UNIT 4

PUBLIC FINANCE

Syllabus:

 Public finance: Meaning, branches - Principle of Maximum social advantage

 Sources of public revenue - Canons of taxation- Direct and indirect taxes – impact and
incidence - Effects of taxation on production, consumption and expenditure
 Public expenditure – causes of growth of public expenditure, effects of public
expenditure on production, consumption and expenditure
 Public debt – sources of public borrowing, methods of debt redemption
 Budget - types

Public finance is the study of the role of the government in the economy. It is the branch
of economics which assesses the government revenue and government expenditure of the public
authorities and the adjustment of one or the other to achieve desirable effects and avoid
undesirable ones. The purview of public finance is considered to be threefold: governmental
effects on (1) efficient allocation of resources, (2) distribution of income, and
(3) macroeconomic stabilization.

In public finance we study the finances of the Government. Thus, public finance deals with the
question how the Government raises its resources to meet its ever-rising expenditure. As Dalton
puts it,” public finance is “concerned with the income and expenditure of public authorities and
with the adjustment of one to the other.”

Accordingly, effects of taxation, Government expenditure, public borrowing and deficit

financing on the economy constitutes the subject matter of public finance. Thus, Prof. Otto
Eckstein writes “Public Finance is the study of the effects of budgets on the economy,
particularly the effect on the achievement of the major economic objects—growth, stability,
equity and efficiency.”

Further, it also deals with fiscal policies which ought to be adopted to achieve certain objectives
such as price stability, economic growth, more equal distribution of income. Economic thinking
about the role that public finance is expected to play has changed from time to time according to
the changes in economic situation.

Before the Great Depression that gripped the Western industrialized countries during the thirties,
the role of public finance was considered to be raising sufficient resources for carrying out the
Government functions of civil administration and defence from foreign countries. During this
period, the classical economists considered it prudent to keep expenditure to the minimum so
that taxing of the people is avoided as far as possible.
Further, it was thought that Government budget must be balanced. Public borrowing was
recommended mainly for production purposes. During a war, of course, public borrowing was
considered legitimate but it was thought that the Government should repay or reduce the debt as
soon as possible.

The Concept of Functional Finance:

But under the impact of the Great Depression of thirties and the Keynesian explanation of it, the
thinking about and role of public finance underwent a sea change. The classical view of public
finance could not meet the requirements of the then prevailing situation.

In order to increase aggregate effective demand and thereby raise the level of income and
employment in the country, public finance was called upon to play an active role. During the
Second World War and after, the Western economies suffered from serious inflationary
pressures which were attributed to the excessive aggregate demand.

So, in such inflationary conditions, the public finance was expected to check prices through
reducing aggregate demand. Thus the budget which was previously meant to raise resources for
limited activities of the Government assumed a functional role to serve as an instrument of
economic regulation.

It came to be realized that government’s taxing and spending policies could go a long way in
mitigating economic fluctuations. Balanced budgets are no longer considered sacrosanct and the
governments can spend beyond their resources without offending canons of sound finance to
restore the health of the economy.

Public borrowing and consequent increase in public debt at the time of depression raises
aggregate demand and thereby helps in raising the level of income and employment. Therefore,
deficit budget and increase in public debt at such times is a thing to be welcomed.

It was further demonstrated by Keynes that deficit financing by the Government could activate a
depressed economy by creating income and employment much more than the original amount of
deficit financing through the process of multiplier.

Thus, after Keynesian revolution public finance assumed a functional role of maintaining
economic stability at full employment level. Therefore, the present view of public finance is not
one of mere resource-raising for the Government but one of serving as an instrument for
maintaining stability through management of demand. Therefore, this present view of public
finance has been described by A.P. Lerner as one of “Functional Finance”.

In developing countries, public finance has to fulfill another important role. Whereas in the
developed industrialized countries, the basic problem in the short run is to ensure stability at full
employment level and in the long run to ensure steady rate of economic growth, that is, growth
without fluctuations, the developing countries confront a more difficult problem of how to
generate a higher rate of economic growth so as to tackle the problems of poverty and
unemployment.

Therefore, public finance has to play a special role of promoting economic growth in the
developing countries besides maintaining price stability. Further, for developing countries mere
economic growth is not enough; the composition of growing output and distribution of additional
incomes ought to be such as will ensure removal of poverty and unemployment in the developing
countries.

Therefore, public finance has not only to augment resources for development and to achieve
optimum allocation of resources, but also to promote fair distribution of income and expansion in
employment opportunities. This is the functional view of public finance in the context of the
developing countries.

Public finance is broadly divided into four branches. These are Public Expenditure, Public
Revenue, Public Debt and Financial Administration.

Under Public Expenditure, we study the various principles, effects and problems of expenditure
made by the public authorities.

Under the branch of Public Revenue, we study the various ways of raising revenues by the public
bodies. We also study the principles and effects of taxation and how the burden of taxation is
distributed among the various classes in the society.

Public Debt is the study of the various principles and methods of raising debts and their
economic effects. It also deals with the methods of repayment and management of public debt.

The branch of Financial Administration deals with the methods of budget preparation, various
types of budgets, war finance, development finance, etc.

Principle of Maximum Social Advantage

The fiscal or budgetary operations of the state have manifold effects on the economy. The
revenue collected by the state through taxation and the dispersal of public expenditures can have
significant influence on the consumption, production and distribution of the national income of
the country.

The fiscal operations of the government resolve themselves into a series of transfers of
purchasing power from one section of the community to another, along with the variations in the
total incomes available in the community. In fact, the fiscal activities of the state affect the
allocation of resources, the use of resources from one channel to another, hence, the level of
income, output and employment.

Hence, it is desirable that some standard or criterion should be laid down to judge the
appropriateness of a particular operation of public finance — the government’s revenue and
expenditures. In a modern welfare state, such a criterion can obviously be nothing else but the
economic welfare of the people.

It follows, thus, that the particular financial activity of the state which leads to an increase in
economic welfare is considered as desirable. It may be considered as undesirable if such an
activity does not cause an increase in the welfare or even sometimes, it may be the cause of a
reduction in the general economic welfare. The guiding principle of state policy has been
technically desirable as the Principle of Maximum Social Advantage by Hugh Dalton.

According to Dalton, the principle of maximum social advantage is the most fundamental
principle lying at the root of public finance. Hence, the best system of public finance is that
which secures the maximum social advantage from its fiscal operations. Maximum social
advantage is the maxim for the states. The optimum financial activities of a state should,
therefore, be determined by the principle of maximum social advantage.

It is obvious that taxation by itself is a loss of utility to the people, while public expenditure by
itself is a gain of utility to the community. When the state imposes taxes, some disutility or
dissatisfaction is experienced in the society. This disutility is in the form of sacrifice involved in
the payment of taxes — in parting with the purchasing power.

Similarly, when the state spends money, some utility is created in the society. Some satisfaction
is experienced by a group of people in the society on whom, or for whom, the public expenditure
is incurred by the state. This is the social benefit of welfare of the public expenditure.

As such, the maximum social advantage is achieved when the state in its financial activities
maximise the surplus of social gain or utility (resulting from public expenditure) over the social
sacrifice or disutility (involved in payment of taxes.) The principle of public finance, thus,
requires the state to compare the sacrifice and benefits of the society in its fiscal operations.

The principle of maximum social advantage implies that public expenditure is subject to
diminishing marginal social benefits and taxes are subject to increasing marginal social costs.
Thus, an equilibrium is reached when social advantage is maximised, i.e., when the size of the
budget is such that marginal social benefits of public expenditures are equal to the marginal
social sacrifice of taxation.

Dalton states, “Public expenditure in every direction should be carried just so far, that the
advantages to the community of a further small increase in any direction is just counter-balanced
by the disadvantage of a corresponding small increase in taxation or in receipts from any other
sources of public expenditure and public income.”

Thus, a rational state seeks to maximise the net social advantage of its fiscal operations. The
social net advantage is maximum when the aggregate social benefits resulting from public
expenditure is maximum and the aggregate social sacrifice involved in raising the public revenue
is minimum. According to the principle of maximum social advantage, thus, the public
expenditure should be carried on up to the marginal social sacrifice of the last unit of rupee
taxed.

Diagrammatic Representation:

In technical jargon, the maximum social net advantage is achieved when the marginal social
sacrifice (disutility) of taxation and the marginal social benefit (utility) of public expenditure are
equated. Thus, the point of equality between the marginal social benefit and the marginal social
sacrifice is referred to as the point of aggregate maximum social advantage or least aggregate
social sacrifice.

The equilibrium point of maximum social advantage may as well be illustrated by means of a
diagram, as in Fig. 1.

In Fig. 1, MSS is the marginal social sacrifice curve. It is an upward sloping curve implying that
the social sacrifice per unit of taxation goes on increasing with every additional unit of money
raised. MSB is the marginal social benefit curve. It is a downward sloping curve implying that
the social benefits per unit diminishes as the public expenditure increases.

The curves MSS and MSB intersect at point P. This equality (P) of MSS and MSB curves is
regarded as the optimum limit of the state’s financial activity. It is easy to see that so long as the
MSB curve lies above the MSS curve, each additional unit of revenue raised and spent by the
state leads to an increase in the net social advantage.

This beneficial process would then be continued till marginal social sacrifice (MSS) becomes
just equal to the marginal social benefit (MSB). Beyond this point, a further increase in the
state’s financial activity means the marginal social sacrifice exceeding the marginal social
benefit, hence the net social loss.

Thus, only under the condition of MSS = MSB, the maximum social advantage is achieved.
Diagrammatically, the shaded area APB (the area between MSS and MSB curves, till both
intersect each other) represents the quantum of maximum social advantage. OQ is the optimum
amount of financial activities of the state.

Further, the ideal of maximum social advantage is attained by the state, if the following
principles of financial operation are followed in the budget.

1. Taxes should be distributed in such a way that the marginal utility of money sacrificed by all
the tax-payers is the same.

2. Public spending is done, such that benefits derived from the last unit of money spent on each
item becomes equal.

3. Marginal benefits and sacrifices must be equated.

To sum up, all fiscal operations, both as regards revenue and expenditure, should be treated as a
series of transfer of purchasing power that must ultimately increase the economic welfare of the
people. In this context, Dalton enunciated the principle of maximum social advantage and
asserted that financial operations of the government must be in accordance with this principle in
a welfare state.

SOURCES OF PUBLIC REVENUE

A government needs income for the performance of a variety of functions and to meet its
expenditures. The income of the government through all sources like taxes, borrowings, fines,
fees, grants etc. is called public revenue or public income. Public revenue can be classified into
two types: tax revenue and non-tax revenue.

1. Tax revenue.

Taxation is the major source of public revenue. In all countries, the largest part of the public
revenue is raised through taxes. Taxes may be imposed on income or wealth. These taxes may be
direct or indirect.
Taxes of the Central Government

a. Income tax.

This is most important type of direct tax and almost everyone is familiar with it. TDS is its
famous synonym and whosoever is earning above a minimum amount (tax exemption limit) has
to pay income tax.

b. Corporate Tax.

Companies operating in India are taxed as per the corporate tax rate on their income. This tax is
one of the major sources of revenue for government.

c. Wealth Tax.

This is in addition to the income tax and is levied if your net wealth exceeds Rs.30 Lakh at the
rate of 1% on the amount exceeding Rs.30 Lakh.

d. Property Tax/Capital Gains Tax.

This is levied on the capital gains arrived by selling property and stocks. Tax rates are different
for long term and short term capital gains.

e. Gift Tax/ Inheritance or Estate Tax.

Amount exceeding Rs.50000 received without consideration by an individual/Hindu Joint

Family from any person is subjected to gift tax as income under "other sources". There are
exemptions like money received from relatives is not taxable. Marriage gifts and money received
through inheritance are also exempt from gift tax. Inheritance tax was earlier in practice but has
been repealed by the government.

f. Security Transaction Tax (STT).

STT is levied on transactions (sale/purchase) done through the stock exchanges. STT is
applicable on purchase or sale of various financial products like stocks, derivatives, mutual funds
etc.
 g. Custom Duty.

Custom duties are indirect taxes which are levied on goods imported to/exported from India.
There are different rules for different types of goods and sectors. Government keeps on changing
these rates so as to promote import/export of specific goods.

h. Excise Duty.

Excise duties are indirect taxes which are levied on goods manufactured in India for domestic
consumption. Like custom duty, there are a number of rules which keep on changing as per
government discretion.

i. Service Tax.

Service providers in India are subject to service tax, which is charged on the aggregate amount
received by the service provider. Services like leasing, internet/voice, transport, etc. are subject
to service tax.

j. GST

Taxes of the State Governments

There are various taxes that an Indian citizen needs to pay to its government. Some taxes that one
needs to pay to its state government are-

Taxes levied by the State Governments are:

a. Land Revenue. It is the oldest tax in almost all the countries of the world.

b. Agricultural Income tax. Tax on income from agriculture comes under the State list.

c. State Excise Duties. State Governments are empowered to levy excise duties on
goods like alcoholic liquors, opium, hemp, etc.

d. Sales Tax/VAT- Taxes on the sale and purchase of goods except newspapers is
levied and collected by the state governments. Sales tax is levied on the sale of
movable goods. Most of the Indian States have replaced Sales tax with a new Value
 Added Tax (VAT) with effect from April 01, 2005. VAT is imposed on goods only
and not services. No VAT is charged on essential commodities, on bullion and
precious stones 1%, on industrial inputs and capital goods and items of mass
consumption 4% and all the other items VAT is levied at 12.5%. VAT rates vary in
different States on Petroleum products, tobacco, liquor etc. A Central Sales Tax at the
rate of 4% is also levied on inter-State sales

e. Stamp duty. Stamp duty for legal documents, registration etc. except for financial
documents are collected by levied and collected by the State governments.

f. Taxes on land and Buildings.

g. Succession and estate duty on agricultural land.

h. Taxes on entry of goods into a local area.

i. Taxes on consumption and sale of electricity.

j. Taxes on vehicles animals, boats.

k. Luxury tax- The Govt. tapped the source of revenue from Hospitality Industry with
the introduction of Luxury Tax w.e.f from November 01, 1996 on the luxuries
provided in various hotels, lodging houses, clubs etc. The Govt. notifies different
rate(s) from time to time and for the different classes of hotels. The present rate of
Luxury Tax is 12.5% and is levied according to the declared tariff w.e.f 2004.

l. Entertainment Tax- Entertainment tax is the tax paid by the entertainment industry
in India. The tax is applicable for entertainment shows, sponsored private festivals,
movie tickets, video game arcades, and amusement parks.

m. Professional Tax- Professional Tax is levied on profession, trade calling and

employment by the Municipal Council of a state. Every company which transacts
business and any person, who is engaged directly or indirectly in any profession,
trade, calling or employment with in the Town Panchayat on the first day of the half-
year for which return is filed, shall pay half-yearly tax at the rates specified according
to the varied tax slabs in different states of India.

n. Road Tax. In India, road tax is a combination of several taxes imposed by the central
and state governments on motor vehicles and road usage. Since the system of taxation
for road transportation is complicated, only taxes directly related to purchasing and
maintaining a motor vehicle will be discussed in this section. The following taxes will
be levied on the purchase of a new vehicle:

Cen VAT (central value added tax) – 10 percent

VAT (value added tax) – the tax rate in the state of purchase

Import duty – 10 percent or 61 percent (for imported cars, motorcycles or imported parts)

Excise duty – 4 percent (for cars and motorcycles manufactured in India)

CST (central sales tax) – 2 percent (a one-off tax on vehicles purchased outside the buyer’s state
of residence)

The state government will impose the following taxes on vehicles in use:

Motor vehicles tax – one-off, lifetime or annual tax (depending on the state) that is calculated
using factors such as engine capacity, cost price, seating capacity, horsepower and/or weight

Passengers and goods tax – tax on the transportation of goods and/or passengers by road

State entry tax – tax on vehicles purchased in one state but transported into another

Tolls

2. Non- Tax Revenue.

The revenue obtained by the government from sources other than taxes is called non-tax revenue.
The sources of non-tax revenue are:

a) Fees.

Fees are another important source of public revenue. A fee is charged by the public authorities
for rendering a service to the citizens. Unlike tax, there is no compulsion involved in the case of
fees. The government provides certain services and charges fees for them. For example, fees are
charged for issuing passports, driving licenses etc.

b) Fines and Penalties.

Fines and penalties are the charges imposed on persons as a punishment for infringements of a
certain law. Their payments are compulsory like taxes.

c) Commercial Revenue.

Another important source of public revenue is price or commercial revenue. It is obtained by the
government by selling some goods and services of public enterprises. The business of the
government for which it receives prices may either be selling goods or rendering services like
train, city bus. Electricity, transport post and telegraphs etc.

d) Surplus from Public Enterprises.

The government also gets revenue by the way of surplus from public enterprises. In India, the
government has set up several public enterprises to render various goods and services to the
public and many of them are making good profits. The profits or dividends which the
government gets can be utilised for meeting the public expenditure.

e) Grants and Gifts.

Gifts are voluntary contributions by individuals or institutions to the Government.

Grant from one government to another is an important source of public revenue in modern days.
The government at the Centre provides grants to the States and State governments provide grants
to the local governments to meet its public expenditure.

Grants from foreign countries are called foreign aid. Developing countries receive foreign aid in
the form of military aid, technological aid etc. from developed countries.

f) Borrowings.

Governments may borrow from the public in the form of deposits, bonds etc. it also includes
loans from the foreign agencies and institutions like IMF and the World Bank.

g) Deficit financing.

Deficit financing in the form of printing new currency is another source of public revenue. But
this may lead to inflation in the long run.

Canons of Taxation:

Canons of taxation refer to the administrative aspects of a tax. They relate to the rate, amount,
method of levy and collection of a tax.

In other words, the characteristics or qualities which a good tax should possess are described as
canons of taxation. It must be noted that canons refer to the qualities of an isolated tax and not to
the tax system as a whole. A good tax system should have a proper combination of all kinds of
taxes having different canons.

According to Adam Smith, there are four canons or maxims of taxation on the administrative
side of public finance which are still recognized as classic.

To him a good tax is one which contains:

1. Canon of equality or equity.

2. Canon of certainty.
3. Canon of economy.

4. Canon of convenience.

To these four canons, economists like Bastable have added a few more which are as under:

5. Canon of elasticity.

6. Canon of productivity.

7. Canon of simplicity.

8. Canon of diversity.

9. Canon of expediency

We shall briefly describe them as follows:

Canon of Equality:

Every fiscal economist, along with Adam Smith, stresses that taxation must ensure justice. The
canon of equality or equity implies that the burden of taxation must be distributed equally or
equitably in relation to the ability of the tax payers.

Equity or social justice demands that the rich people should bear a heavier burden of tax and the
poor a lesser burden. Hence, a tax system should contain progressive tax rates based on the tax-
payer’s ability to pay and sacrifice.

Canon of Certainty:

Taxation must have an element of certainty. 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 amount to be paid ought to be clear and plain to the contributor and to every
other person.”

The certainty aspects of taxation are:

1. Certainty of effective incidence i.e., who shall bear the tax burden.

2. Certainty of liability as to how much shall be the tax amount payable in a particular period.
This the tax payers as well as the exchequer should unambiguously know.

3. Certainty of revenue i.e., the government should be certain about the estimated collection of
revenue from a given tax levied.

Canon of Economy:
This principle suggests that the cost of collecting a tax should not be exorbitant but be the
minimum. Extravagant tax collection machinery is not justified. According to Adam Smith,
“Every tax has to be contrived as both to take and keep out of the pockets of the people as little
as possible over and above what it brings into the public treasury of the state.”

Owing to the complex and ever-changing nature of taxation laws in India, government has to
maintain elaborate tax collection machinery with a large staff of highly trained personnel
involving high administrative costs and inordinate delay in assessment and collection of tax.

Canon of Convenience:

According to this canon, tax should be collected in a convenient manner from the tax payers.
Adam Smith stresses: “Every tax ought to be levied at the time or in the manner in which it is
most likely to be convenient for the contributor to pay it.” For example, it is convenient to pay a
tax when it is deducted at source from the salaried classes at the time of paying salaries.

Canon of Elasticity:

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

Canon of Productivity:

This implies that a tax must yield sufficient revenue and not adversely affect production in the
economy.

Canon of Simplicity:

This norm suggests that tax rates and tax systems ought to be simple and comprehensible and not
to be complex and beyond the understanding of the layman. This is what is rarely found in the
Indian tax structure.

Canon of Diversity:

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

Canon of Expediency:

This suggests that a tax should be determined on the ground of its economic, social and political
expediency. For instance, a tax on agricultural income lacks social, political or administrative
expediency in India and that is why the government of India had to discontinue it.

2. Equity in Taxation:
Equity in taxation refers to fairness or justice in the distribution of the tax burden. Since taxation
implies a burden or sacrifice on the part of the tax payer, modern economists put great emphasis
on justice in taxation and state that taxation should be based on the principle of equity so that
direct money burden as well as real burden should be distributed in a just manner.

The concept of equity has two notions:

(i) Horizontal equity and

(ii) Vertical equity.

Horizontal equity suggests that in the matter of taxation, equal treatment should be meted out to
people in equal economic circumstances, which means that they should pay equal amount of
taxes. Vertical equity means that unequally placed persons should be treated unequally, thus,
economically better placed people should pay more taxes than others.

However, any attempt to achieve vertical and horizontal equity simultaneously is not at all an
easy task and can lead to ludicrous results.

Important Characteristics of a Good Tax System

To judge the merits of a tax system, it must be looked at as a whole. For, a tax system to be a
good one just cannot have all good taxes but none bad at all. The state cannot raise sufficient
revenue and, at the same time, please the tax payers.

As a noted philosopher Edmund Burke once remarked, “It is difficult to tax and to please as it is
to love and to be wise.” In a tax system, therefore, different taxes, good and bad may be
combined together which tend to correct and balance one another’s effects.

Hence, it should be noted that a good tax system does not mean a perfect tax system which
contains only the good taxes based upon the canons of taxation, fetching adequate revenues and
causing no hurt to the tax payer.

A good tax system is one which has predominantly good taxes and which fulfills most of the
canons of taxation: it must yield sufficient revenue, but cause minimum aggregate sacrifice to the
people and minimum obstruction to incentives for production.

A good tax system should possess the following characteristics:

1. It should ensure maximum social advantage. Taxation should be used to finance public
services.

2. It should cause minimum aggregate sacrifice. In a good tax system, the allocation of taxes
among tax payers is made according to the ability to pay. It falls more heavily on the rich and
less on the poor. It should be reasonably progressive so as to minimize the gap of inequality of
income and wealth in the community, thereby ensuring their better distribution.

3. In a good tax system, taxes are universally applicable in the sense that persons with same
ability to pay are treated in the same way without any discrimination whatsoever. In the Indian
tax system, however, this attribute is lacking to some extent. For instance, income tax is not
universal in India, as no income tax is levied on agricultural incomes.

4. It should contain a predominance of good taxes satisfying most of the canons of taxation. That
is to say, the taxes imposed should be more or less equitable, convenient to pay, economical,
certain, productive, flexible and simple as far as possible.

5. The entire structure of the tax system should have built-in flexibility, so that changes are
possible according to the changing conditions of a dynamic economy. It should be possible to
add or withdraw a tax without destroying the entire system and its balancing effect. A rigid tax
structure is very unsatisfactory. Taxation must cope with the changing needs of the modern
government. The capacity to adjust itself to the dynamic conditions of an economy is a virtue of
a good tax system.

6. A good tax system should be a balanced one.

It means there must exist not one kind of taxes but all types in the right proportion. In other
words, it should not contain just progressive, regressive or proportional taxes only, but a healthy
combination of all such taxes. Similarly, it should have a balance of direct and indirect taxes.

7. The tax system should be multiple, but then took a great multiplicity is not desirable. Dalton,
however, suggests that a good tax system has to be also a reasonably efficient administrative
system.

8. Further, in a good tax system there is simplicity, implying the absence of any unnecessary and
avoidable complexities.

9. A good tax system should not hamper the development of trade and industry, but instead help
the rapid economic development of the country. Taxation is designed to mobilize the surplus
resources in the economy and not deprive the private sector of its resources.

Above all, the most fundamental characteristic of a good tax system is the appreciation of the
rights and problems of the tax payer. A good tax system must contain the majority of such taxes
which produce good effects on production and equitable distribution of national income and
wealth. To achieve the socialistic goals of public policy a good tax system plays a very important
role.
It should effectively balance the weight and burden of taxation. The weight refers to absolute
sacrifice, in terms of purchasing power of real income surrendered by the tax-payer. The burden
implies the relative capacity of the tax-payer to bear the tax.

The tax system of one country differs from that of another, depending on the institutional and
historical differences. Nevertheless, as a guiding policy, a good tax system in any country with
any background must seek the maxim of least aggregate sacrifice in its taxation policy.

In a less developed country, the tax system should be designed for the mobilization of economic
surpluses for economic development. Taxes should be such that they help in raising the
incremental savings ratio. Taxes should work as a measure to prevent the flow of funds into
undesired channels of production.

In the developing country, taxes have to serve as a means of curbing consumption and tapping
the resources for development. The tax policy in an underdeveloped country should aim at
stepping up capital formation and mobilizing economic surpluses through the diversion of
resources from private consumption to public investment.

Though a tax system may basically be designed to reduce inequalities of income and wealth,
especially in a poor country, it should not conflict with the object of augmenting production and
providing incentives to work hard and save more.

Thus, the test of a good tax system is its ability to inspire that confidence in the fiscal basis of the
government which sustains public morale and promotes productive efforts, individual zeal and
economic progress.

DIRECT AND INDIRECT TAX

Economists usually classify taxes into (i) direct taxes and (ii) indirect taxes. According to Dalton,
a direct tax is really a tax which is paid by a person on whom it is legally imposed and the
burden of which cannot be shifted to any other person is called a direct tax. J.S. Mill defines
direct tax as “one which is demanded from the very persons who, it is intended or desired, should
pay it.”

The person from whom it is collected cannot shift its burden to anybody else. Thus, the impact, i.
e., the initial or first burden, and the incidence, the ultimate burden of a direct tax — is on the
same person. The tax payer is the tax bearer. For example, income tax is a direct tax.

An indirect tax, on the other hand, is a tax the burden of which can be shifted to others. Thus, the
impact and incidence of indirect taxes are on different persons. An indirect tax is levied on and
collected from a person who manages to pass it on to some other person or persons on whom the
real burden of the tax falls.
Hence, in the case of indirect taxes, the tax payer is not the tax bearer. Commodity taxes are
generally indirect taxes as they are imposed on the producers or sellers, but their incidence falls
upon the consumers as such taxes are wrapped up in the prices.

The gist of distribution thus lies in its shifting. A tax which cannot be shifted is direct; and one
which can be shifted is indirect. Though the conventional distinction between direct and indirect
taxes is logical enough, it is very difficult to apply it in practice. It presupposes a fairly good
knowledge of the particular behaviour of the people regarding tax payments.

Unless we know whether a tax is shifted from the immediate tax payer to someone else, we
cannot categorize it as direct or indirect. Further, difficulties arise when a tax is partially shifted
and partially borne by the person on whom it is imposed.

Does it mean that half the tax is direct, and half indirect? Certainly not. To this difficulty, as
raised by Prof. Prest, we may answer that the possibility of shifting in any degree should be
regarded as the criterion of deciding an indirect tax. And lack of any shifting is to imply a direct
tax.

In the group of direct taxes, thus, income tax, wealth tax, property tax, estate duties, capital gains
tax, capital levy may be included, while commodity taxes or sales tax, excise duties, customs
duties etc. may be grouped as indirect taxes.

Direct taxes have the following advantages in their favour:

(i) Equitable:

The burden of direct taxes cannot be shifted. Hence equality of sacrifice can be attained through
progression. Of course, the very low incomes can be exempted. This cannot be achieved- by
taxes on commodities which fall with equal force on the rich and the poor. The tax raises the
price of the commodity, and the price of a commodity is the same for every person, rich or poor.

(ii) Economical:

The cost of collection of direct taxes is low. They are mostly collected “at the source”. For
instance,-the income tax is deducted from an officer’s pay every month. This saves expense. The
employer acts as an honorary tax collector. This means great economy.

(iii) Certain:

In the case of a direct tax, the payers know how much is due from them and when. The
authorities also know the amount of revenue they can expect. There is certainty on both sides.
This minimises corruption on the part of collecting officials.

(iv) Elastic:
If the State suddenly stands in need of more funds in an emergency, direct taxes can well serve
the purpose. The yield from income tax or death duties can be easily increased by raising their
rate. People cannot stop dying for fear of paying death duties.

(v) Productive:

Another virtue of direct taxes is that they are very productive. As a community grows in numbers
and prosperity, the return from direct taxes expands automatically. The direct taxes yield a large
revenue to the State.

(vi) A means of developing civic sense.

In the case of a direct tax, a person knows that he is paying a tax, he feels conscious of his rights.
He claims the right to know how the Government uses his money and approves or criticizes it.
Civic sense is thus developed. He behaves as a responsible citizen.

Disadvantages of Direct Taxes:

(i) Inconvenient:

The great disadvantage of a direct tax is that it pinches the payer. He ‘squeaks’ when a lump sum
is taken out of his pocket. The direct- taxes are thus very inconvenient to pay. Nobody can help
feeling the pinch.

(ii) Evadable:

The assessee can submit a false return of income and thus evade the tax. That is why a direct-tax
is “a tax on honesty.” There is a lot of evasion. Many of those who should be paying taxes go
scot-free by concealing their incomes.

(iii) Arbitrary:

If taxes are progressive, the late of progression has to be fixed arbitrarily; and if proportional,
they fall more heavily on the poor. Thus, both are bad. The rate of taxes depends upon the whim
of the Finance Minister. This is arbitrary.

(iv) Disincentive:

If the taxes are too heavy, they discourage saving-sand investment. In that case the country will
suffer economically. A high level of taxation discourages investment and enterprise in the
country. It inflicts a lot of damage, on business and industry.

Advantages of Indirect Taxes:

(i) The Poor Can Contribute:

They are the only means of reaching the poor. It is a sound principle that every, individual
should pay something, however little, to the State. The poor are always exempted from paying
direct taxes. They can be reached only through indirect taxation.

(ii) Convenient:

They are convenient to both the tax-prayer and the State. I he tax-payers do not feel the burden
much partly because an indirect tax is paid in small amounts and partly because it is paid only
when making purchases. But the convenience is even greater due to the fact that the tax is “price-
coated”.

It is wrapped in price. It is like a sugar-coated quinine pill. Thus, a tobacco tax is not felt when it
is included in the price of every cigarette bought. It is convenient to the State as well which can
collect the tax at the ports or at the factory.

(iii) Broad-based:

Indirect taxes can be spread over a wide range. Very heavy direct taxation at just one point may
produce harmful effects on social and economic life. As indirect taxes can be spread widely, they
are more beneficial and suitable.

(iv) Easy Collection:

Collection takes place automatically when goods are bought and sold. A dealer collects the tax
when he charges a price. He is an honorary tax collector.

(v) Non-evadable:

They cannot be evaded, as they are a part of the price. They can be evaded only when the taxed
article is not consumed, and ‘his may not always be possible’

(v) Elastic:

They are very elastic in yield, imposed on necessaries of life which have an inelastic demand.
Indirect taxes on necessaries yield a large revenue, because people must buy these things.

(vi) Equitable:

When imposed on luxury or goods consumed by the rich, they are equitable. In such cases, only
the .Veil-to-do will pay the tax.

(vii) Check Harmful Consumption: .

By being imposed on harmful products, they can check consumption of harmful commodities.
That is why tobacco, wine and other intoxicants are taxed.
Disadvantages:

Indirect taxes have some disadvantages too, which are as follows:

(i) Regressive:

Indirect taxes are not equitable. For instance, salt tax in India fell more heavily on the poor than
on the rich, as it had to be paid at the same rate by all. Whether a rich man buys a commodity or
a poor man, the price in the market is the same for all. The tax is wrapped in the price. Hence,
rich and poor pay the same amount, which is obviously unfair. They are thus; regressive.

(ii) Uncertain:

Unless indirect taxes are imposed on necessaries, we cannot be sure of the revenue yield. In the
case of goods, with an elastic demand, the tax might not bring in much revenue. The tax will
raise the price and contract the demand. When the thing is not purchased, the question of the tax
payment does not arise.

(iii) Raising Prices Unduly:

They cause the price of an article to rise b; more than the tax. A fraction of the money unit
cannot be calculated, so ever middleman tends to charge more than the tax. This process is
cumulative.

(iv) Uneconomical:

The cost of collection is quite heavy. Every source o production has to be guarded. Large
administrative staff is required to administer such taxes. This turns out to be a costly affair.

(v) No Civic Consciousness:

These taxes do not develop civic consciousness, because many times the tax-payer does not even
know that he is paying tax. The tax is concealed in the price.

(vi) Harmful to Industries:

They discourage industries if raw materials are taxed. This will raise the cost of production and
impair their competitive capacity.

Impact and Incidence

The term impact is used to express the immediate result of or original imposition of the tax. The
impact of a tax is on the person on whom it is imposed first. Thus, the person who is liabile to
pay the tax to the government bears its impact. The impact of a tax, as such, denotes the act of
impinging.
The term incidence refers to the location of the ultimate or the direct money burden of the tax as
such. It signifies the settlement of the tax burden on the ultimate tax payer.

Incidence emerges when the tax finally settles or comes to rest on the person who bears it. It, in
fact, is the ultimate result of shifting. Hence, the incidence of a tax is upon that person who
cannot shift the burden any further, so he has to himself bear the direct money burden of the tax.

It is, thus, easy to distinguish between the impact and incidence of taxation:

1. Impact refers to the initial burden of the tax, while incidence refers to the ultimate burden of
the tax.

2. Impact is at the point of imposition, incidence occurs at the point of settlement.

3. The impact of a tax falls upon the person fr6m whom the tax is collected and the incidence
rests on the person who pays it eventually. For example, suppose a tax — excise duty — is
imposed on soap.

Its impact is on the producers, in the first instance, as they are liable to pay it to the government.
But, the producers may succeed in collecting it from the consumers by raising the price of soap
by the amount of tax. In that case, consumers eventually pay the tax and so the incidence falls
upon them.

4. Impact may be shifted but incidence cannot. For, incidence is the end of the shifting process.
Sometimes, however, when no shifting is possible, as in the case of income tax or such other
direct taxes, the impact coincides with incidence on the same person.

Effects of Taxes:

The most important objective of taxation is to raise required revenues to meet expenditures.
Apart from raising revenue, taxes are considered as instruments of control and regulation with
the aim of influencing the pattern of consumption, production and distribution. Taxes thus affect
an economy in various ways, although the effects of taxes may not necessarily be good. There
are same bad effects of taxes too.

Economic effects of taxation can be studied under the following headings:

1. Effects of Taxation on Production:

Taxation can influence production and growth. Such effects on production are analysed
under three heads:
(i) effects on the ability to work, save and invest

(ii) effects on the will to work, save and invest

(iii) effects on the allocation of resources.

2. Effects on the Ability to Work & Save:

Imposition of taxes results in the reduction of disposable income of the taxpayers. This will
reduce their expenditure on necessaries which are required to be consumed for the sake of
improving efficiency. As efficiency suffers ability to work declines. This ultimately adversely
affects savings and investment. However, this happens in the case of poor persons.

Taxation on rich persons has the least effect on the efficiency and ability to work. Not all taxes,
however, have adverse effects on the ability to work. There are some harmful goods, such as
cigarettes, whose consumption has to be reduced to increase ability to work. That is why high
rate of taxes are often imposed on such harmful goods to curb their consumption.

But all taxes adversely affect ability to save. Since rich people save more than the poor,
progressive rate of taxation reduces savings potentiality. This means low level of investment.
Lower rate of investment has a dampening effect on economic growth of a country.

Thus, on the whole, taxes have the disincentive effect on the ability to work, save and invest.

3. Effects on the will to Work, Save and Invest:

The effects of taxation on the willingness to work, save and invest are partly the result of money
burden of tax and partly the result of psychological burden of tax.

Taxes which are temporarily imposed to meet any emergency (e.g., Kargil Tax imposed for a
year or so) or taxes imposed on windfall gain (e.g., lottery income) do not produce adverse
effects on the desire to work, save and invest. But if taxes are expected to continue in future, it
will reduce the willingness to work and save of the taxpayers.

Taxpayers have a feeling that every tax is a burden. This psychological state of mind of the
taxpayers has a disincentive effect on the willingness to work. They feel that it is not worth
taking extra responsibility or putting in more hours because so much of their extra income would
be taken away by the government in the form of taxes.

However, if taxpayers are desirous of maintaining their existing standard of living in the midst of
payment of large taxes, they might put in extra efforts to make up for the income lost in tax.

It is suggested that effects of taxes upon the willingness to work, save and invest depends on the
income elasticity of demand. Income elasticity of demand varies from individual to individual.
If the income demand of an individual taxpayer is inelastic, a cut in income consequent upon the
imposition of taxes will induce him to work more and to save more so that the lost income is at
least partially recovered. On the other hand, the desire to work and save of those people whose
demand for income is elastic will be affected adversely.

Thus, we have conflicting views on the incentives to work. It would seem logical that there must
be a disincentive effect of taxes at some point but it is not clear at what level of taxation that
crucial point would be reached.

4. Effects on the Allocation of Resources:

By diverting resources to the desired directions, taxation can influence the volume or the size of
production as well as the pattern of production in the economy. It may, in the ultimate analysis,
produce some beneficial effects on production. High taxation on harmful drugs and commodities
will reduce their consumption.

This will discourage production of these commodities and the scarce resources will now be
diverted from their production to the other products which are useful for economic growth.
Similarly, tax concessions on some products are given in a locality which is considered as
backward. Thus, taxation may promote regional balanced development by allocating resources in
the backward regions.

However, not necessarily such beneficial effect will always be reaped. There are some taxes
which may produce some unfavourable effects on production. Taxes imposed on certain useful
products may divert resources from one region to another. Such unhealthy diversion may cause
reduction of consumption and production of these products.

5. Effects of Taxation on Income Distribution:

Taxation has both favourable and unfavourable effects on the distribution of income and wealth.
Whether taxes reduce or increase income inequality depends on the nature of taxes. A steeply
progressive taxation system tends to reduce income inequality since the burden of such taxes
falls heavily on the richer persons.

But a regressive tax system increases the inequality of income. Further, taxes imposed heavily on
luxuries and nonessential goods tend to have a favourable impact on income distribution. But
taxes imposed on necessary articles may have regressive effect on income distribution.

However, we often find some conflicting role of taxes on output and distribution. A progressive
system of taxation has favourable effect on income distribution but it has disincentive effects on
output.
A high dose of income tax will reduce inequalities but such will produce some unfavourable
effects on the ability to work, save, investment and, finally, output. Both the goals—the equitable
income distribution and larger output—cannot be attained simultaneously.

6. Other Effects of Taxation:

If taxes produce favourable effects on the ability and the desire to work, save and invest, there
will be a favourable effect on the employment situation of a country. Further, if resources
collected via taxes are utilized for development projects, it will increase employment in the
economy. If taxes affect the volume of savings and investment badly then recession and
unemployment problem will be aggravated.

Again, effect of taxes on the price level may be favourable and unfavourable. Sometimes, taxes
are imposed to curb inflation. Again, as an imposition of commodity taxes lead to rising costs of
production, taxes aggravate the problem of inflation.

Thus, taxation creates both favourable and unfavourable effects on various parameters.
Unfavourable effects of taxes can be wiped out by the judicious use of progressive taxation.

ITEMS OF PUBLIC EXPENDITURE

Public expenditure is a sine-qua-non to the welfare states. Public expenditure regulates the
economic activities and helps to attain the long-run and short-run objectives of economic
development. This is the reason for the continuously rising public expenditure and revenue of
our government.

Broadly, public expenditure can be classified into two:

1. Expenditure on Revenue account.

2. Expenditure on Capital account.

A. Expenditure of Revenue Account of Central Government.

Generally, major heads of revenue expenditure are being shown in the budget of the Central
government as defence services, civil services, grants-in-aid, interest payments, tax collection
and economic services. Revenue expenditures are met out of the revenue receipts of the
government like tax revenues and other revenues. This revenue expenditure is incurred for the
normal running of government departments and services, interests on debt etc. Such expenditures
does not result in the creation of assets. A brief description of revenue expenditure has been
detailed below:
 a. Defence Expenditure. Defence expenditure is the most important item in the case of
every government. It is constantly increasing as the modern warfare instruments are
becoming costlier and sophisticated. Popularly there are three major defence services:
Army, Navy and Air Force. The charge on revenue account is as a result of maintenance
of these forces on salaries, dearness and other allowances, pensions and retirement
benefits provided to defence personnel.

b. Civil Services. It includes expenditure on Parliament administration, justice, election and

on the Office of Comptroller and Auditor General. Besides, other types of expenditures
are on Secretariat and attached offices of Ministries of Education and Social Welfare,
Health and family Welfare, Information and Broadcasting, Labour and Employment and
Department of atomic Energy, Science and Technology etc.

c. Grants-in-Aid to States. State governments cannot work properly without the help of
Central governments as their expenses are continuously increasing because of increase in
salaries and allowances of government employees and functional relations with other
states.

d. Interest Payments. This includes expenditure on the payment of interest on the

outstanding debt. In the recent years, these payments have shown a rising trend on
account of the expenditure incurred on the implementation of various plans.

e. Collection of Taxes. Taxes are the most important source of revenue for any
government. The cost of collection of these taxes is also showing a rising trend.

f. Economic Services. It includes the expenditure on Department of Commerce, Shipping

and Transport, Irrigation, Energy, chemicals and Fertilisers, Company Affairs and
Electronics, Industry, Agriculture etc.

B. Expenditure on Capital account.

Capital account expenditure consists of all those expenditures used for the acquisition of assets
like land, buildings, machinery, investments shares etc. The expenditure on capital account is
financed out of the capital receipts like market loans and borrowings by the government from
domestic and foreign sources.

Capital account expenditure as provided in the budget of the government of India is illustrated
below:

a. General services. This head refers the expenditure on currency, coinage and mint. It also
includes expenditures on fiscal services like India’s contribution to IMF and other
international financial institutions. Furthermore, it consists capital expenditures on public
works and expenditures on non-residential buildings.
 b. Defence Services. This head consists of Central Government expenditure on capital in
Army, Navy and Air Force. It includes capital expenditure on the construction of non-
residential buildings, ordinance factories, machine tools and other equipments.

c. Social Services. Social services are useful to raise the efficiency and productivity of
human resources. Therefore they include the expenditure on education, health, art,
culture, family planning, sanitation, water supply, housing, urban development, social
security etc.

d. Economic Services. Capital expenditure on economic services are of the kind of foreign
trade and other allied services like irrigation, animal husbandry, dairy, fishery
development, industrial development, atomic energy, mining, water and power
development, transport and communication etc.

e. Loans and Advances to States and union Territories. Generally, State and Union
Territories face acute shortages of und to meet the requirement of development activities
in the region. Therefore, Central Government provides them loans and assistance to
undertake such developmental activities.

C. Developmental and Non-developmental Expenditures

Public Expenditure which comes under revenue and capital account is developmental and non-
developmental in nature. Therefore they may be classified as:

a. Developmental expenditure on Revenue account.

b. Developmental expenditure on Capital Account.

c. Non-developmental expenditure on Revenue Account.

d. Non-developmental expenditure on Capital account.

a. Developmental expenditure on Revenue Account.

It refers to expenditure under heads like education, art, culture, medical, family welfare, public
health, employment, etc. It also includes expenditure on economic services such as agriculture
and allied services, industries, minerals, foreign trade, water and power development, transport
and communication etc.

b. Developmental Expenditure on Capital Account.

The main items under developmental expenditures on capital account are social community
services, economic services, loans to states and union territories for developmental projects and
public enterprises.

c. Non-developmental Expenditures on Revenue Account.

It includes expenditures on audit, collection of taxes and duties, salaries of defence forces etc.
Besides, payments on administrative services like police, external affairs, pensions, other
retirement benefits, grants to states and union territories are also included in non-developmental
expenditure on revenue account.

d. Non-developmental Expenditure on Capital Account.

It consists of expenditure on state trading schemes, currency, mint, security and printing press
etc.

Increase in Public Expenditure:

There has been a persistent and continuous increase in public expenditure in counties all over the
world. It is due to the continuous expansion in the activities of the state and other public bodies
on several fronts. The modern governments not only perform such primary functions as the civil
administration as well as defence of the country, but also take considerable interest in promoting
economic development of their countries.

Today, the state is taking active part in social and economic matters, such as education, public
health, removal of poverty and in commercial and industrial development. The public
expenditure has increased enormously in recent years mostly due to the development activities of
the state. Hence, the increase in public expenditure is fully justified.

Factors or Causes of Increase in Public Expenditure

One of the most important features of the present century is the phenomenal growth of public
expenditure. Some of the important reasons for the growth of public expenditure are the
following:

1. Welfare State: Modern states are no more police states. They have to look in to the welfare of
the masses for which the state has to perform a number of functions. They have to create and
undertake employment opportunities, social security measures and other welfare activities. All
these require enormous expenditure.

2. Defence Expenditure: Modern warfare is very expensive. Wars and possibilities of wars have
forced the nation to be always equipped with arms. This causes great amount of public
expenditure.
3. Growth of Democracy: The form of democratic government is highly expensive. The
conduct of elections, maintenance of democratic institutions like legislatures etc. cause great
expenditure.

4. Growth of Population: tremendous growth of population necessitates enormous spending on

the part of the modern governments. For meeting the needs of the growing population more
educational institutions, food materials, hospitals, roads and other amenities of life are to be
provided.

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

6. Expansion Public Sector: Counties aiming at socialistic pattern of society have to give more
importance to public sector. Consequent development of public sector enhances public
expenditure.

7. Development Expenditure: for implementing developmental programs like Five Year Plans,
Modern governments are incurring huge expenditure.

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

9. Grants and Loans to State Governments and UTs: It is an important feature of public
expenditure of the central government of India. The government provides assistance in the forms
of grants-in-aid and loans to the states and to the UTs.

10. Poverty Alleviation Programs: As poverty ratio is high, huge amount of expenditure is
required for implementing alleviation programmes.

Justification for increase in Public Expenditure:

Increase in public expenditure can be justified on the following grounds:

1. Assists in increasing state activities,

2. Increase in welfare activities,

3. Reduces disparities between rich and poor,

4. Boom for rapid economic development specially in underdeveloped and backward economy,

5. Provides economic stability, and

6. Brings prosperity etc.

Effects of Public Expenditure on production, distribution and economic stability

Effects of Public Expenditure on Production

Public expenditure has a great bearing on economic development and social welfare of a country.
Following observations may be noted in this regard.

 Effect on Production

According to Dr.Dalton, public expenditure tends to affect the level of production in the
following manner:

1.Capacity to work and save

As a result of public expenditure, capacity to work and save tends to rise. Government
expenditure provides various kinds of social and economic facilities stimulating the capacity to
work of the people. Increased capacity implies increased efficiency and greater employment.
Level of income and saving tends to rise facilitating greater investment and adding to the pace of
growth.

2. Desire to Work and save

Expenditure incurred by the government promotes the will to work and save. As a result, their
income and standard of living tent to rise.

3. Productive Utilization of Resources

Public expenditure restores a balance in the economy by focusing on those areas of production
which generate maximum linkages effect. Public expenditure acts as a pump-priming, attracting
idle resources to their productive utilization. Accordingly, production level tends to raise the
resources from unproductive activities to productive ones. This results in increase in production.

 Effect on Distribution

Public expenditure affects distribution in the following possible ways:

1. Regional Inequality

This is how public expenditure can promote equality across different regions of a country :

i. The government expenditure should focus on development of backward areas, increasing the
level of production and income of the people of those areas. Their standard of living will
increase to catch up with the living standards in developed regions of the country.
ii. Public expenditure should include financial help to the small-scale and cottage industries.
These industries have the merit of easy-diversification across different parts of the country.
Accordingly regional inequality is expected to improve.

2. Distribution of the Dividends of Industrial Development

As a result of public expenditure, the workers employed in the public sector industries are paid
higher wages. They get some facilities also, better than others. Following the public sector
industries, private sector industries also provide higher wages and other facilities to the workers.
Increase in the workers wages will lead to the reduction in economic inequality.

3. Benefit to the Weaker Section

If the government makes public expenditure on social services like education, medical care,
unemployment allowance, labour welfare etc. after collecting resources by way of taxes from the
rich class, it will result in the increase in real income of the poor people, thus tilting the
distribution further in their favour.

4. Increase in the Ability to work of the Poor

Distribution of income can also be influences by increasing the ability to work of the poor with
the help of public expenditure. This objective can be achieved in two ways:

i. Direct Help: The government can provide direct help to the poor people in the form of cash,
commodities and service.

ii. Indirect Help: The government can provide loans to the poor at a low rate of interest. It can
provide them food at fair price. It can provide more social services to them. As a result of it, their
efficiency will be increased. With rise in their income level their standard of living will improve.

 Public Expenditure and Economic Stability

Cyclical changes are an inherent character of a market economy. These changes are called Trade
Cycles, and are manifested as the state of recession, depression, recovery and boom. The states
of recession and depression are particularly dangerous for restricting the pace of growth.
Inflation is equally bad when it tends to be galloping or hyper. Note the following observations
to understand how public expenditure facilities economic stability:

1. Public Expenditure and depression

During depression, the prices of commodities tend to fall. Accordingly there is a fall in
production and employment. Unemployment increases. Both the producers and the consumers
become pessimistic. Producers reduce output because of the lack of demand. Consumers, hoping
for a further fall in prices, suspend their existing consumption needs. Accordingly, reduction in
demand is compounded. As a consequence, the vicious circle of reduced demand, reduced
production, and reduced employment sets in. Here comes the significance of public expenditure.
According to Keynes, in the state depression, the government should plan for a comprehensive
increase in public expenditure. It can be of two types:

i. Compensatory Expenditure

It includes those spending which the government makes on public works so as to increase
employment and aggregate demand. Such spending generate multiplier effect on income. Income
rises in consonance with increased employment, acting as an anti-dote the situation of
depression.

ii. Pump Priming Expenditure

During the depression periods, investment is low. If investment is made in public sector, it will
prompt private investment as well. Public expenditure thus made is called pump priming. Initial
expenditure by the government particularly on infra-structural facilities, tends to be conductive
for an all round growth of private investment.

Taylor categories public expenditure during depression as

(a)Home Relief

(b) Unemployment Compensation Plans, and

(c) Work Projects.

a) Home relief is provided to the poor so as to increase their consumption, without getting their
services. This is a kind of transfer payments expected to raise consumption expenditure.

b) Unemployment Compensation Fund is set with the help of the employers, employees and the
government. Help is provided to the workers during the period of unemployment out of this
fund.

c) Work projects include public works like construction of roads, bridges and dams, etc.
Expenditure on such projects will projects will generate income to combat deflation through
increased demand.

2. Public Expenditure and Inflation

Public expenditure can be used as a policy instrument to curb inflation. It should focus on the
following areas:

i. Increase in Production

Public expenditure should be utilized for increasing production. Increase in production during
inflation implies increased flow of goods and services in the economy. In the backdrop of rising
prices, increased flow of goods and services will help strike a balance between demand and
supply.

ii. Reduction in Consumption

In a state of price-rise, the government should reduce its consumption expenditure. This will
reduce the pressure of demand on the goods and services. Accordingly prices are expected to
fall, or at least their pace of rise will be arrested.

PUBLIC DEBT

Public debt or public borrowing is considered to be an important source of income to the

government. If revenue collected through taxes & other sources is not adequate to cover
government expenditure government may resort to borrowing. Such borrowings become
necessary more in times of financial crises & emergencies like war, droughts, etc.

Public debt may be raised internally or externally. Internal debt refers to public debt floated
within the country; while external debt refers loans floated outside the country.

The instrument of public debt take the form of government bonds or securities of various kinds.
Such securities are drawn as a contract between the government & the lenders. By issuing
securities the government raises a public loan & incurs a liability to repay both the principal &
interest amount as per contract. In India, government issues treasury bills, post office savings
certificates, National Saving Certificates as instrument of Public borrowings.

Classification / Types of Public Debt

Government loans are of different kinds, they may differ in respect of time of repayment, the
purpose, conditions of repayment, method of covering liability. Thus the debt may be classified
into following types:

Major forms of public debt are: 1. Internal and External Debt 2. Productive and Unproductive
Debt 3. Compulsory and Voluntary Debt 4. Redeemable and Irredeemable Debts 5. Short-term,
Medium-term and Long-term loans 6. Funded and Unfunded Debt.

For brevity, the types of public debt are restated in the Chart.
1. Internal and External Debt:

Public loans floated within the country are called internal debt. Public borrowings from other
countries are referred as external debt. External debt represents a claim of foreigners against the
real income (GNP) of the country, when it borrows from other countries and has to repay at the
time of maturity.

External public debt permits import of real resources. It enables the country to consume more
than it produces.

The following points of distinction between internal and external debts are noteworthy:

a. An internal loan may be voluntary or compulsory, but an external loan is normally voluntary
in nature. Only in the case of a colony, an external loan can be raised by compulsion.

b. An internal loan is controllable and can be estimated beforehand with certainty, while external
loans are always uncertain and cannot be estimated so confidently. Its realization is very much
conditioned by international politics and foreign policies of the lending government.

c. Internal loan is in terms of the domestic currency, while external loans are in terms of foreign
currencies.

An important feature of external debt is, that usually foreign exchange resources of the
borrowing country increase when the loans are received in terms of foreign currencies. But,
when there is repayment of such loans, i. e., debt servicing charges, foreign exchange reserve is
depleted to that extent.
Sometimes, however, external loans are repayable in the borrowing country’s domestic currency,
so that foreign exchange resources are least affected. For instance, in the post-independence
period India received loans from U.S.A. under P.L. 480, which were repayable in Indian rupees.

Since under internal debts, borrowing takes place within the country, the availability of total
resources do not rise. Simply the resources are transferred from the bond-holders — individuals
and institutions — to the public treasury, and the government can spend, these for public
purposes.

Similarly, payment of interest for repayment of principal of internal loans would transfer
resources from tax-payers to bond-holders. An internally- held public debt, thus, represents only
a commitment to effect a certain transfer of purchasing power among the people within the
country. It has, therefore, no direct net money burden as such. It amounts to only a redistribution
of income in the community from one section to the other.

External debt, on the other hand, leads to a transfer of wealth from the lender nation to the
borrower nation. When the loan is made through the means of external loans the resources
available to the borrowing nation increase.

However, when a foreign loan is repaid or interest is paid on such loans, there would be a
transfer of resources from the debtor to the creditor countries, causing a decline in total resources
of the debtor country.

To cover the interest and repayment of the principal of an external loan, the debtor government
has to curtail its expenditure in the future or reduce private spending by increasing taxation, thus
cutting the use of resources at home.

The Structure of the Internal Public Debt:

The structure of the internal public debt may be constituted by various types of loan
instruments/obligations of the government. It may be classified as follows:

In particular, for instance, the government of India’s debt obligations includes:

(1) Central and state Government Securities: Dated G-Secs are those securities which are issued
by the Central Government. Similarly, State Development Loans (SDLs), are borrowings of the
State Governments and include the bonds issued by the State Governments. Government
securities are highly liquid instruments available both in the primary and secondary market.

(2) Treasury Bills — the short-term issues (91/182/364 days) of the Government in order to
bridge the gap between revenue and expenditure.

(3)Small Savings — a non-inflationary means of finance — effectuated/tapped through

instruments such as Post Office Savings Bank Deposits, Cumulative Time Deposits, Post Office
Recurring Deposits, National Defence Certificates, 15-year Annuity Certificates, National
Savings Certificates, National Savings Annuity Scheme, National Development Banks, National
Savings Account, Indira Vikas Patra, Kisan Vikas Patra.

(4) Other miscellaneous obligations of the Central Government constituting the internal public
debt in India are: Compulsory Deposit Scheme, Gold Bonds, Public Provident Funds, and items
of unfunded debts and unclaimed balance of State Provident Funds, and other accounts such as
General Family Pension Fund, the Hindu Family Annuity Fund, the Postal Insurance, Life
Insurance, Life Annuity Fund, etc. and unclaimed balance in respect of three-year Interest-free
Prize Bonds.

2. Productive and Unproductive Debt:

Public debt is said to be productive or reproductive, when government loans are invested in
productive assets or enterprises such as railways, irrigation, multipurpose projects etc., which
yield a sufficient income to the public authority to pay out annual interest on the debt as well as
help in repaying the principal in the long run. As such, a productive public debt is self-
liquidating in nature; so the community experiences no net burden of such debt.

An unproductive debt, on the other hand, is one which does not add to the productive assets of a
country. When the government borrows for unproductive purposes like financing a war, or for
lavish expenditure on public administration, etc., such public loans are regarded as unproductive.
Unproductive loans do not add to the productive capacity of the economy, so they are not self-
liquidating. Unproductive public loans thus cast a net burden on the community, as for their
servicing and repayment purpose, government will have to resort to additional taxation.

3. Compulsory and Voluntary Debt:

When government borrows from people by using coercive methods, loans so raised are referred
to as compulsory public debt. Under the Compulsory Deposit Scheme in India, tax-payers have
to compulsorily deposit a prescribed amount and defaulters are punished. This is a case of
compulsory debt.

Usually, public borrowings are voluntary in nature. When the government floats a loan by
issuing securities, members of the public and institutions like commercial banks may subscribe
to them.

4. Short-Term, Medium-Term & Long-Term Debts

i. Short-Term debt: Short term debt matures within a duration of 3 to 9 months. Generally, rate
of interest is low. For instance, in India, Treasury Bills of 91 days and 182 days are examples of
short term debts incurred to cover temporary shortages of funds. The treasury bills of
government of India, which usually have a maturity period of 91 days, are the best examples of
short term loans. Interest rates are generally low on such loans.
ii. Long-Term debt: Long term debt has a maturity period of ten years or more. Generally the
rate of interest is high. Such loans are raised for developmental programmes and to meet other
long term needs of public authorities.

iii. Medium-Term debt: The Government may borrow funds for medium term needs. These
funds can be used for development and non-development activities. The period of medium term
debt is normally for a period above one year and up to 5 years. One of the main forms of medium
term debt is by way of market loans.

5. Redeemable and Irredeemable Debts

i. Redeemable debt: The debt which the government promises to pay off at some future date are
called redeemable debts. Most of the debt is redeemable in nature. There is certain maturity
period of the debt. The government has to make arrangement to repay the principal & the interest
on the due date.

ii. Irredeemable debt: Such debt has no maturity period. In this case, the government may pay
the interest regularly, but the repayment date of the principal amount is not fixed. Irredeemable
debt is also called as perpetual debt. Normally, the government does not resort to such
borrowings.

6. Funded and Unfunded Debts

i. Funded debt: Funded debt is repayable after a long period of time. The period may be 30
years or more. Funded debt has an obligation to pay fixed sum of interest subject to an option to
the government to repay the principal. The government may repay it even before the maturity if
market conditions are favourable. Funded debt is undertaken for meeting more permanent needs,
say building up economic & industrial infrastructure. The government usually establishes a
separate fund to repay this debt. Money is credited by the government into this fund & debt is
repaid on maturity out of this fund.

ii. Unfunded debt: Unfunded debts are incurred to meet temporary needs of the governments.
In such debts duration is comparatively short say a year. The rate of interest on unfunded debt is
very low. Unfunded debt has an obligation to pay at due date with interest.

Redemption of Public Debt

Methods that are adopted for redemption of public debt are: 1. Refunding 2. Conversion 3.
Surplus budgets 4. Sinking fund 5. Terminable annuities 6. Additional Taxation 7. Capital Levy
8. Surplus Balance of Payments.
Redemption is a way of escape from the burden of public debt. Redemption means repayment of
a loan.

1. Refunding:

Refunding of debt implies the issue of new bonds and securities by the government in order to
repay the matured loans. In the refunding process, usually short-term securities are replaced by
issuing long-term securities. Under this method the money burden of public debt is not
relinquished but it is accumulated owing to the postponement of debt redemption.

2. Conversion:

Conversion is not repayment, it is only exchange of new debts for old. It is the process of
converting or altering a loan with a given rate of interest into a loan at a lower rate of interest.
This may take place at the time of maturity or before the time of maturity by the voluntary
acceptance. The government gives notice to the creditors that they should either agree to reduce
the interest rate for future payments or it will exercise the option of repaying the loan, in case the
bond-holders do not accept the lower rate, then the government will raise a new loan at lower
rate of interest and, with the proceeds, pay off the old debt. The effect is to convert a high-rated
loan into a low-rated one. The financial burden is consequently reduced. For this purpose, the
government have to maintain an adequate stock of securities for a smooth functioning of this
method.

3. Surplus budgets:

Quite often, surplus budgets (i.e., by spending less than the public revenue obtained) may be
utilized for clearing off public debts. But in recent years due to ever-increasing public
expenditures, surplus budget is a rare phenomenon. Moreover, heavy taxes have to be imposed
for realizing a surplus budget, which may have dire consequences. Or, when public expenditure
is reduced for creating a surplus budget, a deflationary bias may develop in the economy.

4. Sinking fund:

A sinking fund is a fund created by the government and gradually accumulated every year by
setting aside a part of current public revenue in such a way that it would be sufficient to pay off
the funded debt at the time of maturity. Perhaps, this is the most systematic and best method of
redemption. Under this method, the aggregate burden of public debt is least felt, as the burden of
taxing the people to repay the debt is spread evenly over the period of the accumulation of the
fund. The practice of a sinking fund inspires confidence among the lenders and the government’s
creditworthiness increases thereby.

5. Terminable annuities:
This method of debt redemption is similar to that of the sinking fund. Under this method, the
fiscal authorities clear off a part of the public debt every year by issuing terminable annuities to
the bond-holders which mature annually. Thus, it is the method of redeeming debts in
installments. By this method, the burden of debt goes on diminishing annually and by the time of
maturity it is fully paid off.

6. Additional Taxation:

The simplest measure of debt redemption is to impose new taxes and get the required revenue to
repay the loan principal as well as the interest. This method causes redistribution of income by
transferring the resources from tax-payers to the hands of bond-holders. It may also impose a
burden on the future generation if new taxes are levied to repay the long-term debts.

7. Redemption by Purchase

In this case the government pays off debts by purchasing securities even before the maturity
whenever it has surplus budget. However, surplus budget is a rare phenomenon in modern times.

8. Surplus Balance of Payments:

The redemption of external debt, however, is possible only through an accumulation of foreign
exchange reserves. This necessitates creation of a favourable balance of payments by the debtor
country by augmenting its exports and curbing its imports, thereby improving the position of its
trade balance.

Thus, the debtor country has to concentrate on the expansion of its export sector industries.
Further, loans raised must be productively utilized, so that they may become self-liquidating,
posing no real burden on the economy.

In underdeveloped countries like India, where external debt has increased tremendously, it is
necessary that its burden is reduced by changing the terms of repayment or by rescheduling the
debts.

In fact, the best redemption policy is a that part of the public debt, internal as well as external is
redeemed every year so that there is no mounting of a total real burden of debt upon the present
generation or on posterity.

BUDGET: MEANING AND COMPONENTS

“A government budget is an annual financial statement showing item wise estimates of expected
revenue and anticipated expenditure during a fiscal year.”

Government has several policies to implement in the overall task of performing its functions to
meet the objectives of social & economic growth. For implementing these policies, it has to
spend huge amount of funds on defence, administration, and development, welfare projects &
various other relief operations. It is therefore necessary to find out all possible sources of getting
funds so that sufficient revenue can be generated to meet the mounting expenditure.

A budget is a financial statement prepared prior to a defined period of time, of the policy to be
pursued during that period for the purpose of attaining a given objective. Planning process of
assessing revenue & expenditure is termed as Budget.

The term budget is derived from the French word "Bougette" which means a "leather bag" or a
"wallet". It is a statement of the financial plan of the government. It shows the income &
expenditure of the government during a financial year, which runs generally from 1stApril to
31st March.

Budget is most important information document of the government. Every citizen of a nation
from the common man to the politician is eager to know about the budget as they would like to
get an idea of the:

1. Financial performance of the government over the past one year.

2. To know about the financial programmes & policies of the government for the next one
year.

3. To know how their standard of living will be affected by the financial policies of the
government in the next one year.

According to Taylor, "Budget is a financial plan of government for a definite period".

According to Rene Storm, "A budget is a document containing a preliminary approved plan of
public revenues and expenditure".

Main elements of the budget are:

(i) It is a statement of estimates of government receipts and expenditure.

(ii) Budget estimates pertain to a fixed period, generally a year.

(iii) Expenditure and sources of finance are planned in accordance with the objectives of the
government.

(Iv) It requires to be approved (passed) by Parliament or Assembly or some other authority

before its implementation.

Objectives of a Government budget

Some of the important objectives of government budget are as follows: 1. Allocation of
Resources 2. Reducing inequalities in income and wealth 3. Economic Stability 4. Management
of Public Enterprises 5. Economic Growth and 6. Reducing regional disparities.

Government prepares the budget for fulfilling certain objectives. These objectives are the direct
outcome of government’s economic, social and political policies.

The various objectives of government budget are:

1. Allocation of Resources:

Through the budgetary policy, Government aims to allocate resources in accordance with the
economic (profit maximization) and social (public welfare) priorities of the country. Government
can influence allocation of resources through:

(i) Taxes or subsidies:

To encourage investment, government can give tax concession, subsidies etc. to the producers.
For example, Government discourages the production of harmful consumption goods (like
liquor, cigarettes etc.) through heavy taxes and encourages the use of ‘Khaki products’ by
providing subsidies.

(ii) Directly producing goods and services:

If private sector does not take interest, government can directly undertake the production.

2. Reducing inequalities in income and wealth:

Economic inequality is an inherent part of every economic system. Government aims to reduce
such inequalities of income and wealth, through its budgetary policy. Government aims to
influence distribution of income by imposing taxes on the rich and spending more on the welfare
of the poor. It will reduce income of the rich and raise standard of living of the poor, thus
reducing inequalities in the distribution of income.

3. Economic Stability:

Government budget is used to prevent business fluctuations of inflation or deflation to achieve

the objective of economic stability. The government aims to control the different phases of
business fluctuations through its budgetary policy. Policies of surplus budget during inflation and
deficit budget during deflation helps to maintain stability of prices in the economy.

4. Management of Public Enterprises:

There are large numbers of public sector industries (especially natural monopolies), which are
established and managed for social welfare of the public. Budget is prepared with the objective
of making various provisions for managing such enterprises and providing those financial help.
5. Economic Growth:

The growth rate of a country depends on rate of saving and investment. For this purpose,
budgetary policy aims to mobilize sufficient resources for investment. Therefore, the government
makes various provisions in the budget to raise overall rate of savings and investments in the
economy.

6. Reducing regional disparities:

The government budget aims to reduce regional disparities through its taxation and expenditure
policy for encouraging setting up of production units in economically backward regions.

Impact of a budget:

A budget impacts the society at three levels, (i) It promotes aggregate fiscal discipline through
controlled expenditure, given the quantum of revenues, (ii) Resources of the country are
allocated on the basis of social priorities, (iii) It contains effective and efficient programmes for
delivery of goods and services to achieve its targets and goals.

Components of Government Budget

The main components or parts of government budget are explained below.

1. Revenue Budget
This financial statement includes the revenue receipts of the government i.e. revenue collected
by way of taxes & other receipts. It also contains the items of expenditure met from such
revenue.

(a) Revenue Receipts

These are the incomes which are received by the government from all sources in its ordinary
course of governance. These receipts do not create a liability or lead to a reduction in assets.

Revenue receipts are further classified as tax revenue and non-tax revenue.

i. Tax Revenue:-

Tax revenue consists of the income received from different taxes and other duties levied by the
government. It is a major source of public revenue. Every citizen, by law is bound to pay them
and non-payment is punishable.

Taxes are of two types, viz., Direct Taxes and Indirect Taxes.

Direct taxes are those taxes which have to be paid by the person on whom they are levied. Its
burden cannot be shifted to someone else. E.g. Income tax, property tax, corporation tax, estate
duty, etc. are direct taxes.

Indirect taxes are those taxes which are levied on commodities and services and affect the
income of a person through their consumption expenditure. Here the burden can be shifted to
some other person. E.g. Custom duties, sales tax, services tax, excise duties, etc. are indirect
taxes.

ii. Non-Tax Revenue:-

Apart from taxes, governments also receive revenue from other non-tax sources.

The non-tax sources of public revenue are as follows:-

a. Fees: The government provides variety of services for which fees have to be paid. E.g.
fees paid for registration of property, births, deaths, etc.

b. Fines and penalties: Fines and penalties are imposed by the government for not
following (violating) the rules and regulations.

c. Profits from public sector enterprises: Many enterprises are owned and managed by
the government. The profits receives from them is an important source of non-tax
revenue. For example in India, the Indian Railways, Oil and Natural Gas Commission,
Air India, Indian Airlines, etc. are owned by the Government of India. The profit
generated by them is a source of revenue to the government.
 d. Gifts and grants: Gifts and grants are received by the government when there are natural
calamities like earthquake, floods, famines, etc. Citizens of the country, foreign
governments and international organisations like the UNICEF, UNESCO, etc. donate
during times of natural calamities.

e. Special assessment duty: It is a type of levy imposed by the government on the people
for getting some special benefit. For example, in a particular locality, if roads are
improved, property prices will rise. The Property owners in that locality will benefit due
to the appreciation in the value of property.Thus, due to public expenditure, some people
may experience 'unearned increments' in their asset holding. Therefore the government
imposes a levy on them which is known as special assessment duties. Special assessment
is, therefore, like a special tax that government levies in proportion to the benefit
accruing to property owners to defray the cost of development. It is a payment made
once-for-all by the owners of properties for increase in the value of their properties
resulting from development activities of the government. In India, it is called as
betterment levy.

(b) Revenue Expenditure

Revenue expenditure is the expenditure incurred for the routine, usual and normal day to day
running of government departments and provision of various services to citizens. It includes both
development and non-development expenditure of the Central government. Expenditures that do
not result in the creations of assets are considered revenue expenditure. It is recurring in nature

In general revenue expenditure includes following:-

a. Expenditure by the government on consumption of goods and services.

b. Expenditure on agricultural and industrial development, scientific research, education,

health and social services.

c. Expenditure on defence and civil administration.

d. Expenditure on exports and external affairs.

e. Grants given to State governments even if some of them may be used for creation of
assets.

f. Payment of interest on loans taken in the previous year.

g. Expenditure on subsidies.
2. Capital Budget

This part of the budget includes receipts & expenditure on capital account projected for the next
financial year. Capital budget consists of capital receipts & Capital expenditure.

(a) Capital Receipts

Receipts which create a liability or result in a reduction in assets are called capital receipts. They
are non-recurring and non-routine in nature.

A receipt is a capital receipt if it satisfies any one of the two conditions:

(i) The receipts must create a liability for the government. For example, Borrowings are capital
receipts as they lead to an increase in the liability of the government. However, tax received is
not a capital receipt as it does not result in creation of any liability.

(ii) The receipts must cause a decrease in the assets. For example, receipts from sale of shares of
public enterprise is a capital receipt as it leads to reduction in assets of the government.

Sources of Capital Receipts:

Capital receipts are broadly classified into three groups:

1. Borrowings:

Borrowings are the funds raised by government to meet excess expenditure.

Governments borrow funds from:

(i) Open Market (Public): through the sales of bonds and securities.

(ii) Reserve Bank of India (RBI);

(iii) Foreign governments (like loans from USA, England etc.);

(iv) International institutions (like World Bank, International Monetary Fund).

Borrowings are capital receipts as they create a liability for the government.

2. Recovery of Loans:
Government grants various loans to state governments or union territories. Recovery of such
loans is a capital receipt as it reduces the assets of the government.

3. Other Receipts:

These include:

(a) Disinvestment:

Disinvestment refers to the act of selling a part or the whole of shares of selected public sector
undertakings (PSU) held by the government. They are termed as capital receipts as they reduce
the assets of the government. Government holds ownership in various PSU’s in the form of
equity shares. When the government sells a part or whole of its shares, it leads to transfer of
ownership of PSU’s to the private enterprises.

(b) Small Savings:

Small savings refer to funds raised from the public in the form of Post Office deposits, National
Saving Certificates, Kisan Vikas Patras etc. They are treated as capital receipts as they lead to an
increase in liability.

(b) Capital Expenditure

Capital expenditure refers to the expenditure which either creates an asset or causes a reduction
in the liabilities of the government. It is non-recurring in nature. It adds to capital stock of the
economy and increases its productivity through expenditure on long period development
programmes, like Metro or Flyover, expenditure on building roads, flyovers. Factories, purchase
of machinery etc., repayment of borrowings, etc.

An Expenditure is a capital expenditure, if it satisfies any one of the following two conditions:

(i) The expenditure must create an asset for the government. For example, Construction of Metro
is a capital expenditure as it leads to creation of an asset.

(ii) The expenditure must cause a decrease in the liabilities. For example, repayment of
borrowings is a capital expenditure as it leads to a reduction in the liabilities of the government.
Thus, we see that the budget mirrors projected receipts and expenditures.

Revenue Budget Capital budget

Items of Items of Expenditure Items of receipts Items of Expenditure

Receipts

a) taxes on a) Administrative and a) Loans and a) Public Works

income general services Recoveries

b) taxes on b) Social Services b) Market loans b) Construction of power

property generation plants

c) customs duty c)Economic services c) Small Savings c) construction of roads and

railways

d) Union Excise d) Community Services d) External Loans d) Flood Control Works

Duty

e) Non-tax e) Maintenance of roads e) Other Receipts e) irrigation canals etc.

Revenue and railways

f) other
Revenues

Total Revenue Total Revenue Total Capital Total Capital Expenditure

Receipts Expenditure Receipts

BALANCED AND UNBALANCED BUDGET

Budgets are of two types: Balanced and Unbalanced.

Different Types of Government Budget - Diagram

A. Balanced Budget

A government budget is said to be a balanced budget in which government estimated receipts

(revenue and capital) are equal to government estimated expenditure.

Balanced Budget

Estimated Govt. Receipts = Estimated Govt. Expenditure

Two main merits of a balanced budget are:

(a) It ensures financial stability and (b) It avoids wasteful expenditure.

Two main demerits are:

(i) Process of economic growth is hindered and (ii) Scope of undertaking welfare activities is
restricted.

According to Adam Smith, public expenditure should never exceed public revenues, i.e., he
advocated a balanced budget. But Keynes and modern economists do not agree with the policy of
a balanced budget. They argue that in a balanced budget, total expenditure (public and private)
falls short of the amount necessary to maintain full employment.
Therefore, government should increase its expenditure to close the gap between the expenditure
essential for full employment and expenditure that actually takes place. Ideally, a balanced
budget is a good policy to bring the near full employment economy to a full employment
equilibrium.

B. Unbalanced Budget

The budget in which income & expenditure are not equal to each other is known as Unbalanced
Budget.

Unbalanced budget is of two types:-

1. Surplus Budget

2. Deficit Budget

1. Surplus Budget

The budget is a surplus budget when the estimated revenues of the year are greater than
anticipated expenditures.

Government expected revenue > Government proposed Expenditure.

Surplus budget shows the financial soundness of the government. When there is too much
inflation, the government can adopt the policy of surplus budget as it will reduce aggregate
demand.

Increase in revenue by levying taxes on people reduces their disposable incomes, which
otherwise could have been spend on consumption or saved and devoted to capital formation.
Since government spending will be less than its income, aggregate demand will decrease and
help to reduce the price level.

However, in modern times, when governments have so many social economic & political
responsibilities it is virtually impossible to have a surplus budget.

2. Deficit Budget

Deficit budget is one where the estimated government expenditure is more than expected
revenue.

Government's estimated Revenue < Government's proposed Expenditure.

According to Prof. Hugh Dalton, "If over a period of time expenditure exceeds revenue, the
budget is said to be unbalanced".

Such deficit amount is generally covered through public borrowings or withdrawing resources
from the accumulated reserve surplus. In a way a deficit budget is a liability of the government
as it creates a burden of debt or it reduces the stock of reserves of the government.

Merits and demerits of deficit budget:

A deficit budget has its own merits especially for developing economy For example (i) It
accelerates economic growth and (ii) It enables to undertake welfare programmes of the people,
(iii) It is a cure for deflation as it checks downward movement of prices. At the same time.

It has demerits also such as:

(i) It encourages unnecessary and wasteful expenditure by the government, (ii) It may lead to
financial and political instability, (iii) It shakes the confidence of foreign investors.

The situation of excess demand leading to inflation (continuous rise in prices) and the situation
of deficient demand leading to depression (fall in prices, rise in unemployment, etc.). A surplus
budget is recommended in the situation of inflationary trends in the economy whereas a deficit
budget is suggested in the situation of recession.

In developing countries like India, where huge resources are needed for the purpose of economic
growth & development it is not possible to raise such resources through taxation, deficit
budgeting is the only option.

In Underdeveloped countries deficit budget is used for financing planned development & in
advanced countries it is used as stability tool to control business & economic fluctuations.