Introduction of Taxation

1.1 Define the concept of public finance

Public finance is defined as the study of the financial activities of government and public
authorities. It describes and analyses the expenditures of government and the techniques used
to finance these expenditures. It studies the activities discharged, and services provided by the
government and the taxes being used to generate its funds. It examines the influence of
government financial operations on growth, employment, prices etc.
In simple terms, public finance is a study of the financial aspects of the government. Charles
F. Bastable stated, “Public finance deals with expenditure and income of public authorities
of the State and their mutual relation as also with the financial administration and control”.
Public finance stands for the resources of a public body and a study of the principles to acquire
finances and using the funds for public services and activities.
Carl Plehn defined public finance as, “the science which deals with the activity of the
statesman in obtaining and applying the material means necessary for fulfilling the proper
functions of the State”.
Findlay Shirras defined public finance as, “the study of the principles underlying the spending
and raising of funds by public authorities.”
Hugh Dalton considered public finance as “concerned with the income and expenditure of
public authorities and with the adjustment of the one to the other. The principles of public
finance are laid down regarding these matters”.
Musgrave stated that “the objectives of public finance are allocating resources for the
provision of public services and to ensure growth and development, ensure macroeconomic
stabilization and bring about the desired distribution of incomes”.
It can be summarized from the above-mentioned definitions that public finance is categorized
into public income and public expenditure as two symmetrical branches of the subject.

1.2 Define the concept of private finance

Private Finance is the study of the revenue and expenditure activities of an individual or a
company. Under private finance, individuals or private entities have fewer resources to
generate income, and this income is used to create profit and meet personal desires.

1.3 Distinction between Public and Private Finance:

There is a clear distinction between private and public finance. Public finance refers to the
public funds and their utilization to meet people’s needs, whereas private finance refers to
individual wealth. Given below are the differences in Table:
Table No. 1.1: Distinction between Public and Private Finance

S. Public Finance Private Finance

No.
1. The government agencies balance their income Individual adjusts the expenditure to
and expenditure. the income.
2. A government agency does not save anyfunds Individuals tend to save money and keep
and has to spend whatever revenues have been it aside for rainy days or simply to have
accrued. a surplus budget.
3. The government agencies have the power to A person can only take loan from
raise loans internally and externally. another person or from another external
agency.
4. There is flexibility in public finances, for Individuals do not have unlimited funds.
example, the government can resort to deficit
financing.
5. The government can take recourse to An individual cannot use compulsive
compulsive measures. measures to get income.
6. The government in case of any emergency has A private individual cannot print notes.
the authority to print notes.
7. The scope of public finance is wide. Private finance has limited scope.
8. Has a compulsory characteristic as it has to Private finance can be optional as some
incur certain expenditure which is necessary for expenses can be postponed.
example, defense or civil administration.

It can be summarized that public sector finance comprises all the government owned agencies,
companies, and other offices with the objective of creating social benefits. The main
beneficiary is the citizen. Public finance many a times faces the problem of scarcity. On the
other hand, private finance is related to the corporate sector and individuals. The beneficiary
of private finance is the individual. However, public, and private finance both contribute to
the economy and rely on each other towards economic growth.

1.4 Objectives of Taxation:

The primary purpose of taxation is to raise revenue to meet huge public expenditure. Most
governmental activities must be financed by taxation. But it is not the only goal. In other
words, taxation policy has some non-revenue objectives.
Truly speaking, in the modern world, taxation is used as an instrument of economic
policy. It affects the total volume of production, consumption, investment, choice of
industrial location and techniques, balance of payments, distribution of income, etc.
Here we will discuss the objectives of taxation in modern public finance:
1. Economic Development
2. Full Employment
3. Price Stability
4. Control of Cyclical Fluctuations
5. Reduction of BOP Difficulties
6. Non-Revenue Objective
Objective # 1. Economic Development:
One of the important objectives of taxation is economic development. Economic
development of any country is largely conditioned by the growth of capital formation. It
is said that capital formation is the kingpin of economic development. But LDCs usually
suffer from the shortage of capital.
To overcome the scarcity of capital, governments of these countries mobilize resources so
that a rapid capital accumulation takes place. To step up both public and private
investment, government taps tax revenues. Through proper tax planning, the ratio of
savings to national income can be raised.
By raising the existing rate of taxes or by imposing new taxes, the process of capital
formation can be made smooth. One of the important elements of economic development
is the raising of savings- income ratio which can be effectively raised through taxation
policy.
However, proper care has to be taken, regarding investment. If financial resources or
investments are channelized in the unproductive sectors of the economy the economic
development may be jeopardized, even if savings and investment rates are increased.
Thus, the tax policy has to be employed in such a way that investment occurs in the
productive sectors of the economy, including the infrastructural sectors.
Objective # 2. Full Employment:
Second objective is the full employment. Since the level of employm ent depends on
effective demand, a country desirous of achieving the goal of full employment must cut
down the rate of taxes. Consequently, disposable income will rise and, hence, demand for
goods and services will rise. Increased demand will stimulate investment leading to a rise
in income and employment through the multiplier mechanism.
Objective # 3. Price Stability:
Thirdly, taxation can be used to ensure price stability—a short run objective of taxation.
Taxes are regarded as an effective means of controlling inflation. By raising the rate of
direct taxes, private spending can be controlled. Naturally, the pressure on the commodity
market is reduced.
But indirect taxes imposed on commodities fuel inflationary tendencies. High commodity
prices, on the one hand, discourage consumption and, on the other hand, encourage
saving. Opposite effect will occur when taxes are lowered down during deflation.
 Objective # 4. Control of Cyclical Fluctuations:
Fourthly, control of cyclical fluctuations—periods of boom and depression—is considered
to be another objective of taxation. During depression, taxes are lowered down while
during boom taxes are increased so that cyclical fluctuations are tamed.
Objective # 5. Reduction of BOP Difficulties:
Fifthly, taxes like custom duties are also used to control imports of certain goods with the
objective of reducing the intensity of balance of payments difficulties and encouraging
domestic production of import substitutes.
Objective # 6. Non-Revenue Objective:
Finally, another extra-revenue or non-revenue objective of taxation is the reduction of
inequalities in income and wealth. This can be done by taxing the rich at higher rate than
the poor or by introducing a system of progressive taxation.

1.5 Canons of Taxation

By canons of taxation we simply mean the characteristics or qualities which a good
tax system should possess. It refers to the guiding rules and principle to make tax collection
system effective and functional. In fact, canons of taxation are related to the administrative part
of a tax as it is related to the rate, amount, method and collection of a tax. Canons of Taxation
are broadly classified into two heads as:

A) Adam Smith’s canons of taxation

B) Additional canons of Taxation
A) Adam Smith’s canons of taxation: In his famous book ‘Wealth of Nation’, Adam Smith
presented 4 canons of taxation which are also commonly referred to as the Main Canons of
Taxation. Theyare as follows:
1) Canon of equality or equity: By equality is meant equality of sacrifice.
Accordingly, Canon of equality states that the burden of taxation must be distributed equally or
equitably in relation to the ability of the tax payers. Hence, to ensure canons of equality, taxes
are to be imposed in accordance with the principle of ability to pay.
2) Canon of Certainty: This canon argues that the tax which an individual has to pay
should be certain and not arbitrary with respects to the time of payment, the manner of payment,
the quantity to be paid (tax liability) etc. In other words, Canon of Certainty states that there
must be certain to the taxpayer as well as to the tax-levying authority in respect to certainty of
revenue the government intends to collect over the given time period.

3) Canon of Economy: This canon implies that the cost of collecting a tax should be as
minimum as possible. Any tax that involves high administrative cost and unusual delay in
assessment and high collection of taxes should be avoided altogether.
4) Canon of Convenience: According to this canon, taxes should be levied and collected
in such a manner that it provides the greatest convenience not only to the taxpayer but also to the
government. For example, it is convenient to pay a tax when it is deducted at source from the
salaried classes at the time of paying.

B) Additional canons of Taxation: Some modern writers on Public Finance such as

Charles Francis Bastable (Irish classical economist:1855–1945) provided additional canons of
taxation which areas follows:
1) Canon of Productivity: A tax is said to be a productive one only when it acts as an
incentive to production. Accordingly, this canon implies that a tax must yield sufficient revenue
and not adversely affect production in the economy.

2) Canon of Elasticity: According to this canon, an ideal system of taxation should

be fairly flexible in nature in accordance with the requirement of the country. Flexible taxes
are more suited for bringing social equality and achieving equal distribution of wealth.

3) Canon of Simplicity: The system of taxation should be made as simple as possible

as complicated tax is bound to yield undesirable side-effects. In other words, every tax must be
simple and intelligible to the people so that the taxpayer is able to calculate without any
difficulty.

4) Canon of Diversity: This canon simply implies that taxation must be dynamic
which means that there should be a multiple tax system of diverse nature rather than having a
 single tax system. A dynamic or a diversified tax structure will result in the allocation of
burden of taxes among the vast population resulting in a low degree of incidence of a tax in
the aggregate.

5) Canon of Expediency: This canon states 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.

From the above discussion, it follows that taxation serves the following purposes: (i) To
raise revenue for the government (ii) To redistribute income and wealth from the rich to the
poor people (iii) To protect domestic industries from foreign competition (iv) To promote
social welfare.

1.6 Classification of taxes

Direct and indirect taxation
1. Direct taxation - this is taxation on income. This covers taxes like income tax, profits
tax, gift tax, property tax, corporate tax, and wealth taxes on inheritance.
2. Indirect taxation - this is taxation on expenditure. This covers taxes like VAT, sales,
customs, Goods and Services Tax (GST), excise duties (tax on cigarettes, alcohol etc.).
Progressive, regressive and proportional taxes
Taxes differ according to their impact on different income groups. Some taxes will redistribute
from better-off groups to less well-off and these are called progressive taxes. However, others
will have the opposite effect and these are called regressive taxes. The definitions that you
need to know are:
 Progressive tax - a tax that takes a greater proportion of a person's income as their income rises.
 Regressive tax - a tax that takes a smaller proportion of a person's income as their income rises.
 Proportional tax - a tax where the percentage of income paid in taxation always stays the same.

The balance of these taxes can have a significant effect on income distribution in an economy.
If a government chooses to switch the balance of taxation from progressive to regressive taxes
then the less well-off in society will be hardest hit. In general, direct taxes tend to be
progressive and indirect taxes regressive.
Governments with differing objectives will often aim to change the balance of direct and
indirect taxes. Right wing governments may choose to shift the balance of taxation from direct
to indirect. They will argue that this is more efficient as it allows people to keep more of what
they earn - giving them more incentive to work hard. Taxing people on expenditure is seen as
more economically efficient. However, a switch from progressive direct taxes to regressive
indirect taxes will have an adverse impact on the distribution of income.