Economics of Taxation

Bef 2
 Public Finance
• Public finance is a field of economics
concerned with how a government raises
money, how that money is spent and the
effects of these activities on the economy and
society.
• It studies how governments at all levels—
national, state and local—provide the public
with desired services and how they secure the
financial resources to pay for these services.
 Cont...
1) Public finance deals with the finances of
public bodies – national, State or Local – for
the performance of their functions.
• The performance of these functions leads to
expenditure.
• The expenditure is incurred from funds
raised through taxes, fees, sale of goods and
services and loans.
 Cont...
2) The different sources constitute the revenue
of the public authorities.
• Public finance studies the manner in which
revenue is raised; the expenditure is incurred
upon different items etc.
• Thus, public finance deals with the income
and expenditure of public authorities and
principles, problems and policies relating to
these matters.
IMPORTANCE OF PUBLIC FINANCE
1. Provision of public goods: -For providing
public goods like roads, military services and
street lights etc. public finance is needed.
 Business firms will have no incentive to
produce such goods, as they get no payment
from private individuals.
 Cont...
2. Public finance enables governments to tackle or
offset undesirable side effects of a market
economy.
- The side effects are called spillovers or
externalities.
- For example, pollution. The governments can
introduce recycling programmes to lessen
pollution or they can make laws to restrict
pollution or impose pollution charges or taxes on
activities that bring about pollution.
 Cont...
3. Public finance helps governments to
redistribute income.
- To reduce the inequality in the economy, the
governments can impose taxes on the richer
people and provide goods and services for the
needy ones.
 Cont...
4. As the scope of state participation in the
economic activity is widening, the scope of
public finance has also been increasing.
 Generation of employment opportunities,
control of economic fluctuations like boom
and depression, maintaining economic
stability etc. are some of the thrust areas of
the governments through fiscal operations.
 Contd..
• Governments meet this expenditure partly by
levying taxes on its citizens and partly by
raising loans.
• The financial operations of the governments
with regard to raising and disbursement of
finances are called Public Finance.
• In this session we will discuss the scope of
Public Finance and various terms used in
connection with Public Finance.
 Scope of Public Finance
• Public finance is the study of the income and
expenditure of the State.
• The scope consists in study of the collection of
funds and their allocation between various
branches of State activities regarded as
essential duties or functions of the State.
Scope of Public Finance-Four Parts
 SUBJECT MATTERS OF PUBLIC
FINANCE
• The subject matters of Public Finance can be
broadly classified in to five categories –
a)Public revenue
b)Public expenditure
c) Public debt
d)Financial administration
e)Economic stabilization.
 Public Revenue:

- The income of the states is referred to as

Public Revenue.
In this branch, we study the various ways of
raising revenue by the public bodies.
We also study the principles and effects of
taxation and how the burden of taxation is
shared among the various classes of society
etc.
 Public Revenues
• Public Revenues includes all the income and receipts,
irrespective of their source and nature, obtained by the
Government during any given period of time.
• Source of Public Revenues are:
 Taxes,
 Fees,
 Price
 Fines and penalties,
 Gifts,
 Borrowings, and
 Printing of paper money.
 Cont...
Public Expenditure
• It deals with the principles and problems
relating to the allocation of public spending.
We study the fundamental principles
governing the flow of public funds into
different channels, classification and
justification of public expenditure;
expenditure policies of governments and the
measures adopted for welfare state etc.
 Public Expenditure
• The term 'Public Expenditure' refers to the expenses incurred
by the Government for its own maintenance and also for the
preservation and welfare of the society and economy as a
whole.
• It is the end and aim of the collection of State revenues.
• Public Expenditure may be classified as;
• Expenditure which confers common benefit on all, (public
expenditure incurred on general administration etc.)
• Expenditure which directly confers benefit on certain persons,
and indirectly on the entire society, (Social security, public
welfare, old age pensions etc.)
• Expenditure which confers special benefit on some individuals
(subsidy given to particular industry/individual).
Canons of Public Expenditure
 Canon of benefit
• Canon of benefit states, that
 Public expenditure must result in the
achievement of maximum social advantage.
 Public funds must be spent in those directions
which are most conducive to public interest.
 Canon of Economy
• According to this canon:
 The public authorities should not waste the limited
resources at their disposal.
 Only the minimal necessary amount should be spent
on any given head of expenditure which should aim
at maximum benefit.
 Canon of Sanction
• The canon envisages that there should be
proper procedure of formulating the policy for
public expenditure with sufficient safeguards
for avoiding arbitrariness and influence of
certain vested interests in the matter of public
expenditure.
 Canon of Surplus
• This canon enjoins that the public expenditure
should be as far as possible met from current
public revenues, without resorting to deficits
or borrowings.
 Canon of Elasticity
• As per this canon of public expenditure:
It should be possible to change the size and
direction of public expenditure according to
the requirements of different circumstances.
 Canon of Productivity
• This canon envisages that the public
expenditure should be such as would
encourage production and productive
efficiency in the country.
 Canon of Equitable Distribution
• As the heading suggests this canon is for
equitable distribution of income and wealth
and it is particularly important for those
countries where inequalities exist.
 Focus of Public Expenditure
• Public expenditure is primarily aimed to provide;
• Governance,
• Security and justice to citizens,
• Certain goods and services, namely public goods (like roads, water
supply schemes, electricity, defence forces, etc.)
• Public goods unlike private goods can not be priced and purchased
individually.
• For private goods an individual pays voluntarily, but for the public
goods and services, provision has to be made through compulsory
contributions by the members of the society through taxation.
• Public goods can be 'Pure public goods' or 'Impure public goods’ or
‘quasi public goods‘.
• A road open for use of all without any exclusiveness attached to it , is
an example of 'Pure public goods,'
 Contd..
• Another road having a toll barrier is open to only those who
pay the toll is an example of 'Impure/Quasi public goods.'
• Public expenditure should be predominantly used to provide
'Pure Public goods/services to the citizens.
• There is yet another category of goods, which is 'Merit
Goods,'
• Merit Goods can be defined as goods which have an
overriding importance for almost all the members of the
society, the examples are educational and health needs of the
society.
• Provisions for 'Merit Goods' help the economy in attaining a
high level of efficiency and in contributing for achievement of
basic objectives of the society.
• Public expenditure as such plays an important role in 'Merit
goods.'
 Effects of Public Expenditure
• The important healthy effects of the public
expenditure on the economy of any country
are….Effects on,
 production and employment,
 distribution,
 economic stability, and
 economic growth
 Cont...
• Public Debt
• The governments borrow when its revenue
falls short of its expenditure.
• Public debts is a study of various principles
and methods of raising debts and their
economic effects.
• It also deals with the methods of repayments
and managements of public debts.
 Public Debt
• Public debt is the loans raised by the government.
• This source of Public Finance carries with it the obligation of
repayment along with interest.
• Important of Public Debt
 The Public debt has gained much importance all over the
world, the main reasons for which are;
 Financing Economic development,
 Unpopularity of Taxation,
 Natural calamities,
 Wars for defending the nation,
 Covering temporary budget Deficit,
 Fighting Depression, and
 Controlling Inflation
 Source of Public Debt
• Some of the important sources of Public debt
are;
 Borrowings from individuals,
 Borrowings from Commercial Banks,
 Borrowings from Non-Banking financial
Institutions,
 Borrowings from Central Bank,
 Borrowings from External Sources.
 Budget Deficits
• In ideal circumstances the public expenditure should be equal or
less than 'public receipts' (without borrowings).
• Usually the 'public expenditure' exceeds the 'public receipts.' The
'Gap' between 'public receipts' (without borrowings) and the
'public expenditure' is called deficit.
• Deficits arise because of imbalances in revenue and expenditure.
• In the Indian context fiscal imbalances have both been large and
persistent. the size, regularity and composition of revenue deficit
(in particular) has been a cause of concern.
• The annual budget of Government (in India) indicates three
types of deficits, namely
 Revenue deficit,
 Fiscal deficit, and
 Primary deficit.
 Revenue Deficit
• Revenue deficit is the excess of revenue expenditure of
the government over its revenue receipts.
• Revenue deficit leads to increase in borrowings without
corresponding capital/asset formation.
• Revenue deficit is considered generally less desirable.
• Fiscal Reforms and Budget
Management(FRBM)Act,2003 ,which have been
amended in 2013, provides that the Union Government
shall take appropriate measures to reduce fiscal deficit
and revenue deficit so as to eliminate revenue deficit by
31 March 2017.
 Fiscal Deficit
• Fiscal deficit is the excess of total expenditure of the Government
over its non- debt receipts (revenue receipts, miscellaneous
capital receipts and recovery of loans and advances.)
• Fiscal deficit normally represents the net incremental liabilities of
the Government or its additional borrowings.
• The shortfall can be met either by additional public debt (internal
or external) or by the use of surplus from public account.
• Government may run fiscal deficit and borrow funds for
capital/asset formation or for creation of economic and social
infrastructure.
• It is necessary to analyse various components of the fiscal deficit.
 Primary Deficit

• Resources are needed to finance the interest

payments, which represent the expenditure of the
past obligations and which are independent of
current allocative priorities.
• The payments on account of interest payments are
separated and deducted from the total imbalances
to arrive at the imbalances of current nature.
• Primary deficit therefor represents the current
imbalances net of interest payments.
 Financial Administration

• It deals with the methods of Budget

preparation, various types of Budgets, war
Finance, Development Finance etc.
• Thus, financial administration refers to the
mechanism by which the financial functions
are carried on.
• In other words, financial administration
studies the organizing and disbursing of the
finances of the State.
 Economic stabilization and Growth

• The use of Public revenue and Public

expenditure to secure stability in levels of
prices by controlling inflationary as well as
deflationary pressures is studied.
• Similarly the income and expenditure policies
adopted by the government so as to attain full
employment, optimum use of resources,
equitable distribution of income, etc. are also
studied.
Public Finance and Private Finance
• The understanding and the study of public
finance is facilitated by a comparison of the
public or government finance with private or
individual finance.
• Such a comparison will help us to know how
the aims and objectives and methods of public
Finance operation are similar or differed from
the financial operations of the individual.
Similarities
1.Both the State as well as individual aim at the
satisfaction of human wants through their
financial operations.
- The individuals spend their income to satisfy
their personal wants whereas the state
spends for the satisfaction of communal or
social wants.
2. Both the States and Individual at times have
to depend on borrowing, when their
expenditures are greater than incomes
• 3. Both Public Finance and Private Finance
have income and expenditure. The ultimate
aim of both is to balance their income and
expenditure.
4. For both kinds of finances, the guiding
principle is rationality. Rationality is in the
sense that maximization of personal benefits
and social benefits through corresponding
expenditure.
5. Both are concerned with the problem of
economic choice, that is, they try to satisfy
unlimited ends with scarce resources having
alternative uses.
Dissimilarities
1. The private individual has to adjust his
expenditure to his income. i.e., his
expenditure is being determined by his
income. But on the other hand the
government first determines its expenditure
and then the ways and means to raise the
necessary revenue to meet the expenditure.
2. The government has large sources of revenue
than private individuals. Thus at the time of
financial difficulties the state can raise internal
loans from its citizens as well as external loans
from foreign countries. In the case of private
individual, all borrowings are external in
nature.
3. The state, when hard pressed, can resort to
printing of currency, as an additional source of
revenue. In fact, during emergencies like war,
it meets its increased financial obligations by
printing new currency. But an individual
cannot raise income by creating money.
4. The state prepares its budget or estimates its
income and expenditure annually. But there is
no such limitation for an individual. It may be
for weekly, monthly, or annually.
5. A surplus budget is always good for a private
individual. But surplus budgets may not be
good for the government. It implies two
things.
a)The government is levying more taxes on the
people than is necessary and
b)the government is not spending as much as
the welfare of the people as it should.
6. The individual and state also differ in their
motives regarding expenditure.
- The individuals hanker after profit. Their
business operations are guided by private
profit motive. But the states expenditure is
guided by the welfare motive.
7. The private individual spends his income on various
items in such a manner as to secure equi-marginal
utilities from them.
- The government on the contrary does not give as
much importance to this law as a private individual
does.
- Modern government sometimes incur cretin types of
expenditure from which there do not derive any
advantage but they do incur this expenditure to
satisfy cretin sections of the community.
11. Private Finance is always a secret affair.
Individual need not reveal their financial
transactions to anyone except for filing tax
returns.
But Public Finance is an open affair. Government
budget is widely discussed in the parliament
and out sides.
• Public accountability is an important feature
of public finance.
12. Individuals can plan to postpone their
private expenditure. But the state cannot
afford to put off vital expenditure like
defence, famine relief etc.
• Findlay Shiraz says that compulsory character
is an important future of public finance.
Major Fiscal Functions