1

Public Revenue
The public revenue can be broadly classified into two:

(a) Tax Revenue: It is the most important and major source of public
revenue. Government may require the members of the community to
contribute to the support of governmental functions through the payment
of taxes. An individual has no right to directly demand social services in
return to his payment of tax nor has he any other choice except to pay
the tax when it is levied on him.

Taxes, in general, serve both functions of a revenue system:

(i) they provide funds, and

(ii) they reduce private consumption and investment.

(b) Non-Tax Revenue: Non-tax revenue is derived from public

undertakings called ‘Prices’ and other miscellaneous receipts. It also
raises loans, short-term and long-term, to augment its revenues. Other
minor revenue sources are fees, special assessment, fines, forfeitures and
escheats, tributes and indemnities, gifts and grants.

Adam Smith’s Canon of Taxation

Adam Smith’s contribution to this part of economic theory is still
regarded as classic. His presented theory on taxation is still considered
as the foundation of all discussions on the principles of taxation. There
are four essentials of his theory of taxation, i.e., equality, certainty,
convenience and economy. The first canon is ethical and other three are
administrative in character:

1. Canon of Equality: means the principle of justice, i.e., in accordance

to ‘ability to pay’. This is the most important canon of taxation. It lays
the moral foundation of the tax system. The cannon of equality does not
mean that every taxpayer should pay at the same sum. That would be
manifestly unjust. Nor does it means that they should pay at the same
rate, which means proportional taxation, for a proportional tax is also not
a very just tax. What this canon really means is the equality of
sacrifice. The amount of the tax paid is to be in proportion to the
respective abilities of the taxpayers. This clearly points to progressive
taxation, i.e., taxing higher incomes at higher rates.
 2

2. Canon of Certainty: means the tax which each individual is bound to

pay ought to be certain, and not arbitrary. The time of payment, the
manner of payment, the quantity to be paid, ought to be clear and simple
to the taxpayer. According to Adam Smith, uncertainty in taxation
encourages insolence or corruption.

3. Canon of Convenience: Every tax, according to Adam Smith, ought to

be levied at the time or in the manner in which it is most convenient for
the taxpayers to pay their dues. The canon of certainty says that the
time and the manner of payment should be certain. But the canon of
convenience states that the time of payment and the manner of payment
should be convenient. For example, if a tax on land or house is collected
at a time when rent is expected to be received, it satisfies the canon of
convenience. If the tax can be paid through cheque, or credit card, or
internet, the manner is convenient, but not so if it is to be paid
personally to the taxing authority. In the latter case there will be a lot of
inconvenience and harassment.

4. Canon of Economy: The tax will be economical if the cost of

collection is very small. If, on the other hand, the salaries of the officers
engaged in collecting the tax eat up a big portion of the tax revenue, the
tax is certainly uneconomical. Similarly, such other huge and
unnecessary administrative costs will make the tax collection an
extravagant task. If there is corruption or oppression involved in the
frequent visits to the income tax office and the odious examination by
the taxing officer the canon of economy is not satisfied.

In broader sense, the canon of economy means a tax must not obstruct in
any manner the ultimate prosperity of the country. It would infringe the
canon of economy if it retards the development of trade and industry in
any manner. If incomes are subjected to a very heavy tax, saving may be
discouraged, capital will not accumulate and the productive capacity of
the community will be seriously impaired.

Other Canons of Taxation

1. Fiscal Adequacy or Productivity: The State should be able to function
with the revenue raised from the people by means of taxes. The
government should be free from financial embarrassments. It will be
necessary, therefore, that the tax proceeds should adequately cover the
government expenditure and the government does not run into a
deficit. But at the same time, the government should also not err on the
side of excess. In their zeal to raise more revenue, they should not
cripple, in any manner, the productive capacity of the community.
 3

2. Canon of Elasticity: The canon of elasticity is closely connected with

that of ‘fiscal adequacy’. As the needs of the State increase, the revenue
should also increase otherwise they will cease to be adequate. To meet
an emergency or a period of stress and strain, the government should be
in a position to augment its financial resources. Income tax is considered
to be an elastic tax, as it can be considerably increased when needed.

3. Canon of Flexibility: There is a difference between flexibility and

elasticity. Flexibility means that there should be no rigidity in the tax
system so that it can be quickly adjusted to new conditions; and elasticity
means that the revenues can be increased. The presence of flexibility is
a condition of elasticity. A tax system cannot be altered without bringing
about a revolution or without much flexibility in the tax system.

4. Canon of Simplicity: According to Armitage Smith, a system of

taxation should be simple, plain and intelligible to the common
understanding. This canon is essential if corruption or oppression is to be
avoided.

5. Canon of Diversity: Another important principle of taxation –

diversity. A single tax or only a few taxes will not do. There should be a
variety of taxes so that all the citizens, who can afford to contribute to
the State revenue, should be made to do so. They should be approached
in a variety of ways. There should be a wise admixture of direct and
indirect taxes. But too great multiplicity will be bad and uneconomical.

6. Social and Economic Objectives: In modern times, economists

emphasised that the tax system should be based on the principle that the
effects of taxation should be compatible with the economic and social
objectives and preferences of the community. The social and economic
objectives of a standard tax system are:

(i) Reduction of inequalities in the distribution of income and

wealth: For this purpose, progressive taxes must be levied instead of
proportional taxes.

(ii) Accelerating economic growth: For this purpose, the tax

system must be so designed as to raise the rates of saving and
investment. This is a very important objective for less developed
countries (LDCs), where there is a deficiency of savings and investments.

(iii) Price stability: to ensure stable economic growth. When LDCs

launch economic development programme they have to face inflation or
soaring prices. An integrated tax policy would solve this problem.
 4

Objectives of Taxation in Developing Economies

(a) Ability to contribute to economic development: Each person
should be made to contribute to economic development, according to his
ability to do so. All his unused capacity must be utilised, through
appropriate tax measures, for purposes of economic
development. Suppose a person is making a large saving but he lets it lie
idle. Such saving must be mobilised and channelised into investment.

(b) Mobilisation of economic surplus: In all backward countries, a

significant portion of national output goes to the big landlords and other
idle rich people. A large portion of their income is spent on conspicuous
consumption, e.g., building of palaces, etc. This is unproductive
expenditure and a waste from the point of national
development. Economic growth can be accelerated if an appreciable
portion of this ‘surplus’ income is mobilised and made available for
productive investment.

(c) Increasing the incremental saving ratio: As economic

development proceeds apace, incomes rise. But there is a danger that
propensity to consume may also increase so that extra incomes generated
in the economy are utilised in consumption rather then invested in
production. This has to be prevented. In other words, the consumption
is not allowed to increase in proportion to increase in income. For this
purpose commodity taxes are quite effective.

(d) Income elasticity of taxation: In backward economies, the share

of taxation out of the national income is less than 10%. This share must
be progressively raised as national income increases as a result of
economic development. This needs built-in flexibility in the tax
system. Progressive taxation of income provides this flexibility. Taxation
of goods having a high income-elasticity of demand also imparts to the
tax system much needed flexibility.

(e) Equity: The canon of equity demands that the burden of economic
development must be distributed among the different sections of the
community equitably. That is why the richer classes are prevented from
increasing their consumption in proportion to the rise in their
incomes. This is how they make a sacrifice for the economic
development of their country. The poor people also make a sacrifice
because rising prices curtail their consumption. In this manner, sacrifices
in consumption are shared by all sections of the society. Thus, the burden
of economic development is equitably distributed among all. This is also
known as‘horizontal equity’.
 5

Characteristics of A Good Tax System

(a) Simple, financially adequate and elastic: The tax system should
be simple, financially adequate and elastic. In other words, the system
should be easily intelligible; it should be sufficiently productive of
revenue; and the tax structure should be adaptable to meet the changing
requirements of the economy.

(b) Broad based: The tax system should be as much broad-based as

possible. It should be multiple tax system. There should be diversity in
the system. But too great multiplicity in tax system should be avoided.

(c) Administratively efficient: The tax system should be efficient

from the administrative point of view. It should be simple to
administer. There should be little scope for evasion or accumulation of
arrears. It should be foolproof and knave-proof. Chances of corruption
should be minimised.

(d) Balanced and harmonious: Another important characteristic of a

good tax system is that it should be a harmonious whole. It should have a
balanced structure. It should be truly a system and not a mere collection
of isolated taxes. Every tax should fit in properly in the system as a
whole so that it is a part of a connected system. Each tax should occupy
a definite and due place in the financial structure.

(e) Ensuring the reduction of economic inequalities: A good tax is

that it should be an instrument for the reduction of economic
inequalities. The purpose of public finance is not merely to raise
revenues for the State but to raise the revenue in such a manner as to
reduce the economic inequalities. In this manner, the State may also be
able to divert idle resources in bank balances or lockers to more
productive areas.

(f) Ensuring economic stability: From the point of view of ensuring

economic stability, it is necessary that the tax system must be
progressive in relation to changes in the national income. This means
that when national income rises, an increasing part of rise in income
should automatically accrue to the tax authorities and when national
income falls, as in a depression, the tax revenue should fall faster than
the fall in national income.

(g) Ensuring that national income is increasing: The tax system

should ensure that the national income is increasing during boom
periods. Similarly, in depression, tax revenues should fall faster than
 6

income so that the purchasing power of people does not fall as fast as
their pre-tax income. Thus, an overall progressive tax system is an
important factor in ensuring stability.

(h) An instrument of economic growth: For developing economies,

the tax system has to serve as an instrument of economic
growth. Economic development rather than economic stability is the
objective of under-developed countries. Their tax system must be so
shaped as to accelerate economic development. For this purpose, it must
mobilise the required resources and channelise them into investment. It
must, in short step up savings and investment and raise the level of
income and employment in the economy.

(i) Socially advantageous: The tax system should be socially

advantageous and promote general economic welfare. From this point of
view, taxes on goods of mass consumption should be avoided. The
burden of tax on basic items should not be excessive.

(j) Optimum allocation of resources: The tax system should be so

framed as to ensure that the productive resources of the economy are
optimally allocated and utilised. For this purpose, it is essential that the
tax system should be economically neutral. In other words, it should
interfere as little as possible with the consumers’ choices for
consumption goods and the producers’ choices regarding the use of
factors.

Classification of Tax
Some classifications of taxes are as follows:

1. Proportional & Progressive Tax: A proportional tax is one in which,

whatever the size of income, same rate or percentage is charged.

On the contrary, progressive tax refers to the tax system in which the
rate of tax increases with the increase in table income. It is based on the
principle ‘higher the income, higher the tax’.

2. Regressive & Digressive Tax: A tax is said to be regressive when its

burden falls more heavily on low-income earners / poor than the high-
income earners / rich. It is opposite of progressive tax.

A tax is called digressive when the higher income does not make a due
sacrifice, or when the burden imposed on them is relatively less. This tax
may be progressive up to a certain limit beyond which a uniform rate is
charged.
 7

3. Specific & Advolarem Tax: A specific tax is according to the weight of

the commodity. An advolarem tax is according to the value of a
commodity.

4. Direct & Indirect Tax: Direct tax is one which is paid by the person on
which it is charged. The examples of direct taxes are income tax, wealth
tax, etc.

On the contrary, the indirect tax’s is paid by one person and its burden is
fall on other, generally the consumer. The examples of indirect taxes are
sales tax, central excise duty, custom duty, recreational tax, etc.

Sources of Tax Revenue / Major Types of Tax

1. Income Tax: It is a form of direct tax which is levied on individual’s
total earnings. It is the most effective tax vehicle for attaining equity,
particularly if it is progressive tax. Following are the requirements for an
optimal income tax system:

(a) All incomes should be treated uniformly and all rupees of income
should be accorded equal tax treatment regardless of the source.

(b) Just as ‘equals’ should be treated ‘equally’, ‘unequals’ should be

treated ‘unequally’.

(c) The tax structure should be sensitive to changes in economic

activity in order to dampen the changes

(d) The tax structure should be designed in such a fashion as to

facilitate compliance and in enforcement, consistent with the attainment
of the other objectives.

2. Corporate Tax: The following are the primary tax consequences of the
existence of the corporation:

(a) The corporation’s earnings are accumulated as reserves giving rise

to capital gains.

(b) The division between initial earning of the income and subsequent
payment of dividends encourages government to tax both the corporation
and the dividend earners.

(c) The division between ownership and top management in a large

corporation may cause the reactions to the tax to be different from the
personal income tax.
 8

Under perfectly competitive markets the corporate tax shifted to reduce

the real income of stockholders. Under imperfectly competitive markets
the firms use mark-up price for shifting the tax burden on consumers.

3. Wealth Tax: A wealth tax is a levy upon individuals not corporations,

on the basis of their net wealth. Corporate property is reached via
securities outstanding in the hands of the owners and creditors. The
wealth tax can take form of either progressive or proportional
tax. Wealth tax is not a major source of revenue and in most countries
they form 1 to 2% of the total tax revenue.

4. Sales Tax: Sales tax is applied to all or a wide range of commodities

and services. It is collected from vendors rather than individual
consumers. The sales tax is finally borne by consumers. The sales tax is
often refer to regressive tax relative to income.

5. Excise Duty: It is actually imposed on the manufacturers but the

consumers have to pay it. It is a form of indirect tax imposed on widely
used commodities often regarded as non-essential such as cigarettes,
liquor, tobacco, etc.

6. Custom Duty: Custom duties are of two types:

(i) specific, and

(ii) advolarem.

Specific custom duty is fixed per physical units of goods, e.g., television,
CD players, computers, etc. The advolarem custom duty is according to
the value of a good and charged at a certain rate.

As industrial and commercial development continues the increased use of

custom duties lessens the revenue potential.

7. State Duties: There are several other duties imposed by the

government broadly classified as ‘state duty’. These include the tax on
the earnings of commercial deposits and on sales and purchase of
properties. These are some what different types of tax as:

(a) the taxes imposed by the federal government and used by itself,

(b) the taxes imposed by the federal government and distributed

among provinces, and
 9

(c) the taxes imposed by the provincial governments and used by

themselves.

8. Other Sources:

(i) Fee: It is also a compulsory payment but made only by those who
obtain a definite service in return from the government. The fee covers
the part of the cost of service provided to the consumer / client. The
licence fee, however, is much more than the cost of service and there is
not much of a positive service in return.

(ii) Price: A price is the payment of a service of business character, for

example, charges for travelling on railway. The price is different from
fee. The fee is for public interest. You can escape a price by not
purchasing the said service / commodity.

(iii) Special Assessment: According to Professor Seligman, special

assessment is a compulsory contribution, levied in proportion to the
special benefit derived, to defray the cost of a specific improvement to
property undertaken in the public interest. Suppose the government
build a road or bridge or provide mass transport system or makes suitable
sewerage and water supply arrangements, all the property will appreciate
in value. The State has the right to levy a special tax on the owners of
land or property known as ‘special assessment’.

(iv) Rates: Rates are levied by the local bodies, municipalities and
district boards for local purposes. They are generally levied on
immovable property of the residents, but not necessarily for any special
improvements effected or special benefits conferred.

Sources from Non-Tax Revenues

In Pakistan, following are the sources of non-tax revenue available for
Federal Government:

1. Income from Property & Enterprise: The Government receives

income from the owned lands, forests, mines, canal water and various
public enterprises.

2. Profit from Post Office and TNT: The Government also receives
income from its Post and Telegraph departments

3. Trading Profits: The Government of Pakistan earns trading profits

from exports of rice, cotton and edible oil
 10

4. Interest Receipts: It is the most important head in the NTR

source. The interest and the return from investment received from
various autonomous bodies, and central bank and state-owned banks
come under this head

5. Surcharges: The difference between the sales price and the

production cost / import price of petroleum products, gas and fertilisers
represents the surplus profit or the surcharge, which is used to iron out
the fluctuations in the prices of these essential commodities.

6. Other Sources of Non-Tax Revenue: The other minor heads of non-

tax revenue are:

(i) Dividends and returns

(ii) Receipts from civil administration and other functions

(iii) Miscellaneous sources, which includes passport, CNIC

(Computerised National Identity Card), copyright fees and
other receipts.

Regressive vs. Proportional vs. Progressive Taxes:

What's the Difference?
Tax systems in the U.S. fall into three main
categories: Regressive, proportional, and progressive. Regressive and
progressive taxes impact high- and low-income earners differently,
whereas proportional taxes do not. Property taxes are an example of a
regressive tax; the U.S. federal income tax is a progressive tax example;
and occupational taxes are a type of proportional tax.

Regressive taxes have a greater impact on lower-income individuals than

on the wealthy. Proportional tax, also referred to as a flat tax, affects low-,
middle-, and high-income earners relatively equally. They all pay the same
tax rate, regardless of income.

A progressive tax has more of a financial impact on higher-income

individuals than on low-income earners, with tax rate, and tax liability,
increasing, in line with a taxpayer's income. Investment income and estate
taxes are examples of progressive taxes in the U.S.

Regressive Taxes
 11

Low-income individuals pay a higher amount of taxes compared to high-

income earners under a regressive tax system. That's because the
government assesses tax as a percentage of the value of the asset that a
taxpayer purchases or owns. This type of tax has no correlation with an
individual's earnings or income level.

Regressive taxes include property taxes, sales taxes on goods, and excise
taxes on consumables, such as gasoline or airfare. Excise taxes are fixed
and they're included in the price of the product or service.1

Sin taxes, a subset of excise taxes, are imposed on commodities or

activities that are perceived to be unhealthy or have a negative effect on
society, such as cigarettes, gambling, and alcohol. They're levied in an
effort to deter individuals from purchasing these products. Sin tax critics
argue that these disproportionately affect those who are less well off.2

Many also consider Social Security to be a regressive tax. Social Security

tax obligations are capped at a certain level of income called a wage base
—$147,000 for the 2022 tax year, rising to $160,200 in 2023.3 An
individual's earnings above this base are not subject to the 6.2% Social
Security tax.

The annual maximum that you can pay in Social Security tax is capped at
$9,114.00 in 2022, whether you earn $147,001 or $1 million. Employers
pay an additional 6.2% on behalf of their workers, and self-employed
individuals must pay both halves on earnings up to the wage base.4

Higher-income employees effectively pay a lower proportion of their overall

pay into the Social Security system than lower-income employees
because it's a flat rate for everyone and because of this cap.

Proportional Taxes
A proportional or flat tax system assesses the same tax rate on everyone
regardless of income or wealth. This system is meant to create equality
between marginal tax rates and average tax rates paid. Nine states use
this income tax system as of November 2022: Colorado, Illinois, Indiana,
Kentucky, Massachusetts, Michigan, North Carolina, Pennsylvania, and
Utah.5

Other examples of proportional taxes include per capita taxes, gross

receipts taxes, and occupational taxes.6

Proponents of proportional taxes believe they stimulate the economy by

encouraging people to work more because there is no tax penalty for
 12

earning more. They also believe that businesses are likely to spend and
invest more under a flat tax system, putting more dollars into the
economy.6

Progressive Taxes
Taxes assessed under a progressive system are based on the taxable
amount of an individual's income. They follow an accelerating schedule, so
high-income earners pay more than low-income earners. Tax rate, along
with tax liability, increases as an individual's wealth increases. The overall
outcome is that higher earners pay a higher percentage of taxes and more
money in taxes than do lower-income earners.

This sort of system is meant to affect higher-income people more than low-
or middle-class earners to reflect the presumption that they can afford to
pay more.7

The U.S. federal income tax is a progressive tax system. Its schedule
of marginal tax rates imposes a higher income tax rate on people with
higher incomes, and a lower income tax rate on people with lower
incomes. The percentage rate increases at intervals as taxable income
increases. Each dollar the individual earns places him into a bracket or
category, resulting in a higher tax rate once the dollar amount hits a new
threshold.8

Part of what makes the U.S. federal income tax progressive is

the standard deduction that lets individuals avoid paying taxes on the first
portion of the income they earn each year. The amount of the standard
deduction changes from year to year to keep pace with inflation.
Taxpayers can elect to itemize deductions instead if this option results in a
greater overall deduction. Many low-income Americans pay no federal
income tax at all because of tax deductions.9

Estate taxes are another example of progressive taxes as they mainly

affect high-net-worth individuals (HNWIs) and they increase with the size
of the estate. Only estates valued at $12.06 million or more are liable for
federal estate taxes for 2022—rising to $12.92 million in 2023—although
many states have lower thresholds.10

As with any government policy, progressive tax rates have critics . Some
say progressive taxation is a form of inequality and amounts to a
redistribution of wealth as higher earners pay more to a nation that
supports more lower-income earners. Those who oppose progressive
taxes often point to a flat tax rate as the most appropriate alternative.
 13

Regressive Tax Example

If shoppers pay a 6% sales tax on their groceries whether they earn
$30,000 or $130,000 annually, those with lesser incomes end up paying a
greater portion of total income than those who earn more. If someone
makes $20,000 a year and pays $1,000 in sales taxes on consumer
goods, 5% of their annual income goes to sales tax. But if they earn
$100,000 a year and pay the same $1,000 in sales taxes, this represents
only 1% of their income.

Proportional Tax Example

Under a proportional income-tax system, individual taxpayers pay a set
percentage of annual income regardless of how much they earn. The fixed
rate doesn't increase or decrease as income rises or falls. An individual
who earns $25,000 annually would pay $1,250 at a 5% rate, whereas
someone who earns $250,000 each year would pay pays $12,500 at that
same rate.

Progressive Tax Example

In the U.S., income taxes operate under a progressive system. In 2023,
federal progressive tax rates are 10%, 12%, 22%, 24%, 32%, 35%, and
37%. The first tax rate of 10% applies to incomes of less than $11,000 for
single individuals and $22,000 for married couples filing joint tax
returns.12 The highest tax rate of 37% applies to incomes over $578,125
for single taxpayers and $693,750 for joint married filers.10

Top 4 Principles or Canons of a

Good Tax System
Some of the most important principles or canons of a good tax
system are as follows: 1. Principle or Canon of Equality 2. Canon of
Certainty 3. Canon of Convenience 4. Canon of Economy.

A good tax system must fulfill certain principles if it is to raise

adequate revenue and fulfill certain social objectives. Adam Smith
had explained four canons of taxation which he thought a good tax
must fulfill.

These four canons are of:

ADVERTISEMENTS:
 14

(1) Equality,

(2) Certainty,

(3) Convenience, and

(4) Economy.

ADVERTISEMENTS:

These are still regarded as characteristics of a good tax system.

However, there have been significant developments in economic
theory and policy since Adam Smith wrote his book “The Wealth of
Nations “. Activities and functions of Government have enormously
increased.

Now, the Governments are expected to maintain economic stability

at full employment level, they are to reduce inequalities in the
income distribution, and they are also to perform the functions of a
Welfare State.

Above all, they are to promote economic growth and development,

especially in the developing countries, net only through encouraging
private enterprise but to undertake the task of production in some
strategic industries. Thus, in order to devise a good tax system,
these objectives and functions of Government’s economic policy
must be kept in view.

It may be noted that Adam Smith was basically concerned with how
the wealth of nations or, in other words, production capacity of the
economy can be increased and he thought that private enterprise
working on the basis of free market mechanism would ensure
 15

efficient use of resources and, if left unfettered would bring about

rapid economic growth.

ADVERTISEMENTS:

His ideas about public finance were influenced by his economic

philosophy of virtues of free private enterprise. In proposing the
above mentioned canons of taxation, he was guided only by the sole
objective that Government should be able to raise sufficient revenue
to discharge its limited functions of providing for defence,
maintaining law and order, and, public utility services.

Both the objectives and functions of modern Governments have

increased necessitating large resources. Therefore, the modern
economists have added other principles or characteristics which
taxation system of a country must satisfy if the objectives of modern
Governments are to be achieved. In what follows we shall spell out
in detail the principles and characteristics of a good tax system
starting with the explanation of Smithian canons of taxation.

1. Principle or Canon of Equality:

The first canon or principle of a good tax system emphasised by
Adam Smith is of equality. According to the canon of equality, every
person should pay to the Government according to his ability to pay,
that is in proportion of the income or revenue he et jove onder the
protection of the State.

Thus under the tax system based on equality principle the richer
persons in the society will pay more than the poor. On the basis of
this canon of equality or ability to pay Adam Smith argued that
 16

taxes should be proportional to income, that is, everybody should

pay the same rate or percentage of his income as tax.

ADVERTISEMENTS:

However, modem economists interpret equality or ability to pay

differently from Adam Smith. Based on the assumption of
diminishing marginal utility of money income, they argue that
ability to pay principle calls for progressive income tax, that is, the
rate of tax increases as income rises. Now, in most of the countries,
progressive system of income and other direct taxes have been
adopted to ensure equality in the tax system.

It may, however, be mentioned here that there are two aspects of

ability to pay principle. First is the concept of horizontal equity.
According to the concept of horizontal equity, those who are equal,
that is, similarly situated persons ought to be treated equally.

This implies that those who have same income should pay the same
amount of tax and there should be no discrimination between them.
Second is the concept of vertical equity. The concept of vertical
equity is concerned with how people with different abilities to pay
should be treated for the purposes of division of tax burden. In
other words, what various tax rates should be levied on people with
different levels of income, A good tax system must be such as will
ensure the horizontal as well as vertical equity.

2. Canon of Certainty:
Another important principle of a good tax system on which Adam
Smith laid a good deal of stress is the canon of certainty. To quote
 17

Adam Smith, ‘The tax which each individual is bound to pay ought
to be certain and not arbitrary.

ADVERTISEMENTS:

The time of payment, the manner of payment, the quantity to be

paid ought all to be clear and plain to the contributor and to every
other person. A successful function of an economy requires that the
people, especially business class, must be certain about the sum of
tax that they have to pay on their income from work or investment.

The tax system should be such that sum of tax should not be
arbitrarily fixed by the income tax authorities. While taking a
decision about the amount of work effort that a person should put
in or how much investment should he undertake under risky
circumstances, he must know with certainty the definite amount of
the tax payable by him on his income. If the sum of tax payable by
him is subject to much discretion and arbitrariness of the tax
assessment authority, this will weaken his incentive to work and
invest more.

Moreover, lack of certainty in the tax system, as pointed out by

Smith, encourages corruption in the tax administration. Therefore
in a good tax system, “individuals should be secure against
unpredictable taxes levied on their wages or other incomes. The law
should be clear and specific; tax collectors should have little
discretion about how much to assess tax payers, for this is a very
great power and subject to abuse.”

In the opinion of the present author the Indian tax system violates
this canon of certainty as under the Indian income tax law a lot of
 18

discretionary powers have been given to the income tax officers,

which have been abused with impunity. As a result, there is a lot of
harassment of the tax payers and corruption is rampant in the
income tax department.

3. Canon of Convenience:
ADVERTISEMENTS:

According to the third canon of Adam Smith, the sum, time

and/manner of payment of a tax should not only be certain but the
time and manner of its payment should also be convenient to the
contributor. If land revenue is collected at the time of harvest, it will
be convenient since at this time farmers reap their crop and obtain
income.

In recent years efforts have made to make the Indian income tax
convenient to the tax payers by providing for its payments in
installments as advance payments at various times during the year.
Further, income tax in India is levied on the basis of income
received rather than income accrued during a year. This also makes
the income tax system convenient. However, there is a lot of
harassment of the tax payers as they are asked to come to the
income tax office several times during a year for clarifications of
their income tax returns.

4. Canon of Economy:
The Government has to spend money on collecting taxes levied by
it- Since collection costs of taxes add nothing to the national
product, they should be minimized as far as possible. If the
collection costs of a tax are more than the total revenue yielded by
it, it is not worthwhile to levy it.
 19

More complicated a tax system, more elaborate administrative

machinery will be employed to collect it and consequently collection
costs will be relatively larger. Therefore, even for achieving economy
in the tax collection, the taxes should be as simple as possible and
tax laws should not be subject to different interpretations.

Distinguish between Internal Debt and External Debt?

Do you think that public debt is a burden on future generation?

One of the key concerns associated with large deficit spending is unfair debt
burden to be born by future generations that such spending gives rise to. Massive
pandemic relief spending financed by debt in the US in the past several months,
as expected, has raised serious concerns about its implications for the well-being
of future generations. However, debates have featured more passion and rhetoric
than in-depth analyses, leaving obscure what the crux of the matter really is. This
note is an attempt to clarify.

Intergenerational transfer of debt burden is a complex issue. Yet the debate

typically is cast in such simplistic terms as the future generation having to pay
back debt created by the current generation’s deficit spending by increased tax
payment. It’s not only laymen who think along those lines. So do many
economists. There are so much more to this issue, as demonstrated in this paper.
 20

To facilitate the understanding of such a complex issue, this paper starts with a
few essential points pertaining to the burden of government spending, rather
than burden of debt financing on future generations per se. A detailed analysis of
the latter issue then follows. Throughout the paper, debt burden on the future
generation is defined as a reduction in the maximum level of consumption the
future generation could enjoy as a result of deficit spending by the government of
the current generation. The analysis of debt burden is discussed first in a closed
economy setting, which is an assumption typically (albeit implicitly) adopted in
public debate on the matter. An analysis in an open economy follows. This is a
critical distinction.

Public Expenditure and its effects on different types of economic

activities.
How Does Public Expenditure Affect the Economy?
The budget is the most powerful policy instrument of any government. Without
funding, a policy has no potency. In addition, governments are usually one of the
biggest organizations in any country – in terms of both human and financial
resources. Likewise, budget allocations for public services and programs are of
public concern because they greatly impact on the lives of citizens. But in the
context of the current economic downturn, the size of public sector expenditure
is once again under the spotlight.

Effects of Public Spending on the Economy — the Good, the Bad and the
Neutral
Governments accelerate spending during economic recessions due to the belief
that state intervention can stabilize the economy. Keynesian economists,
during an economic contraction, advocate increases in public spending as part
of a menu of countercyclical fiscal policies that act against the direction of the
business or economic cycle. Named after the British economist John Maynard
Keynes, who advocated for governments’ more active role in the economy,
Keynesian economics sees the necessity of public spending in counteracting the
downward spiral of the market and in growing the economy.

This school of thought believes that government spending promotes economic

growth since financing various spending programs stimulates aggregate
demand and boosts economic growth. When governments construct
infrastructure projects or spend on social services, there is a multiplier effect on
aggregate demand by increasing employment, productivity and investments in
the market.
 21

Although using public spending as an economic stimulus is a common policy

prescription, not all economic thinkers share the same
perspective. Neoclassical economists caution governments against the
negative effects of public spending. According to neoclassical economics, fiscal
policies that promote huge public spending depress the economy because
government expenditure crowds out private investment and consumption.
Neoclassical economists argue that public investments discourage businesses
from investing in the same sectors. This leads to lower private spending on
education, health, transportation, and other goods and services where public
spending is huge. Neoclassical economists see the private sector as the main
driver of economic growth. Hence, governments should take a less active role in
the economy and let corporations invest in market activities.

A third economic school of thought considers public spending as neither a

positive nor a negative contributor to the economy. Instead, public spending is
viewed as an effect of economic growth and not the other way around. Adolph
Wagner, a German economist in the late 19th century, observed in a number of
Western industrializing countries that growth in the economy also causes public
sector expenditures to expand. Wagner linked the increase in government
expenditure to the changing role of the government in the economy. He argued
that the public sector has to adjust as a result of the pressures caused by social
progress in society. With economic growth and prosperity comes an increase in
demand for public services. Likewise, government functions have to be
expanded to ensure that the market runs smoothly.

How does the existence of money overcome the difficulties of

barter economy and simplify the process of buying and selling?

5 Main Difficulties Found in

Barter System – Discussed!
The five main difficulties found in barter system are as follows: 1.
Double Coincidence of Wants 2. Lack of a Standard Unit of Account
3. Impossibility of Subdivision of Goods 4. Lack of Information 5.
Production of Large and Very Costly Goods not Feasible.

Money was not used in the early history of man. Exchanges were
few since each family was self- sufficient. Whatever exchanges there
 22

were, they took the form of barter, that is, exchange of goods for the
other goods. Various difficulties were faced by the people in the
barter economy.

There was no acceptable means of payment for the direct purchase

of goods and services in the barter economy. In other words, in a
purely barter system, there was no generally acceptable medium of
exchange in the form of a particular good or asset which could be
used to buy goods and services and do other types of transactions.

ADVERTISEMENTS:

The following are the main difficulties which were found

in the barter system:
1. Double Coincidence of Wants:
Owning to lack of generally acceptable medium of exchange, a
difficult problem of double coincidence of wants was faced by the
persons who wanted to sell and buy goods. For exchange of goods
persons desiring to exchange goods must specifically want those
goods what others offers in exchange. Thus, an individual who
wants to have a good he must locate another person who offers to
give up the good wanted by him and who is willing to accept in ex-
change the good offered by him.

Thus, under barter system only when wants for buying and selling
goods of different persons coincided the exchange of goods was
possible. A good deal of time was spent by a person in searching for
a man with whom wants coincided. Halm rightly says, “It is next to
impossible that all wishes of bartering individuals should coincide
as to the kind, quality and quantity and value of things which are
 23

mutually desired, especially in a modern economy in which on a

single day millions of persons may exchange millions of goods and
services.”

ADVERTISEMENTS:

2. Lack of a Standard Unit of Account:

A barter economy lacked not only a common medium of exchange
but also a standard unit of account in which prices could be
measured and quoted. In the absence of a common unit of account,
the number of exchange ratios (that is, prices of goods expressed in
terms of each other) between goods would be very large. For
example, two cows for one horse, one cow for two quintals of wheat,
one pen for three pencils and so on. Thus, lack of a standard unit of
account with which to measure values of different goods and
services made exchange or trade difficult.

3. Impossibility of Subdivision of Goods:

Another problem faced under the barter system for exchange of
goods was impossibility of subdivision of goods without loss of their
value. For instance, if a person has a cow and wants to have 5 kg of
wheat, obviously, it is too costly to give one cow for 5 kg of wheat he
requires.

ADVERTISEMENTS:

Then, to do this transaction cow has to be divided. But cow cannot

be divided or cut into pieces because cow will lose much of its value
if it is divided. Thus, impossibility of division of goods for the
purpose of exchange posed a great difficulty and obstructed the
growth of trade.
 24

4. Lack of Information:
Another problem found in the barter system was that in it traders
required a good deal of information for exchange of goods. For
example, if Amit wants to have a saw in exchange of a wooden table
which he has made.

Not only should Amit be able to assess the value of saw but the
maker of a saw should also be able to determine the value of the
wooden table which Amit wishes to exchange. All this required a lot
of information about goods for which people must spend a good
deal of time and resources to obtain such information.

ADVERTISEMENTS:

If there exists a medium of exchange, it will solve half the problem.

However, Amit will still have to determine the value of the table in
terms of the medium of exchange. Thus, if there exists a medium of
exchange, with well-known characteristics, it will reduce the
information costs of trading. Without the medium of exchange
information cost will indeed be very large.

5. Production of Large and Very Costly Goods not

Feasible:
Another problem of barter economy relates to the production of
large, costly goods. Suppose an individual who has technical skill
and equipment to manufacture a car will not have much incentive to
manufacture it in the barter economy.

This is because he can exchange a car with a person who has enough
goods having a value equal to a car so that their exchange with a car
can take place. The car maker must obtain food, clothing and
 25

several other commodities of day-to-day consumption in exchange

for a car. It will be very difficult, almost impossible to find a
prospective buyer who has enough of these goods and services to
give in return for a car.

ADVERTISEMENTS:

It is evident from above that barter system could work in a primitive

economy where life was simple and man was self-sufficient. As man
made some economic progress, division of labour or specialisation
and large-scale production came to exist, barter system could not
fulfill the increasing needs for exchange of goods.

Due to the difficulties of exchange barter economy would have no

large-scale production, no advantage of the use of capital-intensive
specialised machinery and no easy and cheap means in which
wealth could be stored.

The range of goods produced must be much smaller than those

produced in the modern developed economies. To meet the needs
for a common unit of account and also as a generally accepted
medium of exchange and thereby to overcome the difficulties faced
under the barter system, money was invented.
How Did the Invention of Money Affect the Barter System?
Money became a medium of exchange for goods and services, displacing
the barter system. Under the barter system, the transacting parties must
have a demand for the goods or services each offers to facilitate the
transaction. If needs are mismatched, no exchange takes place, leaving
parties unfulfilled.

What Are the Disadvantages of the Barter System?

The barter system often creates an unbalanced system of trade, where
parties are unable to find others willing to trade. The barter system also
lacks a common unit of measurement for goods and services. Since most
 26

goods depreciate with time, they become less attractive for trade and
storing value.

What Are the Disadvantages of the Fiat Currency System?

There is no universal currency. Therefore, to purchase goods and services
in a different country, one must convert their currency to that of the other
nation, and most governments impose exchange rates for these
conversions.

Also, inflation increases the prices for goods and services within an
economy and, subsequently, erodes a currency's purchasing power.

Barter System vs. Currency System: An Overview

The primary difference between barter and currency systems is that a
currency system uses an agreed-upon form of paper or coin money as an
exchange system rather than directly trading goods and services through
bartering. Both systems have advantages and disadvantages,
although currency systems are more widely used in modern economies.

KEY TAKEAWAYS

 Bartering systems were used within the local community, but

advances in technology and transportation make it possible for
modern society to barter on a global level.
 Bartering has its limitations, which led to the creation of currency
systems.
 Currency serves as a medium of exchange, resolving mismatched
demands associated with the barter system.
 In early civilizations, common agreed-upon goods, such as animal
skins or salt, served as a currency that individuals could exchange
for goods and services.
 Most nations use fiat currency in a monetary currency system.

Barter System
Since the beginning of known history, humans have directly exchanged
goods and services with one another in a trading system called bartering.
The history of bartering dates back to 6000 BC. Introduced by
Mesopotamia tribes, bartering was adopted by the Phoenicians. The
Phoenicians bartered goods to those located in various other cities across
oceans.

Traditionally, bartering systems were used within the local community. For
example, a farmer with eggs and milk can trade them to the local baker for
 27

a birthday cake and a loaf of bread. The baker then uses the milk and
eggs to bake more bread, which she gives to the appliance repairman as
payment for repairing her oven.

Today, advances in technology and transportation make it possible for

modern society to barter on a global level.

Bartering makes it easier to negotiate but lacks the flexibility of a currency

system. Many small businesses accept non-monetary payments for their
services, and the IRS treats these bartered transactions the same as
currency transactions for tax-reporting purposes.

Currency System
Bartering has limitations. Consider a local blacksmith who needs two
loaves of bread and a baker who needs plumbing services. Neither has
what the other needs, and as a result, no trade occurs. Currency systems
were developed to eliminate this hassle.

In early civilizations, common agreed-upon goods, such as animal skins or

salt, served as a currency that individuals could exchange for goods and
services.

Pound currency, the currency of the United Kingdom (UK), is the world's
oldest active currency.1
As currency systems progressed over time, coins and paper notes evolved
to support their economies and to encourage trade within the
region. Coinage usually had several tiers of coins of different values, made
of copper, silver, and gold. Gold coins were the most valuable and were
used for large purchases, payment of the military, and backing of state
activities.

Units of account were often defined as the value of a particular type of gold
coin. Silver coins were used for intermediate-sized transactions, and
sometimes also defined a unit of account, while coins of copper or silver,
or some mixture of them, might be used for everyday transactions.

Most countries now use a monetary currency system, but individuals can
still barter or adopt another agreed-upon currency system. These
alternatives may be used in addition to or as a replacement for the national
monetary system in place.

What Are Open Market Operations (OMO)?

 28

Open market operations (OMO) is the term that refers to the purchase and
sale of securities in the open market by the Federal Reserve (Fed). The
Fed conducts open market operations to regulate the supply of money that
is on reserve in U.S. banks. The Fed purchases Treasury securities to
increase the money supply and sells them to reduce it.

By using OMO, the Fed can adjust the federal funds rate, which in turn
influences other short-term rates, long-term rates, and foreign exchange
rates. This can change the amount of money and credit available in the
economy and affect certain economic factors, such as unemployment,
output, and the costs of goods and services.

KEY TAKEAWAYS

 Open market operations are one of three tools used by the Fed to
affect the availability of money and credit.
 The term refers to a central bank buying or selling securities in the
open market to influence the money supply.
 The Fed uses open market operations to manipulate interest rates,
starting with the federal funds rate used in interbank loans.
 Buying securities adds money to the system, lowers rates, makes
loans easier to obtain, and increases economic activity.
 Selling securities removes money from the system, raises rates,
makes loans more expensive, and decreases economic activity.

What Are Reserve Requirements?

Reserve requirements are the amount of cash that banks must have, in
their vaults or at the closest Federal Reserve bank, in line
with deposits made by their customers. Set by the Fed's board of
governors, reserve requirements are one of the three main tools of
monetary policy—the other two tools are open market operations and
the discount rate.

On March 15, 2020, the Federal Reserve Board announced that reserve
requirements ratios would be set to 0%, effective March 26, 2020. Prior to
the change effective March 26, 2020, the reserve requirement ratios on net
transactions accounts differed based on the amount of net transactions
accounts at the institution.1

KEY TAKEAWAYS

 Reserve requirements are the amount of funds that a bank holds in

reserve to ensure that it is able to meet liabilities in case of sudden
withdrawals.
 29

 Reserve requirements are a tool used by the central bank to

increase or decrease the money supply in the economy and
influence interest rates.
 Reserve requirements are currently set at zero as a response to the
COVID-19 pandemic.

Understanding Reserve Requirements

Banks loan funds to customers based on a fraction of the cash they have
on hand. The government makes one requirement of them in exchange for
this ability: keep a certain amount of deposits on hand to cover possible
withdrawals. This amount is called the reserve requirement, and it is the
rate that banks must keep in reserve and are not allowed to lend.

The Federal Reserve's Board of Governors sets the requirement as well as

the interest rate banks get paid on excess reserves. The Financial
Services Regulatory Relief Act of 2006 gave the Federal Reserve the right
to pay interest on excess reserves. The effective date on which banks
started getting paid interest was Oct. 1, 2011.2 This rate of interest is
referred to as the interest rate on excess reserves and serves as a proxy
for the federal funds rate.

The reserve requirement is another tool that the Fed has at its disposal to
control liquidity in the financial system. By reducing the reserve
requirement, the Fed is executing an expansionary monetary policy, and
conversely, when it raises the requirement, it's exercising a contractionary
monetary policy. This latter action cuts liquidity and causes a cool down in
the economy.

Example of Reserve Requirements

As an example, assume a bank had $200 million in deposits and is
required to hold 10%. The bank is now allowed to lend out $180 million,
which drastically increases bank credit. In addition to providing a buffer
against bank runs and a layer of liquidity, reserve requirements are also
used as a monetary tool by the Federal Reserve. By increasing the
reserve requirement, the Federal Reserve is essentially taking money out
of the money supply and increasing the cost of credit. Lowering the
reserve requirement pumps money into the economy by giving banks
excess reserves, which promotes the expansion of bank credit and lowers
rates.

Explain how to use an open market operation to expand the money

supply?
 30

Step 1 : Concept Preface

Monetary PolicyIt's principally the policy created by the financial
authority of a country (like the Fed in the USA or central bank) to control
either the plutocrat force or the cost of short- term loans. It's frequently
targeted towards controlling affectation rate or interest rate for icing price
and currency stability.

Step 2 :Explanation of Solution

The Federal Reserve System is principally the central bank of the USA
engaged in making opinions regarding money force. It not only decides
whether to lower or raise interest rates and, influence macroeconomic
policy but also regulates the nation's banking system to ensure the health
of the bank's balance distance and cover bank depositors.One of the most
important functions of'The Fed'is to conduct the financial policy of the
nation. To achieve this, the central bank implements the three traditional
tools similar as Open Market Operations, changing reserve conditions, and
Changing the reduction rate.To expand the money force, the Fed
specifically uses Open Market Operations as a tool. The Fed sells or buys
theU.S. storeroom bonds to impact the interest levelsand produce
redundant reserves. Hence, as a result it'll increase the plutocrat force by
adding the redundant reserves.

Explain how to use the discount rate to expand the money supply?

Step 1 : Concept Preface

Monetary Policy:It's the policy created by the financial authority of a
country (like the Fed in the USA or central bank) to control either
investors or the cost of short-term loans. It's frequently targeted towards
controlling the interest rate for price and currency stability.

Step 2 :Explanation of Solution

The Federal Reserve System is principally the central bank of the USA
engaged in making decisions regarding the money supply. It not only
decides whether to lower or raise interest rates and, influence
macroeconomic policy but also regulates the nation's banking system to
 31

ensure the health of the bank's balance and cover bank depositors.
One of the most important functions of 'The Fed' is to conduct the
financial policy of the nation. To achieve this, the central bank implements
the three traditional tools: Open Market Operations, Changing reserve
conditions, and Changing the reduction rate.

Step 3 : Result
Changing the reduction rate

At the time of bank runs,

indeed healthy banks adopt finances from the Fed.

The interest rate at which banks repay for similar loans is known as the
discount rate. To control the money supply, the central bank changes the
discount rate and it impacts the lending power of the banks.
To expand the money supply, the Fed would reduce the discount rate. The
discount rate is the interest rate the Fed charges banks that borrow from it.
A lower discount rate makes it more incentive for banks to borrow from it;
all the money banks adopt from the Fed are excess reserves. The money
supply will rise by the increase in required reserves times the money
multiplier.

How does the Expansionary and Contractionary Monetary Policy

affect Inflation?
Effects of Expansionary Policy
1. Increased money supply – higher consumption and greater economic growth

Expansionary policies increase the availability of funds, which, in turn,

leads to increased consumption and greater economic growth. Because
companies have more funds available to them, they increase
production, which then increases the demand for all factors of
production, including human capital.
 32

2. Greater need for human capital – lower unemployment

The greater need for human capital leads to lower unemployment. The
lower levels of unemployment lead to a greater demand for products
as consumption increases. It leads the economy into a virtuous cycle.

Over time, the increased money supply and the abundance of funds
mean that the value of currency drops, and inflation increases. It is
important that inflation rates do not go beyond a certain threshold. To
ensure that rates are kept within a certain range, contractionary
policies may be deployed.

Inflation and interest rates move in the same direction. Expected and
actual inflation rates dictate to central banks whether to increase or
decrease rates. Low inflation rates indicate to central banks that a rate
cut is needed and vice versa.

Some countries adopt a negative interest rate policy. It is implemented

to discourage savings and increase consumer spending. Such low or
negative rates are aimed at increasing inflation as it promotes
increased spending and lower savings.

Risks of Expansionary Policy

1. Overextended debt levels

One of the risks of expansionary policy is debt being overextended.

Because funds are readily available, both corporations and individuals
move to take advantage of lower rates by incurring greater debt. High
levels of debt are not sustainable over a long period and may lead to
damaging results if not analyzed carefully.

2. High inflation rates

The most prominent risk associated with an expansionary policy is the

risk of high inflation. Central banks have a target inflation level, which is
considered ideal for steady inflation growth. The target inflation rate in
the US, as noted by the Federal Open Market Committee (FOMC), is 2%.

If unchecked, inflation can spiral out of control and lead to a situation

that is called hyperinflation, which can have a severe adverse impact on
 33

the economy. In periods of high inflation, prices of items increase faster

than wages do, and real wages along with the standard of living falls.

High inflation also means that real interest earned on savings falls
rapidly, and the currency will depreciate rapidly. Countries with high
inflation rates, such as Venezuela, South Sudan, and Congo, are facing
severe economic depressions.

Effects of Contractionary policy

Contractionary policy is a type of monetary measure which maintains
higher than usual short-term interest rates, or which reduces or even shrink
the rate of growth in the money supply. This reduces economic growth in
the short term and lowers inflation. Contractionary monetary policy can lead
to increased unemployment and decreased borrowing and spending by
consumers and businesses, which can eventually lead to an economic
recession if too aggressively applied. In other words, a contractionary
policy is a kind of policy that lays emphasis on reduction in the level of
money supply for lesser spending and investment thereafter so as to slow
down an economy.

What Is the Quantity Theory of Money?

The quantity theory of money (QTM) also assumes that the quantity of money in
an economy has a large influence on its level of economic activity. So, a change in
the money supply results in either a change in the price levels or a change in the
supply of goods and services, or both. In addition, the theory assumes that
changes in the money supply are the primary reason for changes in spending.

One implication of these assumptions is that the value of money is determined by

the amount of money available in an economy. An increase in the money supply
results in a decrease in the value of money because an increase in the money
supply also causes the rate of inflation to increase. As inflation rises, purchasing
power decreases. Purchasing power is the value of a currency expressed in terms
of the amount of goods or services that one unit of currency can buy. When the
purchasing power of a unit of currency decreases, it requires more units of
currency to buy the same quantity of goods or services.
 34

Throughout the 1970s and 1980s, the quantity theory of money became more
relevant as a result of the rise of monetarism. In monetary economics, the chief
method of achieving economic stability is through controlling the supply of
money. According to monetarism and monetary theory, changes in the money
supply are the main forces underpinning all economic activity, so governments
should implement policies that influence the money supply as a way of fostering
economic growth. Because of its emphasis on the quantity of money determining
the value of money, the quantity theory of money is central to the concept of
monetarism.

Calculating QTM
The quantity theory of money proposes that the exchange value of money is
determined like any other good, with supply and demand. The basic equation for
the quantity theory is called The Fisher Equation because it was developed by
American economist Irving Fisher. In its simplest form, it looks like this:
(M)(V)=(P)(T)
where:
M=Money Supply
V=Velocity of circulation (the number of times
money changes hands)
P=Average Price Level
T=Volume of transactions of goods and services

Discuss the meaning and importance of Public Finance in a Modern Economy.

Public Finance
The area of economics and finance can be quite fascinating to study if you have an
interest in learning about money and how it works. However, finance is not just
about money. It involves much larger components than a layperson may think. One
such component is public finance, and here we will learn some crucial details about
it.

What Is Public Finance?

 35

Public finance is referred to as the management of a country’s revenue,

expenditures, and debt load through different government and quasi-government
institutions. In other words, it is the approach to managing the public funds in a
nation’s economy that plays the most crucial role in the development and growth
of the country – both domestically and internationally.

As you may realize, every country requires monetary power to run. The revenue of
the country is basically the collection of various taxes and returns on investment,
and the government expends from the collection of the revenue. All the revenue
and expenditure are collected by or for the public. This is why it is called public
finance.

Public finance deals with the revenue and expenditure in every state in which the
public is involved, either at the state or central levels. Needless to say,
public finance management plays a crucial role in developing the economy as its
growth primarily depends on its proper utilization

What Is The Role Of Public Finance?

Now that you have a basic understanding of what is public finance, we can move
to the discussion of its roles. You may have already guessed a few of its roles and
what is the importance of public finance. We would still like to highlight the major
roles of public finance and financial economics help.
1. Managing public needs
2. Economic development
 Eradicating inequality
1. Maintaining price stability
2. Fulfilling the basic needs of the nation
3. Creating employment
 Maintaining the value of the currency in the international market

What Is The Importance Of Public Finance?

If you still need clarity on the importance of public finance, we would like to shed
some light on the following facts:
 36

 Public finance manages the income and expenditure by optimum utilization

of the resources.
 It manages the growth and price stability of the economy.
 It provides the necessary needs and infrastructure to the public.
 It takes initiative for the development of the people, further contributing to
the nation’s development.
 It maintains the transparency of the policies and the records of income and
expenditure.
 It compares the actual position with the budgets and accordingly alters the
policies and manages the economy.
 It monitors the functioning and effectiveness of the financial policy.
 It prepares the economic policies for the nation’s development and
economy.

Distinguish between the Incidence and Burden of a Tax?

 Tax incidence is the manner in which the tax burden is divided between
buyers and sellers.
 The tax incidence depends on the relative price elasticity of supply and
demand. When supply is more elastic than demand, buyers bear most of
the tax burden. When demand is more elastic than supply, producers bear
most of the cost of the tax.
 Tax revenue is larger the more inelastic the demand and supply are.
The burden of tax
Depending on the circumstance, the burden of tax can fall more on consumers or
on producers.
In the case of cigarettes, for example, demand is inelastic—because cigarettes are
an addictive substance—and taxes are mainly passed along to consumers in the
form of higher prices.
The analysis, or manner, of how the burden of a tax is divided between
consumers and producers is called tax incidence.
Elasticity and tax incidence
 37

Typically, the incidence, or burden, of a tax falls both on the consumers and
producers of the taxed good. But if we want to predict which group will bear most
of the burden, all we need to do is examine the elasticity of demand and supply.
In the tobacco example above, the tax burden falls on the most inelastic side of
the market. If demand is more inelastic than supply, consumers bear most of the
tax burden. But, if supply is more inelastic than demand, sellers bear most of the
tax burden.
Think about it this way—when the demand is inelastic, consumers are not very
responsive to price changes, and the quantity demanded remains relatively
constant when the tax is introduced. In the case of smoking, the demand is
inelastic because consumers are addicted to the product. The seller can then pass
the tax burden along to consumers in the form of higher prices without much of a
decline in the equilibrium quantity.
When a tax is introduced in a market with an inelastic supply—such as, for
example, beachfront hotels—sellers have no choice but to accept lower prices for
their business. Taxes do not greatly affect the equilibrium quantity. The tax
burden in this case is on the sellers. If the supply were elastic and sellers had the
possibility of reorganizing their businesses to avoid supplying the taxed good, the
tax burden on the sellers would be much smaller, and the tax would result in a
much lower quantity sold instead of lower prices received. You can see the
relationship between tax incidence and elasticity of demand and supply
represented graphically below.
Discuss the criteria that determine the structure of taxation?
Characteristics of an Effective Tax System
‹‹ Go back to An Overview of our Tax System | Go on to Oklahoma’s Tax Mix ››
A good tax system should meet five basic conditions: fairness, adequacy,
simplicity, transparency, and administrative ease.
Although opinions about what makes a good tax system will vary, there is general
consensus that these five basic conditions should be maximized to the greatest
extent possible.
1. Fairness, or equity, means that everybody should pay a fair share of taxes.
There are two important concepts of equity: horizontal equity and vertical equity.
 Horizontal equity means that taxpayers in similar financial condition should
pay similar amounts in taxes.
 38

 Vertical equity is just as important, however. Vertical equity means that

taxpayers who are better off should pay at least the same proportion of
income in taxes as those who are less well off. Vertical equity involves
classifying taxes as regressive, proportional, or progressive.
 Regressive tax: A tax is regressive if those with low incomes pay a
larger share of income in taxes than those with higher incomes.
Almost any tax on necessities, such as food purchased at a grocery
store, is regressive because lower income people must spend a
larger share of their income on these necessities. Oklahoma’s sales
tax is one example.
 Proportional tax: A tax is proportional if all taxpayers pay the same
share of income in taxes. No taxes are truly proportional. Property
taxes often come closest since there is typically a close relationship
between a household’s income and the value of the property in
which they live. Corporate income taxes often approach proportional
because one rate applies to most corporate income.
 Progressive tax: A progressive tax requires higher-income individuals
to pay a higher share of their income in taxes. The philosophy behind
progressive taxes is that higher income people can afford and should
be expected to provide a bigger share of public services than those
who are less able to pay. The federal income tax is the best example
of a progressive tax; the Internal Revenue Service reports that the
top one percent of taxpayers by income paid 37 percent of federal
income taxes in 2016.
While no system of taxes is perfect, it is important to seek horizontal equity
because taxpayers must believe they are treated equally. It is just as important to
seek vertical equity so government does not become a burden to low-income
residents.
2. Adequacy means that taxes must provide enough revenue to meet the basic
needs of society. A tax system meets the test of adequacy if it provides enough
revenue to meet the demand for public services, if revenue growth each year is
enough to fund the growth in cost of services, and if there is enough economic
activity of the type being taxed so rates can be kept relatively low.
3. Simplicity means that taxpayers can avoid a maze of taxes, forms and filing
requirements. A simpler tax system helps taxpayers better understand the
system and reduces the costs of compliance.
 39

4. Transparency means that taxpayers and leaders can easily find information
about the tax system and how tax money is used. With a transparent tax system,
we know who is being taxed, how much they are paying, and what is being done
with the money. We also can find out who (in broad terms) pays the tax and who
benefits from tax exemptions, deductions, and credits.
5. Administrative ease means that the tax system is not too complicated or costly
for either taxpayers or tax collectors. Rules are well known and fairly simple;
forms are not too complicated; the state can tell if taxes are paid on time and
correctly, and the state can conduct audits in a fair and efficient manner. The cost
of collecting a tax should be very small in relation to the amount collected.

The tax structure of an economy depends on its tax base, tax rate, and how the
tax rate varies. The tax base is the amount to which a tax rate is applied. The tax
rate is the percentage of the tax base that must be paid in taxes. To calculate
most taxes, it is necessary to know the tax base and the tax rate. So if the tax base
equals $100 and the tax rate is 9%, then the tax will be $9 (=100 ×
0.09). Proportional taxes (aka flat-rate taxes) apply the same tax rate to any
income level, or for any size tax base. So if Bill earns $50,000 and Jane earns
$100,000, and the tax rate is 10%, then Bill will owe $5,000 in taxes while Jane will
owe $10,000. Many state income taxes and almost all sales taxes are proportional
taxes. Social Security and Medicare taxes are also proportional since the same tax
rate is applied to any earned income up to the Social Security wage base limit,
which, for 2021, is $142,800. The Medicare tax is a proportional tax that applies
to all earned income, = 2.9%. Flat taxes are a fixed amount and do not depend on
income or transaction values, such as a $10 per capita tax.
A regressive tax is higher at lower incomes. The most prominent regressive tax is
the Social Security tax, because the tax drops to 0, when earned income exceeds
the Social Security wage base limit. Regressive taxes especially hurt the poor. The
inequitable effects of regressive or proportional taxes are often mitigated by
payments to the poor and by exempting essential products and services, such as
food, from regressive and proportional taxes.
A tax can also be regressive if it places a greater burden on poorer people. Flat
taxes, for instance, place a greater burden on poor people because, even though
the tax is the same for everyone, the tax is a greater proportion of income for a
poor person than for a rich person. Even proportional taxes can be regressive. For
instance, if the tax rate was 10% for everyone, that 10% of income represents a
greater burden for poor people because they need all their money to live. Taking
 40

10% from a rich person probably would not lower their standard living at all
because they have so much more than what they need to live well. The marginal
utility of money declines with increasing wealth, so much so that taking 10% from
someone who makes $10,000 annually is much more burdensome than taking
10% from someone who earns $1 million annually, even though the tax revenue
from the wealthy person is $100,000 while the tax revenue from the poor person
is only $1000. This is why some rich people pay many millions of dollars for a
painting or other collectibles because they cannot use it to improve their quality
of life, so they invest it.
A progressive tax applies a higher tax rate to higher incomes. So if the tax rate on
$50,000 is 10% and 20% for $100,000, then, continuing the above example, Bill
still owes $5,000 in taxes while Jane must pay $20,000 in taxes. However, almost
all progressive taxes are structured as a marginal tax, meaning that the
progressive tax rate only applies to that part of the income exceeding a certain
amount. The portion of the tax base subject to a particular tax rate, known as
a tax bracket, always has lower and upper limits, except for the top tax bracket,
which has no upper limit. To see the current rates published by the IRS, scroll
down to the bottom of the current tax table from the instructions for Form 1040.
Continuing the above example, if the 20% tax rate is only applied to that portion
of the income between $50,000 and $100,000, then Jane would owe $5000 on
the first $50,000 of income and $10,000 on the 2nd $50,000 of income, a total tax
liability of $15,000.
Without marginal tax rates, a progressive tax would skew economic decisions and
would be viewed as unfair. For instance, if the 20% tax rate was applied to all
earned income and Jane only earned $60,000, then she must pay $12,000 in
taxes, 2.4 times more than Bill's taxes, even though she only made 1.2 times more
than Bill. A more extreme example, consider what happens if Jane makes
$50,001. Then she must pay $10,000, $5000 more than what Bill must pay, even
though he earned only $1 less. Hence, without marginal tax rates, a pay increase
could actually result in a decrease in disposable income. A person's tax bracket is
the highest tax bracket applicable to her income level.
A progressive, marginal tax rate also makes economic sense, since money, like
everything else, has a declining marginal utility. In other words, $1 is worth a lot
more to someone who earns $10,000 per year than to someone who makes $10
million per year. Poor people need the money to buy essentials, whereas rich
people spend their money for luxuries, so the wealthy can pay higher taxes
without seriously lowering their standard of living.
 41

The new Republican tax policy, passed at the end of 2017, known as the Tax Cuts
and Jobs Act, has changed the tax brackets for 2018 and afterwards. Congruent to
the Republicans' tax objective to benefit the wealthy, most of the benefits in the
change to tax brackets go to those who earn more than $200,000. The marriage
penalty has also been eliminated for all tax brackets, except the top 2.
In a Free Market Economy how the govt. performs the allocative, Distributive
and Stabilization Functions?
4 Major Functions of Fiscal Policy
Although particular tax or expenditure measures affect the economy in many
ways and may be designed to serve a variety of purposes, several more or less
distinct policy objectives may be set forth. They include:
1. Allocation Function:
The provision for social goods, or the process by which total resource use is
divided between private and social goods and by which the mix of social goods is
chosen. This provision may be termed as the allocation function of budget policy.
Social goods, as distinct from private goods, cannot be provided for through the
market system.
The basic reasons for the market failure in the provision of social goods are:
firstly, because consumption of such products by individuals is non rival, in the
sense that one person’s partaking of benefits does not reduce the benefits
available to others.
The benefits of social goods are externalised. Secondly, the exclusion principle is
not feasible in the case of social goods. The application of exclusion is frequently
impossible or prohibitively expensive. So, the social goods are to be provided by
the government.
ADVERTISEMENTS:
2. Distribution Function:
Adjustment of the distribution of income and wealth to assure conformance with
what society considers a ‘fair’ or ‘just’ state of distribution. The distribution of
income and wealth determined by the market forces and laws of inheritance
involve a substantial degree of inequality. Tax transfer policies of the government
play an important role in reducing the inequalities in income and wealth in the
economy.
3. Stabilization Function:
 42

Fiscal policy is needed for stabilization, since full employment and price level
stability do not come about automatically in a market economy. Without it the
economy tends to be subject to substantial fluctuations, and it may suffer from
sustained periods of unemployment or inflation. Unemployment and inflation
may exist at the same time. Such a situation is known as stagflation.
ADVERTISEMENTS:
The overall level of employment and prices in the economy depends upon the
level of aggregate demand, relative to the potential or capacity output valued at
prevailing prices. Government expenditures add to total demand, while taxes
reduce it. This suggests that budgetary effects on demand increase as the level of
expenditure increases and as the level of tax revenue decreases.
4. Economic Growth:
Moreover, the problem is not only one of maintaining high employment or of
curtailing inflation within a given level of capacity output. The effects of fiscal
policy upon the rate of growth of potential output must also be allowed for. Fiscal
policy may affect the rate of saving and the willingness to invest and may thereby
influence the rate of capital formation.
Capital formation in turn affects productivity growth, so that fiscal policy is a
significant factor in economic growth.

Importance of Public Debt in the Development of an Economy?

Sovereign debt management is the process of developing and implementing a
strategy for managing the government’s debt in order to raise the necessary
funds, meet risk and cost objectives, and achieve any other sovereign debt
management goals the government may have set, such as developing and
maintaining an efficient government securities market. Governments should
endeavour to guarantee that both the size and pace of expansion of their public
debt is fundamentally sustainable, and that it can be paid under a variety of
situations while fulfilling cost and risk goals in a larger macroeconomic framework
for public policy. Sovereign debt managers share the concerns of fiscal and
monetary policy advisers that public sector debt is on a sustainable path and that
a credible strategy is in place to decrease excessive debt levels. Debt managers
should make sure that the fiscal authorities are informed of how government
funding requirements and debt levels affect borrowing costs. The public sector
debt service ratio, as well as public debt to GDP and tax revenue ratios, are
examples of measures that address debt sustainability.
 43

In numerous countries throughout history, poorly structured debt in terms of

duration, currency, or interest rate composition, as well as significant and unmet
contingent obligations, have been key contributors in causing or propagating
economic crises. For example, crises have frequently emerged as a result of
governments’ undue concentration on putative cost reductions associated with
huge volumes of short-term or floating-rate debt, regardless of the exchange rate
regime or whether domestic or foreign currency debt is involved. When the debt
has to be rolled over, this has left government budgets vulnerable to shifting
financial market conditions, particularly changes in the country’s
creditworthiness. Excessive dependence on foreign currency debt can result in
exchange rate and/or monetary pressures if investors are hesitant to refinance
the government’s foreign- currency debt. Prudent government debt
management, along with strong policies for managing contingent liabilities, can
make nations less susceptible to contagion and financial risk by minimising the
danger that the government’s own portfolio management will become a source of
instability for the private sector. The debt portfolio of a government is often the
country’s largest financial portfolio. It frequently involves complicated and
dangerous financial arrangements, posing a significant risk to the government’s
balance sheet and financial stability. “Recent experience has emphasised the
need for governments to minimise the build-up of liquidity exposures and other
risks that render their economies especially sensitive to external shocks,”
according to the Financial Stability Forum’s Working Group on Capital Flows. 2 As
a result, good risk management in the public sector is equally important for risk
management in other sectors of the economy, “since individual firms in the
private sector often experience significant issues when poor sovereign risk
management leads to liquidity crisis susceptibility. Governments with sound debt
arrangements are less vulnerable to interest rate, currency, and other hazards.
Many governments aim to support these arrangements by setting portfolio
benchmarks relating to the intended currency composition, duration, and
maturity structure of the debt, when possible, to influence the portfolio’s future
composition.
Several debt market crises have brought attention to the necessity of effective
debt management techniques as well as the requirement for a well-functioning
capital market. Although government debt management policies may not have
been the sole or even primary cause of these crises, the maturity structure,
interest rate, and currency composition of the government’s debt portfolio, as
well as significant obligations in respect of contingent liabilities, have all played a
role in the severity of the crisis. Risky debt management methods raise the
 44

economy’s vulnerability to economic and financial shocks, even when

macroeconomic policy settings are solid. These dangers can sometimes be easily
identified. Lengthening borrowing maturities and paying the associated higher
debt servicing costs (assuming an upward sloping yield curve), adjusting the
amount, maturity, and composition of foreign exchange reserves, and reviewing
criteria and governance arrangements in respect of contingent liabilities are all
relatively simple measures that can be taken.
Risky loan arrangements are frequently the result of ineffective economic policies
like fiscal, monetary, and exchange rate policies, but the feedback consequences
are undeniably bidirectional. Sound debt management policies, on the other
hand, have their limitations. Debt management measures are not a panacea or a
replacement for effective fiscal and monetary policy. Sound sovereign debt
management may not be enough to avoid a crisis if macroeconomic policy
settings are bad. By acting as a catalyst for the larger financial market, sound debt
management strategies lessen vulnerability to contagion and financial risk.

Define Monetary Economics. What are the various functions of

money?
Monetary economics is the branch of economics that studies the different
competing theories of money: it provides a framework for analyzing money and
considers its functions (such as medium of exchange, store of value and unit of
account), and it considers how money can gain acceptance purely because of its
convenience as a public good.[1] The discipline has historically prefigured, and
remains integrally linked to, macroeconomics.[2] This branch also examines the
effects of monetary systems, including regulation of money and
associated financial institutions[3] and international aspects.[4]
Modern analysis has attempted to provide microfoundations for the demand for
money[5] and to distinguish valid nominal and real monetary relationships for
micro or macro uses, including their influence on the aggregate demand for
output.[6] Its methods include deriving and testing the implications of money as a
substitute for other assets[7] and as based on explicit frictions.[8]
Dr. Kent Matthews, University of Cardiff
Money, according to the Scottish philosopher David Hume ‘is none of the wheels
of trade: it is oil which renders the motion of the wheels more smooth and easy’.
But this is not true – and that’s just as well, as if that were the case, there would
be no reason to study monetary economics. This is because all economics would
be the microeconomics of general equilibrium and a monetary economy would be
 45

no different from a frictionless barter economy based on perfect information and

zero transactions costs.
Perhaps the simplest way to illustrate the importance of money is to imagine how
the world would be if money didn’t exist. We would have to resort to barter – and
this means that you would have to find someone who had what you wanted, and
you would need to have something (of similar value) that they wanted. This
problem of the ‘double coincidence of wants’ means that barter economies are
much less efficient than monetary economies – as anyone who has been to
Zimbabwe recently (or has studied Weimar Germany) should know. In the
absence of a government that creates a common medium of exchange, money
emerges naturally: cigarettes became the common ‘currency’ in prisoner of war
camps during recent conflicts.
So according to classical economics money is a medium of exchange. It is also a
unit of account: all prices can be expressed in terms of a single scale (dollars, for
example). This idea can also be extended to intertemporal and intergenerational
exchange. Because money acts as a store of value, what is not used in exchange is
saved. Savers (households) demand financial assets including money and
investors (firms and the government) supply these assets. The demand and supply
of financial assets determine an equilibrium rate of interest – but this rate of
interest can be disturbed by monetary policy.
So far, this is still a world of equilibrium. But the critical importance of money is its
role in disequilibrium. Shocks can push the economy out of equilibrium: and this is
reflected in disequilibrium in money. This disequilibrium in money creates
disequilibrium in all other markets and leads to changes in asset prices, exchange
rates, and inflation.
The study of monetary economics enables us to understand not just how an
economy functions efficiently but also how monetary policy can help the
economy adjust from one equilibrium state to another.
Monetary economics is concerned with the effects of monetary institutions and
policy on economic variables including commodity prices, wages, interest rates,
quantities of employment, consumption, and production.
Perhaps the simplest way to illustrate the importance of money is to imagine how
the world would be if money didn’t exist. We would have to resort to barter —
and this means that you would have to find someone who had what you wanted,
and you would need to have something (of similar value) that they wanted. This
problem of the ‘double coincidence of wants’ means that barter economies are
 46

much less efficient than monetary economies – as anyone who has been to
Zimbabwe recently (or has studied Weimar Germany) should know. In the
absence of a government that creates a common medium of exchange, money
emerges naturally: cigarettes became the common ‘currency’ in prisoner of war
camps during recent conflicts.
The study of monetary economics enables us to understand not just how an
economy functions efficiently but also how monetary policy can help the
economy adjust from one state to another and how it can find balance and grow.
Dr. Kent Matthews, University of Cardiff

What is Deficit Financing? What are its effects on growth and

inflation?
Deficit financing is a policy in which government spending is more than it receives
as revenue. The difference between the government spending and revenue
received is being made by borrowing or minting new funds. Although the budget
deficit may occur for several reasons, the term generally refers to the deliberate
efforts to stimulate the economy by lowering the tax rate and increasing
government expenditure. As we have understood, what is deficit financing? This
article lets us learn its objectives, causes, advantages, and limitations.

Types of Deficit Financing

The Different Types of Deficit Financing or Budget Deficit Are:
 Revenue Deficit
 Fiscal Deficit
 Primary Deficit

Let us Discuss the Types of Deficit Financing in Brief:

1. Revenue Deficit: Revenue deficit is the excess of revenue expenditure over
revenue receipts.
Revenue Deficit Formula: Revenue Expenditure - Revenue Receipts, when RE >
RD
2. Fiscal Deficit: Fiscal Deficit is the excess of total expenditure over total
receipt other than borrowings.
 47

Fiscal Deficit Formula: Total expenditure (Revenue expenditure + Capital

Expenditure) - Total Receipts other than borrowing (Revenue receipts + Capital
receipt other than borrowing).
3. Primary Deficit: Primary deficit implies the difference between fiscal deficit
and interest payments.
Primary Deficit Formula: Fiscal deficit - Interest Payment
While the fiscal deficit shows the borrowing requirement of the government
inclusive of interest payment on the past loan, the primary deficit shows the
borrowing requirement of the government exclusive of interest payment on the
past loan. In other words, a primary deficit indicates government borrowing on
account of current year expenditure and current year revenues.

How Does Government Budget Deficit Occur?

A budget deficit or deficit financing occurs when the estimated government
expenditures increase more than the estimated government revenue. Such
differences may be met by either increasing the tax rate or imposing the higher
price of goods and public utility services. The deficit can also be met out by the
accumulated cash balance of the government or by borrowing from the banking
system.

In India, deficit financing is said to occur when the union government’s current
budget deficit is covered by the withdrawal of the government’s cash balance and
by borrowing money from the Reserve Bank of India. When the government
withdraws its cash balance, this cash becomes active and comes into circulation.

Again when the government borrows from the RBI, then in such cases, RBI gives
loans by printing additional currency. Hence, in both cases, the new money comes
into circulation. It should be noted that government borrowing from the bank by
selling bonds is not considered deficit financing.

What are the main Objectives of Deficit Financing?

The Main Objectives of Deficit Financing are:
 48

 To finance expenditures related to defence during war.

 To lift the economy out of depression so that employment, income,
investments rise.
 To instigate the ideal resources and divert resources from unproductive
sectors to productive sectors with the main objective of increasing national
income, leading to higher economic growth.
 To improve the country's infrastructure so that the taxpayer may be certain
that the money they spent in tax is used wisely.

Role of Deficit Financing In Developed Economy

In a Developed Economy, deficit financing played a significant role during the
depression. During the depression period, the level of expenditure and demand
falls to a very low level and the banks and the general public are not willing to
undertake the risk of investment. Instead, they prefer to accumulate idle cash
balances.

All the machinery and capital equipment are available but what lacks is the
incentive to produce due to deficiency in aggregate demand. Suppose the
government instigates additional purchasing power in the economy (through
deficit financing). In that case, the level of effective demand is likely to increase to
meet this demand, the machinery and capital equipment lying idle will be pressed
into operation. Accordingly, the level of production will increase. If this increase
can cope with the increase in aggregate spending level, inflationary tendencies
will not be generated.

What are the Advantages of Deficit Financing?

The foremost thing to be considered is that the deficit is not only worse. When
the economy goes into recession, deficit spending through tax cuts or the
purchase of goods and services made by the government can stop the
devaluation and help to turn the economy back into a position. Hence, deficit
financing helps to stabilize the economy. Also, the outlook of the business
improves as the economy improves due to the deficit financing, and this can lead
to increased investment, an effect known as crowding in.
 49

Deficits enable us to purchase infrastructure and spread the ball across the time,
similar to the way households finance the purchase of a car or house or the way
local governments finance schools with bond issues. This enables us to purchase
infrastructure that we might not be able to afford if it has to be financed all at
once.

When the government employs deficit financing, it usually borrows from the RBI.
The interest paid to the RBI comes back to the government in the form of profit.
Through deficit financing, resources are used much earlier than differently. The
development is accelerated. This enables the government to acquire resources
without much opposition.

What are the Measures to Overcome Deficit Financing?

Following are the measures are taken to overcome the deficit financing:
 The amount of deficit financing should be limited to the needs of the
economy.
 Efforts should be made to eliminate the surplus money hence injected for a
new part. So that saved money is not permitted to return back again to the
mainstream soon after its withdrawal.
 Control on the price of goods, specifically in wage-good, and their equitable
distribution through formal or informal rationing will go a long way in
eliminating the inflationary impact on low-income groups of people and on
the cost structure of the economy.

The above-discussed methods suggest that deficit financing can be an effective

method for economic development. However, if these measures are not adopted
and safety limits are crossed, then the result will surely be harmful.

What is the Relation Between Deficit Financing and Inflation

It is observed that deficit financing is inflationary in nature. As deficit financing
increases aggregate expenditure and hence increases demand, the danger of
 50

inflation becomes larger. This is specifically true when deficit financing is made for
the ill-treatment of war.
This method of financing, specifically during the war, is totally unproductive as it
neither increases the society's stock of wealth nor enables a society to enlarge its
production capacity. The outcome of this results in hyperinflation.

In contradiction, resources arranged through deficit financing get diverted from

civil to military production, hence leading to a shortage of consumer goods. Thus,
the creation of additional money generates inflationary fire. However, whether
deficit financing is inflationary in nature or not depends on the nature of deficit
financing. Being sterile in character, war expenditure made through deficit
financing is definitely inflationary. But if a developmental expenditure is made
through deficit financing, it may not be inflationary but may increase the money
supply.
In other words, “Deficit financing”, adopted for the purpose of strengthening
useful capital during a short period of time, is likely to improve productivity and
eventually enhance the elasticity of supply curves.
Deficit Financing and Inflation
The inflationary implications of deficit-financing is divided into two parts:
1. Inflation in a full-employment economy, and
2. Inflation in an under-developed country or less than full-employment
economy.
1. The first part is related to the inflationary impacts of deficit financing in a
full employment economy. In this regard some writers hold the view that
even under the conditions of full employment, in the long run, there is no
problem of inflation, particularly in economically advanced
countries. However, infact, at full employment a further increase in
aggregate demand through deficit financing results in raising the general
price level instead of adding to aggregate output and employment.
2. In the second part, there are five reasons by which the deficit financing
results into inflation:
(a) When there is a variety of channels into which increased money supply can
flow
 51

(b) Non-homogeneity in skills or efficiency

(c) Supply of resources is perfectly inelastic
(d) Increase in wage rates
(e) Increasing marginal cost

Make an analysis of Tax and Non-Tax revenue sources of the developing country
like Pakistan?
Tax Revenue
 A tax is a legal requirement that individuals and businesses pay to the
government of a country without receiving any direct benefit in return. The
government imposes it on the people.
 Income tax, sales tax, service tax, excise duty, and customs duty are some
of the taxes that a government collects.
o Historically, tax revenue has been the principal source of
government funding.
o Those who earn income such as wages, salaries, rent, interest, and
profit are subject to income tax.
o The tax on the sale of goods is known as sales tax. When we buy
something, a portion of our money goes to the government as sales
tax.
o The tax we pay when we use a service, such as a telephone, is known
as service tax.
o Excise duty is a tax paid by the manufacturer of a product.
o When a product is imported or exported, customs tax is paid.
 All taxes are of two kinds:
o Direct taxes
o Indirect taxes
 This distinction between taxes depends on
o the liability of payment of tax to the government and
o the actual burden of the tax.
 52

Direct Taxes
Direct taxes are levied on an individual’s property or company property and
revenue. Direct taxes are levied on businesses and individuals and are paid
directly to the government. Direct taxes have an impact on people's income
levels as well as their purchasing power. It also aids in the adjustment of the
economy's aggregate demand. Direct taxation can be proportional, progressive,
or regressive.
Indirect Taxes
Indirect taxes are those that affect an individual income or a company's income
and property through their consumption expenditure. Indirect taxes, often known
as compelled payments, are levied on products and services. The service tax is
an example of indirect taxes.
*Click here to read more about Direct Taxes and Indirect Taxes.
Sources of Tax Revenue
 The government is funded through taxes and a range of other non-tax
revenue streams. One of the most important sources of revenue for the
government's operation is taxation. Corporation tax, income tax, customs,
union excise charges, service tax, and a variety of other taxes are all major
revenue generators.
 The primary source of revenue for the government is corporation tax. Both
public and private businesses that are registered under the Companies Act
of 1956 incur corporation tax. It is a tax on a business's net profits. The
collection, surcharge, cess, and other receipts account for the majority of
the revenue.
 The income tax is the government's other source of revenue. Salaried
people must pay taxes, which are separated into a number of tax
brackets with differing tax rates. The income tax includes collections,
surcharges, the Securities Transaction Tax (STT), and other taxes.
 Wealth taxes include real estate taxes, wealth taxes on various sorts of
wealth, and gift taxes. Customs revenue comes from import charges, basic
tariffs, and levies on specific items. Export duties and a cess on
exports also play a role in this.
 Goods and Services Tax (GST) on a wide range of products and services
also contributes to tax revenue.
 53

Non-Tax Revenue
Non-Tax Revenue
Non-Tax Revenue is recurrent income earned by the government from sources
other than taxes. They are revenue receipts that are not derived through the
taxation of the general population. The following are some of the most important
non-tax revenue sources:
 Interests received by the government as a result of loans made to state
governments, UTs, private businesses, and the general public constitute a
significant source of non-tax revenue.
 Fees received by the central power authority of any country are included
in this category. This comprises fees received by the Central Electricity
Authority in India.
 Fees: These are charges levied by the government to pay the cost of
recurrent services. It is a tax-like mandatory contribution.
 License Fee: A license fee is a type of tax levied by the government and its
affiliated entities for engaging in a certain activity, such as starting a
restaurant or operating a heavy vehicle.
 Penalties and fines: Fines are most commonly employed in the context of
criminal law, where a court of law will impose a fine on a person convicted
of a crime.
o Penalty, on the other hand, is employed in both civil and criminal
law. It encompasses both monetary and physical penalties.
 Escheats: If an individual dies without leaving a legally binding bill or legal
heirs, escheats are the transfer of estate assets or property to the
government.
o The government receives a number of funds from international
organizations and foreign governments. Such grants are not a
consistent source of money and are typically given in response to a
national crisis such as war, flood, or natural disaster.
 Forfeitures: A forfeiture is the loss of property without compensation as a
result of failing to fulfill contractual obligations or as a penalty for criminal
behavior. Under the provisions of a contract, forfeiture refers to a
defaulting party's obligation to relinquish ownership of an asset or cash
flows from an asset in exchange for the other party's losses.
 54

 Interests: This category includes interest on loans and insurance supplied

to the government for non-planned and planned schemes, as well as
interest on loans, advanced to PSEs and other statutory entities.
 Communication Services Fees: The license fees from telecom operators on
account of spectrum usage costs that licensed Telecom Service Providers
pay to the government ministry in charge of telecommunications make up
the majority of this.

Elaborate upon the major principles of Public Expenditure which

meant to be adopted in the budgetary process.
Main Principles of Public Expenditure – Discussed!
Principles of Public Expenditure:
Just as there are well-known principles or canons of taxation, similarly it is
possible to formulate some principles to which prudent public expenditure should
conform.
These principles are:
 55

ADVERTISEMENTS:
1. Principle of Maximum Social Benefit:
It is necessary that all public expenditure should satisfy one fundamental test, viz.,
that of Maximum Social Advantage. That is, the government should discover and
maintain an optimum level of public expenditure by balancing social benefits and
social costs. Every rupee spent by a government must have as its aim the
promotion of the maximum welfare of the society as a whole.
Care has to be taken that public funds are not utilized for the benefit of a
particular group or a section of society. The aim is the general welfare.
Government exists for the benefit of the governed and the justification of the
government expenditure is, therefore, to be sought in the benefit of the
community as a whole.
2. Canon of Economy:
ADVERTISEMENTS:
Although the aim of public expenditure is to maximize the social benefit, yet it
does not exonerate government from exercising utmost economy in its expen-
diture. Economy does not mean niggardliness. It only means that extra vagance
and waste of all types should be avoided. Public expenditure has great potentially
for public good but it may also prove injurious and wasteful. Thus, if revenue
collected from the tax payer is heedlessly spent, it would be obviously
uneconomical.
To satisfy the canon of economy, it will be necessary to avoid all duplication of
expenditure and over-lappying of authorities. Further, public expenditure should
not adversely affect saving. In case government activity damaged the individual’s
will or power to save, it would go against the canon of economy.
3. Canon of Sanction:
Another important principle of public expenditnciple of public expenditure is that
before it is actually incurred it should be sanctioned by a competent authority.
Unauthorised spending is bound to lead to extravagance and overspending. It also
means that the amount must be spent on the purpose for which it was
sanctioned.
ADVERTISEMENTS:
Allied to the canon of sanction, there is another viz., auditing. Not only is previous
sanction of public expenditure essential but apost-mordem examination is equally
 56

imperative. That is, all the public accounts at the end of the year should be
properly audited to see that the amounts have not been misspent or
misappropriated.
4. Canon of Elasticity:
Another sane principle of public expenditure is that it should be fairly elastic. It
should be possible for public authority to vary the expenditure according to need
or circumstances. A rigid level of expenditure may prove a source of trouble and
embarrassment in bad times. Alteration in the upward direction in not difficult.
It is easy, rather tempting, to increase the scale of expenditure. But elasticity is
needed tempting, to increase the scale of expenditure. But elasticity is needed
most in the downward direction. When the economy axe is applied it is a very
painful process. Retrenchment of a widespread character creates serious social
discontent.
It is very necessary, therefore, that when the scale of public expenditure had to
be increased, it should be increased gradually. A short spell of prosperity should
not lead to long-term commitments. A fair degree of elasticity is essential if
financial breakdown is to be avoided at a time of shrinking revenue.
5. No Adverse Influence on Production or Distribution:
It is also necessary to ensure that public expenditure should exercise a healthy
influence both on production and distribution of wealth in the community. It
should stimulate productive activity so that income and employment of the living.
But this object of raising of living standards of the masses will be served only if
wealth is evenly distributed. If newly created wealth goes to enrich the already
rich, the purpose is not served. Public expenditure should aim at reducing the
inequalities of wealth distribution.
6. Principle of Surplus:
It is considered a sound or orthodox principle of public expenditure that as far as
possible public expenditure should be kept well within the revenue of the State so
that a surplus is left at the end of the year. In other words, the government
should avoid deficit budget, But the modern economists, especially Keynes, do
not regard surplus budgeting as a virtue, rather deficit budgeting is more useful in
raising the levels of income and employment in the underdeveloped countries. All
the same, budget deficits running over a series of years are considered bad for
the financial stability of the country and they cause inflation which is injurious to
the health of the economy.
 57

What Is the Chicago School of Economics?

Chicago School is an economic school of thought, founded in the 1930s by Frank
Hyneman Knight, that promoted the virtues of free-market principles to better
society.
KEY TAKEAWAYS
 Chicago School is an economic school of thought, founded in the 1930s by
Frank Hyneman Knight, that promoted the virtues of free-market principles
to better society.
 The Chicago School includes monetarist beliefs about the economy,
contending that the money supply should be kept in equilibrium with the
demand for money.
 The Chicago School's most prominent alumnus was Nobel Laureate Milton
Friedman, whose theories were drastically different from Keynesian
economics.
Understanding the Chicago School of Economics
Chicago School is a neoclassical economic school of thought that originated at the
University of Chicago in the 1930s. The main tenets of the Chicago School are
that free markets best allocate resources in an economy and that minimal, or
even no, government intervention is best for economic prosperity. The Chicago
School includes monetarist beliefs about the economy, contending that the
money supply should be kept in equilibrium with the demand for money. Chicago
School theory is also applied to other disciplines, including finance and law.
The Chicago School's most prominent alumnus was Nobel Laureate Milton
Friedman, whose theories were drastically different from Keynesian economics,
the prevailing school of economic thought at the time. The theories developed
there were based on intense mathematical modeling to test disparate
hypotheses.
One of the bedrock assumptions of the Chicago School is the concept of rational
expectations. Friedman's quantity theory of money holds that general price levels
in the economy are determined by the amount of money in circulation. By
managing general price levels, economic growth can be better controlled in a
world where individuals and groups rationally make economic allocation
decisions.
 58

Also beneficial to an economy, according to the Chicago School, is the reduction

or elimination of regulations on business. George Stigler, another Nobel Laureate,
developed theories regarding the impact of government regulation on businesses.
Chicago School is libertarian and laissez-faire at its core, rejecting Keynesian
notions of governments managing aggregate economic demand to promote
growth.
Important Contributions
The Chicago School is also known for its contributions to finance theory. Eugene
Fama won the Nobel Memorial Prize in Economic Sciences in 2013 for his work
based on his well-known efficient market hypothesis (EMH). In awarding the
prizes, The Royal Swedish Academy of Sciences said, "In the 1960s, Eugene Fama
demonstrated that stock price movements are impossible to predict in the short-
term and that new information affects prices almost immediately, which means
that the market is efficient. The impact of Eugene Fama's results has extended
beyond the field of research. For example, his results influenced the development
of index funds."
Criticisms of Chicago School of Economics
The Chicago School enjoyed prestige and loyal adherents before the financial
crisis and Great Recession. Former Fed Chair Alan Greenspan was thought to be a
proponent of the Chicago School—a monetarist in his thoughts about the money
supply, and a follower of Ayn Rand-style libertarianism. In a similar vein, the
efficient market hypothesis may have colored former Fed Chair Ben Bernanke's
views when he appeared before U.S. Congress on March 28, 2007, and stated that
"the impact on the broader economy and financial markets of the problems in the
subprime market seems likely to be contained."
If markets behave efficiently, the Chicago School theory goes, then there would
unlikely be any major imbalances, let alone a crisis like the one that unfolded in
the last few years of that decade. During the conflagration of the financial crisis,
there were questions about why Chair Bernanke and others in top positions did
not adequately regulate the banking sector. Other academics turned on the
Chicago School. Paul Krugman, a Nobel Laureate himself, was critical of the basic
tenets of the Chicago School. Another notable economist, Brad DeLong of the
University of California, Berkeley, said that the Chicago School had suffered an
"intellectual collapse."
Explanation to the Theory:
 59

The Cambridge economists—like Alfred Marshall and A. C. Pigou—presented an

alternative to Fisher’s version of Quantity Theory.
They have attempted to establish that the Quantity Theory of Money is a theory
of demand for money (or liquidity preference). The Cambridge version of the
Quantity Theory of Money is now presented.
ADVERTISEMENTS:
Formally, the Cambridge equation is identical with the income version of Fisher’s
equation: M = kPY, where k = 1/V in the Fisher’s equation.

Here 1/V = M/PT measures the amount of money required per unit of
transactions and its inverse V measures the rate of turnover or each unit of
money per period.
So if k and Y remain constant, P is directly proportional to the initial quantity of
money (M).

Explain the main reasons of increasing significance of Public Finance in a mixed

economy.
What is a Mixed Economic System?
The mixed economic system is defined as an economic system that combines the
elements of a market economy and the elements of a planned economy. It is a
synthesis of socialism and capitalism, which contains both private enterprises and
public enterprises. Most modern economies implement a mixed economic
system.
 60

A mixed economic system brings the advantages of free markets and also
government intervention. However, there are also concerns about
the sustainability and efficiency of a mixed economic system.
Summary
 A mixed economic system synthesizes the elements of a market economy
and the elements of a command economy.
 In a mixed economic system, free markets co-exist with government
intervention, and private enterprises co-exist with public enterprises.
 The advantages of a mixed economy include efficient production and
allocation of resources, as well as improvement of social welfare.
How Does the Mixed Economic System Work
A mixed economic system takes on both the characteristics of a market economy
and a planned economy. In the market economy, private enterprises are free to
set up businesses and make profits. The market (supply and demand) determines
the prices of goods and services, as well as the allocation of resources.
In a command economy, on the other side, the government regulates the market
or owns the key industries. Production and sales of goods are determined by the
government. Cuba and North Korea are some of the few countries with a
command economy.
In a mixed economic system, the private sector and public sector co-exist. There is
a certain level of economic freedom so that the private sector can decide the use
of capital and seek profits. It simultaneously allows the government to intervene
in some economic activities and industries. Through providing public goods and
collecting taxes, the government can create more social welfare.
 61

The United States follows a mixed economic system. Most of the industries in the
U.S. are dominated by private enterprises with a certain level of government
intervention, such as agricultural subsidies and financial regulations.
Some essential industries, such as national defense, public transportation, and
package delivery, are partially publicly owned. The mixed economic system is the
most common and practical system in modern society. A pure command economy
or market economy only exists theoretically.
Benefits of a Mixed Economic System
Combining the features of a market economy and a command economy, a mixed
economic system carries advantages from both sides
1. Efficient allocation of resources
Resources are allocated efficiently to where they are needed the most in the
private sector. Hence, customers’ needs can be better met.
2. Incentives for innovation and production efficiency
In a free market with competition, the enterprises that can produce more
efficiently are rewarded with higher profits. Companies are thus motivated to
allocate capital to achieve innovation and efficiency of production. Customers can
receive the best value for what they paid for.
3. Government support
The public sector in a mixed economy alleviates the disadvantages of a free
market. Private companies might neglect some industries that are essential or
bring social welfare because of their low profitability. In a mixed economy,
government intervention can support these key industries, such as education,
defense, and aerospace, through subsidies or ownership.
The government also takes care of the less competitive companies and
disadvantaged individuals. For example, tax is an effective tool to reduce
inequality by redistributing incomes. The government can also implement health
care, retirement, and other programs to improve the welfare of the general
society.
Drawbacks of a Mixed Economic System
It is difficult to determine what elements of free markets and government
intervention a mixed economic system should contain. It varies among different
societies at different periods without a fixed standard.
 62

1. Lack of government support

If the economy is given too much freedom, disadvantaged groups will not receive
sufficient support from the government. If the economy sees excessive
government intervention, enterprises will be disincentivized to produce
efficiently. It is crucial for a mixed economy to find a balance.
2. Undue influence from private enterprises
As private enterprises and government intervention are combined in the same
system, large corporations may seek to lobby the government. They may
influence legislation or activities to benefit themselves.
Government intervention also leads to moral hazards. Private enterprises,
especially the large ones, might take more risks since they know they are too big
to fail. The government will bail them out if they fall into economic crises.
Criticisms of the Mixed Economic System
There are many criticisms of mixed economic systems. The Austrian school of
economics questions the sustainability of a mixed economy. It states that any
government intervention will lead to unintended consequences that require
further intervention.
For example, price controls can cause shortages in supply, and the government
needs to take extra actions to stimulate production. Therefore, a mixed economy
is unstable and tends toward socialism.
Another criticism is from the Public Choice economists. They suggest that the
interaction of the markets, government policymakers, and economic interest
groups will drive the policy away from the public interest. The interested groups
will take away some resources from productive activities and use them to
influence economic policy for their own benefits.

Examine the principles which should govern public expenditure and

explain their implications.
What the causes of increase in Public Expenditure in recent years?
How does Public Expenditure effect the economy of a country?

Causes of Increase in Public Expenditure:

(a) Size of the Country and Population:
 63

We see an expansion of geographical area of almost all countries. Even in no-

man’s land one finds the activities of the modern government.
Assuming a fixed size of a country, developing world has seen an enormous
increase in population growth. Consequently, the expansion in administrative
activities of the government (like defence, police, and judiciary) has resulted in a
growth of public expenditures in these areas.
ADVERTISEMENTS:
(b) Defence Expenditure:
The tremendous growth of public expenditure can be attributed to threats of war.
No great war has been conducted in the second half of the twentieth century. But
the threats of war have not vanished; rather it looms large. Thus, mere
sovereignty, demands a larger allocation of financial sources for defence
preparedness.
(c) Welfare State:
The 19th century state was a ‘police state’ while, in 20th and 21st centuries
modern state is a ‘welfare state’. Even in a capitalist framework, socialistic
principles are not altogether discarded. Since socialistic principles are respected
here, modern governments have come out openly for socio-economic uplift of the
masses.
ADVERTISEMENTS:
Various socio-economic programmes are undertaken to promote people’s
welfare. Modern governments spend huge money for the purpose of economic
development. It plays an active role in the production of goods and services. Such
investment is financed by the government.
Besides development activities, welfare activities have grown tremendously. It
spends money for providing various social security benefits. Social sectors like
health, education, etc., receive a special treatment under the government
patronage. It builds up not only social infrastructure but also economic
infrastructure in the form of transport, electricity, etc.
Provision of all these require huge finance. Since a hefty sum is required for
financing these activities, modern governments are the only providers of money.
However, various welfare activities of the government are largely shaped and
influenced by the political leaders (Ministers, MPs, and MLAs to have a political
mileage, as well as by the bureaucrats (MPLAD)).
 64

(d) Economic Development:

Modern government has a great role to play in shaping an economy. Private
capitalists are utterly incapable of financing economic development of a country.
This incapacity of the private sector has prompted modern governments to invest
in various sectors so that economic development occurs.
Economic development is largely conditioned by the availability of economic
infrastructure. Only by building up economic infrastructure, road, transport,
electricity, etc., the structure of an economy can be made to improve. Obviously,
for financing these activities, government spends money.
(e) Price Rise:
Increase in government expenditure is often ascribed to inflationary price rise.

How Does Public Expenditure Affect the Economy?

The budget is the most powerful policy instrument of any government. Without
funding, a policy has no potency. In addition, governments are usually one of the
biggest organizations in any country – in terms of both human and financial
resources. Likewise, budget allocations for public services and programs are of
public concern because they greatly impact on the lives of citizens. But in the
context of the current economic downturn, the size of public sector expenditure
is once again under the spotlight.

Discuss different discretionary methods of fiscal policy adopted by the state to

achieve rapid economic growth?
Discretionary fiscal policy is a change in government spending or taxes. Its
purpose is to expand or shrink the economy as needed.
Tools
Discretionary fiscal policy uses two tools. They are the budget process and the tax
code. The first tool is the discretionary portion of the U.S. budget. Congress
determines this type of spending with appropriations bills each year. The largest is
the military budget. All other federal departments are part of discretionary
spending too.
 65

The budget also contains mandatory spending. This includes payments

from Social Security, Medicare, Medicaid, Obamacare and interest payments on
the national debt. Congress mandates these programs. They are the law of the
land. Congress must vote to amend or revoke the relevant law to change these
programs. Therefore, changes in the mandatory budget are very difficult. For that
reason, it isn't a tool of discretionary fiscal policy.
The second tool is the tax code. It includes taxes on workers' incomes, corporate
profits, imports and other excise fees. Only Congress has the power to change the
tax code. Congress’ changes to the tax code have to be done by enacting new
laws. These laws must be passed by both the Senate and the House of
Representatives. But the president has the power to change how tax laws are
implemented. He can send directives to the Internal Revenue Service to adjust the
enforcement of rules and regulations.
Types
There are two types of discretionary fiscal policy. The first is expansionary fiscal
policy. It’s when the federal government increases spending or decreases taxes.
When spending is increased, it creates jobs. It happens directly through public
works programs or indirectly through contractors. Spending on public works
construction is one of the four best ways to create jobs.
Job creation gives people more money to spend, boosting demand. According to
Keynesian economic theory, that increases economic growth.
When the government cuts taxes, it puts money directly into the pockets
of business and families. They have more money to spend. This also boosts
demand and drives growth. When spending and tax cuts are done at the same
time, it puts the pedal to the metal. That's why the American Recovery and
Reinvestment Act ended the Great Recession in just a few months. It used a
combination of public works, tax cuts, and unemployment benefits to save or
create 640,000 jobs between March and October 2009.12 Studies show
that unemployment benefits are the best stimulus.3
Supply-side economics says that a tax cut is the best way to stimulate the
economy. Stronger economic growth will make up for the government
revenue lost. That's because it generates a larger tax base. But tax cuts only work
if taxes were high in the first place. According to the underlying economic theory,
the Laffer Curve, the highest tax rate must be above 50% for supply-side
economics to work. Tax cuts are not the best way to create jobs.
 66

Expansionary fiscal policy creates a budget deficit. This is one of its downsides. It’s
because the government spends more than it receives in taxes. Often there’s no
penalty until the debt-to-GDP ratio nears 100%. At that point, investors start to
worry the government won't repay its sovereign debt. They won’t be as eager to
buy U.S. Treasurys or other sovereign debt. They will demand higher interest
rates. This makes the debt even more expensive to pay back. It can create a
downward spiral. For example, look at the Greek debt crisis.
Contractionary fiscal policy is when the government cuts spending or
raises taxes. It slows economic growth. A spending cut means less money goes
toward government contractors and employees. That then reduces job growth.
When Congress raises taxes, it also slows growth. Higher taxes reduce the amount
of disposable income available for families or businesses to spend. It
decreases demand and slows economic growth.
Discretionary fiscal policy should work as a counterweight to the business cycle.
During the expansion phase, Congress and the president should cut spending and
programs to cool down the economy. If done well, the reward is an ideal
economic growth rate of around 2% to 3% a year.
Instead, politicians keep spending and cutting taxes regardless of where we are
in the boom and bust cycle. If they do it during a boom, it overstimulates the
economy and creates asset bubbles, and leads to a more devastating bust. It’s
one reason for the 2008 financial crisis.
Unfortunately, democracy itself ensures an expansionary discretionary fiscal
policy. Why? Because lawmakers get elected and re-elected by spending money
and lowering taxes. That's how they reward voters, special interest groups and
those who donate to campaigns. Everyone says they want to see the budget cut,
just not their portion of the budget.
Discretionary Fiscal Policy versus Monetary Policy
At its best, discretionary fiscal policy should work in alignment with monetary
policy enacted by the Federal Reserve. If the economy is growing too fast, fiscal
policy can apply the brakes by raising taxes or cutting spending. At the same time,
the Fed should enact contractionary monetary policy. It does this by raising
the fed funds rate or through its open market operations.
If the economy is in a recession, discretionary fiscal policy can lower taxes and
increase spending while the Fed enacts an expansionary monetary policy. It will
be done by lowering the fed funds rate or through quantitative
 67

easing. The Federal Reserve created many other tools to fight the Great
Recession. When working together, fiscal and monetary policy control the
business cycle.
Since the 1990s, politicians have enacted expansive fiscal policy no matter what.
That means it's up to the Fed alone to manage the business cycle. A relentless
expansionary fiscal policy forces the Fed to use contractionary monetary policy as
a brake when the economy is booming. Higher interest rates reduce capital and
liquidity, especially for small businesses and the housing market. That ties the
hands of the Fed, reducing its flexibility.

State and briefly explain the Quantity Theory of Money in term of

Classical and Cambridge Chicago School of Thought?
The Quantity Theory of Money

Quantity theory of money begins with equation of exchange (Fisher, 1911), an identity
relating to the volume of transactions at current price to the supply of money times the turn
of over each dollar.
{Turnover rate of money measures the average number of times each dollar is used in
transactions during the period .This is called velocity of money.}
According to Irving Fisher, this identity is expressed as:
MVT ≡PTT
M= Quantity of money
VT= Transaction velocity of money
PT= Price index of items traded
T= Volume of transaction
The transaction variable (T) includes both sales and purchases of newly produced goods and
exchanges of previously produced goods and financial assets.
Another expression of equation of exchange focused only on income transaction.
MV≡PY
M= Quantity of money
V= Income of velocity of money (the number of times the average dollar is
used in transaction involving current out-put)
P= Price index for currently produced output)
 68

Y= level of current output.

PY
V≡ {this equation is also an identity}
M
Fisher et al postulated that the equation of exchange determines the price level.
According to fisher, price level varies –
1. Directly as the quantity of money in the circulation (M).
2. Directly as the velocity of its circulation (V).
3. Inversely as the volume of the trade done by it (T).

The first one is called the “Quantity theory of money”. According to classicals output is
supply determined and a measure of real economic activity. Money was assumed to be
metallic such as gold. Money was assumed to be exogenously controlled by monetary
policy authority.
According to Fisher velocity of money was determined by payment habits and payment
technology of society.
For Example:
 Average length of pay period (Smaller average money holding if pay periods are short at
any given income level which leads to increase velocity of money).

 Practice of using charge accounts or bank charge cards (Frequent use of charge
accounts by the consumer also increases money velocity).

 Prevalence of trade credit among businesses (Frequent use of trade credit by

businesses also increases money velocity).

According to Fisher, the equilibrium level of velocity was determined by such Institutional
factor and could be regarded as fixed for the short run.

 With output fixed from supply side, the equation of exchange expresses a relationship of
proportionality between the exogenously given money supply and price level.
MV̄=PȲ
OR
V
P= M
Y
Above equation explains that price level depends on supply of money. e.g. - 10% in M
leads to 10% increase in P.
 Thus quantity theory of money determines the price level.

The Cambridge Approach to the Quantity Theory of Money

 69

How the changes in money supply affect the price level can be easily answered by
Cambridge approach of Quantity theory of money.
The Cambridge approach was given by Alfred Marshall and A.C. pigou.
This approach also demonstrated the proportional relationship between quantity of money
and price level.

 Marshall mainly focuses on the individual’s decision on the optimal amount of money to
hold. Some money is held for the convenience in transaction. Money also provides the
security to meet unexpected obligations.

On the other hand Pigou was of the opinion that currency held in the hand yields no
income. So money will be held only if its yields in the terms of convenience and security are
more than income lost from not investing in productivity.

 Marshall and the other Cambridge economists assumed that the demand for money
would be proportional to income.
The Cambridge equation is Md=kPY
Money demand (Md) is assumed to be a proportion (k) of nominal income, the price
level (P) times the level of real income(y).
 The demand for money depends on the level of transactions, which may be supposed
to vary closely with income.
 k is assumed to be stable in short run, depending, as in fisherman formulation, on the
payment habits of the society.
 In equilibrium
M=Md=kPȲ
The exogenous supply of money must equal the quantity of money demanded.
 k is fixed in short run and real output (Ȳ) is determined by supply condition.

Based on two conditions i.e. Stable k and supply determined real output (Ȳ),
Cambridge equation also reduces to a proportional relationship between price level
and money supply.( As in fisherian approach, the quantity of money determines the
price level ).
 The formal equivalence of Cambridge equation and fisher’s version of equation of
changes can be seen in rewriting equilibrium equation (i.e. M =M d = kPȲ).

1
M. = PȲ
k
By comparing fisher’s equation i.e. MV̄=PȲ, we find that both equation are equivalent
1
with V equals to .
k
For example:
 70

If individuals wish to hold an amount equal to one- fourth of the nominal income in the
form of money, the number of times the average dollar is used in income transaction
will be 4.
 Although both the fisher version and Cambridge version of quantity theory are formally
equivalent.
 The Cambridge focus was on the quantity theory as the theory of the demand for money.
 The cambrdge focus on money demand leads to an answer to the question about the way
money affects the price level.
 An excess supply of money led to increased demand for commoditites and upward
pressure on the price level.

What Is the Chicago School of Economics?

Chicago School is an economic school of thought, founded in the 1930s by Frank
Hyneman Knight, that promoted the virtues of free-market principles to better
society.
KEY TAKEAWAYS
 Chicago School is an economic school of thought, founded in the 1930s by
Frank Hyneman Knight, that promoted the virtues of free-market principles
to better society.
 The Chicago School includes monetarist beliefs about the economy,
contending that the money supply should be kept in equilibrium with the
demand for money.
 The Chicago School's most prominent alumnus was Nobel Laureate Milton
Friedman, whose theories were drastically different from Keynesian
economics.
Understanding the Chicago School of Economics
Chicago School is a neoclassical economic school of thought that originated at the
University of Chicago in the 1930s. The main tenets of the Chicago School are
that free markets best allocate resources in an economy and that minimal, or
even no, government intervention is best for economic prosperity. The Chicago
School includes monetarist beliefs about the economy, contending that the
money supply should be kept in equilibrium with the demand for money. Chicago
School theory is also applied to other disciplines, including finance and law.
The Chicago School's most prominent alumnus was Nobel Laureate Milton
Friedman, whose theories were drastically different from Keynesian economics,
 71

the prevailing school of economic thought at the time. The theories developed
there were based on intense mathematical modeling to test disparate
hypotheses.
One of the bedrock assumptions of the Chicago School is the concept of rational
expectations. Friedman's quantity theory of money holds that general price levels
in the economy are determined by the amount of money in circulation. By
managing general price levels, economic growth can be better controlled in a
world where individuals and groups rationally make economic allocation
decisions.
Also beneficial to an economy, according to the Chicago School, is the reduction
or elimination of regulations on business. George Stigler, another Nobel Laureate,
developed theories regarding the impact of government regulation on businesses.
Chicago School is libertarian and laissez-faire at its core, rejecting Keynesian
notions of governments managing aggregate economic demand to promote
growth.

Loan Creates Deposits? Discuss the process in the light of functions

of a Commercial Bank?
Explain the Functions of Modern Commercial Banks in detail?
What is Commercial Bank?
A commercial bank is a kind of financial institution that carries all the operations
related to deposit and withdrawal of money for the general public, providing
loans for investment, and other such activities. These banks are profit-making
institutions and do business only to make a profit.
The two primary characteristics of a commercial bank are lending and borrowing.
The bank receives the deposits and gives money to various projects to earn
interest (profit). The rate of interest that a bank offers to the depositors is known
as the borrowing rate, while the rate at which a bank lends money is known as
the lending rate.
Related link: Banking and its Type
Function of Commercial Bank:
The functions of commercial banks are classified into two main divisions.
(a) Primary functions
 72

Accepts deposit : The bank takes deposits in the form of saving, current, and
fixed deposits. The surplus balances collected from the firm and individuals are
lent to the temporary requirements of the commercial transactions.
Provides loan and advances : Another critical function of this bank is to offer
loans and advances to the entrepreneurs and business people, and collect
interest. For every bank, it is the primary source of making profits. In this process,
a bank retains a small number of deposits as a reserve and offers (lends) the
remaining amount to the borrowers in demand loans, overdraft, cash credit,
short-run loans, and more such banks.
Credit cash: When a customer is provided with credit or loan, they are not
provided with liquid cash. First, a bank account is opened for the customer and
then the money is transferred to the account. This process allows the bank to
create money.
(b) Secondary functions
Discounting bills of exchange: It is a written agreement acknowledging the
amount of money to be paid against the goods purchased at a given point of time
in the future. The amount can also be cleared before the quoted time through a
discounting method of a commercial bank.
Overdraft facility: It is an advance given to a customer by keeping the current
account to overdraw up to the given limit.
Purchasing and selling of the securities: The bank offers you with the facility of
selling and buying the securities.
Locker facilities: A bank provides locker facilities to the customers to keep their
valuables or documents safely. The banks charge a minimum of an annual fee for
this service.
Paying and gathering the credit : It uses different instruments like a promissory
note, cheques, and bill of exchange.
Types of Commercial Banks:
There are three different types of commercial banks.
Private bank –: It is a type of commercial banks where private individuals and
businesses own a majority of the share capital. All private banks are recorded as
companies with limited liability. Such as Housing Development Finance
Corporation (HDFC) Bank, Industrial Credit and Investment Corporation of India
(ICICI) Bank, Yes Bank, and more such banks.
 73

Public bank –: It is a type of bank that is nationalised, and the government holds
a significant stake. For example, Bank of Baroda, State Bank of India (SBI), Dena
Bank, Corporation Bank, and Punjab National Bank.
Foreign bank –: These banks are established in foreign countries and have
branches in other countries. For instance, American Express Bank, Hong Kong and
Shanghai Banking Corporation (HSBC), Standard & Chartered Bank, Citibank, and
more such banks.
It gives loans and advances:
The second major function of a commercial bank is to give loans and advances
particularly to businessmen and entrepreneurs and thereby earn interest. This is,
in fact, the main source of income of the bank. A bank keeps a certain portion of
the deposits with itself as reserve and gives (lends) the balance to the borrowers
as loans and advances in the form of cash credit, demand loans, short-run loans,
overdraft as explained under.

How does the central bank control credit in the economy?

Methods of Credit Control used by Central Bank
The following points highlight the two categories of methods of credit control by
central bank.
The two categories are: I. Quantitative or General Methods II. Qualitative or
Selective Methods.

Category # I. Quantitative or General Methods:

1. Bank Rate Policy:
The bank rate is the rate at which the Central Bank of a country is prepared to re-
discount the first class securities.
 74

ADVERTISEMENTS:
It means the bank is prepared to advance loans on approved securities to its
member banks.
As the Central Bank is only the lender of the last resort the bank rate is normally
higher than the market rate.
For example:
ADVERTISEMENTS:
If the Central Bank wants to control credit, it will raise the bank rate. As a result,
the market rate and other lending rates in the money-market will go up.
Borrowing will be discouraged. The raising of bank rate will lead to contraction of
credit.
Similarly, a fall in bank rate mil lowers the lending rates in the money market
which in turn will stimulate commercial and industrial activity, for which more
credit will be required from the banks. Thus, there will be expansion of the
volume of bank Credit.
2. Open Market Operations:
This method of credit control is used in two senses:
(i) In the narrow sense, and
ADVERTISEMENTS:
(ii) In broad sense.
In narrow sense—the Central Bank starts the purchase and sale of Government
securities in the money market. But in the Broad Sense—the Central Bank
purchases and sale not only Government securities but also of other proper and
eligible securities like bills and securities of private concerns. When the banks and
the private individuals purchase these securities they have to make payments for
these securities to the Central Bank.
This gives result in the fall in the cash reserves of the Commercial Banks, which in
turn reduces the ability of create credit. Through this way of working the Central
Bank is able to exercise a check on the expansion of credit.
Further, if there is deflationary situation and the Commercial Banks are not
creating as much credit as is desirable in the interest of the economy. Then in
 75

such situation the Central Bank will start purchasing securities in the open market
from Commercial Banks and private individuals.
With this activity the cash will now move from the Central Bank to the
Commercial Banks. With this increased cash reserves the Commercial Banks will
be in a position to create more credit with the result that the volume of bank
credit will expand in the economy.
3. Variable Cash Reserve Ratio:
Under this system the Central Bank controls credit by changing the Cash Reserves
Ratio. For example—If the Commercial Banks have excessive cash reserves on the
basis of which they are creating too much of credit which is harmful for the larger
interest of the economy. So it will raise the cash reserve ratio which the
Commercial Banks are required to maintain with the Central Bank.
This activity of the Central Bank will force the Commercial Banks to curtail the
creation of credit in the economy. In this way by raising the cash reserve ratio of
the Commercial Banks the Central Bank will be able to put an effective check on
the inflationary expansion of credit in the economy.
Similarly, when the Central Bank desires that the Commercial Banks should
increase the volume of credit in order to bring about an economic revival in the
country. The Central Bank will lower down the Cash Reserve ratio with a view to
expand the cash reserves of the Commercial Banks.
With this, the Commercial Banks will now be in a position to create more credit
than what they were doing before. Thus, by varying the cash reserve ratio, the
Central Bank can influence the creation of credit.
ADVERTISEMENTS:
Which is Superior?
Either variable cash reserve ratio or open market operations:
From the analysis and discussions made above of these two methods of credit, it
can be said that the variable cash reserve ratio method is superior to open market
operations on the following grounds:
(1) Open market operations is time consuming procedure while cash reserves
ratio produces immediate effect in the economy.
ADVERTISEMENTS:
 76

(2) Open market operations can work successfully only where securities market in
a country are well organised and well developed.
While Cash Reserve Ratio does not require such type of securities market for the
successful implementation.
(3) Open market operations will be successful where marginal adjustments in cash
reserve are required.
But the variable cash reserve ratio method is more effective when the commercial
banks happen to have excessive cash reserves with them.
ADVERTISEMENTS:
These two methods are not rival, but they are complementary to each other.
Category # II. Qualitative or Selective Method of Credit Control:
The qualitative or the selective methods are directed towards the diversion of
credit into particular uses or channels in the economy. Their objective is mainly to
control and regulate the flow of credit into particular industries or businesses.
The following are the important methods of credit control under selective
method:
1. Rationing of Credit.
2. Direct Action.
3. Moral Persuasion.
ADVERTISEMENTS:
4. Method of Publicity.
5. Regulation of Consumer’s Credit.
6. Regulating the Marginal Requirements on Security Loans.
1. Rationing of Credit:
Under this method the credit is rationed by limiting the amount available to each
applicant. The Central Bank puts restrictions on demands for accommodations
made upon it during times of monetary stringency.
In this the Central Bank discourages the granting of loans to stock exchanges by
refusing to re-discount the papers of the bank which have extended liberal loans
to the speculators. This is an important method of credit control and this policy
has been adopted by a number of countries like Russia and Germany.
 77

2. Direct Action:
Under this method if the Commercial Banks do not follow the policy of the Central
Bank, then the Central Bank has the only recourse to direct action. This method
can be used to enforce both quantitatively and qualitatively credit controls by the
Central Banks. This method is not used in isolation; it is used as a supplement to
other methods of credit control.
ADVERTISEMENTS:
Direct action may take the form either of a refusal on the part of the Central Bank
to re-discount for banks whose credit policy is regarded as being inconsistent with
the maintenance of sound credit conditions. Even then the Commercial Banks do
not fall in line, the Central Bank has the constitutional power to order for their
closure.
This method can be successful only when the Central Bank is powerful enough
and has cordial relations with the Commercial Banks. Mostly such circumstances
are rare when the Central Bank is forced to resist to such measures.
3. Moral Persuasion:
This method is frequently adopted by the Central Bank to exercise control over
the Commercial Banks. Under this method Central Bank gives advice, then
request and persuasion to the Commercial Banks to co-operate with the Central
Bank is implementing its credit policies.
If the Commercial Banks do not follow or do not abide by the advice or request of
the Central Bank no gross action is taken against them. The Central Bank merely
was its moral influence and pressure with the Commercial Banks to prevail upon
them to accept and follow the policies.
4. Method of Publicity:
In modern times, Central Bank in order to make their policies successful, take the
course of the medium of publicity. A policy can be effectively successful only
when an effective public opinion is created in its favour.
Its officials through news-papers, journals, conferences and seminar’s present a
correct picture of the economic conditions of the country before the public and
give a prospective economic policies. In developed countries Commercial Banks
automatically change their credit creation policy. But in developing countries
Commercial Banks being lured by regional gains. Even the Reserve Bank of India
follows this policy.
 78

5. Regulation of Consumer’s Credit:

ADVERTISEMENTS:
Under this method consumers are given credit in a little quantity and this period is
fixed for 18 months; consequently credit creation expanded within the limit. This
method was originally adopted by the U.S.A. as a protective and defensive
measure, there after it has been used and adopted by various other countries.
6. Changes in the Marginal Requirements on Security Loans:
This system is mostly followed in U.S.A. Under this system, the Board of
Governors of the Federal Reserve System has been given the power to prescribe
margin requirements for the purpose of preventing an excessive use of credit for
stock exchange speculation.
This system is specially intended to help the Central Bank in controlling the
volume of credit used for speculation in securities under the Securities Exchange
Act, 1934.

Classification of Public Expenditure?

1# Capital & Revenue Expenditure
Capital Expenditure focuses on government expenditure in building and creating
fixed assets. It is considered as a form of investment as they add to the net
productive assets of the economy. It can also be referred as Development
Expenditure as it focuses on increasing the production capacity of the economy as
a whole. Capital expenditure is an investment expenditure and a non-recurring
type in nature.
For example, Expenditure done on
 Agriculture
 Industrial development
 Public enterprises
 Building irrigation dams etc. are considered as capital expenditure.
Revenue Expenditure refers to current or consumption expenditures incurred on
 defense forces
 public health
 79

 education
 civil administration
 maintenance of government machinery and equipment etc.
It is recurrent in nature, that is, it has to be incurred almost every year.
2# Development & Non-Development Expenditure
Development Expenditure, also known as Productive Expenditure is incurring
expenses on the development of infrastructure, public enterprise or agriculture
production capacity which helps in the growth of the economy income. Therefore,
they are termed as productive expenditure. All activities that require expenditure
for economic growth is classified under development expenditure.
Non-Development Expenditure, also known as Unproductive Expenditure refers
to incurring expenses on activities that do not bring in any income to the
government. It includes payment of interests, expenditure on law & order, public
administration etc. that do not create any fixed asset beneficial for the financial
growth of the economy. Therefore, these expenses are termed as Unproductive
Expenditure.
3# Transfer & Non-Transfer Expenditure
Transfer Expenditure refers to incurring expenses on activities which do not
require any corresponding transfer of real resources such as goods & services. It
includes expenses made on Interest payments, welfare benefits to weaker
sections, unemployment allowances, or schemes such as National Old Pension,
wherein, the government does not acquire any income in return, but adds to the
welfare of the society. It can be considered as a redistribution of income within
the society, for the society.
Non-Transfer Expenditure focuses on creation of income or output of expenses. It
includes expenses made on development & non-development activities resulting
in the creation of output directly or indirectly.
For example, expenses incurred on-
 Economic Infrastructure (Power, Transport, Irrigation etc.)
 Social Infrastructure (Education, Health, Family Welfare, etc.)
 Law & Order
 Defense Services
 80

 Public Administration
Non-transfer expenditure focuses on creating a healthy environment for
economic growth.
4# Plan & Non-Plan Expenditure
Plan Expenditure refers to incurring expenses on development activities within
the purview of the planned development programs. It is inclusive of investment as
well as consumption expenditure by the government or the planning commission
of the government.
It includes spending on
 Transport
 Rural Development
 Communication Services
 Agriculture, Energy
 Social Services and more.
Non-Plan Expenditure includes spending on activities that are not mentioned in
the on-going development program of the government. It can be a mix of
development & non-development expenditure.
For example, expenditure done on
 Subsidies
 Defense
 Law & Order
 Maintenance services
 Interest Payments etc.

Public Expenditure and Economic Stability.

As pointed out by Wagner, state functions increase with the
advancement and progress of the economy. In the nineteenth and
early twentieth century, the Government followed laissez-fair policy.
 81

Now, need for active intervention of the Government has been

increasingly felt.
Thanks to J.M. Keynes whose macroeconomic theory clearly brought
out that the working of free-market mechanism does not ensure
economic stability at full employment level. According to his theory,
lapses from full employment or depressions are caused by deficiency
of aggregate demand due to the slackened private investment
activity.
In order to compensate for this shortfall in private investment, the
Government has to step up its expenditure on public works. The
increase in Government expenditure raises aggregate demand
manifold through the working of what Keynes has called income
multiplier.
This helps to push the economy out of depression and to raise levels
of income and employment. Now, this compensatory fiscal policy is
being followed by all the world over, since achievement of full em-
ployment and maintenance of economic stability has become an
important objective of the Government.
ADVERTISEMENTS:
It is in line with the objective of employment that in India, the
Government has taken over several private sick mills and incurs a lot
of expenditure on them so that workers employed in them are not
rendered unemployed.
Further, the Indian Government, both Central and States, incur a lot
of expenditure on relief public works in rural areas when drought
and other natural calamities occurs. Besides, a lot of public
expenditure is being incurred on special employment schemes to
promote employment in the economy.

Public Expenditure and Economic Growth.?

 82

The most important factor in developing countries such as ours that has led to a
phenomenal increase in public expenditure is the expansion in developmental
activities of the Government. In countries like India which have socialistic ten-
dencies the public sector plays an important role in promoting economic growth
and development.
Not only public utility services such as water supply, electricity, post and
petroleum and transport services have been undertaken by the public sector, but
also the Government has invested a huge sum of resources in industrial and
agricultural development of the economy.
Several steel plants, multipurpose irrigation projects, fertilizer factories, coal
mining, exploration and production of oil and petroleum, different kinds of
machine-making industries and chemical plants have been started and are being
operated in the public sector.
ADVERTISEMENTS:
On these a huge amount of expenditure is being incurred by the Government in
India. Owing to these developmental activities of the Government in India, the
proportion of developmental expenditure to the total Government expenditure
has greatly increased. In 2003-04, Central Government’s plan expenditure, which
is mainly developmental expenditure, was 122.3 thousand crores which rose to
137.4 thousand crores in 2004-05.

Distinguish between Direct Taxes and Indirect Taxes?

BASIS FOR
DIRECT TAX INDIRECT TAX
COMPARISON

Meaning Direct tax refers to financial Indirect tax is when the taxpayer
charge, levied directly on the is just the hands that deposit the
taxpayer, and paid outrightly amount of tax to the authority
to the authority which imposing it, while the burden of
imposes it, by the taxpayer. tax falls on the final consumer.

Governed by Central Board of Direct Taxes Central Board of Indirect Taxes

(CBDT) and Customs (CBIC)
 83

BASIS FOR
DIRECT TAX INDIRECT TAX
COMPARISON

Who pays the Individuals, HUF, and Final Consumer

tax? Companies

Nature Progressive Regressive

Incidence and It falls on the same person. It falls on different persons.

Impact

Liability A person on whom the tax is The person receiving the benefits
imposed is liable for its is liable for its payment and not
payment. the person on whom it is imposed.

Evasion Tax evasion is possible. Tax evasion is hardly possible

because it is included in the price
of the goods and services.

Inflation Direct tax helps in reducing Indirect taxes promotes inflation.

inflation.

Imposition and Imposed on and collected Imposed on and collected from

collection from assessees, i.e. consumers of goods and services
Individual, HUF (Hindu but paid and deposited by the
Undivided Family), Company, assessee.
Firm, etc.

Burden Cannot be shifted to another Can be shifted to another person.

person.

Taxable Event When the income or wealth Purchase, sale or manufacture of

of the assessee reaches the goods and provision of services.
maximum limit.
 84

BASIS FOR
DIRECT TAX INDIRECT TAX
COMPARISON

Collection of Difficult Easy

Tax

Key Differences Between Direct Tax and Indirect Tax

As of now, we have discussed the basics of the two types of taxes, now we will
move forward to understand the difference between direct tax and indirect tax:
1. Direct Tax refers to the tax which is paid directly to the government by the
person on whom it is imposed. On the other hand, Indirect tax is a form of
tax that is paid by the taxpayer to the government, but the amount of tax is
recovered from another person, who gets the benefits, i.e. the final
consumer.
2. The Central Board of Direct Taxes (CBDT) functioning under the
Department of Revenue is the authority that administers Direct Taxes in
India. Conversely, the Central Board of Indirect Taxes and Customs (CBIC) is
the authority responsible for the administration of Indirect Taxes.
3. While Direct tax is levied on the assessee, which may include Individual,
HUF, Company, AOP, BOI, etc. Indirect Tax is paid by the final consumer.
4. Direct Tax is progressive in nature, as it is based on the percept of ability to
pay. So, the tax is imposed more on the rich and less on the poor.
Oppositely, Indirect Tax is regressive in nature, as every person contributes
equally to the payment of taxes.
5. Direct Tax is one in which the incidence and impact of the tax fall on the
same person, whereas Indirect tax is a tax in which the incidence and
impact of the tax fall on different persons. Here incidence refers to the
liability for the payment of tax, and impact means actual payment of tax.
6. In the case of a direct tax, it is the taxpayer who bears its burden, i.e. it
cannot be shifted to or recovered from another person. Conversely, in
indirect taxes, the burden of tax can be shifted to another person.
7. Direct taxes are when the assessee on whom the tax is imposed, is liable
for its payment. Contrastingly, indirect taxes is when the person receiving
 85

the benefits is liable for its payment and not the person on whom it is
imposed.
8. Tax evasion is a practice of deliberately avoiding the payment of taxes
while taking recourse to unlawful means. In the case of direct taxes, tax
evasion is possible, whereas, in the case of indirect taxes, tax evasion is not
possible as the amount of tax is hidden in the price of the goods and
services itself.
9. While direct taxes help in controlling inflation, by absorbing excess liquidity
from the market, indirect taxes give rise to inflation or deflation.
10.Direct taxes are imposed on and collected from assessees, which includes
individuals, HUF, companies, etc. whereas indirect taxes are imposed on
and collected from consumers of goods and services but paid and
deposited by the assessee to the government.
11.Direct tax is charged on individuals, HUF, and business entities, and the
burden cannot be shifted to others. As against, Indirect tax is charged on
commodities and services, and its burden can be shifted to others.
12.The taxable event in the case of direct tax, when the income of the
assessee reaches the maximum limit specified under the law, the exceeding
amount will become taxable. Contrarily, whenever there is a
purchase/sale/manufacture of goods and provision of services, it is a
taxable event in the case of indirect taxes.
13.Talking about administrative cost, the administrative cost of direct tax is
greater in comparison to indirect taxes.

Context Direct Tax Indirect Tax

Paid directly to the Paid to the government via

Meaning
government intermediary

Levied on Profits and income Goods and services

Individuals, HUFs and End-consumers of products, goods and

Taxpayer
businesses services.

Tax Rate Directly depends on income Same for everyone

 86

Context Direct Tax Indirect Tax

and profits

Rate of tax is flat so tax burden is

Tax Burden Progressive
regressive

Transfer of
Not transferable Can be transferable
liability

Tax Collection Complex Quite convenient

Types Income Tax and STT Goods and Services Tax (GST)

Evasion Possible Not possible

Fiscal Policy is always formed to achieve Pre-determined

Objectives. Discuss the major objectives of Fiscal Policy of Pakistan
and explain which particular tool of Fiscal Policy is used to achieve
each objective.
What is Fiscal Policy, Its Objectives, Tools, and Types
Fiscal policy is an essential tool at the disposable of the government to influence a
nation’s economic growth. The fiscal policy is used in coordination with the
monetary policy, which a central bank uses to manage the money supply in a
country. The meaning, types, objectives, and tools are discussed in detail below.
What is a Fiscal Policy?
A government uses fiscal policy to adjust its spending and tax rates to monitor
and influence the performance of the country. The fiscal policy is based on
Keynesian economics, a theory by economist John Maynard Keynes. As per the
theory, a government can play a major role in influencing productivity levels in an
economy by adjusting the tax rates and public spending.
 87

So, this policy helps control inflation, address unemployment, and ensure the
health of the currency in the international market. Now that we know what is
fiscal policy let’s understand its objectives and types.
Objectives of Fiscal Policy
 Boosting employment levels
 Maintain or stabilize the economy’s growth rate
 Maintain or stabilize the price levels
 Encourage economic development
 Raising the standard of living
 Maintaining equilibrium in Balance of Payments.

Fiscal Policy Tools

 88

A government has two tools at its disposal under the fiscal policy – taxation and
public spending.
Taxation includes taxes on income, property, sales, and investments. On the one
hand, more taxes means more income for the government, but it also results in
less income in the hand of the people.
Public spending includes subsidies, and transfer payments, like salaries to
government employees, welfare programs, and public works projects. Those who
get the funds have more money to spend.
Types of Fiscal Policy
There are two types of fiscal policy – expansionary and contractionary fiscal
policy.
Expansionary Fiscal Policy
A government uses this type of policy to stimulate economic growth by increasing
spending or lowering taxes, or both. The objective of this policy is to ensure more
money in the hands of the citizens so that they spend more. More spending, in
turn, leads to more income and more job creation.
There have been debates over which is more effective – tax cuts or spending.
Some say that spending in the form of public projects ensures that the money
reaches the consumers. Those in favor of the tax argue that tax cuts allow
businesses to hire more staff. Though there is no consensus on which of the two is
better, the government uses a combination of both tools to boost economic
growth.
Contractionary Fiscal Policy
A government rarely uses this policy as it aims to slow economic growth. You
must be thinking about why any government will want to do that. The answer is
to curtail inflation. Too much inflation has the potential to damage the economy
in the long term. So, the government has to step in to control inflation.

Central Bank as Clearing House?

Function 6 # Clearing House:
Central bank also acts as a clearing house for the settlement of
accounts of commercial banks. A clearing house is an organisation
 89

where mutual claims of banks on one another are offset, and a

settlement is made by the payment of the difference. Central bank
being a bankers’ bank keeps the cash balances of commercial banks
and as such it becomes easier for the member banks to adjust or
settle their claims against one another through the central bank.
Suppose there are two banks, they draw cheques on each other.
Suppose bank A has due to it Rs. 3,000 from bank B and has to pay
Rs. 4,000 to B. At the clearing house, mutual claims are offset and
bank A pays the balance of Rs. 1,000 to B and the account is settled.
Clearing house function of the central bank leads to a good deal of
economy in the use of cash and much of labour and inconvenience
are avoided.
Clearing house for transfer and settlement: Central bank acts as a
clearing house of the commercial banks and helps in settling of
mutual indebtedness of the commercial banks. In a clearing house,
the representatives of different banks meet and settle the inter bank
payments.

Central as a Controller of Credit?

Function 7 # Controller of Credit:
The control or adjustment of credit of commercial banks by the
central bank is accepted as its most important function. Commercial
banks create lot of credit which sometimes results in inflation.
The expansion or contraction of currency and credit may be said to
be the most important causes of business fluctuations. The need for
credit control is obvious. It mainly arises from the fact that money
and credit play an important role in determining the level of
incomes, output and employment.
According to Dr. De Kock, “the control and adjustment of credit is
accepted by most economists and bankers as the main function of a
 90

central bank. It is the function which embraces the most important

questions of central banking policy and the one through which
practically all other functions are united and made to serve a
common purpose.”
Thus, the control which the central bank exercises over commercial
banks as regards their deposits, is called controller of credit.
Controller of credit: Central banks also function as the controller of
credit in the economy. It happens that commercial banks create a lot
of credit in the economy that increases the inflation.