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Public Finance - Unit-1- 2

B.A (Hons.) Political Science (University of Delhi)

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B.Com. (Hons.)
B.A. (Hons.) Political Science/English Semester-IV

Generic Elective–Economics
Public Finance

SCHOOL OF OPEN LEARNING

UNIVERSITY OF DELHI

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Public Finance
Generic Elective Paper for B. Com (Hons)/B.A. (Hons.) Political Science/English Semester III

Declaration:
Reading Material Compiled from Various web-resources available on the Internet for
limited circulation among the students at School of Open Learning, University of Delhi for
non-commercial use.

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Public finance
Introduction
The State in modern times is called a welfare State. The activities of such a modern welfare
State have vastly increased. For a smooth performance of these functions the State nee&
finance. Thus public finance means the finances of public bodies—national, State or local—for
the performance of their functions. The term 'finance' may also refer to financial management
and administration. Public finance thus means the administration of the financial operations of
the public authorities. It refers to that branch of Economics which deal with the income and
expenditure of public bodies and the principles, problems and policies relating to these
matters.

Definition
Carl Plehn defines public finance as. "The science which deals with the activity of statesman
in obtaining and applying the material means necessary for fulfilling the proper functions of
the State."

Scope of Public Finance

1. Public Revenues – In his division we study all those sources from which the
government derives its revenues. An extensive study of the principles of taxation is
an integral part of this branch. Along with this, we also study in this branch the
problem of the incidence of taxation-
2. Public Expenditure – Public expenditure is the beginning and end of the collection
of revenues by the government. As pointed out by Plehn, "Public expenditure is the
end and aim of collection of revenues and of other financial activities of the
statesman". Under public expenditure we study its classification, the canons or
principles which govern it and its effects on production, employment, income
distribution, stability and growth. We also study the reasons for increase in public
expenditure and changes in the pattern.
3. Public Debt –When public revenue falls short of public expenditure, the government
borrows from the public to meet the gap. This is public debt. Under public debt; we
study the reasons, methods and sources of public debt, its effects on production,
consumption, income distribution and economy, the burden of public debt and the
methods of debt redemption
4. Financial Administration –The aim of financial administration is to control
processes and operations of public revenue, public expenditure and public debt. The
scope of financial administration includes the collection, custody and disbursement
of public money; the coordination of expenditure according to a well-formulated
plan; the management of public debt; and the general control of the financial
operations of the state. It also includes the preparation of the budget; its execution
and above all auditing the finances of the state.
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NATURE OF PUBLIC FINANCE

• WHETHER IT IS SCIENCE OR ART OR BOTH

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• PUBLIC FINANCE IS A SCIENCE:- science is the systematic study of any subject which
studies causal relationship between facts.public finance is a syste matic study of any subject
which studies causal relationship between facts. the arguments :-
1. definite and limited field of human knowledge
2. systematic study of facts
3. scientific methods are used to study public finance
4. principles of public finance are empirical
• PUBLIC FINANCE IS AN ART: art is the application of knowledge for achieving
objectives. fiscal policy which is an imp instrument to of public finance makes use of the
knowledge of govt’s revenue and expenditure to achieve the objectives of full employment,
economic equality, economic development and price stability
Is public finance a positive or a normative science public finance as a positive science
• as a positive economics they are concerned as to how public authorities have collected
public revenue, how they make public expenditure and how both are administered.
• they are least interested to know the how revenue and expenditure of the public authority
affect or will affect the social and economic aspects of the life
• the study of effects of fiscal operations or budgetary process were not considered and out
rightly rejected the normative aspects of the subject.
public finance as normative science
1. broaden the scope of public finance
2. include not merley revenue and expenditure process of the government but also the
effects of fiscal operations upon the fiscal and economic aspects of the economy.
3. public finance can not ignore the version of what ought to be
4. which even neo classical robbin economists as positive science
5. public finance has been recognized as a normative operation. fiscal operations are used
to check inflation. unemployment, underemployment, trade cycle etc
Importance of Public Finance
1. Increasing the growth rate of Economy – The role of public expenditure in economic
development lies in increasing the growth rate of the economy, providing more
employment opportunities, raising incomes and standard of living, reducing inequalities of
income and wealth, encouraging private initiative and enterprise and bringing about
regional balance in the economy. All these are achieved by spending on public works,
agriculture: industry, transport and communications, power, financial and banking
institutions, social services etc. The government is able to increase public expenditure
through a budget deficit.
2. Emergence of Social Services – The importance of public finance as also increased due
to emergence of social services which can be performed more conveniently, efficiently
and also at the minimum cost as against individual. Such services are education, health,
social security and protection from certain uncertainties. The need for such social services
is increasing day by day and with them is increasing the importance of public finance.
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3. Reduction in Economic Inequalities – Public finance can playa vital role in reducing
economic inequalities which is the source of dissatisfaction, class-struggles, poverty etc.
The state can levy heavy taxes on richer sections of the society and thereby spend the
income so received on providing food, cheap housing, free medical aid etc. for the poorer
sections of the society. Similarly, heavy taxes can be imposed on the use of harmful
commodities, such as harmful drugs, wine, opium, hashish etc.
4. Increases Employment – Public finance can play vital role in increasing employment
which is the burning problem of almost all the countries of the world, The Governments
these days establish, give grants, subsidies, grant exemption from excise duty, sales tax
etc. to employment-oriented cottage and small-scale industries. Unbalanced budget is also
an indispensable measure of increasing volume of employment during depression.
5. Capital Formation –The economic development, as is well known, depends upon the rate
of capital-formation in the country. Public finance can play a vital role in increasing the
rate of capital-formation in the economy. It can be managed in such a manner as to step up
the rate of saving and investment in the economy. For example, the tax system can be so
managed as to discourage the consumption of non-essential goods and thereby release the
resources for being invested in more productive industries. Further, the tax system can be
employed to increase the rate of private saving which in turn, can be used as the basis for
an increase in public investment.
6. Industrial Development – The governments these days give subsidies and grants to
different industries to enable them to increase the production of essential goods in the
country. These subsidies and grants have special place in the government expenditure of
underdeveloped and backward countries .
Differences or Dissimilarities between public and private finance
The following are the main points of differences or dissimilarities between public and private
finance:
1. Adjustment between Income and Expenditure – An individual determines his
expenditure on the basis of his income. He prepares his family budget on his expected
income during the month. On the other hand, the government first estimates about its
expenditure and then finds out means to raise the necessary income. As pointed out by
Bastable, 'The individual says, I can spend so much', the Finance Minister says, 'I have to
raise so much'
2. Elasticity of Finance – Public Finance is more elastic than private finance. There is not
much scope for changes in private finance while drastic changes can be made in
government finance. For example, a private individual cannot effect any special increase
in his income. As against this the government can increase its income by imposing fresh
taxes on the people.
3. Differences in Objectives – There are a fundamental difference in theobjective of private
and public finance. The motive of private expenditure is personal benefit whereas the
objective of public expenditure is social benefit. An individual always tries to save and a
firm to earn profit. But there are no such considerations on the part of the government,
except the public welfare.
However, there are some public enterprises which are run on profits that are utilised for
public welfare.
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4. Nature of Expenditure – There are differences in the nature of expenditure between the
two". An Individual's expenditure is governed by his habits, customs, fashions etc on the
other hand. The government expenditure depends on its economic and social policies, like
removing unemployment and poverty, reducing income inequalities, providing'
infrastructure facilities, etc
5. Compulsion – There is compulsion in public finance. People have to pay taxes. If they do
not pay, they are punished by fine and imprisonment. BA an individual or firm cannot
force anybody to pay him money. He can file a suit in the court. But even then he may not
receive his money back. The same is the case with loans. The government can force the
people to lend it during war or emergency. But a individual cannot compel any person to
lend him money.
6. Law of Equi-marginal Utility – The private individual spends his me on various items in
such a manner as to secure equal marginal utilities from them. It is only by equalizing the
various marginal utilities that he can secure maximum utility out of his expenditure.
The government on the contrary, does not give as much importance to this law as a
private individual does. Moderngovernments sometimes incur certain types of expenditure
from which they do not derive any advantage, but they o incur this expenditure to satisfy
certain sections of the community
7. Present Vs Future – An individual is more concerned with his present needs and tries to
satisfy them. Life being uncertain and short, he has his immediate gain or profit in view.
On the other hand, government is a permanent organisation. Only the ruling party
changesit is concerned not only with the welfare of present generation but also I with
future generations. It therefore, undertakes and spends on those activities which also
benefit future generations
8. Nature of the Budget – A surplus budget is always good for a private individual. Bin a
surplus budget may not be good for the government. It implies two things: (i) The
government is levying more taxes on the people than is necessary, (ii) The government is
not spending as much on the welfare of the public as it should. Keynes supported a deficit
budget to meet the situation created by depression. Further, the government budget is
passed by the parliament. But the budget of an individual or firm is a private affair without
any controlling authority.
9. Nature of Borrowing – In the case of an individual, there can no internal borrowing". An
individualcannot borrow from himself. He can borrow only from an external agency. The
State, however, can borrow both from internal as well as external sources. It borrows
not only from its own citizens, but also from foreigners.
Budgetary activities of the government results in transfer of purchasing power from some
individuals to others. Taxation causes transfer of purchasing power from tax payers to the
public authorities, while public expenditure results in transfer back from the public authorities
to some individuals, therefore financial operations of the government cause ‘Sacrifice or
Disutility’ on one hand and ‘Benefits or Utility’ on the other.
This results in changes in pattern of production, consumption & distribution of income and
wealth. So it is important to know whether those changes are socially advantageous or not.
If they are socially advantageous, then the financial operations are justified otherwise not.
According to Hugh Dalton, “The best system of public finance is that which secures the
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maximum social advantages from the operations which it conducts.”

Principle Maximum Social Advantage (MSA)

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The Principle of Maximum Social Advantage (MSA)’ is the fundamental principle of Public
Finance.
The Principle of Maximum Social Advantages states that public finance leads to economic
welfare when public expenditure & taxation are carried out up to that point where the benefits
derived from the MU
(Marginal Utility) of expenditure is equal to (=) the Marginal Disutility or the sacrifice
imposed by taxation.
Hugh Dalton explains the principle of maximum social advantages with reference to –
1. marginal Social Sacrifice
2. Marginal Social Benefits
This principle is however based on the following assumptions –
 All taxes result in sacrifice and all public expenditure lead to benefits.
 Public revenue consists of only taxes and no other sources of income to the government.
 The government has no surplus or deficit budget but only balanced budget.
Public expenditure is subject to diminishing marginal social benefit and taxes are subject to
increasing marginal social sacrifice.
THE PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE One of the important
principles of public finance is the so – called Principle of Maximum Social Advantage
explained by Professor Hugh Dalton. Just like an individual seeks to maximize his satisfaction
or welfare by the use of his resources, the state ought to maximize social advantage or benefit
from the resources at its command.

The principles of maximum social advantage are applied to determine whether the tax or the
expenditure has proved to be of the optimum benefit. Hence, the principle is called the
principle of public finance. According to Dalton, “This (Principle) lies at the very root of public
finance”

He again says “The best system of public finance is that which secures the maximum social
advantage from the operations which it conducts.” It may be also called the principle of
maximum social benefit. A.C. Pigou has called it the principle of maximum aggregate welfare.

Public expenditure creates utility for those people on whom the amount is spent. When the
volume of expenditure is small with a slighter increase in it, the additional utility is very high.
As the total public expenditure goes on increasing in course of time, the law of diminishing
marginal utility operates. People derive less of satisfaction from additional unit of public
expenditure as the government spends more and more. That is, after a stage, every increase in

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public expenditure creates less and less benefit for the people. Taxation, on the other hand,
imposes burden on the people. So, when the volume of taxation becomes high, every further
increase in taxation increases the burden of it more and more. People under go greater scarifies
for every additional unit of taxation. The best policy of the government is to balance both sides
of fiscal operations by comparing “the burden of tax” and “the benefits of public expenditure”.
The State should balance the social burden of taxation and social benefits of Public expenditure
in order to have maximum social advantage.

Attainment of maximum social advantage requires that;

a) Both public expenditure and taxation should be carried out up to certain limits and no
more.

b) Public expenditure should be utilized among the various uses in an optimum manner, and

c) The different sources of taxation should be so tapped that the aggregate scarifies entailed
is the minimum.

Assumptions of the Principle

 The public revenue consists of only taxes (and not of gifts, loans, fees etc.) and the state
has no surplus or deficit budgets.

 Public expenditure is subject to diminishing marginal social benefits and the taxes are
subject to increasing marginal cost or disutility.

According to Dalton, maximum social advantage is at a point where the Marginal Social
Sacrifice (MSS) of taxation and Marginal Social Benefit (MSB) are equal. The point of equality
between MSS and MSB is referred to as the point of maximum social advantage or least
aggregate social sacrifice.

Musgrave calls Dalton’s principle as “Maximum Welfare Principle of Budget Determination.”

He puts that the optimum size of the budget is determined at point where Net Social Benefit
(NSB) of fiscal operations to the society becomes zero. The NSB is the difference between
MSB and MSS. (NSB=MSB-MSS). Musgrave presented Dalton’s principle of MSA with some
slight differences.

Diagrammatic Representation

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The curves MSS and MSB show the marginal social scarifies of taxation and marginal social
benefit of public expenditure respectively. MSS curve slopes up words since taxation increases
marginal social sacrifices. MSB curves slopes down wards showing that public benefit goes on
declining with every increase in public expenditure. The ideal point of financial operations is
where the governments collect OM taxation from the society and uses it for public expenditure.
At this point , MSS is exactly equal to MSB (Point E) at OM 1 , MSS is M1 F1 which is less
than MSB (M1 , E1) thus depicting a loss of welfare to the society (E1 F1). Similarly, the
government is collecting OM2 taxation to finance larger public expenditure; The MSS is higher
than MSB by E2 F2. So the ideal level of taxation and expenditure is at OM. According to
Dalton “Public expenditure in every direction, should be carried just so far that the advantage to
the community of a further small increase in any direction is just counter balanced by the
disadvantage of a corresponding increase in taxation or in receipts from any other source of
public income. This gives the ideal public expenditure and income”.

CATEGORIES OF GOODS

PUBLIC GOODS

The indivisible goods, whose benefits cannot be priced, and therefore, to which the principle of
exclusion does not apply are called public goods. The use of such goods by one individual does
not reduce their availability to other individuals. For example, the national defence.

Characteristics of Public goods

1) Non-rival in consumption: - One person’s consumption does not diminish the amount
available to others. Once produced, public goods are available to all in equal amount.
Marginal cost of providing the public goods to additional consumers is ZERO.

2) Non-excludable:- Once a public good is produced, the suppliers cannot easily deny it to
those who fail to pay. That is, those who cannot (or do not agree to) pay its market price
are not debarred or excluded from its use.
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3) Free-rider problem: - People can enjoy the benefits of public goods whether pay for
them or not, they are usually unwilling to pay for public goods. This act is the so-called
free-rider problem.

PRIVATE GOODS

Private goods refer to all those goods and services consumed by private individuals to satisfy
their wants. For example, food, clothing, car etc.

FEATURES

1) Excludable: - The suppliers of private goods can very well exclude those who are
unwilling to pay.

2) Rivalry in consumption: - One person’s consumption reduces the amount available to

others. That is, the amount consumed by one person is unavailable for others to consume.

3) Revealed Preference: - The consumers reveal their preferences through effective

demand and market price. These revealed preferences are the signals for the producers to
produce the goods the individuals want.

Market demand for private goods is obtained by horizontal summation of

individual demand curves and that of a public good is obtained by vertical
summation of individual demand curves.

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MIXED GOODS

Mixed goods are those goods having benefits which are wholly internalized (rival) and others,
the benefits of which are wholly externalized (non-rival). The cost of producing such goods
partly covered by private contributions and partly by government subsidy.

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PUBLIC REVENUE
Public Revenue refers to the revenue of a public authority – Central, State and Local
Governments.
The term „Public revenue‟ may be defined both in a narrow and a broad sense.
In the narrow sense of the term, it includes income from taxes, prices of goods and services
supplied by public enterprises, revenues from administrative activities such as fees, fines, etc.,
and gifts and grants. The incomes from the above sources are described as public revenue. In
the narrow sense, it includes only those receipts which increase the assets of the public
authorities without increasing its liability.
In the broad sense of the term, it includes all „incomings‟. It includes, besides public revenue,
many other sources of income like public borrowings, issue of paper money, etc. Thus, the
term, in its broad sense, includes all kinds of incomes. It is generally described as
„public receipt‟. Thus,

Public Revenue = Taxes + Income from sale of public assets + Administrative revenues + Gifts
and grants.
Public Receipt = Public Revenue + Public Borrowing + Repayment of loan + Issue of paper
currency.
Public Revenue constitutes an important branch of Public Finance.
SOURCES OF PUBLIC INCOME

The various sources of public income may be grouped into four categories – tax revenues,
commercial revenues, administrative revenues and grants and gift.

Taxes
Meaning and Definition :

Taxes form the most important part of the revenues of any State.
“A tax is a compulsory contribution of wealth of person or body of persons for the services of
public powers” (Bastable).
“Taxes are compulsory contributions to public authorities to meet the general expenses of
Government which have been incurred for public good and without reference to special
benefits” (Findlay Shirras).
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Characteristics of a Tax :

A tax possesses the following three important characteristics.

 A tax is a compulsory contribution from the citizen to the public authority. Refusal on the
part of the tax payer to a particular tax to the public authority is liable for punishment by
the court of law.

 A tax imposes a personal obligation on the tax payer. The tax payer has the obligation to
show of all his incomes to the government and pay the eligible amount of tax to the
government. He should not hide the particulars of his income and evade payment of tax.

 The tax revenues are spent for the general and common benefit.
1. Fees
A fee is a charge imposed on the occasion of a special service, the service incidentally in
connection with some comprehensive function, according to H.C.Adams.
Prof. Seligman defines a fee as a “payment to defray the cost of each recurring service
undertaken by the government, primarily in the public interest but conferring a measurable
special advantage on the fee payer.
In simple terms, it is a charge made by the State for a service which is for the general good
but which also confers a special benefit to the fee payer.
Examples :-
2. Court Fees, Registration fees for legal documents, Gun licence fees, Contract fees for
marriages, mortgages deeds, etc., Fees paid into the postal dept, Copy right of books, Issue
of passports, State inspection of weights and measure, etc.,
3. Licences
Sometimes, licences are granted to individuals to do something. As a matter of fact, there
is very little difference between a fee and a licence. Very often, a licence is included under
the head of „fees‟.
4. Fines and Forfeitures
Fines and forfeitures are more or less similar to each other. Fines are penalties levied for
the breach of rules and regulations laid down by the government. They are meant to deter
people from doing something forbidden by law. Forfeitures are penalties imposed on
people for failing to fulfil certain duties. Failures to appear before courts, to complete
contracts as stipulated etc., are examples of forfeitures.
4. Escheats
When owners of estates expire without legal heir or will, those estate will belong to the
Government. The value of these estates are known as escheats.
5. Special Assessments
A special assessment is a levy to defray the cost of a particular improvement, and is
theoretically in proportion to but never excess of, the resulting benefit accruing to the
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property against which it is levied, according to Prof. Shultz. In simple terms, when the
value of the property of people living in an area may rise as a result of some project or
improvement undertaken by the Government, like undertaking of an irrigation project or
construction of roads, is quite reasonable that the cost of such project is distributed in part
or in whole among the property owners. These special assessments are usually levied by
the local authorities, but Central and State Governments also make use of them.
Professor Seligman points out that the special assessment has certain characteristics.
a. There is an element of special purpose.
b. The special benefit to the individuals is measurable.
c. These assessments are not progressive, but proportional to the benefits conferred.
d. They are only for special improvements.
e. They are to defray the cost of specific project concerned.
f. They represent the exercise of the taxing power.
g. They are a compulsory payment.
h. They are capable of apportionment.
6. Receipts from public property
Income from the sale or lease of public property like lands, buildings, mines, forests, etc.,
constitutes one of the items of public revenue.
7. Receipts from public enterprises
The Government receives profit from public enterprises like railways, post-office, the
central bank, tolls, electricity department, etc. Public enterprises are commercial as well as
quasi-commercial enterprises. Commercial enterprises are those whose sole aim is profit-
maximisation eg. French Tobacco Monopoly. In these enterprises, the prices charged are
usually higher than what the prices would be under competition. Quasi-commercial
enterprises are those whose motive is also service or convenience of the people eg.
hospital. In these enterprises, prices may or may not be charged. Of course, incidentally
such services bring profits to the public authority.
8. Public Borrowings
Public borrowings refer to the proceeds of loans floated by the governments. Generally the
Governments borrow from their own citizens, banks in their countries, foreign countries,
and international financial institutions like the I. M. F and the I. B. R. D, etc., Voluntary
public loans from its own citizens are also accounted for under this category.
9. Receipts from the use of the printing press
Receipts from the use of the printing press by the use of paper money for the purpose of
meeting public expenditure are classified under this heading. The issue of token coins also
yields a profit to the Government. Even inflation can be included in this category as a
source of income to the Government.
10. Grants and Gifts
Grants are usually made by one government to another for the performance of a certain

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specified function in a specified manner. Grants-in-aid are given by the Central

Government to the State Government and local bodies, and by the State Governments to
the local bodies.
Gifts are voluntary contributions by private donors to the Government generally for some
specified purpose, especially in periods of war, famines, floods, etc.,

PRINCIPLES OF TAXATION
Introduction :

There are some important qualities necessary for a good taxation. They are known as canons of
taxation. Canons refers of principles.
Adam Smith’s Canons of Taxation :

i. Canon of Equality :
According to this canon, all the citizens of a country are equal before the law. All people should
be treated in an equal way for the purpose of taxation.
ii. Canon of Certainity :
According to this canon, every citizen should know the time of payment, the mode of payment,
the quantity to be paid etc. For example, even in modern days people should know exactly how
much they can pay by way of income tax and other taxes.
iii. Canon of Convenience :
According to this canon taxes should be imposed in such a manner that the people should find it
convenient to pay. For example, farmers can pay tax after harvest. This will help to reduce the
burden of taxation.
iv. Canon of Economy :
According to this canon, the administrative cost of tax collection should be minimum. As a
result the government need not spend a large amount of money in the collection of taxes.
Canons of taxation by other writers:

v. Canon of Productivity :
According to this canon, taxation should be able to increase productivity.
vi. Canon of Elasticity :
The government should follow the principle of elasticity while taxes are imposed. According to
this principle, there should be more revenue during the prosperity and less revenue during the
slack season.
vii. Canon of Diversity :
According to this principle, there should be a number of taxes in a country. A good taxation
should not depend on a number of taxes like direct and indirect taxes.

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EFFECTS OF TAXATION

INTRODUCTION:

Taxation is used not only for raising revenues but also for achieving the socio- economic
objectives in a country. For example taxation is interested in achieving economic growth,
control of trade cycles and removal of income and wealth. Dalton has discussed the effects of
taxation under the following heads.

1. Effects of taxation on production.

2. Effects of taxation on distribution.
3. Other effects of taxation.
1. EFFECTS OF TAXATION ON PRODUCTION
The effects of taxation on production can be discussed in the following ways :
a. EFFECTS ON ABILITY TO WORK AND SAVE :
Taxation means transfer of purchasing power from the hands of individual to the Government.
The purchasing power of the tax payer is reduced. This effect felt more strongly by the poor
people. It curbs the consumption of necessaries and comforts. Therefore heavy taxation on the
people affect their efficiency and ability to work.

At the same time all taxes do not adversely affect the ability of the people. For example, taxes
on commodities like liquor and opium will not affect productivity. They will increase the
efficiency of labour.

Saving depends on income and when income is reduced by taxation saving automatically
declines. Therefore heavy taxation affects the saving also.

b. EFFECTS ON THE DESIRE TO WORK AND SAVE :

Taxation affects the incentives of the people to work, save and invest. If the incentives of the
people are affected production will also automatically affected. Hence we have to analyse the
effects of taxation on the incentives to work, save and invest. The effect of taxation on
economic incentives depend upon the nature of taxes and the psychological reaction of the tax
payers.

Direct taxes like income tax affect the desire to work and save. At the same time taxes on wind
falls will not affect the desire to work and save. Similarly a tax on monopoly profit will not
affect the desire to work and save. But commodity taxation within reasonable limits will not
affect the desire to work and save. On the other hand, if the commodity taxation is heavy it may
affect the desire to work and save.

The comparative effects of an income tax, wealth tax, inheritance tax, and expenditure tax differ
in nature. The income tax and wealth tax generally check the desire of the people to work hard
and save more. A highly progressive income tax discourages most of the tax payer to working

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hard and saving more. But wealth tax has less effect, on the desire to work on the tax payer. In
the inheritance tax is paid by the tax payer from his unearned income and it does not affect his
desire to work and save.

The expenditure tax will have more favourable effects on the desire to work one save than
income tax. A progressive expenditure tax will discourage wasteful expenditure on
consumption and encourage saving and investment. The expenditure tax may be used to change
the composition of consumption.

The psychological reaction of the tax payer also affects the desire to work and save. When a tax
is announced the tax payer immediately feels that it will reduce its income. The psychology of
the tax payer may affect his desire to work hard and save more. This is known as “the
announcement effect”.

The rate of elasticity of income on desire to work and save is also important. If a person has an
elastic demand for income, his incentive to work and save may be affected. Hence production
may suffer. On the other hand if a person has an inelastic demand for income the incentive to
work and save may not be affected by taxation.

During prosperity the burden of taxation is not felt by the tax payers. During times of war also
people does not feel the burden of taxation.

c. EFFECTS OF TAXATION ON DIVERSION OF RESOURCES :

Taxation can affect the composition and pattern of production. Taxation may be used as an
instrument of physical policy for the diversion of resources between industries and regions.
Thus taxation can affect not only the size and growth of production but also the composition
and pattern.

If the product of certain industries are taxed their prices would rise and hence the demand for
their would be reduced. As a result the profit also reduced. Therefore the resources may be
shifted from one industry to another. There are different types of diversion are discussed below.

 BENEFICIAL DIVERSION :
Some diversions are readily beneficial to the progress and prosperity of the people. For example
taxes on intoxication may affect the health and welfare of the people. Therefore these articles
may be taxed.

As a result the resources employed may be shifted from these industries to useful industries.

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 HARMFUL DIVERSION :
When taxes are levied on essential goods the production of these goods affected. As a result
the profit is reduced and may try to produce non-essential goods. In this case the resources
are diverted from the production of useful goods to that of less useful goods.

 DIVERSION OF RESOURCES FROM PRESENT TO FUTURE :

Some times taxes are imposed in order to discourage consumption and to encourage savings.
As a result the resources are diverted from present uses to the future uses. It may affect
present production.

 DIVERSION OF RESOURCES FROM ONE STATE TO ANOTHER STATE :

When a particular state taxes heavily the investment may be shifted from that state to another.
As a result the resources are diverted from one part to another part. Sometimes even
resources may be shifted from one country to another country.

2. EFFECTS OF TAXATION ON DISTRIBUTION :

According Wagner, a German economist taxation should be used as an instrument to reduce
the inequality of income and wealth. The effects of taxation on the distribution of income and
wealth depend upon two factors namely,

a) Nature of taxation.
b) Kinds of taxes.

a. NATURE OF TAXATION :
The nature of taxation refer to the burden of taxation. In the case of regressive taxation the
inequality of income and wealth may increase. In the case of proportional taxation the
inequalities of income and wealth would remains the same. But in the case of progressive
taxation the inequality of income would be reduced.

b. KINDS OF TAXES :
The burden of indirect taxes is generally regressive in nature. Even the poor people are
rejected to heavy taxation. There is no exemption to the poor people in the case of
commodity taxation. Therefore burden of indirect taxes falls more heavily on the poor people
than on rich people.

Direct taxes can be used as an instrument for the equitable distribution of income and wealth.
For example income tax can be made as a progressive tax. The larger incomes are taxes at
higher rates than smaller income. Again the exemption is granted to the low incomes. In the
case of property tax, it reduces the incomes of the owner of the property.

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OTHER EFFECTS
a. EFFECTS OF TAXATION ON EMPLOYMENT :
Taxation reduces the purchasing power of the people which ultimately reduces the effective
demand. As a result the employment also falls down. On the other hand without taxation
production and effective demand improve. This leads to the generation of more and more of
employment.

But the above situation may true of developed countries. The Government needs a large
amount of money for large expenditure in underdeveloped countries. The public expenditure
improves the level of economic activity which turn increases the level of employment.

b. TAXATION AND INFLATION :

The aim of taxation during inflation is reduce to the purchasing power of the people. As a
result the consumption may fall down leading to stability in the economic activity. At the
same time new industries can be encouraged by exempting them from taxation.

CONCLUSION :

Thus taxation has a number of effects on income, raising employment and price level. In
modern days it has some regulatory effects also. Thus taxation is not a mere tool for getting
income but also powerful instrument for socio-economic changes.

https://www.geektonight.com/market-failure/#causes-of-market-failures
What is Market Failure?
In economics, Market failure occurs when there is an imbalance in the quantity of a product
demanded and supplied, which leads to an inefficient allocation of resources.
The success of the market is mainly dependent on the effective allocation of resources.
However, there are situations when markets fail to allocate these resources efficiently, which
is also known as market failure.
Market Failure Definition
Market failure can be defined as a situation where the quantity of a product demanded by
consumers is not equal to the quantity supplied by suppliers. It occurs mainly due to
inefficient allocation of goods and services in the free market.
In such a situation, the social costs incurred in the production of goods are not minimised,
resulting in wastage of resources. Thus, the equilibrium between supply and demand of the
product is not reached.
Market Failure Examples
Let us understand the concept of market failure with the help of an example.

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It is known that wages are defined in accordance with the minimum wage laws. Therefore,
wage rates are established at the going market-clearing wage to raise market wages. On this,
critics argue that employers prefer to employ less minimum-wage employees at a higher
wage cost. Consequently, more minimum-wage workers remain unemployed, thereby
resulting in market failure due to high social costs.
Causes of Market Failures

Market failures are not attributed to a single factor. There are various causes that can result in
market failures. However, there are four most important causes of market failures, as listed in
Figure
Causes of Market Failures are discussed below:
1. Externalities
2. Public goods
3. Information asymmetry
4. Imperfect market conditions
Externalities

Externalities can be defined as an impact of production and consumption of products

affecting the third-party (one who is neither a consumer nor the producer of the product).
Externalities can be either positive or negative.
 Positive externality can be defined as the positive impact of the consumption of a
product on the third-party.
 For example, an increase in education of individuals can result in an increase in
productivity, fall in unemployment and higher political participation in the country.
A positive externality is also known as an external benefit.
 Negative externality can be defined as the negative impact of the consumption of a
product on the third-party. In this case, the social cost of an activity exceeds the private
cost.

Example of a negative externality is noise pollution due to various sources, which can
be mentally and psychologically disruptive for nearby people. Negative externalities are
also known as an external cost.
It is to be noticed that both the above-mentioned externalities can result in market
inefficiencies.
In the case of a positive externality, a producer does not like to invest in the activity unless
the government aids him with a subsidy. Thus, there is underproduction of such goods.
On the other hand, in a negative externality, producers do not take into consideration the
external costs and keep on manufacturing large quantities of goods. Thus, both these
externalities require governmental regulations to prevent market failures.
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Public goods

Public goods are goods that are characterised by non-excludability and non-rivalry.
 By non-excludability, it means that a good that benefits an individual can be used by
others too to derive the same benefits.
 Non-rivalry implies that the enjoyment of using a product does not reduce the
satisfaction of those who have been using it from a certain time.
An example of a public good is the defence system, as it provides protection to all the
individuals of a nation. The problem with these goods is that they can be used by everyone
after made available making it impossible to regain the costs of the provision by extracting
payment from users resulting in market failures

Information asymmetry

Information asymmetry deals with the study of decisions in transactions, wherein one party
has access to more or better information than others. Due to the absence of the same
information to all the participants, individuals or organisations are unable to make the right
decisions. This results in an imbalance of power in transactions that can lead to market failure.
Due to information asymmetry, the following two problems occur:
 Adverse selection: This implies taking advantage of asymmetric information before the
transaction.

For example, a person may be more eager to purchase life insurance due to health
problems than, someone who is healthy.
 Moral hazards: This implies taking advantage of asymmetric information after a
transaction.

For example, if someone has car insurance he may commit theft by getting his car
stolen to reap the benefits of the insurance.
Imperfect market conditions

Market failure is also caused due to imperfect market conditions, such as monopoly
(existence of a single supplier in the market) and oligopoly (existence of few firms that
control the market). In the imperfect market structure, organisations have the market power to
influence prices. This can result in inefficiencies due to the following:
 Existing firms have the power to raise prices to increase their profits while the demand
remains the same.
Various barriers to entry by other firms restrict competition in the market.

 To prevent market failures due to the presence of market power, government

interventions are required to correct the market operations or set prices at a competitive
level.

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FEDERAL FINANCE

MEANING: Federation may be defined as a form of political association in which two or

more states constitute a political unity with a common government but in which the member
states retain a measure of internal autonomy. We can notice some important definitions of
federal finance by experts.

Author Definition

Federation is a form of government in which sovereignty or political

Sir Robert Gorson power is divided between the Central and Local Governments so that
each of them within its own sphere is
independent of the other

Federal principle is the method of dividing the powers so

Kenneth C. Wheare that the general and regional governments are each within its own
sphere, co-ordinate and independent.

Federalism is a special kind of decentralization where the division of

powers ensuring safeguards of the units of federation is
Wallace E.Oates constitutionally protected. Thus, the decision making at a particular
level of government is based on
delegation or constitutionally guaranteed authority.

Federal finance refers to the finance of the federal as well as

R.N.Bhargava of the state governments and the relationship between the two.

Principles of Federal Finance

In a federation there is a division of legislative, executive and financial powers between the
Centre and state governments. The duty of the federal government is to fulfill its
responsibilities towards the states while utilizing its own financial powers within its own
jurisdiction. To preserve federal principles Professor B.P.Adarker, in his celebrated book on
‘Principles and Problems of Federal Finance’ lays down three principles for the smooth
functioning of a federation. These principles of determining the financial policy in a federal
set up are explained below.

1) Principle of Independence and Responsibility: the first principle for the efficient and
smooth functioning of the federal financial system is that each government should have
independent financial resources and should be responsible for raising resources for
meeting its obligations. Financial independence and responsibility are two fundamental
requisites for the success of fiscal federalism. According to Professor. Adarker,”full
freedom of financial operations must be extended to both Federal as well as State
Governments in order that they may not suffer from a feeling of cramp in the discharge
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of their normal activities and in the achievement of their legitimate aspirations for the
promotion of social and economic advancement.” In other words, national and sub-
national governments should be financially independent within their own sphere.
Besides, each government should take the responsibilities of taxing, borrowing and
raising resources in their spheres for performing their functions. The authority which
has the pleasing job of spending money should also do the unpleasant job of taxing it.
Thus, “taxing autonomy and spending autonomy go hand in hand.”

However, it is very difficult to put in to practice the financial independence. This is

because of the problem like uniformity in tax rates throughout the federation, promotion
of economic growth, maintenance of internal and external stability, balancing social
and economic development in all regions etc. cannot be ignored. Professor Adarker
points out, “the cardinal principle to be followed in a financial settlement is that, as far
as practicable, the federal government and the states should be endowed with
independent sources of revenue free from mutual interference and that the balancing
factors should come in only marginally, so as to fill the gaps.”

2) Principle of Adequacy and Elasticity: the principle of adequacy means that the
resources of the federal government and local governments should be adequate so that
each layer of government can discharge its obligations laid upon it. Principle of
elasticity means that there must be feasibility to expand its resources in response to its
requirements especially during the period of internal and external crisis.

3) Administrative Economy and Efficiency: the administrative cost of finances should

be at minimum and there should be no tax evasion. Administrative efficiency can be
achieved, if the resources are allocated properly between the Centre and the state
governments.

Other Principles

1) Principle of Uniformity and Equity: Principle of Uniformity means that there should
not be any discrimination among different units in a federation, while distributing
resources among various states. Thus, the contribution of each state in federal taxes
should be according to ability or economic considerations. Similarly, in order to achieve
equity in taxation, a proper balance between direct and indirect taxes should be
maintained. Therefore, there should be a proper adjustment between federal and state
taxation to make the tax burden on all the citizens equitable as far as possible.

2) Principle of Accountability: freedom and democracy are interwoven in a federal

system. Therefore, the government in a federation should be accountable to its own
legislature for its spending and collecting revenue decisions.

3) Principle of Fiscal Access: this implies that there should not be bar on federal and
state governments in tapping new sources of revenue within their own prescribed areas
to meet the growing financial needs. That is, resources should grow with the expansion

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of responsibilities.

4) Principle of Transfer of Resources: this means that there should be provisions for
transferring the resources from one state to the other. The ideal allocation of resources
between federation and states should be in accordance with the principle of national
minimum which can be achieved through the transfer of resources from rich countries
to poor regions in a federal set-up.

5) Principle of Federal Supervision:there should be supervision by the federal

government to ensure whether state governments follow the rules and regulations with
regard to taxation and expenditure laid down by it from time to time.

6) Principle of Integration and Co-ordination: according to this principle, the whole

financial system of a federation should be well-integrated and coordinated. Integration
of financial systems of federal government and state governments is essential in
contemporary federations. Similarly, coordination is essential for smooth and efficient
functioning of federal financial system.

Social Principle of Federal Finance

The social principle of an effective system of federal finance is fiscal equity. Fiscal equity
requires that individuals in similar economic circumstances should receive equal net fiscal
benefits where they reside in the nation. For achieving fiscal equity in a federal country there
are two ways. Firstly, through introduction of equalizing transfers that provide additional
revenue to areas with relatively low revenue capacities and / or relatively high expenditure
needs, and secondly, through the imposition of basic minimum national standards with
respect to certain public goods.

Types of Fiscal Imbalances

There are two types of fiscal imbalances in a federal nation. They are 1) Vertical Fiscal
Imbalance and 2) Horizontal Fiscal Imbalance.

Vertical Fiscal Imbalance:

The important characteristic of federation is the co-existence of two main levels of

governments having the capacity to raise revenues and responsibility to carry out various
functions. The ideal situation a federation is to have a state of vertical balance. That is, a
matching of expenditure responsibilities and taxing powers, enabling each level of
government to be financially sufficient. The imbalance in this regard is termed to as vertical
fiscal imbalance. That is, vertical fiscal imbalancerefers to the difference between
expenditures and revenues at different levels of governments. Vertical fiscal imbalance arises
when one level of government financial resources exceeding its needs, whilst the other lacks
sufficient resources to carry out its functions. This is a common feature of all multi-level
governments.A common solution to tackle this type of imbalance is a scheme of
intergovernmental grants as a corollary to the allocation of taxing powers.

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Horizontal Fiscal Imbalance:Horizontal Fiscal Imbalance is referred to as the existence of

economic inequalities among the states such that, if they were all to have equal standards to
public expenditure from their own revenue sources, some of them would have to set their
taxes and other charges at a higher overall level to severity than others- a state of affair which
is convenient to describe as inequalities of fiscal capacity. In other words, horizontal fiscal
imbalance refers to the mismatch between revenues and expenditures of governmental units
within a level of governments. Such an imbalance is related to horizontal economic
imbalance. It refers to inter-state economic disparities resulting from differences in area,
climate, topography, soil and mineral resources, factor endowments etc.That is why,
horizontal fiscal imbalances are not exogenous to the States’ fiscal management and do not,
by themselves, provide a rationale for intergovernmental transfers.

Finance Commission

Under the provisions of the constitution, the president is required under Article 280 (1)
to constitute within two years from the commencement of the constitution and there after the
expiration of every fifth year or at such early year time as he may consider necessary.
The commission is charged with tremendous responsibilities of making requisite
recommendations to the president of India. The Finance Commission consists of a chairman
and four members to be appointed by the president.
Functions of Finance Commission
There are two important functions – Suggestive functions and making recommendations – to
be performed by the Finance Commission.

Suggestive Functions

1. To suggest the criteria of distribution between union and States of net proceeds which
are to be, or may be divided between them.

2. It determines the allocation of net proceeds between different states according to their
respective shares of proceeds.

3. Any modification or continuance of the term of any agreement entered in to by the

union government with the government of any State in part B of the First schedule
under clause (v) of Article 178 or Article 306

4. The principle which should govern the grants – in –aid of the revenue of different states
out of the consolidated fund of India.

5. Any other matter referred to the commission by the President of India.

Making Recommendations

1. The percentage of net proceeds of the Taxes which may be divided between Centre and
States.

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2. The allocation of shares of the proceeds of such taxes in percentages between different
States.

3. To determine the principle to govern the grants – in aid of the revenue out of the
consolidated fund of government of India between States.

4. The modification of continuances of the term of agreement regarding the levy of

International customs and duties with part B States.

5. Grants- in- aids in tribal areas and

6. Special grants for any particular state.

Finance Commissions in India

Year Chairman Operationa Year of Report Submission
l Duration
Nov. 1951 K.C. Neogi 1952-57 December 1952
June 1956 K. Santhanam 1957-62 September 1957
December 1960 A.K. Chanda 1962-66 December 1961
May1964 Dr P.V. Rajmannar 1966-69 August 1965
February 1968 MahavirTyagi 1969-74 July 1969
June 1972 Brahmananda Reddy 1974-79 November 1973
June 1977 J.M. Shelat 1979-84 October 1978
June 1982 Y.B. Chavan 1984-89 November 1983
June 1987 N.K.P. Salve 1989-95 March 1990
June 1992 K.C. Pant 1995-2000 November 1994
July 1998 Prof. A.M. Khusro 2000-2005 June 2000
July 2002 C. Rangarajan 2005-10 November 2004
October 2007 Vijay Khelkar 2010-15 DEC-2009
2012 Y.V.Reddy 2015-20 Constituted on 2nd January,
2013.

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Criteria and Relative Weights for Tax Devolution According to Latest Commissions

Report of the Thirteenth Finance Commission: 2010 – 2015 Background

The Finance Commission is constituted by the President under Article 280 of the
Constitution. Its main work is to give recommendations on distribution of central tax
revenues between the Union and the States. The Thirteenth Finance Commission submitted
its report in Parliament on February 25, 2010.
Terms of Reference
The Commission was asked to make recommendations on the following matters:
 The distribution of taxes collected between the centre and the states.
 The principles determining the grants-in-aid to states out of the Consolidated Fund of
India and the sums to be paid to states.
 The measures needed to augment the Consolidated Fund of a state to supplement
the resources of Panchayats and Municipalities.
 To review the state of the finances of the centre and the states in light of the operation
of the States’ Debt Consolidation and Relief Facility that was introduced on the
basis of the recommendations of the previous Finance Commission.
 To review the present arrangements regarding financing of disaster management.
 To suggest a new roadmap for fiscal consolidation in the period between 2010 and
2015.
Findings and Recommendations Sharing of Union tax revenues
 The share of states in net proceeds of shareable central taxes shall be 32 per cent in
each of the financial years from 2010-11 to 2014-15.
 The share of each state in the proceeds of all shareable central taxes in each of the
financial years from 2010-11 to 2014-15 shall be as specified.
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Finances of Union and States

1. Actual share in the tax revenue of the Centre which is devolved to states: The
Eleventh and Twelfth Commissions had recommended that the share of states be fixed
at 29.5% and 30.5% respectively, of central taxes. However, the actual shares devolved
to states have been lower than recommended by previous finance commissions. The
government has explained that when cesses and surcharges are taken into account, the
release to states is in keeping with the recommendations.
Recommendation: The Ministry of Finance should ensure that the accounts reflect all
collections so that there are no inconsistencies in the amounts released to states.

2. Losses in the power sector: Subsidy for the power sector is the largest component of
state government subsidies. The power sector in most states is beset with high losses,
and inefficient infrastructure, resulting in huge losses.

Recommendation: Losses in the power sector are expected to be a major drag on the
finances of State Governments, and therefore, the problems confronting this sector need to be
addressed in a time-bound manner.

3. Reduction of centrally sponsored schemes: Initiatives should be taken to reduce the

number of Centrally Sponsored Schemes and to restore the predominance of fund-
transfers based on Planning Commission recommendations.

Goods and Services Tax (GST)

The Commission has recommended the adoption of the GST and formulated a model GST.
The main features of the model GST are:

 The central portion of the GST would include (a) central excise duties, (b) service
tax, (c) additional customs duties, (d) all surcharges and cesses.

 The state GST would include (a) VAT, (b) central sales tax, (c) cesses and surcharges,
and others such as luxury tax, lottery tax, stamp duties, etc.

 There would be special provisions for certain goods such as petroleum, and exemptions
would be allowed only on the basis of a common list applicable to all states and the
centre.

Union Finances
The central government has recently decided that proceeds from disinvestment shall be used
fully as capital expenditure for social sector programmes. This policy needs to be liberalised
and proceeds should also be used for augmenting critical infrastructure and environment
related projects.

State Finances
The practice of diverting plan assistance to meet non-plan needs of special category states
should be discontinued.

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For PSUs: − All accounts and backlogs of PSU accounts should be cleared by states.

– States need to draw a roadmap for closure of non-working PSUs by March 2011.
Divestment and privatisation of PSUs should be considered and actively pursued.

Power Sector:

– Reduction of Transmission and Distribution (T&D) losses should be attempted.

– Unbundling needs to be carried out on priority basis and open access to transmission
strengthened.

– Proper systems should be put in place to avoid delays in completion of hydro projects.

– Regulatory institutions should be strengthened through capacity building, consumer

education and tariff reforms.

Regarding reforms in the area of pensions, a switch to the New Pension Scheme needs to be
completed at the earliest.

Revised roadmap for fiscal consolidation Central government

– The revenue deficit of the Centre needs to be progressively reduced and eliminated,
followed by emergence of a revenue surplus by 2014-15.

– A target of 68 percentage of GDP for the combined debt of the centre and states should
be achieved by 2014-15.

– The Medium Term Fiscal Plan should be reformed and made a statement of
commitment rather than a statement of intent.

– A number of disclosures including detailed break-up of grants to states, systematised

statement on tax expenditure, compliance costs of major tax proposals, fiscal impact of
major policy changes, should be made with the annual budget.

– The government should list all public sector enterprises that yield a lower rate of return
on assets than a norm which should be decided by an expert committee.

– An independent review mechanism should be set-up by the Centre to evaluate its fiscal
reform process.

State governments:

– States should be able to get back to the path of fiscal consolidation after the disruption
caused in 2008-09, and 2009-10. States with zero revenue deficit or revenue surpluses
in 2007-08 should eliminate revenue deficit by 2011-12. Other states should do so by
2014-15.

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– General category states with zero revenue deficits in 2007-08 should achieve a fiscal
deficit of 3 percent of GDP by 2011-12. Other states should do so by 2013-14.

– States should amend/enact Fiscal Responsibility and Budget Management Acts to

build on the fiscal reform path worked out.

– State-specific grants recommended for a state should be released upon compliance.

– Borrowing limits for states to be worked out by Finance Ministry using the fiscal
reform path, thus acting as an enforcement mechanism for fiscal correction by states.

– Loans from the central government to states and administered by ministries/departments

other than Ministry of Finance, outstanding as at the end of 2009-10, should be
written off.

Local Bodies
Local bodies should be transferred 2.28% of the divisible pool of taxes (over and above the
share of the states), after converting this share to grant-in-aid under Article 275. This amount
adds up to Rs 87519 crores.

Article 280 (3) (bb) & (c) of the Constitution should be amended to make the
recommendations of the State Finance Commissions less binding on state governments.

Article 243(I) of the Constitution should be amended to empower states governments to

constitute and direct state Finance Commissions to give their report before the National
Finance Commission finalises its report.

 State governments should strengthen their local audit departments through capacity
building.

 Bodies similar to the SFC should be set up in states which are not covered by Part IX
of the Constitution (Panchayats).

 Local Bodies should be associated with city planning functions wherever other
development authorities are mandated for this function.

 State governments will be eligible for the general performance grant and the special
areas performance grant only if they comply with the prescribed stipulations.

Disaster Relief

 Assistance of Rs 250 crore to be given to the National Disaster Response Force

(NDRF) to maintain an inventory of items required for immediate relief.

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 Provisions relating to the District Disaster Response Fund in the Disaster

Management Act may be reviewed and setting up of these funds left to the discretion
of the individual states.

 The list of disasters to be covered under the scheme financed through FC grants
should remain as it exists. However, man-made disasters of high-intensity may be
considered for NDRF funding.

Grants-in-aid to States
For augmenting the resources of rural local bodies, the Commission has recommended award
of grant based on certain principles. The grant has two main components.

Basic Grant – For 5 years (2010-11 to 2014-15)

Performance Grant – For 4 years (2011-12 to 2014-15)

A small portion of grants is allocated to Special Area covered by the V & VI Schedules and
areas exempted from the purview of Part X and XI (A) of the constitution.

This grant is called “Special Area Basic Grant”, and accessible for all the five years to meet
some of the development needs of these areas.

GRANTS RECOMMENDED BY THE 13th FINANCE COMMISSION

( in Crore)

Components 2010-11 2011-12 2012-13 2013-14 2014-15 Total

1 General Basic 241.29 279.78 326.99 387.43 458.71 1694.20
Grant

2 General 0.00 95.66 224.41 264.70 312.23 897.00

Performance

3 Special Area 19.39 19.39

Grant
Total 260.68 375.44 551.40 652.13 770.94 2610.59

The Commission has specially recommended using the above grants on the following
components:
 Drinking water supply
 Sewage, solid waste management (rural sanitation)
 Operational Expenses (Maintenance of Accounts, Conducting of Audits, Creation of
Database etc.)
 Non-Plan Revenue Deficit: Eight special category states (Arunachal Pradesh,
Himachal Pradesh, Jammu and Kashmir, Manipur, Meghalaya, Mizoram,
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Nagaland, Tripura) have non-plan revenue deficits. For these states grant of Rs
51,800 crore is recommended.

 Elementary Education: A grant of Rs 24,068 crore is recommended for elementary

education over the award period. The education grant will be additional to the normal
expenditure of the states for elementary education.

 Environment:

− An amount of Rs 5000 crore is recommended as forest grant for the award period.

− Twenty five per cent of the grants in the last three years are for preservation of forest
wealth.

− An incentive grant of Rs 5000 crore is recommended for developing grid- connected

renewable energy based on the states’ achievement in renewable energy capacity
addition from 1 April 2010 to 31 March 2014.

− An amount of Rs 5000 crore is recommended as water sector management grant for

four years.

 Improving Outcomes

− States should be incentivised to enrol residents who participate in welfare schemes

within the Unique Identification (UID) programme. A grant of Rs 2989 crore is
proposed to be given to State Governments.

− A grant of Rs 5000 crore is recommended for reducing their Infant Mortality Rates.

− A grant of Rs 5000 crore is proposed to support improvement in a number of facets in

the administration of justice.

− A grant of Rs 10 crore will be provided to each general category state and Rs. 5 crore to
each special category state to set up an employees’ and pensioners’ data base.
 Maintenances of Roads and Bridges
- An amount of Rs 19,930 crore has been recommended as grant for maintenance of
roads and bridges for four years. This is additional to the normal expenditure incurred
by states.

 State-specific needs

- A total grant of Rs 27,945 crore is recommended for state-specific needs. Release of

this grant and expenditure will be subject to certain conditions.

IMPORTANCE OF LOCAL GOVERNMENTS IN INDIA

“Independence must begin at the bottom. Thus, every village will be a republic or
panchayathaving full powers.”Gandhiji
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India has the distinction of being a unique federal country. Ordinarily, federalism involves
a two tier system – central/union government at the first level and the state/provincial
government at the second level. But the Indian constitution provides for a three tier federal
structure as below: -

Union Government at the top,

State Government in the Middle and LocalGovernment, i.e.,Panchayats and

Municipalities at Grass Root.

As such, in India, Local Government is the third stratum of the Government, the first two
being the central and state Governments. India is known to be the world’s largest democracy.
In constitutional sense, democracy is the system of Government, in the administration of
which, every adult citizen of the country enjoys some direct or indirect share. Keeping in
view the real spirit and high ideas of democracy, Local Government forms an indispensable
part of governance and administration in India. The Local Government’s jurisdiction is
limited to a specific area and its functions relate to the provision of civic amenities to the
population being within its jurisdiction. A Local Government functions within the provisions
of the statute which has created it. It is subordinate to the state or provincial government
which exercises control and supervision over it. But the activities of the Local Government
are not less numerous. Some important functions are explained below.

 Local Government has been undertaking new activities:

- They regulate the conduct of the citizens.

- They are in the nature of service such as provision of mass transport, construction of
houses for the poor, supply of electricity, health centres, parks, play grounds etc.
 Local Government is today much more important in the daily life of a citizen than
the state or central government: The importance of Local government can hardly be
over emphasized when we consider the range, the character and the impact upon the
daily life of the citizen of the functions which local authorities carry out.

 Local Government provides public amenities and services: They are necessary for
the convenience, healthful living and welfare of the individual and the community.
If these services were suddenly to cease, we should relapse into chaos.

 The Local Government institutions are based on the principle of division of

labour: They are indispensable because the aggregate duties of government and local
authorities can thus be shared.

Need for the Study

Town and villages are two distinct entities in India. They have different needs and problems.
The main requirements of towns are the provisions of housing, transport,
communications, water supply,sanitary conditions, community canters, slum clearance
and town planning while main emphasis in the village has to be on improvement of
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agriculture, irrigation facilities, animal husbandry, village industries and the like. The
personnel of Urban Local Government and Panchayati Raj institutions would thus require
specialised training to cater the specific needs of urban and rural areas respectively. The study
therefore, emphasises the need for two distinct set of personnel requirement for the urban and
rural local bodies.

MEANING OF LOCAL GOVERNMENTS

It is not easy to answer the question “what is local government”? Local Government may be
described as government by popularly elected bodies charged with administrative and
executive duties in matters concerning the inhabitants of a particular district or place and
vested with powers to make bye-laws for their guidance. Local Government has been defined
from various angles. It has been defined as “an authority to determine and execute measures
with in restricted area inside and smaller than the whole state.” The term “Local
Government” literally means management of the local affairs by the people of the locality. It
is based on the principle that the local problems and needs can be looked by the people of the
locality better than by central or state governments. The administration of local affair is
entrusted to the representatives elected by the people of the locality on regular intervals.
Though local government institutions enjoy autonomy of operations, it does not mean that
there are no legal restrictions upon them. The central and state governments are free to
prescribe the limits within which a local government has to operate and also reserve the right
to issue directions from time to time. The term “Local Government” or “Local-self-
government’ means the government by freely elected local bodies which are endowed
with power, discretion and responsibility to be exercised and discharged by them, without
control over their decisions by any other higher authority. Their actions are, however,
subjected to the supremacy of the national government. Defining local self-government, it
has been observed that: Local inhabitants representing local body possessing autonomy
within its limited spheres, raising revenue through local taxation and spending its income on
local services constitute the local-self-government. For a better understanding of the
concept of Local Government and its meaning, scope and nature, it shall be desirableto study
a few important definitions and interpretations from various sources. As per the General
Clauses Act, 1897 “Local Government shall mean the person authorized by law to
administer executive K. Venkata Rangiah “Local Government in India”, Bombay
(1969), p. 1. Government in the part of British India in which the Act or Regulation
containing the expression operates and shall include a Chief

Commissioner. The word Local Government also finds mention in the Government of India
Act, 1935. According to eminent scholar and political scientist Clarke, “Local Government is
that part of the Government of a nation or state which deals mainly with such matters as
concern the inhabitants of the particular district of places, together with those matters which
parliament has deemed it desirable should be administered by local bodies, subordinate to the
Central Government. According to
D. Lockard Opines that local government may be loosely defined as a public
organization, authorized to decide and administer a limited range of public policies
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within relatively small territory which is a sub division of a regional or national

government. According to M. Goetz “Self-Government implies merelya form of
communal administration”.

Thus, the essential characteristics of Local Government are (i) its statutory status (ii) its
power to raise finance by taxation in the area under its jurisdiction, (iii) participation of local
community in decision making in specified subjects and their administration (iv) the freedom
to act independently of central control and (v) its general purpose, in contrast to single
purpose, character.

“The greater the power of the panchayats the better for the people…”- M.K.Gandhi.

MAJOR TAXES OF THE LOCAL SELF GOVERNMENTS IN INDIA

1) Taxes on Land and Buildings.
2) Octroi and terminal taxes.
3) Taxes on Animals and Boats
4) Taxes on Vehicles.
5) Taxes on Professions, Trades and Employment.
6) Taxes on advertisement other than those published in newspapers.
7) Other miscellaneous taxes like theatre or show tax, duty on transfer of property,
taxes on goods, passengers carried by roads, railways or tolls etc.

MODEL QUESTIONS

1) Explain the concept of federal finance.

2) What are the important principles of federal finance?
3) What is finance commission? State the functions of finance commission.
4) Explain the important recommendations of the Thirteenth Finance Commission.

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