regarded as the best indicator of a person‟s ability to pay. For
purposes of taxation, gross income is considered unsuitable, for it is composed of cost
elements, but net income is regarded as the best measure of taxpaying ability because
it reflects the sum of net receipts over costs. Net income exempts the minimum
subsistence needs of the individual or of the family group and, therefore, will not
restrict the consumption of low or substandard income groups.

c) Expenditure as the basis. Consumption has been suggested as an index of

calculating taxpaying capacity on the assumption that such expenditure measures the

22
 true utility or satisfaction derived from income. It is true that income is earned to
satisfy consumption but income is not utilized for investment is a very important
aspect of spending, both significant and urgent. There is no sense in taking
consumption expenditure as an index of ability to pay and ignoring saving and
investment expenditure.

Thus, the main index of ability, it seems to be agreed generally, is income while
supplementary indices can both be property and expenditure. In recent years, in many
countries of the world, direct ability of taxation is based on all the three indices.

2.4.3 Ability to Pay and Equality of Sacrifice

Mill interpreted the ability principle in terms of individual sacrifice. He argued that the real
burden of taxation should be equal for all and that “similar and similarly situated persons
ought to be treated equally”. But the term “equal” in equal sacrifice has been interpreted
differently. There are three concepts of equal sacrifice-equal absolute sacrifice, equal
proportional sacrifice and equal marginal sacrifice.

Equal Absolute Sacrifice. Equal absolute sacrifice implies that the total loss of utility as a
result of tax should be equal for all tax-payers. If there are two tax-payers with different
incomes, the one who has more will pay more tax and the one who has less will pay less, but
the sacrifice to both as a result of the tax should be equal. This principle received the greatest
support at one time because of its apparent fairness. Will not a tax system be the most
equitable, if each person's contribution to the support of the government occasioned
equivalent sacrifice?

Equal Proportional Sacrifice. Equal proportional sacrifice implies that the loss of utility as
the result of a tax should be proportional to the total income of tax-payers. Here, too, those
with a higher income will pay more but the ratio of sacrifice to the income will be the same
for all. This can be expressed as:

Sacrifice of Taxpayer A = Sacrifice of Taxpayer B = etc

Income of A income of B

23
This proportional sacrifice principle attempts to relate the sacrifice of tax payment to the
capacity of enjoyment or satisfaction resulting from income. Every taxpayer‟s loss in
proportion to his income should be the same as everyone else's. The difficulty with this
principle is to give a practical shape; besides, the concept is somewhat difficult to grasp.

Equal Marginal Sacrifice. Equal marginal sacrifice implies that the marginal sacrifice for
the different taxpayers should be the same. Since marginal utility of a higher income will be
very much low as compared to a low income, equal margined sacrifice will imply that the
person with a higher income will be expected to bear the heavier burden. In fact, it is under
the minimum sacrifice principle that the total or collective sacrifice of all taxpayers will be
the lowest. Hence, this principle is also known as the least aggregate sacrifice principle of
taxation.

Economists have clearly distinguished the three concepts of equality of sacrifice but are not
agreed upon the merits of the various concepts. Some writers like Cohen-Stuart preferred
equal proportional sacrifice since that would leave the relative position of total utility of tax-
payers unchanged. Some like Marshall and Sidgwick preferred equal absolute sacrifice.
However, Edgeworth and Pigou rejected the absolute and proportional sacrifice principles on
the ground that there was no logical or intuitive choice between them. And they argued in
favor of equal marginal sacrifice principle on the ground of welfare, viz., that it satisfies the
welfare objective of least aggregate sacrifice.

2.4.4 Rate Schedules of Taxation

There are three principal rate schedules of taxation, viz, (a) Proportional taxation, (b)
Progressive taxation, and (c) Regressive taxation. There is no unanimity among the
economists as to which of these tax systems should be applied in preference to the others
while trying to secure the complex fiscal objectives.

Proportional taxation refers to that system of taxation under which each tax payer pays the
same rate of tax whatever is his income. It means that the ratio of tax liability to tax base
remains the same whatever the change in tax base. On the ground of equity, this tax system is
advocated because it does not change the relative position of tax payers or disturb the existing
income distribution pattern. Another important merit is that the tax system is simple and

24
uniformly applicable. Thirdly proportional tax is free from the harmful effects like
disincentive to saving and productivity that are associated with progressive taxation when
imposed steeply. However, these merits should not be over emphasized. The argument that
tax rate may be so steep under progressive system as to produce harmful effect does not
necessarily strengthen the case for proportional taxation which, itself, may be designed with
excessively high rate.

Secondly, though it is claimed to be satisfying the equity criterion of taxation by the

supporters of this system, it does not actually do so. Adam Smith himself wanted that the tax
payment should be 'more than in proportion' to increase in income. The fact is that ability to
pay tax increases more than proportionately to increase in income. Hence proportional tax
does not satisfy the cannon of equity.

Thirdly, the claim of administrative simplicity is more imaginary than real. Under
proportional tax system, every individual income earner has to be assessed irrespective of
income level. Thus, estimation of net income and collection of taxes has to be made at too
numerous points.

Progressive taxation refers to that system of taxation under which the rate of taxation
increases with increase in income, i.e., the higher the income, the higher should be the ratio
of tax. In other words, a tax is said to be progressive when the ratio of tax liability to tax base
increases with increase in tax base. The supporters of progressive taxation justify this tax rate
schedule on the following grounds.

Firstly, it is based on the principle of diminishing marginal utility of income. Hence to

equalize sacrifice on account of taxation, the rich should be made to pay higher rate of tax
than the poor. This is because marginal utility of money for the former is less and, hence, his
ability to pay is more.

Secondly, a more forceful argument is advanced by Seligman according to whom both

productive capacity and consumption increase in larger proportion to the increase in wealth
and income. Hence it is only a question of justice that the rich men should pay higher rates of
tax than the poor do. This is known as faculty interpretation. A social argument is also
advanced in favor of progressive taxation. Thus, it is held that the rich has a responsibility

25
towards the poor in society. If the rich pay taxes in lager proportion, then the government will
have larger funds to invest for the welfare of the poor.

Thirdly, the desire to reduce economic inequality can be better translated into practice
through progressive taxation. Fourthly, progressive taxation has an in-built mechanism to
deal with the undesirable effects of inflation. When income in the society is more than
economically necessary and there is upward pressure of prices, tax rates will automatically
rise at a larger rate than increase in income. This will reduce inflationary pressure. The
opposite will be the case during deflation period. Progressive taxation is, however, subjected
to a sever criticism.

Firstly, the very principle of diminishing marginal utility on which the system of
progressive taxation has been advocated stands on loose ground. Since there is no
objective criterion to decide the marginal utility of income, it is impossible to correctly
determine the degree of progression in tax.

Second, if the rates of progression are heavy, the capacity and willingness to save is affected.
It is the rich who are principal savers. If larger and larger amounts of their income are taken
away by taxation, their capacity to save and, often willingness for it will be reduced.

Thirdly, progressive taxation may also discourage hard work. Since large incomes can be
earned only by hard work and since a handsome amount of the income so earned is taxed
away, people will lose incentive to hard work and earn more incomes. They will rather
choose leisure than work to spend time.

Regressive taxation is inverse to progressive taxation. Hence regressive taxation refers to

that system under which the ratio of tax liability to tax base decreases along with the increase
in tax base. If one is to give theoretical justification for the regressive type of tax system he
has to say that since the rate of tax falls with increase in income, it is an incentive to work
and earn more income and, hence, savings may be encouraged. Since propensity to consume
is very high in low-income economies where the poor are the majority, these taxes can
mobilize reduces by reducing consumption of people. This is, however, an uncomfortable
way of mobilizing taxes.

26
This system of taxation is highly iniquitous because the tax falls more heavily on the poor.
Though the ability to pay decreases along with the fall in income, the poor have to pay larger
proportion of their income than the rich are required to pay. This is a tax on poverty and will
widen the gap between poverty and prosperity. This system of taxation is, therefore,
obviously unjust.

27
 Chapter Three
Direct and Indirect Taxes
The most well-known distinction between direct and indirect taxes was the one made by
J.S. Mill: “A direct tax is demanded from the person who it is intended or desired should pay
it. Indirect taxes are those which are demanded from one person in the expectation and
intention that he shall indemnify himself at the expenses to another.” According to
Mill, taxes were direct or indirect depending upon the fact whether they were actually paid by
the people on whom the burden fell or not. According to this definition, personal income-tax
or a tax upon house occupied by the owner would be called a direct tax, since there would be
no shifting of the burden. A sales tax or a customs duty would be regarded as an indirect tax
since it is said to be shifted by the seller to the purchaser.

In modern times, taxes are classified into direct and indirect on the basis of assessment, rather
than on the point of assessment. Taxes, for instance; can be on income received or on
expenditure incurred. Those, which are imposed on the receipt of income are called direct
while those which are imposed on expenditure are regarded as indirect. On this basis,
income-tax, profit tax and capital gains tax are examples of direct taxes. Excise tax, customs
duties and sales tax (or commodity taxes as they are generally called) are indirect taxes. The
basic difficulty of this classification is that one man's income is another man's expenditure.
Therefore, a tax on the income of someone may also be regarded as a tax on another man's
expenditure.

But as Prof. Prest has pointed out, the distinction between tax on income and tax on
expenditure will hold good if we consider only the household as different from the business
houses. From the point of view of a household, a tax on a person's salary will be a tax on
income and hence a direct tax and a tax on the consumption of fruits will be a tax on
expenditure and hence an indirect tax. But there is no reason why business enterprise should
be excluded from this distinction. Commonly speaking, direct taxes refer to taxes on income
and property and indirect taxes are those imposed on commodities and services.

28
3.1 Direct and Indirect Taxes: A Comparison
Direct and indirect taxes may be compared from three different angles – allocation of
resources, administrative point of view and distributional effects.

3.1.1 Allocative Aspect

Traditionally, economists have maintained that the allocative effects of indirect taxes are
inferior to those of direct taxes. That is, if a certain amount of money is collected from the
community by way of indirect taxes (say, an excise duty) the burden will be greater than if
the same amount were to be collected by way of a direct tax (say, personal income-tax). Fig.
3.1 makes use of the indifference curve technique to illustrate this point.

In Fig.3.1, the horizontal axis represents sugar and the vertical axis represents the money
income of an individual. OA is his income and AB is the price line, before any tax is levied.
The equilibrium position is indicated by point C at which price line AB is tangent to an
indifference curve, IC5. The consumer buys AN quantity of sugar by spending NC amount of
money. Suppose an excise duty is levied on the commodity, making it costlier by the full
amount of the tax. As a result of the higher price, OA income can buy only OB1 quantity of
the commodity and, therefore, the new price line after excise duty is AB1. The consumer has
to move to a lower equilibrium position indicated by D on AB1. The individual can now buy
only AM quantity instead of AN and spend MD amount of money to buy it. Out of MD
amount spent by the person, ED goes to the government by way of the excise duty (the
difference between the old and the new price lines is the tax). Thus, the excise duty on sugar
has been responsible for reducing the quantity the consumer buys and lowering his welfare
(IC1 instead of IC5).

29
Figure 3.1. Indifference Curve Analysis of Direct & Indirect Taxes

Suppose this amount ED is taken by the government by way of a personal income tax. The
consumer's income will be reduced to OA1. As the price of sugar remains the same, the new
price line A1B2 will be parallel to the original price line AB. The new price line passes
through point D. The consumer can now reach a new equilibrium position at point F which is
on a higher indifference curve (IC3). Point F is to the right of point D indicating that the
consumer will buy a larger quantity of sugar AM' and that he would be deriving greater
satisfaction. This means that an income-tax of equal amount is preferable to an excise duty,
from the consumer's point of view, since it reduces consumer's welfare much less than an
equivalent commodity tax. In other words, a direct tax has less harmful effects on the
allocation of resources than an indirect tax.

3.1.2 Administrative Aspect

Direct and indirect taxes may be compared from the point of view of administrative cost and
efficiency. From the administrative point of view, direct taxes are not levied on low incomes
and suitable exemptions in tax are provided for income-tax. Before World War I, it was
thought, even in advanced countries, that income-tax could not be levied on wage-earners. In
other words, from the administrative point of view, indirect taxes were considered superior to
direct taxes. They are easy to collect; they are convenient and are difficult to evade.

However, such a comparison between direct and indirect taxes does not hold good because of
many factors. First, those income groups which are exempted from the operation of direct

30
taxes on the ground of equity and justice are not exempted from payment of indirect taxes.
Second, the modem administrative machinery for tax assessment and tax collection has been
revolutionized so much that income taxes and other direct taxes can be levied even on the
lowest income groups. It is, therefore, clear that a proper comparison between direct and
indirect taxes cannot be made on the ground of administrative cost and efficiency.

Professor Prest mentions certain circumstances when the administrative argument in favour
of indirect taxation becomes strong. For instance, there may be a very large number of small,
independent producers; or many may be illiterate and incapable of keeping accounts; and
barter and subsistence sections of the economy may be quite significant. These actors are
specially applicable to underdeveloped countries and they are responsible for the
predominance of indirect taxation in these countries.

Hence, comparison between direct and indirect taxes on the basis of administration in such a
way that the former are inferior to the latter is defective.

3.1.3 Distributional Aspect

A comparison may be made between direct and indirect taxes on the basis of their
distributional aspect. It used to be held that direct taxes were pre-eminently suited to bring
about reduction in the inequality of income in the capitalist system. Hence, direct taxes were
considered very progressive. At the same time indirect taxes fall on all incomes and,
therefore, they have been regarded as generally regressive.

However, a close examination will show that the two types of taxes are governed by the same
principles as regards their distributional effects and that they are not basically different from
each other. It is further pointed out that any scheme of redistribution of income which may be
considered desirable can be achieved by either type of taxation. But the process of achieving
such redistribution will be different.

In the case of direct taxes, the adjustment takes place through the factor market, for there is a
systematic relationship between the size of income and the amount of tax payment. In the
case of indirect taxes, the process of adjustment will be through the commodity market. On
this basis, it is difficult to speak of direct taxes as progressive and indirect taxes as regressive.

31
In fact, if a direct tax is passed on to the consumer, it will be regressive. Likewise, an indirect
tax on luxury goods may shift factors of production from these industries to those lines of
production which meet the demands of the common masses and thus an indirect tax can be as
progressive as any direct tax.

We may conclude our comparison of direct and indirect taxes by pointing out that:
a) direct taxes are superior to indirect taxes on allocative and distribution grounds; and
b) indirect taxes are superior to direct taxes on the ground of administrative cost and
efficiency.

In general, economists prefer direct taxes to indirect taxes. However, as we have mentioned
already, indirect taxes have a significant role to play in the mobilization of resources for the
Government especially in the developing countries in which the vast majority of people are
quite poor and cannot contribute anything to the government by way of direct taxes.

3.2 The Case of Direct Taxes

3.2.1 Merits of Direct Taxation
Direct taxes claim four important merits. First, they are based on the principle of ability to
pay so that the burden of taxation is distributed on different people and institutions in a just or
equitable manner. They are amenable to fine gradations or progressions. Secondly, direct
taxes satisfy the canon of certainty. The taxpayer is certain as to how much he is expected to
pay and the State can estimate the yield from direct taxes fairly accurately and adjust its
income and expenditure.

Thirdly, direct taxes are elastic in the sense that with the increase in income and wealth of the
people, the yield of direct taxes will also increase. Elasticity also implies that the
government's revenue can be increased simply by raising the rates of taxation. To modern
governments, with continuously expanding needs such elastic taxes are very useful indeed.
Finally, direct taxes create civic consciousness in that the taxpayers are made to feel directly
the burden of taxes and hence take intelligent and keen interest in the way public income is
spent. The tax-payers are likely to be more mindful about their rights and responsibilities as
citizens of the State.

32
The advantages of direct taxes are, therefore, equity, certainty, elasticity and civic
consciousness.

3.2.2 Demerits of Direct Taxes

Among the disadvantages of direct taxes, four points may be emphasized:
i. Direct taxes tend to be arbitrary because it is indeed difficult to have an objectively
just basis of ability. The rate of income-tax, for example, will depend upon the
political complexion of the government. A conservative government may levy a low
rate of tax while a leftist government may impose a stiff rate. But experience and care
can lead to justice in taxation and arbitrariness can be reduced if not completely
eliminated.

ii. Direct taxes are taxes on honesty and they tempt people to evade them by hiding their
income and wealth partly or fully. But with the passage of time administrative
machinery is being tightened and tax evasion and avoidance are being reduced to the
minimum.

iii. Direct taxes are inconvenient in the sense that the tax-payer has to prepare and supply
income returns disclosing all the sources of his income to the tax authorities.
Accounting procedures are so numerous and so difficult to comply with, that in most
cases, individual tax-payers have to get the help of professional income-tax
practitioners to prepare their returns.

iv. Direct taxes are often regarded as expensive to collect, since each and every tax payer
will have to be separately contracted by the tax authorities. Elaborate machinery has
to be designed to contact and assess tax-payers and also to prevent tax evasion.

An evaluation of the demerits of direct taxes will bring out the important fact that the
demerits arise mainly because of administrative difficulties and are not due to the non-
applicability of any economic principles.

33
 3.3 The Case for Indirect Taxes
3.3.1 Merits of Indirect Taxation
Among the advantages of indirect taxation the most important are convenience, difficulty of
evasion, elasticity and social benefit.
i. Indirect taxes are regarded as convenient, for they are imposed at the time of purchase
of a commodity or the employment of service so that the tax-payers do not feel the
burden of the tax. Besides, the burden of indirect tax is not completely felt, since the
tax amount is actually hidden in the price of the commodity bought. They are also
convenient because generally they are paid in small amounts and at intervals and not
in one lump sum. They are convenient from the point of view of the government also,
since the tax amount is collected generally as a lump sum from the manufacturer or
the importer. Apart from convenience, indirect taxes can be made to satisfy the canon
of ability, especially if they are imposed on commodities which may mainly be
demanded by higher income groups.

ii. Indirect taxes are difficult to evade because they are generally included in the price of
commodities purchased. Evasion of an indirect tax will mean giving up the
satisfaction of a given want. However, indirect taxes may sometimes be evaded by
such methods as falsification of accounts, smuggling, etc.

iii. Some of the Indirect taxes can be elastic, just as direct taxes are elastic, that is, the
revenue yielded by these taxes can be increased, when necessary. Such taxes should
be imposed on commodities with inelastic demand. However, such indirect taxes will
clash with the principle of equity. For instance, commodities with inelastic demand
will normally be necessities which are consumed by the lower income groups. Taxes
on such goods will obviously be regressive.

iv. Indirect taxes enable everyone, even the poorest citizen, to contribute something
towards the expenses of the State. Since direct taxes leave lower income groups from
their scope, indirect taxes make them share in the financial burden of the State.
Moreover, indirect taxes perform a social and economic service to the community in
general and the poorer sections in particular when they restrict the consumption of
such articles as harmful drugs and stimulants.

34
3.3.2 Demerits of Indirect Taxation
Indirect taxes have been criticized on various grounds. First, they are regarded as unjust and
inequitable since they fall on, all persons indiscriminately, irrespective of their ability to pay.
When mass consumption goods are taxed, the burden is borne more by the poor than by the
rich. It is true that indirect taxes can be made progressive and gradations can be introduced
but, generally speaking, commodity taxes do not discriminate between people according to
their ability to pay.

Secondly, indirect taxes are extremely uncertain. Taxes on commodities with elastic demand
were particularly uncertain since quantity demanded will be affected by the imposition of
taxes. In fact, a higher rate of tax on a particular commodity may not bring in more revenue.
As Dalton wittily put it, here is the case of two plus two adding up to only three or even less
than three.

Lastly, indirect taxes do not create any social consciousness as the taxpayers, in most cases,
do not feel the burden of the tax to pay.

3.4 Superiority of Indirect Taxes over Direct Taxes

In spite of their demerits, indirect taxes are regarded as better from the point of allocation of
resources:
a) Indirect taxes which are confined to goods with zero elasticity of demand (absolutely
inelastic demand) or low elasticity are regarded the best.
b) Indirect taxes are useful where external diseconomies exist on the production side or
on the consumption side. Examples for such diseconomies on the production side are
smell or smoke nuisance and on the consumption side is drunkenness. Indirect
taxation is useful in that they discourage the people from consuming harmful goods
like liquor and drugs.
c) Indirect taxes have been found to be superior to direct taxes, since their effects on
incentives to work and save may not be so harmful (unless, of course, they fall on
capital goods).
d) They are also suitable for purposes of income correction. If they are imposed on those
goods which have a high income elasticity of demand, they yield highly satisfactory
results. In this case, ad valorem duties (according to value) rather than specific duties

35
 would be preferable since the tax revenue would change in response to a change in
price and also change in consumption.
e) Finally, as it is difficult, if not also improper, to levy direct taxes on low income
groups, the only way the poor can be asked to pay for government expenditure is
through commodity taxes. This is the conventional argument in favour of indirect
taxes. This argument has lost its significance these days particularly in advanced
countries, where there has been great administrative improvement and efficiency in
the field of taxation and where the difficulties of taxing the low income groups have
been overcome.

36
 CHAPTER FOUR
4. Public Expenditure
Chapter Objectives
This is a chapter which deals with the expenditure of the government. We have noted on
several occasions that public expenditure side of the governmental activity received scant
attention from economic theorists until 1930's when depression spread throughout the world.
The world underwent a series of socio-economic and political changes. With the emergence
of welfare ideals of state craft, public expenditure started rising tremendously. There arose
the necessity of a sound theoretical guide line for public expenditure.

With increasing state activities caused by depression, post war economic reconstruction and
public welfare programmes of government, the study of public expenditure received
increasing attention. Today, the study of public finance is not complete without a proper
analysis of public expenditure. Accordingly, in this chapter we deal with issues like meaning
of public expenditure, causes for the increments in public expenditure; canons, theories and
accountability in public expenditure, effects of public expenditure, and contents of
development expenditure will be discussed.

Thus, after studding this chapter students will be able to:

 Define public expenditure
 Realize why public expenditure increase from time to time
 State the different theories of public expenditure and make a comparison among the
different theories by considering their strong and weak sides
 Explain the effect of public expenditure both on production and employment
 Recognize what government expenditure could incorporate so as to achieve its
objectives of economic development.

Public expenditure refers to the expenses which the government incurs for its own
maintenance as also for the society and the economy as a whole. These days, some
governments are incurring expenditure to help other countries and that would also from a part
of public expenditure. With expanding state activities, it is becoming increasingly difficult to
judge what portion of public expenditure can be ascribed to the maintenance of the
government itself, and what portion to the benefit of the society and the economy.

37
Historically, public expenditure has recorded a continuous uptrend over time in almost every
country. However, traditional thinking and philosophy did not favor the growth of public
expenditure. Instead, it considered market mechanism as a better guide in working of the
economy and allocation of its resources. It was argued that each economic unit was the judge
of its own economic interests and the government was certainly not able to decide on behalf
of others. Furthermore, while a private economic unit was guided by its own economic
interests, the public sector would have no such motivation.

Accordingly, efficiency would be at low ebb there. Had this philosophy been practiced in its
entirety, public expenditure would not have grown as rapidly as it did. In reality, however,
the problems of labor exploitation, economic and social injustice and such like things
assumed serious proportions and would not be ignored. The result was that along with the
advocacy of laissez faire, various socialist and welfare ideas also gained currency. And, of
course, the governments found that they could no longer remain silent spectators of the
miseries of the people.

4.1 Causes of Growth in Public Expenditure

Some of the basic causes of ever-increasing public expenditure have been mentioned in the
theories associated with the issue. However, under the changing situation of the modern
world, many more factors are at work behind the continuous growth of public expenditure.
The most important causes are the following.

i. Population growth. The growth in the numbers particularly in developing countries

has been a major cause of the continuous rise in public expenditure. Along with
growth in the numbers, the responsibility of government relating to public services
has been multiplied. To check the growth of population, again, the government has to
incur a huge expenditure.

ii. Increasing urbanization. As the rural areas cannot subsist the growing population,
there is a continuous rush to the urban areas. The size of cities is becoming larger and
larger, while newer urban habitations are springing up. The maintenance of

38
 complexity of life has, therefore, become costlier and the government has to squarely
face the problem.

iii. Provision of economic overheads. Without the creation and maintenance of

economic overhead facilities, no country can develop. These facilities like provision
of a good system of transport and communication, generation of electric power, etc.
require heavy investment of capital which does not flow from private sector sources.
Hence, government has to assume these responsibilities if the basic requirements of
development are to be satisfied at all. Thus, public expenditure on account of
economic infrastructure is of huge size in developing countries.

iv. Maintenance of law and order. Along with the growth of population, urbanization
and complexities of modern economic and sociopolitical life, law and order problems
have also multiplied. The government responsibilities of internal protection of people
from breach of peace by antisocial elements have gradually become multi-sided
requiring government expenditure of more and more funds.

v. Welfare activities. Previously, public expenditure was limited by only a few

functions of government, viz, the defense, maintenance of law and order and
administration. But, presently, the countries have emerged as modern welfare states
where the greatest good of the greatest number is the main objective of statehood. The
government now has to assume such responsibilities as family and child welfare,
social security like old age pension, unemployment benefit, sickness benefit, etc.
housing for the poor, welfare of handicapped and backward classes, rehabilitation of
displaced persons, subsidy on food and production inputs, etc. Public expenditure on
welfare programmes has, therefore, become tremendous with the passage of time.

vi. Provision of public goods and utility services. Public goods are those that are
consumed equally by all. They cannot be sold in the private market. Defense and
police services, justice, roads, irrigation and flood control projects, public parks, etc.
are all examples of public goods. They involve huge investment and have to be
provided by the government. Moreover, there has been a growing trend of public

39
 utility services like railways and other transport services, postal, telegraph and
telephone services, electricity services, etc. coming under the government sector.
They all involve heavy expenditure on installation and maintenance.

vii. Servicing of public debt. A substantial part of the huge expenditure program of
government is met from public borrowings. This is because resources cannot be
mobilized from taxation beyond a limit. Hence, modern states incur considerable
internal and external public debt. The repayment of debt and obligation to pay service
charges become huge.

viii. International obligation. Finally, the modern states have to maintain many
international socio-political and economic links. They have to maintain diplomatic
relations, economic links with international institutions like I.B.R.D. ( the
International Bank for Reconstruction and Development), I.M.F. ( International
Monetary Fund) etc, Socio-cultural and academic exchange relations, linkage with
development programs of the type of economic cooperation, gifts and donations,
regional economic integration and membership of other international organization like
UNO (United Nations Organization), etc – all these involve a considerable amount of
public expenditure.

4.2 Public expenditure: Canons, Theories and Accountability

In the earlier part we vividly discussed public expenditure in relation to the reasons for its
growth. This part is devoted to canons and theories of public expenditure on the one hand and
its public accountability and control on the other. In the last part of the discussion, a section is
devoted to accountability of public expenditure.

4.2.1 Canons of public expenditure

As in the case of taxation, there are a number of canons for public expenditure also. Some of
these canons may be regarded as principles, while others are no more than general guidelines
for the public authorities to help them in their task of planning and execution of public
expenditure properly. Thus, Findlay Shirras suggests that public expenditure should be
beneficial to society while incurred economically and should not be wasteful or made without

40
previous sanction. Other economists have added a few more guidelines. Taking all of them
into consideration, the following will be the canons of public expenditure.

i. Canon of Benefit. Public expenditure should be so planned and implemented as to

bring about the greatest possible benefit to society. This canon is simply a reminder to
the public authorities that whatever they spend they should do it according to the
principle of maximum social advantage. What it means is that all such expenditures
which do not bring benefit to society should be avoided. Thus, all non-essential
expenditures should be cut to the minimum. Benefit from public expenditure may be
identified with achievement of proper allocation of economic resources, proper
distribution of income and wealth in society and stability of price level and growth of
economy. This canon also points to the need of undertaking a cost-benefit analysis of
the competing schemes of public expenditure before the final selection of investment
project is made.

ii. Canon of economy. Public expenditure should be incurred carefully so that there is
no wastage of funds. Since resources are limited in the society, they have to be most
properly utilized. Economical use means most proper utilization. Hence the canon
remains a constant reminder that resources must not be misused or wasted. Most
important reasons of wasteful expenditure are faulty planning, faulty execution,
corrupt practice and delay due to time lag between plan and execution and, hence,
escalation of prices. These types of wastage have to be avoided at any cost. It must be
noted here that benefit to society cannot come without proper pursuit of the canon of
economy.

iii. Canon of surplus. This canon requires that expenditure of public authorities should
be kept within the limits of current revenues. If possible, the expenditure should be
less than the earnings of government so that the surplus so generated can be used
when there is unavoidable deficit. Surplus can be generated either by controlling
expenditure or by increasing current revenues. Of late, however, there has been much
change in the thinking around budget policy. The occurrence of depression and the
need for achieving price stability and economic growth often requires deficit
financing, i.e. excess of expenditure over current revenues. Hence, a choice of surplus

41
 or deficit budget is decided by the merit of the case. This canon is, however, an
important reminder of the fact that the government should not overspend and run into
debts and that a deficit spending should be avoided as far as possible.

iv. Canon of sanction. This canon requires that the public authorities should not be
allowed to spend funds without having a previous sanction from appropriate authority
for the purpose. It also requires that funds sanctioned for a particular expenditure
should not be diverted to a different purpose and spent thereon. In a democracy, such
sanctioning authority is vested on the legislature. Since there are different agencies in
the governmental set up for executing public expenditure programs, detailed
authorizations are worked out for different spending agencies so that misuse and
wastage of expenditure can be avoided. In order to deal with emergency purposes of
expenditure, some discretionary sanctioning power is also vested on some important
officials.

v. Canon of elasticity. Canon of elasticity requires that the rules of public expenditure
should not be too rigid to achieve the real purpose and that it should be allowed to
vary according to the needs and circumstances. For example, if the economy suffers
from unemployment and deficiency of demand, there should not be a rigidity that the
budget should be balanced. Under such situation, the government should go for a
deficit budget and inject additional purchasing power into the economy so that
effective demand is increased and factors of production are employed on larger scale.
Or in case of emergent situations like flood relief, sanctioning authority should be
vested with the lower rank spending unit since there is no time to secure sanction
from higher authorities. Flexibility of expenditure should be provided under such
circumstances.

vi. Canon of certainty. This canon requires that public authorities should clearly know
the purpose and extent of public expenditure. The spending unit should be certain as
to the amount and objective of public expenditure. This requires a proper expenditure
plan well thought out beforehand. The canon of certainty is followed through the
preparation of budget. The budget details the amount and purpose of expenditure for

42
 the whole financial year. It is through the budget that the spending authorities have
proper knowledge of the use of public funds. In the absence of such a certainty, fiscal
discipline cannot be maintained and there will be unnecessary wastage and
overspending.

4.3 Effects of public expenditure on production and distribution

4.3.1 Effects on Production and Employment
The expenditure of the Union Government on development is meant to promote production
and employment in the country. Expenditure on agriculture and allied services, industries and
minerals, water and power development, transport and communication and other expenditures
on community and social development by the Union and State Governments help directly to
raise the level of production and employment in the country. Further, the enormous
expansion in expenditure by the Union and State Governments is to boost demand for goods
and services and thus to boost production. The level of production and the level of
employment in any country depends upon three factors, viz.,

a) Ability of the people to work, save and invest,

b) Willingness to work, save and invest, and
c) Diversion of economic resources as between different uses and localities.

It is possible to influence all these factors through public expenditure either for the better or
for the worse.

Ability to Work, Save and Invest. If public expenditure can increase the efficiency of a
person to work, it will promote production and national income. Public expenditure on
education, medical services, cheap housing facilities and recreational facilities will increase
the efficiency of persons to work. At the same time, public expenditure can promote income
of the people. Finally, public expenditure, particularly repayment of public debt, will place
additional funds at the disposal of those who can invest. Thus, it will be seen that public
expenditure can promote ability to work, save and invest and thus promote production and
employment.

43
Willingness to Work, Save and Invest. The effects of public expenditure on the willingness-
as different from ability to work and save and invest on production are not clear enough.
Pensions, interest on loans, provident fund and other government payments provide security
and safety to a person, and therefore, reduce the willingness of persons to work and save;
why should a person work hard and save when he knows well that he will be looked after by
the government when he is not in a position to earn an income?

Diversion of Economic Resources. Public expenditure has far-reaching effects on the

utilization of economic resources as between alternative uses. Public expenditure can bring
about a better allocation of economic resources as between the present and the future. In a
free capitalist society very little provision is made for the future. This is because people
prefer the present rather than the future and, therefore, they do not make adequate provision
for the future. The State on the other hand, is the custodian of the interests of the future
generations also and, therefore, has to see that adequate provision is made for the future.
Public expenditure on transport, irrigation and other projects which yield both immediate
return as well as social and economic benefits for generations to come, are some examples.
Secondly, the government spends money in the conservation of economic resources which
are very essential for the future. Thirdly, the government spends money for encouragement of
research and invention, promotes education and training, looks after public health and
sanitation and also takes the responsibility of social security measures. It is necessary to
emphasize that the diversion of economic resources in all these ways will greatly increase
production.

Generally, the effects of public expenditure on production and employment are favourable.
Taxation, taken alone, may check production; but public expenditure, taken alone, should
almost certainly increase it. The development expenditures of the Central and State
Governments aim at raising the level of production and employment in the country. It is
possible that production will be adversely affected if public expenditure is carelessly planned,
but it will positively stimulate production if carefully planned.

4.3.2 Effect of public expenditure on distribution of income

These days, every government aims at reducing inequalities of income. Public expenditure
(as part of fiscal policy) can be used by the government to achieve this aim. While taxes,

44
particularly progressive direct taxes, have the effect of reducing the incomes and wealth of
the higher income groups, public expenditure has the effect of raising the incomes of the
lower income groups. Government's expenditure on education, public health and medicine,
housing, etc., is directed to help the poor and the lower income classes (who make use of
government schools and hospitals). At the same time, social security schemes are run by the
government for the benefit of the working classes so that they may be protected from
unemployment, accidents, sickness and old age. Thus, public expenditure, if carefully
planned and executed, will help in redistribution of income in favour of the poor provided, of
course, taxation is used to reduce the incomes and wealth of the higher income groups.

4.4 Public expenditure and control of inflation

Inflationary pressures may be considerably lessened if government expenditure is reduced.
This may be taken as a simple and direct solution, but for the fact that, in the majority of
cases, the most serious type of inflation has always been due to enormous government
expenditure. This type of situation may be due to war when large sums are spent for military
purposes or due to preparations for war during peace time. However, the government can
suitably change and adjust its expenditure during an inflationary period so that the
inflationary pressure may be reduced.

For instance, all those schemes which may be justified during a period of depression and low
level of employment may be omitted during an inflation. At the same time, the government
can postpone the construction of social capital such as post offices, schools, etc., which will
increase the size of income of people but will not contribute to the increase of goods.
Secondly, the government can give subsidies to those industries which are producing
inflation-sensitive goods so as to accelerate their production or to enable producers to sell
them at lower prices.

4.5 Content of Development Expenditure

Development expenditure of the government should aim at stimulating and supplementing
private initiative and enterprise. It is possible-and some governments of developing countries
have attempted to do so-to eliminate the private sector altogether and plan for the entire
economy as a whole. There is some advantage in that. But many may not like a communist
pattern of economic development which is rapid, of course, but may prove to be nevertheless

45
ruthless and inhuman. In a democratic setup, with parliamentary institutions, emphasis will
have to be not on the elimination of the private sector but the setting up of a mixed system in
which private enterprise will be given active encouragement and, at the same time, the
government will become an interested and active participant in development activities.

a) Stimulating private initiative. Development expenditure of the government will take

the form of stimulating private initiative and enterprise. Direct stimulation is done by
the Government helping the private sector through loans, subsidies, tax concessions
and exemptions and providing market and other information and research facilities.
The government can set up special banking and financial institutions whose main aim
will be to provide finance for medium and long-term periods at low rates to help the
private sector industries with adequate finance. In many underdeveloped countries,
the government will have to set up a strong commercial banking system with a central
bank at the top. These are direct methods of helping the private sector to expand and
develop.

b) Provision of social and economic overheads. Indirect stimulation of the private

sector may be done by the government through the provisions of social and economic
overheads -education and public health will come under the first head, and provision
of power, transportation, communication, etc., will come under the second head. The
private sector industries would reap enormous benefits of economies of production
from these facilities provided by the government. Social and economic overheads are
necessary and essential prerequisites for economic growth. In fact, there are many
competent authorities who would like governments of underdeveloped countries to
provide only these facilities and leave the rest to the private sector.

c) Public enterprises. The government will have to start and run such undertakings
which the private sector may be unwilling to undertake, either because profit margins
are low or almost nothing, or because they require huge capital investment and a long
time to yield returns. These enterprises may not be appealing to the private sector
from the commercial point of view but may be of great significance from the point of
view of economic welfare of the community as well as that of economic progress. In
this group will come all the key and basic industries, development of irrigation

46
resources, electric power, etc. In fact, any industry which is necessary for the country
and which will help in the growth of the economy can be taken up by the government.
The idea, however, is not to compete with the private sector but really to supplement
and complement it.

47
 CHAPTER FIVE
5. Government Budgeting
Chapter Objectives
This is the last chapter for the first module which deals on the government budget. There was
a time when the activities of government were few and, hence, much importance was not
attached to government budgeting. It was rather a mere report for information of legislature.
But, in the modern times when countries are fast becoming welfare states with increasing
responsibilities of government, the activities of public authorities have expanded and
government budgeting has become a chief instrument of economic development. In this
chapter issues like meaning of the government budget, theories of government budgeting,
classification of budget and the role of budget will be discussed and analyzed.
Thus, after studding this chapter you will be able to:
 define what government budget is
 state the various classification of budget
 explain the role the government budget can play as instrument of economic policy.

5.1 Meaning and purpose of government budget

Meaning.
Today, the government budget is much more than a statement of income and expenditure of
public authorities. It is a reflection of not only taxation and public expenditure policy, but
also of a plan for future course of action. From the study of the budget, one can make an
assessment as to the extent to which it is designed to secure the normative ideals of
allocation, distribution, stabilization and growth. According to Bastable, budget has come to
mean the financial arrangements of a given period, with the usual implication that they have
been submitted to the legislature for approval.

Though budget is a program for future action and is generally framed for a year, it presents a
picture of the details of expenditure, taxation and borrowings for three consecutive years, i.e.,
the actual receipts and disbursements of the previous year, the budget and revised estimates
of the current year and the estimated receipts and expenditures of the coming fiscal year. If,
for example, the current year is 2005-06 and the budget is to be framed for the fiscal year
2006-07, then the estimated receipts and expenditures, i.e., budget estimate for 2006-07 will
be accomplished side by side with the actual budget account of receipts and expenditures for

48
2004-05 and the budget as well as revised estimates for the current year 2005-06. The fiscal
year in one country, for instance, comprises the period from 1st July to 31 June. Though
budget estimates for the coming fiscal year contain proposals of taxation, borrowing and
public expenditure, the government in course of implementation of the budget programs
might face shortage of funds due to some important additions of activity and, hence, might be
in the necessity of fresh proposal of revenue receipts and expenditure which are made in what
is called a “Supplementary Budget”. In this way, the action plan of the original budget gets
revised.

A good budget should be one that will enable the legislature and the people to appreciate the
proposals of receipts and disbursements in the context of prevailing state of economy of the
country. For this purpose, the budget plan should be accompanied by a report of pre-budget
survey of the economic conditions and prevailing financial position of the government. A
good budget should be one that will draw up programs of action in such a manner that the
proposals can feasibly be translated into realization. They should not be over-ambitious and
should be within the means, financial and otherwise. Another important requirement of a
good budget is that it should depict a clear picture of the state of performance relating to
programs of the government in the previous year so that it becomes possible to see what have
been achieved, what have been the shortcomings and decide as to what course of action
should be adopted in the budget plan.

The budget undergoes through different stages of action. Firstly, the budget frame is
structured. The government asks different departments to submit their proposed programs of
action for the coming year. After all such proposals are received, they are consolidated into
an overall budget plan. In the second stage, the budget is presented in legislature for its
approval. At this stage, the legislature carefully considers the proposals.

There may be additions or alternations in budgetary provisions as considered necessary by

the legislature. After the budget is approved, the government is authorized to take action on
the budget. Thirdly, the implementation of the budgetary programs is the next stage.
Revenues are raised and public expenditures relating to the budget plan are made. In the forth
and the last expenditures relating to the budget plan are made. In the fourth and the last stage,
a scrutiny and Parliamentary Committees look after how best financial abuse can be
prevented.

49
Purpose. The purpose of government budget is varied. There are a number of objectives
which the budget seeks to attain simultaneously. The overall purpose is to use the budget as
instrument of government economic policy. The following are the chief purpose of the
budget.

To achieve any purpose, a planning is necessary. The government needs to achieve many
goals all of which cannot be attained at a time. A proper plan of action is, therefore,
necessary. A budget is such a plan which explicitly mentions the programs that are to be
taken up in the course of the fiscal year. Secondly, implementation of a program requires
availability of necessary funds. The extent of availability depends upon the budgetary sources
of revenue. Hence, that program-structure has to be built which can be supported by the
funds. This is the most important purpose of the government budget.

Thirdly, to achieve efficiency in public expenditure, physical targets of achievement are

specified in the budget. In fixing the physical targets, careful considerations is given to the
factors of efficiency in course of implementation of the programmes so that nearer the actual
achievement at the close of fiscal year, the higher is the efficiency of level of expenditure
agencies.

Fourthly, most of the countries, particularly in developing world, today have taken up their
task of their economic development in the phased manner of five year plans and long-drawn
perspective plans. In order that the planned targets are achieved at the end of the plan period,
resources have to be found. The annual government budgets are framed with an eye to the
provision of necessary funds for the purpose. Lastly, the government budget serves the
purpose of public accountability of funds to a considerable extent. The first control is
imposed at the budgeting framing level itself when the government asks different
departments to submit their own budgets. Because the departments know that their
programmes of expenditure will be scrutinized by the government level, they become careful
to observe economy in the budget. The next stage of control is imposed by the legislature
which is the ultimate authority to decide the size and extent of the budget. At the end of the
financial year, again, the government and its various departments are responsible to the
legislature for their action and budgetary performance. Hence, budget serves as a powerful

50
weapon of financial control in respect of both collection of revenues and disbursement of
them.

5.2 Budget Framing

A government budget is framed in the shape of a financial plan which is a statement of
income and expenditure relating to various economic and other activities that the government
intends to perform in the coming period. The structure of budget frame may be different in
different countries.
i. Revenue and Capital budget. Many countries, particularly the less developed ones,
prepare budget in two parts, viz., the revenue and capital budgets mainly because the
government has to spend enough resources on economic infrastructure without which
development process cannot start. Capital budget in these countries separates the
revenue expenditure items of capital account from those of current or revenue
account.

The main sources of government revenue are taxes and borrowings from internal sources on
one hand and loans and grants from other governments and international agencies on the
other. In the revenue budget, the current expenditure is met out of domestic taxation, while
the expenditure on capital account is made out of domestic and foreign borrowings.
Government obligations for some extra-ordinary expenditure particularly in the initial stages
of development arise on account of economic overheads like roads and railways, electricity
generation, schools and hospital buildings and facilities and other investment projects which
require special revenues and are generally financed by borrowing. Such expenditures and
receipts are shown in the capital budget.

51
Since capital projects are very important as they will form the sources of regular flow of
productive services in future, the long drawn financial plan and its consequence on the
economy over years ahead can be read from the capital budget. Such a separation of the
budgets secures expenditure discipline and, hence, the lenders can form a clear idea about the
solvency or otherwise of the country. It is, therefore, very important for developing countries
to frame such a type of budget. The above table will give an idea of the structure of revenue
and capital budgets.
ii. Incremental and Zero-base Budgets. The budget, in order to be meaningful, should
be appraised occasionally and requests for grant of fund should be properly reviewed.
The review is necessary at both administrative and legislative levels. But, there is a
general tendency to confine the exercise of scrutiny within the area of changes
proposed for particular budget items rather than to extend over every aspect of the
whole programme structure. Past levels of expenditure are taken as given and only
new additions to or reductions from the past outlay are examined. This is what is
known as 'incremental budgeting' which should not be allowed to be in vogue since it
cannot ensure proper allocation of economic resources. „Such a focus on increases
and reductions can well lead to hardening of the bureaucratic arteries, maintain old

52
 programmes that go unexamined simply because no substantial changes are called for
in the budget‟. This deficiency of incremental budgeting is done away with by what is
called „Zero-base budgeting‟.

Since every outlay in the budget has some attainment objective, either short-run or longrun, it
is necessary to regularly examine the expenditure components in the light of anticipated
results. In the case of budgeted expenditure having been associated with long term objective,
the time-bound expected result-component should be examined occasionally. This is what is
done by Zero-base budgeting. It is not necessary, however, that each and every programme
be reviewed afresh or restructured anew every year under the zero-base budgeting, though
such necessity might arise in case of some of the programmes. But it does require that
programmes should not go unscruitnished in any case for a long period. Such budgeting is a
new technique of bringing the spending agencies under a regular scrutiny and accountability.
Zero-base budget, therefore, acts as a constant reminder of the necessity of utmost efficiency
in public expenditure and in resource allocation programmes.

iii. Plan and non plan budgets. Most of the underdeveloped and developing countries
pursue planned economic development through periodic plans. The basic aim of
economic planning is to achieve repaid development in different sectors like
agriculture, industry, power, transport, etc. and to raise per capita income, remove
poverty, unemployment and regional disparity so that social justice can be achieved.
East African countries practice five-year plans. A part of the budgetary receipts and
expenditures is devoted to the administration and implementation of the plans. The
part of budgetary receipts which goes to finance the plan expenditure and the outlays
on planned developmental heads constitute the plan budget, while the remaining part
of the budgetary resources and expenditures is referred to as the „Normal‟ or „Non-
plan budget.‟

iv. Balanced and Unbalanced Budget. Government budget may be balanced or

unbalanced. Unbalanced Budget may be either a surplus budget or a deficit budget.
When the government revenues are equal to government expenditures, the budget is
balanced and when they are not equal, the budget is unbalanced. P. E. Taylor explains
the nature of budget balance in the following terms. (a) A budget is balanced if during
the budget period revenue receipts are exactly equal to cost payments. (b) If revenue

53
 receipts for the budget period are greater than cost payments, the difference is budget
surplus and (c) if revenue receipts for the budget period are less than cost payments,
the difference is budget deficit.

In the advanced countries, a balanced budget is pursued at a time when the economy suffers
neither from inflation nor from unemployment or depression so that the objective of
maintaining full employment with price stability is achieved. When the economy suffers from
inflation, a surplus budget is operated while a deficit budget is pursued when the economy
suffers from unemployment. The developing and underdeveloped countries suffer normally
from idle resources and, to make their proper use, additional expenditures are incurred and,
hence, they mostly pursue deficit budgets.

5.3 Modern Classification of Budget

There are many governmental functions on which expenditure is planned in the budget. To
get a fuller picture of the various implications of budget frame, a proper analysis is necessary.
Modem budgeting recognizes this need and attempts to classify the budget from different
analytical angles. The Economic Commission for Asia and Far East explains this necessity in
the following words. The systems of classification provide information on the working of
budgetary process.

Since such a process has a multitude of functions and objectives, different types of
classification are needed, either singly or in combination, to serve the purpose of
appropriation, programme management and review, evaluation of plan implementation, and
financial and economic analysis. The various ways in which the public sector transactions can
be classified are (a) by organization, (b) by object, (c) by function, (d) by their economic
character, (e) by programme and (f) by origin of the purchases affected by the government.
Accordingly, from different analytical view points, we may classify the budget in the
following ways.

i. Functional Classification. A better idea of government expenditure is obtained from

functional classification since it goes by purpose of expenditure rather than by
departments of government. As the United Nations says, “It classifies public

54
 expenditure by specific governmental function such as defense, health, education,
promotion of agriculture, etc”.
Since the resources of government are limited and since the functions of government are
many, the latter are essentially competing objectives. Therefore, it is important to determine
the extent of budgetary resources that can be earmarked for each of these purposes of public
expenditure. This is what the functional classification does.

ii. Economic Classification. Economic classification seeks to categorize the

government receipts and expenditures into different classes of economic significance
so that the pattern of resource allocation and its impact on the rest of the economy can
be readily grasped. This classification shows how expenditure for a particular
purpose, say, health, is divided between such classes of economic significance as
current expenditure on goods and services, capital formation, current transfers, capital
transfers and loans. It also shows how expenditure belonging to a particular category,
say, capital formation, is designed to serve different purposes. Obviously, such
classification provides important macroeconomic information that are essential for
construction of national accounting data.

Economic classification broadly categorizes public expenditure into two classes, viz., current
expenditure and capital expenditure. Current expenditure is divided into three classes each of
which, again, is sub divided into four classes, as shown in the following table.

55
Similarly, capital expenditure is divided into five classes. viz., gross capital formation, capital
transfers, investment in shares, loans and advances and repayment of public debt. Again gross
capital formation, capital transfers and loans and advances are also sub-divided into more
significant categories as shown in the table.

iii. Programme Budgeting Classification. Under this classification, the budget would
frame a programme structure to attain a particular objective and specify spending to
attain it. We may think of all those expenditures allocated to the set of programmes
under a particular objective as belonging to a total spending agency which is
responsible for attainment of the objective. If, for example, the objective is poverty
removal, these expenditures would constitute the poverty removal programme. It is
important to note that since these expenditure agencies are inter-related, some

56
 programmes expenditure would draw support from a number of agencies. To explain
the anatomy of programme budgeting, let us take the following example.

In this way, there may be as many specific objectives as would be helpful in securing the
objective of purpose. A more detailed programme budgeting will break down each of these
programmes into what are known as programme elements. For example, 'Enrolment Incentive
Programme' may be broken down into such programme elements as (a) supply of school
uniform, (b) free tuition and free supply of books, (c) scholarship scheme and (d) mid-day
meal scheme. Such a programme element is considered as the smallest unit of analysis. A
fully developed system of programme budgeting requires expenditure to be allocated against
each of these programme elements.

57
 iv. Performance Budgeting Classification. The scientific treatment to budget making is
well demonstrated in the programme and performance budgeting. The approach is
essentially managerial in outlook. Burkhead defines performance budget as one which
presents the purposes and objectives for which funds are requested, the costs for
programmes proposed for achieving these objectives and quantitative data measuring
the accomplishments and work performance under each programme.

The difficulty of functional budget to detect whether the anticipated benefits from
expenditure is really materialized is overcome by the performance budget. Its main purpose is
to measure the benefits and to relate them to costs incurred. The targets to be achieved during
the budget period are set as objectives. Thus, a determination of attaining a specific amount
of benefit from a particular outlay inevitably takes into consideration some sort of cost-
benefit analysis on the basis of either past performance or comparative study of the relevant
market situation.

In the mixed economy of developing countries where a part of the budget is concerned with
planned development programmes and a time bound achievement of objectives is all the
more necessary, the role of performance budgeting is paramount. This classification also
helps to detect the pockets of inefficiency in administration as well as resource allocation so
that corrective steps may be designed to improve the efficiency level of administering and
executing the development programmes.

5.4 Budget as an Instrument of Economic Policy

Government budget is an important instrument of economic policy in both developed and
developing countries. In the developed countries, the economy operates at full employment
level and, hence, there does not exist unemployed resources. But the economy is subjected to
trade cycle and, therefore, occasionally faces the problems of depression or unemployment
and inflation or pressure of excess purchasing power. In the underdeveloped countries, the
economy operates at less than full employment level and, hence, the main problem is how to
attain economic growth. In these poor countries, growth process is faced with a number of
problems. They are allocational, distributional and stabilisational. Budget serves as an

58
important device to achieve economic development in these countries also. The following are
the important ways in which the government budget can influence the economy of a country.

1) Revenue Raising Device. The government requires enough revenue to discharge its
fiscal responsibility. Modern countries have increasingly become welfare states with
larger and larger state activities coming under the fold of public sector. Hence,
resources have to be found in sufficient quantity. Budget secures this purpose through
a financial plan. The receipts side of the budget clearly mentions the sources and the
extent of funds for the purpose of financing state activities.

2) Building of Economic Overheads. The main reason of underdevelopment, of the

poor countries is absence of proper economic infrastructure. Without proper transport
and communication system, large scale generation of electric power, establishment of
basic and key industries and proper training facilities for workers and entrepreneurs,
industrial development is not possible. Similarly, agricultural production and
productivity cannot improve in the absence of proper irrigation facilities, flood control
measures, technological improvement with research and development activities, etc.
These facilities must be provided by the government. The cost of supplying these
services is heavy and cannot be raised directly from the beneficiaries. Therefore, these
facilities are supplied free of direct charges through the budgetary provisions. Thus,
budget has a tremendous influence on the industrial and agricultural development.

3) Diversion of Resources to More Useful Production. Free market mechanism leads

to production of those goods which give maximum profit to private enterprises. Hence
private investment is generally concentrated on the production of luxury commodities.
It is, therefore, necessary to divert resources to the production of more useful goods
and services, particularly of the kind of mass consumption ones. This can be done by
government interference through the budget. Imposition of heavy tax on harmful and
less essential goods and tax exemption or tax concessions granted to more essential
goods and services can divert resources to the production of right kind of goods and
services. Grant of facilities through budgetary expenditure can also do the same job.

4) Proper Allocation of Resources. Most efficient allocation of resources is given by

the equality between marginal cost and price which is possible only under perfect

59
 market conditions. Underdeveloped countries seriously suffer from malallocation of
resources. The general market conditions in private sectors are set by existence of
monopoly, monopolistic competition and oligopoly. To correct this misallocation, the
government has to interfere either in the form of production subsidy or supply of
goods and services by public authorities so that the gap between average revenue (i.e.
price) and the marginal cost is reduced as far as possible. This is the reason why the
heavy investment public welfare industries which are subjected to decreasing cost
conditions are increasingly coming under the fold of public sector.

5) Balanced Development. Underdeveloped countries suffer from regional imbalance in

economic development. Left to the private sector which is motivated by profit
maximization, the industries will be located in the urban and already-developed areas.
The government can correct this geographical imbalance by setting up public sector
industries in backward areas. Moreover, the development of agriculture and small
scale and village industries can be secured through government patronage in the form
of supply of infrastructure facilities and various incentive or subsidy measures. This
will develop the economy of rural areas.

6) Income and Employment. Since underdeveloped countries are low income

economics, people live in poverty and, hence, saving and investment is very low.
Income of the people can be increased only through increased productivity and
production. Budgetary provisions can go a long way to achieve this. When
agricultural technology is improved through budgetary programmes, the income of
the people engaged in agriculture rises. People get gainful employment in the sector.
Improvement in small scale industries in the rural areas and setting up of public sector
industries in the backward regions will increase employment opportunities in these
industries. The budgetary provisions of employment-related tax concessions can
influence creation of employment opportunity in the private sector also.

7) Saving and Investment. In underdeveloped countries, the level of saving and

investment is very low. Moreover, without increased saving and investment,
economic growth cannot be achieved. Due to low level of income, marginal
propensity to consume is very high and, hence, the mass people cannot save. Public

60
 saving is, therefore, necessary. Taxation of various types serves this purpose. The
saving and investment of private individuals are also influenced by the savings-
investment-related tax concessions and other budgetary subsidy programmes.
Capacity and willingness to work, save and invest of the people is increased through
various human capital formation measures and creation of employment opportunities.
These are all done through budgetary expenditures.

8) Poverty Removal. Poverty removal programme is a part and parcel of the budget in
underdeveloped countries. All expenditure measures are designed in such a way that
they directly or indirectly influence reduction of poverty in the economy. Thus, when
budgetary resources are spent on account of education, whether general or technical
and vocational or on health measures, land reforms, flood control and irrigation, etc,
an important objective is to remove poverty of people. Direct budgetary programmes
for poverty removal are those of increasing employment opportunities and creation of
community assets like employment insurance, social security, consumption subsidy,
public distribution system and price support programmes, low-income housing, area
development, input supply, agricultural wage restructuring, etc.

9) Full Employment and Price Stability. An important function of the budget is to

secure the objective of full employment and price level stability. We have seen how
this should be done in the case of depression and inflation. When the economy, on the
other hand, suffers from neither inflation nor deflation, the budget is to maintain full
employment and prevailing prices through judicious programmes of public
expenditure and taxation. In this case, a balanced budget is helpful in developed
countries. In the underdeveloped economies where resources are not fully employed
public expenditure programmes and tax incentive measures are put into operation to
secure full employment.

10) A Check to Misuse of Public Funds. Since budget is a financial plan relating to
public revenues and public expenditures for the budgeted period, it imposes definite
restraints on the tax gatherer and public funds spender. The legislature and the people
know from the study of budget how the revenues will be raised and how will they be
spent. Revenue mobilization and public expenditure activities will be put to scrutiny

61
 of the legislature and also of the members of public. In case of inefficiency or misuse
in the task of budgetary performance, the executive agencies will be accountable. This
will definitely put a check on the improper use and mishandling of public funds.

Questions for Review and Discussion

1) Define Government Budgeting.
2) Account for the purposes of budgeting.
3) What are the features of a good budget?
4) The Government Budget is supposed to undergo through different stages of action.
List and explain each stage of action.
5) Account for the major distinctions between the classical and the modern theories of
budgeting. Which one do you think more realistic?
6) In the classical theory of budgeting it is stated that there are two views of the balanced
budget theory. Explain them.
7) The modern theory of budgeting, which is a counter measure against economic
fluctuations of business cycle, advocates flexible budget policy. Discuss what should
be the budget policy as the business cycle fluctuates.
8) Discuss the modern classification of budget.
9) Government budget has major roles to play as instrument of economic policy both in
advanced and developing countries. Discuss.

62
 CHAPTER SIX
PUBLIC DEBT
In this chapter we will cover five sections: 1) Nature and kinds of public debt. 2) Effects of
public debt. 3) Public debt in a developing economy.

Learning objectives
After studying this chapter, you should be able to
- Explain the objectives of public debt
- Explain the nature of public debt and the burden of public debt
- Discuss the effects of public debt on consumption, distribution, production and on
economic activities.
- Discuss the different methods of redemption of public debt and estimating debt
burden of a country.
- Explain the differences of taxation and pubic debt
- Explain the role of public debt in economic development

6.1 NATURE AND KINDS OF PUBLIC DEBT

Public debt is of recent growth and was unheard of prior to the 18th century. In modern
times, however, borrowing by the States has become a normal method of government
finance along with other sources such as taxes, fees, etc. The government may borrow
from banks, business houses, other organizations and individuals. Besides, it can
borrow within the country or from outside. The government loan is generally in the
form of bonds (or treasury bills if the loan is required for short periods) which are
promises of the government to pay to the holders of these bills the principal sum along
with interest at the stated rate. Borrowing is resorted to in order to provide funds for
financing a current deficit. This definition very clearly explains the three features of
public debt.
1) Public debt arises in the form of borrowings by the treasury or by the state
exchequer.

63
 2) The government borrows a certain amount now but promises to pay in the
future not only the principal amount but the interest also.
3) The government borrows when there is a budget deficit i.e. public expenditure
is more than revenue.

Classification of Public Debt

Public debt can be classified in different ways according to various factors like
sources of borrowing and purpose of loan.

1. Source of Borrowing (internal debt and external debt).

There are two sources of public debt, internal and external. Internal debt refers to
public loans floated within the country, while external debt refers to the obligations of
a country to foreign governments, or foreign nationals or international institutions.
Though external debt is becoming very common these days, there has been general
prejudice against foreign debt, based on ignorance and faulty economics.

2. Purpose of the loan (Productive and unproductive debt)

Public debt is said to be productive if the investment yields an income which will not
only meet the yearly interest payments of the debt but also help repay the principal
over the long run. All public debt can be said to be productive in another sense too.
The government may undertake certain projects through loans which may not be
productive in the sense given above but which may be really useful to the
community – for example, a railway line connecting a backward region, an
irrigation work to prevent famine conditions in an area, and so on. In this sense all
public debt is productive. But in many cases, public debt may be contracted during
war-time to finance war. Such debt is unproductive because it does not create an
asset; it is a dead-weight debt or a useless burden on the community.

3. Funded debt and unfunded or floating debt.

64
Broadly speaking, funded debt is a long-term debt, undertaken for creating a
permanent asset and the government normally makes arrangements about the
mode and the time of repayment. Unfunded and floating debt is a relatively short-
period debt meant to meet current needs. The government undertakes to pay off
the unfunded debt in a very short period, say, within six months. Treasury bills are
examples of unfunded debt. The rate of interest on unfunded debt is lower.

4. Time Duration of loan (short, medium, and long term loan).

According to time duration of the loan, public debt can be classified into short
term, medium term, and long term loans. Short term loan is usually incurred for a
period varying from three months to one year. Usually government gets such loans
from the central (national) banks by using treasury bills. These loans are also called
‘ways and means advances’. Such loans are obtained to overcome temporary
deficits in payment to be made by the government in the course of one year to pay
salaries etc.

Medium term loans are those which are obtained for more than one year but less
than ten years. Usually the governments borrow only long term loans for more
than ten years.

Why Public Debt is incurred?

(Causes of public debt)
Public loans in modern times are necessary to meet difficult situations. In the first
place, modern governments do not have any large accumulated balance or treasure to
meet a budget deficit. Normally, the annual expenditure of the government should be
and is met by annual income. But because of many circumstances the yield from
taxation and other sources may not be equal to the actual expenditure. Similarly, there
may be unplanned and unexpected emergency situations like major fires, floods and
famines. It may not be possible to secure funds through taxation. Short-term
borrowing in anticipation of tax collections in subsequent years is ordinarily used in
the above two circumstances.

Secondly, a factor which necessitates public loans is war. Modern warfare is so costly
that the normal income through taxation falls short of the actual war expenditure. A

65
public loan is a better and easier method of collecting revenue than taxation.
Governments, therefore, have to borrow extensively from individuals and institutions
towards war financing. In fact, the enormous increase in public debt in most countries
is due mainly to the First and Second World Wars.

Thirdly, public borrowing is considered very useful to remedy a depression. Business

depression and unemployment are generally due to deficiency of demand for goods
and services. Keynes advocated increased public expenditure financed through
borrowing and not through taxation. For, while taxation will reduce the incomes of the
public and their demand still further, borrowing will have no such effect. Besides,
loans enable the government to make use of idle and unutilized funds of the public.

Finally, public loans are resorted to for development purposes. Underdeveloped

countries interested in the development of their natural resources to the optimum level
find public borrowing a very useful device to finance the various development
projects.

Sources of Public Borrowing

Every government has two major sources of borrowing-internal and external.
Internally, the government can borrow from individuals, financial institutions,
commercial banks and the central bank. Externally, the government generally borrows
from individuals and banks, international institutions and other governments.

When individuals purchase government bonds, they are diverting fund from private
use to government use. More important than individual subscribers to government
bonds are the financial institutions such as insurance companies, investment trusts,
mutual savings banks, etc. These non-banking financial institutions prefer government
bonds because of the security provided by the latter and also due to their high
negotiability and liquidity. While individuals and non-banking financial institutions
take up government bonds out of their own funds, the commercial banks can do so by
creating additional purchasing power known as credit creation. The central bank of the

66
country can subscribe to government loans. By purchasing government bonds, the
central bank irradiates the account of the government. Borrowing from the central
bank is the most expansionary of all the sources, for not only the government secures
funds for its expenditure but the commercial banking system gets additional cash
which can be used as the basis for further credit expansion.

Government may borrow from other countries too to finance war expenditure or to
pay for development projects or to payoff adverse balance of payments. Two
important sources have become prominent. They are: (a) international financial
institutions, viz., the IMF and World Bank, which give loans for short term to payoff
temporary balance of payments difficulties and for long term for development
purposes; and (b) government assistance generally to assist in development projects.
For developing countries, external sources of borrowing are becoming considerably
important in recent years.

6.2 EFFECTS OF PUBLIC DEBT

We should clearly distinguish economic effects of public borrowing from economic
effects of public debt. Borrowing refers to the method of securing funds, and it is one
of the four alternatives available to the government-the other sources being taxation,
profits from State enterprises and money creation. The effects of borrowing, therefore,
relate to government expenditure financed through borrowing as different from the
effects of a similar programmed financed by taxation. On the other hand, the effects of
public debt refer to the effects on the economy which are caused by the existence of
public debt, after it had been incurred.

Public borrowing from individuals and firms has effects on all aspects of economic
life.
They may be considered as follows:
1. Effects on consumption. The effect of public debt on consumption depends
upon how it is financed by individuals. If they lend to the government out of
their idle savings, consumption is not affected. If they buy out of past savings it

67
 has only a limited impact on present expenditure. But if they lend by cutting
present savings, it may make them feel less secure and so they may reduce
consumption. But if the people feel that they have invested in government
securities which are considered safe investment, they may actually increase
their consumption.

2. Effects on Production and Investment. The effect of public debt on

production depends upon whether it affects private investment or not. If people
buy government bonds by selling their shares or debentures in private
individual firms, there is an adverse effect on private investment. But if the
money borrowed by the government is for productive purpose, over all
production is not affected. But if it is used for wasteful or non-productive
purpose, total investment is affected negatively.
If people buy government bonds by taking away their bank deposits, bank‟s lending
capacity is reduced and this again affects private investment. Private investment is not
affected only when it is financed by people out of their idle funds.

If the government uses the funds for productive purpose, it can repay it out of income
generated by these projects. But if pubic debt is used for unproductive purposes, it can
be repaid only by through additional taxation in future which affects future
consumption as well as production by reducing future disposable incomes. However,
if public debt is used for welfare schemes, it may increase people‟s efficiency to work
and thus improve productive capacity.

3. Effects on Distribution. Public debt is bound to have effects on distribution of

income because it involves transfer of purchasing power from one sector to
anther. Usually government bonds are purchased by the richer section. But the
burden of tax to repay the debt falls on all sections including the poor. To that
extent the inequality of income will increase. If the bondholder and taxpayers is
the same people, theoretically there will be no effect on redistribution of

68
 income. Hence redistribution of income effects of public debt depends upon
whether the taxpayers and the bond holders are the same people or not.

However if the public debt is used for public welfare programmes especially the poor,
inequalities of income deceases. But if public borrowing creates inflation, the
beneficial effects of redistribution will be neutralized as prices rise.

4. Effects on National Income. Public debt has an adverse effect on national

income only if private investment is adversely affected. However if
government expenditure is incurred on capital goods, it gives incentive to
greater production and this again increases the income. Government investment
financed by public debt will have a multiple effect on national income. If
public debt is financed by commercial banks and national banks, the credit
creation and the public expenditure from that will have a very large
expansionary effect on national income.

5. Effects on Resource Allocation. Unlike tax finance, public debt has little
effect on resource allocation. Public borrowing curtails business investment
activities but the decline of business investment varies from one industry to
another. Allocation of resources is not affected much.

6. Effects on Liquidity. Effect of public debt on liquidity is favorable because

the governments bonds are liquid assets which can be sold in the market
whenever the bondholders need money. So public debt increases the volume of
liquid assts in the country. Secondly the larger quantity of such liquid
government bonds can result the failure of monetary policy. For example, when
national bank tries to control inflation through monetary policy tools like bank
rate, the commercial banks can increase their cash reserves by selling
government bonds.

69
6.3 PUBLIC DEBT IN A DEVELOPING ECONOMY
Public borrowings may be for short and long periods but we are interested only in
longterm borrowings for purposes of investment. Since voluntary loans come from
voluntary savings, the scope for domestic borrowings will be limited. The reasons for
this are not far to seek: low income levels of the masses, very low savings of the
peasants and the middle classes, the perpetual attempt towards higher consumption,
etc. The small minority of the rich does save a considerable portion of their incomes,
but these savings are not generally available to the government. The only good source
for the government is the banking system and the financial institutions. But the
banking system is still undeveloped and the financial institutions are too few to be
significant.

Even though domestic borrowings may not be of much importance during the initial
years of economic development, its importance would grow as time passes. With
increased tempo of economic development incomes rise and savings also rise. The
government tries to stimulate savings through educative propaganda, tax concessions
and exemption, etc. Besides, the government promotes the setting up of a sound
banking system and a well organized money and capital market and a whole set of
financial institutions/financial intermediaries. These institutions help in the
mobilization of savings and make them available for investment.

Public Borrowings from Foreign Sources

A developing country borrows from three foreign sources: Foreign capital markets,
foreign governments and international institutions. In the past, governments generally
floated loans in foreign capital markets and expected the foreign nationals to subscribe
to them. But nowadays the demand for funds is so large and political and other
difficulties are so numerous against private foreign investment that prospects of
investment of funds by foreign nationals and institutional investors in government
securities seem to be not attractive. The government of a developing country can
lessen political and social unrest and economic instability by appropriate measures but
it would be difficult to convince foreign nationals and make them accept government

70
bonds as riskless. After all, the repayment of interest and principal over the long
period implies a high degree of risk and what guarantee can there be in the promises
of a government which may be overthrown by another in no time.

In recent years, advanced countries are taking great interest in the economic
development of underdeveloped and developing countries. Intergovernmental loans
are becoming very significant these days. Besides, international institutions, such as
the World Bank and the I.D.A, Asian Development Bank (ADB) etc., are important
sources from which developing countries draw for purposes of development. But these
institutions insist upon certain minimum conditions before granting loans and many
developing countries may not be able to fulfill them.

Conditions Necessary for Foreign Loans

Foreign loans enable a developing country to secure capital and technology which it
cannot get internally and which are so essential for economic development. But the
total burden of a foreign loan is higher than that of an internal loan of equal extent,
because the former involves also a transfer problem. Besides, debt redemption to
foreign countries means a corresponding exhaustion of national income and moreover
makes greater demand on the gold and foreign exchange treasures of the country. It is
essential therefore, that great care is taken in the matter of securing foreign loans. It is
but natural that certain internal conditions are fulfilled so as to justify foreign loans.
a) The foreign loan should be used to stimulate economic growth directly. This
will facilitate repayment later.
b) The foreign loans should be invested in such a way that the country secures a
favourable balance of trade in the future. This is necessary, as we have pointed
out earlier, because foreign loan involves a transfer problem, viz., the necessity
to transfer from the debtor country to the creditor country. This would further
necessitate the excess of exports over imports.
c) Foreign loans will be justified only if the productive resources of the country
are insufficient to bring about a planned pace of growth. This is so because the
gross burden of foreign borrowing is higher than that of domestic borrowing.

71
A backward country is not justified in borrowing from abroad unless internal sources
are inadequate and there could be proper use of loan proceeds. The existence of an
adverse balance of payments alone cannot be a sufficient reason for borrowing. It is
not really necessary that foreign loan should be used on projects which will increase
exports andv check imports and thus help in remedying adverse balance of payments.
What is required basically is the development of the total national product and not be
development of exports only. However, there may be circumstances under which even
a temporary adverse balance of payments may have serious adverse effects on
economic development. Foreign borrowing will be justified here, again, not to remedy
adverse balance of payment but to prevent internal disturbances.

Public Debt management

Public debt management refers to important policy decisions to be made with regard to public
debt. This is an important aspect of modern public finance as it is now accepted that public
debt is an active fiscal tool just like taxation and public expenditure, all of which have varied
effects on the economy. Hence the floating and repayment of debt should be carefully
planned. The forms of public debt, the terms of loan with regard to interest and duration, the
ownership pattern are all crucial issues in management of public debt. In short public debt
management is concerned with the policy decisions on the structural characteristics of public
debt.

Objective of public management

Public debt management can help the Government to achieve several goals. Important
objectives of public debt management in this respect are:
1. It should not have any adverse effect on the economy, especially on willingness and
ability to work and save
2. During inflation public debt management should aim at curtailing aggregate demand
3. During depression it should help to raise aggregate demand in order to improve
employment.
4. Public debt management can help to secure funds during War.
5. It should go hand in hand with monetary policy to strengthen the money market.

72
Principles of public debt management
Phillip E. Taylor points out that a general principle of public debt management should be to
get loans from the public without undue coercion or force. The raising of loans by the
government as well as its redemption should not interfere with the smooth functioning of the
economy. The government should not enter the loan market when it is not convenient to do
so. Accordingly following principles of Public Debt management can be stated.
1. Minimum interest cost. The first principle of public debt management is that the
government should keep the interest cost of the loan at the minimum. If the interest is
low, it will impose less burden of taxation at the time of redemption
2. Satisfaction of investor‟s needs. Public debt should be managed in such a way that the
needs of different types of investors should be satisfied with regard to the type of
securities as well as general terms. The terms of loan should attract the public to
invest in government securities.
3. Funding of short-term debt into long-term debt. Public debt management should
enable the Government to convert short-term loans into long-term loans. But such
funding operations should not harm economic stability because the conversion of
short-term loans into long-term loans will necessarily result in a rise in the interest
rates. This rise in interest rate on Government securities will affect the volume of
private investment. The low demand for short term securities will reduce their interest
rate and may even make such funds go out of the country.
4. Co-ordination of public debt policy with monetary and fiscal policy. Public debt
management should not clash with monetary or fiscal policy. The Government may
want to keep interest rates low. So it might advise the central bank to follow a cheap
money policy of low interest rates. This will encourage inflationary trends. Such a
problem can be avoided if there is a proper co-ordination of public debt policy with
monetary and fiscal policy.
5. Composition of public debt and maturity. If the public debt programme results in a
large proportion of short-term debt held by commercial banks, there will be a high
degree of liquidity in the market. This can generate inflation. If the holders of such
liquid assets try to monetise their debt obligations before maturity, controlling
inflation will be difficult.

73
An analysis of the objectives and principles of debt management makes it clear that debt
management is a subtle art. The basic requirement of an efficient public debt management is
that from the time of floating the debt to its redemption, the strains and friction are kept to the
minimum. Public debt has become an important instrument of fiscal policy and public debt
management should be coordinated with general economic policy to realize maximum social
advantage.

Short notes questions

1. Explain public debt? What is the difference between taxation and public borrowing?
2. Explain the differences between public debt and private debt.
3. Explain the importance of public debt in developing economy.
4. Explain the methods of estimating debt burden.
5. Does deficit finance always lead to inflation?
6. Discus the different methods of redemption of public debt.
7. Explain the effects of public debt on the economy of a country
8. Explain the nature of the burden of public debt.
9. Explain the various classification of public debt.
10. What are the objectives of public debt?

74
 CHAPTER SEVEN
DEFICIT FINANCING
In this chapter we will discuss four sections: 1) the meaning of deficit financing.
2) Objectives of deficit financing. 3) Effects of deficit financing. 4) Limits of deficit
financing.

Learning objectives
After discussing these sections, you should be able to
- Know the meaning and different methods of deficit financing.
- Discuss the objectives of deficit financing.
- Explain the effects of deficit financing.
- Explain deficit financing and capital formation
- Discuss deficit financing and economic growth.

7.1 MEANING OF DEFICIT FINANCING

Deficit financing has become an important tool of financing government expenditure. In
simple terms it means the way the gap between excess of government expenditure over its
receipts is financed. However the concept of deficit financing is interpreted in different ways
in the western countries.

In the western countries whenever the public expenditure is greater than its revenue receipts,
it is financed through public borrowing or creation of new money. Whenever there is deficit
in the current account, its financing becomes deficit financing. Even public borrowing is a
way of deficit financing.

In the modern sense public borrowings to finance excess of public expenditure over revenue
is included in the capital account of the budget. After including these borrowings in the
capital account, there may still be a deficit in the budget. The method adopted by the
government to finance this overall budget deficit in the current and capital account together is
known as deficit financing.

75
Thus budget deficit and deficit financing are two different concepts. Budget deficit is a
narrower concept, referring to excess of public expenditure over current revenues. Most
countries adopt a wider concept of deficit financing whereby any method adopted to bridge
the budget deficit even after borrowings, becomes deficit financing. Further in the narrower
concept, the budget deficit is managed through market borrowing out of public saving. So it
is non-inflationary. But in the broader sense of deficit financing, it refers to borrowing from
the banking system. Hence it is inflationary in character.

Different Methods of Deficit Financing

Governments can adopt three methods of deficit financing and the impact is different in each
case. Firstly governments can borrow from non-bank investors or commercial banks. This is
considered non-inflationary as it tends to replace private expenditure. For example when
government borrows from commercial banks, their liquidity is reduced so that it reduces
loans to the private sector. Thus the government borrowing from commercial banks replaces
private expenditure and hence it is non-inflationary. If the non bank investors get loans from
the commercial banks against their fixed deposits and use it to lend to government it would
be inflationary.

In the second case when the government draws from its cash balances with the central
(National) bank it is not inflationary. But in the third method when the government borrows
from the central bank against its securities, the central bank creates new money by resorting
to the printing press. This would again result in a secondary reaction of expansion of bank
credit. This type of deficit financing by loans from central bank tends to be highly
inflationary.

7.2 OBJECTIVES OF DEFICIT FINANCING

Deficit financing has been ascribed an important role in fiscal policy on account of increases
in public expenditure on various accounts. The different objectives of deficit financing make
it clear.
1. To finance wars. Deficit financing has been found to be the simplest and quickest
method to finance huge War expenditures. War time emergency makes it difficult for
government to raise urgent resources through its usual methods of taxation and public
borrowing. The funds obtained through deficit financing are used by the government

76
 to purchase goods and services to fight war. This raises the aggregate demand.
Resources are mobilized by the government not for productive purpose but for war
efforts which is unproductive.

Thus the rise in aggregate demand and non-availability of sufficient goods result in an
inflationary price rise. The experience of Germany during the two world wars is a classic
example of the harmful effects of Wartime inflation. During First World War, the German
paper Mark depreciated so much in value that one gold Mark could not be purchased by even
one billion papers Mark. Similarly during Second World War, the ratio of gold to paper
currency became as low as 0.01 per cent on account of deficit financing. However, wartime
emergency requires a quick mode of financing. Hence deficit financing cannot be avoided.
Precautions should be taken to control private demand.
2. To fight unemployment during depression. Keynes advocated deficit financing as an
important tool of solving the problem of involuntary unemployment during
depression. This unemployment during depression occurs due to lack of effective
demand since private spending is low. Therefore the only way to combat
unemployment would be for the government to invest in public works programmed to
create employment. Further during depression welfare payments to be made by the
government would also increase. Government cannot get finance for this expenditure
out of taxation or public borrowing as taxable capacity and ability to contribute to
government loans is very low during depression. Hence the government has to borrow
from the banking system. Thus deficit financing becomes the best mode of financing
anti-deflationary expenditure. Keynes suggested that the investment undertaken by the
government will result in a multiple increase in incomes via the multiplier effect.
However the operation of the multiplier may not be that successful in underdeveloped
countries as there is unutilized or idle capacity in both agricultural and industrial
sectors. Supply of working capital is also very low. On the other hand marginal
propensity to consume is very high. Thus Keynes' multiplier may actually raise the
aggregate demand instead of raising the aggregate supply. Hence deficit financing to
combat unemployment in underdeveloped countries requires great caution in handling
so that inflationary pressures are not generated.

3. To promote economic development. Deficit financing can go a long way in promoting

economic development in underdeveloped countries. There are two issues to be

77
 discussed here. First refers to the way in which deficit financing can be used to
finance development projects. Second whether deficit financing for development
results in inflationary potential. The major obstacle to development in these countries
is low rate of capital formation which is not enough for sufficient investment to
provide jobs for the large number of unemployed. With increasing population the
level of unemployment also increases necessitating greater capital formation. Low
incomes of people reduce the taxable capacity as well as ability to save. For the same
reason, government cannot raise resources through public borrowing too. Hence
deficit financing becomes the only way of mobilizing required resources, in
developing countries. Deficit financing can help to stimulate the rate of investment
indirectly.

Deficit financing for development first of all increases incomes and thus savings too. It
results indirectly in forced saving too because when the government purchases goods and
services for its projects, people do not get them. So the reduced private spending results
in larger saving.

If the government uses deficit financing to undertake productive projects then output would
increase and it may not be inflationary. But there are certain rigidities in the developing
countries which do not result in complementary factors for investment.

Firstly there is a lack of entrepreneurship and technical know-how. Secondly there is no

adequate infrastructure such as organizations, market communications etc. These market
imperfections fail to increase effective supply along with increasing demand and these causes
rising prices.
Further elasticity of supply is not the same in different sectors of the economy. For example
elasticity of supply tends to be low in agriculture than in industry. In the initial stages of
development if the government expenditure is directed towards these sectors whose elasticity
of supply is low, it is certain to increase incomes and demand in these sectors but lack of
supply response would raise prices. In all these cases, if deficit financing used for
development schemes results in inflationary price rise, the government should carefully raise
taxation to siphon off the excess purchasing power in the hands of the people.

78
Another way in which deficit financing can promote development is when it increases the
incomes of the entrepreneurs whose propensity to save is high. In fact this may result in
greater inequality of income. But in the initial stages, higher propensity to save of the
entrepreurial class is a welcome feature in the interest of general economic development. This
fits into the theory of imbalanced growth given by A.O. Hirshman.

In general it is accepted now that so long as care is taken to avoid inflationary potential,
deficit financing is a very useful instrument of development in developing countries.

Deficit financing should preferably be used for quick yielding projects in the initial stages so
that the increase in production will control inflationary pressure. If development projects
have long gestation period, deficit financing for such projects would bring in inflationary
price rise. Hence in developing countries deficit financing should be carefully used in the
initial stages to lay a good foundation for necessary infrastructure for development.

4. To mobilize surplus, idle and unutilized resources. Keynes had advocated deficit financing
for the mobilization of surplus labour and other resources during depression. This argument
may be applicable to underdeveloped countries only with limitations. If deficit financing is
used to employ such labour in the agricultural sector in these countries, it may
create inflationary price rise.

On the other hand deficit financing is recommended for its ability to create new resources in
these countries. When deficit financing raises prices in these countries, it reduces
consumption and savings become forced. Thus deficit financing is recommended in
developing countries for the mobilization of forced savings or for the creation of new
resources, which again can be used for next stage of development. That is why W. A. Lewis
said that "Inflation for the purpose of capital formation is in due course selfdestructive".

5. To finance the Plans. In developing countries which have adopted planned economic
development huge resources are required for implementation of government investment. The
government takes greater interest to create infrastructure, industrial development in vital
sector besides transport and communication. Deficit financing is a. useful tool to finance the
Plans.

79
6. To serve as an alternative tool. Underdeveloped countries suffer from low taxable capacity
and low savings. Hence government's ability to raise resources gets constrained. Therefore
there is no harm in resorting to deficit financing as an alternative source of mobilizing
resources besides taxation and public borrowing.

7.3 EFFECTS OF DEFICIT FINANCING

Deficit financing can make or mar progress if it is not carefully planned. It has diverse effects
depending upon how it is handled. The major effects pertain to inflation and distribution of
income.
1. Deficit financing and inflation. There are two views regarding the impact of deficit,
financing on prices. The first view is that deficit financing is pro inflationary. This view holds
that the first impact of deficit financing is on the creation of new money. Deficit financing is
recommended for the creation of capital goods whose gestation period is long. There is
increase in money incomes in this sector. But consumer goods producing sector does not
respond quickly to bring more production. This results in rise in prices of consumer goods
which may prove to be spiraling. The price rise will be greater if market imperfections exist
as bottlenecks to increased production.

Further, a part of the increased incomes, in the absence of sufficient goods to spend, may be
channelized into commercial banks who may use it for further credit creation. In fact in
developing countries the inflationary pressures are due to monetary expansion after deficit
financing. Inflation then tends to be demand-pull type while deficit financing in developed
countries causes cost-push type of inflation on account of long-term gestation projects.

The poor developing countries are not well equipped in terms of monetary and fiscal policy
to control inflation. Hence there is a possibility that unabated inflation on account of deficit
financing may hinder economic development of these countries.

The second view holds that deficit financing is not necessarily inflationary because public
sector has emerged as a dominant sector in these economies. If this additional finance is
utilized for productive purposes, it need not be inflationary. Deficit financing is required to
provide finance for increasing output at stable prices. If deficit financing is not resorted to
there may be a decline in prices which will have an adverse effect on output and employment.

80
W. A. Lewis points out that there are three stages in the impact of deficit financing. In the
first stage, only capital goods industries are created through deficit financing and as they have
long gestation, prices rise steeply. In the second stage, the rise" in prices makes people reduce
consumption which results in forced savings which increases investment. In the third stage,
the capital formation of the first stage begins to bring consumer goods to the market which
helps to lower prices. Therefore deficit financing is 'dangerous and painful' only in the first
stage. In Lewis' view inflationary potential of deficit financing is therefore self-destructive.
Others however point out that if the consumer goods are not increased in the second and third
stages due to some constraints, inflation becomes rampant.

2. Effect on distribution of income. Deficit financing has certain undesirable effects on the
distribution of income. Deficit financing provides incentives to entrepreneurs through larger
profits on account of rising prices. But the same rising prices reduce real incomes of the wage
earning class. This leads to a distribution of income in favour of the profit earning classes.
Hence inequality of incomes widens. This is very much against the social objectives of
equitable distribution of income and wealth.

Thus an analysis of the objectives and effects of deficit financing proves that it is a
doubleedged sword. Its effects can be good so far as it promotes capital formation and does
not allow for a steep increase in prices. Its effects can be harmful if the inflationary potential
goes uncontrolled, bringing about adverse effects on distribution of incomes and wealth, thus
increasing inequality. The exact impact of deficit financing depends upon the mode of deficit,
governments' attitudes and policies, reaction of the private sector and growth of the public
sector.

Deficit financing can be a very useful and effective fiscal tool for development in under
developed countries if it is used only for capital formation to channelise resources into
productive areas. The mild price rise on account of deficit financing in the early stages acts as
an incentive to entrepreneurs to increase productive activity. Such a functional rise in prices
is harmless.

81
7.4 LIMITS TO DEFICIT FINANCING
It is now recognized that deficit financing is a bad master but can be a good servant i.e., it
should be handled carefully without using it excessively. This raises the question as to what is
the safe limit for deficit financing. Several factors are to be considered in determining the
safe limit.

1. Growth rate of the economy and money supply. The money supply should expand to
facilitate the growth rate of the economy. Suppose the total money supply in the economy is
4,000 million Birr and the growth rate of the economy is 5 per cent, it requires an additional
money supply Birr. 200 billions per annum to sustain the growth rate. Hence deficit financing
can be used to create Birr 200 billions per annum. But since it is used for productive assets
creation, deficit financing can be even more than 5 per cent of the money supply. Thus even 7
or 8 per cent expansion in money supply on account of deficit financing need not be
inflationary in developing countries.

2. The efforts made by the government to mobilize its resources. Deficit financing should
be used only as a last resort after all alternative source of finances are exhausted. The public
will not mind the effects of deficit financing when they know that the government ha
undertaken all efforts to mobilize other resources and only when they are exhausted, deficit
financing is adopted.
3. Control of incomes and prices. Deficit financing to finance government projects enters
the income stream in the form of wages and salaries. It is this increasing incomes and wages
which exert an inflationary pressure. Hence a proper control over income and prices acts as a
control over the inflationary potential of deficit financing.

4. The growth of monetized sector. It is the existence of a large non-monetised sector which
aggravates the inflationary potential of deficit financing. The extent to which the non-
monetized sector is brought into the ambit of monetized sector, acts as a safe limit to deficit
financing.

5. Increase in the production of public sector. Deficit financing is incurred to finance

public sector projects. If their production increases, this increase in production will cushion

82
the inflationary potential of deficit financing. It is for the same reason deficit financing
should not be incurred for unproductive purposes.

6. Promotion of imports. Deficit financing is bound to increase incomes in the initial stages
which causes and increase in demand for goods and services. Since production does not
increase immediately in the early stages, the inflationary pressures can be kept within safe
limits by permitting import of goods. This of course depends upon the foreign exchange
reserves to the country.

7. Restriction on credit A large portion of new money created through deficit financing may
reach the banking sector in which case it gives them an opportunity to create credit further.
Restriction on credit can limit inflationary pressures.

8. Direct and indirect control. Government should adopt various measures to control prices
directly and indirectly. Direct control refers to the control of prices beyond the stipulated
levels. It is a type of administered prices. Indirect controls result in government's improving
the public distribution system to supply goods to the people at reasonable prices.

9. Public spirit of cooperation and toleration. Some economists point out that "The role of
public understanding and public cooperation is a factor in tending to diminish the price effect
of deficit financing". Unless the government enjoys the public cooperation, it will have to
face open, popular and political opposition to further use of deficit financing when the prices
rise excessively. The spirit of tolerance on the part of public acts a limit on government's use
of deficit financing.

In the final analysis the state of the economy, the purpose for which deficit financing is
incurred, the control over money expansion, prices and incomes, the magnitude of the deficit
financing, are all factors /which, limit the government's powers to resort to deficit financing
excessively.

83
Short Note Questions
1. Discuss the objectives of deficit financing
2. Explain the effects of deficit financing.
3. Why deficit financing is the feature of developing countries?
4. Distinguish between deficit budgeting and deficit financing
5. Does deficit financing help developing countries? Explain.
6. Does deficit financing necessarily lead to inflation?
7. Express your view on the limits of deficit financing.

84