Vaghela Nayan kSDJ International College

Public Finance

Meaning of public finance• The study of public finance as a branch of economics has come to occupy a

very important place in economic literature since last nine decades.• Up to the end of 19th centaury, general view held by the economists was

that the main function of the State were to defend the country against foreign aggression and to maintain law and order at home.

• The state was not supposed to interfere in the economic activities of the people relating tp production, exchange, distribution, etc. these were to be left to the private sector and private enterprise.

• This concept of state prevalent at that time was known as the Police State.• But in recent years, things have changed substantially. Modern state is no

longer police state, instead the concept of Welfare State has came to accepted by government all over the world.

• Apart from defense and internal security, the government in modern time initiates a number of measures for economic and social development of the country.

Definitions:

1. Findlay Shirras: ‘Public finance is the study of the principles underlying the spending and raising of funds by public authorities.’

2. Dalton: ‘Public Finance is one of those subjects which lie on the border line between economics and politics. It is concerned with the income and expenditure of the public authorities and with the adjustment of one to the another.’

3. Prof. R.A. Musgrave: ‘The allocative, redistributive and stabilizing function of the state and therefore of the public finance.

• In a way public finance is a study of how the government raises its revenue and how it spends that revenue.

• The concept of public finance is broadly divided into four parts:1. Public Revenue 2. Public Expenditure 3. Public Debt and4. Financial Administration

Difference between Public Finance and Private FinanceSr. No. Public Finance Private Finance

1. Public finance is macro economic problem. Private finance is micro economic problem.

2. The motive is to satisfy collective wants of the people. (public welfare)

The motive is to satisfy personal wants.

3. The public income is generally adjusted to the public expenditure.

An individual adjusts his expenditure on the basis of his income.

4. Public finance is more elastic as compared to private finance, as government can make big and drastic fluctuations in its budget.

For an individual big and deliberate changes in his income and expenditure are not so easy. He can not have frequent and large changes in his income and expenditure.

5. Public finance also take into consideration the future aspects, as its existence is probably forever. (for future generation too)

An individual is more guided by the present benefits that he is about to acquire.

6. Public finance frames a deficit budget in time of war, depression or during the process of economic development.

An individual generally arranges a surplus budget. (high income and lower expenditure.)

7. Public finance uses public money for public welfare and therefore cannot be kept secret.

The individual financial transactions are his own affair and can be kept secret.

Principle of Maximum Social Advantage• Prof. Huge Dalton occupies an important place in the science of public finance.• Pigou has named this as Principle of Total Social Welfare while other writers call

it as Principle of Public Finance.• According to Dalton, A best system of Public Finance is that which secures

maximum social advantage to public. The fiscal operations of the state should be governed by the principle of maximum social advantage, and so the planner and the policy maker should always bear this principle in mind while raising revenue through taxation and incurring expenditure on different heads.

• The government levies tax on some sections of the society and on the other hand it spends that revenue in providing amenities to other section of the community.

• Therefore, there can be two sections of the society, one who pays tax and another who gains from public expenditure.

• It should be noted here that, the community who pays tax, is sacrificing a part of their disposable income by each increased unit of the tax levied in them and the benefits to the gaining community increases with each increased unit of public expenditure.

• Now, the principle of maximum social advantage requires that the revenue and expenditure of the State should be so managed that maximum net advantage occurs to the society taking into account the social sacrifice involve in taxation and the social benefit flowing from public expenditure.

• The state of maximum social advantage is the level of fiscal operation at which the marginal social sacrifice and the marginal social benefit both are equal.

• If the state proceed beyond this point, the marginal social sacrifice will be more than the marginal social benefit , and so there will be loss of social welfare.

• When government continuously increases the tax on the community, the money stock with the public decreases and so the marginal utility of money will increase. People will now be keen to have liquid cash with them.

• On the other hand continues flow of public welfare will reduce the marginal utility available from such expenditures.

• This can be easily illustrated with the help of a schedule and a diagram:

Units of money taxes and public expenditure

Marginal social sacrifice Marginal social benefit

1 7 43

2 10 38

3 14 33

4 19 28

5 25 25

6 32 20

7 40 15

• It will be clear from the above table and diagram that as the government imposes additional taxes to raise revenue , the marginal social sacrifice increases at a rapid rate due to increasing disutility.

• On the other hand, as the government spends more and more money, the marginal social benefit derived by the members of the society diminishes due to diminishing marginal utility.

• In the above diagram the MSS and MSB are taken on OY axis while TAX and PUBLIC EXPENDITURE are taken on OX axis.

• The diagram shows the point of combination where the marginal social sacrifice of the society and marginal social benefit is equal at point P where taxation and expenditure is at point T.

• Any point before T will keep an idle capacity to gain social advantage and any point after T will lead to higher amount of social sacrifice.

• Limitations of the principle of Maximum Social Advantage:1. It is difficult to measure marginal social sacrifice and marginal social benefit

arriving from taxation and public expenditure.2. Certain taxes are in fact increases the net benefit to the society rather to add in

the amount of social sacrifice. E.g. taxes on intoxicants and injurious drugs.3. In some cases, public expenditure may lead to burden instead of benefits, e.g.

expenditure on war and servicing of war debts.4. As the entire public expenditure is not financed by taxation, a part of it is

furnished by borrowings which involves little sacrifice as the government repays the loans with interest.

5. Most of the modern governments have adopted the principle of functional finance, in which there will be surplus financing during prosperity and deficit financing during depression. This certainly does not permit any such consideration like equalization of marginal social welfare and marginal social sacrifice.

Public Revenue• Meaning:• Public revenue means revenue of the government and other public bodies. The

common methods of raising public revenue are:1. Taxes 2. Fees 3. Fines and penalties 4. Price5. Special Assessment 6. Gifts and grants, etc.• In general the main source of public revenue is taxation and therefore we must

derive a meaning of tax.• Tax is a compulsory payment made to the State by almost every citizen of the

country: non –payment of tax is a punishable offence.• It is payment for meeting certain expenses incurred by State for conferring

common benefits to the society; it is a contribution for the general or common use and not for any specific purpose or individual benefit.

Canons of Taxation/ Characteristics of a good Tax System:

1. Canon of Equality: every fiscal economist is of the opinion that taxation must ensure justice. The canon of equality or equity implies that the burden of taxation must be distributed equally or equitably in relation to the ability of tax payers. Social justice demands that the rich people should bear heavier burden of tax and poor a lessor burden. Progressive taxation is best suited to this canon.

2. Canon of Certainty: Taxation must have an element of certainty. ‘The tax which each individual is bound to pay ought to be certain and not arbitrary. The time of payment, manner of payment, amount to be paid ought be clear and plain to contributor and to every other person.’ there must be certainty in the aspects like; who will bear the tax?, period and amount of tax, how must to collect from tax?.

3. Canon of Convenience: Tax must be collected in a convenient manner from the tax payer. ‘Every tax ought to be levied at the time or in a manner in which is most likely to be convenient for the contributor to pay it.’ as TDS is being deducted at the time of salary from source only.

4. Canon of Economy: This canon suggests that the cost of collecting tax must be minimum. An extravagant tax collection machinery is not justified. ‘Every tax has to be contrived as both to take and keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state.’ The cost of collection of tax must not be very high

5. Canon of Elasticity: Taxation should be elastic in nature in the sense that more revenue is automatically fetched when income of the people rises. This means that taxation must have built-in flexibility.

6. Canon of Productivity: This implies that a tax must yield sufficient revenue and not adversely affect production in the economy.

7. Canon of Simplicity: Tax rules and tax system ought to be simple and comprehensible and not to be complex and beyond the understanding of the tax payer. This is what is rarely found in Indian Tax Structure.

8. Canon of Diversity: Canon of diversity implies that there should be a multiple tax system of diverse nature rather than having a single tax system. In the former case, the tax payer will not be burdened with a high incidence of tax in the aggregate.

Types of Tax

• Indian tax system have adopted three different bases for the collection of tax from the people. These are:

A. Based on rate of tax.1. Proportional tax2. Progressive tax3. Regressive tax4. Digressive tax

B. Specific and Ad valorem TaxC. Direct and Indirect Tax.• We shall discuss each head in detail now.

A. Based on Rate of Tax:

1. Proportional Tax: Tax in which the rate of tax remains constant, though the tax base changes, are called proportional tax. Here the tax base may be income, money, value of property, wealth or goods, etc. income is however regarded as main tax base, because it is the determinant of taxable capacity of the person.

In proportional tax system, tax vary in direct proportion to the change in income. If income is doubled the tax amount will also doubled. It is a constant proportion of rising income2. Progressive Tax: Taxes in which the rate of tax increases are called progressive

taxes. In this system the amount of tax paid will increase at a higher rate than increase in tax base or income, for the taxation amount is the product of multiplying the base by tax rate and both increases in progressive tax. As income increases and tax rate on base also increases, the tax payer with higher base will have to bear more burden of tax.

3. Regressive Tax: When the rate of tax decrease as the tax base increases, the taxes are called regressive taxes.

4. Digressive Tax: Taxes which are mildly progressive, hence not very steep, so that high income earners do not make a due sacrifice on the basis of equity, are called digressive. In digressive taxation, a tax may be progressive up to a certain limit; after that it may be charged at a flat rate.

• Now the question arises that which amongst these four system is good? On the basis of the merits of these systems we can decide upon the same.

• Merits of Proportional Tax:1. It leaves the tax payer in the same relative economic status.2. It is simple to calculate and administer. It is very convenient to estimate.3. Proportional taxation is not as repugnant to tax payers as progressive tax.4. The effect on willingness to work hard and save is not adverse in the case of

proportional tax.

• Merits of Progressive Tax:1. It is more equitable, as a larger part is taxed on higher incomes . It is justifiable just

as the law of diminishing marginal utility operates in the case on money. Disutility of paying high tax by rich is not as much as that of poor in paying even a low tax.

2. Progressive tax can be justified on the ground that higher incomes contain surpluses, which have cent percent capacity to bear tax. It complies with the canon of capacity.

3. Progressive taxes are more economical, as the cost of collection does not rise when the rate of tax increases.

4. Progressive tax has greater revenue productivity than proportional tax..5. The progressive tax system also complies with the canon of elasticity. For a rise in

income is automatically taxed under the system so that revenue increases with economic expansion.

6. Progressive taxes are an engine of social improvement. The strong should assist the weak and should aid the poor. This social morale is well sustained by progressive taxes.

7. Progressive taxation can lead to a better distribution of income and wealth, hence an increase in general welfare of the community. According to Kaldor, the desire to reduce economic inequalities can be regarded as a justification for adopting a highly progressive tax system.

B. Specific and Ad valorem Tax: According to the method od assessment, tax on commodities may be classified into two types – Specific and Ad valorem.• Taxes which are based on specific qualities or attributes of goods are called specific

taxes. Specific taxes are generally assessed on the weight, number or volume of the commodity, e.g. specific excise duties may be levied on cloth as so many paise (say 10 paisa) per meter.

• Taxes which are levied entirely on the basis of money value of the goods are called ad valorem taxes, e.g. sales tax on commodity may be levied as some percent (say 3 percent) on its selling price.

• Specific taxes are easy to calculate and to administer. On the other hand, ad valorem taxes are difficult to administer and collect as they involve the assessment of value of goods. The price of every grade of article is to be verified before the levy of tax.

• But ad valorem taxes are more equitable in incidence, as they are based upon the value of the article so that the canon of ability to pay is fulfilled.

• Specific taxes are regressive in character that when same specific tax is levied on different qualities of goods, a relatively higher burden falls upon low quality cheap goods which are generally consumed by the poor.

• Thus, on equity point of view, ad valorem taxes are preferred to specific taxes.

C. Direct and indirect taxes:• Economists usually classifies taxes into (i) direct taxes and (ii) indirect taxes.• According to Dalton a direct tax is really a tax paid by a person on whom it is legally

imposed and the burden of which cannot be shifted to any other person is called direct tax.

• “One which is demanded from the very person who, it is intended or desired, should pay it” the person from whom it is collected cannot shift its burden to any body else.

• Thus impact , i.e. the initial or first burden, and incidence, the ultimate burden of a tax – is on the same person. The tax payer is the tax bearer, e.g. Income Tax is a direct tax.

• Indirect tax is a tax the burden of which can be shifted to others. The impact and incidence of indirect tax are on different persons.

• An indirect tax is levied on an collected from a person who manages to pass it on to some other person or persons on whom the real burden of tax falls. Tax payer is not the tax bearer.

• Commodity taxes are generally indirect taxes as they are imposed on the producers or sellers, but their incidence falls upon consumers as such taxes are wrapped up in the prices.

• Merits of Direct tax:1. Equity: direct taxes like income tax, wealth tax, etc. are based on principle of ability to

pay. So the equity or justice in allocation of tax burden is well secured by these taxes.2. Progressive: usually direct taxation is progressive in effect. Since direct taxes can be

designed with fine gradation and progressiveness, they can serve as an important fiscal weapon of reducing the gap of inequalities in income and wealth. Direct taxes thus lead to the objective of social equality.

3. Productive: Direct taxes are elastic and productive. Revenue from direct taxes increase or decreases automatically with the change in the national income or wealth of the country.

4. Certainty: the canon of certainty is perfectly embodied in direct taxation. Compared to indirect taxes direct taxes are more exact and precise in estimating the revenue. Further, in direct taxes, the tax payer knows how much he has to pay and the state can estimate the yields correctly.

5. Economy: The canon of economy is well maintained in direct taxation. Direct taxes like income tax is being collected annually in lump sum, the administrative cost of such collection will be minimum as compared to the indirect taxes like sales tax, excise duties, etc. which are collected at short intervals and which involve a high cost of collection.

6. Educative: Direct taxes have an educative value as they create a civic sense among the tax payers. Citizens realize their duty to pay taxes and because of the direct burden of taxes they become conscious and keep vigil on how the public income is spent by the government in a democratic country.

7. Anti-Inflationary: Direct taxation can serve as a good instrument of anti-inflationary fiscal policy designed to maintain the price at stable level. The excessive purchasing power during inflation can be mopped up from the community through increased direct taxes.

• Demerits of Direct Taxation:1. Pinching: Since direct taxes are to be paid in a lump sum they pinch the tax payer more.

Thus the announcement effect of a direct tax always tends to cause resentment among the tax payers.

2. Inconvenient: Direct taxes do not conform to the canon of convenient as returns of income ta, wealth tax, etc. are to be filed in time and complete records are to be maintained up to date by each individual tax payer. It is very inconvenient to pay these taxes as they are collected in lump sum.

3. Evasion and Corruption: since the assessment of direct taxes depend upon the voluntary declaration of the tax payer about his income, wealth, etc. there is great scope of tax evasion bay concealing real income. In direct taxation, honesty is taxed and dishonesty is rewarded. This leads to corruption also.

4. Uneconomical: direct taxes are not so economical as they are claimed to be. They are uneconomical when the tax base is narrow. Each and every assesse needs to be contacted individually and requires huge amount of money.

5. Narrow Based: direct taxes are generally narrow based; therefore a large section of masses remains untouched and to that extent, they fail to achieve their objective of promoting civic sense among the citizens. Especially the poor section of the community remains untouched under direct taxes.

6. Arbitrary: the nature and base of direct taxes are arbitrarily decided by exchequer. The Finance Minister uses his own value judgments in determining the taxation potential of the tax payer. There is no scientific formula or base for evolving the mode of gradation and progression on direct taxes.

7. Disincentiveness: direct taxes being based on economic and wealth, if they are excessive may discharge savings and kill the intencive to work hard.

• Merits of Indirect tax:1. Convenient: Indirect taxes are more convenient to pay. These taxes generally being

on commodities, are wrapped up in prices, hence the tax payer does not feel the burden directly.

2. Less Pinching: the announcement effect of indirect taxes does not provoke resentment, because they cause less annoyance to the public as they are not felt directly. The main merit of an indirect tax is that it is always disguised and it pinches the tax payer less as he is kept in the dark about how much tax he has paid on his total purchases.

3. Not easily Evadable: indirect taxes are difficult to evade as they are usually merged with prices.

4. Broad based: Indirect taxes usually being commodity taxes has a broader scope than direct taxation. The low income strata of society which are exempt form direct tax can be easily caught in the net of taxation through indirect taxes to undergo the sacrifice according to their ability to pay. It can be said as a balancing factor in the equity of the taxation.

5. Social Value: indirect taxes have a high social value. They can serve to improve social morale and public health by discouraging consumption of such harmful commodities as intoxicants and tobacco.

6. Forced Saving: Indirect taxes are an effective means of mopping up consumer’s surplus and thereby diverting the saving potential of the community at large into the hands of the government, which can be utilized fruitfully in expediting the process of capital formation in the country.

7. Complementary: Additional revenue can be easily obtained by introducing an indirect tax rather than a direct tax, without revealing its real burden to the public. Indirect taxes in fact can serve as complementary to direct taxes. If a person escapes from direct taxation, he will be caught in the net of indirect taxation.

8. Progressive: Indirect taxes on luxuries and semi-luxuries are progressive in effect as they fall on rich people’s consumption outlays.

• Demerits of Indirect Taxation:1. Inequality: Indirect taxes are unjust and inequitable as they are regressive in effect.

Since they are charged at a proportional rate on commodities of general consumption, their burden falls more heavily upon the poor section of the society. They are not levied according to the principle of ability to pay.

2. Less Productive: Indirect taxes do not conform to the canons of the economy and productivity, as these taxes involve many stages, the cost of collection is usually high in relation to the revenue yielded. Further, an indirect taxes is not as productive as a direct tax.

3. Inflationary Potentiality: Indirect taxes prove to be inflationary when excessively relied upon. They sometimes benefit more the traders than the government when prices tend to go up by more than the amount of the tax.

4. Disincentive Effect on Saving: Indirect taxes discourage savings when the people have to spend more with a rise in the prices of commodities.

5. No Educative Value: Indirect taxes being invisible, and as they are collected through middlemen like traders, they have no direct link between the tax payers and the government; hence, they do not promote any civic sense.

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