Assignment

PUBLIC FINANCE

Course- B.COM (HONS.)

Date of submission- 15th April 2022

Question NO. 1
What are the "Market failures"? Discuss various
reasons for market failures, especially in the
context of public good and externalities.
Solution:-
Market failure is a situation in which the free market leads to
misallocation of society's scarce resources in the sense that there is
either overproduction or underproduction of particular goods and
services leading to a less than optimal outcome. The reason for market
failure lies in the fact that though perfectly competitive markets work
efficiently, most often the prerequisites of competition are unlikely to
be present in an economy. Market failures are situations in which a
particular market, left to itself, is inefficient. We shall first try to
understand why markets fail and later, in the subsequent unit, proceed
to identify the role of government in dealing with market failure.
For example, a thermal power plant that uses coal may not have to
include or pay completely for the costs to the society caused by fumes
it discharges into the atmosphere as part of the cost of producing
electricity.
There are four major reasons for market failure. They are:
• Market power
• Externalities
•Public goods
• Incomplete information
Let us understand these in detail-

I. Market Power-
Market power or monopoly power is the ability of a firm to profitably
raise the market price of a good or service over its marginal cost. Firms
that have market power are price makers and therefore, can charge a
price that gives them positive economic profits. Excessive market
power causes the single producer or a small number of producers to
produce and sell less output than would be produced in a competitive
market. Market power can cause markets to be inefficient because it
keeps price higher and output lower than the outcome of equilibrium
of supply and demand.

II. Externalities-
Externalities are also referred to as 'spillover effects', 'neighborhood
effects' 'third-party effects' or 'side-effects', as the originator of the
externality imposes costs or benefits on others who are not responsible
for initiating the effect. Externalities may be unidirectional or
reciprocal. Suppose a workshop creates earsplitting noise and imposes
an externality on a baker who produces smoke and disturbs the
workers in the workshop, then this is a case of reciprocal externality. If
an accountant who is disturbed by loud music but has not imposed any
externality on the singers, then the externality is unidirectional.
Externalities can be positive or negative. Negative externalities occur
when the action of one party imposes costs on another party. Positive
externalities occur when the action of one party confers benefits on
another party.
Examples:
If individuals decide to switch from consumption of ordinary vegetables
to consumption of organic vegetables, then their price will rise.
The four possible types of externalities are:
• Negative production externalities
A negative externality initiated in production which imposes an external
cost on others may be received by another in consumption or in
production.
As an example, a negative production externality occurs when a factory
which produces aluminum discharges untreated waste water into a
nearby river and pollutes the water causing health hazards for people
who use the water for drinking and bathing. Pollution of river also
affects fish output as there will be less catch for fishermen due to loss
of fish resources. The former is a case where a negative production
externality is received in consumption and the latter presents a case of
a negative production externality received in production.
• Positive production externalities
A positive production externality initiated in production that confers
external benefits on others may be received in production or in
consumption.
For Example- The case of a beekeeper who locates beehives in an
orange growing area enhancing the chances of greater production of
oranges through increased pollination.
A positive production externality is received in consumption when an
individual raises an attractive garden and the persons walking by enjoy
the garden.
• Negative consumption externalities
Negative consumption externalities are extensively experienced by us
in our day to day life. Such negative consumption externalities initiated
in consumption which produce external costs on others may be
received in consumption or in production.
Examples to cite where they affect consumption of others are smoking
cigarettes in public place causing passive smoking by others, creating
litter and diminishing the aesthetic value of the room and playing the
radio loudly obstructing one from enjoying a concert.
• Positive consumption externalities
A positive consumption externality initiated in consumption that
confers external benefits on others may be received in consumption or
in production.
For example, if people get immunized against contagious diseases, they
would confer a social benefit to others as well by preventing others
from getting infected. Consumption of the services of a health club by
the employees of a firm would result in an external benefit to the firm
in the form of increased efficiency and productivity.
How do Externalities Cause Market Failures?

III. Public goods

A public good (also referred to as collective consumption good or social
good) is defined as one which all enjoy in common in the sense that
each individual’s consumption of such a good leads to no subtraction
from any other individuals’ consumption of that good.
There are two fundamental characteristics of public goods that lead to
market failure.
Non-rivalry: A good is non rival in consumption if more than one
person can consume the same unit of good at the same time. The
consumption from individual does not diminish the amount available
for others.
Non-excludability: A good is non-excludable if the supplier cannot
prevent consumption by people who do not pay. If the person does not
contribute to the provision of that good, they cannot be prevented
from enjoying that good.
Public good is thus any good that has non-rival in consumption and
non-excludable.

Characteristics of Public Goods-

• Public goods yield utility to people and are products (goods or
services) whose consumption is essentially collective in nature. No
direct payment by the consumer is involved in the case of pure public
goods.
• Public good is non-rival in consumption. It means that consumption of
a public good by one individual does not reduce the quality or quantity
available for all other individuals. When consumed by one person, it
can be consumed in equal amounts by the rest of the persons in the
society. That is, your consumption of a public good in no way interferes
with its consumption by other people. For example, if, you eat your
apple, another person too cannot eat it. But, if you walk in street light,
other persons too can walk without any reduced benefit from the
street light.
• Public goods are characterized by indivisibility. For example, you can
buy chocolates or ice cream as separate units, but a lighthouse, a
highway, an airport, defence, clean air etc. cannot be consumed in
separate units. In the case of public goods, each individual may
consume all of the good i.e. the total amount consumed is the same for
each individual.
•Public goods are generally more vulnerable and non-excludable to
issues such as externalities, inadequate property rights, and free rider
problems.
The Free Rider Problem
A free rider is a consumer or producer who does not pay for a
nonexclusive good in the expectation that others will pay. On account
of the free rider problem, there is no meaningful demand curve for
public goods. If individuals make no offers to pay for public goods, then
the profit maximizing firms will not produce them.

IV. INCOMPLETE INFORMATION

Complete information is an important element of competitive market.
Perfect information implies that both buyers and sellers have complete
information about anything that may influence their decision making.
People are ignorant or not aware of many matters in the market.
Generally they have inaccurate or incomplete data and consequently
make potentially ‘wrong’ choices / decisions.
Information failure is widespread in numerous market exchanges.
When this happens misallocation of scarce resources takes place and
equilibrium price and quantity is not established through price
mechanism. This results in market failure.

Question 2.
Write a detailed essay on the Ability-to-pay theory
of taxation and its practical usefulness.
Solution:-
The ability-to-pay philosophy of taxation maintains that taxes should be
levied according to a taxpayer's ability to pay. The idea is that people,
businesses, and corporations with higher incomes can and should pay
more in taxes. The progressive tax, or higher tax rates for people with
higher incomes, is based on this principle.
Income is accepted as fair index of measurement. Because amount
and source are also considered.
Approach to measure ability to pay theory
1. Subjective Approach: Based on the psychological or mental reaction
of the taxpayer. Estimate the tax burden or sacrifices undergone by
him. Each taxpayer should made equal sacrifice.
2. Objective Approach: Professor Seligman has used the term faculty to
indicate ability in the objective. Also known as faculty theory of ability
to pay. It takes various external factor including taxpayer income,
property etc. to measure the tax liability of an individual.
e.g., for example, it considers that not only the income as search but
also how his income has earned and how this property is acquired.
INDEX OF ABILITY TO PAY
● Property: Accumulated wealth and property was considered the
index of ability to pay rather than income. But property is not primary
test of ability, but it can be a supplementary index of ability due to
following reasons:
I. Important source of income but all property does not yield income
II. Not continuous
III. May Vary
IV. Property is taxed on its capital value
V. Regarded supplementary shows.
a. Ownership of property give the owner additional capacity of paying
tax.
b. Greater degree of paying tax ability
● Income: The second index ability to pay can be accepted as income.
Gross income includes the elements of cost while net income is
obtained after paying cost .Net income is a better index of measuring
tax paying than gross income Adam Smith was the first who accepted
income as a measure of tax paying ability now it is Generally Accepted.
● Size of the family: It is also considered. A large size of the family with
Given income may have smaller tax paying ability than of small size. So,
size of family can be considered while determining the tax pain ability
of an individual. But cannot be taken as the primary measure of tax
paying ability.
● Consumption: consumption expenditure has been suggested as a
measure of estimating tax paying ability of an individual. Taxation on
property and income can be manipulated / Fisher and professor kador
advocated taxation on expenditure. But it has not attained an
prominence. Income is the most widely used as measurement of tax
paying ability.
DEVELOPMENT OF THE ABILITY TO PAY
● Distribution of tax payment should be just
● Taxation according to faculty or ability
● It means first property and then income
● Argument for progressive taxation is based on faculty
● Traced back to an easy by Guicciardinii and a case for proportional
Taxation was made by Bodin.
● Principle Amended and developed by Bodin, Rousseau, Sismondi,
Mill, Wagner, and Franklin Roosevelt
● JS mill rejected the benefit approach, and A Different principle of
Taxation is needed this new Principle I E principle of faculty or ability to
Pay is based on the logic that all should be treated equally.
Justification to ability theory
● Equality of sacrifice
● Diminishing marginal utility
● Faculty interpretation, Faculty is represented by the Income, wealth
and property level of taxation should increase in higher proportion then
increase in income and property.
Defects
According to Prof. Seligman: property index suffers from the limitation:
i. Property tax is regressive
ii. Lack of ability to reach private property
iii. Lack of uniformity
iv. Incentive to dishonesty

Question-3
Briefly discuss the current issues of india’s tax
system.
Solution:-
Current issues of India’s tax system:-
 Direct Taxes: The tax paid is known as such because the burden
directly falls on the taxpayer. The government levies tax on the
residents, business entities and non-business entities. The tax
levied depends on the capacity of the individual and the
residential status.
Disadvantages-
1. Inconvenient: as they are directly being levied to the taxpayer it
pinches the taxpayer so they find ways to avoid paying tax
2. Evadable: the taxpayer can submit false returns and evade the
taxes.
3. Social conflict: Direct tax encourages social conflict as not every
part members of the society has to pay direct taxes.
4. Discourages Savings and Investment: Excessive increase in direct
taxes may discourage savings and investment which in long term
will affect country’s economy.

 Indirect Taxes: These taxes are levied indirectly on the taxpayer. It

is a vast ocean as many number of taxes come under indirect
taxes such as Customs, Union Excise Duties, Service Tax,
Entertainment Tax, Tax on Vehicle etc., These taxes are governed
more by notifications given time to time by the Government
rather than an Acts enacted by the Parliament.

Disadvantages of Indirect Taxes:

1. Inequitable: The Burden of Indirect Taxes is more on poor people
than Rich People. Hence Indirect Taxes are considered to be
Inequitable
2. Uneconomical: As government has to make a lot of expenses for
collection of the Indirect Taxes, These Taxes are considered as
uneconomical. Final Consumer has to pay much higher amount
than received by the government.
3. Uncertainty: Amount of Indirect Tax Collection cannot be
predicted as increase in Indirect Tax Results in Increase in Prices
of the commodity and thus reduces the demand of the
commodity. Hence there is always uncertainty over the amount of
indirect taxes collected
4. Inflationary: As Indirect Taxes increases the prices of the
commodity, they are considered as inflationary. If Government
depends more on indirect taxes, then Inflation will keep on
increasing.

 Tax Evasion: It is one of the main problems faced in India. People

evade tax through illegal and unfair means. They may claim lesser
profit, gains or turnover than the actual. They get the tax
refunded, by making misrepresentation before the tax authorities.
People evade tax by means of Smuggling, Evasion of Sales Tax,
VAT, Income Tax, Customs Duty, Excise Duty etc., Taxes being the
major source of income for the Government, evading of tax
causes economic inequality, many projects have be put on hold,
welfare programs have to set aside. The reasons for the evasion
of tax are that there is a high rate of taxation, failure to curb
bribery, lack of simplified procedures and lack of organized and
systematic administrative structure.
 High Rate and Low Yield of Direct Taxes:
In India, as in other LDCs, the rate of direct tax is very high but the
Contribution to the total tax rev-enue is very low.
 In the 1950s, the rate of income tax in India was one of the
highest in the world but the rev-enue was very insignificant. This
is because high tax rates encouraged tax evasion and avoidance
on a large scale. It may be noted in this context that tax avoidance
refers to arranging one’s finan­cial affairs within the law so as to
minimise taxa-tion liabilities, as opposed to tax-evasion, which is
failing to meet actual tax liabilities through, e.g., not declaring
income or profit. So, the Government gradually reduced the tax
rate over the years. In spite of this, the rate of income tax in India
is one of the highest in the world even today. The higher tax rate
(including surcharge) at present is 30% (plus surcharge of 2%).

 Double Taxation of Dividends:

Moreover, due to double taxation of dividend, the rate of
domestic saving and capital formation has failed to increase
appreciably.
Companies pay corporation and other taxes (such as excess profit
tax or surtax) to the Government. A portion of net profit after tax
is usually distributed among sharehold-ers in the form of
dividend. A portion of such dividend income is again taxed away
in the form of personal income tax.
Consequently, those who pay tax on dividend income cannot save
much and companies find it increasingly difficult to raise financial
resources on a large scale. It is often al-leged that one of the
cause of industrial stagnation in India has been the high rate of
taxation and slow growth of corporate capital. The problem has
assumed serious proportions in recent years.
 Absence of Agricultural Income Tax:
An­other feature of India’s tax system is that there is no tax on
agricultural income. Agriculture is the dominant sector of the
 Indian economy. The con-tribution of agriculture and related
activities to India’s GDP was 29.3% in 1999-00. Planned
in-vestment on agriculture has also increased over the years. But
agriculture has failed to make any contribution to the introduction
of the Govern­ment’s tax revenue. Since agriculture is a state
subject, the introduction of the agricultural income tax system at
the Central level has not been possi-ble. This is another reason for
undue reliance on indirect taxes.
 Reliance on Indirect Taxes: The share of Indirect taxes has gone
up in the last two years compared to that of the previous years.
This is because they apply equally to both rich and poor without
consideration for the income levels. If this carries on then the
government takes a major hit in the revenue of the Government
as direct taxes which are levied based on the income levels tend
to bring more revenue to the Government.
 Black Money: A country having flow of Black Money is also known
as having a Parallel Economy through an illegal economic
operation. The money, which is being made by the people without
being accounted for it to the government, is known as Black
Money.
Black Money has an impact on the economy as it provides us with
the false information about the actual economy. Due to which the
economic planning looses it’s worth, because they are based on
macro-economic parameters, which completely ignore the black
money. It will have a serious effect on the country’s economic
fiscal system as most of the Government income is based on the
taxes collected.
As per the Direct Taxes Enquiry Committee “Black money and tax
evasion, which go hand in hand, have the effect of seriously
undermining the equity concept of taxation and warping its
progressiveness. Together, they throw a greater burden to the
economy.”
The black money creates inequalities among people. The overall
consumption pattern is titled in favor of rich and elite classes.