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Public Finance

Public Finance

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Published by Deepak Ehn

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Published by: Deepak Ehn on May 28, 2011
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Study Note - 8
This Study Note includes
Direct & Indirect Taxes
Canons of Taxation
Effects of Taxation
Deficit Financing
It relates to the earning and spending activities of public authorities viz. Government. Agovernment not only earns money in diverse ways it can also create ‘new’ money for its spending by borrowing from central bank. Apparently, therefore government has no fixed budgetconstraint as private sector unit faces. It is not forced to cut its coat according to cloth. Ratherthe level of public spending determines public revenues to be acquired. Herein lies the basicdifference between Public Finance and Private Finance. A private household or a corporate body cuts its coat according to its cloth that is, its spending is influenced by its earning.Another point of contrast between Private Finance and Public Finance is that, private individualor corporate body can earn as much as possible. But the government not only earns money indifferent ways but it has the power to create new money to bridge the gap between its normalearning and spending. Against its securities the Central Bank can grant the Government loan by the creation of new money.
Tax revenue is the vital source of public income. A tax is a compulsory contribution collectedfrom citizens for which the tax payers cannot expect any quid pro quo i.e. direct benefit fromthe payee. Its compulsory nature and absence of benefit to payers are two features by whichtaxes differ from non tax revenues like fees, fines etc. Taxes are sources of public income butthat is not all. They are used for bringing distributive justice, controlling inflation, achievingfull employment, curtailing consumption etc.
Public Finance
Objectives of Taxation
According to classical writers every tax is an evil. J.B. Say stated that –“The very best of allplans of finance is to spend little and the best of all taxes is that which is least in amount”. Thisis because the classical economists believed in the golden rule of zero income and zeroexpenditure by the government. But after the Great Depression of 30s’ a great change has takenplace in our conception to the ideal for which government should tax.Firstly, the primary objective of taxing is to raise resources from private hands inorder to carry out diverse activities of the public authorities. With the passage of time the activities of modern governments have increased substantially, Accordinglythe need for finance has also increased. The easiest way of raising resources is bythe use of tax mechanism. If fact, tax revenue every where in the world exceeds theother sources of public revenue. Thus tax is an important way of diversion of resources for socio-economic purpose by the government from private hands.Secondly,some taxes are imposed with the object of restricting the use of someobnoxious goods. An excise duty on wine restricts its use which is socially desirable.Similarly a tax on import may lead to a restriction of import and thus may help insaving foreign exchange.Thirdly, taxes are also used with the objective of controlling inflation or cyclicalfluctuations in the society. In a period of Demand pull inflation, the governmentmay leave less in the hands of the people by imposing heavy Direct Taxes. As aresult people’s disposable income will be less and so the excess demand will becurtailed to some extent. Similarly in a period of Economic prosperity, thegovernment can tax at a high rate and the money thus obtained may be used in aperiod of depression and unemployment.Lastly, tax is an important source of development finance. The poorer countriesneed large amount of fund for investment in diverse growth oriented projects. Oneway of financing such development activities is by widening and also by increasingthe rate of taxation. It leads to involuntary savings on the part of the populationand is an import source of capital formation.
Tax payers do not always pay the money from their own pockets. In some cases they do so and bear the burden of taxation i.e. the hardships of paying the tax. In some other cases, the recordedpayers of a tax pay it after collecting the money, partly or wholly, from some one else. In otherwords, in the former cases the tax burden is not shiftable while in the latter cases they areshiftable. An Income Tax payer pays the taxable money from his own income. On the otherhand, a seller of products pays Sales Tax after collecting it from buyers in the form of higherprice (Cost Price + Local Taxes). So Income Tax payers cannot shift the tax burden while thesales tax payers can. A direct tax is a tax whose burden cannot be shifted e.g., Income Tax,
Wealth Tax etc. A tax is said to be indirect whose burden is shiftable from the tax payers tosome other person e.g., Salea Tax, Amusement Tax, Excise Duty etc.Further in Direct Tax impact and incidence fall on the same person. The tax payer himself hasto pay the money from his own pocket. The burden of such a tax cannot be shifted either backward or forward.So, the basis of classifying taxes into direct and indirect is the shiftability of tax. Choice betweendirect and indirect taxes is difficult. They have theit respective merits and demerits.
Merits of Direct Taxes
Firstly, generally the rate of tax increases as Income or value of property increase indirect taxation. That is such taxes are progressive in character. Those who aresupposed to have higher ability to pay are required to do so.Secondly, such taxes can be used for redistribution of income and wealth. Thedisparity between the income of different income groups and of inherited wealthcan be reduced by a graded system of Direct Taxes.Thirdly, such taxes are economical and easy to collect. The cost of collection is notvery high.Fourthly, the prayers pay such taxes consciously. He gets enough time for itspayment. Lastly, such taxes are highly productive. They bring more revenue to thepublic Authorities.
A direct tax is not a rose without thorns. It has its blemishes too. They are supposed tohave a positive disincentive effect on work, income and savings. It is but quite naturalthat people may not like to work hard and earn more if they are forced to pay off a largepart of hard earned income. Similarly, people may get disincentive to invest in buildingand property if inheritors are to pay high death duties.Secondly, heavy burden and not being shiftable, such taxes may create a desire toevade them by payers. This may create black wealth and unaccounted income.Public revenue is likely to be less.Thirdly, the tax axe falls more heavily on salaried class who cannot conceal theirincome while those who earn excessive windfall income like trader, business men,speculators can conceal their income. This is unfair and unjust. The total burden of such tax falls on a small percent of population and a vast majority could remainoutside tax net.

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