M.A.

ECONOMICS
SEMESTER - II

PUBLIC ECONOMICS
SUBJECT CODE : 93307
 © UNIVERSITY OF MUMBAI
Prof. Suhas Pednekar
Vice Chancellor
University of Mumbai, Mumbai.

Prof. Ravindra D. Kulkarni Prof. Prakash Mahanwar

Pro Vice-Chancellor, Director
University of Mumbai. IDOL, University of Mumbai.

Programe Co-ordinator : Ms. Rajashri Pandit

Asst. Prof-Cum Asst.-Director , IDOL
University of Mumbai , Mumbai – 400098.

Course Co-ordinator : Dr. Gopal Eknath Ghumatkar

Assistant Professor of Economics
IDOL, University of Mumbai, Mumbai – 400098.

Course Writers : Dr. Suresh Eknath Ghumatkar

Assistant Professor & Head,
Dept. of Economics, Arts, Science & Commerce
Balbhim College,
Beed, Maharashtra – 431122
: Dr. Jyotsana S. Lal
Assistant Professor, Dept. of Economics,
M. M. P. Shah Women’s College of Arts and
Commerce (Autonomous), Matunga.
: Mr. Anil Zende
Assistant Professor, Dept. of Economics,
Karmaveer Bhaurao Patil College,
Vashi, Navi Mumbai.

November 2021, Print I

Published by : Director
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Mumbai University Press
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 CONTENTS
Chapter No. Title Page No

MODULE I
1. Government in a Market Economy– I 1-12
2. Government in a Market Economy– II 13-29

MODULE II
3. Provision of Public Goods 31-41
4. Evaluation of Public Expenditure 42-56

MODULE III
5. Basic Concepts of Tax and Tax Theory 57-70
6. Taxation and Implications 71-91

MODULE IV
7. Reforms and Government – I 93-103
8. Reforms and Government – II 104-119

*****
 M.A. Economics
Semester II
Public Economics
credits : 06

Module I: Government in a Market Economy:

Theorems of Welfare Economics: lmplications, Lump Sum Taxes and TransfersRationale for
State lntervention:Market Failures and Externalities, Tax and Regulation, Distribution, Social
Choice, Voting Rules, Arrow Impossibility Theorem

Module 2: Public Expenditure: Rationale and Evaluation: (l2 Hours)

Public Goods: Pure and Local, Optimal provision, Lindahl's Voluntary Exchange Approach,
Preference Revelation Mechanism, Private Provision of Public Goods, Merit Goods,Club Goods
Evaluation of Government Expenditure: Elements ofCost-Benefit Analysis.

Module 3: Taxation:
Basic Concepts of Tax Theory: Direct vs. Indirect Taxes, Ability to Pay, Horizontal and Vertical
Equity. Commodity Taxation: Tax Rules, Optimal Commodity Taxation, Public Sector Pricing Income
Taxation: Equity and Efficiency, Taxation andLabour Supply, Optimal Income Taxation (linear and
non-linear). Tax Evasion: Basic Model, Auditing and Punishment.

Module 4: Reforms and Government:

Fiscal Rules: Rationale, International and Indian Experience. Decentralisation: Decentralisation Theo-
rem. India’s Federal Structure: Taxation powers, Expenditure responsibilities, Intergovernmental trans-
fers, VAT, GST.

References
 Atkinson A.B. and J.E. Stiglitz: Lectures on Public Economics, New York: McGraw-Hill,1980.
 Cullis J. and P. Jones: Public Finance and Public Choice, OUP, 1998.
 Hindriks J. and Gareth D. Myles : Intermediate Public Economics, MIT Press, 2006.
 Myles G.: Public Economics, Cambridge University Press, 1995.
 Oates W.: Fiscal Federalism, Harcourt, Brace Jovanovich, 1972.
 Purohit M.: Value Added Tax, Gayatri Publications.
 Tresch R.: Public Finance: A Nonnative Theory, Academic Press, 1995.

*****
 MODULE I

1
GOVERNMENT IN A MARKET
ECONOMY - I
Unit Structure
1.0 Objectives
1.1 Introduction
1.2 Theorems of Welfare Economics
1.3 Lumpsum Taxes and Transfer
1.4 Summary
1.5 Questions

1.0 OBJECTIVES

After studying this module, we will come to know how important is

government‘s intervention in market economy, also we will come to know
what are the means government have to intervene in economy. Also, its
impact on economy. Further this module will put light on following
points, that is Market failure, Taxes, redistribution, social choice voting
rules arrows impossibility theorem.

1.1 INTRODUCTION

The study of public economics has a long tradition. It developed out of the
original political economy of John Stuart Mill and David Ricardo, through
the public finance tradition of tax analysis into public economics, and has
now returned to its roots with the development of the new political
economy. From the inception of economics as a scientific discipline,
public economics has always been one of its core branches. The
explanation for why it has always been so central is the foundation that it
provides for practical policy analysis. This has always been the motivation
of public economists, even if the issues studied and the analytical methods
employed have evolved over time.

In the broadest interpretation, public economics is the study of economic

efficiency, distribution, and government economic policy. The subject
encompasses topics as diverse as responses to market failure due to the
existence of externalities, the motives for tax evasion, and the explanation
of bureaucratic decision-making. In order to reach into all of these areas,
public economics has developed from its initial narrow focus on the
1
collection and spending of government revenues to its present concern
with every aspect of government interaction with the economy.

Public economics attempts to understand both how the government makes

decisions and what decisions it should make. To understand how the
government makes decisions, it is necessary to investigate the motives of
the decision makers within government, how the decision makers are
chosen, and how they are influenced by outside forces. Determining what
decisions should be made involves studying the effects of the alternative
policies that are available and evaluating the outcomes to which they lead.
These aspects are interwoven throughout the text. By pulling them
together, this book provides an accessible introduction to both of these
aspects of public economics.1

1.2 THEOREMS OF WELFARE ECONOMICS

1.2.1 Pareto-Efficiency:
Problem is that of judging among allocations with different distributional
properties. What is needed is some process that can take account of the
potentially diverse views of the consumers and separate efficiency from
distribution. To achieve this, economists employ the concept of Pareto-
efficiency. The philosophy behind this concept is to interpret efficiency as
meaning that there must be no unexploited economic gains. Testing the
efficiency of an allocation then involves checking whether there are any
such gains available. More specifically, Pareto-efficiency judges an
allocation by considering whether it is possible to undertake a reallocation
of resources that can benefit at least one consumer without harming any
other. If it is possible to do so, then there will exist unexploited gains.
When no improving reallocation can be found, then the initial position is
deemed to be Pareto-efficient. An allocation that satisfies this test can be
viewed as having achieved an efficient distribution of resources. To
provide a precise statement of Pareto-efficiency that applies in a
competitive economy, it is first necessary to extend the idea of feasible
allocations of resources. When production is included, an allocation of
consumption is feasible if it can be produced given the economy‘s initial
endowments and production technology. Given the initial endowment, ω,
the consumption allocation x is feasible if there is production plan y such
that
x = y + ω. ...1

Pareto-efficiency is then tested using the feasible allocations. A precise

definition follows.

Definition:
A feasible consumption allocation xˆ is Pareto-efficient if there does not
exist an alternative feasible allocation x such that:

2
i. allocation x gives all consumers at least as much utility as xˆ, and
ii. allocation x gives at least one consumer more utility than xˆ.

These two conditions can be summarized as saying that allocation xˆ is

Pareto efficient if there is no alternative allocation (a move from xˆ to x)
that can make someone better off without making anyone worse off. It is
this idea of being able to make someone better off without making
someone else worse off that represents the unexploited economic gains in
an inefficient position.

It should be noted even at this stage how Pareto-efficiency is defined by

the negative property of being unable to find anything better than the
allocation. This is somewhat different from a definition of efficiency that
looks for some positive property of the allocation. Pareto-efficiency also
sidesteps issues of distribution rather than confronting them. This is why it
works with many consumers.

1.2.2 Theorem of Welfare Economics:

The welfare properties of the economy, which are commonly known as the
Two Theorems of Welfare Economics, are the basis for claims concerning
the desirability of the competitive outcome. In brief, the First Theorem
states that a competitive equilibrium is Pareto-efficient and the Second
Theorem that any Pareto-efficient allocation can be decentralized as a
competitive equilibrium. Taken together, they have significant
implications for policy and, at face value, seem to make a compelling case
for the encouragement of competition. The Two Theorems are easily
demonstrated for a two-consumer exchange economy by using the
Edgeworth box diagram. The first step is to isolate the Pareto-efficient
allocations. Consider figure 1.1 and the allocation at point a. To show that
a is not a Pareto-efficient allocation, it is necessary to find an alternative
allocation that gives at least one of the consumers a higher utility level and
neither consumer a lower level. In this case, moving to the allocation at
point b raises the utility of both consumers when compared to point a—we
say in such a case that b is Pareto-preferred to a. This establishes that a is
not Pareto-efficient. Although b improves on a, it is not Pareto-efficient
either: the allocation at c provides higher utility for both consumers than b.
The allocation at c is Pareto-efficient. Beginning at c, any change in the
allocation must lower the utility of at least one of the consumers. The
special property of point c is that it lies at a point of tangency between the
indifference curves of the two consumers. As it is a point of tangency,
moving away from it must lead to a lower indifference curve for one of the
consumers if not both. Since the indifference curves are tangential, their
gradients are equal, so
MRS1 1,2 = MRS2 1,2.(1.2)

This equality ensures that the rate at which consumer 1 will want to
exchange good 1 for good 2 is equal to the rate at which consumer 2 will

3
want to exchange the two goods. It is this equality of the marginal
valuations of the two consumers at the tangency point those results in
there being no further unexploited gains and so makes c Pareto efficient.
The Pareto-efficient allocation at c is not unique. There are in fact many
points of tangency between the two consumers‘ indifference curves. A
second Pareto-efficient allocation is at point d in figure 1.1. Taken
together, all the Pareto-efficient allocations form a locus in the Edgeworth
box that is called the contract curve. This is illustrated in figure 2.12. With
this construction it is now possible to demonstrate the First Theorem. A
competitive equilibrium is given by a price line through the initial
endowment point, ω, that is tangential to both indifference curves at the
same point. The common point of tangency results in consumer choices
that lead to the equilibrium levels of demand. Such an equilibrium is
indicated by point e in figure 2.12. As the equilibrium is a point of
tangency of indifference curves, it must also be Pareto-efficient. For the
Edgeworth box, this completes the demonstration that a competitive
equilibrium is Pareto-efficient. The alternative way of seeing this result is
to recall that each consumer maximizes utility at the point where their
budget constraint is tangential to the highest indifference curve. Using the
MRS, we can write this condition for consumer has MRSh 1,2 = p1/p2.
The competitive assumption is that both consumers react to the same set of
prices, so it follows that
MRS1 1,2 = p1 p2 = MRS2 1,2. (1.3)

Comparing this condition with (2.18) provides an alternative

demonstration that the competitive equilibrium is Pareto-efficient. It also
shows again the role of prices in coordinating the independent decisions of
different economic agents to ensure efficiency. This discussion can be
summarized in the precise statement of the theorem.

First Theorem of Welfare Economics:

It has been deemed by several economists that perfect competition is an

ideal market form which ensures the attainment of Pareto optimality or
maximum social welfare as it fulfils all the marginal conditions required
for the purpose. Essentially Pareto optimality involves efficiency in the
use and allocation of resources at the disposal of a community. As seen
above, if Pareto efficiency is not achieved it implies one can be made
better off without anyone being made worse off. In this case there is scope
of increasing social welfare by reorganisation of resources, say through a
public policy. An important feature of general equilibrium reached in
perfectly competitive markets leads to maximum social welfare or
economic efficiency in the sense of Pareto optimality. This is known as
the first or fundamental theorem of welfare economics. According to this
theorem, all possibilities of increasing welfare of the individuals from
exchange between them or and allocation of resources in the production of
different goods. In other words, the firs fundamental theorem of welfare
economics postulates that general competitive equilibrium Pareto optimal.
We shall show below how perfectly competitive equilibrium leads to the
4
first theorem of welfare economics. In what follows we shall show how
equilibrium under perfect competition satisfies all the marginal conditions
required for the achievement of Pareto optimise We shall further explain
what are the major obstacles in the way of maximizing social welfare or
achieving Pareto optimality.

Perfect Competition and Optimal Distribution of Goods or Efficiency

in Exchange:

The condition for Pareto optimality with regard to the distribution of

goods among consumers requires that the marginal rate of substitution
(MRS) between any two goods, say ―X‖ and ―Y‖, must be the same for
any pair of consumers. Let ―A‖ and ―B‖ be the two consumers between
whom two goods ―X‖ and Y are to be distributed. Under perfect
competition prices of all goods are given and same for every consumer. It
is also assumed that consumers try to maximize their satisfaction subject
to their budget constraint. Now, given the prices of two goods, consumer
―A‖ will maximize his satisfaction when he is buying the two goods ―X‖
and Yin such amounts that:
MRSAxy = Px/Py …………………………………………………..1

Likewise, the consumer B will also be in equilibrium (maximise his

satisfaction) when he is purchasing and consuming the two goods ―X‖ and
―Y‖ in such amounts that:
MRSBxy = Px/Py ……………………………………………………2

Since this is essential condition of perfect competition that prices of goods

are the same or uniform for all consumers, the price ratio of the two goods
Px/Py in equations (1) and (2) above will be the same for consumers ―A‖
and ―B‖. It, therefore, follows from equations (1) and (2) above that under
conditions of perfect competition marginal rate of substitution between
two goods ‗X‘ and ‗Y‘ will be equal for the two consumers. That is,
MRSAxy = Px/Py= MRSBxy = Px/Py

This result will hold good between any pair of goods for any pair of
consumers.

Perfect Competition and Optimal Allocation of Factors:

The second marginal condition for Pareto optimality relates to the optimal
allocation of factors among the production of various goods. This
condition requires that for the optimal allocation of factors marginal rate
of technical substitution (MRTS) between any two factors. say labour and
capital of any pair of firms must be the same in the production of any pair
of products. This condition is also satisfied by perfect competition. For a
firm working under perfect competition prices of factors it employs are
given and constant and it is in equilibrium(that is, minimizes cost for a
given level of output)at the combination of factors where the given
isoquant is tangent to an is o-cost line. As is well known, the slope of the
5
isoquant represents marginal rate of technical substitution between the two
factors and the slope of the is o-cost line measures the ratio of the prices of
two factors. Thus, under perfect competition a cost minimizing firm
producing good ―X‖ will equate MRTS between labour and capital with
the price ratio of these two factors. Thus, under perfect competition
MRSxLK = w/r…………………. (1)

where ‗w‘ and ‗r‘ are the prices of labour and capital respectively and
MRTSxLK is the marginal ate of technical substitution between labour and
capital in the production of good ‗X‘. Similarly. firm B producing good Y
and working under perfect competition will also equate his marginal ate of
technical substitution between the two factors with their price ratios. Thus
MPSYLK = w/r …………………. (2)

Since under perfect competition, prices of factors are the same for all the
firms, each firm will adjust the use of factors in such a way it‘s his
marginal rate of technical substitution (MRTS) between labour and capital
in the production of goods is equal to the same factor price ratio in other
words w/r will be the same for all of them and to this MRTS LK of firms
producing different commodities will be made equal. It therefore follows
from (1) and (2) above that under perfect competition
MRSxLK = MPSYLK

We thus see that perfect competition ensures optimal allocation of

resources as between different firms using these resources for production
of commodities.

Perfect competition and General Economic efficiency:

The most important condition for the attainment of Pareto optimum is one
which refers to the optimum direction or composition of production. In
other words, this condition requires how much amounts of different goods
should be produced and resources allocated accordingly. This refers to the
general condition for optimum allocation of resources which has also been
called the condition for General Economic Efficiency. This condition
states that marginal rate of substitution between any two commodities for
any consumer should be the same as the marginal rate of transformation
for the community between these two commodities Under conditions of
perfect competition, each firm to be in equilibrium produces so much
output of a commodity that its marginal cost is equal to the price of the
commodity. Thus, for firms in perfect competition, MCx= Px, MCy, = Py,
where MCx, and MCy, are marginal costs of production of commodities
‗X‘ and ‗Y‘ respectively and ‗Px‘, and ‗Py‘, are prices of commodities ‗X‘
and ‗Y‘. Therefore, it follows that firms in perfect competition will be in
equilibrium when they are producing commodities in such quantities that
MCx/MCy = Px =Py……………………… (1)

The ratio of marginal costs of two commodities represents the marginal

rate of two commodities represents the marginal rate of transformation
6
between them. Therefore, for each firm working un der perfect
competition.
MRTxy= MCx/MCy=Px/Py…………………….(2)

When there prevails perfect competition on the buying side, each

consumer maximises his satisfaction and is in equilibrium at the point
where the given budget line is tangent to his Indifference curve. In other
words, each consumer is in equilibrium when:
MRSxy= Px/Py,

Since, under perfect competition, the ratio of prices of two commodities

Px/Py is the same for a consumer and a producer, it follows from (1) and
(2) above that MRSxy =MRTxy

Figure No. 1.1

Pareto-Optimal composition of
output under perfect competition

Likewise, this will hold good for any other pair of commodities. Thus,
perfect competition satisfies the marginal condition required for the Pareto
optimal composition or direction of production. This is shown In Figure
1.1 where at the tangency point Q between Indifference curve IC2,
reflecting the preferences of the consumer and the transformation curve
TT‘ representing the production possibilities of the community, the
general equilibrium occurs under perfect competition. At this equilibrium
point Q, OM quantity of product X and ON quantity of product Y are
being produced and the consumer is at its highest possible indifference
curve IC2, and MRSxy=MRTxy any deviation from this product mix (OM
of X and ON of Y) will lower the welfare of consumers. Thus, the
competitive equilibrium at point Q represents Pareto optimal direction of
production.

7
Perfect Competition and Optimum Degree of Specialisation:
Pareto optimality with regard to the degree of specialisation in production
by various firms requires that the marginal rate of transformation (MRT)
between any two products be the same for any two firms that produce the
two products. Let us assume two firms A Beach producing the two
products ‗X‘ and ‗Y‘. The Pareto optimum with regard to the degree
specialisation of products requires that:
MRTAxy=MRTBxy

where MRT represents marginal rate of transformation between products

X and Y.

Now, a firm working under perfect competition and producing two

products will equals marginal rate of transformation between X and Y
(MRTxy) with the price ratio of the two products so as to maximise its
profits. A multi-product firm will be in equilibrium where a given
transformation curve is tangent to an is o-revenue line. The tangency of
the is o-revenue curve with the transformation curve implies the equality
of marginal rate of transformation between the two products with the price
ratio of the two products. Since under perfect competition prices of all
products are the same or uniform for all firms, the firms are merely price
takers having no individual influence over the prices of the products. As a
result, all firms under perfect competition will equate their marginal rate
of transformation between the two products with the same ratio of prices
of the products. This will render the marginal rate of transformation
between the two products equal for all firms. In terms of notations used
above, under perfect competition the firm A will be in equilibrium when:
MRTAxy=Px/Py

Similarly, under perfect competition the firm B will be in equilibrium

when.
MRTBxy=Px/Py

Since product price ratio Px/Py is the same for both the firms, it follows
that un der perfect competition.
MRTAxy= MRTBxy

The fulfilment of this condition regarding optimal degree of specialisation

under perfect competition can also be shown in another way. As is quite
well known, a firm under perfect competition equates price with marginal
cost of production of a commodity in order to maximise Is profits. Since
marginal cost of every product produced by a firm under perfect
competition will be equalised with its price, the ratio of marginal costs of
two products produced by the firm be equal to the ratio of prices of two
products. Thus, the firm A will be in equilibrium under perfect
competition with:
MCAx/MCAy= Px /Py
8
Likewise, the firm B will be in equilibrium when
MCBx/ MCBy= Px /Py

Since prices of two products, Px, and Py are the same for all the firms
working under perfect competition, the price ratio of the products, Px /Py
will also be the same. It therefore follows from above that:
MCAx/ MCBx= MCAx/ MCBx

Now, the ratio of marginal costs of two products MCx/ MCy represents the
marginal rate of transformation, between the two products (MRTxy). Hence
the marginal rate of transformation between the two products (MRTSxy)
will be the same for the two firms thus.
MRTAxy=MRTBxy

Perfect Competition and Optimum Factor-Product Relationship:

The fourth condition required for the achievement of Pareto optimality
states that marginal rate of transformation between any factor and any
commodity must be the same for any pair of firms using the factor and
producing a product. Marginal rate of transformation between a factor and
a commodity implies marginal physical product (MP) of the factor in the
production of that commodity.

Therefore, this condition requires that marginal physical product of a

factor must be the same for all firms using the factor and producing a
commodity. This condition is also satiated under conditions of perfect
competition. To be in equilibrium a firm under perfect competition in the
factor market will employ such an amount of the factor that equates price
of the factor with the value of the marginal product (VMP) of the factor.
Now, value of the marginal product of the factor is marginal physical
product of the factor (MPP) multiplied by the price of the commodity (Px).
Let us take labour as an example of a factor of production and w as the
price of labour, that is, its wage rate. Thus,
VMP of a factor – MPL, Px

It follows from above that under perfect competition for any firm A to be
in equilibrium,
w = VMPAL =MPAL .Px
w/Px =MPAL………………………………..(1)

Likewise for another firm B to be in equilibrium

w = VMPBL =MPBL .Px
w/Px =MPBL………………………………..(2)

Since under perfect competition price of factor ‗w‘ as well as the price of
product (Px) is the same for all firms, it follows from (1) and (2) above that
MPAL =MPBL
9
That is marginal physical products of a factor is the same in both firms A
and B producing a commodity. This will hold good for any pair of firms
working under perfect competition.

Second theorem of welfare Economics:

According to above explanation perfectly competitive general equilibrium
leads to the first or fundamental theorem of welfare economics, that is,
competitive equilibrium is Pareto optimum. There is also a second
theorem of welfare economics according to which for every Pareto
optimal situation there is a competitive equilibrium, given the initial
income distribution or factor enduement. Take for instance the case of
Pareto optimality of exchange. When the Indifference curves, are convex
to the origin, every efficient allocation (i.e., Pareto optimal distribution) on
the contract curve for exchange is a competitive equilibrium for some
given initial distribution of goods or allocation of factors (1e income)
among individuals. This Implies that whatever the initial distribution of
Income In a society the corresponding Pareto optimality or economic
efficiency with regard to exchange and distribution of goods among the
Individuals can be reached through perfectly competitive equilibrium.
Consider Figure next where allocation of goods, between two individuals
is shown. If initial distribution of goods between the two goods is given by
point K, then perfect competition can lead to the determination of price
ratio of goods as shown by price line P1, P1, so that through exchange the
two individuals can reach at point S which depicts higher level of welfare
for both and as it lies at the contract curve, it is Pareto optimal. Similarly,
If Initial distribution of goods (i.e. real income) is given by point R, then
perfect competition can determine price ratio of the two goods as given by
price line P2, P2, so that through exchange the two individuals can reach
point

Ton the contract curve which is Pareto optimal.

Fig No. 1.2

(Ref: Dr. H L Ahuja, Advanced Economic theory, 19th Revised edition.)

10
1.3 LUMPSUM TAXES AND TRANSFER

The discussion of the Second Theorem noted that it does not describe the
mechanism through which the decentralization is achieved. It is instead
implicit in the statement of the theorem that the consumers are given
sufficient income to purchase the consumption plans forming the Pareto-
efficient allocation. Any practical value of the Second Theorem depends
on the government being able to allocate the required income levels. The
way in which the theorem sees this as being done is by making what are
called lump-sum transfers between consumers.

A transfer is defined as lump sum if no change in a consumer‘s behaviour

can affect the size of the transfer. For example, a consumer choosing to
work less hard or reducing the consumption of a commodity must not be
able to affect the size of the transfer. This differentiates a lump-sum
transfer from other taxes, such as income or commodity taxes, for which
changes in behaviour do affect the value of the tax payment. Lumpsum
transfers have a very special role in the theoretical analysis of public
economics because, as we will show, they are the idealized redistributive
instrument.

The lump-sum transfers envisaged by the Second Theorem involve

quantities of endowments and shares being transferred among consumers
to ensure the necessary income levels. Some consumers would gain from
the transfers; others would lose. Although the value of the transfer cannot
be changed, lump-sum transfers do affect consumers‘ behaviour because
their incomes are either reduced or increased by the transfers—the
transfers have an income effect but do not lead to a substitution effect
between commodities. Without recourse to such transfers, the
decentralization of the selected allocation would not be possible. The
illustration of the Second Theorem in an exchange economy makes clear
the role and nature of lump-sum transfers. The initial endowment point is
denoted ω, and this is the starting point for the economy. It we assume that
the Pareto-efficient allocation at point e is to be decentralized, then the
income levels have to be modified to achieve the new budget constraint.
At the initial point the income level of h is pωˆ h when evaluated at the
equilibrium prices pˆ. The value of the transfer to consumer h that is
necessary to achieve the new budget constraint is Mh − ˆpωh = ˆp xˆ h −
ˆpωh. One way of ensuring this is to transfer a quantity x 1 1 of good 1
from consumer 1 to consumer2. But any transfer of commodities with the
same value would work equally well.

There is a problem, though, if we attempt to interpret the model this

literally. For most people, income is earned almost entirely from the sale
of labour so that their endowment is simply lifetime labour supply. This
makes it impossible to transfer the endowment since one person‘s labour
cannot be given to another. Responding to such difficulties leads to the
reformulation of lump-sum transfers in terms of lump-sum taxes. Suppose
that the two consumers both sell their entire endowments at prices pˆ. This
11
generates incomes pωˆ 1 and pωˆ 2 for the two consumers. Now make
consumer 1 pay a tax of amount T 1 = ˆp x 1 1 and give this tax revenue to
consumer 2. Consumer 2 therefore pays a negative tax (or, in simpler
terms, receives a subsidy) of T 2 =−ˆp x 1 1 = −T 1. The pair of taxes T 1,
T 2 moves the budget constraint in exactly the same way as the lump-sum
transfer of endowment. The pair of taxes and the transfer of endowment
are therefore economically equivalent and have the same effect on the
economy. The taxes are also lump sum because they are determined
without reference to either consumer‘s behaviour and their values cannot
be affected by any change in behaviour.

Lump-sum taxes have a central role in public economics due to their

success in achieving distributional objectives. It should be clear from the
discussion above that the economy‘s total endowment is not reduced by
the application of the lump-sum taxes. This point applies to lump-sum
taxes in general. As households cannot affect the level of the tax by
changing their behaviour, lump-sum taxes do not lead to any distortions in
choice. There are also no resources lost due to the imposition of lump-sum
taxes, so redistribution is achieved with no efficiency cost. In short, if they
can be employed in the manner described they are the perfect taxes.

1.5 SUMMERY

Pareto-efficiency judges an allocation by considering whether it is

possible to undertake a reallocation of resources that can benefit at least
one consumer without harming any other. If it is possible to do so, then
there will exist unexploited gains. The welfare properties of the economy,
which are commonly known as the Two Theorems of Welfare Economics,
are the basis for claims concerning the desirability of the competitive
outcome. An important feature of general equilibrium reached in perfectly
competitive markets leads to maximum social welfare or economic
efficiency in the sense of Pareto optimality. For every Pareto optimal
situation there is a competitive equilibrium, given the initial income
distribution or factor enduement. The discussion of the Second Theorem
noted that it does not describe the mechanism through which the
decentralization is achieved. It is instead implicit in the statement of the
theorem that the consumers are given sufficient income to purchase the
consumption plans forming the Pareto-efficient allocation. Any practical
value of the Second Theorem depends on the government being able to
allocate the required income levels

1.6 QUESTIONS

1. What is Pareto-Efficiency?? Discuss in detail.

2. Explain Perfect competition and General Economic efficiency.
3. Explain Second theorem of welfare.
*****
12
 2
GOVERNMENT IN A MARKET
ECONOMY – II
Unit Structure
2.0 Objectives
2.1 Introduction
2.2 Rationale for State Intervention
2.3 Market Failure and Externalities
2.4 Tax
2.5 Distribution
2.6 Social Choice, Voting Rules, Arrow‘s impossibility Theorem
2.7 Summary
2.8 Questions
2.9 References

2.0 OBJECTIVES

1. Student must understand need and importance of state intervention in

economy.
2. To study what is market failure and concept of externality.
3. To understand taxation and distribution of resources.
4. Understanding, in democracy how individual make their choices
regarding welfare.

2.1 INTRODUCTION

This unit is framed according to the need of knowledge students should

pusses after completion of their masters in economics. After studying this
unit student will have enough knowledge about wide area of economics in
this student will able to understand need and importance of government
intervention in market economy. Also, we will able to understand concept
of market failure how government intervention can cure it. Importantly
how society takes decision about welfare and what are the obstacles in it.
This unit will clear all the points maintained above.

2.2 RATIONAL FOR STATE INTERVENTION

The standard justification of state intervention takes as its starting point
the behaviour of the economy in the absence of the government, that is, in
13
the hypothetical situation of a free market economy. From the basic
theorems of welfare economics, if this economy is perfectly competitive
and there is a full set of markets, then, assuming that an equilibrium exists,
it is Pareto-efficient; i.e., no one can be made better off without someone
else being worse off. If it is assumed that social decisions should be based
on individual welfare, and that individuals are likely to know better than
the government what makes them happy, this creates a presumption that
state intervention is not necessary on efficiency grounds. For some, this
efficiency argument for decentralization understates the full value of the
free market, since they value the right to choose in itself; others believe
that there is a relationship between the form of economic organization and
political control.

The proposition about the efficiency of competitive equilibrium is used as

a reference point to explain the roles of government activity. The first of
these is that Pareto efficiency does not ensure that the distribution that
emerges from the competitive process is in accord with the prevailing
concepts of equity (whatever these may be). One of the primary activities
of the government is indeed redistribution. Ideally, this would be achieved
through measures that did not destroy the efficiency properties, and much
of welfare economics is based on the assumption that no distortionary
―lump-sum‖ taxes and transfers can be carried out. For reasons discussed
later, such instruments are not typically available in a sufficiently flexible
form, and the government has to employ income and wealth taxes, social
security benefits related to unemployment or wages, etc.

Second, the economy may not be perfectly competitive. It is the expressed

object of antitrust policy to ensure that firms do not collude or that
individual firms do not obtain a sufficiently large share of any market that
they can, by restricting their output, increase the price to consumers. But
there are some cases where it would be inefficient to have a large number
of competing firms. It is widely recognized that in many production
processes there is an initial stage of increasing returns to scale. If the point
of minimum average costs occurs at so high an output that a single firm
would have a significant portion of the market, then, although it might be
feasible to divide the firm up into competing units, this would increase
costs. Notable examples of such ―natural monopolies‖ are telephones and
electricity. In the absence of government intervention, these industries
would be likely to be controlled by a few firms, with consequent
monopoly power. Accordingly, governments may control such industries
directly like United Kingdom or regulate them like United States.

One central set of economic activities in which the assumption of

increasing returns to scale seems to be particularly important is research
and development. There may be competition—in the sense of free entry—
in these activities, yet a firm that discovers a new product or a new process
has a significant effect on the market, even if only temporarily. There is
not the perfect competition of the basic theorems of welfare economics,

14
and the resource allocation generated by the market is not in general
Pareto-efficient.

Even if the economy were competitive, it may not ensure a Pareto-

efficient allocation of resources. The theorem requires that there be a full
set of markets for all relevant dates in the future and for all risks.
Typically, a full set of futures and insurance markets does not in fact exist.
There may be partial substitutes, for example the stock market, but it can
be shown that the allocation remains inefficient in many circumstances,
and indeed opening additional markets may worsen the allocation
(Newbery and Stiglitz, 1979). Similarly, the theorem presupposes perfect
information, or that the information that is available is not affected by the
actions of individuals. The analysis of markets with imperfect information
has only recently begun, but it is already apparent that the welfare
economics theorems need to be modified significantly (Stiglitz, 1980).
The presence of imperfect information is likely to confer monopoly
power. Where competition is maintained, an equilibrium may not exist,
and when it does exist it may not be Pareto-efficient.

Furthermore, the basic theorem requires that the full equilibrium should be
attained. Yet, because of incomplete markets or imperfect information or
other reasons, capitalist economies have frequently been characterized by
under-utilization of resources (of a kind that creates a strong presumption
of inefficiency). Most dramatic of these failures of the market economy
are the fluctuations that periodically lead to substantial unemployment. It
is now accepted as a responsibility of the government to ensure a low level
of unemployment (although views as to what is acceptably ―small‖ may
change over time). More generally, the fact that the market economy can
lead to such massive under-utilization of resources calls in question the
appropriateness of the competitive equilibrium model. It is not obvious
that—as some economists have suggested—once the problem of
unemployment has been ―solved‖, the classical model of the market
economy, with its welfare implications, becomes applicable. It is more
reasonable to suppose that the problem of unemployment is only the worst
symptom of the failure of the market. There are indeed many other
examples that suggest the limited applicability of the competitive
equilibrium model: persistent shortage of particular skills, balance of
payments disequilibria, regional problems, unanticipated inflation, etc.
Even if the economy is well described by the competitive equilibrium
model, the outcome may not be efficient because of externalities. There
are innumerable examples where the actions of an individual or firm affect
other directly (not through the price system). Because economic agents
take into account only the direct effects upon themselves, not the effect on
others, the decisions they make are likely not to be ―efficient‖. Air and
water pollution are perhaps the most notable examples, and there has been
much controversy about the appropriate method of handling these, e.g.,
regulation, taxes, or subsidies.

15
A particular category of commodities for which the market will not
necessarily ensure the correct supply are public goods, of which defence
and basic research are conventional examples. These have the
characteristic that the consumption of these commodities by one
individual need not detract from that available to others.Some of these
goods are specific to particular locations (e.g., the transmission of radio or
television), and are referred to as local public goods.

Finally, there are what Musgrave said ‗merit wants.‘ This is a category of
goods where the state makes a judgement that some goods are ―bad‖ and
some are ―good‖ or and attempts to encourage good like education and
discourage the bad like alcohol. This is different from the arguments
concerning externalities and public goods, in that with merit wants, the
―public‖ judgement differs from the private evaluation, rejecting a purely
individualistic view of society. This may lead to public spending on merit
goods or extra taxes on ―demerit‖ goods. The ethical basis of such
judgements is a question of some dispute, and some writers have tried to
bring such objectives within the framework of individualistic judgements,
by extending the latter to include views about the nature of society. Thus,
a person may have private interest in reducing the tax on tobacco, because
cigarettes are important in his private utility function, but in his social
judgements reduction in cigarette consumption would be desirable.

It is clear that, even if we accept the basic theorem of efficiency of the

competitive economy as a valuable reference point, following aresome
other important reasons for government intervention: (1) distribution, (2)
failure of perfect competition, (3) absence of futures and insurance
markets, (4) failure to attain full equilibrium, (5) externalities, (6) public
goods, and (7) merit wants.

2.2 MARKET FAILURE AND EXTERNALITIES

2.3.1 Externalities:
An externality represents a connection between deferent economicagents
which are outside the price system of the economy. As the level of
externality generated is not controlled directly by price, the standard
efficiency theorems on market equilibrium cannot be applied. The market
failure that can result raises a potential role for correction through policy
intervention. Externalities and their control are a subject of increasing
practical importance. The greenhouse effect is one of the most significant
examples of the consequences of an externality but there are any number
of others, from purely local environmental issues to similarly global ones.
Although these may not appear at first sight to be economic problems,
many of the policy responses to their existence have been based on the
economic theory of externalities. The purpose of this chapter is to
demonstrate the consequences of the existence of externalities and to the
review policy responses that have been suggested. In particular, it will be
shown how the unregulated economy generally fails to reach an efficient
outcome and to what degree this can be corrected using standard tax
16
instruments. The chapter begins with a discussion of alternative definitions
of an externality which differ in whether they focus on effects or
consequences. Adopting an effect-based definition, it is then shown how
the market generally fails to achieve efficiency. This lack of efficiency is
contrasted to the claim of the Coase theorem that efficiency will be
eliminated by trade. An emphasis is placed on the role of missing markets
and inefficiency in bargaining with incomplete information. The design of
the optimal set of correctives, or Pigouvian, taxes is then addressed under
alternative assumptions about the feasible degree of differentiation
between different households and firms. The chapter is completed by
contrasting the use of taxes with direct control through tradable licences
and value of internalisation.

Although the nature of an externality as an effect inflicted by one agent

upon another may seem very clear at an intuitive level, once a
formalisation is attempted a number of issues arise that need to be
resolved. Of most importance is the question of whether the existence of
an externality should be judged by its effects or by its consequences. Since
both approaches have some merit, but can lead to different classifications,
there is no universally agreed definition of an externality. This section
discusses two alternative definitions and describes the representation of
externalities adopted in the following analysis.

Definitions In the literature there have been a number of alternative

definitions of an externality and several attempts at providing
classifications of various types of externalities; a survey is presented in
Baumol and Oates in year 1988. There are two major definitions of
externalities, the first defines an externality by its effects and the second
defines by the reason for its existence and its consequences.

The first definition of externalities: An externality is present whenever

some economic agent‘s welfare (utility or profit) includes real variables
whose values are chosen are chosen by others without particular attention
to the effect upon the welfare of the other agents they affect. This is a very
broad definition but does have the advantage of allowing an externality to
be recognised from its effects. The definition also implicitly distinguishes
between two broad categories of externality. A production externality is
said to exist when the effect of the externality is upon a profit relationship
and a consumption externality is present whenever a utility level is
affected. Clearly, an externality can be both consumption and a production
externality simultaneously. For a household, an externality can affect
either the consumption set or the utility function. In either case, final
welfare will be affected. Similarly, for a firm, an externality may
determine the structure of the production set or it may enter the profit
function directly. The difficulty with this definition is its dependence upon
the institutional context in which it is placed. The following example of
Heller and Starret (1976) illustrates this point. In a barter economy with
two households, the utility of each household is dependent upon the
quantity that the other household is willing to give up in exchange. From
17
the definition above, this must clearly count as an externality although
such a classification seems inappropriate. If the institutional setting is
altered by the introduction of competitive markets, then the externality is
removed.

Based on this reasoning, Heller and Starret in year 1976 provide an

alternative definition of externalities that relates to existence of markets
and the consequences of the externality: An externality is present
whenever there is an insufficient incentive for a potential market to be
created for some good and the nonexistence of this market leads to a non-
Pareto optimal equilibrium.

Although the conditions of the second definition are stronger than those of
the first so that, for a given institutional framework, the externalities it
identifies will be a subset of those identified by the first, in most cases the
two definitions will delineate precisely the same set of effects as
externalities. On this basis, the first definition is adopted as the
determinant of what constitutes an externality. The second definition is
still important, however, due to it directing attention to the question of
why some markets exist and some do not.

2.3.2 Market Failure:

Market Failure means do not act in a manner which it tends to encourage
competition and bring about efficiency. Market economy provides private
goods efficiently. The markets are characterized by imperfect competition,
production is subject to decreasing cost. Consumers are forced with
advertisement. So, it said that market mechanism is not considered to be
appropriate for the provision of social / public goods.

It is also said that the market is not in a position to solve the complete
economic problem. Some time it never functions efficiently due to
externalities. Here externalities mean it is a situation where consumption
are shared and not be limited to particular consumer.

The market functions appropriately if there is exclusion principle works.

At the same time market also responds to the effective demands of
consumer. There are certain problems like unemployment, inflation and
economic can be solved through market only. Here, market failure occurs
in case of provision of public good, thus, when market failure occurs
budgetary provision is required if consumption is non-rival and exclusion
is inappropriate.

 Market Failure in case of non-rival Consumption:

Non-rival consumption is the best feature associated with the public good.
In other words, non-rival consumption means equal number of benefits are
offered to all i.e., consumption benefit of public park derived by an
individual ‗X‘ do not affect the consumption benefit of other individuals
in the society. Here marginal cost is zero for use public park. However,
though the marginal cost is zero, the cost of providing public park itself is
18
not free of cost. Thus, market fail in covering of the cost of public goods /
social goods and this could be covered by political procedure of the
budget.

 Market Failure and Non-Excludability:

As we know market fails because of rival consumption and where
exclusion principle does not work. This could be explained with the
following example. Considering travelling a crowded Road during peak
hours. In this situation, the use of the existing road is conspicuously rival
and exclusion becomes highly essential and effective. This example shows
a situation where exclusion becomes inevitable but is not feasible due to
market failure.

 Collectivism and Market Failure:

The features of non-rival consumption and non-excludability need not
work hand in hand quite frequently work in unity. It is observed that the
goods can be classified into four parts depending up their consumption
and excludability features as below.

1. Rival- Exclusion Feasible: The private good case tells us the

combination of consumption with excludability provision of these goods
through market is definitely both feasible and efficient. In rest of the case
market failure occur.

2. Rival- Exclusion Not-feasible: Market failure is because of non-

excludability or rise in the cost of exclusion.

3. Non-Rival Exclusion Feasible: Market failure takes place due to non-

rival consumption.

4. Non-Rival Exclusion Not Feasible: impedimentis presentherei.e. non-

rival consumption and non-excludability. except the first it is mentioned in
the above the market failure occurs in all cases. The concept of social
good is applicable in case III and IV but Case No. II is exclusively
applicable for Merit good.

Market Imperfections:
As in perfect competition price setting by market only and not seller.
Thus, in the market buyer and seller individually cannotinfluence price.
But, of a single firms have some control over price and potential
competition which results in imperfect competition and an inefficient
allocation of resources.

If an industry comprises one firm producing a product for which there are
no close substitutions is called ―Monopoly‖. In this moment monopoly is
still constrained by market demand. Monopolist sets price above average
cost and such a firm generally earn economic profit.

19
In competition economic profit will attract the new firms in to the
industry. Sometime, a rational monopolist with the help of Government
control the entry of new firms in the market and preserve economic profit
in long run. This creates the impact of society loss and benefit of more
products at lower price.

We find the number imperfectly competative markets structures between

monopoly and perfect competition. In one hand Oligopolist with small
number of firms follow a certain degree of price setting power and on the
monopolistic industry with large number of firms set the price for their
product on the basis of differentiation of product or brand name.

It is clear on the basis of above discussion all kind imperfection in the

market structure results in to lower output, underproduced and prices
which above than they were in the perfectly competitive market. Besides,
the equilibrium condition P = MC does not hold, this system fails to
provide the most efficient product mix.

What people want to be produced by the market depends upon the

argument that is P = MC. But this argument rests on two conditions (1)
Price provide a good approximation of the social value. (2) Marginal cost
provides a good approximation of the product‘s social opportunity cost.

2.4 TAX

Public expenditure theory defines the legitimate areas of public concern as

well as the permissible forms that policy may take. Moreover, as indicated
above, public expenditure theory often contains its own theory of taxation
in the sense that the expenditure decision rules define a set of taxes and
transfers necessary to guide the market system to an optimum. Taxes
contribute to the pursuit of efficiency and equity in these instances.

The theory of taxation becomes interesting in its own right only when the
expenditure decision rules indicate the need for specific government
expenditures without simultaneously specifying how those expenditures
are to be financed. When this occurs, the same criteria that guide public
expenditure analysis also apply to the collection of tax revenues. In
particular, taxes should promote society‘s microeconomic goals of
allocational efficiency and distributional equity.

A natural tension arises between tax policy and the goal of allocational
efficiency, however. Most taxes generate distortions in the market system
by forcing suppliers and demanders to face different prices. These
distortions misallocate resources, thereby generating allocational
inefficiencies. Resource misallocation is not desirable, of course, but it is
an unavoidable cost of having to raise tax revenues. One goal of normative
tax theory, then, is to design taxes that minimize these distortions for any
given amount of revenue to be collected. Alternatively, if the government
must use one of two or three specific kinds of taxes to raise revenue,
20
normative tax theory should indicate which of these taxes generates the
minimum amount of inefficiency. Normative issues such as these are part
of the allocational theory of taxation and, just as with the allocational
issues of public expenditure theory, the guiding principle is pareto
optimality. According to the pareto criterion, the government should
collect a given amount of revenue such that it could not raise the same
amount of revenue with an alternative set of taxes that would improve at
least one consumer‘s welfare without simultaneously lowering the welfare
of any other consumer. If such pareto improvements are impossible, then
tax policy satisfies the pareto criterion of allocational efficiency, even
though it necessarily generates inefficiencies relative to a no-tax situation.

The second unavoidable effect of taxes is that they reduce taxpayers‘

purchasing power so that they necessarily become part of the
government‘s redistribution program. The government naturally wants its
taxes to contribute to society‘s distributional goals, but there are two
difficulties here. The first is that the distributional theory of taxation
suffers from all the indeterminacies of redistribution theory in general.
Thus, while public sector economists generally agree on normative tax
policy with respect to society‘s allocational goals, there is considerable
disagreement as to what constitutes good tax policy in a distributional
sense. The second difficulty is the inherent trade-off between equity and
efficiency in taxation. Generally speaking, achieving greater redistribution
requires levying higher tax rates on the ―rich‖ but, as we shall discover,
higher tax rates tend to increase inefficiency. In addition, taxing a
particular good might be desirable in terms of society‘s distributional
goals but highly undesirable on efficiency grounds, or vice versa.
Understanding the nature of these kinds of equity efficiency trade-offs has
always been a primary goal of normative tax theory.

Two additional subsidiary goals of tax policy are ease of administration

and simplicity, which relate to the practical problem of collecting taxes.
The ease of administration criterion adopts the tax collectors‘ point of
view. A tax has to be easy for a department of revenue to administer or it
will not be used. Private information comes directly into play here. Self-
interested taxpayers have a strong incentive to avoid paying taxes, and
they can do so if they are able to hide information about themselves from
the government‘s tax collectors. Illegal avoidance of taxes is called tax
evasion. Legal sanctions or just plain old honesty may prevent some
people from cheating on their taxes, but not everyone. Therefore, the
design of any tax has to address the problem of potential evasion.

Consider an income tax as an example. Suppose the government wants to

tax high-income taxpayers at a higher rate than low-income taxpayers as
part of its re distributional policy. It may not be able to do this, however, if
high-income taxpayers can hide much of their income from the authorities
and thereby evade much of their proper tax liability. Also, the hiding of
income forces the government to raise average tax rates to collect a given
amount of revenue, which increases the inefficiencies associated with the
21
tax. Finally, some taxes are easier to evade than others. Therefore, the
relative ease of evading different taxes has to be considered in determining
what mix of taxes to use to meet the government‘s total revenue
requirements.

The goal of simplicity adopts the taxpayers‘ point of view. Taxpayers have
to be able to comply with the tax laws fairly easily for a tax to be used.
They must be able to understand the tax laws and not suffer undue
recordkeeping and filing burdens. A clear example of this principle is the
preference in less-developed countries for taxing businesses rather than
people. The average person is not educated enough to maintain records on
income or prepare and file an income tax form, regardless of how honest
or dishonest he or she may be. Therefore, the less-developed countries tax
businesses simply because they are able to collect taxes on businesses.

2.5 DISTRIBUTION

If all the appropriate market and technical assumptions hold, would there
be anything at all for the government to do? The answer is yes, because of
society‘s concern for end-results equity. A perfectly functioning market
system can assure an efficient allocation of resources. Perfect competition
also satisfies the process equity norm of equality of opportunity and is
likely to generate a high degree of social mobility. But, even a perfectly
functioning market economy cannot guarantee that the distribution of the
goods and services will be socially acceptable. As noted above, the market
takes the ownership of resources as a given at any point in time. If society
deems the pattern of ownership to be unjust, then it will probably find the
distribution of goods and services produced by these resources to be unjust
as well. Moreover, there are no natural market mechanisms to correct for
distribution imbalances should they occur, nothing analogous to the laws
of supply and demand, which, under the stringent conditions listed above,
automatically select pareto-optimal allocations. Thus, a decision
concerning the distribution of income is the first order of business in
public sector economics in the sense that it cannot be assumed away. Even
in the best of all worlds, with all the appropriate market and technical
assumptions holding, the government has to formulate some policy with
respect to the distribution of income if society cares about end-results
equity. Society might simply choose to accept the market-determined
distribution, but this is still a distribution policy requiring a collective
decision on the part of the citizens even though it involves no actual
redistribution. Moreover, no country has ever made this choice. At a
minimum, then, a normative theory of the public sector must address the
fundamental question of distributive justice: What is the optimal or just
distribution of income?

We have already noted that the search for an optimal income distribution
has not achieved a consensus. The only point to add is that any attempt to
solve the distribution question is at odds with the preferred government-
as-agent ground rule that follows from the principle of consumer
22
sovereignty. By its very nature, a redistribution of income must violate the
principle of consumer sovereignty, so long as the losers in the
redistribution do not willingly surrender some of their incomes. Therefore,
redistribution policy cannot be based entirely on consumers‘ preferences,
with the government simply acting as a passive agent responding to their
preferences. It requires a collective decision articulated through some kind
of political process, one in which government officials are likely to play a
very active role. Normative public sector theory cannot be entirely devoid
of political content. Politics necessarily enters the theory through society‘s
attempt to resolve the distribution question.

The collective political decision is troublesome for normative public

sector theory, however, because of the lack of a consensus on a set of
distribution norms to guide the decision. Furthermore, the theoretical
difficulties spread far beyond the distribution question. Since an economic
system is a closed system in which all decisions are ultimately interrelated,
any public policy decision on the distribution of income necessarily affects
all the allocational issues as well. The government cannot simply make a
particular redistribution decision, for better or worse, and be done with it.

Public sector economics has never totally come to grips with this problem.
Economists have all too often assumed away distributional problems in
order to analyse more comfortable allocational issues, knowing full well
that separating allocational and distributional decisions is often not
legitimate and may produce normative policy prescriptions quite wide of
the mark. Some theoretical studies that do incorporate distributional
considerations into their models make no attempt to justify particular
distributional norms. Rather, the government‘s distributional preferences
are simply taken as given, and normative policies are described with
respect to these preferences. The spirit of the analysis is to ―have the
government provide us with a set of distributional preferences, and we will
tell it what it should do.‖ Perhaps this is all economists can hope to do
with the distribution question, but it is at least unsettling that the resulting
policy decision rules depend upon an assumed pattern of distributional
preferences that has no special normative significance.

2.6 SOCIAL CHOICE, VOTING RULES, ARROW’S

IMPOSSIBILITY THEOREM

Arrow‘s Impossibility Theorem the social sciences ran headlong into a

brick wall in 1951 when Kenneth Arrow published his general
impossibility theorem. There is no other way to put it. Arrow‘s theorem is
truly devastating to democratic societies. Arrow was commissioned by the
Department of Defence to develop a theory of how democratic societies
should make decisions about public goods such as defence. He approached
the problem of social decision making in the manner of cooperative game
theory: Develop a minimal set of axioms to guide the social decision
process that would be acceptable to a democratic society and then

23
determine the implications of those assumptions. Arrow put forth five
axioms that he thought a democratic social decision process should
possess. He then proved that, in general, no social decision process can
simultaneously satisfy all five axioms. Arrow‘s theorem does not imply
that a democratic society cannot make social decisions. They clearly can,
and do. But it does imply that a democratic society cannot, in general,
formulate consistent social decisions under a minimal set of conditions
that would be acceptable to it. Arrow‘s theorem applies to social decisions
on any issue, including the attempt to formulate a consistent social welfare
function for resolving the problem of distributive justice. All students
interested in public sector economics should have at least an intuitive
understanding of Arrow‘s general impossibility theorem. It is considered
by many to be the landmark result in twentieth-century political
philosophy.

Arrow's Conditions of Social Choice:

We have seen earlier that the value judgments of a superman or a dictator
about social welfare may not be valid due to various types of biases in
human mind. As a result, a superman's or dictator's value judgements or
vales do not truly reflect the social choice. Arrow was the first welfare
economist who attempted to lay down reasonably necessary conditions for
achieving the social ordering which reflects the desire or the ordering of
all individuals of the society. There are many ways in which social choice
can be derived. Choice may be made by a dictator or through custom and
tradition, or by some spiritual or religious head as was done in a traditional
society or by individuals comprising a society through voting. The
problem of social choice is easiest in a dictatorial rule in which all the
social choices are made by the dictator and all the individuals comprising
the society are compelled to accept It. Similarly, in a traditional society
various religious and spiritual rules or customs make the problem of the
social choice are easy. No Individual can disregard the social choice made
by a religious and spiritual head.

But the problem of making a social choice based on individual ordering

becomes difficult in a democratic society in which every Individuals is
free to have his own individual ordering of various social states. Now, a
pertinent question is as to whether the social choice can consistently be
derived from Individual orderings. Prof. Arrow has laid down certain
necessary conditions which social choices must satisfy in order to reflect
the individual orderings. He has laid down the following five conditions
which must be met for an acceptable social welfare function. In last, these
conditions reflect the value judgements of Arrow himself,

Condition 1: Transitivity or Consistency:

The first condition mentioned by Arrow is that social choices must be
consistent or transitive. Transitivity of the social choices impels that if an
alternative ‗A‘ is socially preferred to alternative Band alternative ‗B‘ is
socially preferred to alternative ‗C‘, then alternative ‗C‘ will not be
socially preferred to alternative ‗A‘. If alternative Cis found to be socially
24
preferred to ‗A‘, then the condition of transitivity would be violated and
the choice would be inconsistent. It may be mentioned that the question of
transitivity arises only when the social ordering has the properties of
convexity. By convexity we mean that the various alternatives must be
related to each other by preference or by indifference. Thus, two
alternatives are said to be related or connected if for any pair of
alternatives, ‗A‘ and ‗B‘, either ‗A‘ is preferred to ‗B‘ or ‗B‘ to ‗A‘ or
there is Indifference between the two. Thus, the condition of transitivity
must be found in the social choice because it has been considered by
Arrow as a condition for consistent social choice.

Condition 2: Responsiveness to Individual Preferences:

The second condition is that social ordering must depict responsiveness to
individual preferences. It states that social ranking must respond positively
to the individual ranking. This means that the social choices must change
in the same direction as the choices of the individuals constituting the
society. To quote Arrow, the social welfare function is such that the social
ordering responds positively to alteration in individual value or at least not
negatively. This implies that social choice reflects the values of different
individuals of the society and it changes as the individual values change.
Suppose an alternative ‗A‘ is socially preferred to ‗B‘ on the basis of a set
of individual orderings. If change occurs in the ordering of individuals so
that some individuals prefer alternative ‗A‘ more strongly than before and
no one's preference for it declines, then ‗A‘ must remain socially preferred
to ‗B‘. It is worth mentioning that this condition would be violated "if
there were some individuals against whom society discriminates in the
sense that when their desire for some alternative increases relative to other
alternatives, the social desirability of that alternative is reduced.

Condition 3: The Condition of Non-Imposition:

The third condition is of non- imposition. This states that social choices
must not be imposed independently of individual preferences. For
instance, it implies that if no individual in the society prefers alternative
‗B‘ to alternative ‗A‘ and any one or few other individuals in the society
prefer alternative ‗A‘ to alternative ‗B‘, then society must prefer ‗A‘ to
‗B‘. This condition implies that the choice of an alternative by the society
must satisfy Pareto criterion. This also implies that the social choice must
not be determined by anyone outside the community.

Condition 4: The Condition of Non-Dictatorship:

The fourth condition relates to the existence of non-dictatorship. It states
that social choices must not be dictated by any one individual in the
community. For instance, ‗A‘ must not be socially preferred to ‗B‘ only
became any one individual in the society prefers ‗A‘ to ‗B‘ irrespective of
the preferences of other individuals. If this condition is violated, then the
individual whose preferences are regarded as social preferences will in
fact be a dictator. This condition implies that the social choices must be
determined by the democratic method of voting by all individuals rather
than dictatorial one of imposition of his will by an individual.
25
Condition 5: Independence of Irrelevant Alternatives:
The fifth condition is of d doe independence of irrelevant alternatives.
According to this, social ranking of any two alternatives is determined
exclusively by individual ranking of these two alternatives alone and
should not be affected at all by individual preferences with respect to other
alternatives. In other words, a most preferred alternative out of a given set
of available alternatives must be independent of (that is, not affected by)
other alternatives, which are not available. Suppose three alternatives, ‗A‘,
‗B‘ and ‗C‘, are available and society prefers ‗A‘ to ‗B‘ and ‗B‘ to ‗C‘. If
‗C‘ were no longer available, then this condition implies that it must not
be the case that society then prefers ‗B‘ to ‗A‘. Thus, the social preference
of ‗A‘ over ‗B‘ depends only on individual preferences of just these two
Ted and arses that the alternatives, ‗A‘ and ‗B‘, and not on any other
alternative which is not immediately relevant.

The above five conditions of Arrow reflect his value judgements and they
seem to be quite reasonable set of conditions for making social choices in
a free democratic society However. Arrow has shown that it is impossible
to make social choices without violating at least one of the above five
conditions. In other words, it is not possible to construct a social welfare
function on the basis of Individual values that satisfy all the above
conditions.

(Ref: Dr. H L Ahuja, Advanced Economic theory, 19th Revised

edition.)

According to Impossibility Theorem, in a democratic country public

choice for public goods based on majority of voting are not sufficient for
social welfare maximisation through supply and consumption of public
goods by the government and people respectively. Besides majority of
voting, the above-mentioned conditions should be satisfied, that enable to
arrive at effective social indifference curve and the social welfare
function. Hence, this theory is known as the impossibility theorem.
The impossibility theorem of Arrow can be explained with the help of
example. Three voters (A, B, C) are selecting among three budgetary
policies (X, Y, Z). Policy alternative X represents a decision to build three
public libraries, policy Y, a decision to build two libraries, and policy Z, a
decision to build one library.
Examples of Majority Voting: Individual Preferences for Alternative
Budget Policies
Table No. 2.1
A. Results: Intransitive Policy Alternatives
Voter Preference 1 Preference 2 Preference 3
A X Y Z
B Y Z X
C Z X Y
B. Results: Transitive Policy Alternatives
26
 Voter Preference 1 Preference 2 Preference 3
A X Y Z
B Y Z X
C Z Y X

In above table, A) illustrates a situation in which majority voting violates

the set of conditions necessary for consumer sovereignty to be maintained
in collective democratic decision making. Condition 1, the transitivity
condition, in particular, is violated, leading to what is known as the
impossibility theorem or voting paradox. Since a majority of the voters
(two out of three) prefer policies X to Y, Y to Z and Z to X, the result is
intransitive or inconsistent in that there is no winner. The sequence in
which the voting occurs would determine the final outcome is illogical
result. The outcome is arbitrary since either Z, X or Y will win depending
on the ordering of the voting sequence. The transitivity occurs because one
voter prefers two extreme policies (Z for one library and X for three
libraries) over the median or intermediate alternative, Y for two libraries.
This is an unlikely position for a voter to take. To prefer three libraries as
a second choice instead of two libraries. When it is graphed, the result is
twin-peaked preference function for voter C.

If voter C behaves in a more rational manner and prefers two libraries as a

second choice, the intransitive problem disappears and the solution
becomes determinate. This is depicted in above table by outcome B) with
showing a single peaked preference function for voter C. we begin with a
pairing of Y versus Z, Y wins over Z and also defeats X. Finally, a pairing
Y versus Z finds Z the winner, but Y wins over Z. Thus, Y is the clear-cut
winner despite the ordering of the voting sequence. These results also
indicate budgetary size.

Arrow's impossibility theorem of public choice can be presented with the

help of figure below.
Figure No. 2.1

Intransitive Policy Alternatives

Voter A Voter B Voter C

27
 Figure No. 2.2

Transitive Policy Alternatives

Voter A Voter B Voter C

The impossibility theorem of Arrow is criticised on various grounds as

follows.
1. Arrow's theorem could not show intensity of public choices of people
for public goods.
2. Arrow has depicted a very pessimistic scenario of political process of
arriving at fiscal decision, for supplying public goods.
3. We cannot say common voter reveals his preference for public goods
through voting only.
4. It is not true that, the government always taken into account public
choices for public goods of people while supplying them.
5. Arrow‘s theory cannot be applied to public goods of heterogeneous in
nature.

Even though, Arrow's theorem of public choice is criticised severely, its

total importance cannot be discarded. This theorem explains how the
government provides public goods to its citizens in a democratic country.
Only majority of voting to reveal public preferences for public goods is
not sufficient, but consistency in choice is also a must for fiscal decision
and social welfare maximisation. The noteworthy merit of the theory is, it
describes how it is possible to materialise social welfare maximisation of
the society through supply of public goods by the government.

2.7 SUMMARY

The standard justification of state intervention takes as its starting point

the behaviour of the economy in the absence of the government, that is, in
the hypothetical situation of a free market economy. From the basic
theorems of welfare economics, if this economy is perfectly competitive
and there is a full set of markets, then, assuming that an equilibrium exists,
it is Pareto-efficient. An externality represents a connection between
deferent economic agents which are outside the price system of the
economy. As the level of externality generated is not controlled directly by
price, the standard efficiency theorems on market equilibrium cannot be
applied. The market failure that can result raises a potential role for
correction through policy intervention. Public expenditure theory defines
the legitimate areas of public concern as well as the permissible forms that
28
policy may take. Moreover, as indicated above, public expenditure theory
often contains its own theory of taxation in the sense that the expenditure
decision rules define a set of taxes and transfers necessary to guide the
market system to an optimum. Taxes contribute to the pursuit of efficiency
and equity in these instances. of society‘s concern for end-results equity.
A perfectly functioning market system can assure an efficient allocation of
resources. Perfect competition also satisfies the process equity norm of
equality of opportunity and is likely to generate a high degree of social
mobility.He then proved that, in general, no social decision process can
simultaneously satisfy all five axioms. Arrow‘s theorem does not imply
that a democratic society cannot make social decisions.

2.8 QUESTIONS

1. Explain theorems of welfare economics.

2. Discuss need for State Intervention.
3. What is Externalities how it leads Market towards Failure.
4. Explain Arrow‘s impossibility Theorem.

2.9 REFERENCES

1. Jean Hindriks and Gareth D. Myles, (2013)INTERMEDIATE PUBLIC

ECONOMICS, second edition.
2. Dr. H L Ahuja, Advanced Economic theory, 19th Revised edition.
3. Chand S.N.,(2008) Public finance.
4. Atkinson A B and J E Stiglitz, lecture on public Economy, New York
cgraw Hill (1980)

*****

29
 MODULE II
3
PROVISION OF PUBLIC GOODS
Unit Structure
3.0 Objectives
3.1 Introduction
3.2 Classification of Goods
3.3 Optimal Provision of Public Goods: Pure and Local
3.4 Merit goods
3.5 Lindahl‘s Voluntary Exchange Approach
3.6 Conclusion
3.7 Questions
3.8 References

3.0 OBJECTIVES

The major objectives of the present unit are as follows:

1. To understand the concepts of public goods, private goods,Club goods
and Merit goods;
2. To analyse the provisions for supplying public goods;
3. To study the Lindalhl‘s Voluntary Exchange approach;

3.1 INTRODUCTION

Government plays a vital role in, more or less, all types of economic
systems. Government makes provisions in its public budget to provide
public goods to the people so that social welfare can be promoted. To
make provision of supply of public goods by the government, it should
know choices, preferences and priorities of the people for public goods.
This demands to study preferences or choices of people for public goods.
The present unit discusses the supply of public goods to be made by the
government by making their provision in its budget through taking into
consideration public preferences or choices revealed by the people. Hence,
the present unit study the different categories of goods in public
economics, optimal provision of public and local goods, concept of merit
goods and Lindahal‘s approach of public expenditure.

The present unit is classified into following segments:

31
3.2 CLASSIFICATION OF GOODS

There are four categories of goods in economics, which are defined based
on two attributes. The first attribute is excludability, or whether people can
be prevented from using the good. The second is whether a good is rival in
consumption: whether one person‘s use of the good reduces another
person‘s ability to use it.

Combinations of these two attributes create four categories of goods:

Table No. 3.1

Excludable Non- excludable

Rival Private Goods Common Goods
Food, clothing, car, Fish stock, timber, coal
personal electronics
Non- Club Goods Public Goods
Rival Cinemas, private parks, Air, national defence
satellite TV

 Private goods: Private goods are excludable and rival. Examples of

private goods include food, clothes, private vehicles. There are usually
limited quantities of these goods, and owners or sellers can prevent
other individuals from enjoying their benefits by charging price for it.
So private goods are exchanged for payment. Private goods are scares,
which causes competition for it. Since people have to pay to obtain it,
private goods are much less likely to encounter a free-rider problem
than public goods and so the market will efficiently allocate resources
to produce private goods. In daily life, examples of private goods
abound, including food, clothing, and most other goods that can be
purchased in a store. Take an example of an ice cream cone. It is both
excludable and rivalrous. It is possible to prevent someone from
consuming the ice cream by simply refusing to sell it to them if they
are not ready to pay for it. Additionally, it can be consumed only once,
so its consumption by one individual would definitely reduce others‘
ability to consume it.

 Common goods: Common goods are non-excludable and rival.

Because of these traits, common goods are easily over-consumed,
leading to a phenomenon called ―tragedy of the commons‖. In this
situation, people withdraw resources to secure short-term gains
without regard for the long-term consequences. A classic example of a
common good is fish stocks in international waters. No one is
excluded from fishing, but as people withdraw fish without limits
being imposed, the stocks for later fishermen are depleted.

 Club goods: Club goods are excludable but non-rival. This type of
good often requires a ―membership‖ payment in order to enjoy the
benefits of the goods. Non-payers can be prevented from access to the
32
 goods. Cable television is a classic example. Broadband or mobile
network also belong to this category. It requires a monthly fee, but is
non-rival after the payment. The characteristics of goods place them
either towards the pure private good end or towards the pure public good
end. There are many goods, which are indivisible, and which many
individuals could consume simultaneously upto the capacity constraint,
thereafter the good becomes congested. These exists some exclusion
technology, which makes it possible to charge individual prices for the
use of the commodity. Swimming pools, golfcourses, bridges, etc. are
considered as club goods

 Public goods: A public good is a good whereby no individual can be

excluded from benefiting from it. This could come in the form of a
government public good such as street light, defence, public park or a
natural public good such as air, sunlight. Public goods are non-
excludable and non-rival. Individuals cannot be excluded from using
them, and use by one individual does not reduce the good‘s availability
to others. Examples of public goods include the air we breathe, public
parks, and street lights. Public goods may give rise to the ―free rider
problem‖. A free-rider is a person who receives the benefit of a good
without paying for it. This may lead to the under-provision of certain
goods or services. Public goods can be pure or impure. Pure public
goods are those that are perfectly non-rivalrous in consumption and
non-excludable. Impure public goods are those that satisfy the two
conditions to some extent, but not fully.

Following are the important features of public goods.

1. Non-excludability:
Non-excludability means that the producer of the good is unable to
prevent others from using it. For instance, it would be extremely difficult
to prevent each person from using a traffic light. Public goods such as
defence, policing, and the law are all non-excludable. Everyone benefits
from policing, which makes it impossible to charge some but not others. In
turn, this presents us with the ‗free-rider problem‘.

2. Non-rival Consumption:
In every economy, some goods are provided by the government to the
entire people. Non-rivalry means that more than one person can use the
good without diminishing others ability to use it. Specifically, public good
is the one that is provided to the society as a whole and consumption by
one individual doesn‘t reduces its availability. Public goods are consumed
jointly. As a result of this they are non-rival in nature.

3. Externality:
The benefits accrued from public good is external to the consumer. Public
goods are subject to the principle of consumer sovereignty. They are
produced on the basis of individual preference, but the satisfaction derived
from public goods by an individual consumer is independent of his own
33
contribution. This is so because, the cost met by government through
budget.

4. Benefit Obscure:
Public goods are obscure in nature. It is very difficult to realise the benefit
from public good. The example of street light, it is difficult to measure
that how much benefits received from street light by all the citizens of the
country.

5. Payee and Beneficiary not identical:

Generally, public goods are beneficiary but at the same who pays for it to
make its provision certainly not a real beneficiary. In other words, through
government budget pubic goods are made available, it means payee and
beneficiaries are not identical.

3.3 OPTIMAL PROVISION OF PUBLIC GOODS: PURE

AND LOCAL

The production of public goods results in positive externalities for which

producers don‘t receive full payment. Consumers can take advantage of
public goods without paying for them. This is called the ―free-rider
problem‖. If too many consumers decide to ―free-ride,‖ private costs to
producers will exceed private benefits, and the incentive to provide the
good or service through the market will disappear. The market will thus
fail to provide enough of the good or service for which there is a need.
Government funding and proper provision for public goods as per
requirement of people is difficult task to perform. The problem then is
how the government should determine how much of such goods are to be
produced and allocated. The difficulty lies in deciding the type and quality
of a public good that should be supplied and how much a particular
consumer should be asked to pay.

The government uses cost-benefit analysis to decide whether to provide a

particular good. If marginal benefit is greater than marginal cost there is
an under allocation of a public good. If marginal cost is greater than
marginal benefit there is an over allocation of a public good. When
marginal cost = marginal cost, then there is an optimal allocation of public
goods.

3.3.1 Demand for Public Goods:

The aggregate demand for a public good is the sum of marginal benefits to
each person at each quantity of the good provided. The economy‘s
marginal benefit curve (demand curve) for a public good is thus the
vertical sum all individual‘s marginal benefit curves. The vertical
summation of individual demand curves for public goods also gives the
aggregate willingness to pay for a given quantity of the good.

34
 Figure No. 3.1

The sum of the individual marginal benefit curves (MB) represent the
aggregate willingness to pay or aggregate demand (∑MB). The
intersection of the aggregate demand and the marginal cost curve (MC)
determines the amount of the good provided. Optimal quantity of public
good is G*

This is in contrast to the aggregate demand curve for a private good, which
is the horizontal sum of the individual demand curves at each price.
Unlike public goods, society does not have to agree on a given quantity of
a private good, and any one person can consume more of the private good
than another at a given price.

The efficient quantity of a public good is the quantity that maximizes net
benefit (total benefit minus total cost), which is the same as the quantity at
which marginal benefit equals marginal cost.

3.3.2 Mathematical explanation of optimal provision of pure public

good:

Suppose Mr. John has preference over cookies (C) and Missiles (M): UJ
(C, M)

To John, the marginal utility of missile is worth,

35
For Tom, preferences are UT(C,M)

The marginal utility for of missile is worth

Unlike the case of private goods, where aggregate demand is found by

summing the individual demand horizontally, with public goods aggregate
demand is found by summing vertically.

The social marginal benefit of the next missile is the sum of John and
Tom‘s marginal rate of substitution: MRSJ,TM,C

The efficiency requires,

∑ (i is every individual)

So the social efficiency is maximized when the marginal costs are set
equal to the sum of MRS, rather than individual MRS.This is because the
good is non rival. Since a unit can be consumed by all the consumers,
society would like the producer to take into account all consumers‘
preferences.

3.3.3 Provision of Local Public Goods:

Local public goods are public goods that can be enjoyed only by residents
in the local community: for example, local public school, beaches, parks,
etc. are typical examples of public goods. TieboutCharles (1956) proposed
a different solution for provision of local public goods. He suggests that
lots of public goods are provided by local expenditures, and if there were
enough communities, individuals would reveal their true preferences for
public goods by the choice of community in which to live (in much the
same way as individuals reveal their preferences for private goods by their
choices).

Where there is a wide range of choices, all those deciding to live in the
same community would have essentially the same taste, and there would
be no problem of reconciling conflicting preferences. This is an interesting
idea since it suggests that the invisible hand can solve the important
problem of under-provision of public goods.

People living nearby may or may not be excludable, but people living
farther away can be excluded. Such goods that are produced and
consumed in a limited geographical area are local public goods. Schools
are local—more distant people can readily be excluded. With parks it is
more difficult to exclude people from using the good; nonetheless, they
are still local public goods because few people will drive 30 miles to use a
park.
36
Suppose that there are a variety of neighborhoods, some with high taxes,
better schools, big parks, beautifully maintained trees on the streets,
frequent garbage pickup, a first-rate fire department, extensive police
protection, and spectacular fireworks displays, and others with lower taxes
and more modest provision of public goods. People will move to the
neighborhood that fits their preferences. As a result, neighborhoods will
evolve with inhabitants that have similar preferences for public goods.
Similarity among neighbors makes voting more efficient, in turn.
Consequently, the ability of people to choose their neighborhoods to suit
their preferences over taxes and public goods will make the neighborhood
provision of public goods more efficient. The ―Tiebout theory‖ shows that
local public goods tend to be efficiently provided. In addition, even private
goods such as garbage collection and schools can be efficiently publicly
provided, when they are local goods, and there are enough distinct
localities to offer a broad range of services.

3.4 MERIT GOODS

So far, we have classified economic goods into categories of private and

public good based on their consumption characteristics-joint or private.
Goods that have higher degree of joint or collective consumption
characteristic are usually provided by the public sector and those goods
with lower degree of joint consumption can be supplied by the private
sector. But, there can be exception to this tendency as we may notice in a
society.

Sometimes, the public sector may decide to actively participate in the

allocation of certain economic goods which are essentially private goods-
rival and excludable in consumption-and therefore can be otherwise
supplied by the private sector. These economic goods are considered by
the government as meritorious or important as they generate large social
benefits for every individual and the society. Examples of such goods and
services are education, healthcare, job training program, public
library and others. For these goods, the government thinks that everybody
in a society should consume a certain level of these goods irrespective of
their ability to pay for those goods and also believes that if left to the
private sector alone, these goods will be under provided. These
governmentally supplied or heavily subsidized private goods are called the
Merit goods in economics.

In 1959 R. A. Musgrave developed the concept of Merit goods. Goods and

services (which may be efficiently provided by the private sector) actually
provided by the public sector in view of the normative consideration that
all should be able to benefit from them have been labelled as merit goods.
The merits goods play an important role in welfare maximization. Merits
goods are also called as public good but their provision cannot be
explained in the same way as the provision of public goods. The provision
of merit goods depends upon the choice. These goods are under-consumed
37
in a free market because of ignorance and externalities. As we know
Education and health services are good examples of merit goods. If they
are left to free market choice these goods will not be produced in adequate
quantity.

Merit goods are under provided or supplied at a less than optimal level by
the private sector because the private market for such goods suffers from
market failure that is the equilibrium outcome of the private market does
not maximize social efficiency. There are three main reasons for this
market failure and need of public provision for merit goods:

Firstly, consumption of merit goods generates large positive externalities

which means social marginal benefit (SMB) from merit goods
consumption exceeds the private marginal benefit (PMB) that is
SMB>PMB. For example, we can think about education. An individual
receives private benefit from education through higher productivity,
income and better job in his or her life but others in the society also gains
in terms of social benefit to get an educated, enlightened and responsible
citizen. Therefore, consumption of education does not only create benefit
for that person but also for others in the society which is not accounted for
in the private market equilibrium. Secondly, people suffer from imperfect
information regarding the consumption of merit goods. Government feels
that individuals may not act in their own best interest partly because they
don‘t have complete information about the long-term benefits of merit
goods. Let‘s take the example of education again. Education is a long-term
investment decision for children. The costs of education are paid in the
current period but the benefits from education in terms of higher
productivity, income, greater occupational mobility, better employment
opportunities could be received in distant future. Sometimes, people are
unaware of these long-term benefits of education for their children and
therefore, under consume it. Third, the equity ground is another
argument for the public provision of merit goods. Families with low
income do not have the ability to pay for their children‘s education even
when they know the benefits of education. Therefore, subsidized or free
education from government can help them to attain that desired level.
Therefore, merit goods can be provided both privately and publicly as we
can see both private and public schools, hospitals, health insurance and
other services to coexist in a society.

3.5 LINDAHL’S VOLUNTARY EXCHANGE APPROACH

The first clear formulation of a theory of public expenditure was presented

by Knut Wicksell and Erik Lindahl. Voluntary Exchange Approach is the
analysis of the provision of public goods which seeks to establish
conditions under which these goods can be provided on the basis of
unanimous agreement. Under the Voluntary exchange model, tax levels
are determined automatically, because taxpayers pay proportionately for

38
the government benefits they receive. Putting it another way, the
individuals who benefit the most from public goods pay the most taxes.

The voluntary approach was first advanced by Knut Wicksell who

argued that:
 Each public good should be financed by a separate, identifiable tax.
 The unanimous agreement of all members of the society would be
required to decide on the amount of the good to be supplied.

Erik Lindahl (21 November 1891 – 6 January 1960) was a Swedish

economist. He was also an advisor to the Government of Sweden and the
central bank. Lindahl model discusses the question of financing public
goods in harmony with individual benefits. The quantity of the public
good satisfies the requirement that the total marginal benefit equals the
marginal cost of providing the good. Erik Lindahl was deeply influenced
by his professor and mentor Knut Wicksell and proposed a method for
financing public goods permissible to show that consensus of people. As
people are different in nature, their preferences are different, and
consensus requires each individual to pay a somewhat different tax for
every service, or good that he consumes. If each individual‘s tax price is
set equivalent to the marginal benefits received, each individual is made
better off by provision of the public good and may accordingly agree to
have that service level provided.

Lindahl tax is a system of taxation in which individuals pay for the

provision of a public good in accordance to their marginal benefits. So
each individual pays according to his/her marginal benefit derived from
the public good. e.g. If A loves scenic beauty and likes to be close to
nature he might be ready to pay 5 dollars per day for sitting in a park,
whereas a college student who does not visit the park very often will not
be ready to pay so much, but might agree to pay 1 dollar. So a person who
values the good more pays more. In such cases, the problem of supply of
the public good, at optimal levels arises. Lindahl taxation is a solution for
this problem.

Lindahl tries to solve the following 3 problems:

 Extent of state activity
 Allocation of the total expenditure among various goods &services
 Allocation of tax burden

39
 Figure No. 3.2

In the Lindahl model, if SS* is the supply curve of public goods it is

assumed that production function of public/social goods is linear and
homogenous. DDa is the demand curve of taxpayer A, and DDb is the
demand curve of taxpayer B. The vertical summation of the 2 demand
curves results in the community‘s total demand schedule for public goods.
A and B pay different proportions of the cost of the services. When QN is
the amount of public goods produced, A contributes NE and B contributes
NF; the cost of supply is NG. Since the state is non-profit organization, it
increases its supply to OM. At this level, A contributes MJ and B
contributes MR (the total cost of supply). Equilibrium is reached at point P
on a Voluntary-exchange basis.

Lindahl equilibrium:
Lindahl taxes are also known as Benefit taxes. Lindahl equilibrium is a
sort of economic equilibrium under such a tax. It is a method of finding
the optimal level for the supply of public goods or services. The Lindahl
equilibrium happens when the total per unit price paid by each individual
equals the total per unit cost of the public good.

In the Lindahl tax scheme it is essential that the system should provide for
a Pareto optimal output of the public good. The other important condition
is that the Lindahl tax scheme should connect the tax paid by an individual
to the benefits he derives. This system promotes justice. If the individual's
tax payment is equivalent to the benefits received by him, and if this
linkage is good enough then it leads to Pareto optimality. Consider the
following figure:
40
 Figure No. 3.3

So, it is observed that X is paying P*45% per unit, and Y is paying P*55%
per unit, and the economy produces Q* units. This point is called the
Lindahl equilibrium, and the corresponding prices are called Lindahl
prices. ThusLindahl equilibrium is a theoretical state of an economy
where the optimal quantity of public goods is produced and the cost of
public goods is fairly shared among everyone.

3.6 CONCLUSION

Thus, this unit is devoted to classification of goods in Public Economics,

provision of Public goods and Lindahl‘s Voluntary Exchange Approach.
The unit discusses four categories of goods in Public Economics based on
two attributes- Excludability and Non-excludability. Merit goods are
another category of public goods, supply of which can be done by private
as well as public provision. Provision of public goods is one of the
difficult tasks for government. It is necessary to undertake the production
of public goods and their supply to the people, which enables social welfare
maximization. The efficient quantity of a public good is the quantity that
maximizes net benefit (total benefit minus total cost), which is the same as
the quantity at which marginal benefit equals marginal cost. The unit
thoroughly describes Voluntary Exchange Approach for the provision of
public goods which seeks to establish conditions under which these goods
can be provided on the basis of unanimous agreement. Lindahl tries to
solve the problems of provision of public goods by fixing extent of state
activity, allocation of total expenditure among various goods & services
and by allocation of tax burden. Besides this, the unit also highlights the
TieboutCharles solution to provision of Local public goods.

3.7 QUESTIONS

Q1. Explain various categories of goods noticed in Public Economics.

41
Q2. What is Public goods? Highlight the main features of public goods.
Q3. Illustrate the optimal provision of Pure and Local Public goods.
Q4. Illustrate the optimal provision of Public goods.
Q5. What is Merit goods? What is the need of Public Provision for Merit
Goods?
Q6. Analyse the Lindahl‘s Voluntary Exchange Approach.
Q7. What is Lindahl tax, explain the Lindahl‘s equilibrium?

3.8 REFERENCES

1. Dr. RanjiniNeogi, Theory of Public Finance: Private goods, Public

goods and Merit goods, e-pathshala, SGTB Khalasa College, New
Delhi.
2. Dr. RashmiChoudhary, Theory of Public Finance: Voluntary
Exchange Model, e-pathshala, SGTB Khalasa College, New Delhi
3. Singh S. K , ―Public Finance, Theory and Practice‖, S. Chand and
Company, New Delhi.
4. Karl E. Case and Ray C Fair, ―Principles of Economics‖ 5th Edition,
Pearson Publication, New Delhi, (2012),
5. Musgrave R. A. and Musgrave Peggy B. ―Public Finance in Theory
and Practice‖,New York, McGraw Hill Co. 1973
6. Brown & Jackson (1987). Public Sector Economics, Basil Blackwell,
Oxford.
7. Tyagi, B. P. (1997-98). Public Finance, Jai PrakashNath& Co.,
Meerut.
8. Lekhi, R. K. (1998). Public Finance, Kalyani Publishers, Ludhiana.
9. Buchanan, J. M. (1970). The Public Finances, Richard D. Irwin,
Homewood.
10. Agrawal R. C., Public Finance, Theory and Practice, L. N. Agrawal
Publication, Agra.
11. Bhatiya H. L., Public Finance, Vikas Publication House Pvt. New
Delhi.
12. Mithari D.M., Modern Public Finance, Himalaya Publishing House,
Mumbai.
13. https://boycewire.com/public-goods-definition-and-examples/

*****

42
 4
EVALUATION OF PUBLIC EXPENDITURE
Unit Structure
4.0 Objectives
4.1 Introduction
4.2 Preference Revelation Mechanism
4.3 Private Provision of Public Goods
4.4 Evaluation of Government Expenditure: Cost Benefit Analysis
4.5 Conclusion
4.5 Questions
4.6 References

4.0 OBJECTIVES

1. To insight into Preference revelation Mechanism

2. To explain the private provision of Public Goods
3. To analyze the Cost benefit theory to evaluate Government
expenditure project.

4.1 INTRODUCTION

To smooth supply of public goods, planners should have knowledge about

individual preference functions. In the democratic countries, the
government takes into account public preferences for the public goods and
makes provision of their supply by allocating productive resources for their
productions. This enables proper and rational allocation and utilization of
productive resources whereby social welfare maximization can be
materialized through the consumption of public goods produced. This is
analyzed by the theories in Public Economics. They are known as the
theories of public choice or social choice. Present unit elaborate theories
of social choices given by Wicksell and Arrow. Private provision of public
goods and evaluation of government expenditure through cost benefit
analysis are also illustrated.

The present unit is classified into following segments:

4.2 PREFERENCE REVELATION MECHANISM

In social choice theory, preference revelation is a field of study related to

the establishment of the demand for the public good. According to some
43
economists, if the government planners do not have "full knowledge of the
individual preference functions", it is likely that public goods will be
under supplied or over supplied.

The conditions that must hold if a public good is to be provided at a

Pareto-efficient level are well established in the economics literature and
were first set out formally by Samuelson (1954, 1955). Assuming that
the public good is financed out of non-distortionary taxation, these
conditions require that the good be provided up to the level at which
iMRSgx= MRTgx

Where MRSgxis the marginal rate of substitution between the public good
g and a private good numeraire, x; MRTgx is the marginal rate of
transformation between two goods; and there are i consumers of the public
goods.

Government in any type of economy endeavorsto maximize social welfare.

But it should be known to the government for which public goods people
have shown their choices. People should make choice of public goods
preferred by them. In the democratic countries, the government takes into
account public preferences for the public goods and makes provision of
their supply by allocating productive resources for their productions. This
enables proper and rational allocation and utilization of productive
resources whereby social welfare maximization can be materialized through
the consumption of public goods produced. This is analyzed by the theories
in Public Economics. They are known as the theories of public choice or
social choice.

The theories of public or social choice include the following theories

1. Wicksell's Approach to reveal Public Choice: Absolute and Relative
Unanimity Principle/Approach
2. Arrow‘s Impossibility Theorem

1. Wicksell's Approach:
In the democratic government countries, political process is very much
important to provide public goods by the government. Since people reveal
preferences for public goods through political process, the government can
allocate productive resources in the society for the production of public
goods. Public choices for public goods, problems in revealing public
preferences and solutions have been discussed for the first time by a
Swedish economist Knut Wicksell. This is known as Wicksell's Approach
to reveal public choice. It is divided into Absolute Unanimity Approach
and Relative Unanimity Approach.

The efficient allocation of productive resources in the society requires

political process. Even in the democratic form of government based
society individual preferences of the people for public goods are taken into
consideration, still there remain problems. Individual preferences based on
44
the concept of an equal vote for all, are unlikely to be revealed and
implemented effectively by a system of simple majority voting. Where a
majority of 50% plus one vote may carry a decision. Hence, a minority of
50% minus are of the citizens may be obliged to help pay for a public type
economic good with their taxes, even though they do not desire the
allocation of the good. Such costs to be "political losers" of a majority
voting decision are referred to as voter externality costs. According to
Wicksell, in a democratic form of government country Absolute
Unanimity method can be used for revealing public preferences for the
public goods by the people. On the basis of preferences for public goods
revealed by the people, the government can provide these public goods
through allocation and utilization of the productive resources for their
production. The provision of supply of a public good can be made by the
government in the public budget, and by supplying it to the people can
achieve social welfare maximization. But for this 100% people should cast
their votes in favour of supply of that public good by the government. If
one of them is against the supply of that public good, then the government
cannot take that fiscal decision and provide for that public good. This is
known as Absolute Unanimity Approach of the Wicksell, which is useful
in decision making about supply of public goods by the government, but
difficult. Therefore, an alternative mechanism of revealing preferences for
public goods in the democratic country was evolved, that is Relative
Unanimity Approach.

Since a single voter by casting vote against the fiscal decision to supply a
public good by the government under Absolute Unanimity Approach,
Wicksell propounded an alternative approach or solution to reveal public
preferences for the supply of public goods by the government, which is
known as Relative Unanimity Approach or Qualified Majority Voting.
Under this approach, the approval percentage for a budget policy should
be as close to low percent. A majority of one thirds (1/3), two thirds (2/3),
three fourths (3/4), or five sixth (5/6) might be required for approval of a
budget policy under the unanimity rule. This enables to know that an
individual and his vote against the budget policy cannot restrict supply of
that public good, and cannot exploit the people who are in favour of that
fiscal decision. This rule allows an acceptance number of collective
decisions to be made. It also facilitates to reduce voter externality costs. A
scientific number of votes allow to supply that public goods by the
government by making its provision in public budget. Hence, it is very
simple principle of revealing public preferences for public goods by the
people and their supply as well by the government.

According to Wicksell, marginal benefit from a public expenditure should

be related to the marginal tax cost of providing the public good, and then
the relative unanimity rule should be applied to the government decision.
This is consistent with his preference for the voluntary exchange approach
to public goods allocation.

45
Thus, the government can collect preferences of the people for public
goods through absolute or relative unanimity rule and by allocating and
utilising productive resources can supply public goods to the people
whereby social welfare of the society can be maximised. This approach
also provides for spending and revenue decision by the government
simultaneously. Hence, it is an important theory of public choice.

But Wicksell's theory or approach to public choice is criticised on the

following grounds.
1. In a democratic country, first it is decided which and how much
quantity of public goods to be provided, and then they are supplied to
the people.
2. Government cannot impose taxes on the people in proportion of its
public expenditure.
3. In a democratic country, government estimates its public expenditure
first, and then it endeavors for collecting necessary revenue, therefore
this theory of public choice is not useful for the government decision
making.
4. All people do not know to reveal preferences for public goods being
supplied by the government, only a few people know that.
5. In reality, the government does not take into consideration public
choices for the supply of public goods to the people.

2. Arrow's Impossibility Theorem of Public Choice:

Kenneth Arrow has explained the problems involved in decision making
by the government. In a democratic country fiscal decision of the
government to supply public goods cannot only depend on the majority of
voting. A majority of voting is not sufficient only in fiscal decision of the
government for supplying public goods. It does not indicate the effective
social indifference curve, and consequently the social welfare function.
Hence, this theory is known as the Impossibility theorem. According to
Arrow, following conditions must be met if a collective decision reached
under majority voting conditions is to accurately reveal the individual
economic preferences, which constitute the effective social indifference
curve and the social welfare function:
1. Social choices must be transitive or consistent. That is, a unique social
ordering must exist which will yield a clear-cut winning alternative
regardless of the ordering sequence in which alternative choices are
voted on.
2. The social welfare function must be non-perverse in the sense that an
alternative policy which might otherwise have been chosen by the
society must not be rejected.
3. The rankings of the choices in the social welfare function between two
alternatives must be independent of the ranking by individuals of other
alternatives, which are irrelevant to the choice between the two

46
 alternatives. The elimination of any one alternative must not influence
the ranking of the other alternatives in the social welfare function.
4. Voters must have free choices among all alternative policies.

The impossibility theorem of Arrow can be explained with the help of

example. Three voters (A, B, C) are selecting among three budgetary
policies (X, Y, Z). Policy alternative X represents a decision to build three
public libraries, policy Y, a decision to build two libraries, and policy Z, a
decision to build one library.

Table No. 4.1

Examples of Majority Voting: Individual Preferences for Alternative
Budget Policies
a) Results: Intransitive Policy Alternatives

Voter Preference 1 Preference 2 Preference 3

A X Y Z
B Y Z X
C Z X Y

b) Results: Transitive Policy Alternatives

Voter Preference 1 Preference 2 Preference 3

A X Y Z
B Y Z X
C Z Y X

In above table, a) illustrates a situation in which majority voting violates the

set of conditions necessary for consumer sovereignty to be maintained in
collective democratic decision making. Condition 1, the transitivity
condition, in particular, is violated, leading to what is known as the
impossibility theorem or voting paradox. Since a majority of the voters (two
out of three) prefer policies X to Y, Y to Z and Z to X, the result is
intransitive or inconsistent in that there is no winner. The sequence in which
the voting occurs would determine the final outcome is illogical result.
The outcome is arbitrary since either Z, X or Y will win depending on the
ordering of the voting sequence. The transitivity occurs because one voter
prefers two extreme policies (Z for one library and X for three libraries) over
the median or intermediate alternative, Y for two libraries. This is an
unlikely position for a voter prefer three libraries as a second choice instead
of two libraries.

When it is graphed, the result is twin-peaked preference function for voter

C. If voter C behaves in a more rational manner and prefers two libraries as
47
a second choice, the intransitive problem disappears and the solution
becomes determinate. This is depicted in above table by outcome b) with
showing a single peaked preference function for voter C. we begin with a
pairing of Y versus Z, Y wins over Z and also defeats X. Finally, a pairing Y
versus Z finds Z the winner, but Y wins over Z. Thus, Y is the clear cut
winner despite the ordering of the voting sequence. These results also
indicate budgetary size.

The impossibility theorem of Arrow is criticized on various grounds as

follows:
1. Arrow's theorem could not show intensity of public choices of people
for public goods.
2. Arrow has depicted a very pessimistic scenario of political process of
arriving at fiscal decision, for supplying public goods.
3. We cannot say common voter reveals his preference for public goods
through voting only.
4. It is not true that, the government always taken into account public
choices for public goods of people while supplying them.
5. Arrow‘s theory cannot be applied to public goods of heterogeneous in
nature.

Even though, Arrow's theorem of public choice is criticized severely, its

total importance cannot be discarded. This theorem explains how the
government provides public goods to its citizens in a democratic country.
Only majority of voting to reveal public preferences for public goods is not
sufficient, but consistency in choice is also a must for fiscal decision and
social welfare maximization. The noteworthy merit of the theory is, it
describes how it is possible to materialize social welfare maximization of
the society through supply of public goods by the government.

4.3 PRIVATE PROVISION OF PUBLIC GOODS

In general, the private sector underprovides public goods because of the

free rider problem. Private provision of a public good creates a positive
externality (as everybody else benefits), Goods with positive externalities
are under-supplied by the market.

There are some interesting examples of the free rider problem in practice.
Only 7.5% of public radio listeners in New York contribute to the
stations–that is, there is a lot of free-riding. In the United Kingdom, the
BBC charges an annual licensing fee for all television owners. Many users
of file sharing services never contribute for downloading the files; they
only download files. Some of these services, give download priority to
those who contribute.

48
Consider two people, Ben and Jerry, and two consumption goods, ice
cream and fireworks. Set the prices of each good at $1, but fireworks are
a public good. Assume that Ben and Jerry have identical preferences.

Ben and Jerry benefit equally from a firework. Each person chooses
combinations of ice cream and fireworks in which his own MRS equals
the ratio of price. For both Ben and Jerry, they set:
= 1, =

Whereas optimal provision requires:

With identical preferences, the optimal condition is:

( )

This implies

We know that marginal utilities diminish with increasing consumption of a

good. In this example, optimal provision would require that fireworks are
consumed until their utility equals half the marginal utility of ice cream.
Thus, each individual buys too much ice cream privately.

Under what circumstances are private market forces likely to solve

the free rider problem?
The free rider problem does not lead to a complete absence of private
provision of public goods. Private provision works better when:

1) Some Individuals Care More than Others: Private provision is

particularly likely to overcome the free rider problem when individuals are
not identical, and when some individuals have an especially high demand
for the public good.

2) Altruism: When individuals care about the benefits and costs to others
in making their consumption choices.

3) The warm glow: The warm glow model is a model of public good
provision in which individuals care about both the total amount of the
public good and their particular contributions as well. In this case, the
public good becomes more like a private good, though it also does not
fully solve the under-provision problems.

4.4 EVALUATION OF GOVERNMENT EXPENDITURE:

COST BENEFIT ANALYSIS
The most popular method of project evaluation is to consider the cost
benefit analysis of different projects and then to select involving lesser
49
cost and yielding greater benefit. Cost Benefit Analysis is the comparison
of costs and benefits of public goods projects to decide if they should be
undertaken.

The role of cost benefit is explained by Prof. Marglin as, “The

perspective and Five year Plans determine the broad strategy of
growth by allocating resources among sectors. But the strategy of
growth embodied in the Plans leaves many tactical questions
unsolved, and it is these tactical decisions that are the province of cost
benefit cost analysis.”

Measuring the effectiveness of the public expenditure is essential in the

analysis of the public sector‘s performance, the efficiency being an
indicator of the performance. Cost benefit analysis is a method of
measuring the efficiency of public spending. The cost-benefit analysis is
an effective tool for making decisions regarding spending the public
money in the public sector, but there may be some errors, such as errors of
omission, of forecasting, of evaluation and measurement. The quality and
accuracy of the Cost Benefit Analysis depends also on the skill and
goodwill of the analyst and on the complexity of the project.

It provides superior criteria for project evaluation in planned economy. It

helps the planning authority in making correct investment decisions to
achieve optimum resource allocation by maximising the difference
between present value of benefits and costs of a project.

Thus, cost benefit analysis ―describe and quantify the social advantages
and disadvantages of a policy in terms of a common monetary unit.‖ The
objective function can be expressed as Net Social Benefit
(NSB)=Benefits—Costs.

The equality of marginal social costs and benefits means each and every
activity of the Government should be extended to that level at which the
marginal social benefit from the activity equal marginal social costs. The
Marginal Social Benefits (MSB) are the gains to the numbers of the
community as a whole from Government expenditure. Marginal Social
Costs (MSC) are taken as the benefits from private sector production
which are foregone due to the transfer of resources to the public use. The
optimum level of each public activity is attained when MSB, from all
activities are equal to one another. The benefits to the society from the last
rupee spend on education for instance must be the same as those from the
last rupee spent on defence.

General Conditions for Cost Benefit Analysis:

The project selection must be made on cost benefit analysis to formulate
optimal development plans. The first step of project evaluation is to
consider a list of cost and benefits of a project. It depends upon the nature
of the project. The social benefits of a project include the contribution that

50
the project would make to the attainment of national goals. There are four
criteria of Cost-Benefit:
(i) B—C
where, B = Benefits
C = Costs In this criterion -
Net Social Benefit = Benefits – Costs

The adoption of the B—C criterion favours a large project and makes
small and medium size projects less beneficial. Thus, this criterion helps
in determining the scale of project on the basis of the maximisation of the
difference between B and C.

(ii) B—C/I
where, B = Benefits
C = Costs
I = Direct Investment.

The formula B—C/I is ―for determining the total annual returns on a

particular investment to the economy as a whole irrespective of to whom
these accrue‖. If the private investment happens to be very large, then
even high value of B—C/I may be less beneficial to the economy. Thus,
this criterion is not much useful to achieve satisfactory results.

(iii) ∆B/∆C
where, B = Benefits
C = Costs
∆ = Increment
It determines the size of project.

(iv) B/C

The best and most effective criterion for project evaluation is B/C. In this
criterion, the evaluation of project is done on the basis of benefit-cost
ratio. If B/C=1, then the project is marginal because the benefits occurring
from the project just cover the costs. If B/C, then benefits are less than
costs-so the project is rejected. If B/C=1, the benefits are more than costs
and the project is profitable and hence, it is selected.

The higher the benefit cost ratio, more profitable will be the project.
The criterion discussed above does not account for the time factor. In fact,
the future benefits and costs cannot be treated at par with present benefit
and cost. Therefore, project evaluation requires discounting of future
benefits and costs because society prefers present to the future.

51
If time factor is considered then criteria for social costs benefits are
following:
1) Net Present Value Criterion (NPV):

This is an important criterion for project evaluation.

NPV=Present value of benefit—Present value of operating and
maintaining costs—Initial outlay. It is also expressed as the net present
value of benefits criterion so that,
NPV of benefit = Gross present value of benefits—Gross present value of
costs.

If NPV > O then the project is socially profitable. If there are number of
mutually exclusive projects, then the project with the highest net present
value of benefits will be chosen.

The NPV criterion is not accurate method for project evaluation as it

neglects the time horizon. Capital investments give benefits after a lapse
of some time. Therefore, future benefits and costs cannot be equated with
present benefits and costs. So it becomes essential to discount future
benefits and costs because society prefers present to future.

The discount factor is expressed as:

Only those projects should be selected in which present value of benefits

exceeds the present value of costs. The ratio of present value of benefit to
present value of cost should be greater than 1 for the selection of a project.

2. The Internal Rate of Return Criterion:

The criterion refers to the percentage rate of return implicit in the flows of
benefits and costs of projects. Margin defines the internal rate of return
(IRR) as the discount rate at which present value of return minus cost is
zero. The mathematical formula for the computation IRR:

52
In case of mutually exclusive projects, the project to be selected must have
highest rate of return.

Relation between NPV and IRR:

The NPV at the social discount rate and the internal rate of return are two
criteria which are frequently used for choosing projects. The relation
between NPV and IRR is illustrated with the help of a diagram.
Figure No. 4.2

As NPV falls, the discount rate increases and a situation arises when NPV
becomes negative. The rate at which NPV changes from positive to
negative is IRR. For the selection of project, the IRR must be higher than
its discount rate i.e. r > i.

In the above figure, IRR is taken as 10 per cent be selected for

development so long as NPV > O and r (10 per cent) > i (5 per cent). For
complex projects, these two criteria can give different results but mostly
they are interchangeable.

NPV criterion is commonly used for project evaluation in private and

public sectors. But the NPV criterion is technically superior, since IRR
can give an incorrect result in special circumstances.

3. Social Rate of Discount (SRD):

Since society prefers present to future, so future generations are likely to
have higher levels of income. If the principle of diminishing marginal
utility operates, then the utility gains to future generations from a given
amount of benefits will be less than the utility gains to the present
generations so the future gains must be discounted.

The rate at which future benefits must be discounted to make them

comparable with present benefit is called ‗Social Rate of Discount‘. In
other words, it is the rate of premium which the society puts for preferring
the present consumption to future consumption.

This is illustrated with the help of a diagram

53
 Figure No. 4.2

The present consumption A1 is taken along horizontal axis and future

consumptions A2 taken along vertical axis. A1 A2 is the transformation
frontier or investment possibility curve. It consists of a series of projects
arranged from right to left in order of their rate of return, the cost of
sacrifice of present consumption and the return is the gain of consumption
in future.

The society will choose from the various investment possibilities so as to

reach its highest social indifference curve SI, The society reaches an
optimal position when transformation curve A1A2 equals its social
indifference curve SI at point G.

The slope of the transformation curves represents the rate of return on

investment and the social indifference curve represents the rate of time
preference. Thus, social discount rate is determined by the equality of the
rate of return on investment and rate of time preference at point G.

If the social discount rate is high, short period projects with higher net
benefits are preferred. On the contrary, when the discount rate is low, long
period projects with lower net benefits are selected.

Limitations of Cost Benefit Analysis:

Cost benefit analysis is a powerful technique regarding the selection and
rejection of project even then it is not free from drawbacks.

1. Difficulties in Benefit Assessment:

The correct estimation of benefits from a project becomes difficult due to
uncertainty regarding the future demand and supply of the products from a
new project. Another difficulty arises from the existence of external
54
economies. The presence of external economies may lead to the selling of
the product of project at price equal to marginal cost and not equal to
average cost which will create a deficit and efforts are made by a special
levy on consumers or through budgetary resources.

2. Arbitrary Discount Rate:

The social rate of discount assumed for any project is arbitrary. There is
no perfect method to find social discount rate. It remains a subjective
phenomenon. But if there is a small change in social discount rate it may
change the full results of project evaluation. The arbitrarily large discount
rate does not help in calculating the net present value of benefits of long
term projects.

3. Ignores Opportunity Cost:

It also ignores the problem of opportunity cost.

4. Problem of Externalities:
The side effects of a project are difficult to calculate in this analysis. There
may be technological and pecuniary externalities of a river valley project,
such as the effects of flood control measures or a storage dam on the
productivity of land at other places in the vicinity.

5. Difficulties in Selecting Appropriate Decision Rules:

There are three decision rules for the evaluation of project. These are NPV
criterion, IRR criterion and SRD criterion. All these criteria have their
own advantages and disadvantages. Therefore, it becomes difficult to
decide as to which criterion should be used for the evaluation of the
project because the wrong selection will lead to false conclusions.

6. Difficulties in the Cost Assessment:

Cost estimates are made on the basis of the choice of techniques, locations
and prices of factor services used. Market prices of factors of production
are used for this purpose provided they reflect opportunity cost.

But in developing countries, market prices usually do not reflect the

opportunity costs, because there is fundamental disequilibria which is
reflected in the existence of massive under-employment at the prevailing
level of wages, the deficiency of funds at prevailing interest rates and the
shortage of exchange at current rates of exchange.

The equilibrium level of wage rates will be considerably lower than

market wages while equilibrium interest rates will probably be much
higher than market rates. To remove this difficulty, the use of ‗shadow
prices‘ or ‗accounting prices‘ have been suggested by J. Tinbergen, H.B.
Chenery and K.S. Kretchmer. These shadow prices reflect the intrinsic
value of factors of production. In the cost benefit analysis, we cannot take
the opportunity cost of labour as zero.

55
7. Neglects Joint Benefits and Costs:
It ignores the problems of joint benefits and costs arising from a project.
There are number of direct and indirect benefits flowing from river valley
project but is difficult to evaluate and calculate such benefits separately.
Similarly, the joint costs that cannot be separated are calculated benefit-
wise.

4.5 CONCLUSION

The present unit is devoted to the theory of public choice and Cost-Benefit
Analysis. Preference revelation Mechanism is described through two
social choice theories, Wicksell approach and Arrow‘s Impossibility
Theorem. There are the number of problems in revealing public choices
for public goods by the people. These problems or difficulties are
discussed by the theories of public choice. The present unit discusses
private provision of public goods and throw some light on circumstances
where private provision of public goods can solve the free rider problem.
The present unit thoroughly explains one of the most popular theories of
public expenditure, that is Cost-Benefit Analysis with its limitations.

4.6 QUESTIONS

Q1. Explain the Wicksell approach of Public choice theory.

Q2. Illustrate Arrow‘s Impossibility theorem of social choice.
Q3. What is Preference Revelation Mechanism, illustrate through
Wicksell approach to reveal Public choice?
Q4. Explain the private provision of public goods. How the private
provision of public goods solves the free rider problem?
Q5. Evaluate the Cost-Benefit analysis.
Q6. Explain the Cost-Benefit criteria?
Q7. How can Government expenditure project be evaluated through Cost-
Benefit analysis? Discuss.
Q8. What are the limitations of Cost-Benefit analysis?

4.6 REFERENCES

 Dr. RanjiniNeogi, Theory of Public Finance: Private goods, Public

goods and Merit goods, e-pathshala, SGTB Khalasa College, New
Delhi
 Dr. Rashmi Choudhary, Theory of Public Finance: Voluntary
Exchange Model, e-pathshala, SGTB Khalasa College, New Delhi
 Singh S. K ,―Public Finance, Theory and Practice‖, S. Chand and
Company, New Delhi.
56
 Karl E. Case and Ray C Fair, ―Principles of Economics‖ 5th Edition,
Pearson Publication, New Delhi, (2012),
 Musgrave R. A. and Musgrave Peggy B.―Public Finance in Theory
and Practice‖,New York, McGraw Hill Co. 1973
 Brown & Jackson (1987). Public Sector Economics, Basil Blackwell,
Oxford.
 Tyagi, B. P. (1997-98). Public Finance, Jai Prakash Nath & Co.,
Meerut.
 Lekhi, R. K. (1998). Public Finance, Kalyani Publishers, Ludhiana.
 Buchanan, J. M. (1970). The Public Finances, Richard D. Irwin,
Homewood.
 Agrawal R. C., Public Finance, Theory and Practice,L. N. Agrawal
Publication, Agra.
 Bhatiya H. L., Public Finance, Vikas Publication House Pvt. New
Delhi.
 Mithari D.M., Modern Public Finance, Himalaya Publishing House,
Mumbai.
 https://boycewire.com/public-goods-definition-and-examples/

*****

57
 MODULE III

5
BASIC CONCEPTS OF TAX
AND TAX THEORY
Unit Structure
5.0 Objectives
5.1 Introduction
5.2 Sources of Public Revenue
5.3 Meaning of Tax
5.4 Features of Tax System
5.5 Objectives of Taxation
5.6 Canons/Principles of Taxation
5.7 Tax Theory
5.8 Summary
5.9 Questions

5.0 OBJECTIVES
After going through this unit you will be able to
 Understand the meaning of tax and know the features and objectives
of tax system.
 Know the sources of public revenue.
 Understand the canons or principles of taxation.
 Explain the theories of taxation.

5.1 INTRODUCTION

The role of government in socio-economic development of the nation is

enhancing. Public sectors expenditure is required in both developed as
well as developing economies. The theory says that with the progress of
economy the size of public expenditure increases. To fulfill the
expenditure requirements, government always trying to increase revenue
sources. There are three main sources of income in the hand of
government. These are taxes, charges/fees and borrowings.

Government of India‟s finance minister announced the central budget at 1

February 2020. The total budgetary provisional expenditure was 30.42
lakh crore. 22.46 lakh crore were collected from tax revenue and non tax
58
revenue plus non debt capital. Remaining 8 lakh crore were collected debt
to fulfill the public expenses. As the mentioned in budget, tax revenue is
the biggest source of government for income.

During the present situation every government tries to increase tax

revenue to increase the public expenditure. For that purpose several
reforms are being made in taxation system and enhanced taxes to collect
more receipt. The government of India was never levied service tax before
1995. Considering the increasing share of service sector in national
income service tax started from 1995. Now from 2017, GST (Goods and
Service Tax) is being stated to implement and most of services are brought
into GST.

5.2 SOURCES OF PUBLIC REVENUE

Sources of public revenue are as tax, fees, profit from public enterprises,
fine, grants, donation and betterment tax etc.

1. Tax:
Taxes are the main source of public income. The government withdraw a
part of people‟s income is called tax. There are several types of types.
Generally taxes are categorized as direct and indirect taxes. Direct taxed
are being paid by the person on whom government levied it and indirect
tax are the taxes which are transform from one person to another.

2. Fees:
Fees is the one of income source of government. Government provides
several administrative and other services to the people. To consume such
services government impose charges on it like educational fees, court fees,
health fees, registration fees etc.

3. Profit from Public Enterprises:

Government runs several enterprises in the country with several
objectives. It produces certain goods and services. The profit of such
industries is the income of government. For example Government runs
railway, during the period of rail minister Lalu Prasad Yadav, Indian rail
was in profit. This profit is the income of government. There are several
industries like navratna, miniratna industries running in profit in India.

4. Fine:
The government of any country establishes rules and regulation for
smooth functioning of the society. If somebody crosses the rules and
regulations, it imposes the fines. The amount of collected fine is the
income source of government but it is imposed to follow the rules of acts.
Fine are compulsory to pay if someone crosses the rules and regulations.

5. Grants:
One government gives grants to another government. Like, central
government gives grants to state governments and state governments give
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grants to local governments. It is being given by one country to another
country also.

6. Donations:
Some time at the situation of adverse condition like flood, earthquake,
tsunami, Covid19 pandemic government collect donations from the public
of nation and state. During the Covid19 pandemic Indian government
collect the donation in the account of P.M. care fund.
Every government uses several options to collect income according to the
need of public expenditure. Taxes are being imposed by the governments
to collect the income. Taxes are the biggest source of public
income/revenue. Now we will see the details about taxes, classifications of
taxes, principles of taxes and theories of taxes.

5.3 MEANING OF TAX

Tax is the amount of income which is to pay honestly to the government

by citizens without any expectation to refund it. It may be levied on
property, income, at the time of purchasing any goods and services, selling
goods and services. Tax is a compulsory payment to the government by
people without any expectation of some return. If the person denies to pay
tax it will be punished in the court of law.

According to Adam Smith, “A tax is a contribution from citizens for the

support of the state”.

Prof. Seligman: “A tax is a compulsory payment from a person to the

government to defray the expenses incurred in the common interests of all
without reference to special benefits conferred”.

Taussing: “The essence of a tax as distinguished from other charges by

government in the absence of a direct quid pro qua between the tax payer
and pubic authority”.

Bastable: “Tax is a compulsory contribution of the wealth of a person or

body of persons for the service of the powers”.

Dr. Dalton: “A tax is a compulsory contribution imposed by a public

authority irrespective of the exact amount of service rendered to the tax-
payer in return and not imposed as penalty for any legal offence”.

Findlay Shiras: Taxes are compulsory contribution to public authorities

to meet the general expenses of the government which have been incurred
for the public good and without reference to special benefits.”

Economists have defined the definition of tax. From the above definitions
we can conclude that the taxes are in compulsory nature not voluntary
nature. It reduces the expendable income of the tax payer and the
purchasing power of the public. In the other side public authority expend
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the income to promote productive activities from collected through
imposing taxes. To levy tax on public, it has also some goal to attain in the
economy like to increase employment opportunities, to reduce poverty, to
expand infrastructural facilities, to reduce income and regional inequalities
etc. The government tries to promote economic stability and growth in the
economy through collection of tax.

5.4 FEATURES OF TAX SYSTEM

Important features of tax systems are as following:

1. Tax in a payment to public authority:

The taxes are imposed by public authority on the people. In other word
taxes are the payment by the people to the public authority mean
government only. If the person pays a specific amount every year to any
social welfare society is not called taxes. It is called donation. Taxes are
being paid by people to the governments.

2. Tax is compulsory pay:

Taxes are compulsory to pay to the government. Whatever tax rate levied
by government it have to pay. For example, if government fixed income
tax rate at 10% on above 5 lakh rupees annual income, the person who
have more than 5 lakh rupees income have to pay tax on above income.
Exception is only when government gives exception.

3. It is sacrifice of income:
People are legally bound to pay taxes to the government from its income.
When the people pay the tax amount, the amount of tax is the sacrifice of
income by tax payer. At the time of purchasing goods and services, due to
indirect taxes on transaction consumer sacrifice extra goods and services
due to the tax increases prices of goods and services.

4. Benefit and taxes are independent:

People have to pay taxes not for receive any type of benefit from the tax
amount. Government expenditure is for welfare of people but it not fixed
that only tax payers are eligible to receive the benefit of government
facilities.

5. Kinds of Taxes:
A taxes are in different kinds. Taxes are categories in to two categories
these are direct and indirect taxes. Income tax, property tax, wealth tax are
the examples of direct taxes. Goods and service tax, service tax, excise
duty, sales tax are the indirect taxes.

6. Public welfare is the main aim of taxes:

Levy of taxes is the one of element of the fiscal policy of the government.
Government levied taxes with several aims. Public welfare is the common
aim has been shown behind every type of tax by the public authority.

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7. Legal sanction:
Once a tax levied by the government it became legal sanction. If a person
failed to pay taxes is liable to legal punishment.The nation‟s authority can
impose taxes.

5.5 OBJECTIVES OF TAXATION

The main objectives of taxation are as follows.

1. To raise public revenue:

The main objective of taxation is to raise public revenue to meet ever
increasing public expenditure. To achieve the goal of welfare state, every
government has to increase the public expenditure with growth of
economy. The government always tries to promote economic development
of the economy and secure nation from external as well as internal
enemies of the society. To maintain such aim it requires revenue which
has been tried to bring from taxes by the government.

2. To reduce inequalities in income and wealth:

Developing countries are suffering from the problem of income and
wealth inequalities. Inequalities are not good for the development of
country. So, the government tries to reduce inequalities to maintain
equality in society. For that purpose, direct Tax is one of the elements
through government can reduce the gap of inequality between rich and
poor.

3. To regulate the economy:

It is one of the main objectives of the taxes. Government regulates
consumption, production, import and export of the country through taxes.
There are several products which are harmful to the health of society.
Government increased taxes on such productions and tries to decrease
consumptions of such products like, cigar, tobacco, alcohol etc. The
government imposes import and export duties to protect local industries.
On the other hand some time export duties are being levied by the
government to stop certain goods and services which necessary goods
have scarce in the country. In overall taxes are being imposed by the
government to regulate the economic transactions to the development of
country.

4. To Increase National Income:

It is the objective of taxation to increase national income with increase of
per capita income. Government collected revenue from taxes to use it
productive purposes. It leads to increase national income of the country
and enhance employment opportunities. High growth rate of national
income indicates progressive nation.

6. To established economic stability:

Economy faces trade cycles in certain situations. Now a days of
globalization, other countries trade cycles are affecting our countries
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economy like financial crises of 2008 in the America. To established
economic stability in the economy both monetary and fiscal policies are
being used. Economic stability consists by maintaining price level,
maintaining full employment and adequate foreign currency. To control
inflation and deflation government uses taxes as the measure to correct it.
Government expends collected tax revenue to run employment generation
programs like MNREGA in India.

7. Proper Standard:
It is another objective of taxation. According to A.P.Lerner, “Taxes should
not be imposed simply because the government needs money. Economic
transactions should be taxed only when it is thought desirable to
discourage these transactions. Individuals should be taxed only when it is
desirable to make the tax-payer poorer.”

8. To Promote Capital Formation:

In underdeveloped and developing countries, promotion of capital
formation is main objectives of capital formation. The Government invests
money from collection of tax in Independent investment which promotes
private investors to increase induced investment. It leads to promote
capital formation in the country.

9. Political Objectives:
To attaining political objective in the democratic country, taxes are being
used as weapon. The middle class and poor people of a country are being
happy when the government imposing high rate of taxes on rich people. It
gives high revenue with political profit to the ruling governments.

5.6 CANONS/PRINCIPLES OF TAXATION

Tax is the source of public revenue for the every government in the
modern age. If taxes are increases government revenue also increased and
vice-versa. Every government has to expenditure more to fulfill the public
needs and develop the country. But, at the other side additional burden of
taxes on the tax payer effect adverse on the productivity of producer
means taxpayer. It became certain responsibility of government at the time
of imposes taxes on tax payer to keep their condition in the mind and levy
accessible taxes. As we saw in the objectives of taxes, taxes should not
adverse impact on the efficiency and productivity of the tax payer.

It is the big question before policy makers as how the taxes can be levied
and what should be the pattern of taxes. At the time of every new tax
imposition it should be seen that the capacity to pay the taxes, no
discrimination and positive impact on the economy. Economists have
suggested various canons/principles of about taxation. The canons of
taxation are time to time suggested by economists for good taxation
policy. There are no exact canons of taxation.

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A. Adam Smith’s Canons of Taxation:
Findlay Shiras commented on contribution of Adam Smith as; “No genius,
however, has succeeded in considering the principles into such clear and
simple canons as has Adam Smith.” Smith was the first writer to give a
detailed and comprehensive statement of the canons of taxation. Adam
Smith stated four canons of taxation these accepted universally.
1) Canon of Equality
2) Canon of Certainty
3) Canon of Economy
4) Canon of Convenience

1. Canon of Equality:
It is the base of good tax system. It is said that a good tax is that tax which
is based on the principle of equality. This canon means the tax should be
levied according to the paying capacity of the individual. Adam Smith
explained it as, “The subject of every state ought to contribute towards the
support of the government as nearly as possible, in proportion to their
respective abilities, that is, in proportion to the revenue which they
respectively enjoy under the protection of state.”

The principle states that the rich people must be subjected to higher
taxation compare to the poor. In short Adam Smith stressed that everyone
should pay according to his ability to pay. It is on the base of equality
because the rich person has low marginal utility to money and poor has
greater marginal utility to money. Both of them should sacrifice equally.

2. Canon of Certainty:
There should not be confusion about the payment of tax. According to
Adam Smith, “The tax which each individual is bound to pay ought to be
certain and not arbitrary. The time of payment, the manner of payment, the
quantity to be paid, all ought to be clear and plain to the contributor of the
tax.”

In other words the time of payment, amount to be paid, method of

payment. The place of payment and the authority to which tax is paid
should certain. The certainty creates confidence and easier to tax payer to
manage and pay taxes.

3. Canon of Convenience:
Adam Smith quotes, “Every tax ought to be levied at the time or in the
manner in which it is most likely to be convenient for the contributor to
pay.” Taxes should be levied in such manner which provides the
maximum of convenience to the tax payers not inconvenience to the tax
payer. For example, income tax from the salaried person should be
collected at the time of salary. Land revenue should be collected at the
harvest time which is convenience to the tax payer. It becomes convenient
to the tax payers and tax collecting authority also. At one time tax amount
would be collected with low cost of collection.
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4. Canon of Economy:
It means the cost of tax collection should be minimum means negligible.
The maximum amount of tax collection should be deposited in the
government treasury. Thus, other extra expenses should be avoided in the
process of tax collection. Objectives of tax collection would be fulfilling if
the principle of economy followed during tax collection strictly. In other
words maximum tax collection should be done with minimum expenditure
on tax collection. It increases productivity of taxes.

All of above canon of taxation are significant and have important place in
every financial structure. Importance of these canons has been described
by the Prof. Shiras as, “Today Adam Smith canons continued to be
regarded as almost an essential part of the study of finance and they have
had a considerable effect on practical finances.”

B. Other Canon of Taxation:

Other than Adam Smith canon of taxation there is other canon of taxation
as following.
1) Canon of Productivity.
2) Canon of Elasticity.
3) Canon of Simplicity.
4) Canon of Neutrality.
5) Canon of Variety.
6) Canon of Expediency.
7) Canon of Co-ordination.

1. Canon of Productivity:
In the word of Prof. Bastable, “The canon of taxation must be based on the
productive lines. Taxation is believed to accumulate enough money for the
government to run its administration efficiently. It must be enough to
enable the government to secure enough facilities for the people.”
Productive taxes help to government to collect more amount taxes with
least expenditure on with it, there are no unfavorable effect on the saving
potential of the people.

2. Canon of Elasticity:
Canon of elasticity means taxes should be levied in such manner that when
taxes became inconvenience to the tax payer it should be decreased. At the
time adverse circumstances government could be levied more taxes meet
the need of emergency.

3. Canon of Simplicity:
Each and every tax should be simple, easy and understandable to the
common people. If the tax system is complicated, tax payers seek
assistance of tax experts and they lost extra money on the assistance of tax
experts. Government should make the simple rules and regulations of tax
system.
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4. Canon of Neutrality:
Taxes should be neutral means it must have not any inflationary and
deflationary effect on the economy.

5. Canon of Variety:
There should be proper mixture of direct and indirect taxes. The burden of
paying tax should not centralize on one group of people but it should be
diversified in such a way all people should pay the tax according to their
ability to pay.

6. Canon of Expediency:
The tax payers should have no doubt about tax desirability. At the time of
imposition of taxes it should be seen favorable and unfavorable effect of
taxes from the view of point of social, economic and political.

7. Canon of Co-ordination:
There should be co-ordination between various taxes and various taxes
imposing authorities. If there is absence of coordination, over and double
tax will be levied which will be inconvenience to the tax payers.

The good taxation policy requires the canon of taxes implemented in the
tax system. But actually there is no country in the world where all canons
are fulfilling by tax system. Taxes should be best good effects and least
bad effects on the economy and tax payers.

5.7 TAX THEORY

5.7.1 Ability to Pay:

Ability to principle is widely accepted for securing the justice of equity
taxation. Tax has been to pay according to his ability to pay. It is based on
the posses of income and property to the person. If the person posses more
income property, it should be pay more and vice versa. First of all Italian
Economist GrikiArdini have presented progressive tax principle on the
base of ability pay. Bodin, Sismodi, J.S.Mill, Rosusseau, Wagner,
Roosevelt and Adam Smith also accepted the principle of ability pay
taxes.

According to ability to pay theory, the person should pay as it can bear of
able to pay tax. If the person has more ability to pay, it has to pay more
and if less ability to pay should be pay less. This principle works with the
diminishing marginal utility of money. The rich person has less marginal
utility of money. So it will pay more but not sacrifice less and poor person
pay less taxes but sacrifice more because poor person has more marginal
utility of money.

The ability to pay principle is based on three main grounds.

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a. Equal Sacrifice:
According to J. S. Mill, “What would be more equitable than a situation
under which each person‟s contribution to the support of government
resulted in equal sacrifice for all.” It means, the sacrifice of each tax payer
should be equal.

b. Law of Diminishing Marginal Utility of Income:

With every increase of income, marginal utility of money decreases. In
other side if income is decreased marginal utility of money increases. It
implies to make tax burden equally, the rich one should be taxed heavily
compare to poor person. The absolute poor person should be exempted
from taxation. This concept of diminishing marginal utility of money
derived from the general diminishing marginal utility.

c. Interpretation of Faculty:
According to Prof. Hubson, “Economic surplus is the part of income
which can bear the tax burden. Whit the increasing faculty, the economic
surplus also increases and inviting more in proportion to the increases and
inviting more in proportion to the increase in income and wealth, as the
level of economic surplus is increased. ” As the tendency of individual,
after completion of certain needs certain resources are left which is also
known as economic surplus. It gives more ability pay more.

Determinants of Ability to pay:

i. Property:
Property is the one of the best determinants of the ability to pay. In general
sense we can that if a person have more property, it has more ability to
pay. Property is the important source of the income. But all type of
properties never gains income. There several possibilities about property.
The income from property does not flow continuously; income from
property may vary from place to place. The property is taxed according to
its capital value and if the property does not yield any income, it would be
unfair to tax it. In short property is not main index of ability to pay but
supplementary.

ii. Income:
Property or wealth is the stock concept and income is a flow concept.
Ability to pay tax is on the base of flow concept. So, income is became the
main determinants of ability to pay. If a person has more income, it
pursues more ability to pay and vice versa. Subsistence income should be
exempted from the taxes because it requires living a life. The net income
above subsistence income is main determinants of ability to pay taxes.

iii. Size of the Family:

Size of family is affecting the ability to pay of tax payers. A large family
with a fix amount of income can have less ability to pay and the small
family with same income would be more ability to pay taxes. The size of
family should be taken on account at the time of leving taxes according to

67
the principle of ability to pay. But yet this index is being not implemented
in practice.

iv. Consumption Expenditure:

According to Prof. Kaldor, “Consumption rather than income should be
the basis of taxation.” Consumption measures the person who actually
withdraws the resources from the economy for its personal use. Some
developing countries are imposing expenditure tax and some are imposing
excess tax on luxury goods.

Subjective Approach to Measures of Ability to Pay Taxes:

There are three interpretations of equal sacrifice as follow.
a. Equal Absolute Sacrifice.
b. Equal Proportional Sacrifice.
c. Equal Marginal Sacrifice.

a. Equal Absolute Sacrifice:

Equal absolute sacrifice implies that the total loss of utility sacrifice
should be equal for all tax payers belonging to different income groups. It
means rich person should pay higher taxes and comparatively poor person
should pay less tax. Actually the rate taxes should depend on the marginal
utility of income of tax payers. This type of taxes are called progressive
tax system. A.C.Pigou agreed that it was justified to adopt higher degree
of progressive in case of higher income group.

With the help of formula;

{U(Y) – U(Y - T)}R = {U(Y) – U(Y - T)}P

Whereas;
U = Utility of Income
Y = Income
T = Tax
R = Person first
P = Person Second

The absolute amount of utility of money lost as a result of tax payment

should be equal to everybody. If we assume there are two persons paying
tax in the community R and P, equal amount of sacrifice though both are
different income group.

b. Equal Proportional Sacrifice:

It implies that the loss of utility for taxpaying should be proportional to the
total income to the tax payer. In that sense, higher income group tax
payers will pay more than lower income group. But, the ratio of sacrifice
to their income will be same for all groups of income.

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It can be expressed in mathematical term as;

Rate of Tax = Sacrifice of tax payer X / Total Income of X =Sacrifice of

tax payer Y / Total Income of Y
It is possible in the progressive taxes. The proportion of sacrifice should
be equal in all income groups of tax payers.

c. Equal Marginal Sacrifice:

According to Musgrave, “It is the ultimate principle of taxation.” This
principle is also called as „least aggregate sacrifice principle. According to
this principle, the total sacrifice by all taxpayers should be lowest.
Explanation with the help of formula as;

Mu (Y-T)R = Mu (Y- T)P

Formula shows;
Mu = Marginal Utility of Income
R = One tax payer
P = Second tax payer
Y = Income
T = Tax

It shows the marginal sacrifice for the different tax-payers should be the
same. Aggregate sacrifice for the all income groups of the community
should be the least.

Limitations of Subjective Approach:

1) The counting of equality in marginal sacrifice of all income groups is
very difficult. To every individual is differs about taste, temperament
and attitude to pay taxes.
2) Sacrifice is a subjective phenomenon so that it is not easy to measure
exactly by tax imposing public authority.
3) Measurement of declining marginal utility of income is not possible in
practice.
4) Marginal Utility varies with each type of income. Marginal utility of
the income earned from property is lesser than the income earned by
person from own work.
5) Subjective approach of utility and sacrifice is only an ideal approach.
It ignores reality of practical life.
6) Professor Musgrave found that, “It remains to be seen whether a
workable and reasonable meaningful measure of utility, can be
developed in time and whether, thereby the subjective concept of
ability to pay can be given an operational meaning.”

Finding out such difficulties in subjective approach, some economists

have suggested alternative approach that is an objective approach to
measure the ability to pay of tax payers. Prof. Seligman used term
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„faculty‟ to introduce ability to pay in objective term. This approach also
has some limitations because objective approach is based on the principle
of regressive tax pattern.

Merits of Ability to Pay Theory:

Merits of ability to theory are as following;

1. Natural Justice:
It is the natural thing that the person who poses more income has to pay
more and who is poor unable to pay tax. This theory applies the same
thing at the time levy of taxes. In that sense the theory of ability to pay
make justice naturally.

2. Horizontal and Vertical Equity:

Horizontal and vertical equity is being satisfied by this theory. Horizontal
equity means equal tax to equal ability groups. The vertical equity means
unequal treatment to unequal ability to pay groups. High income group
have high ability to pay and low income group have low ability to pay.
The tax according to this theory maintains both types of equity.

3. Income Inequality Reduces:

Taxes according to ability to pay theory, helps to reduce income inequality
in developing economies. It takes larger amount of tax payment from rich
income group and the poor whose income is less than resistance gives
excuse in tax paying. It reduces some level of income inequalities.

4. Merits of progressive tax:

Ability to pay theory is on the base of progressive tax system.
Automatically the merits of progressive taxes are comes with this theory.

5. Achievement of social justice:

Social justice is being achieved with the help of this theory of taxation, it
refers high tax rate on high income group and the poorest people are not
only exempted from it but also provided several subsidies for resistance.

Demerits of Ability to Pay:

1. Base on Wrong Assumption:

The base of this theory is on equal sacrifice and equal sacrifice is
depending on cardinal approach of utility which is subjective which is
unable to count practically. Utility is a state of mind and depends on
psychological and other.

2. Unclear Theory.
There is no conclusive definition of ability to pay principle or equal
sacrifice principle. Equal sacrifice has three interpretations these are equal
absolute sacrifice, equal proportional sacrifice and equal marginal

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sacrifice. Nobody can say which one is purely scientific approach to count
equal sacrifice.

3. This theory is unable to cover indirect taxes.

Income is the basic index of this theory. Income index is related to direct
taxes but indirect taxes like income sales tax, GST etc. are being
implemented without the principle of ability to pay. Whether the purchaser
is rich or poor both have to pay same tax. It makes unequal sacrifice.

4. Utility is personal.
This theory is based on equal sacrifice rule. Sacrifice means utility of
income is differ with every individual. Because, each person is differ from
each other inrespect to physically, mentally or emotionally.

5.8 SUMMARY

Although there several demerits of ability to pay theory, it is more

applicable and progressive system to follow the rule of equality. It helps
economy to reduce income inequality. Direct taxes are being levied in the
most of countries according to this ability to pay theory.

5.9 QUESTIONS

1. What are the sources of public revenue?

2. Give the definition of tax and explain the features of tax system.
3. What is the meaning of tax ? What are the objectives of taxation?
4. Explain the canons of taxation given by Adam Smith?
5. Explain other canons of taxation?
6. What is ability to pay approach? Explain the determinant of ability to
pay.
7. What are the merits and demerits of Ability to pay theory?

*****

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 6
TAXATION AND IMPLICATIONS
Unit Structure
6.0 Objectives
6.1 Introduction
6.2 Direct and Indirect Taxes
6.3 Choice between Direct and Indirect Taxes
6.4 Taxation and Labour Supply
6.5 Horizontal and Vertical Equity
6.6 Equity and Efficiency
6.7 Public Sector Pricing
6.8 Income Tax
6.9 Corporation Tax
6.10 Expenditure Tax
6.11 Commodity Taxation
6.12 Tax Evasion and Tax Avoidance
6.13 Effects of Tax Avoidance and Evasion
6.14 Punishments provision in tax law
6.15 Summary
6.16 Questions

6.0 OBJECTIVES

1. To study the concepts of direct and indirect taxes.

2. To study the income tax, corporation tax, expenditure tax, commodity
taxation.
3. To study the difference between tax evasion and tax avoidance and to
study the effects of tax avoidance and evasion.
4. To study the horizontal equity and vertical equity.

6.1 INTRODUCTION

Taxes are various types are being levied in various countries. Even in a
single country to fulfill the canons of taxation several taxes are being
levied by the tax authority. These are basically categories in to two parts;
direct tax and indirect tax. Income taxes are come under direct taxation
and commodity taxes comes under indirect taxes. There several positive as
well as negative impacts of these taxes on individuals as well as society
and sectors of economy. This part of the schedule is about discussion of
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types of taxes its implications in India and effects of it on the sectors of
economy.

6.2 DIRECT AND INDIRECT TAXES

According to Prof. Dalton, “A direct tax is really paid by a person on

whom it is legally imposed, while an indirect tax is imposed on one
person, but paid partly or wholly by another, owing to consequential
change in the terms of some contract or bargaining between them.” Thus,
direct tax is not shifted to another while indirect taxes are the tax which is
being shifted to pay by another partly or wholly. Income tax and property
tax are the examples of direct taxes. Excise duties, Sales tax, GST are the
examples of indirect taxes.

J.S.Mill clearly define the distinction between direct and indirect taxes as,
“A direct tax is one, demanded from the very person who is intended or
desired should pay it. Indirect taxes are those which are demanded from
one person in the expectation and intention that he shall identify himself at
the expenses of another.”

Thus, it defines that, direct taxes are actually paid by the person on whom
taxes are imposed. Indirect taxes are imposed on one person and it has
been paid partially or wholly by another person. Income tax, property
taxes are the direct taxes paid by the same person on whom these taxes are
imposed. Excise duty, Sales tax, Goods and Service tax are the examples
of indirect taxes imposed on one person and paid by another person
wholly or partially. The burdens of indirect taxes are shifted by
manufacturer or seller to the consumer. Indirect taxes are also called tax
burden shifting taxes.

Prof. D. Macro explained it as “Direct taxes are those taxes which affect
the income of taxpayer when it receives such income whereas indirect
taxes are those taxes which affect the individual consumption and transfer
of property. Indirect taxes affect the income at the time when the
consumer goes to buy goods.”

6.2.1 Direct Tax:

Direct tax is a tax that a person or institution pays directly to the entity that
imposed it.

According to Prof. Dalton, “The direct tax is a tax which is really paid by
a person on whom it is legally imposed.”

Merits of Direct Taxes:

Following are the merits of direct tax:

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1. Direct taxes are economical. Cost of collecting of these taxes for
authority is relatively lower.
2. Direct taxes are easy to follow progressive principle which directed by
the principle of equity.
3. Direct taxes are useful to decrease income inequality from the
economy.
4. Certainty. Direct taxes satisfy the principle of certainty.
5. Elastic. Tax amount increase with increases of tax rate. Direct taxes
fulfill canon of elasticity. If income increases, tax amount also increase
and vice versa.
6. Awareness among people. People are well aware about paying taxes.
This is not applying for indirect taxes.
7. Easy to understand. The direct taxes are easy to understand even to
leman.
8. Civic Consciousness. Direct taxes create civic consciousness among
the masses. People became aware about their rights.

Demerits of Direct Taxes:

Following are the demerits of direct taxes.

1. Unpopular tax. Direct taxes are imposed collected directly from tax
payer. It appears quite painful to the tax payers. So, it is unpopular in
the public.
2. Inconvenience tax. It is found that direct taxes are requiring numerous
accounting and other formalities.
3. Uneconomical Tax. If there are number of taxpayer with
comparatively low income, with high cost to collection of less tax
amount. To collect the taxes, it requires more staff and machinery
which means unproductive cost of authority is high.
4. Chances of tax evasion. There is possibility of tax evasion because
people are not always ready to government without any earning on it.
The tax payer sees directly its sacrifice and do not ready to sacrifice
the income which was earn with hard work.
5. Uncertainty in tax. Sometimes there is uncertainty with direct taxes.
For example from2020 in India, The person who is earning more than
5 lakh rupees should pay 5% income tax on the amount between 2.5
lakh to 5 lakh. If the person has less than 5 lakh Rs. Annual income
have no tax. Such uncertainty is being made by different governments.
6. Big obstacle to capital formation. Heavy direct tax effect adversely on
capital formation in the economy. Specifically in developing economy
it becomes big obstacles to capital formation.

74
7. Narrow scope. Direct taxes are unsuccessful to bring civil
consciousness among all people because it levied only on certain
income groups of society.
8. Political Interest. For the political interest, government tries to levy
heavy taxes on rich people and exempt poor people to show the
government is with poor and middle class people and against of rich
people for voting gain.

6.2.2 Indirect Tax:

According to A. R. Prest, “Indirect tax is a termed as indirect, custom

duties, excise duties, stamp duties is the indirect taxes.”

According to J.S. Mill, “Indirect taxes are those which are demanded from
one person in the expectation and intention that he shall identify himself at
the expenses of another.”

In other words, “Indirect taxes are taxes which are collected indirectly
from the tax payers. These are levy on one person and shifted to pay to
other person are called indirect taxes.”

Merits of Indirect Taxes:

There are some merits of indirect taxes explained as following:

1) Convenient: Indirect taxes are distributed in small intalment which
are convenient to pay. These are included in the price of goods and
services and paid by tax payers without feeling any sacrifice.
2) Elastic: Indirect taxes are highly elastic because if government
requires extra revenue can be collect from increasing indirect taxes
without becoming unpopular in society. Specifically by increasing
taxes on inelastic demand goods and service. Like Government of
India increases taxes on petroleum products during COVID19 period
also.
3) Less possibility of tax evasion: About indirect taxes, tax evasion is
impossible because indirect taxes are already included in the price of
commodity which being purchased by customer.
4) It achieves aim of social welfare: Reduction of unhealthy goods is
good for the welfare of society. Heavy taxes on such products
increases prices of such products and the consumption such products
reduces.
5) Progressive in Nature: Sometimes indirect taxes are become
progressive in nature. When government levy high rate of taxes on
luxurious goods which are purchased only rich people.
6) Easy to collect: Generally indirect taxes are easy to collect because
these taxes are included in the price of commodity. These are collected
from producer or seller collectively.
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Demerits of Indirect Taxes:

Following are the demerits of indirect taxes found in reality these are as:
1) Regressive: Indirect taxes are regressive in nature. The same rate of
indirect taxes is being paid by rich and poor person. It shows high
level of sacrifice of poor one and lower income sacrifice by rich one.
2) Uncertainty in Tax Revenue: When indirect tax is levied on goods
and services prices of goods and services rises and demand decreased.
It is very difficult to anticipate the tax revenue about indirect taxes
when the demand of good is highly elastic.
3) Absence of Civil Consciousness. About indirect taxes, the consumer
unable to feel or see about burden of tax. Generally tax payer fail to
see irregularities of taxes imposes on him about indirect taxes.
4) Indirect Taxes are Inflationary: When indirect taxes are levied on
the goods and services price level of goods and prices tends to
increase. In that sense indirect taxes are inflationary nature.
5) Unpopular: Sometimes the sellers are hike prices of products with the
name of increases in indirect taxes. So, it became unpopular in public.
6) Inequitable: Indirect taxes are more inequitable because about
indirect taxes poor person pays more proportion of its income and rich
person pays less proportion of its income.
7) Discourage Savings: Due to indirect taxes, people have to pay more
on the purchase of necessary goods and services. It forces to save less
than before indirect taxation.

6.3 CHOICE BETWEEN DIRECT AND INDIRECT

TAXES

There are some merits and demerits of both direct and indirect taxes. The
question comes before the government to which tax to levy for less
inconvenience to people and collect high level of revenue. In fact, both
types of taxes are supplementary to each other. Most of the countries are
levied both types of taxes.

Direct tax is specifically levy on the income of a person. There is a matter

about the requirement of minimum income for necessary consumption.
Income tax can be paid by tax payer only on above the income of required
basic expenditure. In the developing countries; very people can pay the
income tax. In such situation indirect taxes are useful to collect more
revenue which are being paid by all those purchase the goods and services.
Almost all the counties are levied both types of taxes in their countries.

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6.4 TAXATION AND LABOUR SUPPLY

6.4.1 Taxation and supply of Resource:

Several types of resources involves in the process of goods and services
production. These factors determine the state of growth and development
of the economy. Supply of land, labour, capital, Manager and row material
are the resources or factors of production. Tax policy affects the supply of
these resources. In terms of land, it is natural source but hold by a person
and make available on rent. If government levied tax on rent of lend the
supply of land affects. There are number of long term forces determine the
total labour supply and its productivity. About the source of capital, if tax
levied on the interest the supply of capital is affects. In the modern era,
manager pays key role the production process while tax on the salary or
profit will affect supply of it.

6.4.2 Effect of taxation on labour supply:

The effect of taxation labour supply is being seen through choice between
work and leisure by given labour force. To see this effect the theory
assumes there is a typical worker, who has an option to choose the length
of working day. It is also assume that wages are on time rate basis. It
means longer working hours more wages income but less leisure.

Choice of our assumed worker between work and leisure has been
presented in the diagram 6.1
Figure No. 6.1

Hours of leisure and work have been measured along horizontal OX axis
and the earnings measured along vertical axis OY. The per hour wage rate
is Rs. OW1/OL1= OW1/24 per hour. Indifference curves have been drawn
with leisure and income/work. The workers choose any one combination
on the earning opportunity line W1L1. There is an equilibrium point at E
where earning opportunity line connects to the indifference curve A. There
are leisure OM1 hours, and work is E1L1 and daily income of this supply
of labour is Rs. E1M1. At the time of no taxes, marginal rate of substitution
between leisure and earnings is equal to the wage rate at equilibrium E 1
point.

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6.4.3 Specific tax and Supply of Labour:
If the government levied a specific tax like poll tax on the income of
worker, the workers try to maintain previous income minimum for giving
the taxes. Worker tries to reduce leisure and work more. The diagram 6.2
introduces about the effects of tax on choice of leisure and earning hours.
Figure No. 6.2

In the diagram 6.2 earning opportunity line shifts from W1L1 to W2L2
which shows reduction of earnings of worker. The worker reduces its
leisure from OM1 to OM3 it results increase of working hours from M1L1
to M3L1. Now worker out of his total earning F3 M1 he pays F3E3 for tax.

6.4.4 Progressive Income Tax and Labour Supply;

With increasing marginal and average income workers, tax rate is
increasing is called progressive tax. There is an adverse effect found on
labour supply of progressive tax. Once worker knew about high earning
has to pay more taxes workers prefer for more leisure and less work. If the
wage rate increases with progressive tax, workers work lesser than before
and prefer more leisure to avoid paying tax.

6.4.5 Proportional Income Tax and Labour Supply:

Proportion tax is the tax which is equal to the all income group tax payers.
Proportional tax causes both substitution and income effects. The
substitution effect is it became relatively cheaper leisure on costlier
earnings. It would tend to increase leisure and reduce labour supply. With
proportion tax a new equilibrium point will push to the point E2 shown on
diagram 02.2.

6.4.6 Indirect Taxes and Supply of Labour:

Almost indirect taxes are included in the price of product whether it will
be goods or services. It does not effect on the money earning of the
workers but it effects on the real income of the person. When government
imposes indirect taxes or increases the rate of indirect taxes, the real
income of workers is reduced. To maintain the previous consumption
expenditure workers tries to increase work hours and decrease hours of
leisure if there is no scope of increase earning automatically.

Sometimes increase in indirect taxes effect adversely on the consumption

of the workers. Workers shifts from high quality goods to low quality
78
goods or sometime it stop the consumption of such goods for preferring
leisure. Direct effect is being seen of direct taxes but effects of indirect
taxes are seen in long time indirectly on consumption expenditure.

6.5 HORIZONTAL AND VERTICAL EQUITY

6.5.1 Horizontal Equity:

Horizontal equity in taxation related to the equal treatment of people on
the ground of equal economical position. In simple word, equal tax rate
should be levied on equal income group of people. For instance, income
tax is progressive in manner but it has a principle of horizontal equity. But
for the principle of efficiency horizontal equity has been given second
preference. for example, the labour supply of second earner in the family
that means women or children gives some concession in taxes even equal
payment as the man of family. Women are exempted certain more amount
from income tax than male.

The authority needs to find out set of taxes which may meet the
requirement of efficiency and with horizontal equity objects.

Horizontal equity has several interpretations as mentioned below;

1) Every citizen of country should pay equal taxes.
2) Those benefited equally by public expenditure should pay equal taxes.
3) Equal taxes should be bear by all tax payers with equal abilities.

Above three interpretations are not found relevantly. Principle of

horizontal equity faces certain drawbacks as follows.
1) It is difficult in present era to put this principle into operation as ability
to pay cannot be determined.
2) There is a difference in cost of living in rural and urban area even in
different part of the nation. In such situation, horizontal equity will
panic to the tax payers who live in expensive area.
3) A difficulty arises to bring horizontal equity in time span.
4) Principle of horizontal equity also faced problem when tax payers have
uneven flows of income tax rates are not proportional.

6.5.2 Vertical Equity:

Vertical equity relates to the share of tax bear by rich and poor person
differently. It is a principle help to bring income equality in the society.
Specifically vertical equity refers to the principle of ability to pay taxes.
Those have more ability to pay should pay more than the people of less
ability to pay. But with this principle efficiency of working person
affected. By nature more working person gets more income. If authority
imposes high taxes on maximum working people and tax exemption to the
no working people, it would difficult to increase the national income of

79
the economy. Vertical equity approach damages the efficiency of work of
the person. The person prefer for not to work more and pay less.

For example in India, There is an income tax on above the income of 5

lakh from the year 2019-20 and no income tax if the person has annual
income 5 lakh Rs or below it. It is good but if a person earn 1000 Rs.
More than 5 lakh Rs. It should pay 5% of income tax on 2.5 lakh Rs.
Outoff 5 lakh income and 10% income tax on 1000 Rs. Earn by him by
doing extra work. In that condition, instead to pay 12700 Rs tax by doing
extra work, it will prefer to earn less than 5 lakh Rs. This type of tax is
useful to follow principle of vertical equity but it harms efficiency of work
and effect badly on the national income also.

The principle of vertical equity is not conducive to determine the structure

of tax rates. It mentions simply that the rich person should pay higher
taxes than poor. It refers to progressive taxes. Proportional taxes are taxed
equal proportion on everybody‟s income which relates more to horizontal
equity. This is depended on interpersonal comparison of utility of income.
New welfare economics has discarded the concept of interpersonal
comparison of utility of sacrifice.

This principle is most suitable on political grounds. In case of higher

degree of inequality in the distribution of income and wealth, practice of
progressive taxation is perfectly fitted on socio-political basis. The
progressive taxation has been accepted by widely to levy high rate on rich
than poor.

6.6 EQUITY AND EFFICIENCY

To achieve equity principle at the time of imposing tax burden is the social
objectives of the government. It is always tray to achieve this. Because,
tax is a sacrifice of satisfaction of people and it should be minimum and
equal. Less tax burden is the ideal taxation system. But the issue of less
burden and is associated with the problem of conflict between equity and
efficiency. There is two type of equity principle as horizontal equity and
vertical equity as we studied earlier.

The second principle is efficiency, which requires imposing more tax

burden to collect more revenue by low cost. But, the issue of excess
burden and is associated with the problem of conflict between efficiency
and equity.

Ursula Hick concludes, “The excess burden varies directly with elasticity
of supply and demand of the taxed product or factor. The assumption is
the perfect competition prevails and that there are no closely related
products or factors that partial equilibrium is justified, and that the
marginal utility of money may be taken to be constant and the demand
curve looked upon as marginal utility curve.”

80
Excess burden and loss of consumer surplus has been shown in figure no.
6.3
Figure No. 6.3

In figure no. 6.3, Amount of commodity demand has shown on OX axis

and unit price of commodity shown on OY axis. AB is utility cum demand
cure downward sloping from left to right. OC is being assumed constant
cost of the product. The CG on the OY axis is unit tax which loss of
consumer surplus. When tax burden impose on the product the price of
product tends to increase from OC to OG. Due to price increases, demand
of commodity also decreases from OF to OJ and consumer surplus loss by
IEK.

Explained as;
Loss of consumer surplus = IEK.
IEK = ½ IKEL = ½ KE.KI

Tax revenue collection = CGIK = KC.KI

Elasticity of Demand (Ed) =

⸫
⸫

Or

According to Prof. Musgrave, “Society must ask itself what price, in terms
of excess burden, it wishes to pay to secure certain equity objectives. In
this sense, the narrow criterion of efficiency as avoidance of excess burden

81
must be subordinated to a broader concept of efficiency under which
conflicting objectives are reconciled.”

6.7 PUBLIC SECTOR PRICING

Public sector of nation or state provides certain goods and services to

increase social welfare of the society with the public cost like, transport
services, postal services, telecommunication services, core industrial
products etc. The government is being charged to use these goods and
services to raise government revenue. There are so many conditions at the
time of pricing such goods. Because government provide such facilities
not for maximizing profit but for maximizing social welfare even baring
some loss. Maximizing welfare of society is the basic aim to provide.
Several criteria are being set in variety of markets conditions for pricing
public sector goods.

Wear and Friedman observed, “The great bulk of older established

research on pricing principles in incompatible with the actual practice of
public sector pricing.” According to the recommendation of British White
Paper about nationalized industries, marginal cost pricing, has minimal
effect on the prices that these industries charged. Indeed, there is little
evidence that governments have taken much notice of more recent state of
the art work on public sector pricing principles.

Principles of public sector pricing as;

Maximization of social welfare is main base of all principles of public
sector pricing. This principle is on the base of several assumptions
assumed in the theoretical perspective. There is absence of rival and
significant cost of transaction. Prices are equal to the marginal cost only;
equity is being achieved by transforming income instead of altering prices.
Public sector services should be charged at the intersection of the demand
curve by short run marginal cost curve is required for maximizing
efficiency.

6.8 INCOME TAXATION

Income tax comes in the category of direct taxes. Income tax occupies
prominent place in the field of direct taxes especially in developing
countries India is not exception for it. Income tax was introduced by Sir
James Wilson firstly in 1860. Initially it was the central revenue source
but later it has been divided between centre and state to achieve vertical
equity between centre and state. Income tax was reintroduced in 1869,
which was discontinued in 1865. According to the Act 1922 income
determined on the basis of mechanism of administering the tax and the
rate at which tax was to be levied. This act remained from 1922 to 1961 on
the statute book with several amendments time to time. According to the
recommendations of Law Commission and Direct Taxes Administration
Enquiry Committee, income tax Act, 1961 came into force.
82
There was a step system of income tax before 1939. After the amendment
income tax Act 1939, the income tax structure was designed on slab
system. It is found that in India continuously amendments have been made
time to time in the slabs of Income tax. There are three main concepts of
income tax. These are Concepts of economic gains, Concept of Service
flow, Concept of net accretion. These concepts are define the about the
procedure of types to levy income tax on certain types of methods.

Income tax is being implemented to bring of vertical as well as horizontal

equity and it is based on principle of ability to pay principle. Income tax is
generally a progressive tax because it levied with high rate on high income
group and less on less income group. Poor people are exempted from it.

Merits of Income tax:

1) Income tax is levied with the principle of ability to pay principle.
2) It has progressive nature: High rate on high income and lesser on less
income.
3) Income tax is easy to locate and its incidence is not shift forward and
backward.
4) It is useful to reduce income inequalities.
5) It is also useful instrument to maintain economic stability with growth.
6) Canon of certainty, economy, productivity, convenience and elasticity
are being satisfies by income tax.

Present Position of Income Tax and its Rules:

Everyone (weather it is resident or nonresident) who earns an income from
any source except agriculture is subject to income tax in India. In other
words, income tax is a tax on the income received by any individual or a
Hindu undivided family or any tax payer other than companies and
farmers. Particularly income tax is levied on income from salary, income
from house property, income from capital gains, income from business
and professional and income from other sources etc.

If we take here the assessment year 2021-22, income tax slabs are
available in option to the tax payer to prefer both old and new income tax
regime/slabs in India. There was an exemption for senior citizen and super
senior citizen by some income amount. Before 2014, there was an
exemption to women also but after that it has vanished by the government
elected form 2014 in India.

The tax rate applicable has been same to normal resident as well as non-
residents irrespective of age. There are three categories made by the
government about the age of individuals. That are 1) Below 60 years, 2)
Between 60 to 80 years called senior citizens and 3) Above 80 years age is
called super senior citizen. There are varied of tax slab rules according to
age of citizen in only first slab not all slabs.

83
Old Tax Regime: (Income Tax Slabs)

For normal citizen For senior citizen For super

senior citizen
Income Rate Income Range Rate Rate
Range
Up to Rs. Nil Up to Rs. 3 lakh Nil Nil
2.5 lakh
Rs. 2.5 lakh 5% Rs. 3 lakh to Rs. 5% Nil
to Rs. 5 lakh 5 lakh
Rs. 5 lakh to 20% Rs. 5 lakh to Rs. 20% 20%
Rs. 10 lakh 10 lakh
Above Rs. 30% Above Rs. 10 30% 30%
10 lakh lakh

There are allowed all deductions including Section 80C, Section 80D etc.
of the Income Tax Act 1961 in the old tax regime. If the tax payer wishes
to get such all deductions he can prefer old tax regime or new tax regime.
The second option of income tax slabs has been made available for tax
payer by the authority in India. The following is new tax regime in option
available for the same assessment year (AY),

New Income tax regime/slabs in India ( for AY 2021-22)

Income tax slabs Rate of Income Tax

Up to Rs. 2.5 lakh Nil
Rs. 2.5 lakh to Rs. 5 lakh 5%
Rs. 5 lakh to Rs. 7.5 lakh 10%
Rs. 7.5 lakh to Rs. 10 lakh 15%
Rs. 10 lakh to Rs. 12.5 lakh 20%
Rs. 12.5 lakh to Rs. 15 lakh 25%
Above Rs. 15 lakh 30%

Surcharge on Income Tax:

Surcharge is being imposed on the high income group on the amount of
income tax being paid by individual or institution. In short surcharge is an
additional charge or tax. About Indian income taxation as following
surcharges are being charge

Surcharge rate on Income range for assessment year 2021-22

Income Range Surcharge rate for

AY 2021-22
Rs. 50 lakh to Rs. 1 Crore 10%
Rs. 1 Crore to Rs. 2 Crore 15%
Rs. 2 Crore to Rs. 5 Crore 25%
Rs. 5 Crore to Rs. 10 Crore 37%
Above Rs. 10 Crore 37%
84
Health and Education Cess: 4% Health and education Cess has been
levied on the amount of income tax plus surcharge.

Net Income Range Rate of Health and

Income Tax Education Cess
Up to Rs. 2.5 lakh Nil Nil
Rs. 2.5 lakh to Rs. 5 lakh 5% 4%
Rs. 5 lakh to Rs. 10 lakh 20% 4%
Above Rs. 10 lakh 30% 4%

Alternative Minimum Tax (AMT): AMT applies to the non-corporate

tax payer, those haven‟t be less than 18.5% (+HEC) of adjusted total
income counted as per section 115JC. If the income is solely convertible
into foreign exchange, the rate AMT is 9% instead of 18.5%.

Those persons net income is not exceeding of Rs. 5 lakh are able get
rebate of Rs. 12500 from income tax amount. In short, there is income tax
on the person whose net annual income is less than Rs. 5 lakh.

Dual Income Tax Slab System:

Government of India introduced dual income tax slab rules as noted
above. It is on the choice of taxes payer to which chooses and pay the tax
accordingly. One system is on the basis of old regime which levies more
rate of tax but gives several types of deduction. The second is one which
levies less tax rates but Income tax payers should leave the following
deductions from income tax.

1) (Section 10(5)) travel concession, 2) (Section 10 (13A)) House Rent

Allowance, 3) (Section 10 (14)) Official and Personal allowances, 4)
(Section 10(17)) Allowances to MPs/MLAs, 5) etc. total 22 sections
deduction are vanished for the tax payers those choose new income tax
slabs.

6.9 CORPORATION TAX

Corporation tax is the direct tax. It is a tax levied on the income earned by
the corporate bodies of company. Corporation tax is paid from the taxable
net profit earned by the corporations during financial year. After paying
corporation tax, remain amount of profit is distributed among share
holders. Before 1960, there was super tax on companies known as
corporation tax. From 1960-61, the income tax on companies was also
included in corporation tax. From 1965, these both taxes integrated in one
Corporation Tax.
Main characteristics of corporation tax:
1) Corporation tax has to pay by companies as flat rate according to define
by Finance Act.

85
2) There are certain concessions granted to companies to pay corporation
tax.
3) New manufacturing companies exempted from corporation tax for five
years.
4) Companies are in under obligation to pay income tax.
5) New industries in backward region are exempted for first 10 years from
corporation tax.

6.10 EXPENDITURE TAX

Expenditure tax is direct tax and it is levied on the amount of consumption

expenditure of tax payers instead of income.Economists as J.S.Mill,
Alfred Marshal, Pigou, Fisher argued in favor of expenditure tax on the
ground of equity and administrative efficiency. Because, expenditure is
also considers one of the main effective tests to denote taxable capacity of
a person. According to Prof. Kaldor, “The expenditure tax is conceptually
simpler and more satisfying than an income tax. It is more favorable to
work, savings, risk supply and will lead to a much greater rate of
economic progress.” He believed that expenditure tax is sounder than the
income tax,

Death duty, wealth tax, capital gain tax are the example of direct taxes and
comes under the income taxation.

6.11 COMMODITY TAXATION

When commodities are being taxed at the time of production or the

process of productions are called commodity taxes. Commodity taxes are
levied by centre government as well as state governments in India. Two
types of commodity taxes are being levied by the central government of
India. They are excise duty and custom duty.

6.11.1 Excise Duty:

The excise duty is a tax levied on the production of commodity before it
reaches to the consumer. According to the Constitution of India, the
central government is empowered to levy excise duties on almost all
commodities produced in a country excluding alcoholic liquors, opium
and other narcotics. These excluded products are being levied excise duty
by the states in India. It is the most crucial source of revenue to the Union
Government. It was provision to transfer some of amount central excise
duty from centre to state governments as recommended by the Finance
Commission of India.

The excise duty was not popular till 1930. There were earlier excise duties
on motor spirit in 1917, on kerosene in 1922, on silver in 1922, excise
duty on cotton yard in 1924 which was abolished in 1934. From 1934,
other commodities as sugar, steel ingots, matches etc. came under excise
86
duty. Fr the required revenue during Second World War, government
brought more commodities under a preview of excise duty. In 1949, excise
duty on mill made cloth re imposed by government.

The Taxation Enquiry Commission of 1953 recommended not only to

increase in the number of commodities but also increase in the existing
rate of excise on tea, cloth, kerosene, matches, sugar etc. State
governments agreed to abolish sale tax on textiles, sugar and tobacco in
1957 and centre impose additional excise duty on it. The scope of excise
duty has been enhanced time to time by the government. According to
Article 272, excise duty is being levied and collected by it is sharable
between centre and state.

Union Excise Duty Share to State recommended (by Finance

Commission:

(In percentage)

Finance Commission Share to the States

First Finance Commission 40%
Second Finance Commission 25%
Third Finance Commission 20%
Fourth Finance Commission 20%
Fifth Finance Commission 40%
Seventh Finance Commission 40%
Eight Finance Commission 45%
Ninth Finance Commission 45%
Tenth Finance Commission 47.5%

Thus the union excise duties are crucial for centre tax revenue as well as
share for states. It is an indirect tax levied on production of commodities
and producer included partial or total in the price of commodity which is
paid by consumer.

6.11.2 Custom Duties:

Taxes levied on foreign trade are called custom duties. Custom duties are
collected from main two heads. They are import duty and export duty.
Custom duties were the important source of revenue for the Indian
government. After the Second World War, its share declined considerably.

There are four main objectives of custom duties.

1) To protect home industries from foreign commodity competition.
2) To increase productivity of home industries.
3) To rise government revenue.
4) To make sufficiency of necessary goods in country.

87
6.11.2.1 Import Duties:
Import duties are being imposed as ad valorem on the import
commodities. These are imposed according to Schedule I and II of the
Indian Tariff Act 1934 subject to changes made by time to time. The main
idea behind import duty is to restrict import and protect domestic market
as well as industries. It helps to rise government revenue through import
duties. The import duty collected by the government at the time of
entering imported goods in a country. The import duty increases the price
of import commodities and according to the law of demand, demand of
such commodity from the citizens of country declines and domestic
producers get protected.

With the accordance of Fiscal Commission of 1929, import duty levied on

certain commodities as discriminating foreign policy in India. That means
import duty started from 1929. From 20 August 1965, the import duty was
rationalized under Finance Act 1965. The rate of import duty on raw
material was fixed at 40 percent ad valorem, on semi processed and
intermediate goods 60% and on finished consumer goods at 100%.

The committee under chaired by L. K. Jha proposed reforms in the import

duties. It suggested lowering the rates of taxation on different inputs and
machinery to give protection and discouragement of import of final goods.

6.11.2.2 Export Duty:

When the government imposes tax on the commodity at time of exporting
from country is called export duty. British government was imposed
export duties on the export from India in mid nineties to increase the
revenue of British government. During the First World War, export duty
was abolished and again it started to be levied.

After independent of India, export duty levied on large extent. There was
not the objective to collect revenue behind export duty. The main
objectives of export duty were to achieve stability of domestic prices in
the internal market, to reduce export of raw materials, to attain self
reliance in necessary goods. Export duties were levied on a number of
items such as coffee, tobacco, hides, skins, leather, black pepper, mica etc
in the Budget bill of 1986-87. To increased export of the country,
government initiated by time to time with making changes in export
import policies.

There are several commodity taxes imposes by centre as well as states.

Commodity taxes are indirect taxes in nature as well as almost are
proportional or regressive. Ability to principle is not properly applied with
almost all of them. But high excise duties on alcoholic liquor, tobacco and
such other products help to reduce its consumption which will protect the
society and at other side it increases revenue of the state government to
enhanced cost on public sector to promote economic growth and
development. Now there is Goods and Service Tax (GST)started from
1917 in India where 50:50 percent revenue goes to centre and state.
88
6.11.3 Optimal Commodity Taxation:
Optimal tax means the structure of designing and implementing a tax that
maximizes a social welfare function. The social welfare function is
typically a function of individuals‟ utilities. It refers to maximize the
aggregate of individual utilities.

6.12 TAX EVASION AND TAX AVOIDANCE

6.12.1 Tax Evasion:

It is the universal thing of the almost all countries that problem of tax
evasion and tax avoidance is existed. The Royal Commission on Income
Tax highlighted in early 20‟s that evasion of income tax existed beyond
question inn present time. The citizens are not loyal to pay the taxes on
income they earn from public expenses. They are doing such practices
continuously. The position in the developed nations like USA and France
was also alarming. In India, tax evasion is existed and the people of India
not paying taxes with royalty.

“Tax evasion means any activity which aims at hiding, understating or less
than actual reporting income to reduce tax liability is term as tax evasion.”
In other words, it means not paying a tax or paying less than actual have to
pay is called tax evasion. Tax evasion is punishable offence in India.

Basically tax evasion is the root cause of black money in the country. It
effect on inflation in an economy affects on the several part of the society
particularly poor society. It also has been discouraging the productive
system of the economy. The government deprived from tax revenue and
the productive means developmental activities remain stand. It has been
claimed by the Wanchoo Committee of Direct Taxes as, “It is no
exaggeration to say that black money and tax evasion is like a cancerous
growth in the country‟s economy which, if not checked in time, is sure to
lead to its ruination.” Tax evasion is the illegal way to avoiding tax
liability and avoidance is taking advantages of loop-holes to avoid paying
taxes.

Estimates of Tax Evasion:

Tax evasion has been estimated time to time by different committees in
India. The Taxation Enquiry Commission has estimated tax evasion was
Rs. 50 crore. During the assessment year 195-54, Prof. Kaldor stated that
the Rs. 200 to 300 crore taxes evaded in the country. Rangnekar estimated
black money grew by 13.3 percent from 6.9 percent during 1961-62 to
1969-70. According to Wanchoo Committee estimates, only income tax
evaded of Rs. 470 crore during 1968-69. According to S. M. Prasad‟s
estimates, tax evasion increased from Rs. 701 crore to Rs. 12611 crore
during 1953-54 to 1979-80. Such increasing trend of tax evasion is being
seen in the Indian economy.

89
Causes of tax evasion:
Wanchoo Committee means the Direct Taxes Administration Committee
has pointed out following causes of tax evasion.
1) There is high rate of taxes in direct tax laws.
2) The donations to political parties in India.
3) Corrupt business practices.
4) Economy on shortage and consequent controls and licenses.
5) High rate of sales tax and other indirect taxes.
6) There is ineffective enforcement of tax laws.
7) Deterioration of moral standard.

Other causes of tax evasion in India:

8) There is faulty maintenance of accounts.
9) Complexity and rigidity in tax laws.
10) Improper and inefficient implementation of laws.
11) High rate of cash transaction.

6.12.2 Tax Avoidance:

Tax avoidance is the practices to avoid paying taxes by using loop-holes
of the tax laws. Tax payer uses the advantages of the loop-holes of the tax
law to pay less taxes than actual it has pay. It is found that there is nobody
wants to pay taxes honestly to the government. Everyone tries to reduce
the tax burden by using advantages of the given concessions in the tax
laws. The new concept has been given it as tax planning of individuals.

According to Josef Stieglitz, there are three principles of tax avoidance.

These are as 1) postponement of taxes, 2) tax arbitrage across individuals
facing different tax brackets, 3) tax arbitrage across income streams facing
different tax treatment.

There are several anti avoidance legislation made in the world.

Specifically there are two kind of anti-avoidance measures as; General
Anti Avoidance Rules (GAAR) and Specific Anti Avoidance Rules
(SAAR). The GAAR refers to the set of generic anti-avoidance rules. The
SAAR targets to a specific avoidance practice or technique.

6.13 EFFECTS OF TAX AVOIDANCE AND EVASION

Tax evasion and tax avoidance practices are resulted to over burden on the
others tax payers and the less government expenditure which reduces the
developmental practices in the country. In this regard President Roosevelt
stated which is relevant to the situation of India, “Methods of escape or
intended escape from tax liability are many. Some are instances of
avoidance which appear to have, color of legality, others are on the border

90
line of legality, and others are plenty contrary even to the letter of law. All
are alike in that they represent determined efforts on the part on those who
use them to dodge the payment of taxes which are based on ability to pay.
All are alike in that failure to pay result to in shifting the tax load to the
shoulders of others less able to pay and mulcting the Treasury of the
government‟s just due.”

Tax evasion increases black money and its effects on the economy. There
is interlinking between the tax evasion and black money as; tax evasion
leads to the creation of black money and the black money utilization
secretly in business for earning more income inevitably leads to tax
evasion. In short, the tax evasion and black money go hand in hand. They
imposes automatically greater burden on the honest tax payers and it leads
to more income inequality. It leads to concentration of wealth in the hand
of faulty persons it is dangerous to the economy and social ethics.

The tax evasion diverts tax energy from legal productive activity to the
non productive activity. The faiths of honesty tax payers on laws are
missed by such persons those are evade tax burden. The Wanchoo
Committee has said correctly, “it is no exaggeration to say that black
money and tax evasion is like a cancerous growth on the country‟s
economy which, if not checked in time, is sure to lead its ruination.” Thus
the tax evasion makes the big problem in the social health.

6.14 PUNISHMENTS PROVISION IN TAX LAW

Following are the tax evasion punishments.

1. For not filling income tax return:

Taxpayer is compulsion to file income tax return before the due date as
required according to Income Tax Act under 139 subsections 1. If a tax
payer fails to fill income tax return assessing authority can impose penalty
of Rs. 5000 or more than that.

2. Failure to pay tax:

If a tax payer fails to pay wholly or partly –self assessment tax or fee and
interest , the taxpayer will be declare as defaulter according to the Income
Tax Act section 140A (1). As per the Section of 221 (1), the assessing
officer can declare tax payer as defaulter and fine on it not more than the
tax amount to pay. But if the person provides valid reason the fine will be
exempted by the assessing officer.

3. Failure to Get Accounts Audit:

With the demand notice for tax payment received by tax payer and unable
to pay tax within given 30 days it declare as defaulter. According to
section 92(E), such defaulter has penalty of Rs. 1 lakh.

91
4. Concealment of Income:
If some is found concealing tax, it will be punished under section 271 (C)
of income tax Act. There is a provision of 100% to 300% penalty of tax
evaded. The penalty of tax evasion will be varies under certain
circumstances.

5. Failure to comply with Income Tax Notice:

Whenever the Income Tax department issues a tax notice; the tax payer
has to comply. If it failure to comply enables the assessing officer to send
a notice under section 145(1) or 143(2) can ask the taxpayer to file the
return of income and to furnish in writing all details of assets and
liabilities.

Study of Public finance gives the knowledge of Governments economic

policies specifically fiscal policies. How the government of public sector
uses different fiscal policies and instruments of fiscal policy to established
economic stability in the country with maintaining steady economic
growth and development.

6.15 SUMMARY

This chapter of the subject introduced about the taxes which are liked by
the government but not liked by the citizens of the country. Here citizen
has been used instead of tax payer because everyone is paying taxes either
direct or indirect. Some are paying direct as well as indirect taxes also. All
are paying indirect taxes either they are from economically rich group or
economically poor group. The study of this subject is useful for the
student in academic carrier and their daily life.

6.16 QUESTIONS

1. Explain the merits and demerits of direct taxes.

2. Explain the merits and demerits of indirect taxes.
3. Explain the relationship between taxation and labour supply
4. Write not on
i) Horizontal equity
ii) Vertical equity
iii) Income taxation
iv) Corporation tax
v) Expenditure tax
vi) Exicse Duty
vii)Custom Duty
viii) Tax Evasion
ix) Tax Avoidance
*****
92
 MODULE IV
7
REFORMS AND GOVERNMENT-I
Unit Structure
7.0 Objectives
7.1 Introduction
7.2 Fiscal Rules
7.3 International and Indian Experience
7.4 Decentralisation
7.5 Summary
7.6 Questions

7.0 OBJECTIVES

After completing Post graduation level study, it is expected that, students

should know What is fiscal policy? how it is framed and what are the rules
state should follow while preparing it? This module will help students to
answer above questions. Also, this module put light on decentralisation of
fiscal policy. Taxation system and taxation power, government
expenditure, intergovernmental fiscal relations.

7.1 INTRODUCTION

Fiscal policy is an important part of public finance. According to Paul

Samuelson, fiscal policy means a policy announced by Government in
respect of public expenditure and taxation. Arthur Smithies says that fiscal
policy is a policy under which government uses the tools of public
expenditure, taxation and public debt which effects on production,
employment and income level of a country. Prof. Lipse says that fiscal
policy is a tool of achieving the macro-economic goals of economic
development of a country. Thus, fiscal policy is a policy implemented by
Government for macro-economic objectives of economic development, we
will realise the meaning of fiscal policy with the help of the various
objectives given below.

7.2 FISCAL RULES

According to OECD‘s(Organization for Economic Co-operation and

Development)budgeting practices and procedures, A fiscal rule is a long-
term constraint on fiscal policy through numerical limits on the budgetary

93
aggregates. Without overall limits, incremental budgeting can become an
open-ended process in which governments accommodate demands by
spending more than they have. A fiscal rule has two fundamental
characteristics. First, it presents a constraint that binds political decisions
made by the legislature and by the executive. And second, it serves as a
concrete indicator of the executive‘s fiscal management. While fiscal rules
can help governments to achieve fiscal objectives and discipline, there is
no one-size-fits-all rule for every country.

Fiscal rules can have different national legal foundations, and may be
enshrined in constitutions, or primary or secondary legislation. Other
countries may stipulate fiscal rules in public political commitments or in
internal rules set out by the ministries of finance. Australia is an
interesting example as it has in place all four kinds of rules. The legal
basis for three of them is the Budget Honesty Act, which is a strong
political commitment; in the case of the debt rule, it is founded in
legislation. Japan and Korea have only expenditure rules, in both cases as
internal rules and policies.1

7.2.1 Aims of Fiscal Rules:

According to David Cowen, Director IMF Capacity Development Office
in Thailand (CDOT) fiscal rules should aim to wards following goals.2

1. Simplicity The rule should be understood by decision-makers

and the public.
2. Sustainability Compliance with the rule should suffice to ensure
long- term sustainability.
3. Stabilization Following the rule should contribute to
macroeconomic stability, or at least not add to
volatility.
4. Operational It should be possible to translate the rule into clear
Guidance guidance in the annual budget process.
5. Resilience To build credibility, a rule should last and not be
abandoned after a shock.
6. Verification It should be possible to verify if the government has
complied with the rule.
The rule should be understood by decision-makers
1. Simplicity
and the public.
Compliance with the rule should suffice to ensure
2. Sustainability
long- term sustainability.
Following the rule should contribute to
3. Stabilization macroeconomic stability, or at least not add to
volatility.
4. Operational It should be possible to translate the rule into clear
1
https://www.oecd-ilibrary.org/docserver/gov_glance-2013-26-
en.pdf?expires=1621580112&id=id&accname=guest&checksum=5061DFE2D3A5123CDAA03D8B5D2E45A
0
2

https://www.unescap.org/sites/default/files/02_%5BCowen%5D_Making%20Fiscal%20Rules%20Work_IMF.p
df
94
 Guidance guidance in the annual budget process.
To build credibility, a rule should last and not be
5. Resilience
abandoned after a shock.
It should be possible to verify if the government has
6. Verification
complied with the rule.

7.2.2 Types of fiscal rules:

1. Debt rules -Set an explicit limit for public debt.
2. Budget balance rules -Constrain the evolution of the debt ratio.
3. Expenditure rules - Limit total / primary / current spending.
4. Revenue rules - Set ceilings or floors on revenues.

7.2.3 Success of fiscal rules:

A. More successful:
 Under stable/good economic conditions.
 For controlling local government finances.
 When exiting from fiscal crisis: seen in some case (although they
could be a case of mistaken causality)

B. Less successful:
 With lack of societal support.
 During severe economic crisis.
 In coping with all economic circumstances.
 When they bite: induce avoidance/creative accounting.

7.2.4 Fiscal rules and fiscal responsibility laws (FRLs):

FRLs are useful instruments in supporting desired fiscal outcomes. FRLs
provide a legal framework that embeds in law an agreed set of policies,
processes, or arrangements intended to improve fiscal discipline,
transparency, accountability, and stability by requiring governments to
commit to monitorable fiscal policy objectives and strategies. Their
success depends crucially on appropriate design and wide political support
and acceptance.

Fiscal rules can make the requirements of FRLs more focused and
binding. Fiscal rules have to balance the requirements of enforcement with
the need for flexibility in accommodating changing economic
circumstances. FRLs and fiscal rules need to be supported by adequate
fiscal monitoring and management capacities and be calibrated to country
specific circumstances.

7.2.5. Need for FRL’s:

1. Debt and deficits paths

- Unsustainable.
95
 - Pro-cyclical
- No consideration of inter-generational issues.
2. Lack of fiscal/budget discipline.
3. No anchor for fiscal policy.
4. Fiscal policy not a transparent, accountable, and/or orderly process.
5. Sometimes no actual fiscal policy—budget policy drives the day.

7.3 INTERNATIONAL AND INDIAN EXPERIENCE

7.3.1. International Experience:

1. Chile – 2006 Fiscal Responsibility Act

– Fiscal Rule: Structural balance
– Established various funds including a pension and stabilization fund
– Increased fiscal reporting of contingent liabilities

2. Ireland – 2012 Fiscal Responsibility Act

– Fiscal Rules: General budget balance and debt rules, consistent with
Stability and Growth Pact; includes corrective mechanisms and
sanctions.
– Set out medium-term budgetary objectives
– Increased fiscal reporting
– Established a fiscal council.

3. Peru – 2013 Fiscal Responsibility and Transparency Law

– Fiscal rules: Structural balance rule and debt rules, including
sanctions
– Required a medium-term macroeconomic framework
– Set out a fiscal stabilization fund for national government
– Established a Fiscal Council.

4. Thailand – 2018 Fiscal Responsibility Act

– Fiscal rule on public investment
– Set up the National Fiscal Policy Board
– Required a medium-term fiscal framework
– Established process rules including on virements and setting of debt
limits
– Featured transparency and accountability requirements.

7.3.2. Indian Experience:

The FRBM Act is a law enacted by the Government of India in 2003 to

ensure fiscal discipline – by setting targets including reduction of fiscal

96
deficits and elimination of revenue deficit. It is considered as one of the
major legal steps taken in the direction of fiscal consolidation in India.
The full form of FRBM is Fiscal Responsibility and Budget
Management.

Need for FRBM Act:

In India, the borrowing levels were very high in the 1990s and
2000s. Indian Economy was weak as it had high Fiscal Deficit, high
Revenue Deficit, and high Debt-to-GDP ratio. By 2003, the continuous
government borrowing and the resultant debt had severely impacted the
health of the Indian economy. Much of the borrowing was utilized for
interest payments of previous borrowings, but not for productive-purposes.
This resulted in interest payments becoming the largest expenditure item
of the government. Many economists then warned the government that
this condition is not sustainable. They advised legal steps to prevent India
to fall into a debt-trap.

Parliamentarians of India too felt that there should be control on the

government of India not to resort to a high level of borrowing to fund its
expenditure. Hence in 2000, they introduced a bill to bring responsibility
and discipline in matters of expenditure and debt. This bill was passed by
the Indian Parliament in 2003 and came to be known as the Fiscal
Responsibility and Budget Management Act.

The Fiscal Responsibility and Budget Management (FRBM) Act,

2003:
The Fiscal Responsibility and Budget Management Bill (FRBM Bill) was
introduced in India by the then Finance Minister of India, Mr. Yashwant
Sinha in December 2000. The provisions provided in the initial versions of
the bill were too drastic. After much discussions, a watered-down version
of the bill was passed in 2003 to become the FRBM Act. The FRBM
Rules came into force from July 5, 2004.

Objectives of FRBM Act.:

FRBM Act is all about maintaining a balance between Government
revenue and government expenditure. The intention of the Fiscal
Responsibility and Budget Management Act was to bring –
Fiscal discipline.
 Efficient management of expenditure, revenue and debt.
 Macroeconomic stability.
 Better coordination between fiscal and monetary policy.
 Transparency in the fiscal operation of the Government.
 Achieving a balanced budget.

Additionally, the act was expected to give the necessary flexibility to

Reserve Bank of India (RBI) for managing inflation in India.

97
Provisions of the Fiscal Responsibility and Budget Management Act
The FRBM rules mandate four fiscal indicators to be projected in the
medium-term fiscal policy statement. These are:
1. Revenue deficit as a percentage of GDP
2. Fiscal deficit as a percentage of GDP.
3. Tax revenue as a percentage of GDP.
4. Total outstanding liabilities as a percentage of GDP.

The FRBM Act set targets for fiscal deficit and revenue deficit:
The FRBM act also provided for certain documents to be tabled in the
Parliament of India, along with Budget, annually with regards to the
country‘s fiscal policy. This included the Medium-term Fiscal Policy
Statement, Fiscal Policy Strategy Statement, Macro-economic Framework
Statement, and Medium-term Expenditure Framework Statement. For
details check the details of the budget documents.

Initial FRBM Targets (to be met by 2008-09):

1. Revenue Deficit Target: revenue deficit should be completely
eliminated by March 31, 2009. The minimum annual reduction target
was 0.5% of GDP.
2. Fiscal Deficit Target: fiscal deficit should be reduced to 3% of GDP
by March 31, 2009. The minimum annual reduction target was 0.3% of
GDP.
3. Contingent Liabilities: The Central Government shall not give
incremental guarantees aggregating an amount exceeding 0.5 per cent
of GDP in any financial year beginning 2004-05.
4. Additional Liabilities: Additional liabilities (including external debt
at current exchange rate) should be reduced to 9% of the GDP by
2004-05. The minimum annual reduction target in each subsequent
year to be 1% of GDP.
5. RBI purchase of government bonds: to cease from 1 April 2006.
This indicates the government not to borrow directly from the RBI.

Did the government meet the FRBM targets by March 2009?:

No. Implementing the act, the government had managed to cut the fiscal
deficit to 2.7% of GDP and revenue deficit to 1.1% of GDP in 2007–08.
However, the targets were not met. The global financial crisis (2007-08)
led the government to infuse resources in the economy as the fiscal
stimulus in 2008. Therefore, fiscal targets had to be postponed temporarily
in view of the global crisis.

Amendments in the FRBM Act:

In 2012 and 2015, notable amendments were made, resulting in relaxation
of target realisation year. A new concept called Effective Revenue Deficit
(E.R.D) was also introduced. The requirement of ‗Medium Term

98
Expenditure Framework Statement‘ was also added via amendment in
FRBMA.

FRBM Targets after Amendment to FRBM Act in 2012 (to be

achieved by 2015)
1. Revenue Deficit Target: revenue deficit should be completely
eliminated by March 31, 2015. The minimum annual reduction target
was 0.5% of GDP.
2. Fiscal Deficit Target: fiscal deficit should be reduced to 3% of GDP
by March 31, 2015. The minimum annual reduction target was 0.3% of
GDP.

FRBM Targets after Amendment to FRBM Act in 2015 (to be

achieved by 2018)
1. Revenue Deficit Target: revenue deficit should be completely
eliminated by March 31, 2018. The minimum annual reduction target
was 0.5% of GDP.
2. Fiscal Deficit Target: fiscal deficit should be reduced to 3% of GDP
by March 31, 2018. The minimum annual reduction target was 0.3% of
GDP.

Recommendations of FRBM Review Committee headed by NK Singh:

The government believed the targets were too rigid. In May 2016, the
government set up a committee under NK Singh to review the FRBM Act.
The committee recommended that the government should target a fiscal
deficit of 3 per cent of the GDP in years up to March 31, 2020, cut it to 2.8
per cent in 2020-21 and to 2.5 per cent by 2023.

The Committee suggested using debt as the primary target for fiscal
policy. This ratio was 70% in 2017.These are the targets set by NK Singh:
1. Debt to GDP ratio: The review committee advocated for a Debt to
GDP ratio of 60% to be targeted with a 40% limit for the centre and
20% limit for the states.
2. Revenue Deficit Target: revenue deficit should be reduced to 0.8% of
GDP by March 31, 2023. The minimum annual reduction target was
0.5% of GDP.
3. Fiscal Deficit Target: fiscal deficit should be reduced to 2.5% of GDP
by March 31, 2023. The minimum annual reduction target was 0.3% of
GDP.

Latest FRBM Targets:

The latest provisions of the FRBM act requires the government to limit the
fiscal deficit to 3% of the GDP by March 31, 2021, and the debt of the
central government to 40% of the GDP by 2024-25, among others.

99
The Act provides room for deviation from the annual fiscal deficit target
under certain conditions.
Escape Clause in the FRBM Act:
Escape clause refers to the situation under which the central government
can flexibly follow fiscal deficit target during special circumstances. This
terminology was innovated by the NK Singh Committee on FRBM.

In Budget 2017, Finance Minister Arun Jaitley deferred the fiscal deficit
target of 3% of the GDP and chose a target of 3.2%, citing the NK Singh
committee report.
However, the Comptroller and Auditor General of India (CAG) pulled up
the government for deferring the targets which it said should have been
done through amending the Act.
In 2018, the FRBM Act was further amended. Specific details were
updated in sub-section (2) of Section 4. The clause allows the govt. to
relax the fiscal deficit target for up to 50 basis points or 0.5 per cent.
Under FRBM, if the escape clause is triggered to allow for a breach of
fiscal deficit target, the RBI is then allowed to participate directly in the
primary auction of government bonds, thus formalising deficit financing.

The Escape Clauses can be invoked:

 By the Government after formal consultations and advice of the Fiscal
Council.
 With a clear commitment to return to the original fiscal target in the
coming fiscal year.

In 2020, Finance Minister, Nirmala Sitharaman used the escape clause

provided under the FRBM Act to allow the relaxation of the target.
Finance Minister revised the fiscal deficit for FY20 to 3.8 per cent and
pegged the target for FY21 to 3.5 per cent.

Note: The Act exempts the government from following the FRBM
guidelines in case of war or calamity.

Current status of Fiscal Deficit and Revenue Deficit:

Table No. 7.1
Revised Budget 2021-22 2022-23
Estimates Estimates (Projections) (Projections)
2019-20 2020-21
1. Fiscal 3.8 3.5 3.3 3.1
Deficit
2. Revenu 2.4 2.7 2.3 1.9
e
Deficit
3. Primary 0.7 0.4 0.2 0.0
Deficit
100
 4. Gross 10.6 10.8 10.7 10.7
Tax
Revenu
e
5. Non- 1.7 1.7 1.5 1.5
tax
Revenu
e
6. Central 50.3 50.1 48.0 45.5
Govern
ment
debt
7. Of 0.7 0.8 0.9 0.9
which
Liabiliti
es on
account
of EBR

 Fiscal Deficit (FD)- The Fiscal deficit as per the Indian Budget 2020-
21 was estimated 3.5 % of GDP.
 Revenue Deficit (RD)- The Revenue Deficit as per the Indian Budget
2020-21 was estimated 2.7 % of GDP.
 Effective Revenue Deficit (ERD)- The effective revenue deficit as per
the Indian Budget 2020-21 was estimated 1.8 % of GDP.
 Tax to GDP ratio: 10.8
 Debt to GDP ratio (Central Government): 50.1

What if there is no Fiscal Discipline?:

If there is no fiscal discipline, the government (executive) may spend as it
wishes.

A country is just like a house; if the expenditure is too much and if there is
no revenue to balance the high expenditure, the country will eventually
fall into a debt trap, which may finally result in its collapse.

Conclusion:
The FRBM Act seeks to achieve long-term macroeconomic stability,
while generating budget surpluses, prudential debt management, limiting
borrowings to cut down deficits and debt, greater transparency, removal of
fiscal impediments and providing a medium-term framework for
budgetary implementation.

As seen in the above analysis, different governments have failed to

achieve the FRBM targets set to be achieved in 2008 even by 2020.
Though the Act aims to achieve deficit reductions prima facie, an
important objective is to achieve inter-generational equity in fiscal
101
management. This is because when there are high borrowings today, it
should be repaid by the future generation. But the benefit from high
expenditure and debt today goes to the present generation.
Achieving FRBM targets thus ensures inter-generation equity by reducing
the debt burden of the future generation.

7.4 DECENTRALISATION

FISCAL DECENTRALIZATION is in vogue. Both in the industrialized

and in the developing world, nations are turning to devolution to improve
the performance of their public sectors. In the United States, the central
government has turned back significant portions of federal authority to the
states for a wide range of major programs, including welfare, Medicaid,
legal services, housing, and job training. The hope is that state and local
governments, being closer to the people, will be more responsive to the
particular preferences of their constituencies and will be able to find new
and better ways to provide these services. In the United Kingdom, both
Scotland and Wales have opted under the Blair government for their own
regional parliaments. And in Italy the movement toward decentralization
has gone so far as to encompass a serious proposal for the separation of
the nation into two independent countries. In the developing world, we
likewise see widespread interest in fiscal decentralization with the
objective of breaking the grip of centra planning that, in the view of many,
has failed to bring these nations onto a path of self-sustaining growth. But
the proper goal of restructuring the public sector cannot simply be
decentralization. The public sector in nearly all countries consists of
several different levels. The basic issue is one of aligning responsibilities
and fiscal instruments with the proper levels of government. As Alexis de
Tocqueville observed more than a century ago, "The federal system was
created with the intention of combining the different advantages which
result from the magnitude and the littleness of nations" (1980, v. I, p. 163).
But to realize these "different advantages," we need to understand which
functions and instruments are best centralized and which are best placed in
the sphere of decentralized levels of government. This is the subject matter
of fiscal federalism. As a subfield of public finance, fiscal federalism
addresses the vertical structure of the public sector. It explores, both in
normative and positive terms, the roles of the different levels of
government and the ways in which they relate to one another through such
instruments as intergovernmental grants. These direct taxes, states have
the power to levy indirect taxes like those on commodities and services
such as GSI.

Besides tax revenue, states have other sources of receipts on revenue

account. These are non-tax revenues such as interest receipts dividends
from state enterprises etc.

Then there are receipts on capital account, which are loans taken from the
market in the form of bonds and securities, and loans, which flow from the
centre. In addition, there are receipts like share in central taxes, grants aid
102
and other receipts of funds from the centre for centrally sponsored
schemes.

7.5 SUMMARY

According to OECD‘s (Organization for Economic Co-operation and

Development) budgeting practices and procedures, A fiscal rule is a long-
term constraint on fiscal policy through numerical limits on the budgetary
aggregates.

Types of fiscal rules:

1. Debt rules - Set an explicit limit for public debt.
2. Budget balance rules - Constrain the evolution of the debt ratio.
3. Expenditure rules - Limit total / primary / current spending.
4. Revenue rules - Set ceilings or floors on revenues.

The FRBM Act is a law enacted by the Government of India in 2003 to

ensure fiscal discipline – by setting targets including reduction of fiscal
deficits and elimination of revenue deficit. It is considered as one of the
major legal steps taken in the direction of fiscal consolidation in India.
The full form of FRBM is Fiscal Responsibility and Budget Management.

7.6 QUESTIONS

1. What are fiscal rules? Explain its aims.

2. Discuss briefly Indian and international experience of fiscal rules.

*****

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 8
REFORMS AND GOVERNMENT – II
Name
Unit Structure
8.0 Objectives
8.1 Introduction
8.2 India‘s Federal Structure
8.3 Taxation Power
8.4 Expenditure responsibilities
8.5 Intergovernmental Transfer
8.6 VAT, GST
8.7 Summary
8.8 Questions
8.9 References

8.1 OBJECTIVES

1. To understand India‘s Federal Structure.

2. To know taxation powers of deferent government authority.
3. To understand Expenditure responsibilities.
4. To know how intergovernmental transfer took place.
5. To understand Value added Tax and Goods and Service Tax.

8.2 INTRODUCTION

A federation is a form of government in which the sovereign or political

power is divided between the central and the state or local governments
such that each government, within its own sphere, is independent of the
other. Under the federal system of government, there is a sovereign
authority in the centre, and under it are the different units of the
government. The duties and rights of these government units are
determined in a certain well-defined way in the Constitution. Some of the
functions of these units are independent of the direct control of the centre,
and for the performance of these functions, the right to collect revenue and
to incur expenditure is given to them. The general principles of public
finance are applicable equally to the federal as well as the unitary forms of
government. However, the federal system of government has some of its
specific problems in regard to finance.

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What is a federal set-up:
In the words of Robert Gorson Federalism is a form of government in
which sovereignty or political power is divided between the central and
the local government so that each of them, within its own sphere is
independent of the other. In other words, federalism may be considered as
a form of political association in which two or more states constitute a
political unity with a common government, but in which the member
states retain a measure of internal autonomy. In such a setup, there is more
than one government for each region or state. Thus, under the federal
system of the government, sovereign authority lies in the centre or federal
or union government. The concept of federal finance was developed in
America between 1776-79. Federal finance means division and
coordination of different items of income and expenditure between the
central government, state government and local governments, under this
system of federal finance, there is adequate independence of state and
local governments as to their income and expenditure. According to Dr.
R.N. Bhargava, "the term "federal finance' refers to the finance of the
federal as well as of the state governments and the relationship between
the two." In federal finance, central authority (central government) holds
superiority over all units (state governments), but these units are given
autonomy in certain matters.

History of federal finance in India:

India is a 'federal republic' and this provision is enshrined in the country's
Constitution. The financial powers and responsibilities of the different
government units have been clearly defined in the Indian Constitution.
However, while the Constitution of India and the provisions mentioned
therein are the final stage in the development of federal finance in India,
the growth of the federal system of finance in the country has been
achieved through an evolutionary process over the past one hundred years.
From the complete centralisation of financial powers to the present system
of federal finance, the financial system in this country has passed through
several stages. The history of the gradual evolution of federal finance in
India may be studied under the following five periods: 1. First period-1833
to 1870. 2. Second period-1871 to 1918. 3. Third period–1919 to 1935. 4.
Fourth period-1936 to 1949. 5. Fifth period from-1950 to yet. (Beginning
after the commencement of the present Constitution of India) In this
period, we include: (i) The Deshmukh award, and (ii) The allocation of
revenue resources between the centre and states in the country as laid
down in the Constitution of India, 1950.

1. First Period (1833-1870):

In 1833, the financial system was completely centralised by a Charter Act
of British Government which provided for the appointment of the
Governor of Bengal as the Governor-General of India and the Governors
in different states were made subordinate to him for financial matters. The
revenue was collected in the name of the Government of India and the
Governor-General had full powers to spend it. All expenses and
appointments were to be sanctioned by the Governor-General. In fact, the
105
Governor's influence on the Governor-General of India and their tactics in
showing deficits in their respective states, was the sole criteria for the
determination of the volume of grants in aid of the states. That is why, this
system had all the defects of being uneconomical, inconvenient and
lethargic which are stated as below:
A. This system was uneconomical and inconvenient.
B. It was lethargic in administration and the state held resentment against
it.
C. The Governors of states had a constant tendency to show deficits in
their respective states and personal influence was the main criterion for
the grants-in-aid from the centre.

2. Second Period (1871-1918):

Before 1871, the central government in the country had complete control
over the revenue and expenditure in the country. The provinces were given
fixed grants by the central government to enable them to cover their
expenses. This practice resulted in uncertainty for the central finances and
led to the incurring of wasteful expenditure by the provincial
governments. The frequent practice of disbursing the grants-in-aid on the
basis of uniformity to the provinces was also unsuitable for a large country
like India with great diversities in the local conditions. Consequently, in
1871, Lord Mayo took the first step towards financial decentralisation and
some decentralisation in the financial matters was introduced in the
country in 1871. This decentralisation was introduced in the form of a
system of 'provincial financial settlements'. Under this system, certain
heads of expenditure like forest excise, stamps, land revenue, police, jails,
education, medical services, registration, roads and civil works, which
were regarded as local in character were made over to the provinces.
Consequently, for the management of these departments, the provincial
governments were given annual fixed lump sum grants of Rs. 4.68 crores
and some limited powers of taxation. Although the allocation of revenue
resources between the centre and the provinces was not based on sound
financial principles, nevertheless it represented the first step towards the
emergence of the system of federal finance in India. In 1882, the system of
giving fixed grants to the provinces was abolished and the revenue
resources were divided into the following three categories or heads:

A. Imperial heads: Under this head, the centre retained the entire profits
of the commercial departments and the proceeds from customs, salt and
opium. As the income derived from these departments was not sufficient
to cover the central expenditure, other sources of revenue including
income tax, were divided between the central and provincial governments.

B. Provincial heads: The central government retained a proportion, fixed

in the case of cach province, of the proceeds of the main heads of revenue
collected in the provinces, based on an assessment of the latters' respective
needs. In practice, since no definite standards of needs were evolved,

106
allocation to the provinces was largely a result of history. These consisted
of the civil departments and provincial works.

C. Divided heads: The revenue from 'divided heads' being insufficient to

meet the needs of the provincial governments, was supplemented by
means of fixed cash assignments, recurring as well as non-recurring,
which continued to remain an important feature of the system. This
category included the revenue derived from excise duties, assessed taxes,
stamps, forests and registration.

3. Third Period (1919-1935):

The movement towards the system of financial decentralisation in the
country was further consolidated under the Montagu-Chelmsford Reforms
which took practical shape in the form of Government of India Act, 1919
which came into force in 1921. This Act provided for the clear separation
of state financial resources from those of the centre. Land revenue, excise
duties, stamps and irrigation charges were the important resources of
revenue which were now given to the states. Meston Award It was under
this idea that the Financial Relations Committee (under Lord Meston) was
constituted to recommend, a scheme of provincial contribution to the
central government. This committee suggested a scheme which was based
upon what it called the 'initial contributions' and 'standard contributions'.
The operations of Meston Scheme led to heavy deficit for provinces.
Provincial governments demanded changes in the system of financial
arrangements so that provincial autonomy could be achieved. Several
proposals were put forth for constitutional changes. This led to the
formation of successive enquiry committees to examine those proposals.

A. Indian Taxation Enquiry Committee, examined, among other

matters, the division of sources of revenue and the structure of financial
relations between the centre and the provinces, and recommended that-
general stamp, excise duty on foreign liquors manufactured in the country
and opium should be transferred to the power to levy and administer
income tax; if any division of taxes is to be made, income tax should be
the main balancing factor; a share of income tax may be assigned to the
provinces and it should be distributed on the basis of centre; provinces
should not be given the domicile.

B. First Peel Committee, 1931 suggested that: All income tax proceeds
should be transferred to the provinces at the outset of federation, collection
and administration being in federal hands; federal tax revenues would be
mostly derived from indirect taxation; any resultant federal deficit could
be met from provincial contributions which would be extinguished in
definite stages over a period of 10 to 15

C. Percy Committee, 1932 was, accordingly, appointed to examine these

issues. The Committee recommended that: Any procedure for distribution
should be simple, cosily understood and administratively workable;
allocation on the basis of collections would lead to gross injustice between
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the provinces; distribution on the basis of population is not wholly
scientific but could be adopted in certain circumstances; the basis of origin
may be theoretically commendable but would lead to arbitrariness;
ultimately, the basis of residence in one of two forms is preferable; income
tax should be shared between the centre and the provinces and the share of
the provinces should not be altered from year to year but should be fixed
for a term of years, subject to a revision every five years in the light of
actuals; and federal grants, if and when they become feasible, should be
distributed on the basis of population.

D. Second Peel Committee, 1932 proposed a two-fold division of the

proceeds of taxes on income into shares, which would be assigned as a
permanent constitutional arrangement, to the centre and the provinces
respectively.

E. White Paper on Indian Constitutional Reforms, 1931 recommended

that: A prescribed percentage, not less than 50 per cent and not more than
75 per cent, of the net revenue derived from taxes on income other than
agricultural income should be assigned to the provinces on a prescribed
basis; both the federation and the provinces should have the power to levy
surcharges on income tax for their own purposes; the federal legislature
should be empowered by law to assign to the units the whole or part of the
yield of salt duties, excise duties and export duties; and in respect of
certain taxes, including terminal taxes and death duties, while the power to
levy the tax would vest solely with the federation, the proceeds would be
distributed to the provinces.

F. Parliamentary Committee, 1934, reforms, generally agreed with the

proposals made in the White Paper and suggested that: The provincial
share of income tax should be prescribed by an Order-in-Council; the
share of the provinces might not exceed half of the net revenue from
income tax; and provinces should not be empowered to impose surcharges
on personal income tax. The Joint Parliamentary Committee's proposals
relating to income tax were incorporated in the Government of India Act,
1935.

G. Government of India Act,1935. This Act did not make any changes in
the allocation of heads between the centre and the units. It revived, in a
somewhat modified form, the earlier principle of dividing the proceeds of
certain central heads of revenue.

4. Fourth Period (1936-1949):

According to the Act of 1935, there was a complete separation of federal
and provincial sources of revenue. However, the princely states had to
remain outside the system of federal finance in the country. Under this
provision, the sources of revenue of the provinces, constituted the land
revenue, irrigation charges, excise duties on alcoholic liquors, opium,
narcotic drugs, medical and toilet preparations, agricultural income tax,
stamps and registration. The central resources comprised of corporation
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tax, custom duties, railway, telegraph, broadcasting, currency and coinage
and military receipts. Moreover, the Act also provided for certain taxes
which were to be levied and collected by the central government but some
share of it was to be distributed among the states. It had the provision for
certain other taxes which were to be levied and collected by the states, but
the receipts were to be shared between the centre and states. The Act also
made another provision of grants-in-aid to those states which must be in
need of financial help. Finally, taxes on succession to non-agricultural
property, were to be imposed by the federal government, but were to be
wholly assigned to the provinces. Otto Niemeyer Report This Act had
another provision of financial enquiry to be made before the introduction
of 'provincial autonomy". Sir Otto Niemeyer was appointed in 1936 to
enquire into the financial relations between the centre and the states. He
recommended the following measures:

1. Fifty per cent of the proceeds of income tax should be assigned to the
provinces. As regards distribution among the provinces, substantial justice
would be done by fixing the scale of distribution partly on residence and
partly on population.

2. The centre should retain, for the first five years, out of the provincial
share, a sum equivalent to the amount by which the central share plus the
contribution from the Railways falls short of Rs. 13 crores a year. The
amount retained from the provincial share should be surrendered to the
provinces over a further period of five years.

3. The provinces' share of the jute export duty should be raised from 50 to
62.5 per cent of the net proceeds.

4. The outstanding debts to the centre from Bengal, Bihar, Assam, North
West Frontier Province and Orissa, contracted prior to 1 April 1935 should
be cancelled and also the reduction in the outstanding loan of the central
provinces.

The above recommendations were accepted and incorporated in the

Government of India (Distribution of Revenues) Order, 1936. This Order,
subject to a change made in 1940, continued to regulate the allocation of
revenues between the centre and the units until the partition of the country
in August 1947.

It was decided that, for the duration of the Second World War the centre
should be permitted to retain a fixed sum of Rs. 4.5 crores out of the
provincial share of income tax. This continued from 1940 to 1945. In each
of the next five years, the sum retained by the centre was reduced by Rs.
75 lakhs per year over the previous year and the full provincial share was
restored to the provinces in 1950-51.

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5. Fifth Period (After Independence):
The Constitution of India made the same financial provisions as were
provided in the Government of India Act, 1935. As a Finance Commission
could be set up only after the Constitution came into force on 26 January
1950, the states' share of income tax and its distribution and the payment
of grants-in-aid under Articles 273 and 275 of the Constitution had to be
regulated by Order of the President for the period between the
commencement of the Constitution and the appointment of a Finance
Commission. Some of the states had expressed dissatisfaction with the
arrangements for the allocation of income tax and jute export duty made
by the Government of India, immediately after Partition. Hence, it was
decided that these matters should be referred to an impartial authority for
reconsideration.

Deshmukh Award:
Towards the end of 1949, C.D. Deshmukh was requested to look into
these matters. The Deshmukh Award was given effect to from 1 April
1950 and remained in force for two years ending with 31 March 1952. As
a Finance Commissioner could not be appointed immediately, the
Government of India invited Shri C.D. Deshmukh to examine the question
of division of tax revenues between the centre and the state. Shri
Deshmukh gave his Award in January 1950.

The Award determined the diets of income tax and net proceeds between
the centre and the states. The Award remained in force till Finance
Commission was set up under Article 280 of the Indian Constitution.

8.3 TAXATION POWER

Division of Resource Raising Powers:

To meet the expenditures involved in the performance of functions, the
governments at different levels have been assigned powers to raise
resources.

Receipts of Central Government:

There are various sources of receipts of the central government classified
into revenue receipts and capital receipts. Among the revenue receipts the
most important is the tax revenue. A part of the tax receipts is statutorily
transferred to the states as per the recommendations of the Finance
Commission. The various types of taxes allotted to the centre may be
listed under three categories:
1. Taxes on income and expenditure, which include income tax,
corporation tax and expenditure tax.
2. Taxes on property and capital transactions which cover estate Taxes
property duty, wealth tax etc.
3. Taxes on commodities: A major change in the indirect tax structure
was made with the implementation of The Goods and Services Tax
110
 (GST) on 1 July 2017. Since GST is a destination-based tax, an end
user consuming any goods or services is liable to pay it. The tax is
received by the State in which the goods or services are consumed and
not by the state in which such goods are manufactured. GST have
following three types.

1. Central GST (CGST) is a tax levied on intra-state supplies of both

goods and services by the central government and governed by the CGST
Act.

2. State GST (SGST) will also be levied on the same intra-state implies
that both the Central and the State governments will agree on combining
their levies with an appropriate proportion for revenue sharing between
them.

3. Integrated GST (IGST) is a tax levied on all inter-state supplies of

goods and services and will be governed by the IGST Ad Tax will be
shared between central and state governments.

Apart from tax revenue there are other sources of revenue receipts. These
include dividends from railways, posts and telegraphs, RBI, public sector
undertakings and interest receipts on loans given to states.

As regards capital receipts, the government has the legal power to borrow
from the domestic as well as the international markets, as also from world
institutions and foreign governments.

Receipts of State Government: Like those of the Centre, receipts of

states are classified into revenue and capital receipts. The revenue receipts
come mainly from taxes on agricultural income, profession tax, property
and capital transactions like stamp and registration, land revenue, urban
immovable property tax and surcharge on cash crops. Besides

8.4 EXPENDITURE RESPONSIBILITIES

Division of Functions: The principle underlying the division of functions

assigns Countrywide tasks to the centre and state/region. Similarly, the
tasks of local importance are assigned to municipalities in towns and
panchayats in villages.

A. Central Government Functions: The several functions of the central

government are classified into developmental and non-developmental
functions. Developmental functions are the ones which promote growth
and welfare of the people, for e.g., provision of social and community
services (education, public health, science and technology, labour and
employment etc.); economic services (agriculture and allied services,
industry and minerals, transport and communications, foreign trade etc.);
and grants in aid to states for developmental purposes. Non-developmental
functions include maintenance of law and order (police, defence);
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maintenance of external relations; grants to states for non-developmental
purposes.

B. State Government Functions: The various responsibilities of the

states are also grouped under two categories: developmental and non-
developmental. Developmental functions include: social and community
services; economic services etc. Non-developmental functions include
administrative services, payment of pensions, interest payments on loans.

Justification for the Division:

1. Defence and communication services 'are to be provided uniformly
throughout the country and thus should be the responsibility of the
centre.
2. Benefits accrue due to economies of scale in the provision of these
services due to the large size of the country.
3. Critical areas such as foreign investment and foreign trade which
require a national agenda, are with the centre.
4. Further, services which differ from region to region like agriculture,
are assigned to the states.

Problems:
The existing division of functions has the following problems:
1. There is over lapping of functions in important areas like education
and health. required freedom and autonomy to the regions in respect to
their designing and implementation and thus do not benefit the
targeted groups.
2. Many of the centrally sponsored schemes do not provide the required
freedom and autonomy to the regions in respect to their designing and
implementation and thus do not benefit the targeted groups.

8.5 INTERGOVERNMENTAL TRANSFER

In spite of the clear-cut division of the powers and the financial resources
between the central and states, there is an imbalance in the division of
resources, this imbalance is in favour of the Centre. increased over the
years, their revenue resources have not increased substantially.

Transfer of Resources from Centre to States:

The constitution itself has recognised the finance inadequacy of states and,
therefore, the constitution has made a provision for the transfer of
resources from the centre to states. These transfers are of three types:
1. Transfer of a part of tax proceeds from centre to the states. This is
done through the agency of Finance Commission.
2. Transfer in the form of grants and loan from centre to states. These too
are done through the Finance Commission.
112
3. Transfer in the form of plan assistance for plan projects. This takes
place through the planning commission.

The above scheme of transfer does not solve the problem of financial
imbalance

Finance Commissions:
Article 280 of the Constitution of India has made provision for the
appointment of a Finance Commission. The Finance Commission
(Miscellaneous Provisions) Act was passed in 1951. According to the
provisions of the Act, the Commission is appointed every five years. It
includes a chairperson and four other members.

The functions of the Finance Commissions are:

(a) To recommend the distribution of net tax proceeds and allocation of
shares of such proceeds between the Union and the States.
(b) Grants-in-aid recommendations for covering the gap between current
revenues and expenditures of the States, and for removal of regional
disparities between the States. The Commission also recommends
special purpose grants to a State.
(c) The Finance Commission may look into and study specify. problems
and issues in the interest of healthy and sound financial relations
between the Centre and States, on the advice of the President. These
issues include extent of indebtedness of States, debt relief measures
and special expenditures required to be made by States.

So far 14 Finance Commissions have been constituted. The 14h Finance

Commission was constituted in January 2014 under the chairmanship of
Dr. Y.V. Reddy, former governor of the RBI. The Commission submitted
its report to then President Pranab Mukherjee in December 2014. The
Government of India has accepted the recommendations of the
Commission for the period 2015-16 to 2019-20. Some of the major
recommendations of the 14th Finance Commission that have been
accepted by the Government of India are:
1. States' share in the net proceeds of Union tax revenue to be increased
from previous 32% to 42%.
2. Eight Centrally Sponsored Schemes (CSS) delinked from the Centre
support. 30 such CSS have been identified, but have not yet been
delinked from Centre support due to national priorities and legal
obligations. CSS are special purpose grants or loans given by Central
Government to State Governments to plan and implement programmes
to help achieve national goals and objectives. Some examples of CSS
are Jawaharlal Nehru National Urban Renewal Mission (JNNURM),
Rashtriya Krishi Vikas Yojana, Sarva Shiksha Abhiyan, National
Mission on AYUSH.
3. States to share higher fiscal responsibility for the existing CSS
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4. Revenue compensation to States under GST should be for five years;
100% in first three years, 75% in fourth year and 50% in the fifth year.
States are expected to have lower tax collection due to imposition of
GST.
5. An autonomous and independent GST Compensation Fund be created.

8.6 VAT, GST

8.6.1 VAT:
VAT is a multi-stage tax levied at each stage of the value addition chain,
with a provision to allow input tax credit (ITC) on tax paid at an earlier
stage, which can be appropriated against the VAT liability on subsequent
sale.

VAT is intended to tax every stage of sale where some value is added to
raw materials, but taxpayers will receive credit for tax already paid on
procurement stages. Thus, VAT will be without the problem of double
taxation as prevalent in the earlier Sales tax laws.

Presently VAT is followed in over 160 countries. The proposed Indian

model of VAT will be different from VAT, as it exists in most parts of the
world. In India, VAT has replaced the earlier State sales tax system.

One of the many reasons underlying the shift to VAT is to do away with
the distortions in our aerier tax structure that carve up the country into a
large number of small markets rather than one big common market. In the
earlier sales tax structure tax is not levied on all the stages of value
addition or sales and distribution channel which means the margins of
distributors/ dealers/ retailers at large not subject to sales tax earlier.

Thus, the sales tax pricing structure needs to factor only the single-point
levy component of sales tax and the margins of manufacturers and dealers/
retailers etc, are worked out accordingly. Internal trade and impeded
development of a common market. Prices by an amount higher than what
accrues to the exchequer by way of revenues from it.

Also, there was the problem of multiplicity of rates. All the states,
provided for plethora of rates. These range from one to 25 per cent. This
multiplicity of rates increases the cost of compliance while not really
benefiting revenue.

Heterogeneity prevailed in the structure of tax as well. Apart from general

sales tax, most states used to levy an additional sales tax or a surcharge. In
addition, the states levied luxury tax as also an entry tax on the sale of
imported goods.

All these practices of heterogeneity in structure as well as rates cause

diversion of trade as well as shifting of manufacturing activity from one
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State to another. Further, widespread taxation of inputs relates to vertical
integration of firms, i.e., the earlier system of taxes militated against
ancillary industries and encourages them to produce more and more of the
inputs needed rather than purchase them from ancillary industries.

The earlier system of commodity taxes is non-neutral. It interferes with the

producers' choice of inputs as well as with the consumers' choice of
consumption, thereby leading to severe economic distortions.

8.6.2 GST:
Background of GST A comprehensive GST based on the Value Added
Tax (VAT) principle was first suggested by the Kelkar Task Force in
December 2002. The introduction of GST in India was first announced in
the Union Budget 2006-07. Since then, the Empowered Committee of
Ministers had worked on preparing the back ground material for GST and
the draft GST Acts. Implementation of GST finally materialised with the
Parliament passing the Constitutional Amendment Act in September 2016,
followed by the State Legislatures and GST was rolled out with effect
from 1 July 2017 (including Jammu and Kashmir with effect from 8 July
2017).

As stated by the President of India Sri Pranab Mukherjee on the launch of

GST from the Central Hall of Parliament on 30 June 2017, ―GST is the
result of a broad consensus arrived at between the Centre and the States
and is a tribute to the maturity and wisdom of India‘s democracy‖.

Definition of GST:
GST is a tax on supply of goods or services or both and a single tax on
entire value chain of supply, right from the manufacturer to the consumer.
Credit of input taxes paid at each stage will be available in the subsequent
stage of value addition, which makes GST essentially a tax only on value
addition at each stage. The final consumer will thus bear only the GST
charged by the last dealer in the supply chain, with set-off benefits at all
the previous stages. GST is a consumption-based tax i.e., tax accrues to
the State where goods and / or services are finally consumed.
There are three components of GST as follows: -
• Central Goods and Services Tax (CGST): payable to the Central
Government on supply of goods and services within the State/Union
Territory.
• State/Union Territory Goods and Services Tax (SGST/UTGST):
payable to the State/Union Territory Government on supply of goods
and services within the State/Union Territory.
• Integrated Goods and Services Tax (IGST): in case of inter-state
supply of goods and services, IGST is levied by the Government of
India. Equivalent IGST is also levied on imports into India. IGST shall
be apportioned between the Union and the States as per the provisions
of IGST Act.

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• GST Compensation Cess: In addition to GST, a cess named GST
Compensation Cess can be levied on notified goods and services and
currently such cess is levied on pan masala, tobacco, aerated drinks,
cars and coal.

Taxes submerged in GST:

A. Central Taxes:
1. Central Excise Duty (except five Petroleum and tobacco products)
2. Service Tax.
3. Counter vailing duties on Customs.
4. Additional duties of excise on Duty of goods of special importance.
5. Additional duties of excise on Textiles and textile articles.
6. Special Additional duty on Customs.
7. Excise Duty on medicinal and Toilet preparation.

B. State Taxes:
1. State Value Added Tax (VAT)/Sales Tax (except five petroleum
products and alcoholic liquor for human consumption)
2. Entertainment Tax (other than the tax levied by the local bodies)
3. Central Sales Tax (levied by the Centre and collected by the States)
4. Octroi and Entry tax
5. Purchase tax
6. Luxury tax
7. Taxes on lottery, betting and gambling

Key legislations:
The Constitution (One Hundred and Twenty Second Amendment) Bill,
2016, for introduction of Goods and Services Tax in the country was
passed by Rajya Sabha on 3 August 2016 and by Lok Sabha on 8 August
2016. Consequent upon this, the President of India accorded assent on 8
September 2016, and the same was notified as the Constitution (One
Hundred and First Amendment) Act, 2016. The following Acts were
passed for implementation of GST with effect from 1 July 2017: -
• The Central Goods and Service Tax Act, 2017;
• The Union Territory Goods and Service Tax Act, 2017.
• The Integrated Goods and Service Tax Act, 2017;
• The Goods and Service Tax (Compensation to States) Act, 2017

The above Acts were assented by the President of India on 12 April 2017
and enacted with effect from21 July 2017. In addition to the above, each
of the States have also passed the SGST Act.

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All the above Acts were further amended vide the CGST Amendment Act,
2018 and the GST (Compensation to States) Amendment Act, 2018, the
IGST (Amendment) Act, 2018 and the UTGST (Amendment) Act, 2018
notified on 29 August 2018 and made effective from 1 February 2019.

Goods and Service Tax Council:

In terms of Article 279A (1) of the Constitution of India, as amended, the
President of India constituted the GST Council with effect from 12
September 2016. The GST Council is a constitutional body for making
recommendations to the Union and the State Governments on the issues
related to GST. The GST Council, a joint forum of the Centre and the
States, is chaired by the Union Finance Minister and members are the
Union State Minister of Revenue or Finance and Ministers in-charge of
Finance or Taxation or any other Minister nominated by each of the
States. As per Article 279A (4), the Council will make recommendations
to the Union and the States on: -
a) The taxes, cesses and surcharges levied by the Union, the States and
the local bodies which may be subsumed in the GST;
b) The goods and services that may be subjected to, or exempted from
GST;
c) The model GST Laws, principles of levy, apportionment of GST
levied on inter-State trade supplies and the principles that govern the
place of supply (POS);
d) The threshold limit of turnover below which goods and services may
be exempted from GST;
e) The rates including floor rates with bands of GST;
f) Any special rate or rates for a specified period, to raise additional
resources during any natural calamity or disaster;
g) Special provision with respect to the States of Arunachal Pradesh,
Assam, Jammu and Kashmir, Manipur, Meghalaya, Mizoram,
Nagaland, Sikkim, Tripura, Himachal Pradesh and Uttarakhand; and
h) Any other matter relating to the GST, as the Council may decide.

While discharging the functions conferred by this article, the GST Council
shall be guided by the need for a harmonised structure of goods and
services and for the development of a harmonised national market for
goods and services.

Goods and Services Tax Network:

Goods and Services Tax Network (GSTN) was registered on 28 March
2013 under Section 8 of the Companies Act, 2013 as a Non-Government
Company and a ‗Not for Profit Organisation‘. It was formed to provide
common and shared Information Technology (IT) infrastructure and
services to the Central and State Governments, taxpayers and other
stakeholders for implementation of the GST. The Government of India
holds 24.5 per cent equity in GSTN and all the States of the Indian Union,
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including NCT of Delhi and Puducherry and the Council, together hold
another 24.5 per cent. The balance 51 per cent equity is with non-
Government financial institutions. It was decided (May 2018) to convert
GSTN into a fully owned Government Company. Further action on this
decision was yet to be taken by the Government.

8.7 SUMMARY

A federation is a form of government in which the sovereign or political

power is divided between the central and the state or local governments
such that each government, within its own sphere, is independent of the
other. India is a 'federal republic' and this provision is enshrined in the
country's Constitution. The financial powers and responsibilities of the
different government units have been clearly defined in the Indian
Constitution. But Indian federal system has long history In 1833, the
financial system was completely centralised by a Charter Act of British
Government which provided for the appointment of the Governor of
Bengal as the Governor-General of India and the Governors in different
states were made subordinate to him for financial matters. In 1873 The
provinces were given fixed grants by the central government to enable
them to cover their expenses. The movement towards the system of
financial decentralisation in the country was further consolidated under the
Montagu-Chelmsford Reforms which took practical shape in the form of
Government of India Act, 1919.According to the Act of 1935, there was a
complete separation of federal and provincial sources of revenue. The
Constitution of India made the same financial provisions as were provided
in the Government of India Act, 1935. As a Finance Commission could be
set up only after the Constitution came into force on 26 January 1950. In
India taxation powers divided in to parts Central government and state
government. Also, expenditure responsibility also divided in same parts
also there are some transfers of funds. over a period of time taxation
system also changed and developed.

8.8 QUESTIONS

1. Explain the need for financial regulations.

2. Explain the need for FRBM Act.
3. Explain the structure of financial federation in India.
4. Explain the difference between value added tax and goods and services
tax.
5. Discuss the need for decentralization and the Indian experience.

REFERENCES

 Jean Hindriks and Gareth D. Myles, (2013) INTERMEDIATE

PUBLIC ECONOMICS, second edition.
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 Dr. H L Ahuja, Advanced Economic theory, 19th Revised edition.
 Chand S.N.,(2008) Public finance.
 Atkinson A B and J E Stiglitz, lecture on public Economy, New York
cgraw Hill (1980)
 Chand S.N., Public finance, volume 2
 Government at a Glance (2013) OECD Library.
 David Cowen, Director IMF Capacity Development Office in Thailand
(CDOT) ADBI-UNESCAP Seminar on Fiscal Governance Sustainable
Growth and Development in the Asia and Pacific Region April 24 -
25, 2019 Bangkok.

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