UNIT 1 NATURE ANDSCOPE OF FINANCIAL ADMINISTRATION

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Objectives Introduction Financial Administration : Meaning Financial Administration : Importance Nature of Financial Administration Scope of Financial Administration Components of Financial Ad~inistration Let U S ' S U b p ~ Key Words References Answers to Check Your Progress Exercises

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OBJECTIVES

After studying this unit, you should be able to : discuss the meaning, importance of financial administration explain the nature of financial administration highlight the enlarging scope of financial administration; and identify the components of financial administration.

1.1 INTRODUCTION
Finance is the life blood of every organisation; Personnel and materials which are needed for the functioning of any office, industry, enterprise can be made available only if money is provided. The efficiency of operating systems and maintenance systems depends upon the effectiveness of financial system as every administrative act may have financial implications. The significance of finance to public administration is quite obvious as is evident from the remark of Lloyd George: "Government is finance". Financial administration, as an important aspect of public administration islas anc~ent as organised governments all over the world. In its rudimentary form, it was performing certain limited functions till medieval times. In the pre-modern times, it was conceived within the structure of legislative control over executive. Soqio-economic forces unleashed by industrial revolution have given a new meaning and a dynamic content to financial administration. In the changed context, it is expected to meet dynamic needs of planned development and social change. In this unit we shall discuss the meaning, importance, nature and scope of Financial Administration. The unit will also give us an idea about the various components of Financial Administration.
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1.2 FINANCIAL ADMINISTRATION : MEANING
The term Financial Administration consists of two words viz. 'Finance' and 'Administration'. The word 'administration' refers to organisation and management of collective human efforts in the pursuit of a conscious objective. The word 'Finance' refers to monetary (money) resource. Financial Administration refers to that set of activities which are related to making available money to the various branches of an office, or an organisation to enable it to carrying out its objectives. Whether it is the Department of Agriculture, Railways, Road Transport Corporation, Primary Health Centre, Municipality o r Gram Panchayat, o r for that matter, a family, its day-today activities would depend updn the availability of funds with which financial
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Financial Administration : Basin and Objectives

Now let us get to know some more accurate definitions of Financial Administration. According to L.D. White, "Fiscal Management include's those operations designed to make funds available to officials and to ensure their lawful and efficient use? According to Jaze Gaston "Financial Administration is that part of government organisation which deals with the collection, preservation and distribution of public funds, with the coordination of public revenue and expenditure, with the management of credit operations on behalf of the State and with the general control of the fina~cial affairs of public household:' Though this definition covers some important aspects of fiscal management, it fails to project a comprehensive scope of financial administration. Perhaps, after realking this limitation, G.S. La11 states that financial administration is concerned with all the aspects of financial management of the State. Since public administration is more and more concerned with public affairs and public interest, the frontiers of financial administration are expanding and therefore there is a need for a comprehensive definition of financial administration. As an attempt towards this direction, the following definition is presented. "Financial Administration includes all the activities which generate, regulate and distribute monetary resources needed for the sustenance and growth of the members of a political community ," The Distinction between Public Finance and Private Fiance Finance function appears to be a generic process which takes place in both public and private organisations. But, one should not conclude that the principles and norms which are applicable to private finance are equally applicable to public finance, for despite the challenge to the historic "separate but equal doctrine" from the integrationist movement of recent times, public organisations continue to possess certain distinct characteristics. Dissimilarities between public finance and private finance are quite sharp and clear. 'According to Sundaram, these dissimilarities can be outlined as follows: Publk Finance 1) Adjustment of income to expenditure la) Popular control 2) Elastic resources 3) Resource mobilisation through coercive power 4) 5) Tendency towards deficit Direction of expenditure towards public service Private Finance 1) Adjustment of expenditure to income la) Corporate control 2) Limited resources 3) No such power 4) 5) Tendency towards balanced budgets Towards profit maximisation

The importance of Financial Administration was not considered till after industrial revolution. The concept of minimum government as an offshoot of laissez faire doctrine, dictated observance of minimum taxation. When social life became more complex as a result of industrial revolution, the role of the government increased manifold. Further, the concept of welfare state has caused phenomenal increase in state activity. The governments have entered into new areas which were kept out of the purview of the State. In this changed context, financial administration has gained greater significance for exploring ways and means to generate resources to meet the ever-increasing public expenditure. The Great Depression (1929-33) had exposed the weaknesses of neutral economic stance of the governments. It enhanced the quest for stability in income and employment as well as for equality and social justice. Based on Keynesian perspective, the State has assumed an active and positive role for expanding national income and employment. It has also taken up the task of ensuring equity and
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~nfluencing socio-economic life of the people. Defence and administrative the expenditure ldst its nonproductive label and assumed a new significance as a lever for stimulating iricome and employment levels. Financial administration was entrusted with the responsibility of formulating effective policies to achieve these new objectives of the State. It was called upon to transform financial resources into public purposes and thus to improve the lot of the individual through distributive justice. With the advent of democracy, as a popular social institution, the concept of 'parliamentary'control over public purse' has received universal acceptance. The principles of "no taxation without tepresentation", i.e. "no public expenditure without parliamentary sanction" have become the guiding canons of modern political communities. There appeared an urgent need to devise a simple and systematic financial procedure in order to make financial system intelligible to the common person. Financial administration became an instrument of 'modern governments for making "popular sovereignty" a social reality. The concept of planned development has enabled public administrators to play an active and dynamic role in the formulation and implementation of development schemes and projects. The time and cost of implementing these projects have become critically important. The accent of financial administration has shifted from one of controlling the disbursement of funds to one of management of various development projects and programmes. The rise of performance budgeting and other related budgetary innovations represent remarkable achievements of financial administration in meeting this challenge. From the early eighties onwards, resource crunch has become a very serious problem of modem governments. While there is a tremendous pressure on the modem governments to increase their expenditure outlays to meet the ever expanding ambitions and demands of the people the taxpayers are unable or unwilling to bear additional tax burdens. In this dilemma, a need has arisen for a careful prioritisation of public expenditure. Hence a study of financial administration and management which are a part of public administration has become important to seek out ways for eliminating unwanted expenditure and ensuring optimisation of output on a limited resource base. Zero Base budgeting is an attempt in this direction. To sum up, financial administration is playing a dominant role in modem times.
ChecLYaUrProgressl Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.

Nabre and Scope of Financial AdmlnistraUon

1) Explain the meaning of Financial Administration.

2) List any three points of distinction between public and private finance.

3) Why has the study of financial administration become important in recent times?

Finmcid Adminls(ratIon :Basla and Objectives

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1.4 NATURE OF FINANCIAL ADMINISTRATION
%ere are two different views regarding the nature of financial administration. These are i) Traditional view; ii) Modern view.

i) Traditional View
Advocates of this view conceive financial administration as a sum total of activities undertaken in pursuit of generation, regulation and distribution of monetary resources needed for the sustenance and growth of public organisations. They emphasise upon that set of administrative functions in a public organisation which relate to an arrangement of flow of funds as well as to regulating mechanisms and processes which ensure proper and productive utilisation of these funds. When one looks at this vlew from systems perspective, it represents an integral sub-system of supportive system. A financial administrator shoulders responsibility for ensuring adequate financial backing for running public organisation in the most efficient manner. Hidher job is to plan, programme, organise and direct all financial activities in public organisations so as to achieve efficient implementation of public policy. The participants of this system are considered as financial managers and they discharge managerial functions of financial nature. Further, this view reflects the stand taken by pure theorists of public finance like Seligrnan. The central thesis of pure theory of public finance is that public finance should deal with the pr~blems public of income, public expenditure and public debt in an objective manner without any relation to a set of values and premises of the political party in power. Accordingly, theorists of financial administration subscribing to this view take a value-neutral stany. For instance, Jaze Gaston reflects this view when he says that financial adminihtration is that part of government organisation which deals with the collection, preservation and distribution of public funds.
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ii) Modem view The modem view considers financiaLadministration as an-iategral part of the overall management process of public organisations rather than one of raising and disbursing public funds. It includes all the activities of all persons engaged in public administration, for quite obviously almost every public official takes decisions which of are bound to have some direct or indire~t'conse~uences financial nature. Further, it rejects the value-neutral stand of the traditional theory. It combines in itself three prominent theories of public finance, viz., the socio-political theory as expounded by Wagner, Edgeworth and Pigou, the functional theory of Keynesian perspective and activating view of modem public finance theorists. According to this view financial administration has the following roles. a) Equalising Role : Under this role financial administration seeks to demolish the mequalities of wealth. It seeks, through fiscal policies, to transfer income from the affluent to the poor. b) Functional Role : Under normal circumstances the economy cannot function on its own. Under this role, financial administration seeks to ensure, through taxation, public expenditure and public debt, and proper functioning of the economy. It evolves policy instruments to maintain high economic growth and full employment. C) Activating Role :Under this role financial administration involves the study of such steps that will facilitate a smooth and rapid flow of investment and its optimal allocation to iricrease the volume of national income. d) Stabbing Role : Under this role, the objective of financial administration is the stabilisation of price level and inflationary trends through fiscal as well as monetary policies. e) Participatory Role :According to this view, financial administration involves formulation and execution of policies for making the state a producer of both public and private goods with the objective of maximising social welfare of the community. It also seeks to promote economic development through direct and indirect participation of the State.

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Thus, finmcial administration provides a framework of choices regarding ends and means which reflect the nature and character of the State and its ideological base as well as its values. For instance, financial administration of skialist countries differ from that in democratic countries. Thus,the essence of financial administration would differ under different socio-political systems depending upon particular.mode of operation of socio-economic and political forces.

Nature and Seop of Financial Administration

1.5 SCOPE OF FINANCIAL ADMINISTRATION
In Section 1.2 where we have discussed the meaning of financial administration, Gaston Jaze's definition, quoted in that context, points out that the government organisatien which deals with the following four aspects constitutes financial administration. These include : 1) The collection, preseryation and distribution of public funds. 2) The coordination of public revenues and expenditure. 3) The management of credit operations on behalf of the State. 4) The general control of the financial affairs of the government. In modern governments all the above aspects are dealt with by the Finance Department and its subordinate agencies. Though the Finance Department may be considered as central financial agency of modem governments, it cannot be equated with financial administration. Its role constitutes financial management rather than financial administration. As a financial manager it deals with the systems, tools and techniques contributing to economic decision making in government. These processes are, in fact, the integral part of financial administration. The scope of financial administration is much wider than what these processes suggest. According to some authorities on public administration, the term financial administration refers to the financial processes and institutions involved in legislative financial control. In their view, the scope of financial administration encompasses the preparation of estimates, appropriation of funds, expenditure control, aciounting, audit, reporting, review and so on. In a democratic context, this view may gain wider acceptance as it ensures executive responsibility to legislature. But, the experience of modem democracies has shown that the legislative involvement in the determination of the desired volume, range and direction of programmes, the use of independent judgement relating to the financial resources required by administrative agencies is becoming nominal day by day. It is a known fact that the average member of the legislature is not adequately informed to ensure effective control over executive. Thus, the view appears to be of no significant validity. Further, legislative control of financial aspects of the government does not represent the scope of financial administration in its entirety. Yet another view advocates a budget oriented outline for the scope of financial administration. According to them the scope of financial administration is limited to the preparation of budget, the enactment of budget and execution of budget. Though the budget is the core of financial administration, certain operations which precede budget preparation are equally important. There is a pertinent need to include planning process as an integral part of financial administration. In the ultimate analysis, there is a need to adopt an integrated approach so that all the above views are incorporated into the scope of public administration. As an outcome of such an approach, the following aspects emerge as the core areas of financial administration. i) Financial planning ii) Budgeting iii) Resource mobilisation iv) Investment decisions v) Expenditure control vi) Accounting, Reparting and Auditing i) Financial Planning :In a restrictive sense one may consider budgeting as planning since its basic concern is to facilitate the formulation and adoption of policies and programmes with a view to achieving the goals of government. But planning, in a broad sense;includes the concerns in terms of whole range of government policy and it demands a time frame and a perception of the inter relationships among policies.

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Financial Administration : Basin

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It looks at a policy in the framework of long-term economic consequences. There is a need to coordinate planning and budgeting. The cokept of planning-programming-. Budgeting System (PPBS) represents an attempt in this direction. Financial Administration, under this phase, should consider the sources and forms of finance, forecasting expenditure needs, desirable fund flow patterns and so on. ii), Budgeting :This area is the core of financial administration. It includes examination and formulation of such important aspects as fiscal policy, equity and social justice. It also deals with principles and practices associated with refinement of budgetary system and its operative processes. iii) Resource M o b h t i o n :Imposition of taxes, collection of rates and taxes etc. are associated with resource mobilisation effort. Due to the ever increasing commitments of government, budgetary deficits have become regular feature of government finance. In this context deficit financing assumes greater importance. But deficit financing, if used in an unrestrained manner, may prove to be a dangerous problem for a nation's econgqy for it can cause galloping inflation. Another challenge faced by administration is tax evasion and growth of parallel economy. Finally public debt constitutes yet another element of state resources. The proceeds of debt mobilisation effort should be used only for capital financing. Thus, modem financial administrator has to be fully conversant with all the dimensions of resource mobilisation efforts.
: iv) Investment ~ecisiins Financial and socio-economic appraisal of capital expenditure constituteswhat has come to be known as project appraisal. Since massive investments have been made in the public sector a thorough knowledge of the concepts, techniques and methodology of project appraisal is indispensable for a financial administrator. v) Expenditure control :Finances of the modem governments are becoming quite inelastic. Almost every government is suffering from resource crunch. Further, the society cannot be taxed beyond a certain point without doing a great damage to the economy as a whole. Thus, there is an imperative need for careful utilisation of resources. Executive control is a process aimed at achieving this ideal. Legislative control is aimed at the protection of the individual tax payers interest as well as public interest. There is also the need to ensure the accountability of the executive to the legislature. Accounting, Reporting and Auditing :These aspects are designed to aid both the executive control and legislative control. In India, the Comptroller and Auditor General (C & AG) and the Indian Audit and Accounts Department over which the C & AG presides ensure that the accounting and audit functions are performed in accordance with the provisions of the Constitution.

We shall be discussing in detail about these areas in subsequent blocks of this course. Check Your Progress 2 Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit. 1) What, according to traditional view, is the role of financial administration?

2) Discuss any two roles of financial administration as propounded by modem public finance theorists.

3) What are the financial processes and institutions involved in legislative financial control?

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4) Highlight the.comprehensiveview regarding the scope of financial'admin&ation.

16 COMPONENTS OF FINANCIAL ADMINISTRATION .
Theorists of public finance have identified three elements of public finance. They are : a) Public Revenue b) Public Expenditure c) Public Debt Since financial administration concerns itself with public finance and deals with the principles and praqtices pertinent to the proper and efficient administration of the state finances, the thinkers of financial administration have included the administrative aspects in the &ope of finahcial'administration. Some other thinkers, taking clue from Luther Gulick, have tried to project POSDCORCs view wherein : P - Stands for Financial Planning 0 - Stands for Financial Organisation such as Finance Ministry S - Stands for financial Personnel D - Stands for Direction such as Financial advise CO - Stands for Coordination of Income and Expenditure R - Stands for Financial Reporting such as accounting C - Stands for control which includes executive control, audit control and legislative control. The above exposition does not reveal the exact picture related to the elements of financial administration. An organisational system consists of the following basic elements : a) The People b) Work and structure c) Systems and procedure People represent human resources of the organisation. Work and structure represent efforts and processes concerning definition of tasks and roles, and organisation of I eporting relationships. Systems and procedures represent framework to facilitate interactions between the people and the work. These interactions result in organisational output. it is possible to identify the following elements of financial administration : a) Human Element Tax payers Fee Remitters Suppliers (Funds and materials) Employees (Public Officials) Entrepreneurs (Politicians) Customers & Common person

FhuxiPl Adminhtration : Basics and Objeckives

b) Work and Structures The Legislature and its financial committees The Cabinet The Finance Department The Administrative Departments The Executive Departments The Audit Department c) Systems and Procedures Planning Systems Budgeting systems and procedure Coritrolling systems such as accounting and auditing. Human element consists of participants whose involvement is determined'by contribution-inducement equilibrium. This consideration implies that people, for instance, wish to contribute their money (tax etc.) and support the government as long as there is a feeling on their part that they are suitably rewarded for their sacrifice and support. No public organisation can easily overlook this consideration. Work and structure refer to the organisation processes viz. divisional processes and integration processes by means of which organisation subdivisions are created with a provision for mutual interaction. Systems and procedures are the devices which link the people to the work and structure. These three components interact with each other to produce organisational outcomes. No discussion on administration's components would be complete unless there is a reference to the environment which affects content, character and capabilities of the components. Financial administration is enveloped by two environments. Every one is aware of suprasystem known as socio-economic and political enviornment in which the financial administration operates. There is an intermediary sub-system' comprising the goals pursued by financial administration, the norms, values, beliefs and behaviour as reflected in the culture: of financial administration and the nature of technology employed by financial administration. The overall picture may be presented in the form of the following illustration :

Systems
procedures

Check Your Progress 3 Note : i) Use the space given below for your answers.
ii) Check your answers with those given at the end of the unit.
1) What, according to POSDCORC view, are the major elements of financial

administration?

Nature and Scope of Financial Administration

2) Identify the elements of an organisational system.

1.7 LET US SUM UP
All societies have their financial administrative systems as an integral component of its public administrative system. In contemporary societies, financial administration began to assume the multifaceted role in order to secure 'maximum human welfare. Public finance and private finance have much in common although there are certain distinct differences. Financial administration, in its evolutionary process, has proved to be,a dynamic entity capable of developing itself into a potential measure to meet requirements of changing socio-economic demands from time to time. Of late, financial administration has assumed the role of a provider of choices with regard to ends and means for a society. As we have discussed, its scope is expanding day by day and at present it encompasses many dynamic aspects such as financing, planning and budgeting, resource mobilisation and its investment, public expenditdre, control including financial control etc. The human element, work and structure, and systems and procedures constitute its important elements.

KEY WORDS
Comptroller and Auditor General (C & AG) : The C & A G is one of the Constitutional authorities appointed by the President of India. The C & AG performs such duties and exercises such powers in relation to the audit of accounts of the union and of the states and of any other authority or body as may be prescribed by or under any law made by Parliament. Deficit Financing :It refers to means of financing the deliberate excess of expenditure over income through printing of currency notes or through borrowing. Fiscal Poliq :It is that part of economic policy which is concerned mainly with the revenues and expenditure of the government. It spells out the application of taxation, public expenditure and public debt to realise certain public objectives. Functional Theory : The doctrine which advocated that government should pursue whatever fiscal measures are necessary to achieve non inflationary, full employment and economic growth without regard -to budget balancing. Galloping inflation : It occurs when a persistent inflation gets out of control and there is decline in value of money. In this situ'ation each increase-in prices becomes the signal for an increase in wages and costs which again pushes prices up still further. Great Depression : The World wide depression that started in 1929 and lasted till 1935. It was characterised by low economic activity and mass unemployment. Laissez Faire : Non-interference policy of the government in economic affairs. Performance Budget :It is generally understood as a system of presentation of public expenditure in terms of functions, programmes, performance units viz., activities, projects etc. reflecting primarily the governmental output and its cost. system (PPBS) : It is a technique for optirnising Planning-programming-budge* allocation of funds in the budget by exercising proper choices among. programmes which compete for limited sources. It emphasises selection of best programmes out of a number of alternatives available, which could be implemented with a given quantum of resources.

lhmd.l Administration : and objecti'vcs

! h e b p o l i t i d theory :This theory as advocated by Wagner laid emphasis on looking

at each economic problem in its social and political context and thereby arriving at an appropriate solution. Wagner, for example, was in favour of using taxation for reduction of income ineqwlities.
System :An arrangement of interrelated and interdependent elements of a phenomenon so as to function as an organic whole.
Zen, base budgetiw :It is an operating, planning and budgetary process which

requires each manager to justify hidher entire budget request in detail from scratch. It shifts the burden of proof to each manager to justify why any money should be spent at all, as well as how the job can be done better.

1.9 REFERENCES
Burkhead, Jesse. 1956. Government Budgeting, John Wiley & Sons: NewYork. Groves, ~ a r o l dM. 1958. ~ i k n c i Government, Fifth Edition, Henry Colt and Co.: ; n~ New York. Lall, G.S. 1976. Public Finance and Financial Administration in India, Kapoor: New Delhi. Pinto P. J. J., 1943. System of Financial Administration in India, New Book Company: Bombay. Premchand A, 1963. Control of Public 'Expenditure in India, Allied Publishers: New Delhi. Sundaram K. P.M., 1974. Indian Public Finance and'Finoncia1Administration, Sultan Chand & Sons: New Delhi. Thavaraj, M.J.K., 1978. Financial Administration of India, Sultan Chand & Sons: New Delhi. Wattal, P.K., 1962. Parliamentary Financial Control in India, Second Edition, Minema Book Shbp : Bombay.

1.10 ANSWERS TO CHECK YOUR PROGRESS

fl -Your answer should include the following points :
Literal .meaning of Financial Administration which refers to that set of activities which are! related to making available money to the various branches of an office, or an organisation to enable it to carrying out its objectives, Finance function as a managerial process Finance function of the government Finance function as a social process.
2) Your answer should include any three of the following points:

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Adjustment of income to.expenditure versus expenditure to income Popular versus corporate control Elasticity of resources Coe'rcion Deficit versus balanced bydger Motive of public expenditurepublic service versus profit maximisation. 3) Your answer should include the following points: Shift in accent of Financial ~dministration from controlling the disbursement of funds to management of various development projects and programmes Financial Administration becoming an instrument of modem governments for making "popular sovereignty" a social reality Rise of budgetary innovations in Financial Administration Development of .emphasis in Financial Administration on seeking out ways for eliminahng unwanted expenditure and ensuring optimisation of output on a
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Check Ywr Progress 2

Nature and h p e of Financial Administration

1) Your answer should include the following points:
Arrangement of funds flow ' Regulatory mechanism Supportive system Value neutral stance. 2) Your answer should include any two of the following points,: Fqualising role Functional role Activating role Stabilising role.

3) Your answer should include the following points :
Preparation of estimates Sanction of appropriations Expenditnre control Accounting and auditing.

4) Your answer should include the following points : Financial planning Budgeting Resource mobilisation Investment decisions Expenditure control Accounting and auditing.

1) Your answer should include the following points : Financial planning Financial organisation. Financial personnel e Financial advice Coordination o income and expenditure f Financial reporting Executive, legislative and audit control. 2) Your answer should include the following points : Human element Work and structure Systems and procedure.

UNIT 2 OBJECTrVES AND PRINCIPLES OF FINANCIAL ADMINISTRATION
Structure
Objectives Introduction Financial Administration : Objectives Principles of Financial Administration Financial Administration in I?dia
2.4.1 Historical Perspective 2.4.2 New Emerging Trends

Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

2.0 OBJECTIVES
In the previous unit an attempt has been made to familiarise you with various aspects of the nature, scope and significance of financial administration. Now, in this unit, an effort i~ made to throw light on cektain other fundamentalsof financial administiation. After a study of this unit you should be able to : discuss the objectives of fiscal policies aimed at securing certain social and economic goals as envisaged in contemporary public policies describe ways and means as well as appropriate institutional instruments to secure the above objectives explain Indian .experience in formulation and execution of fiscal measures through certain fiscal institutions and processes from time to time highlight certain trends and their utility in the light of contempbrary challenges faced .by modern democratic political societies like India; and discuss the need to comprehend various aspects of financial administration as a way out to consider contemporary socio-economic problems and the solutions therefor.

In the early stages of modern age, governments played the role of an umpire to ensure a free play of market forces. Governments have had a single objective viz., affording protection to the basic socio-economic framework and the privileged sections and interest groups from hostile forces threatening the system from inside as well as outside. In this context, financial administration reflected least public spending asits basic objective. With the addition of regulatory and welfare functions to the sphere of government, the functional role of financial administration was articulated in terms of mobilisation of resources and their productive deployment. It was expected to achieve the broad objectives spelled out in public policies from time to time. Its aim was to achieve the objectives o f the government with the maximum possible level of efficiency at the least expenditure. It is a known fact that there is no universal agreement about ends of the State. For instance, an autocratic government of Hitlerian type may piefer "military might" to basic human requirements whereas a welfare state with a commitment to socio-economic equity may wish to raise the quality of life of its citizens in preference to arms race. Therefore, one may think that there cannot be a set of objectives, other than efficiency and economy, which can be visualised by a student of financial administration. But, it is not impossible to think in terms of certain common objectives pursued by financial administration all over the world when one looks at the experiences of the governments throughout the world; Such an exercise may not facilitate prescription of a set of objectives by a student of financial administration, but it will certainly help hirnlher to have a view of hisher own as to what the objectives ought to be.

In this unit, we will discuss the objectives and principles of Financial Administration. We shall also trace the evolution of financial administration in India and also highlight some of the emerging trends.

Objectives and Rindpks d Flnaneial Administration

FINANCIAL ADMINISTRATION : OBJECTIVES
The vagaries of the market in the developed countries, for instance, have led to an enlarged scope of financial administration which is characterised by deficit budgets, massive public debt and deficit financing. Similarly, in the developing countries, where governments have assumed the role of a facilitator of development, fiscal policies and administration reflect a set of multiple objectives such as stability, development, self-reliance, reduction of interpersonal inequalities in income and wealth, and balanced regional development. Interestingly these countries also utilise the same instruments of action. Even though political ideologies, or ecpnomic doctrines are of crucial importance in the management of the affairs of the state, there are certain fundamental objectives of financial administration which transcend, politico-economic compulsions. These are as follows : 1) Management of the finances of public household 2) ~mplementationof projects and programmes 3) Provision for public goods and social services 4) Growth, Employment and Price Stability 5) Capital formation b) Productive deployment of national funds 7) Facilitating smooth flow of parliamentary processes 8) Achieving equity and equality. 1) Management of finances of Public Household :Just as in an individual household, the public authorities are concerned with the satisfaction of human wants and their major problem is to ensure the best application of limited means to secure given ends. In this context, a financial manager focuses hisher attention on mobilisation of resources and their rational deployment, in conformity with the rising expectations of the people. 2) Implementation of projects and programmes : A welcome development in financial administration is related to ensuring optimal public investment decisions through project formulation, appraisal and implementation. The emphasis has shifted from expenditure control to the implementation of projects within the stipulated time schedule and expenditure ceiling. 3) Provision for public goods and social services : Since the benefits from public goods and social goods are available to one and all notwithstanding one's contribution to public exchequer, no one will offer payments for the sypply of such goods. Provision of public goods like public parks, social services like public health, sanitation cannot be left to the private sector which is motivated by profit rather than service to the people. Budgetary support for such services becomes a legitimate concern for fiscal policy makers. 4) Growth, Employment and Price Stability :Modem governments are expected to focus attention on socially desired rate of economic growth, high employment and a reasonable degree of price level stability and a positive balance of payments position. Achievement of these objectives cannot come about automatically. There is need for policy initiatives on the part of public authorities.

5) Capital Formation : Economic development of a nation, to a great extent, depends upon the capital formation through increased savings. No amount of State's coercive power can achieve this objective. Appropriate financial and fiscal measures such as discriminatory taxation and monetary policy instruments may be employed to accomplish this objective. 6) Productive deployment of funds :A major problem of under-developed countries is the allocation of investible funds between competing projects and programmes. The entzpreneurs may prefer 'risk free' and 'quick yielding' investment rather than those which are essential in national interest. In order to ensure flow of investible funds into desirable channels, Planning Commission lays down guidelines regarding priorities for different types of investment for both public as well as private sector. The finance ministry takes up the task of ensuring adherence to national priorities both in the public sector and the private sector.

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FinaRCI.l Admtnfstration: Basics and Objectlva

7) Facilitating smooth flow of parliamentary processes : The basic tenet of representative governments throughout the w-orld is the supremacy of the representative institutions and their control over executive branch of the government. One of the most important dimensions of this is the control of legislature over use of public funds. Financial administration through its budgetary process and audit function enables and ensures the supremacy of the legislative body over the executive. 8) Achievement of equity and equality : The distribution of income and wealth depends upon the distribution of factors of production and factor pricing determined through the market mechanism. It also depends upon the transmission of property rights through inheritance as well as personal earning abilities. Such distribution may not be in conformity with what society considers a "fair" or "just" state of distribution. Equity, however, has to be achieved through an evolutionary process without giving scope for class conflicts and large scale violence. There should be a progressive reduction in the concentration of economic power. At the same time, equal opportunities for every one in every sphere will have to ensure non-occurrence of fresh inequalities. Financial administration, through its fiscal policies, such -as progressive taxation; grants, subsidies etc. can help movement towards greater equality of wealth and opportunities.
T o sum up, the objectives of financial administration can be broadly categorised as stability, equity and growth and the effect of these objectives is very important to bring about socio-economic transformation in a desirable direction.
C~YourproeFess1 Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.
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1) What are the objectives which are reflected in the fiscal policies of the developing countries?

2) What are the fundamental concerns -of financial administration which transcend politico-economic compulsions?

2.3 PRINCIPLES OF FINANCIAL ADMINISTRATION
In the beginning of the 20th Century thinkers like Adams considered financial administration as a component'of Science of Financec Some of the contemporary authors also hold similar views. According to these authors financial administration is a fiscal science. Since "fisc" is a part of the govemment machinery, finandal administration reflects the nature, character and scope of the State. Moreover, financial administration is concerned with actual problems and hence, its ends and means depend upon the type of the economy. Due to this cultural specificity, it is very difficult to accept the claims that the financial administration is a science and as a consequence of this realisation one has to know that'the norms of financial administration for a country at any given time depend upon the objectives of national

policy and prevailing socio-economic and political realities. Because of these limitations, some of the economists like Hicks treated public finance as an art. Under this situation it becomes very difficult to think in terms of principles of financial administration. However, if one studies the evolution of financial administration and its administrative patterns through cross-national and cross-cultural contexts, it is possible to infer some broad guidelines in the form of pragmatic concepts. Accordingly, the following may be listed as some of the important principles in this regard. 1) 2) 3) 4) 5) 6) 7) 8) The principle The principle The principle The principle The principle The principle The principle The principle of of of of of of of of primacy of public interest, public choice and public policy political direction and control correspondence unity of organisation and management stability and balance simplicity and flexibility conduct, discipline and regularity public trust and accountability.

Objectives and Principles 01 Financial Administration

Let us discuss these principles in detail as follows. i) The principle of primacy of public interest, public choice and public policy Professor Adams, in his "Science of Finance", stated that the Science of Finance treats of the wants of the State and the means of their supply and hence the fiscal policy should not impair the patrimony of the State. H e considered this dictum as an important axiom of fiscal policy and administration. The patrimony, according to him, consists in a flourishing private industry. But this concept of the State's patrimony has undergone a drastic change and at present it is public interest which can be considered as locus as well as focus of the State activity. Public interest can be interpreted in various ways such as the common good, the general welfare, the overall quality of life of contemporary and subsequent generations, the collective realisation of social values, rights and privileges. For, fiscal policy and administration, it is imperative to concentrate on those types of activities which make a definiteand justifiable contribution to the accomplishment of public interest and public satisfaction as expressed in public policies. It is quite essential to realise that fiscal policy is expected to subserve the broad aims as spelt out in public policies. One should be clear about the meaning of public choice. Some erroneously try to identify the public choice with the choice of the greatest number or the aggregation of individual and group interests. Public choice is a choice which encompasses common life and is shared by all.

2) The principle ofpolitical direction a d c m t d
Every society possesses what may be called politico-legal framework for conditioning all fohns of human gctivity, both public and private. This structure is found in basic laws of the land and in prevailing customs, conventions and traditions by which political ideals and ideas find their way. Financial administration, as a subsystem of public administration, should conform to these political ideas and ideals as expressed through the constitutional process of the society. Further, it should adjust itself to the political structure of a particular society to which it is attached. In modem times, democratic ideas and ideals have replaced all the previous structures and ideals. Therefore, the system of financial administration is to be organised and operated in a manner so as to secure compliance with the will of legislature as expressed through the Appropriation Act, the Finance Act and other policy devices, both public and fiscal. In order to ensure its control over financial administration of the executive government, the legislature takes an account of financial functions through an independent audit organisation.
3) The Principle of Correspondence

This principle implies that there should be a causal relationship between the objectives of financial administration and the functions, the human and material resources necessary to accomplish such objectives. In other words, the type of functions, the personnel required to handle them and the physical facilities necessary for the purpose should have a rational mutual interrelationship. The essence of this principle is that the objectives and the functions should provide the basis for staffing and equipping of the financial organisation.

Administration and Objectives

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4). The Principle of Unity of Organisation and Management

P.J.J. Pinto, an Indian authority on financial administration, gave prominence tothis principle. He links centralisation to efficiency. While elaborating he clarified that it should not be taken to mean centralisation of every minute detail at the top of hierarchy. According to him it does mean that the work of the different financial and non-financial agencies is coordinated and highly evaluated by the top officials of the government. This dictum does not mean centralised decision making and decentralised implementation. Experiences of developing countries have exposed the inadequacy of centralised decision making. Now, the need of the hour became centralised direction and decenGalised decision making and decision implementation. The concept of administrative financial control has given way to the concept of management of results. Under this changed context, this principle should be taken to mean centralised guidance for facilitating decentralised decision making with a view to securing optimum production as well as optimum utility. The concept of ,national planning is a good example.

5) The principle of stability and balance It is a known fact that the financial administration is characterised by technical expertise and hence cannot be handled by unskilled and non-trained personnel. This character poses serious problems when there is a loss of specific trained personnel. Therefore, this principle calls upon financial organisations to develop capacity to withstand losses of specific trained personnel without serious corisequences to effectiveness,and efficiency. For this purpose, there is need for effective-manpower planning together with a good programme for human resource development.
6) The principle'of simplicity and flexibility In a democratic era electorate functions as the fountain of all authority. All other democratic institutions, including parliament, derive their authority from electorate. Therefore, it is very essential that the financial system and its procedures should be simplified in such a mannepo as to become intelligible to the layman. According to P.J:J. Pinto, if this prin&ple is implemented properly, it can economise the costs. The principle of flexibility implies that the financial organisation should develop capacity to adjust itself. to fluctuations on work flows, human compositions and physical facilities.
7) The principle of conduct, discipline and regularity The principle of conduct implies that the officials of public financial organisations should act ethically and set high ethical standards and styles to the people. Income tax officials, for instance, could be very effective in preventing tax evasion by s e t t i ~ g ethical examples themselves.

The principle of discipline implies that the objectives, rules and regulations, the policies, procedures and programmes must be honoured by each participant of public financial organisation. No organisation can function effectively without f r financial im discipline. The practising administrators are prone to use imposed discipline which may not yield desirable outcomes. What is needed is voluntary or self-discipline. The principle of regularity implies that no public organisation, including financial organisation, can afford to function at intervals. We should bear it in mind that the administrative task is a continuous process.

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8) The principle of Public Trust and Accountability Financial administration collects and disburses public funds as a public trust. But, it is quite vulnerable and can lead to misuse of these funds for personal interest. Financial administration has therefore to be held publicly answerable for proper use ~f funds at several levels such as political, legal, administrative, organisational, professional, moral and aspirational. Here accountability implies answerability for me's responsibility and for trust reposed in an official.
Check Your Progress 2 Note : i) Use the space,given below for your answers. ii) Check your answers with those.given at the end of the unif.

1) What are the important principles of financial administration?

Objectives and Principles of Financial Administration

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2) What is the focus of the principle of correspondence?

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2.4 FINANCIAL ADMINISTRATION IN INDIA
Now we shall discuss the system of financial administration in India from historical perspective and its,emerging trends.

2.4.1 Historical Perspective
Financial administration, as a practice, is not new to India. In Ramayana, there is a reference regarding balanced budgeting. Financial administration reached an advanced stage o i development as early as 4th century B.C. Kautilya's Arthasastra was a treatise on-financial administration. It contained several sound principles of public finance and financial administration. Mauryan administration carried out its fiscal functions in conformity with these principles. Land revenue was a principal source of revenue and it was based on land yields. Taxes were also imposed on commodities such as gold, cattle, etc. Income from public works constituted a major source of non-tax revenue. Public borrowing and deficit financing were unknown. There was a well organised financial structure which included offices of the Collector General, the Treasurer General, the Accountant General, Fiscal decisions were influenced by royal whims and fancies and there was no sound system of financial accountability. Gupta's period had more or less a similar system of financial administration. Mughal period saw anelaborate and systematic financial system. Land revenue continued to stay as the main source of revenue. It was being levied after a systemic process known as survey and settlement. The basic structure of revenue administration was designed in India by Shershah. Raja Todarmal, a noble of Akbar's Durbar, systematised it and codified the principles of revenue administration in the form of a manual which was adapted by Britishers at a later date. They have created intermediate relationships on land matters. Jazya, Income Tax, capi~atiJon etc., constituted other direct taxes. tax Indirect taxes comprised custorfis, sales tax, octroi and excise duties. There was a network of government and non-government treasuries for collection, custody and disbursement of public funds. Though the aforesaid heritage has left their indelible foot prints on fiscal history of India, a beginning for the modern financial system was made during British rule. During this period, financial administration has passed through several distinct phases of development. One can broadly divide financial administrative history of India b t o following four distinct phases : Period I (1765-1858) .. creation of structure and concretisation thereof. Period I1 (1860-1919) , , .. ~ e v e l o ~ hof Systems and ~nt Procedures.

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Period 111 Period IV

(1919-1947) (1950-till date)

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Demdcratisation and Decentralisation Development orientation.

Financial Administration : Basics and Objectives

Period I : Creation of structure and concretisation thereof Acquisition of Diwani Rights in 1765 marked the commencement of financial administration of British India. All the powers were vested in the East India Company and these were exercised by it through the Board of Control. Revenues from India were treated as commercial earnings of the East India Company. The British government could only influence the Company administration through indirect methods as provided for in various Regulating Acts. The superintendence and control of public finances vested separately in each of the Presidency headed by a Governor. The Governor-General of India could not utilise these funds unless he got a specific permission from the Board of Control. However, he could use these funds during war period. In 1833, the British Parliament swung into action when there was a gross mismanagement of company administration. Under the Government of India Act 1833, the East India Company lost its authority to govern India on its own. It held the property as trust for the Crown. The Act vested the superintending and controlling authority in the Governor-General of India. The Governors lost their authority as they could not create any new office, or grant any salary or allowance or gratuity withhut sanction from the Governor-General. The Finance Secretary to the Government of India was charged with the responsibility of conducting and co-ordinating financial operations such as preparation of estimates, provisions of ways and means, negotiation of loans, and supervision of accounts. He was to review all proposals for new expenditure. The Accountant General of Bengal became Accountant General of India and he was entrusted with the responsibility to submit financial returns and accounts to the Finance Secretary. There was no authority to conduct audit as it remained with the provinces. With a view to strengthening the hands of the Finance Secretary through a combination of finance and acco;nts,he was i a d e Accountant ~ e n e r aof 1ndia in 1854. This i system could not last long. In 1857, under the reforms initiated by Lord Canning, the Finance Secretary was given exclusive charge of finance. The Accountant General of India who took over accounts function from the Finance Secretary was invested with the responsibility for audit. The process of consolidation of financial administration had begun in 1858. The Act of 1858 brought the formal authority of the East India Company to an end. The British Government assumed supervision and control over Indian financial system. The Act had provided for the Secretary of State for India, with the Council of India to assist him, as a Minister of State in the British cabinet, responsible for Indian financial and administrative affairs. No appropriations could be made from Indian finance without his prior approval. The Governor-General enjoyed delegated financial authority. The Secretary of State for India controlled Indian finances through several ways such as approval of budget, control of expenditure through a system of rules and regulations as expressed in codes and executive orders. He was assisted by a finance committee and the finance secretary who headed the Finance Department of the India office as an adviser. The Council of India, which was required to discharge a watch-dog role, failed to play its role as it had no means to control an 'absolutist' secretary of state. The parliamentary control over the Secretary of State for India was quite ineffective for various reasons such as lack of time, lack of interest, and developments in the national movement in India. The Secretary of State for India emerged as the 'de facto' authority. But he was not in a position to exercise effective control due to such limitations like ignorance of local conditions, absence of effective communication system, geographical factors (distance) etc. He had no option except to delegate significant financial authority to the Governor-General of India who emerged as actual master of financial activities of India. In India there was no authority to control him as the legislative council had no authority to examine financial matters. The era of excessive dependence of provinces on the centre which began from 1833 continued under the Government of India Act 1858. The Accountant General continued to exist in his inferior status as compared to the Governor-Geheral of India. The Finance Member was to preside over and direct the Finance Department. He performed a number of duties with regard to India's finances. He prepared annual financial statement, watched the progress of income and expenditure so as to ensure soundness of the financial system. supervised and administered monetarv svstem-and

supervised and controlled Provincial Finance Departments. The Finance Department under the leadership of the Finance Secretary, had to ensure that the restrictions imposed by the Secretary of State for IndiA were adhered to and that the rules and regulations were observed. It had dual power, namely pre-budget scrutiny and expenditure sanction.

Objectives and Rind*

o f FiluncW AdminLstnrion

Period II : Development of systems end procedures The Governor-general found it impossible to handle financial problems single-handedly. In 1859, in response to hjs request, the post of the Finance Member was created in the Executive Council to assist him. Wilson was the First Finance Member. Till then there was no system of budgeting as the law did not provide for it. Wilson presented the first budget to the legislative council on 18-2-1860, although the law did not require him to d o so. Though the council did not discuss his budget, his presentation created great interest in finance. It set a precedent by which whenever therp was a financial purpose the budget was presented in the council and discussed in greater detail. From 1861-62 annual budget system was established. The Councils Act of 1892 authorised the Governor-General of India-in-Council to frame rules authorising discussion of the budget in the legislative council with no right to alter the budget proposals. But the members were not free to move any resolutions. There was a constant agitation both inside and outside the house, to secure popular control over public purse. Congress in its annual sessions of 1895 and 1896, passed resolutions for fullfledged budget system. The Act of 1909 provided for an elaborate discussion of annual budget with a provision for passage of resolutibns on budget estimates. Though the Act of 1909 is a significant step towards budgetary development, it yielded limited benefits as these resolutipns were not binding on the government. The Act of 1919 introduced modem system of legislative approval of the budget. The legislature was empowered to assent or refuse its assent or reduce the amount referred to therein. But the system suffered from two limitations. ~ i r s t l <the government could overrule popular opinion. Secondly, the list of non-votable items accounted for more than half of the budget. The Act of 1935 made no remarkable change in this system.
In 1860, the Accountant General was designated as Auditor General of India and was responsible for discharge of several functions such as accounting, supervision of public department operations etc. The Act of 1919 gave statutory status to him. He was independent of the government so as to enable him to perform his watch-dog functions effectively.

Period 111 :Democratisation and deceptralisation Upto 1909 the Central Legislature was loaded with powerful bureaucracy. The Minto-Morley Reforms of 1909 contemplated limited induction of eledted elements in the Central Legislature. But under the Act of 1919, the non-officials formed the majority in the provincial councils and the Central Legislature was enlarged and made more popularly representative. This Act provided for maximum popular representation to provincial governments. It also envisaged dyarchy in the provincial governments in which the process of provincial autonomy was completed in 1937 when popular governments were formed under the Government of India Act of 1935. The dyarchy was introduced in the Centre under the Act of 1935 according to which about 20 per cent of the expenditure was brought under popularly elected members of the Viceroy's Executive Council. But special powers enjoyed by the Governorgeneral had frustrated popular participation.
There was no Central Government before 1833. The era of dependence of the provinces on the Centre began in 1833. The dependence was so much that no Governor could create a permanent post carrying salary of more than Rs. 101- per month. The same system continued under the Act of 1858. The basic premise was that the Empire must be treated as a whole, not a collection of separate States.' Though provincial authority was augmented through various contracts and settlements made in 1870,1877,1882,1897,1904 and 1911. this basic premise remained unaltered till 1919. The Act of 1919 was a landmark in fiscal federalism. It brought about a statutory distribution of powers and responsibilities between the Centre and the provinces. Provinces were not required to submit their budgets on transferred subjects. But, this Act envisaged significant powers for the Governor-General to supervise and control the Governors. For instance, he could send directions in the

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form of messages tovthe Govenfor: The basic features and structures of fullfledged federalism were introduced in 1935 which continues to exist even today.

Paiod IV :Development orientation
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Independence brought basic changes in the political context of financial administration. There was a formal acceptance of the principle of executive responsibility to the legislature. The budgetary and other systems and procedures were tuned to subserve this principle and its implementation. Legislative Committees began to take active iatere,st in the form, content, legality and regularity of public spending. The Comptroller and Auditor-General became a constitutional authority with a responsibility to aid legislative control. The financial administration gradually shifted its focus from stability to welfare, development and equity. Planning and Budgeting got united in the form of Performance Budgeting in 1974which gave result orientation to financial processes. The system of financial control has been basically restructured so as to make it an instrument of plan implementation. Consequently, significant powers were delegated to spending departments through various delegation schemes such as the khemes of 1%5. 1958. 1962. 1968 and 1975. The res$nsibility for financial control has been fixed firmly on spending departments. This was sought through two means. First one was the scheme of Integrated Financial Advice and the second was the separation of audit and accounts. In order to meet the growing financial needs of development expenditure, budget became an instrument of resource mobilisation. Consequently, several steps were taken to rationalise tax structure. Kaldor's tax proposals, Wanchoo Committee Report, Jha Committee Report stand out as instances of these steps. Deficit finance became a regular feature as the government had to cope with tremendous pressure of quickening the pace of development. Nationalisation of banking system was considered as an instrument to channel national funds towards development activities. Public sector assumed significant importance in advancing the goals of development and equity. There were certain undesirable consequences. Galloping inflation, sinking balance of payments position, increasing negative returns from public sector, shrinking public savings and resource base etc., have had a cumulative impact on financial administration in such a way that the government had to take steps to set right these tendencies. Some of these aspects would be discussed in tf next sub-section which deals with the emerging trends. To sum up, during period I the basic thrust h a d k e n on the formulation of financial organisation with the aim of creating centres of control and direction in the form of Secretary of State and Governor-General. Period I1 was characterised by efforts to \ evolve a sound budgetary system and its practice. Period I11 saw responses to freedom movement and as a result of which gradual induction of popular element was attempted. It also saw decentralisatioqof authority and creation of federal structures. .The last phase is characterised by orientation towards people and their well-being and development.

Check Your Fmgress 3 Note : i) Use the space givm below for your answers. ii) Check your answers with'those-given at the end of the unit. 1) "Financial Administration is not new .to India." Comment.

2) What are the principal phases of development in the financial administrative history of India?

Objectives and Principles of Financial Administration

3) Give an account of the development of financial systems and procedures in India.

4) Explain how financial administration took a new turn after 1950.

2.4.2 New Emerging Trends
1) Regulation and control of fiscal deficit

Development efforts in India are characterised by an order of investment much higher than the available domestic resources. The gap should have been met from favourable balance of payments and external remittances. But Indian policy framers met this gap by creation of credit on excessive dosage of money supply. Deficit financing was used as an alternative to resource mobilisation including taxation. Tbe annual average rate of deficit financing began,to rise year after year. It was far in excess of conceivable safety limit which is said to be set by the rate of growth of supplies of consumer goods, degree of monetisation of economy; and the extent of control over production and distribution. As an outcome of such indiscriminate deficit financing, a high rate of inflation has characterised the economy since the middle of sixties. It has also caused balance of payments problems. This situation culminated into an economic crisis in July, 1991. The government had to take a number of measures for overcoming this crisis. The main objective .was to control fiscal deficit and bring it down to 5 per cent of G.D.P.. (national income) by 1992-93. 2) Cutback on non-development expenditure A substantial portion of Indian resources are frittered away in non-development expenditure which is an unproductive channel. There has been a tremendous increase in non-development expenditure. A significant amount of this expenditure is associated with extravagance, inefficiency and infructuous public policies and activities. Massive outlay on defence and law and order have also contributed towards this trend. Public policy has focuse'd its attention on lowen'ng of expenditure. The bulk of the savings are sought from the cuis on subsidies, defence spending, resource transfers to public enterprises, current and capital spending. The government declared that during the remaining part of the financial year, there will be no net additions to expenditure through supplementary appropriations unless such proposals are supported by matching savings elsewhere. 3) Development of zero base perspective Budgetary decisions in India have been characterised by Incrementalist approach. Though no wholescale installation of zero base budgeting was attempted, expenditure policy that evolved during the last five years took into account the basic premises of this new budgetary concept. No area of government spending was sought to be exempted from scrutiny.

Financial Administration : Basics, and Objectives

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4) Application of contingency approach Contingency approach emphasises analysis and understanding of rill subsystems of public organisation alongwith the supra-system of environment so that public policie: and administrative actions can be adapted and adjusted to the demands of specific situations and contexts. It enables the public administrator to evolve a practical answer to a complex problem. The approach of the government to meet recent economic crisis has reflected the basic elements of this latest theofy. For instance, though the government has political authority and basic inclination towards deficit financing, it is forced to take decisions to the contrary. It was because of the circumstances of the situation. Similarly, the concepts of self-sufficiency and social equity are no longer the dominant considerations of the Government as is evident from the open door policy towards foreign participation with a special emphasis on Non-Resident Indians and a host of other public policy decisions which are being taken in pursuit of orientation of the economy to market mechanism.

5) De-emphasised public &tor In India the rationale for public enterprise'had been based on the premise that the state ownership was desirable for the achievement of national objectives. This value consideration resulted in large scale at-nationalisation. Recurring losses of a large number of public enterprises, need for resources for bringing down the fiscal deficit, global trends'towards privatisation of public enterprises have all changed the government's policy towards the public sector. New industrial policy of the government has brought an end to this thinking. We shall be discussing about.the features of new industrial policy of the government in Unit 3 of this block. For instance, the Eighth Plan's outlay on public sector is to the tune of 43.2 per cent as against 54 per cent on the Seventh Plan. The Government is against providing additional budgetary support to public sector. In fact, the trend is towards removal of the distinction between public sector and private sector and towards the emergence and of "national sector" in which publi~sector private sector merge with each other. The government's move to solicit equity participation of private sector in public sector'enterprises is a significant policy measure indicating the new approach.
goods and .16)Non-bureaucratic delivery of publicgovernmentservices in termsbf providing Following public choice theorists, the is thinking
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public goods and services competitively to avoid the pitfalls of public monopoly. The government, for instance, is seriously thinking in terms of involving private sector in power generation and distribution, electronic media and telecommunications, roads etc. 7) Focus on decentralised responsibility for financing development plans , Union Government has had the responsibility for plan formulation as well as plan financing The state governments could execute centrally sponsored schemes rather than the schemes supported by their budgetary provisions. This tendency on the part of the State led to a lack of concern for resource mobilisation. This syndrome is evident from increasing emphasis of the state governments on populist measures. As a back-up to economic reforms the Union Government has veered round to the concept of "indicative planning". This changed outlook pervades the formulation of the Eighth Five Year Plan. The Union Government, is now promoting cooperativ federalism and is therefore, seelcing an active role for the state government in resource mabilisation.

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8) Towards deregulation and liberalisation Union Government m an effort to provide full freedom to market mechanism so as to maximise productive potential of enterprising business people is moving towards a free market economy. Industrial policy has been suitably amended to accodpodate genuine requirements of private sector and foreign direct investment. We shall be discussing the important features of this irl Unit 3 of this block. Similar changes have been made in Trade Policy and Commercial policy.
There is a growing feeling that the inequalities of income and wealth may get accentuated and that the poor and weaker sections of society may be left to tend for themselves. This unfortunate trend can be largely redressed through increased expenditure on social services and rural development programmes. There is already evidence that the government is taking policy initiatives like strengthening of public

distribution system and other means to ensure that growth is not achieved at the cost of equity. To sum up, these new trends are intended to liberate market forces from bureaucratic control. These trends were found to be quite in conformity with the requirements of underdeveloped countries. In fact, some countries have registered astonishing breakthrough with similar policy packages. Therefore, the government did not face any major resistance against its approach. A major failure though expected, has been the inability of the government to contain price rise. The government is seeking a period of two to three years to show concrete outcomes. One has to wait and see if the new policies can pull the country out of economic stagnation and the price paid . , for such is also affordable.

Objectives and Principles of Financial AdminlsCration

Check Your progress 4 Note : i) Use the space given below for your answers. ii) Check your answers with those givkn at the end of the unit. 1) Outline the emerging trends in financial administration of 1ndia.
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2) What are the budgetary concepts which have found their way into Indian economic reforms package?

2.5 LET US SUM UP
In the early stages "least public expenditure" Gas the main objective of government. Gradually, the functional role of financial administration has undergone a change. It has come to be viewed in terms of mobilisation of resources and their productive deployment. Though financial administration is expected to subserve the broad objectives specified in public policies of a given time, there are certain fundamental objectives which are pursued by financial administrators as is evident from the experience of developed and underdeveloped countries. As we discussed in the unit, management of the finances of public household, facilitation of economic growth, ensuring full employment, price stability and equitable distribution of wealth are some of the important objectives of financial administration. Due to cultural specificity, it may not be possible to lay down universal principles of financial administration. However, based upon our experience in cross-national and cross-cultural contexts, we can infer certain principles to serve as broad guidelines. These include, primacy of public policy and political direction and control; unity of organisation and management; correspondence among objectives, functions and resources; stability; simplicity; balance and flexibility etc. Financial administration in India reached an advanced position as early as 4th century B.C. There is much in the fiscal history of India that one can feel proud of. A beginning has been made to establish modern system of financial administration during British period. The period between 1765 to 1858 saw several measures for creating a sound structure of financial administration. Wilson was the first to introduce financial budgeting which was refined later. By 1919, we have had well developed financial systems and procedures. Democratisation and development orientation became landmarks in the financial historv of the countrv. Owine to unfavourable balance nf navmenta and onllnnino

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inflation, the government had to take Wry radical steps in 1991. These include control of fiscal deficit, cut-back on bureaucfacic controls, hard options for resource mobilisation, de-emphasised public sactor and indicative planning. There is a possibility and hope that the move CiWards a market economy and integration with the global economy may usher in an e h of economic prosperity. Strong doubts, however, persist. The government's l d i l i t y to roll-back the prices is one such area of concern. One has, perhaps, to wait f& two to three years for favourable results to start issuing in.

2.6

KEY WORDS

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W ~ n e of Payments : It is a kind of i"..' e statement that records all transactions between individuals, firms and gover@&taf units of one nation and individuals, firms, governmental units o all o t h q , f ns. It gives a record of all transactions between the residents of country a*' % *ofthe world with payments expressed in & : terms of country's currency. < Dlwanl Rights :The East India Compartyl dcuting the right to collect taxes in Bengal, Bihar and Orissa in 1765. Dyarchy :It is the two level governmeqti~troduced the provincial level under the at Montague-Chelmsford Act of 1919. It &ded the whole administration between the 'reserved' subjects (controlled by couMlors) and 'transferred' subjects (controlled by the ministers). Factors of Production : The resouqes hjuired to produce a commodity i.e. land, labour and capital. Free Market Economy : An economy Which is not planned, controlled or regulated by the government. It is a competiriv&eebnomy. The factors of production are privately owned and production takes &ace at the initiative of the private enterprise. GovernmGeneralof India-ln-Council :*fhe system of governance in India by the East India Company was basically conducted by the Council alongwith the GovernorGeneral. Indicative Plrrlrning : It is planning byA&dication of desirable targets rather than by compulsion. 2 , , Integrated Financial Advice : This s&m was introduced in 1975-76 in Indian financial system wherein the ~inami~;&dviser functioning in respective administrative ministry, was made r t s p s i b l e both to the administrative ministry as well as Ministry of Finance. The idea &lad this was to enable the Financial Adviser to associate with the administrative m@@y in a large measure in developmental activities and also function under fbe *era1 guidance of the Ministry of Finance. Jlla Committee : The Indirect TaxaEnquiry Committee was constituted by the Government of India under the C h a h @ h l p of L.K. in 1974. It was set up w12h Jha the objectives of examining the role $>indirect taxation in promoting economic use of scarce resources, in mobilising , its impact on prices and costs and to suggest suitable reforms in the indkm%Fation system. Manpower W i n g : It is the p&$ r St o developing and determining objectives, policies and programmes that will &vebp, utilise and distribute personnel or human resources in an organisation so as to &hieve desired goals. Wanchoo Committee :The D i r e c t ~ M s Enquiry Committee set up by the Government of India in 1970 under f&&Pirmanship of Mr. Justice R.N. Wanchoo. The Committee was to recommend c &H M $e , effective measures for unearthing black money, checking avoidance of tax, s M e s t improvements in tax assessment and administration.
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.,* Adams, H.C., 1908. The Science o f k c e , Henry Holt and Company: New York Bhargava R.N., 1977. Indian Public $ q r r c e , . ~ . ~ .Bhargava & Sons: Chandausi. H.N. 1954. Financing ~ow&nr, Htnry Holt and Company: New York.

REFERENCES

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.t.;_.

rover.

Hicks, u.K., 1951. Public Finance, Nisbet & Co. Ltd: London. Icall, G.S., 1976. Public Finance and Financial Administration in India, H.P. Kapoor: New Delhi. Musgrave & Musgrave, 1989. ' Public Finance in Theory and Practice, McGraw Hill Book Company: New York. Pinto J.J., 1943. System of FinancialAdministration India, New Book Co. : Bombay. Sundharam, K.P.M., 1974. Indian Public Finance and Financial Administration, Fourth Edition, Sultan Chand & Sons: New Delhi. Thavaraj, M.J., 1978. Financial Administration of India, Sultan Chand & Sons : New Delhi.

Ob]ectlve~and Prlnclpla of Flnanclal Admlnl~tratlon

2.8

ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress 1 1) Your answer should include the following points : Stability Development Self-reliance Reduction of interpersonal inequalities in income and wealth Balanced regional development.

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2) Your answer should include the following points : Management of the finances of public household Implementation of projects and programmes Provision for public goods and social services Growth, employment and price stability Capital formation Productive deployment of national funds Facilitating smooth flow of parliamentary processes Achieving equity and equality.
Check Your Progress 2

1) Your answer should include the following points : Primacy of public interest, public choice and public poli& Political direction and control Correspondence Unity of organisation and management Stability and balance Simplicity and flexibility Conduct, discipline and regularity Public trust and accountability. 2) Your answer should include the following points: The principle of correspondence emphasises on causal relationship between the objectives of financial administration and the functions, the human and material resources necessary to accomplish such objectives The objectives and functions provide the basis for staffing and equipping of the organisation.
Check Your Progress 3
1) Your answer should include the following points : Reference regarding balanced budgeting in Ramayana Kautilya's Arthasastra was a treatise on financial administration During Mauryan administration fiscal functions were carried out in conformity with sound principles of public finance and financial administration Gupta's administration, Mughal administration have left their marks on fiscal history of India. 2) Your answer should include the following points : The financial administrative history of India can be divided into four distinctive phases

i

FlnaneU Administration :Basks and Objectives

First period (1765-1858) was Characterised by Creation of Structure and its Stabilisation. The Second period (1860-1919) saw the efforts to develop budgetary procedure. Third period (1919-1947) was one which focused its attention on democratisation of structure and decentralisation of procedures Final stage (1950-till date) witnessing development orientation. 3) Your answer should include the following points : Presentation of the first budget by Wilson, the first finance member, to the legislative council in 1860 .* Establishment of annual budget system from 1861-62 The Councils Act of 1892 provided for discussion of the budget Introduction of modern system of legislative approval of the budget by the Act of 1919. The Act gave statutory status to the Auditor General of India.

4) Your answer should include the following points : The f o ~ u of financial administration is on welfare and growth rather than s stability The system of financial administration has been restructured to subserve the needs of plan implementation Budget became an instrument for resource mobilisation Fiscal policy began to champion the cause of development, self-reliance and social equity.

CbeeLYourproIirese4 1) Your answer should include the following points : Regulation end control of fiscal deficit Cutback on non-development expenditure Development of zero-base. perspective Application of contingency approach De-emphasised public sector Non-bureaucratic delivery of public goods and services Decentralised responsibility for financing development plans Deregulation and liberalisation. 2) Your answer should include the,following points : Zero-base budgeting Contingency approach Indicative planning.

UNIT 3 MIXED ECONOMY
Structure
dbjectiv? Introduction Mixed Economy - Concept and Salient Features Evolution of Mixed Economy in India Private and Public Sectors in India Mixed Economy - Recent Trends and an Appraisal Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

3 0 OBJECTIVES .
After reading this unit you should be able to : explain the basic concepts of mixed economy, capitalism, socialism and the salient features of mixed economy trace the evolution of mixed economy in India by examining various Industrial Policy Resolutions e describe the respective roles of private sector and the public sector in the Indian economy; and discuss recent policy changes introduced in India and an appraisal 'of their significance.

31 .

INTRODUCTION

: India's development experience is inextricably linked with India's decision to opt for

/

a mixed economy in the beginning of her own planning process. There neither was nor is even now a consensus among social scientists whether the choice of the mixed ' economy concept was right for India. On the one hand, the heavy industry bias, insufficient resource allocation, noncompetitive nature of Indian economy in the global context, (high cost economy and'shackling of the growth impulses) are all traced to this decision to opt for mixed economy. It implied a significant degree of government intervention and control. On the other hand, the left-wing economists have viewed the adoption of mixed economy framework as being "little more than a deGce for legitimising the rule of the capital in direct collaboration with the State. They seem to regard it as axiomatic that a mixed economy represents nothing more than a compromise weighted heavily in favour of the vested interests." It has nevertheless to be conceded that market forces left to themselves cannof offer a solution to the problem of poverty, when millions of people live so close to subsistence and a large number below subsistence level. Also, given the way India's culture has evolved, a centrally planned economy with the State steering the social and economic change is an impossible model for the country. Pursuit of a mixed economy, therefore, has been the only feasible proposition.

What has been, however, suitable in the fifties is not necessarily suitable in the nineties. The politico-economic map of the world, particularly of the socialist bloc, has been redrawn and can hardly be recognised. Minimal State cannot be the answer in view of the heterogeneity of the coubtry and the vast magnitude of poverty. As we witness the poor performance of the public sector it a + p that the pervasive I and intrusive role of thestate has also lost-its relevance. Thus,'let us examine the'

Financlal Administration : Basics and Objectlver

MIXED ECONOMY FEATURES

- CONCEPT AND SALIENT

Mixed economy implies demarcation and harmonisation of the public and private sectors. In it, free functioning of the market mechanism is not permitted and the government intervenes or regulates the private sector in such a way that the two sectors become mutually re-inforcing. A mixed economy represents an achievable balance between individual initiative and social goals. Planning and market mechanisms are so adjusted that each is used for realising the objectives of the 'economy to which it is most suited. There is a commitment on the part of both the sectors to national objectives and priorities. Ownership of sectors is used by some to classify them. A system comprising cooperative organisations would be called a cooperative commonwealth. A system of joint sector organisations gives another type of mixed economy. A system in whict sector and private sectors are present is the mixed economy of the both publi~ conventional type. This mixed economy could be ad-hoc or a systematic type depending upon the extent of coverage by the public sector of core sector of the economy. The other consideration would be the extent to which the two sectors have been integrated and harmonised with the policy objectives of the economy as a whole. It would be an economy that shows concern for the welfare objectives of the weaker sections through a combination of public distribution system, poverty alleviation programmes as also the production priorities based 'on a market economy. It could also be an economy that emphasises the social objectives of equity, employment, self-reliance, etc. There would be a varying degree of the mix of planning and market economy in each type of mixed ewnomy. At times, it is held that every economy is a mixed economy and that the concept of mixed economy is neither precise nor worthwhile. It has, however, to be appreciated that the concepts of planned economy and market economy have definite ideological and operational profiles. The concept of mixed economy represents a middle position between these two extrpmes. This concept is flexible and has its own means and methods of approaching economic, political and social issues. To achieve clarity in the understanding of the concept of mixed economy, let us discuss the meaning and characteristics of Capitalism, Socialism.

Capltalism Capitalism has been defined as an economic system stressing individual initiative with a central role for a market economy, the profit motive and ownership of means of production,by private individuals and corporations. Under capitalism, all means of production such as farms, factories, mines, transport are owned and controlled by private individuals and firms. Those who own these means of production are free to use them as they like in order to earn private profit. The State or government takes least part in the economic activities of the people. The government looks after only such matters as defence, foreign affairs, currency and coinage and some important civil works such as the construction of roads and bridges because private individuals may not find it profitable to undertake such works. Adam Smith was of the opinion that interests of individuals and thpse of the society coincide. The government, therefore, has no role in economic activities. In fact, the State was inherently incapable of undertaking such activities. State undertaking would mean wastage of society's resources. Things should be allowed to take their own llrse and there was, therefore, no need for planning or a pre-detennined framework tor guiding the economic activities of the people.
Eeaentials of Capltalism 1) The Rlght of Rlvate Property : The various means of production are under the private ownership of individuals. The private individuals can hold, use or sell them as they like. Right of inheritance by the sons and daughters or other legal heirs is implicit in this right. 2) Freedom of Enterprlrc : There is no restriction on the right of the individual to enaaae in any business ar enterprise for which he hos the necessary means. 3) Rdlt Motlve :Prufit motive is at the heart of a capitalist?^ ssytem. It is profit, not &y altruistic feelings, which makes an entrepreneur invest in any economic activity.
+ .

4) Competition : Competition exists among producers, sellers, buyers, job seekers, employers, investors etc. This is achieved thmgh cost control, price cutting, advertisements etc.

Mlxed Economy

5) Consumers Sovereignty :In a free market ecbnomy, wishes and preferences of the consumers direct the economic activity. The msumer occupies a key role in the system. 6) Price S y a t p :It is the price mechanism w w h makes the capitalist economy fun-ction automatically without there being any central direction or controy on production, consumption or distribution decisbesrs. 7) Inquelltien of In :Unequal distributiopcrf property among individuals leads to unequal distribution of incomes. There is a wriee gulf between the incomes of the rich and the poor. Since there is no central planning authority'to make the fundamental economic decisions and thus to allocate productive resoviccs among various competing uses, the market economy uses the price mechanism,9vhichplays a vital role in the working of the economy. Any imbalances are solved an8,corrcctedautomatically through the price mechanism and demand-supply inter*. There are adequate rewards for greater efficiency and hard work through hi@W compensation. There is also incentive to save and invest and provide for w r incomes for the present and future generations. Market mechanism also enables entsprcneurs to take risks for higher profits, undertake innovations giving rise to technological progress. Capitalism is not a rigid but an envolving and dynamic concept. It has successfully fought off many crises and emerged stronger. Capitalism has an ugly face also -it divides t&wqiety into those who are vulgarly rich and indulge in ostentatious consumption, .-those who are the wretched of the earth and do not have even two square me&*^ day. The incentive system is also vitiated by the inequalities of income which ravated. Consumers' sovereignty is a myth. In fact large corporation controls et which it is supposed to serve and "even bend the consumers to its sts which capitalism imposes on the society are in the form of infl ent, and cyclical fluctuations. Prof. Galbraith sums up the ineffectiveness m i t a l i s m thus : "There ismuch that - as it cannot put a man into the market can usefully encourage and accaspace so it cannot bring quickly into existencqi&bl industry where there was little create an integrated industrial or no steel making capacity before. Nor can it-ly plant. Above all no one can be certain that it'* do so in countries where development has lagged and where there is only need for development but an urgent demand that it should occur promptly. 30trust to the market is to t.ake an unacceptable risk that nothing, or too little, w@ happen."

n 4
'I

in which the material means of "Socialism is an economic organisation of production are owned by the whole commuqjt$s:to a general economic plan, all of such aocialised planned members being entitled to benefit from the prodilction on the basis of equal rightsifPl *nst As this, democratic socialism is characterised by public ownership of at least 3)ra "strategically important material means of production" while, at the same ti* maintaining individual freedom of both consumption and occupatiorl. =.

1) It is based on social and economic plan*, collective ownership of facton of production, social welfare and cooperaiw 2) Sosiali8t economy requires a central a u to determine the p a l s of society and coordinate the community's efforts tO' mnin those goals. 3) Sodalist *nomyis a centrally planned &nomy, with the central authority planning thb allocation of resources so as @,attain the goals and objectives of the society.

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d

4) Equity or equitable distribution of incomcr is central to aocialism. 5) Social welfare rather than private profit 4@tracterises a socialist society's goals.

FirunrW A d d n i a t r a ~ n :

and obWvca

Oemocratic socialism, which is a milder form of socialism shares with capitalism existence of private sector, inequality of incomes, freedom of consumen and produckrs (subject to the demands of central'planning), and existence of price mechanism. Socialism ensures full employment, a high rate of growth, dignity of labour and absence of exploitation of labour, relatively equitable distribution of income and wealth & absence of wastages associated with capitalistic system of production. As against these merits, the system leads to loss of efficiency and enterprise, and incentives for hard work and initiative are missing. There is too much doctrinaire rigidity which pervades economic decision-making without regard to consequences. Power is concentrated in the hands of the State which takes all decisions regarding investment, production, distribution and consumption. This leads to bureaucratisation, redtape and a very cumbersome and expensive system of administration which cannot deliver the goods. Resource allocation is arbitrary as there is no rational or workable pricing system which normally guides alloca~ion .decisions. In the absence of competition, production is inefficient and costly, and . quite often there are shortages particularly of consumer goods. Salient Features of Mixed Economy :~ a v i described the two extremes of capitalism n~ anh socialism, it is now possible to define a mixed economy in functional terms. A mixed economy is characterised by : i) ii) a balance between the market economy and the planning mechanism; a clear demarcation of the boundaries of public sector.and private sector so that 'the core sector and strategic sectors are invariably in the publir sector; iii) while profit motive influences decision-making in the private sector, the economic viability criteria for investment decisions in the public sector is based on social cost-benefit analysis; iv) the ownership of means of production as between public sector, private sector, joint sector and cooperative sector is so decided that there is a balance between personal and social incentives and sectional and general interests; v) there is occupational fkedom and freedom of consumers' choice; vi) the government intervenes to prevent undueconcentration of economic power, and monopolistic and restrictive trade practices; vii) the government endeavours to take care of the consumption levels and objectives of the weaker sections of the society through public distribution system, poverty alleviation programmes etc.; viii) social objectives of equity, employment, balanced regional development, family welfare are emphasised; ix) the doctrinaire rigidities of socialism are avoided and a pragmatic approach to decision-making for promoting economic growth is usually adopted; and x) mixed economy is not merely an economic concept and the rights of the individual are respected and protected subject only to the requirements of public law and order and morality. It is incorrect to regard every country as a mixed economy just because some features of capitalism or socialism are present in that system. By this test, USA is a capitalist country and erstwhile USSR and China can be classified as socialist countries. The mere presence of some characteristicsof a mixed economy is not enough. These are not their dominant characteristics. Countries like Sweden, Norway, Austria, France, India, and Israel are mixed economies. A mixed economy must have the structural characteristics and also profess the social democratic ideology. Countries that put greater stress on decentralised socialist market tend to approximate to or are approaching a mixed economy in the allocative aspect. Capitalist countries that put more stress on an egalitarian distribution of property and incomes (Japan, South Korea, Taiwan and Singapore) are approaching the mixed economy ideal from the other end. Thus even though mixed economy is a mixed form of capitalism and socialism, it has an identity of its own. The evils of extreme economic systems of pure capitalism and pure socialism are avoided in a mixed economy. It presents a middle path.

3.3 EVOLUTION OF MIXED ECONOMY IN INDIA
As early as the First Five Year Plan, the Indian policy makers decided that the State must not only assume the responsibility of providing the infrastructure facilities and the social overheads, but shoula also undertake direct promotional work. It was recognised that the government should intervene in the industrial field and accordingly the development of basic and strategic industries was earmarked to the public sector. It was also recognised that the task of economic development of the country was so large that the initiative of both the private and public sectors had to be harnessed for optimal growth. The concept of mixed economy was evolved so that both the private and public sectors could contribute to the process of growth. It was considered that individual enterprise and initiative would be the best catalysts of change in the sphere of agriculture, organised industries, small scale industrial units, trade and construction. With the announcement of the Industrial Policy Resolution, 1956, the concept of mixed economy was given a definite shape and policy direction. Even before that, the Industrial Policy Resolution of 1948 had sought to establish mixed economy, with both private and public sectors, increasing controls in government hands for regulating all industries. The two main instruments of industrial policy were the Industries (Development and Regulation) Act of 1951 and the Companies Act of 1956. These two Acts conferred un the government, through licensing procedure, the power of regulating location, production and expansion of major industries in the country. Industrial Policy Resolution, 1956 The Avadi Resolution of the Indian National Congress declared the establishment of a socialistic pattern of society as the aim of economic and industrial policy of the government. The Resolution made it clear that "the State will necessarily play a vital part in starting and operating big projects through overall controls of resources, trends and essential balances in the economy ... with strategic controls over the private sector to prevent the evils'of anarchic industrial development." Consequently, the Parliament adopted on 30th April, 1956, a new Industrial Policy Resolution, the main features of which were as follows : The industries were classified into three categories : Schedule A : Those industries which were to be the sole responsibility of the State. This list included 17 industries - arms and ammunition, atomic energy, iron and steel, heavy machinery required for mining, heavy electrical industries, coal, mineral oils, mining, iron ore and other important minerals (like copper, lead and zinc, etc.), aircraft, air transport, railways, ship-building, telephone, telegraph and wireless equipment, and generation and distribution of electricity. Schedule B : There were about a dozen industries in the list, where the State might establish new units or existing units might be progressively nationalised. In these industries, the private sector was guaranteed plenty of opportunity to develop and expand. It included the following industries : Other mining industries, aluminium and other non-ferrous metals not included in Schedule A , machine tools, ferro alloys and steel tools, chemicals, antibiotics and other essential drugs, synthetic rubber, pulp, road and sea transport. Schedule C :Industries in this Schedule consisting of the rest of the industries, not included in Schedules A and B, would be in the private sector and would be subject to the social and economic policy of the government. The Industries (Development and Regulation) Act of 1951 and other relevant laws would apply to these industries. Among other things, the resolution emphasised that fair and non-discriminatory treatment would be given t~ private sector industries and their development, encouraged by developing transport facilities and by providing financial assistance. The regulation recognised that the private sector by itself could not bring about rapid industrialisation of the country. It, therefore, provided vital and expanding scope for public sector industries. At the same time, private sector was assured of an important place in the industrial structure of the country. The resolution a s acknowledged the lo important role of village, cottage and small scale industries.

-

Flnenclei Admlnlstretion : Beslcs end ObJectlves

The resolution accorded a prominent role to the public sector. The apprehensions of the private sector that the public sector would develop at their cost did not turn out to be correct and private sector found ample scope for its expansion.
Industrlpl Pollcy Reeolutlon, 1977 The new Industrial Policy of 1977 was very critical of the 1956 Resolution on tht ground that "Unemployment has increased, rural-urban disparities have widened and the rate of real investment has stagnated. The growth of industrial output has been no more than three to four per cent per annum on the average. The incidence of industrial sickness has become widespread and some of the major industries are worst affected. The pattern of industrial costs and prices has tended to be distorted and dispersal of industrial activity away from the urban concentration has been very slow". Other points of criticism were that international giant indust## concerns had penetrated the protected Indian market and monopolistic power of the large business houses had increased. The new policy focused on the development of small scale sector, cottage and household industries and the tiny sector. It further provided for using provisions of the Monopolies and Restrictive Trade Practices Act against expansion of larger industrial houses. The public sector was to be used for providing strategic goods of basic nature gnd also for maintaining supplies of essential goods. In areas where foreign collaboration was not required because of the availability of indigenous technical know-how, such collaboration agreementswere not be renewed.

Apart from giving greater importance to village and small scale sector and at the same time instilling a se'nse of fear among large industrial houses, the new policy did not lead to much achievements.
IadurtrW Pdley o 1 f m Outlining the Industrial Policy of 1980, it was stated, "The Industrial Policy , announcement of 1956 reflects the value system of our country anqhas shown conclusively the merit of constructive flexibility, In terms of this resolutibn, the task of raising the pillars of economic infrastructure in the country was entrusted to the public sector for reasons of its greater reliability; for the very large investments required and the longer gestation period of the projects for economic development, The 1956 Resolution, therefore, forms the basis of this statement? The policy accorded priority to optimum utilisation of installed capacity, balanced regional development, agro-baaed industrieg, export-oriented industries and promoting "economic federalism" by equitable spreading of investment over small but growing industrial units in urban as well as rural areas.

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Check Your Progrea~ 1

Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit. 1) What are the salient features of mixed economy?

2) What are the highlights of the Industrial Policy Resolution of 19561

3.4

PRIVATE AND PUBLIC SECTORS IN INDIA

Private Sector The concept of mixed economy adopted by India implied the rejection of the idea of immediate nationalisation of the private sector. It further implied a regulated private sector and the fast expanding public sector, especially in basic and heavy industries such as steel, engineering, fertiliser, power and transport. The piivate sector is dominant in agriculture and allied activities in retail and most of the wholesale trade, cottage, rural and small scale industries, most of consumer goods industries like textiles, jute, cement, sugar, radio receivers and numerous other consumer goods industries. A number of capital goods industries such as engineering, chemicals, electionics, etc., are also in the private sect'or. Most of the professional services are in the private sector. It can be said that private sector in India including agriculture and trade, contributes nearly 80 per cent to the national income whereas the public sector contributes the balance 20 per cent of the national income. Private sector in India can be divided into two parts : (a) the organised sector and (b) the unorganised sector. The organised sector is modernised, adopts capital intensive methods of production, and has easy access to the capital markets and banks. It uses modern means.of communications, and adopts all methods to manipulate demand to suit its needs. Profit motive is the basis of all the activities of this sector. The main method of planning for this sector is to so organise the economy that the producers get sufficient facilities and inputs, and find ir most profitable to so conduct their activities as to reach the plan production targets. P more risky, and ' long-term gestation projects and infrastructure are left to the public sector. In an open economy, the most intensive competition could come from abroad for goods produced by the organised sector. In its desire to industrialise rapidly, India wanted to develop many industries which could not stand competition from abroad. Exchange scarcity and the need to conserve foreign exchange led to import controls. Import substitution was encouraged irrespective of the comparative advantage. Industries needing imports for their production were permitted on condition that they indigenised rapidly and costs hardly entered into consideration. Since 1960, industrial units with investment of more than a certain sum had to apply for a licence for manufacturing a new article or for substantial expansion. According to Prof. D.T. Lakdawala : "There was sometimes overlicensing also, but at the stage when it was found that there was excess productlon, issue of new licences was stopped till demand overtook supplies. Import pre-requisites for production, import of technology, foreign capital and collaboration, were all sparingly permitted and allowed generally after a great time lag so that production in the organised sector became highly profitable. The profits were, however, often enough not fully reflected in the books of account. Price and distribution controls only generally served to drive production and profits underground and divert production to channels less amenable to controls. The whole economy began to seethe with corruption and black market, and bureaucracy and political machinery becatne a big rentier group." Unorganised private sector is spread over a vast area and it has been difficult to enforce policy interventions. Secondly, due to lack of awareness, education and training, and the absence of catalytic agencies, this sector has not been able to take full advantage of the facilities extended to them. Thirdly, organised sector often competes and also complements the unorga~isedsector. Managing these interrelationships has been difficult. For example, incentives intended for handloom sector have often been siphoned off by the powerloom sector. The unorganised sector often is a poor-technology, poor-remuneration sector and is often exploited in trading, credit, etc. Radical policy changes are, therefore, called for to make this sector viable.
Publlc Sector Prior to Independence, there was practically no such thing as the public sector in India. Railways, posts and telegraphs, ordnance factories and a few assorted factories constituted the public sector. Only after the Industrial Policy Resolutions of 1948 and 1956, the government made concerted efforts to make the public sector the dominant sector in the Indian economy. It was supposed to have control over "the commanding heights" of the economy. Among the important objectives assigned to the public sector are :

Administration md Objectives

: Basics

1) to help in the rapid economic growth and industrialisation of the economy and create the necessary infrastructure for economic development

2) to earn return on investment and thus generate resources for development
3) 4) 5) 6) 7)
to promote redistribution of income and wealth to create employment opportunities to promote balanced regional development to assist the development of small-scale and ancillary industries; and to promote import substitution, save and earn foreign exchange for the economy.,

The following table gives us an idea of the growth of public sector enterprises in India :

Total Investment (Rs. in crores)
1
2

No. of enterprises
3

Aeoa 1.4.1951

29 948

5 47

Aeon 1.4.61

These are the Central Government public sector enterprises. In addition, there are a large number of various State Government public enterprises like irrigation projects, State Electricity Boards, State Road Transport Corporations, State Financial Corporations etc. These enterprises also exclude departmental undertakings like railways. The enterprises also included in the table above, large as they are account for only about half of the gross capital formation of all public enterprises. Major contributiorl of the public sector has been through the development of new sophisticated industries, and giving a more mass welfare bias to the existing services. New skills were created and professional management in industry which was hitherto maidy confined to multi-nationals, became widespread. Ever ~ i n c e third plan, the the public sector investment largely accounts for somewhat more than half the total plan investment. Apart from the normal government activities and departmental undertakings, basic and heavy industries like steel, heavy electrical and nonelectrical machinery, machine tools, etc., were developed in the public sector. These were industries which would take a long time to fructify and were risky. It was felt that, by and large, private industry would not be attracted to them or would only be prepared to come on terms which would not be acceptable to the nation. Existing units in the private sector were left untouched with the exception of banking, insurance, oil, coal and power. Many of the sick units providing employment on a large scale were also nationalised. Financial performance of public sector enterprises has been quite disappointing. Excluding the oil sector, which is highly profitable, the other public sector enterprises have been incurring net losses or making only a marginal profit. Even if the oil industry is included, the overall ratio of net profits after tax as a percentage of net worth are just about 4.5 per cent in 1990-91 as against 5.4 per cent in 1989-90. The sectors which have been heavily losing include fertilisers, heavy engineering, consumer goods, urban transportation, coal, textiles, and contract and construction Some of the factors which are responsible for the poor performance of the public sector are as follows : i) Administered pricing policy of the government in respect of urban transportation, coal, fertiliser industries, etc. is fully responsible for non-recovery even of costs of production. The concerned public enterprises can hardly be called inefficient, even though they are unprofitable.

ii) The nature of a large number of enterprises is such that they have long gestation
periods and quite often there are heavy cost overruns because of the gestation beriods and intervening inflation.

iii) Excessive manpower recruitment due to political decisions. iv) Under utilisation of capacity. v) Excessive government controls in the matter of investment decisions, fixation of selling prices, wages and income policies, location decisions and personnel policy. The failures of the public sector are largely rooted in the political and bureaucratic controls clamped on the enterprises. Unless genuine autonomy is given to the professional management of the public sector in all matters which are properly speaking business decisions, there is hardly any future for the public sector.

Mixed Econom:

3.5

MIXED ECONOMY - RECENT TRENDS AND AN APPRAISAL

The decade of the 1980s witnessed a rapid expansion of the industrial activity in India which can be attributed mainly to the reforms undertaken in both industrial and trade policies. Further policy changes became necessary for accelerating the industrial growth in the 1990s in order to consolidate the achievements of the last decade. The new policy initiatives were announced by the government in the Statement on Industrial Policy on 24th July, 1991. The policy deregulates the economy in a substantial manner. The major objectives of the new policy package will be : to build on the gains already made correct the distortions or weaknesses that might have crept in maintain sustained growth in productivity and gainful employment further encourage growth of entrepreneurship and upgrade technology in order to attain international competitiveness. All sectors of industries whether small, medium or large, belonging to the public, private or cooperative sector are to be encouraged to grow and improve on their past performance. The provisions of the new policy are : i) Industrial licensing was abolished for all projects except in 18 industries where strategic or environmental concerns are paramount or where industries produce goods with exceptionally high import content. With this, 80 per cent of industry has been taken out of the licensing framework.

ii) The MRTP Act was amended to eliminate the need for prior approval by large
companies for capacity expansion or diversification. This will enable Indian firms to become large enough to compete effectively in the global markets. iii) The tequirement of phased manufacturing programmes was discontinued for all new projects. iv). Areas reserved for the public sector were narrowed down, and greater participation by private sector was permitted in core and basic industries. In place of the seventeen areas earlier reserved for investment by the public sector, only eight .such areas are now reserved. These eight are mainly those involving strategic and security concerns.
v) Government clearance for the location of projects was dispensed with except in the case of 23 cities with a population of more than one million.

vi) A National Renewal Fund has been set up to ensure that the costs of technological change and modernisation industry would not be borne by the workers. It will be used to provide a safety net to workers in sick an dnon-viable enterprises, and to finance their retraining and redeployment. Along with a reform of industrial policies, steps were taken to facilitate the inflow of direct foreign investment. These non-debt-creating inflows will reduce reliance on fixed interest-debt and also bring in new technology, marketing expertise and modem managerial practices. The following measures were taken in this regard : i) The limit of foreign equity holdings was raised from 40 to 51 per cent in a wide range of priority industries.

ii) The Foreign Investment Promotion Board has been set up to negotiate with large international firms to expedite the clearance required for projects in non-priority industries.

L

Flnanclal Adrnlnlstratlon: and ObJectlves

iii) Technology imports for priority industries are automatically approved for royalty payments upto certain limits. iv) In order to make the economy competitive with the rest of the world, rupee was made partially convertible. This will boost our exports and also promote efficient import substitution. v) The practice of government control over capital issues, as well as over pricing of issues including fixation of premium, has been done away with. vi) Import duties were substantially reduced and rationalised in order to ensure that the high tariff walls do not perpetuate a high cost non-competitive Indian industry. Thus deregulation will reduce the role of government regulatory agencies. Delays in project implementation will be greatly reduced. Increased competition will lead to enhanced pressure on enterprises to reduce their costs and to improve quality. The public sector was originally conceived as holding the commanding heights of the economy and leading to technological advance. The public sector has contributed significantly to the diversification of India's industrial structure. But its contAbution in terms of generating internal resources for further expansion has fallen far short of expectations and its inability to do so has now become a major constraint on economic growth. It is imperative that the public sector attains the objectives originally set for it. This will require a sustained improvement in productivity and profitability. The budget support to public sector enterprises will need to be scaled down and they will be expected to maintain financial discipline in their operations. In 1991-92, the Government undertook a limited disinvestment of a part of public sector equity to the public through the public financial institutions and mutual funds in order to raise non-inflationary finance for development. This process of disinvestment in the public sector enterprises is being continued in 1992-93. .It is expected that disinvestment will also bring in greater public'accountability and help to create a new culture in their working which would improve their efficiency. Recognising that sickness is a serious problem in many public sector units, the Government amended the Sick Industrial Companies Act to bring public sector undertakings also within its purview. This makes the sick public sector units subject to the same discipline as private sector units including reference to the Board of Industrial and Financial Reconstruction (BIFR) for identification of a viable restructuring package or closure as the case may be. Indian experience has shown that the pursuit of a mixed economy framework in a developing economy is a feasible proposition. It can lead to a modest rate of growth and also substantial growth of productive capacify in key sectors of the economy. Values of a social democracy have been assiduously nurtured and significant results have been achieved in reducing inequalities through various poverty alleviation programmes. Recent changes in the direction of economic policy have, however, led many'to doubt whether the Nehruvian model of mixed economy and all that went with it, is still in place. If mixed economy is viewed as a path which avoids the rigours of both capitalism and socialism, then mixed economy has served the country well and may continue to do so in future. In spite of lib=ralisiifion o r deregulation, we have not moved to a stateof market economy. All that has happgned js that we have started questioning and even demolishing the complex regulatory frameworks administered by an overloaded bureaucracy which failed to orient itself to the task of development administration. Controls and regulatory mechanisms never formed part of the core of development strategy, being themselves largely an inheritance of the war economy which the British Government had clamped on the country only to maximise procurement for military consumption. Removal of these controls will only make the economy more vibrant and dynamic without losing sight of the socio-economic perspectives it has set for itself.
Cbeck Your Proryess 2

Note : i) u s e the space given below for your answers. ii) Check your answers with those given at the end of the unit. 1) What are the objectives of the public sector in India?

Mixed Economy

2) Briefly describe the factor6 responsible for the poor performance of the public
sector.

......................................................................................................... ........................................................................................................... .........................................................................................................
3) Enumerate the key provisions of the New Industrial Policy of 1991.

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4) What other steps have been taken to deregulate the economy?

LET US SUM UP
h e d economy implies demarcation and harmonisation of she public and private sectors. In it free functioning of the market mechanism is not permitted and the government intervenes or regulates the private sector in such a way that the two sectors become mutually reinforcing. There is a commitment on the part of both the sectors to national objectives and priorities. It is a middle path between the two extreme systems of capitalism and socialism. Capitalism has been defined as an economic system stressing individual initiative for a market ewnomy, the profit motive and ownership of means of production by private individuals and corporations. On the other hand, socialism is an economic organisation of society in which the material means of production are owned by the whole community to a general plan, all members being entitled to benefit from the results of such socialised planned production on the basis of equal rights. In India, the concept of mixed ewnomy was evolved so that both the private and public sectors could contribute to the process of economic growth. The Industrial Policy Resolution of 1956 gave a definite shape to it by clearly demarcating the areas in which each sector would operate. The two instruments of policy were the Industries (Development & Regulation) Act of.1951 and the Companies Act of 1956. These two Acts conferred on the government through licensing procedure, the power of regulating location, production and expansion of major industries in India. The Industrial Policy Resolutions of 1977 and 1980 further refined the operational framework of mixed ewnomy in India. Private sector in India contributes nearly 80 per cent of the national income whereas the public sector contributes the balance 20 per cent. The organised private sector is modernised, capital-intensive and has access to modem financial services. Over the years, however, the private sector, has become a high cost sector, and hence non-comwtitive with the international sector,

F l n a c u Ad-tration

: Basics

and Objectives

The public sector was supposed to have control over the commanding heights of the economy. Its objectives included helping the country in the rapid economic growth and industrialisation, generating resources for further investment, creating employment opportunities and promoting social welfare through more equitable income distribution, etc. It has grown from 5 enterprises in 1950-51to 236 in 1990-91 and its investment has gone up from Rs. 5 crore in 1950-51to over Rs. l(IOOOO crore in 1990-91. The performance of the public sector has, however, been quiie disappointing. Among the many factor's responsible for this are political interference, administered price policy, excessive manpower and under-utilisation of capacity. The new Industrial Policy was announced on 24th July, 1991 which sought to delicense and deregulate the economy in many ways. Areas reserved for the pubfic sector have been narrowed down. Several other measures relating to liberalising trade and foreign investment have also been taken. With the dismantling of artificial controls, it is expected that the economy will become internationally competitive, and economically efficient. The social dimensions of the mixed economy continue to be given a pride of place in the emerging scenario.

3.7 KEY WORDS
Capitalism :Capitalism has been defined as an economic system stressing individual initiative, with a centralrole for a market economy, the profit motive and ownership of means of production by private individuals and corporations. Disinvestment of Public Sector Equity :It was government's policy announced in 1991 wherein in order to raise resources, encourge wider public participation and promote greater accountability, a part of the government's shareholding in selected public sector undertakings would be offered to mutual funds and investment institutions in the public sector, as also to workers.

Equity : It is a fonnof financing the organisation under which capital stock is held in the form of shares.

Foreign Investment Promotion Board (FIPB) : It was set up in 1991 entrusted with
the functions of expeditious clearance of foreign investment proposals, establishment of contact with and inviting selected international companies to invest in India in appropriate ventures and periodically review the implementation of projects cleared bv the Board. ~ndustries(~evelo~ment& Regulation) Act 1951 :The main objective of the Act is the development and regulation of Indian industries in a manner benefiting the policy of planning, socialistic society and other social, economic considerations. Market Economy : An economic system in which the question of what to produce, how much to produce and for whom are decided in an open market through the free operation of demand and supplv. Monopolies Restrictive and Trade Practices (MRTP) Act : The MRTP Act was adopted by the government in 1969 with the objective of ensuring that the operation of economic system does not result in the concentration of economic power to the common detriment for the control of monoplies, for the prohibition of monopolistic and restrictive trade practices and matters connected with it. It aims at controlling the concentration of economic power or prohibiting monopolistic or restrictive trade practices only when they are prejudicial to public interest. Socialism :Socialism is an economic organisation of society in which,the material means of production are owned by the whole community to a general economic plan, all members being entitled to benefit from the results of such socialised planned production on the basis of equal rights.

3.8 REFERENCES
Wiles, P. J.D. 1975. Economic Institutions Compared, Basil Black Well : Oxford. Namjoshi, M.V. 1984. The Mixed Economy, Himalaya: Bombay. Jha, L.K. 1980. Economic Strategies for the 1980s, Allied : New Delhi. 1QCiR. Asian Drama. Pennuin : London.

3.9 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1
1) Your answer should include the following points : Balance between the yarket economy and the planning mechanism A clear demarcation d boundaries of the public sector and the private sector Objectives of equity, social welfare, employment etc. The government intervenes and regulates the private sector to secure adherence to national objectives and priorities

Mixed Economy

2) Your. answer should include the following points :
The establishment of a socialistic pattern of Society, giving importance to the expansion of public sector Classification. of industries into three categories : Schedule A : 17 industries reserved for the public sector Schedule B : About a dozen industries where the State could establish new units or nationalise the existing ones Schedule C : Rest of the industries to be in the private sector. Private sector assured of an important role in the industrial structure of the country.
Check Your Progress 2

1) Your answer should include the following points :
Objectives of the public sector include, helping the country in the rapid economic development and industrialisation generating resources for further development promoting balanced regional development creating employment opportunities, and promoting social welfare and self-reliance. Your answer should include the following points : Among the factors responsible for the poor performance of theSpublicsector are : Unrealistic pricing .policy Political interference in business decision-making. Excessive manpower Under utilisation of capacities i Government controls in wage & income policies, personnel policies, investment decisions etc.
3) Your answer should include the following points : Abolition of industrial licensing Dilution of the MRTP Act o n l y eight areas reserved for public sector as against seventeen areas reserved earlier Establishment of a National Renewal Fund.

4) Your answer should include the following points : The limit of foreign equity holdings raised in priority industries Expeditious clearance of foreign investment proposals in non-priority industries Partial convertibility of rupee Government control over capital issues withdrawn.

UNIT 4 CENTRE-STATE FINANCIAL RELATIONS - I
Structure
4.0' 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9

Objectives Introduction Federalism - Meaning Basic. Features of Federalism Principles of Fiscal Federalism Evolution of Fiscal Federalism in India Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

'*

After going through this unit, you should be able to : explain the meaning of the concept of federation discuss the basic features relating to federations describe the important principles of fiscal federalism; and trace the history of the growth of. fiscal federalism in India.

.

4.1 INTRODUCTION
?he classic concept of federalism which envisaged two parallel governments of coordinate jurisdiction, operating in water-tight compartments is nowhere a functional reality now. Federalism is not a static paradigm. Federalism has come to be understood as a dynamic process of cooperation and shared action between two or more levels of government, with increasing interdependence. "The framers of the Indian Constitution took due note of these changing concepts and functional realities. Avoiding a dogmatic approach, they fashioned a suigeneries system of two-tier polity in which the predominant strength of the ~ h i o ' n blended with the essence of is cooperative federalisni. Several features and provisions of the Constitution appear to have been'deliberately designed to institutionalise the concept of cooperation." The pri;nary lesson of India's history is that, in this vast country, only that polity or system can endure and protect its unity, integrity and sovereignty against external aggression and internal disruption, which ensures a strong centre with paramount powers, accommodating at the same time, its traditional diversities. Another feature of India's Constitutional history that stands out like a sore thumb is the reality that "too centralised an administration is incompatible with the size and diversity of the country. It breeds administrative inefficiency and local disconten The Centre-State ' financial rdlations need to be reviewed in this framework.

?

In India, the state of financial relations between the centre and the state goverments has become a matter of serious wntroversy. The states have often voiced their concern at their increasing financial dependence on the centre. The centre, on the other hand, finds fault with the states for their lack of a sense of responsibility and indifference to the basic tenets of financial discipline and resource mobilisation. Thus the centre-state financial relations have often been marked by tensions and acrimony. It is, therefore, of the utmost importance that the nature of this controversy be analysed objectively, in the light of the basic features and principles of fiscal federalism, evolution of centre-state relations and, the related provisions of the Constitution. We shall be concentrating on these issues in this unit.

i

.

4.2 FEDERALISM - MEANING
All political systems have peaple with differing and often conflicting demands and different abilities to achieve them. Various groups of people in such systems have, however, common and shared concerns. On the one hand, these groups of people have separate identities and would like to retain their internal autonomy; on the other hand, their deeper socio-economic and cultural interests get articulated through the participative political processes and institutions. The function of government is to mediate between different interest groups within a legal and organisational framework which binds them together. The distinctive feature of such a political system is that public policy decision-making and its implementation are divided between a multi-tier system consisting of two governments, i.e., a central government and a set of unit governments. The central government is known as the federal government and the unit governments are known as the state governments. The political system which is characterised by multi-level governments is known as a federation. Sir Robert Garron defined a federation as : "a form of government in which sovereignty or political power is divided between the central and local government so that each of them within its own sphere is independent of each other." Similarly according to K.C. Wheare, "By federal principle, I mean the method of dividing powers w that the general and regional governments are each within its , sphere coordinate and independent." Thus the powers of the government are divided substantially according to the principle that there is a single independent authority for the whole country (federal government) in respect of some matters and that there are independent regional authorities for other matters (state governments). The view emphasising independence of the two levels of governments is not generally accepted. It is pointed out that "the tremendous grdwth of concurrent powers" in a federal form of government during the present century and the overlapping of government functions is so great that to suggest that the two levels of government are in fact restricted to separate spheres is quite unrealistic. The growing phenomena of concurrent powers has led to a shift of emphasis from the outdated doctrine of dual federalism to that of cooperative federalism.

Centre-State Financial Relations-I

4.3 BASIC FEATURES OF FEDERALISM
Independence and Coordination Conventional definitions of a federation usually lay emphasis on the fact that between the two levels of government, there is a division of powers such that the central government is given specified functions and the states enjoy the residual (non-specified) powers. The outstanding example of such a federation is USA. As already noted, growth of concurrent and overlapping functions as between the two levels of government has led to the emergence of coordinative pr cooperative federalism. The very wide use of grants-in-aid and other discretionary transfers had led to the shift away from independence. Some writers have gone to the other extreme of suggesting that federalism has been reduced to a myth. In actual practice, centripetal tendencies tend to be the dominant feature and the power of the federal purse ultimately leads to the establishment of the authority of the federal government. The central government is seen to be representing the nation and as being directly responsible to the national electorate. On the other hand, the nation is the aggregate of the units which comprise it. The electorate, the members of the central parliament, the bureaucracy and politicians will tend to project demands and attitudes which originate and relate to the units. In such a situation, the central government will serve as the receptacle for the interaction of the interests of the units. In this process, there is bound to be a conflict of interests, in some cases at least, betwcen the central government and the unit governments, or between$he-different unit governments. The central government has, therefore, to play a mediatory role as between the units. Institutional mechanisms have to be created to resolve such cbnflicts particularly between the central government and the state governments.
The fundamental process of the formation of a federation is guided by the dual consideration of self-interests of the units as also mutuality and commonality of larger objectives which, bind the federating units together. Thus the two way process bf guarding self-interest and yet reaching out beyond it for the realisation of common

Financial Administration : Basics and Objectives

aspirations which may be rooted in culture, religion. race, language, internal or external security o i a shared history is continudly at work. This makes for cooperation, mutual accommodation and compromise. This is the essence of a functioning federation which is characterised not so much by independence as by coordination. A federal state should combine genuine independence of action with genuine interdependence. A federal Constitution should guarantee to "each of the two levels of government an independence of each other sufficient to enable them to engage the continuing support of significant elements of the political system". Further, there should be a constitutional and political system which links the two levels with a significant degree of interdependenix such that neither level can subordinate the other to it, nor act wholly independent of the other across the whole range of government functions. This is indeed a daunting task, but has nevertheless to be attempted. This is the only way for imparting necessary strength as well as flexibility to an ideal federation.
Rationale for coming together There is an inherent urge among the federating units to come together in a federation so that the political and material interests of the units can be better safeguarded through the nation that is brought intq existence. This process usually takes place through two opposite processes.

i)

Federation by disaggregation, that is, by a process of decentralisation - a previously existing state of a unitary character breaks up to form a federal state :

ii) Federation by aggregation, that is, by a process of centralisation -a number of previously independent units agree to come together to form a federal state in which they continue to maintain their individualities. In most cases, federations have been brought about through the aggregation principle, i.e., by a kind of compact between the units existing as independent states before the formation of the federation e.g. USA. Examples of the other type, viz., through the operation of disaggregation principle, are India, Brazil, Nigeria. In the case of federations by aggregation, the initial impulse for coming together determined the distribution of powers and functions between the federal and constituent units. If the urge to unite was strong, the powers vested in the central government have relatively been quite extensive, thus making the central government very powerful. The needs and the rationale for federating have, therefore, always dictated what the character of a federation will be. In India, the central government is very strong vis-a-vis the states whereas the Nigerian federation is developing into a rather loose kind of federation. The powers of unit governments vis-a-vis the federal government have varied from federation to federation. There is a continual shift in the relative powers of the centre and the units. This shift is not peculiar to federations. The unitary forms of governments had also to contend with the dilution of their powers because of changes in political and economic fields. Whether a nation would like to adopt a federal or a unitary government would depend on various factors. The rationale for decentralisation of powers and functions is very great in large countries, particularly if such countries have sizeable groups of population with different languages, cultures, religions etc. Small countries can manage well enough with a unitary form of government. Socially, culturally and' politically small countries are usually very compact systems. Even in unitary states, quite a few functions are delegated to local bodies which are best suited to collectinglocal taxes assigned to them by the central government. This delegation is, however, quite limited. Decentralisation of powers, functions and responsibilities has been necessitated by the increasing complexity of modern life, the need to associate local people in solving their problems and providing local services. Decentralisation provides the conceptual as well as the operational underpinning of federations.
Econo~nic Determinants

Decentralisation of powers and resources through federalism is regarded as a better solution to achieve economic take-off, optimal resource use, removal of regional economic disparities and strengthening of bargaining power in the global market. In developing countries, it is possible to enhance allocation of resources on health, education, poverty alleviation and social services. The objectives of equity and balanced regional development may, however, not be served at least in the short run. Theoretically, with the breaking down of barriers to trade and free movement of

labour and capital being allowed, the factors of production will move to regions where returns are the highest. In the USA, however, the territorial expansion of the federation intensified the clash of economic interests between the Northern and the Southern States. The South feared a situation of permanent economic inferionty to the North and hence the attempt to secede from the federation. The formation of the federation in the first place was prompted by the desire to protect their farming, trading and the need for integrated market serving the primary interests of the rising industrial and commercial classes. The Commonwealth of Australia was a later creation through a similar process of aggregation and integration promoted by more or less similar considerations. The dominance of maritime provinces has also accounted for a strong centre in Canada. In the case of India, the extreme centralisation which characterised Indian administration under the British rule was designed to subserve the British economic interests. But centralising features were gradually modified in response to the nationalist struggle.

Centre-State Financial Relations-1

Check Your Progress 1
Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit. 1) What d o you understand by the term federation? How are federations formed?

2) In a federation, what is emphasised more -the independence of the constituent units or their cooperative and coordinative role which may compromise their independence to an extent?

3) Cite some examples where formation of federations was prompted by economic interests of the constituent units.

4.4 PRINCIPLES OF FISCAL FEDERALISM
Independence and Responsibility The'central facet of federations is t k division of powers and functions between the federal government and the state governments. The division of financial resources and obligations as between the two levels of governments should correspond to the division of powers and functions. Earnest efforts have to be made to ensure that each level of government is financially self-sufficient and independent of each other to the maximum extent possible. Political autonomy will be meaningless unless it is supported by financial autonomy. No doubt, concerns which are of national character, or which transcend the interests of one unit, should be entmsted to the

:

and Objectives

central government. Functions of a purely local character, confined to a unit in each instance, should generally be left to the Central Government. Normally, there should be o occasion for the central government to encroach upon jurisdiction of the unit go ernments and vice-versa. In times of national emergencies, however, the c nstituent units shed some of their political and financial jurisdiction in favour of the central government for achieving national objectives. Federal Constitutions usually contain specific provisions to cope with such contingencies.

d."

Adequacy and Elasticity Financial independence also implies that central and unit governments should have adequate financial powers to perform their exclusive functions. The correspondence between revenues and functions should be understood in a dynamic sense. The sources of revenue should be -elastic enough to. keep pace with the growth of responsibilities in the specified spheres of activity. In order to implement a process of national development, the central governments were made financially strong both in terms of powers and resources. Customs revenue is, therefore, left in all federations to the central government. Same is the case with direct taxation. The sources of revenue for each level of government should be such that the revenues generated should not remain static but should be quite elastic. The revenues should increase as the needs of the governments grow. None of the governments would want to be burdened with static sources which will soon fall behind the demand that a government will have to face and meet. ~fficiency The system of distribution of functions should conform to the requirements of efficiency and economy. "No matter how well intentioned a scheme may be or how completely it may harrnonise with the abstract principles of justice, if the tax does not work administratively, it is doomed to failure". Two factors determine the effectiveness of different taxes, namely, nature of the tax and the character of administration. A land tax for instance, may be expected to be administered best by local authorities because "it is, after all, the local assessors who may be presumed to possess the most exact knowledge of the local conditions upon which the value of the land depends". One of the reasons for the formation of a federation is that a government atathefederal level will be efficient for the nation as a whole: The division of sources is, therefore, based on the principle of relative interest and efficiency. Taxes which have an inter-state base, like customs, income and wealth tax are assigned to the federal government and those which have a local base, like sales tax and entertainment tax, are assigned t o the states. Costs of collection of taxes, the feasibility of levying taxes at the nationwide level rather than at the local level are important consideratiohs in the allocation of powers and functions. Equity Fiscal federation is viewed within the framework of welfare economics. Equitable distribution of wealth and income of the community are the proper concerns of a welfare state. Experts argue that the entire system of federal and state taxation and expenditure should be so framed as to impose equal burdens and confer equal benefits upon similarly placed persons irrespective of their residence. From the point of view of the nation, there is a distinct advantage in taxing the richer states more and spending that revenue in poorer states since the sacrifice in extra taxation in richer states is less than the benefit that will be derived if that money were spent in poorer states. The ideal is to maximise national benefit from the state and federal expenditure. This would necessitate a reduction of welfare generating expenditure in richer states and an increase in such expenditure in poorer states. Federal fiscal operations have an equalising role in respect of tax bukdens and benefits from public expenditure as between the affluent and less fortunate states.

i

Distributive aspects of income and wealth are best performed by the central government. If redistribution policy is left to the state governments regional disparities may be perpetuated. Rich may leave the region where redistribution measures are more egalitarian, while the poor will move to such regions. Progressive income tax which is an important redistribution measure must be uniform throughout the country. This is possible only when the tax is entrusted to the national government.

Equalisation Transfers It does not usually happen that the revenues appropriate to federal and state exploitation yield exactly the sums of money required for performing their respective functions.

Centre-State Finandd Relations-l

In most federations, elastic sources of revenue are in the hands of the federal government which has surplus resources. Through various means, federal governments have further widened their sources of revenues. The resulting financial imbalance between the federal and unit governments necessitates transfer of revenue to the unit governments in order to enable them to perform their constitutional functions. In fact, there has been a major extension in the functions of both the levels of governments. While the federal governments have been able to mount the requisite mobilisation efforts, the state governments, mostly with inelastic Sources of revenue, which cannot be stretched beyond a certain extent have been hamstrung in their efforts to meet these expanding demanqs, particularly those in the social services sector. Hence the need for fiscal equalisation. Fiscal equalisation has been defined as a systematic process of inter governmental financial transfers directed towards equalisation of the budget capacity or economic performance. A fiscal equalisation is intended to make it possible for the governments to provide a standard range and quality of services for their citizens. The fiscal capacity of a government is its relative revenue raising capacity on the one hand, and its relative cost of providing a standard range and quality of services, on the other. Fiscal performance is defined as a government's fiscal effort with reference to its revenue capacity. In a programme of fiscal capacity equalisation, governments are enabled to provide services on a standard scale while imposing standard burdens in the form of taxes and other charges. Fiscal capacity equalisation concept has meant devolution of responsibility and decentralisation in the decision making process. It is in fact the federalist answer to the problem of regional inequality.

fiscal performance equalisation, on the other hand, involves specification of performance norms and standards to be followed by the beneficiary governments. Obviously such an exercise wiil involve influencing the policies and efforts of these ,governments with regard to resource mobilisation and public spending. Fiscal performance equalisation may erode the autonomy of the constituent governments ,and is not likely to be welcomed.
One of the instruments of financial transfers is grants-in-aid. It represents a sum of money assigned by a superior to an inferior governmental authority either out of the exchequer of the former or out of sources of revenue especially designated. Grants are different from compulsory sharing or assigning of taxes, contractual payments or loans. Grants can be classified as statutory or discretionary, open or close-ended, general (unconditional) or specific (conditional), flat or tapering, and so on. There are several principles such as compensation, financial need, and the enforcement of a national minimum standard of social services which constitute the basis on which grants are generally made. Grants may be distributed on the basis of population, area, density of population, per capita income or a composite index combining these and other variables. Subsidies are another form of financial transfer for achieving fiscal equalisation. A subsidy policy would provide maximum help to the states that most need funds, preserve for them a larger and more independent governing role and relieve the national government of administrative burdens. Apart from grants-in-aid and subsidies, sharing of taxes and'joint exploitation of a source of revenue are also used to bring about fiscal equalisation transfers. Most federations have established inter-governmental financial institutions for deliberation and cooperation between the two levels of government and to smoothen the process of adjustment in fiscal processes.
A

Conflict and Compromise A division of powers, functions and resources that would satisfy federal governments and federating units in the dynamic situation that has been changing fast, is not a practicable proposition any longer. The rationale for the formation of federations cornp. from political, cultural, social, historical, strategic and economic considerations. Administrative and political considerations may often outweigh wnsidtrations of costs and benefits. The political boundaries and the pattern of

Financial Administration : Basics and Objectives

benefit distribution may not #ways match. When units which happen to be the bigger beneficiaries are large and affluent, integration may be promoted even thqugh smaller units may nurse a grievance. In the reverse case of larger gains going to small and poor units, the large and affluent units may frustrate the integration process. Given the division of resources, it may not always be possible for the states to pool together a level of resources that will be perceived to be adequate for satisfying the developmental objectives and aspirations of people of the states concerned. Policies and strategies for effecting credible equalising fiscal transfers have turned out to be extremely controversial exercises. While the state governments have been jealously guarding their rights as provided for in the Constitution, they quite often find the federal governments' encroachment on their jurisdiction irresistible. The Constitutions generally provide for the creation of inter-governmental institutions to act as the forum for the resolution of conflicts. In the ultimate analysis, however, it is the perception of the federating units as regards their long-term interests being served through the membership of the federation that helps resolve these tensions through compromise, accommodation and perhaps some amount of coercion.

EVOLUTION OF FISCAL FEDERALISM IN INDIA
Mobilisation, sharing and utilisation of financial resources play a very crucial role in all systems of multi-tier government and can give rise to difficult problems of inter-governmental relations unless handled in a spirit of mutual understanding and accommodation. In some of these systems, the national and lower tiers of government have concurrent powers in regard to certain taxes, borrowings and outlays. This concurrency of jurisdiction often results in serious economic and administrative problems which have to be sorted out through difficult negotiations, or resort to 7ourts. In other bifurcated systems, there is a clear-cut division of powers of taxation and borrowings between the national and lower levels of government, which by its very nature, can rarely match their resources and needs. It requires a mechanism for adjusting the surpluses and deficits, and reducing unavoidable vertical or horizontal imbalances of different constituent units, through resource transfers. India falls in the latter category. The Constitution allots separate legislative heads of taxation to the Union and the states. There are no taxes in the sphere of their concurrent jurisdiction. Borrowings and foreign exchange entitlements are controlled by the Union. Growth of Fiscal Federalism : A highly centralised financial system came into being in India with the take-over of the administration by the British Crown from the East India Company in 1858. The GovernorjGeneral-in-Council retained complete control over provincial resources as well as expenditure. The provincial governments remained entirely dependent on annual allotments by the Central Government for the maintenance of their administration. It was soon realised that decentralisation was necessary for governing a country of sub-continental dimensions like India and the first step in this direction was t a ~ e n 1870. The fiscal history of the next sixty in years is very largely a process of gradual devolution of powers to the provinces from the Central goverment. The Montague-Chelmsford Report which led to the passing of the Government of India Act, 1919, recognised the necessity of separating the resources of the central and provincial governments to support provincial enfranchisement. The authors of the report observed : "The provinces are the domain, in which earlier steps towards the progressive realisation of responsible government should be taken. Some measure of responsibility should be given at once, and our aim is to give complete responsibility as soon as conditions permit." Accordingly, under the devolution rules framed under the Act, customs, non-alcoholic excises including salt, general stamp duties, income tax and receipts from railways and posts and telegraphs, were assigned to the Government of India. Land revenue, irrigation charges, alcoholic excises, forest receipts, court fees, stamp duties, registration fees and certain minor sources of revenue were allotted to the provinces. This devolution scheme was criticised on the ground that the resources assigned to the provinces did not have adequate growtb'potential and were insufficient for their rapidly increasing needs, whereas the central revenues were capable of expansion,

although its needs were rel3tively stationary. The working of the financial relations, was, therefore, reviewed by a number of expert committees, particularly, in early 1930's. The provisions incorporated in the Government of India Act, 1935, were based on these reviews.
The Government of India Act, 1935 : This Act constitutes the next landmark in the country's financial administration. It divided the revenue sources into three categories :

Centre-State Financial RektioabI

i) Exclusively Federal. ii) Exclusively Provincial. iii) a) Taxes levied by the Federal government but shared with the provinces or assigned to them. b) Taxes levied by the Federal Government but collected and retained by the Provinces. The scheme also envisaged grants-in-aid from the Centre to the provinces in need of assistance as approved by the former. The Government of India Act, 1935, laid the foundations for a system of elaborate but flexible financial arrangements betwenen centre and the provinces. The long history of the evolution of public finance in India shows very complex factors at work. However, one clear discernible trend is that while it is wholly possible to divide the taxation powers and allocate resources, it is difficult to establish a balance between need and resources. The various stages of evolution helped confirm the maxims : i) that no decentraiised government can be established without allocating to it sufficient financial powers; and ' ii) that the central government is the appropriate authority to levy a tax where uniform rate is important and locale is not a guide to its true incidence.
Check Your Progress 2 Note : i) Use the space given below for'your answers. ii) Check your answers with those given at the end of the unit.

1) Enumerate the prirciples of fiscal federalism. Is federalism compatible with the autonomy of the unit governments?

2) Define the following terms : a) Fiscal equalisation b) Fiscal capacity c) Fiscal performance

3) Briefly describe the. contribution of the Montague-ChelmsfordReport to the
evolution of fiscal federalism in India. '

Financial Administration : Basics and Objectives '

......................................................................................................... .........................................................................................................

4.6 LET US SUM UP
Federation is a form of government in which sovereignty or political power is divided between the central government and state governments so that each of them within its own sphere is coordinate and independent. Independence is, however, moderated by the fact that there are overlapping functions between the two levels. Cooperative federalism represents the reality of federations more accurately. Considerations of self-interest on the one hand and mutuality and commonality of larger objectives on the other bind the federating units together. Federations are formed either when a previously unitary state breaks up to form a federal state or when a number of previously independent units agree to come together to form a federal state. Reasons of security, shared history, cultural, religious or linguistic bond as much as the economic interests provide the rationale for federations. ~inancial autonomy implies that the central and state governments should have adequate resources to perform their exclusive functions. Political autonomy without financial autonomy will be meaningless. The sources of revenue of both levels, particularly the states, should be elastic enough to keep pace with the growth of responsibilities and functions. Distribution of functions should be on the basis of where they can be performed efficiently and revenues should be assigned to those levels of government where they can be administered efficiently and economically. State governments should be enabled to provide a uniform level Of public services. The weaker states with inadequate fiscal capacity can be helped through financial transfers like grants-in-aid, subsidies etc. The fiscal equalisation transfers by the centre may provide an opportunity to it to encroach upon the jurisdiction of state governments. Since the states are sure to resent such attempts, intergovernmental institutions are created to smoothen out any tension or acrimony between the different levels of government. "Mobilisation, sharing and utilisation-of financial resources play a very crucial role and can give rise to difficult problems of intergovernmental relations unless handled in a spirit of mutual understanding and accommodation." A highly centralised financial system came into being in India with the takeover by the British Crown from the East India Company in 1858. Through a series of gradual reform measures, ultimately leading to the enactment of Government of India Act, 1935, the rigours of the excessive centralisation of powers were moderated and federalism came to be accepted as being inevitable. This Act laid firm foundations of a system of elaborate but flexible financial arrangements between the centre and the provinces.

4.7

KEY WORDS

~edripet.i: Moving o r tending to move towarde centre.
Enfranchisement: It is the condition of assigning someone right to vote in elections. Federation: It is a form of government in which sovereignty or political power is divided between the central government and state governments so that each of them within its own sphere is coordinate and independent. Federation by disaggregation: It is a process of formation of a federation through decentralisation-a previously existing state of a unitary character breaks up to form a federal state. Federation by aggregation: It is a process of formation of a federation through centralisation-a number of previously independent units agree to come together to form a federal state in which they continue to maintain their individualities. Fiscal equalisation transfers: It is a systematic process of intergovernmental financial transfers directed towards equalisation of the budget capacity or economic performance of the weaker states. Grants-in-aid, subsidies etc. are some of the
~v-m-lar

.

Fiscal capacity: Fiscal capacity of a government is its relative revenue raising capacity on the one hand, and its relative cost of providing a standard range and quality of services, on the other.

centre-State Financial Relations-i

4.8 REFERENCES
'rhavaraj, M.J.K. 1978. Financial Administration of India, Sultan Chand & Sons: New Delhi. Sinha, R.K. 1987. Fiscal Federation in India, Sterling: New Delhi. Thimrnaiah G. & H. Rao, 1986. Finance Commission and Centre State Relations, Ashish: New Delhi. Commission on Cent1 2 State Relations (Sarkaria Commission) Report, 1988. Manager, Government of India Publications: New Delhi. The Ninth Finance Commission, Second Report (1990-95), 1990. Manager, Government of India Publications: New Delhi.

4.9

ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress 1 Your answer should include the following points: 1) Federation is a form of government in which sovereignty or political power is divided between the central government and state governments so that each of them within its own sphere is coordinate and independent. Federations are formed either when a previously unitary state breaks up to form a federal state, which is known as disaggregation. Alternatively, when a number of previously independent units agree to come together to form a federal state, this is known as the principle of aggregation. 2) Your answer should include the following points: Independence or autonomy of the units is ensured through a division of powers and functions which can be eiercised by a level independently of the other. There has, however, been a growth of overlapping functions. Division of powers and resources can give rise t o serious problems, unless there is a spirit o cooperation, f understanding and accommodation. Independence and coordination are, therefore, both essential for the functioning of a federation.

f 3) USA, Commonwealth o Australia and Canada.
Check Your Progress 2

1) Your answer should include the following points: i) Independence and responsibility ii) Adequacy and elasticity iii) Efficiency iv) Equity v) Equalisation transfers vi) Conflict resolution 2) Your answer should include the following points: a) Fiscal equalisation: It is a systematic process of intergovernmental financial transfers directed towards equalisation of the budget capacity or economic performance of the weaker states. b) Fiscal capacity: Fiscal capacity of a government is its relative revenue raising capacity on the one hand and its relative cost of providing a standard range and quality of service, on the other. c) Fiscal performance: It is the government's fiscal effort with reference to its revenue capacity. 3) Your answer should include the following points: The Montague-Chelmsford Report led to the passing of Government of India Act, 1919. It recognised the necessity of separating the resources of the central and provincial governments to support provincial enfranchisement. Accordingly a division of powers and resources was clearly laid down.

UNIT 5 CENTRE-STATE FINANCIAL RELATIONS-I1
Structure
Objectives Introduction Division of Functions and Resources under the Constitution The Finance Commission The Planning Commission Centre-State Financial Relations : A Critical Appraisal Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

After going through this unit, you should be able to : explain the constitutional provisions regarding the division of functions and resources and other financial powers between the Union and the States describe the structure, functions and status of the Finance Commission and the role played by it in respect of Centre-State financial relations discuss the structure, broad functions and role of Planning Commission in the transfer of resources from the Union to the States; and critically evaluate the Centre-State 'financial relations as they have evolved over the years.

5.1 INTRODUCTION
Federations, old and new, are characterised by a clear division of functions and resources between the federal government and the unit governments. Framers of the Indian Constitution were acutely aware of the conflicts and problems which were faced by the old federation's in the sphere of financial relations. They also had the additional benefit of the pre-existing financial system embodied in the Government of India Act, 1935. The Constitution envisages that fiscal resources would be transferred to the States on the recommendations of.the Finance Commission. The role of the Finance Commission has, however, come to be limited mainly to channe~isin~revenue transfers. The capital resources for planned development are. of on now tra~sferred the recommendations of the Planning Commission. The National Development Council, members of which, among others, include Chief Ministers of all States, reviews the working of the national plans, considers questions of national developmental policy and recommends measures for the implementation of the objectives and targets set out for the national plans. These institutions are expected to play a very effective role as adequate forum of consultation and cooperation between the states and union, but within a centralised framework. In this unit we will discuss the constrtutional provisions relating to divisiba of knctions and resources between the centre and states, role of Finance Commission a n d PIanning Commission. A critical Appraisal of centre-state financial relations shill also be done.

5.2

DIVISION OF FUNCTIONS AND RESOURCES UNDER THE CONSTITUTION

Federntion or Union

The bas~c reature ot a tederation is that the powers are s divided that the central o and state governments are each within its sphere coordinate and independent. India

is a federation ot States. The Constitution of India which came into force in 1950 provided for a clear-cut division of functions and revenue resources between Union and States. The Seventh Schedule of the Constitution contains a detailed distribution of functions between the central and state governments in the form of three lists i.e., union, state and concurrent lists. The functions of the central government are specified in the Union list which includes defence, atomic energy, foreign affairs, railways, national highways, posts and telegraphs, currency and coinage, foreign exchange, inter-state trade and heavy and basic industries. The functions assigned to the states as enumerated in the state list include law and order, police, administration of justice, education, medical and public health, agriculture, irrigation, power, forests, fisheries, cooperatives, rural and community development and slum clearance. Apart from the union and state lists, there is a third list known as the concurrent list. Functions of an inter-state nature, such as commercial and industrial monopolies, labour disputes, social legislation, social security and.economic and social planning have been placed under the concurrent legislative powers of the central and state governments. In the event of a clash between. the laws of the central and state governments over a concurrent area, the former i.e. the central law prevails. The Constitution describes India as a 'Union of States'. A motion to designate India as a 'Federation of States' was rejected by the Constituent Assembly. Dr. B.R. Ambedkar put it very succinctly thus;

Centre-StateFinancial Relations-11

". .. though India was to be a federation, the federation was not the result of an .
agreement by the States to join in a federation and that the federation not the result of an agreement. no State has the right to secede from it. The federation is a Union because it is indestructible. Though the country and the people may be divided into different States for convenience of administration, the country is one integral whole, its people a single people living under a single imperium derived from a single source. The Americans had to wage a civil war to establish that the States have no right of secession and that their federation was indestructible ." The Drafting Committee thought that it was better towmake it clear at the outset rather than to leave to speculation or to dispute.
Financial Powers In effecting a division of resources, the Constitution provides for a strong centre. The Constitution ensures the supremacy of the action of the Union Government over the fairly comprehensive Union list as also over concurrent jurisdiction. Allocation of the heads of taxation between the union and the states is based on ;he broad principle that taxes which are location-specific and relate to subjects of local co<sumption have been assigned to the states.

Those taxes like for example Income tax which are of inter-state significance and where the place of residence is not a correct guide to the true incidence of tax have been vested in the union. This clear-cut division of heads of taxation between the union and the states has minimised the scope for conflicts and litigation between them. The taxes over which the union has legislative jurisdiction can be classified as follows : a) Taxes which are to be levied and collected by the Union and the entire proceeds therefrom are to be retained by it. These include corpcration tax and customs duties. b) Taxes which are levied and collected by the Union but proceeds are shared with the States. These are income tax, and excise duties. c) Taxes which are levied by the Union but collected and retained by the States. These are estate duties and terminal taxes on goods and services. d) Taxes which are levied by the Union but collected and retained by the States. These are excise duties on medicinal and toilet preparations (containing alcohol), opium, etc. In achuon, there are exclusively state taxes, i.e., taxes levied and collected by the states and appropriated by them. This category includes land revenue, taxes on . .~ . . - - - . .-.. - .~

.

FLnancid Administration : Basics and Objeftlves

Article 286 of the Constitution forbids taxation by states of a) imports into or exports from the tercitory of India; b) Inter-state trade; and the c) sale of goods dec1ared.b~ Parliament by law to be essential for the life of the community. The property of the union is exempt from state taxation. The property and income of the states are exempt from the union taxation. In addition to the provisions for tax-sharing, Article 275 of the Constitution provides for both general purpose and specific grants. However, it has been left to the Parliament to decide which states are in need of grant assistance and to what extent subject to the recommendations of the Finance Commission. The borrowing powers of the central and state governments are regulated by Articles 292 and 293 of the Constitution. The central government can borrow on the security of the Consolidated Fund of' India within and outside the country subject to the limits, if any, specified by the Parliament. The state governments can borrow generally only within the temtory of India with the consent of the central government. The central government may also give loans to the state governments, subject to such conditions as are laid down in a law of Parliament. If the President of India is satisfied that a situation has arisen where the financial stability or credit of India or any part of the temtory thereof is threatened, the President may declare financial emergency under Article 360 of the Constitution. In these abnormal and emergent circumstances, both collection and distribution of revenues in state governments are made by the central government or state governments as decided by the Parliament. Allocation of financial powers, and resources between the centre and the states, is indeed the most vital and yet the most difficult task. The revenues of the federations have undoubtedly. been growing. In some federations like the United States of America, where the federation and the states have concurrent taxation powers, there has been a lot of litigation which is inherent in the exercise of overlapping powers. In Australia and Canada, negotiations and agreements played an important part in determining the shares in the proceeds of'taxes. In such situations, it is political expediency rather than time-honoured conventions which come handy in resolving conflicts. With regard to allocation of financial resources between the centre and the states as said earlier there are constitutional provisions that : i) the states are entitled to a significant share in federal taxes; ii) the proceeds of certain taxes levied by the centre are totally assigned to the states; and iii) there is a system of grants-in-aid to the states. One criticism that is often voiced regarding the allocation of financial resources between the centre and the states in India is that elastic and substantial sources of revenue have been assigned to the centre whereas the states, which have been entrusted with important developmental and welfare functions, have been entrusted with inelastic and inadequate sources of revenue.

5.3 THE FINANCE COMMISSION
Finance Commission and Planning Commission are the two important bodies through which fiscal transfers between the centre and states are effected. As we have said earlier, in the allocation of resources between the centre and the states, major elastic sources of revenue have been assigned to the centre. The fact that the Constitution provides for obligatory sharing of income tax receipts and permissive sharing of Union Excise Duties, is an implicit acknowledgement of the inadequacy of 'States' sources of revenue. The Constitution, however, did not specify the share of the state or its inter se distribution. The Constitution, therefore, provides for the setting up of a Finance Commission periodically for this purpose. The functions of the Finance Commission are to make recommendations to the President in respect of : 1) the distribution of net proceeds of tilxes to be shared between the Union and the .States and the allocation of shares of such proceeds among the States

.~

2) the principles which should govern the payment of the Union grants-in-aid of the revenue of the States; and
3) any other matter concerning financial relations between the Union and the States.

Centre-State Fin'ncid Re'ations-l?

The Finance Commission is a quasi-judicial body and it acts independent of the centre and the states. The specific terms of reference of each Finance Commission are drafted by the Ministry of Finance at the Centre. The state governments are not consulted in the matter. Practical difficulties in working out a consensus approach, amongst different states at times ruled by different political parties with different viewpoints, seem to have discouraged consultations with the state governments. In the absence of a clearly specified and constitutionally recognised institutional mechanism for revenue-sharing between .the federal and state governments in some of the important federations, numerous adjustments had to be resorted to. In the first place, because of concurrent taxation powers in federations like USA, Australia and Canada, "which level uses what kind of tax and what extent has been decided more by custom and negotiation, included in statute, or agreement, than by Constitutional provision". In USA, at least, the tax system which dame to be developed over the years is described to be uncoordinated and overlapping. The other federations have faced similar or worse problems. The Finance Commission in India on the other hand, because of its constitutional status constitutes a unique arrangement. Because of this status and the fact of being an expert body, the devolution of resources i.e. tax-sharing and grants-in-aid has been removed from the arena of political bargaining. Even though the Commission is an advisory body, its recommendations, along with the action taken thereon, have to be placed before the Parliament. According to the Constitution, the Finance Commission should consist of a Chairman and four other members. According to the Finance Act, 1951, the Chairman shall be a person with experience in public affairs. The four members should have been or be qualified to be appointed as Judge! of the High Court, or should have specialised knowledge of economics, financial matters or finance and accounts of the government. The constitutional status accorded to it. and its functioning as a semi-judicial expert body has earned for the Finance Commission high regard of the Union and the States.
The Approach

la Ind~a.so far ten Finance Commissions have been set up and thev adopted a
common approach with regard to fis'cal transfers from centre to states. Some uniform principles or considerations have been kept in view by the Finance Commissions in making their recommendations. The first Finance Commission laid down certain principles as follows : Firstly, the additional transfer of resources from the centre must be such as the centre should bear without undue strain on its resources taking intoaccount its responsibility f for such vital matters as the defence of the country and the stability o the economy. Secondly, the principles of distribution of resources between !he states and the determination of grants-in-aid must be uniformly applied to all. Thirdly, the scheme of distribution should attempt to lessen the ipequalities between the states (First Finance Commission Report). The First Finance Commission further observed: "It is not the purpose of any system of grants-in-aid to diminish the responsibilities of the State governments to balance their own budgets. The method of extending financial assistance should be such as t o avoid any suggestion that the Central Government had taken upon themselves the responsibility for helping the states to balance their budgets from year to year." The Eighth Finance Commission gave primacy to national interest as a whole. Their paramount consideration was reconciling the need to accelerate the development of! backward states without hindering the further development of the more advanced ones. The commission, therefore, took steps to reduce the regional imbalances between the states in addition to covering revenue gaps.

Admidstration :Basics sod ObJcetlva

The Ninth Finance Commission (Second Report) also observed : "The manner of transfer of resources should be such as to preserve fiscal autonomy of the states and to promote fiscarresponsibility on t h l part of both the centre.and the states. Central transfers invariably involve questions of inter-state equity and such equity can be attained in a system of federal ,transfers only if fiscal prudence, tax effort and growth impulses are not penalised." Resource Transfers Share of Income Tax :Article 270(1) of the Constitution provides for distribution of taxes on income between the union and the states, in such manner as may be prescribed by the President after considering the recommendations of the Finance Commission. The First Finance Commission fixed the state's share of the divisible pool at 55 per cent which.karlier was 50 per cent..This was progressively raised to 60 per cent, 66 per cent, 75 per cent by the second, third and fourth Commission respectively. The sixth and seventh commissions raisedit hrther to 80 per cent and 85 per d n t respectively. m e eighth and ninth Finance Commissions have retained it at that level. S b of Excise Duties : This is another tax whose proceeds are shared by the union with the states. Under Article 272 of the Constitution, union duties on excise other than that on medicinal and toilet preparations as mentioned in the union list are levied and collected by the centre, but if Parliament provides by law may be shared between the centre and the states. The states' share has F e n successively mcreased. The growth is mainly due to : a) b) c) d) increase in the number of commodities taxed increase in rates rise in prices; and increase.in the output of taxable commoditiks.

The states' share in divisible pool of excise duties was 40 per cent of only three commoditiks. The share was raised by the second and third commissions and fourth commission raised the share to 20 per cent of all commodities. The fifth and sixth finance commissions maintained the level, seventh commission raised it to 40 per.cent . of all commodities, eighth raised it to 45 per cent of all commodities. Ninth Commission retained it at that level.

Grants-in-aid :Under Article 280 of the Constitution, the Finance Commissions have been given the right of making recomniendations regarding the payment of grants-in-aid of the revenues of the states out of the Consolidated Fund of India. Article 275 provides for the payment of such funds to the states which are actually . in need of assistance. But the controversies that arise with regard to grants-in-aid is because the term 'need' has not been clearly defined in the Constitution. The first Finance Commission listed six principles of grants-in-aid which have been followed by later Finance Commissions also with varying degrees of emphasis. These are : 1) budgetary needs; 2) tax efforts; 3) economy in expenditure 4) standard of social services. 5) special obligations; and 6) broad purpose of national importance. The first Finance Commission recommended specific grants for jute producing states, special grants to eight states for promoting primary education. The second Finance Commission did not recommend the grants for primary education.
The third Finance Commission tried to widen'the scope of the grants-in-aid by including grants for plan outlays also. It was of the view that total impact of grants-in-aid should be of an order which would enable the states, along with the surplus out of devolution, to cover 75 per cent of the revenue requirements of thier plans. Quite contary to this, the fourth Finance Commission confined itself to non-plan revenue expenditure and thus limited the scope of Article 275 to cover only the non-plan grants. Similar views were expressed by the fifth commission. The sixth Finance ~ommissio"identified certain administrative services such as
aenersl
srlminirtmtinn nrlm;nd+nt;nn nf ;a to . ci n

s

;nil

- \i m n r ~ r w 4 ~ l rln n l

n..-L

assprimary education, medical and public health, welfare of scheduld cistes, scheduled tribes and other backward classes as to be of crucial iinportance. It recommended that those states whose expenditure on these items in per capita terms was below the all states average should be enabled to come upto such an average by the last year of the award. Such additional provisions were taken into account for determining quantum of overall plan revenue gap. oo twk'the view that grants-in-aid should only be a The seventh Finance C - n residuary means of assistance and should be used not merely to fill in the uncovered revenue gaps but should be used to narrow down the disparities in the standards of administrative and social services of the states. The eighth Finance Commission broadly agreed with the views of the seventh Finance Commission. The successive Finan& Commissions have, therefore, broadly followed the residuary financial assistance approach in recommending the grants-in-aid. The basic objectives underlying the ninth Finance Commission's approach and methodology were : a) phasing out the revenue deficit of the Centre and States in such a manner that the deficit is reduced to zero or a relatively small figure by 31st March, 1995; b) equity in the distribution of fiscal resources both vertically and horizontally; and c) promotion of fiscal discipline and efficiency in the utilisation of resources. The Finance Commissions, have played a very important role in the field of federal finance, in spite of certain limitations under which,they had to function. Some of these limitations include : i) Constitutional limitations =.it has to function under the given framework. ii) Constraints imposed by the Union on the Finance Commission by prescribing certain terms of reference. iii) Non-implementation of important recommendations of the Finance Commission by the union government. iv) Problems arising out of the methodologiesfollowed by the Finance Commission. Some of the states have made suggestions for improving the working of the Finance Commission. These have been Summarised by the Sarkaria Commission as follows: a) m e funmons of he-Finance bmmission be enlarged. It should 2;s ~onsider plan and other transfers andlor undertake comprehensive annuallperiodical reviews of theefinancial performance of the Union and State Governments. b) The Finance Commission should be made a permanent or standing body to cope with enlarged responsibilhies. c) The coordination between the Finance Commission and the Planning Commission should be improved so that an integrated view of the flow of Central assistance to the States becomes possible. d) It should be provided with a permanent and well-equipped secretariat to carry out studies and maintain operational continuity for the benefit of the subsequent Fiance Commissions. As regards the terms of reference being given by the centre, it has already been pointed out earlier that differences of opinion betyeen the states themselves do not allow a consensus to emerge. The union government,.however, initiated steps to securestherepresentation of states on an official level committee set up to finalise the terms of reference. This arrangement is considered adequate for the purpose. On the non-implementation of the recommendations of the Finance Cdmmissioni, the Sarkaria Commission has listed three such occasions upto Seventh Finance Commission which the central government could not implement for various reasons. However, the criticism that the union government did not implement the report of the eighth Finance Commission in the first year itself, has been found to be valid and the Sarkaria Commission calls it rather unfortunate. It hopes such occasions will not arise in future. There has been a long-standing suggestion that the Finance Commission should consider plan and other transfers in addition to non-plan revenue transfers. While conceding that plan transfers could be considered by them, the fourth Finance

ccobc-st.tr

~ i a ~ c i d Relatkns-11

b'inancial Administration : Basics and Objectives

Commission observed that "the importance of planned development is so great that there should not be any division of responsibility in regard to any element of plan expenditure. The Planning Commission has been specially constituted for advising the Government of India and the State Government in this regard. It would not be appropriate for the Finance Commission to take upon itself the task of dealing with the State's new plan expenditure" The suggestion regarding a permanent Finance Commission did not find favour with the Sarkaria Commission which felt an active involvement of the Finance Commission in determination of annual transfers would be at the cost of objectivity. There is no denying the fact that the Finance Commissions have done an impressive amount of work in the field of federal finance, which has been better known as the Indian Finance Commission's approach to federal finance. Inspite of the several limitations in their approach and methods, they have on the whole succeeded in maintaining the basic equilibrium in the finances of the state governments.
Check Your' Progress 1

Note : i) Use the space given below for your answers. ii)' Check your answers with those given at the end of the unit.
1) Broadly indicate the classification of taxes over which the union has legislative

jurisdiction.

..

2) Describe the functions of the Finance Commission.

3) Comment on the limitations of the functioning of the Finance Commission. What suggestions have been made by the Sarkaria Commission for improving the. functioning of the Finance Commission?

5.4 THE PLANNING COMMISSION
As said earlier the Planning Commissibn is another important body which has an important place in Centre-State financial relations. The genesis of economic planning in India necessitated the introduction of plan assistance to states to enable them to undertake various developmental programmes envisaged in the five year plans. The responsibility for taking decisions and implementing them rests with the union and the state governments. The resolution emphasised the need for "adequate coordination" between the development schemes initiated by the union and the states and for comprehensive planning based on a careful appraisal of resources and essential conditions of progress.

The broad functions of the Planning ~ommissiodinclude: assessment of material, capital and human resources; formulation of a plan for their most effective and balanced utilisation; determination of priorities and allocation of resources for completing each stage of the plan; determination of machinery for securing successful implementation of the plan; appraisal of progress and recommending adjustments in policies and measures during the execution of the plan; and making of interim and ancillary recommendations on current development policies, measures, etc.. From the very beginning, the Prime Minister has been the Chairman of the Commission. The Deputy Chairman is an eminent person, usually a politician, holding the rank of a Cabinet Minister. There are two types of members of the Planning Commission in addition to the Minister for Planning. There are a few full-time members who are eminent public persons, economists, social scientists, technical experts or administrators. In addition, the Commission has as its members, a few Cabinet Ministers like the Finance Minister, Defence ~in'ister, etc., who attend only very important meetings of the Commission. A large secretariat has been established to assist the Planning Commission in its work. The Planning Commission has Advisers (State Plan) who perform a very important role vis-a-vis the States. On the one hand, they assist the Planning Commission in finahsing the state and on the other, In monitoring the progress of vari6us developmentprogrammes in the states. They also interact with the state governments in implementation of the plan. They are and assist them in resolving these thus expected to function as an active link between the Planning Commission and ihe state governments.

Centre-State Financial Relations-11

National Development Council The setting up of the National Develbpment Council in August 1952 on the suggestion of the Planning Commission itself, may be regarded as the most significant step for promot'ing understanding and consultation between the Union and the state governments on planning and common economic policies. It was assigned the three important functions of (i) reviewing the working of the National Pla; [iom time to time; (ii) considering important questions of social and economic policy affecting national development, and (iii) to recommend measures for the achievement of the aims and targets of the national plan. Presently, besides the Prime Minister who is the Chairman, its members include the Chief ministers of all the States and Union Territories, Ministers of the Union Cabinet. The Council can meet "as often as may be necessary and at least twice in each year". Although the NDC is not a statutory body, its very composition gives it a unique character and its recommendations are treated with respect by the union and the state governments. It imparts a national character to the entire process of planning. Devolution of Resoaraa Devolution of resources Worn the union to the states may be placed under three categories: i) transfers based on the recommendations of the Finance Commission; ii) transfers by way of assistance for execution of the plans recommended by the Planning Commission, including centrally sponsored schemes; and iii) others consisting of small savings, loans, assistance for natural calamities, etc., canalised through the Union Finance Ministry.
As already stated, the transfers effected on the recommendations of the Finance Commission (also called statutory transfers) are normally determined for a period of five years. Bulk of these transfers are unconditional and have a built-in buoyancy with respett to the growth of the concerned tax reoeipts. These transfers accounted for about 40 per cent of the total transfers during the period 1951-85.
A substanrral part of the transfers in the second category are by way of assistance for the execution of the state plans. These accounted for 31 per cent of the total transfers from the union to the states during the period 1951-85. If to these transfers are added

Finrraelnl Administratba :Basics and Objectives

those on account o central and centrally sponsored plan-scheme, the totality of the f plan transfers during the period 1951-83, works out to about 41 per cent of the total transfers. The central assistance for the plans is based on the recommendations of the Planning Commission. It includes loans and grants. The third category of transfers'are given for various purposes by the union government. These are in the form of grants and loans for relief of natural calamities, improvement of roads, ttpgrading salaries of teachers, etc. During 1951-85, such transfers amounted to 19 per cent of the transfers. Central assistance is an important instrument for reducing regional inequalities and augmenting finances particularly of less developed states for meeting their developmental needs. Plan assistance has always been crucially important for state plans and presently about 50 to 60 per cent of state plan outlays are met from central assistance. The amounts given as plan assistance in the form of grants (30 per cent) and loans (70 per cent) has always been determined on the basis of prescribed criteria. Nevertheless; in actual practice stronger states could get away with a larger slice than what was their due. It is often alleged that in as much as only 40 per cent of the total transfers from the Union have been effected on the recommendations of the Finance Commission, the transfers through the Planning Commission and the Union Ministries (for Centrally Sponsored Schemes) have been discretionary in character (implying subjectively arbitrary). Firstly, the Plan assistance is not mandatory on the union government. Secondly, allocation of Central assistance is subject to the approval of the National Development Council on which all Chief Ministers are represented. Thirdly, bulk of central assistance (grants And loans) is decided according to prescribed criteria, population being a major criterion, backwardness of the states, other special problems also being other important criteria. This is done under what is known as the'Gadgil Formula or modified Gadgil Formula. Fourthly, in the case of centrally sponsored schemes, the pattern of financing, viz. Central assistance vis-a-vis States own contribution for various schemes is determined and known well in advance. As Sarkaria Commission has observed: "It is not humanly possible to derive foolproof formula which would make the totality of central transfers confirm fully to the ideal of automatic and free-from interference devolution. Some amount of flexibility and room for subjective judgment will have to be left to the concerned institutions to deal with the specific situations as they arise. What is really important is that the institutions involved should function in a fair and non-partisan manner and take decision with due discernment and expertise which are implicitly acceptable to the states"

5.5

CENTRE-STATE FINANCIAL RELATIONS - A CRITICAL APPRAISAL

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The centre-state relations in a new federation like India are quite complex. In older federations like USA, Canada and Australia, a general acceptance of the financial relations between the federal governments and the states makes for a far more smooth relationship. The general complaint against the financial relations between the union and the states concerns the division of resources. i) The states have a grievance that by and large the taxes with the Union are quite elastic whereas those left with the states are inelastic and their tax base is also narrow. Of the various taxes levied by them, only Sales Tax and to some extent the State Excise Duties have shown a degree of elasticity. Land Revenue has lost its importance. In 1951-52, it yielded Rs. 49 crore, comprising 21 per cent of their own tax revenue. In 1984-85, it was about Rs. 300 crore, constituting only 2.6 per cent of their own tax revenue. The states and some of the critics maintain that the Constitution has assigned to them the responsibility for development works, rural and social uplift, building of social overheads. Additionally, the reponsibitity for the maintenance of law and order, the expenditure on general administration has also gone up by leaps and bounds. Thus there are gaps between the revenue and expenditure. ii) Extending the above criticism, it is held that there is inadequate devolution of taxes levied and collected by the central government, thereby reducing the finances available for state activities, within their sphere of responsibility.

iii) The heavy dependence of the states on the union for financial resources has resulted in progressive erosion of the jurisdiction, authority and initiative of the states in their own constitutionally defined spheres. . iv) The states have also to depend on the union for their share of the enormous financial resources. These includk the banking sector and other financial institutions, foreign a.id and in the last resort deficit financing supported by the Reserve Bank. v) The states are obligated to submit their five year plans, including the items within the sphere of their own responsibility to the Planning Commission created by the central government -and there is interference and control by the letter over the plans of individual States. There is also a gradual decline inthe relative share of State's Plan outlay in the total, growing outlay of the union on state subjects, and proliferation of centrally sponsored schemes. Thus, the intrusive planning process along with inadequate and inelastic tax base leading to resource constraints and dependence on the Union, constitute the bulk of the criticism by the states of actual operation of fiscal federalism in India. It is not correct to say that the foregoing criticism is representative of the,perceptions of all the states. In fact, according to Sarkaria Commission,.most of the states are of the view that the existing constitutional arrangements are basically sound and there is no need to make any changes in the division of the areas of taxation envisaged in the Constitution. In fact, one state has pointed out that any transfer of taxation areas now with the union to the states would make the rich states richer and the poor states poorer. The finances of the Union Government are in none too happy a position. There is no balance from current revenues (surplus on revenue account). The Union finances have.been reeling under massive deficits leading to desperate remedies in the year 1990-91 and 1991-92 (Refer to Unit no. 6). More than 100 public.sector enterprises are incumng losses every year. Similarly, over the years, most of the states have given exemptions on Land Revenue, etc., whereas the gross volume and value of agricultural production have increased manifold during this period. Only a few states are levying a nominalbAgricultural Income Tax and that too to an insignificant extent. Agricultural Income Tax is not easy to administer. Large commercial losses have also been incurred by the public sector enterprises year after year. The difference between the states own resources and their revenue expenditures over a period of years is not an infallible measure of the extent of their dependence on the resource transfers from the Union. The main snag is that the quantum of revenue expenditure of a state carries a substantial component relatable to revenue received by transfer from the union. This component is a variable factor which has an incremental effect on the level of the'state's revenue expenditure. The so-called narrow tax-base of the states, therefore, cannot be related quantitatively to the level of their revenue expenditure as the latter itself depends upon their total revenue res,ources including revenue transfers from the Union. A state government has in fact conceded after a quantitative analysis that the state's indirect taxes (Sales Tax on Passengers and Goods, Electricity Duty and Stamp Duties and Registration Fees) are fairly elastic to prices and income, but their direct taxes such as Land R e ~ e n u e ~ a n d .Profession Tax, are highly inelastic. If one takes note of the broad trends of revenue centralisation and expenditure decentralisation in other federations, one can say that generally all over the world, the federal governments have a large and increasing control over revenues. This is particularly true of Australia and to a large extent of the United States of America. A more balanced situation, however, exists in Canada. A comparative study conducted under the auspices of National Institute of Public Finance and Policy has observed.

Centre-State Financial Relations-I1

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"We may conclude that there is a slightly higher degree of centralisation of revenues in India than is generally found in the economically developed federations. But the expenditure decentralisation in India is greater than in those federations. As a result, the degree of dependence on the centre, in terms of the share of federal transfers in State's revenue is higher. However, in so far as the transfers take place in the form of Constitutionally assigned taxes the high share of federal transfers cannot be said to be an indication of dependence"

Financial Administration : Basics and Objectives

Indebtedness of States : One of the major problem areas in Centre-State financial relations pertains to the mounting central loans. As per the Ninth Finance commission Report (second Report), total debt of states is estimated to be Rs. 899461 crore, as on 31.3.89 of which liabilities to the central government form about 63 per cent. Provident funds, reserve funds and deposits are the next largest source of debt financing, amounting to 23 per cent of the state's total debt. Market loans constitute almost 12 per cent of the debt and the residual is negotiated loans from public financial institutions and others. About 11 per cent of the debt is short-term. The major cause for the rapid rise in state's indebtedness'is due to investment under the plans, but more recently to the states resort to cover part of revenue expenditure. As far as market borrowings are concerned,-under each five year plan, each state is allocated a share on a net basis, i.e. of repayments due in the year. The states find that their repayment obligations to the centre are absorbing a large and ever-increasing proportion of fresh loans. These cut into plan resources to a substantial extent. The states' representation to the Ninth Finance Commission, among others, was in regard to.reduction of repayment burden, write-off loans used- for social infrastructure, the pattern of central plan assistance to be changed to have a higher proportion of grants, e.g. 50:70 proportion of grants to loans, etc. In channeling market loans, allocation of capital funds by the centre favour the weaker states. Had the moneys been borrowed by all the states directly from the market, the richer states would have gained in competition. The Ninth Finance Commission points out that if the centre is asked to bear the cost of borrowing funds, the amounts available for direct transfers to the states would be reduced. The "Central Government is not acting merely as a financial agent on behalf of the States in order to reap economies of scale in obtainiog funds from me market, but also aims to fulfil certain national purposes such as promoting development and helping weaker States". It felt that the solution to the government debt problem lay in using f borrowed funds efficiently and productively for capital expenditure instead o revenue expenditure. It held that, in future, scheduling of loans should be avoided and that the terms on which the funds were lent by the centre to the states must be reasonable and equitable. It recommended certain debt relief measures for the states. According to Sarkaria Commission : "The present division of fields of taxation between the Union and the States is based on economic ;nd administrative rationale. Levying of taxes with inter-state base and where uniformity in rates is desirable, are with the Union Government. Taxes that are location-specific are with the States. Consensus of efficiency and equity in administration of taxes and the imperative need for the Union to have adequate resources, inter alia, to help the States with lower level of socio-economic development and tax-potential leave hardly any scope for shifting any major sources of revenue of the States from the present allocation of areas of taxation to the Union". We may note here the views of the Administrative Reforms Commission Study Team that "if at all, a review of taxation power is carried out, economic considerations would most probably compel a shift in favour of the Union and not the other way" Check Your Progress 2 Note : i) Use €.hespace given below for your answers. ii) Check YBur answers with those.given at the end of the unif.
1) Staterhe broad functions of the Planning Commission.

2) What are the functions of the National Development Council?

3) What are the major sources of devolution of resources from the union to the states?

Centre-state Financial Relations-11

4) Point out the areas of conflict in federal finance between the centre and states.

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5.6

LET USSUMUP

India is a Union of States. The Constitution of India which came into force in 1950 provides a clear-cut distinction between union and state functions and revenue resources. Allocation of heads of taxation between the union and the states is based on the broad principle, that the taxes which are location-specific and relate to subjects of local consumption have been assigned to the states. Those taxes which are of inter-state significance have been vested in the union. There is no concurrent jurisdiction in regard to taxation powers. Income Tax and Excise Duties are shared with the states. The central government can borrow both within and outside the country whereas the states can borrow only within the country with the consent of the central government. The Constitution provides for the setting up of a Finance Commission. The functions of the Commission are to make recommendations to the President in respect of :

1) the distribution of net proceeds of taxes to be shared between the Union and the States; and

2) the principles which should govern the payment of the Union grants-in-aid.
The principles generally observed by the Finance Commission are that the resource transfers from the union should not cause undue strain on its resource base; that their distribution among the states should follow uniform criteria and, the scheme of distribution should attempt to lessen the inequalities between the states. The need to protect national interests, preserve the autonomy of states and promote fiscal discipline among the union and the states are other important criteria. State's share of Income Tax and Excise Duties have been successively increased by the FinanceCommissions. As regards grants-in-aid, the principles generally followed in making recommendations are : budgetary needs, tax efforts, economy in expenditure, standard of social services and special obligations. Though the Finance Commissions have functioned under various constraints, t k y have earned high regard of the union and the states because of their status, quasi-judicial approach and expert recommendations. The Planning Commission was set up in 1950 with the objective mainly of formulating plans for the most effective use of the nation's resources. National Development Council is the apex body of the nation for the approval of the various plans and policies. The Planning Commission recommends transfer of resources by way of assistance for the execution of the State Plans including Centrally Sponsored Schemes. In spite of the criticism that the Planning Commission's recommendations are dependence-generating for the states, by and large it is' felt that these transfers are fairly objective and flexible. ' A s we have discussed in the unit, a critical a p p r a h l of Centre-State financial relations indicates inadequate devolution of resources to the states, heavy dependence of states on Centre for finances, increasing indebtedness of states etc., which need careful examination.

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5.7 'KEY WORDS
Capital Expenditure : It is the expenditure incurred for creating concrete assets of a material character in the economy like land, building, machinery etc. Centrally Sponsored Schemes: Plan schemes sponsored by Central Ministries on subjects falling in the State list, to be implemented by the state governments, financed largely by the central government. Concurrent List: Functions of an inter-state nature such as commercial and industrial monopolies, labour disputes, social legislation etc. have been placed under the concurrent legislative powers of the central and state governments. In the event of a clash between the laws of the Central and State Governments over the concurrent area the former prevails. Gadgil Formula: Gadgil formula or Income Adjusted Total Population (IATP) was evolved in 1969-70 to allocate plan assistance among the States. Under this formula, 30% of the assistance is made in the form of grants and 70% in the form of loans. The total resources allocated to the states on the basis of this formula are determined in terms of 60% on the basis of population, 10% on the basis of per capita tax efforts, 10% on the basis of continuing major and medium irrigation, power projects, 10% on the basis of special problems (floods, drought, tribal areas) of individual states, and 10% was to accrue to the poorer States on the basis of economic backwardness. Revenue Expenditure: It is the expenditure incurred towards normal running of government departments. Sarkaria commission: The Commission on centre-state Relations was formally constituted by the Government of India, Ministry of Home Affairs on June 9,1983 under the Chairmanship of R.S. Sarkaria (a retired judge of Supreme Court). The objective of the Commission was to eramine the working of existing arrangement between the centre and the states and recommend such changes in the said . arrangement as may be appropriate within the present constitutional framework. State L i t : It lists functions and powers with respect to which a state legislature has exclusive powers to make laws (List I1 of Seventh Schedule of the Constitution). It includes subjects like agriculture, law and order, public health etc. Terminal Tax: It is imposed on goods arriving in a city or town by rail. It is realised by the railways on behalf of the municipality on commission basis.
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Union List: It contains the distribution of functions assigned to the Union and in respect of which the Parliament has the exclusive power to.make laws. It includes subjects like defence, external affairs, railways etc. (List I in the Seventh Schedule of the Constitution).

5.8 REFERENCES
Bhargava, P.K. 1982. Centre-State Resource Transfers in India, Academic Press: Gurgaon. Dewan Paras, 1981. Union States Fiscal Relations, Light and Life Publishers: New Delhi. Government of India, 1988. Report of the Commission on Centre-State Relations, General Manager: Nasik. Government of India, 1989. Report of the Ninth Finance Commission (Second Report), Manager of Publications, New Delhi* Sinha R.K., 1987. Fiscal Federalism in India, Sterling: New Delhi. Thimmaiah, G & H. Rao, 1986. Finance Commission and Centre-State Financial Relations, Ashish; New Delhi. Thavaraj, M.J.K. 1978. Financial Administration of India, Sultan Chand & Sons: New Delhi.

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5.9 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1

1) Your answer should include the following points: Taxes which are to be levied and collected by the Union and the entire proceeds therefrom are to be retained by it. These include Corporation tax & Customs Duties. Taxes which are levied and collected by the Union but proceeds are shared with the states. These are income tax and excise duties. Taxes which are levied and collected by the union but retained by the states. These are estate duties and terminal taxes on goods and services. These are taxes which are. levied by the union but collected and retained by the states. These are.excise duties on medicinal and toilet preparations (containing alcohol and opium).

Your answer should include the following points: The Constitution provides for the setting up of a Finance Commission. Broadly its functions are to make recommendations to the President in respect of: 1) the distribution of net proceeds of taxes to be shared between the Union and the States and the allocation of such shares among the States. 2) The principles which should govern the payment of the Union grants-in-aid of the revenues of the States; and 3) any other matter concerning financial relations between the Union and the States.

3) Your answer should include the following points: Constitutional limitations relating to the functioning of Finance Commission. Constraints imposed by the Union Government by prescribing certain terms of reference Non-implementation of important recommendations of the Finance Commission by the Union Government Problems arising out of the methodologies adopted by the Commission.
The suggestions offered by the Sarkaria Commission in this context include: Enlarging the functions of the Finance Commission Making it a permanent o r standing body to cope with enlarged responsibilities. Facilitating coordination between the Finance Commission and the Planning Commission. Provision of a permanent and well equipped Secretariat to the Commission.
Check Your Pmgress 2

1) Your answer should 'include the following points: The broad functidns of the Planning Commission are: Assessment of material, capital and human resources; formulation of a plan for their effective and balanced utilisation; allocation of resources; review and mid-term appraisal; policy issues of a developmental nature. 2) Your answer should include the following points: Functions of the National Development Council are: reviewing the working of the National Plan from time to time. considering important questions of social and economic policy; and recommending measures for the achievement of the aims and targets of the National Plan. 3) y o u r answer should include the following points: Devolution of sources include: transfers based on. the recommendations of the Finance Commission transfers by way of assistance for execution of the plans recommended by the Planning Commission.
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4) Your answer should include the following points: Inelastic tax resources and narrow tax base of the states Inadequate devolution of taxes levied and collected by the central government thereby reducing finances given to the states Heavy dependence of the states on the union for financial resources leading to progressive erosion of their jurisdiction, authority and initiative. Rising indebtedness of states.

UNIT 6
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FISCAL POLICY, EQUITY AND SOCIAL JUSTICE

Objectives Introduction Fiscal Policy-Meaning Objectives of Fiscal Policy Fiscal Policy in Operation-Some Highlights Fiscal Policy-Equity and Social Justice Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

6.0

OBJECTIVES

After going through this unit, you should be able to : explain the meaning and scope of fiscal policy indicate the important objectives of fiscal policy highlight the contribution of fiscal policy in defusing the recent crisis in the balance of payments faced by the country; and discuss fiscal policy instruments and their; utility in bringing about a significant measure of equity and social justice in the society. '

6.1

INTRODUCTION

The term "fiscal" has been derived from the Greek word 'fisc' for basket which symbolised the treasury or the public purse. It simply means the exchequer or the government treasury. Fiscal policy is that part of economic policy which is mainly concerned with the revenues and expenditures of the government. It often includes public debt. Resources are raised through taxes, non-tax sources and borrowings within the country and from abroad. The policies that the government pursues in respect of raising revenues, levying taxes on income, commodities, services, exports, imports and those relating to public expenditure have a tremendous impact on the economy. In this unit we will discuss the meaning, scope and objectives of fiscal policy. We will also highlight the significance of various instruments of fiscal policy in bringing about equity and social justice in the society.

6.2

FISCAL POLICY-MEANING

Broadly speaking, fiscal policy is concerned with raising and spending financial resources and public debt operations to influence the economic activities of the community in desired ways. It is also concerned with the allocation of resources between the public and private sectors and their use in accordance with national objectives and priorities. It aims at using its three major instruments-taxes, public expenditure and public debt-as balancing factors in the development of the economy. According to Premchand "Formulation of fiscal policy presumes the identification and clear recognition of the institutional aspects of government finance, such as tax

systems, their incidence and shifting, budget formulation and execution, and financial management ." Since the state has come to occupy a pivotal role in the economic development of a country, fiscal policy is being increasingly used, through a policy of taxation of Income, commodities, imports and exports, a well designed policy of public expenditure and a policy of borrowings, to influence the economic development of the country. Government budgeting is clearly the most important instrument through which the fiscal policy is channelled. In fact, fiscal policy has come to be identified with budgetary policy and the two terms are often used interchangeably.

6.3

OBJECTIVES OF FISCAL POLICY

The important objectives of fiscal policy include :

i) To increase the rate of capital formation In order to promote and sustain economic development, the rate of capital formation has to be much higher than that prevailing in most of the underdeveloped countries. A high rate of economic growth, sustained over a long period is an essential condition for achieving a rising level of living. Since an increase in the rate of growth does not come about automatically, the main objective of fiscal policy is to allocate more resources for investment and to restrain consumption.
ii) Reduction in economic inequalities of income and wealth A major contribution of fiscal policy consists in minimising the adverse distributional impact of government policies. For instance, in a developing country like India, the need for alleviation of poverty is self-evident. There is, however, yet no evidence that the process of economic development has had any positive economic impact on the impoverished classes. Mobilisation of resources for financing the anti-poverty programmes, such as Integrated Rural Development Programme, Jawahar Rozgar Yojana, employment guarantee schemes, etc., is an important objective of fiscal policy in India. In any case, in a democratic society political realities would not permit a further widening of the distribution patterns than at present. Either by itself, or in conjunction with other measures of social and economic reforms, the current fiscal policy has considerable potential for reducing inequalities of income. CumuIative inequalities may take time to melt away. iii) Balanced growth A primary feature of the economic scenario in developing countries i their excessive s dependence on agriculture rather than on industries and other non-agricultural occupations. The process of economic development gives rise to a greater variety of economic occupations, lesser dependence on land, and the need to provide employment to additional labour which results from mounting population pressure. Balanced development not only across income groups, but also across regions in the country can be achieved through appropriate fiscal policy instruments. Another kind of balance is that between the public sector and the private sector. There is no such thing as a pure market economy or a total centrally planned economy. Once the appropriate mix and the economic role of the state have been decided on, fiscal policy instruments a r e pressed into service to bring about the desired policy changes. iv) Economic and social overheads Fiscal policy has to be so formulated that adequate resources are available to the government for funding social expenditure which benefit the poor. Heavy investments have to be made in infrastructure for sustaining growth in agriculture and industry. The development of transport and communication, water management and irrigation projects, large scale investments in health and education, cannot be left to the private sector. Such investments are heavy and generally beyond the capacity of the private sector. Privatesector is generally interested in projects with adequate and quick returns. The government, therefore, has to have a fiscal policy which will alIow such investments in social overheads. Such investment will allow private capital to come in and by raising the productive capacity and production, the government can generate profits.

v) Control of inflation There are various causes of inflation. There can be too much money in the hands of people and two few goods and services availrble for buying. An increase in government expenditure results in an increase in payment of salaries, wages, purchase of goods and services. This puts more income in the hands of the people. An increase in wages of industrial workers also increases money income. Wages also constitute costs of inputs. If costs go up, so do prices. This is cost-push inflation. Thus inflation results either because there is too much demand (because of increased purchasing power) for too few goods or because the costs of inputs having gone up the prices rise. An appropriate fiscal policy can help in controlling inflation. A noninflationary financing of planned development will require a greater reliance on surplus generated by the budget and public sector undertakings and a reduced dependence on borrowed funds. vi) Progressive tax structure Taxes and subsidies have direct consequences for the poor to the extent that they bear the burden of taxes or benefits from the subsidies. In a developing country like India, the tax structure relies heavily on indirect taxes. This is not surprising, given the stage of development, low income levels of the majority of the people and the scope for commodity taxes offered by the growth of industry and trade. The government should try to increase the scope oT the indirect tax system, both through low tax rates on essential commodities and through subsidised distribution of foodgrains, edible oils and sugar. At the same time, an effort has to be made to increase the share of direct taxes in total tax revenue over a period of time, so that the fiscal system as a whole becomes progressive. What matters, however, is not the tax rates on paper, but the actual collections and their incidence. Fiscal policy must, therefore, ensure that taxes, as levied, are fully collected and strong action is taken to curb tax evasion. Check Your Progress I Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit. 1) What is the central concern of fiscal policy? What are the major aspects of government finance that fiscal policy is concerned with?

Flscd PoUq, EquYy md Sodd Jurtkc

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Indicate the important objectives of fiscal policy.

6.4

FISCAL POLICY IN OPERATION -SOME HIGHLIGHTS

Control of Inflation Currently, inflation has been described as the most important problem that the economy is faced with. A number of demand-pull and cost-push factors have been mentioned as potential causes. The inflationary surge is led mainly by agricultural goods. The prices of manufactured goods have not even kept pace with average inflation, and, have lagged well behind the rise in agricultural prices. Along with demand-pull factors, supply factors (scarcity or short supply) have determined the pattern of relative price changes. Agricultural prices were increased by a rather *or kharif crop of 1990 which followed on the heels of a poor rabi crop earlier in the

same year. Imports could not be used to increase supplies and dampen prices because of the severe balance of payments problem being faced by the economy. The sharp increases in procurement prices for foodgrains have also contributed to the inflationary pressure. The excess demand pressures in the economy were primarily generated by expansionary fiscal policies of the central and state governments. Firstly, the investment expenditure of the government has far exceeded their savings. The excess demand of the government represented by its excess over saving has been met from these sources: (I) domestic borrowing; (2) foreign borrowing; and (3) borrowing from Reserve Bank of India. While borrowing from the commercial banking system cannot go beyond a point, foreign borrowings are also no longer freely available to finance excess of expenditure over receipts from domestic borrowings. If ,the recourse to foreign borrowings is to be reduced, either domestic investment must be reduced. with undesirable consequences, or domestic savings must be raised. The third source for borrowings is the Reserve Bank of India. This is directly connected to the expansion of money supply and consequently to inflation. The monetised deficit (that is, the part of the fiscal deficit that leads to an increase in money supply) has been rising. The monetised deficit of the central government shows a fair degree of correspondence with the rate of inflation. Apart from the immediate net increase in expenditure, monetisation of the deficit builds up a level of liquidity which leads to a general increase in demand, and hence inflation, in the succeeding years. Thus the government needs to reduce its reliance on all the three present sources of funds : compulsory borrowings through the banking system, the monetised deficit and foreign borrowings. In order to reduce the fiscal deficit, the government has had to permit an increase in the administered prices of some basic goods and services. It incidentally increased input costs in the rest of the economy, thereby bringing about cost-push inflation also. Devaluation of the rupee in July, 1991 led to an increase in import costs. In order to combat inflation, the Government launched a massive effort to correct the fiscal imbalance by reducing the fiscal deficit from 8.4 per cent of Gross Domestic Product (GDP) in 1990-9 1 to 6.5 per cent in 1991-92 and further to about 5 per cent in 1992-93. Other measures in this direction include containing the growth of aggregate demand; tightening of selective credit controls; and revamping and extending the public distribution system. Results will take some time to show up. Balance of Payments The domestic and external sectors of an economy are interrelated. When domestic income is equal to domestic expenditure, the external accounts are in balance. Excess domestic demand caused by an excess of investment over saving leads to domestic inflation. It can also result in a deficit in the balance of payments. India entered the decade of nineties with large internal and external financial imbalances which made the economy highly vulnerable to external shocks. The Gulf crisis resulted in a higher import bill and a further loss of export markets and remittances. External commercial borrowings declined sharply. The drying up of commercial loans was accompanied by a substantial net outflow of deposits by NonResident Indians. The rapid loss of reserves prompted the government to take,a number of counter measures leading to a reduction in imports. Import reduction beyond a point would affect the entry of the essential inputs into industry and transport, petroleum products and fertilisers. This led to a decline in industrial production and a fall in exports as import compression had reached a stage when it threatened widespread loss of production and employment and verged on economic chaos. The government, therefore, moved to implement a programme of macroeconomic stabilisation through fiscal correction. A key element in the stabilisation effort was the attempt to restore fiscal discipline. Both the balance of payments problems which were building up over the past few years and the persistent inflationary pressure were the result, of large budgetary fiscal

deficits which characterised the economy year after year. The budget deficit was about Rs. 11,000 crore in 1990-91. A reversal of the trend of fiscal 'expansionism was essential to restore macro-economic balance in the economy. The budget for 1991-92 brought down the deficit to about Rs. 7,000 crore. Similarly, reduction in the fiscal deficit (the overall resource gap of the Government) was envisaged by about two percentage points from around 8.4 per cent of GDP to 6.5 per cent of GDP. This was to be followed by a further reduction in 1992-93 to 5 per cent of the GDP. These improvements in fiscal performance were made possible by the decision to abolish export subsidies, increase fertiliser prices, as well as the steps taken to keep non-plan expenditure (including defence expenditure) in check. These measures have reduced total expenditure, thereby reducing the current account deficit. These fiscal policy measuns have been complemented by (i) exchange rate adjustment (devaluation of the rupee), (ii) a programme of structural reforms of trade, and (iii) industrial and public sector policies. The objective is to evolve an industrial and trade policy framework which would promote efficiency, make the economy internationally competitive, promote exports and generally integrate the Indian economy with the global economy. While the crisis has blown over, the policy reforms introduced by the government are necessary from the long term point of view. Cut in Expenditure Ever since the beginning of the planning era in India, the central government expenditure has increased enormously. The total expenditure which was Rs. 529 crore in 1950-51 has gone up to Rs. 1.19.087 crore in 1992-93 (budget estimates), an increase of 225 times. Revenue expenditure has grown at a faster rate. It went up from Rs. 347 crore in 1950-51 t o 89,570 crore in 1992-93. Capital expenditure, however, grew at a slower pace. It increased from Rs. 183 crore in 1950-51 to Rs. 29,5 17 crore in 1992-93, an increase of 161 times. All this when the national income during the same period went up from Rs. 8,938 crore to Rs. 4,25,672 crore (estimated), which is about 48 times. (For further details, see Unit 10 of Block 3.) Another disturbing feature of the Union Budgets is the mismatch between revenues and expenditure of the wrong kind. Beginning with second plan right up to fifth plan, the revenue account of the budget always had a surplus and this partly offset the deficit in the capital account. But during the sixth plan the revenue account no longer assumed the "compensatory role". Beginning 1988-89, the capital account has been showing a surplus and thus playing the reverse role of moderating the revenue account deficit. Thus the plain meaning of this situation is that the government cannot raise enough revenues to sustain the ordinary business of governing the country. It has to borrow from the capital market to pay for its day to day expenses.
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What an underdeveloped country should aim at is to have a surplus in its revenue account by raising maximum resources, through taxation, and by keeping the consumption expenditure as low as possible. This surplus should be used to finance the capital budget. The deficit on the revenue account is either an index of an inadequate tax policy or possible extravagance in public expenditure on consumption or both. Such deficits would mean negative savings and consumption of capital. The effect of deficit financing is to cause a rise in the domestic price level and to generate demands for wages. This leads to an increase in prices of input costs making the economy noncompetitive. Substitution of foreign goods for domestic goods may lead to balance of payments problems and depreciation of the exchange value of the rupee. A reduction in government expenditure, by reducing excess demand, will soften inflationary pressure.

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Can government expenditure be reduced? "The newly evolving analysis of bureaucracy by economists provides more rigorous underpinning for an old conclusion popularly known as 'Parkinsons Law' (Refer to Section 6.7 for explanation). Bureaucrats maximise their own utility and the principal variable in their "utility function" is power. Power can be roughly measured by a proxy such as the size of the bureaucrat's budget, or the size of the department by the number of employees. Bureaucrats identify themselves with the stated goals of their department and achieve their satisfaction in life in large part by expanding their activity. They will strongly resist any attempt to dismantle a government organisation. The governments, even when they make genuine efforts to reduce expenditure, usually d o

so by slowing down the rate of expenditure growth. Reduction in the absolute level of expenditure is rarely possible. Dahl and Lindblom pointed out in 'Income Stabilization in a Developing Democracy' (Max Milliken, ed. Yale University Press. New Haven 1956), government expenditures generally mean that "services are performed, values are realised, administrative organisations developed, expectations expanded, clienteles formed, interest groups created, pressures mobilised, and once these are set in motion, they cannot easily be contracted". The balance of payments crisis that overtook the government left it with no option but to take corrective fiscal action immediately. Containing and reducing non plan expenditure has been the avowed policy of the government for some years now. It is only with the budget for 1991-92 and 1992-93, that a serious effort has been made in this direction. The important policy initiatives introduced in the 1991-92 budget included (i) reduction in the fertiliser subsidy; (ii) abolition of cash compensatory scheme; and (iii) disinvestment in some selected public sector enterprises. As a result of these adjustments, the provision for nonplan expenditure, excluding interest payments, in 1991-92, represented a reduction of about 5 per cent compared with the provision in the revised estimates for 1990-91, and a reduction of almost 15 per cent in relation to what would have had to be provided, but for the fscal correction. Interest charges are the largest single item of nonplan expenditure and account for Rs. 32,000 crore in the budget estimates for 1992-93 and account for about 27 per cent of the total expenditure and about 38 per cent of the nonplan expenditure. The provision for 1992-93 represented an increase of Rs. 4,750 crore over the revised estimates for 1991-92. lnterest charges are a committed expenditure reflecting the cumulative effect of past deficits. These charges can be controlled by reducing the reliance on borrowed funds, and making the debts productive and self-liquidating. In the ultimate analysis, a reduction in revenue expenditure and hence revenue deficit can alone provide a solution of lasting nature. This indeed is a daunting task. Expenditure on defence and subsidies are the other major components of nonplan expenditure. In real terms, the defence expenditure has already been contained, if not marginally reduced. The question of subsidies is being investigated by a Parliamentary Committee. In any effort at reducing expenditure and hence deficits, the first casualty usually is plan expenditure. Even though in nominal terms, plan expenditure is marginally Higher, in real terms it represents a significant reduction. This is in tune with the new economic philosophy of the government which accords larger economic space to the private sector. With this multipronged strategy, the government has been able to bring down the fiscal deficit from 8.4 per cent of the GDP (1990-9 1) to 6.2 per cent in 1991-92and hopes further to reduce it to almost 5 per cent in 1992-93. This shows a welcome recognition of the paramount need to restore macroeconomic balance and manage the balance of payments.

6.5

FISCAL POLICY-EQUITY JUSTICE

A N D SOCIAL

According to the long term fiscal policy, the major contribution of fiscal policy to poverty alleviation has to come through an effective programme for (i) mobiIisation of additional resources which can be used for financing the anti-poverty programmes, (ii) for improving the social and economic services on which the poor mainly,rely and (iii) for financing the heavy investments in infrastructure, which are necessary for sustaining growth in agriculture and industry. The anti-poverty programmes and social services have to be financed by the government. Fiscal policy has to be so formulated that adequate resources are available to the government for funding social expenditure which benefits the poor. Alleviation of poverty has been an objective of the government policy, particularly after the fourth five year plan. Several special programmes have been in operation over the last two decades focusing on the poor as the target group. As a result, the extent of incidence of absolute poverty had declined over the years. The overall improvement in human resources, as evident from the estimates of incidence of poverty made by the Planning Commission, is given in the table below:

I

D t h m of Incidence of Poverty (per cent)

Urban
All India

41.2

38.2 48.3

.28.1 37.4

20.1 29.9

51.5

L

l i

The reduction in the incidence of poverty is being brought about both by (I) the growth of the economy, particularly in agriculture, and (2) by the implementation of development programmes especially designed to improve the incomeearning opportunities of the poor. In the coming years, the Centre's expenditure policies will accord an even higher priority to programmes benefiting the poor, such as the Integrated Rural Development Programme, the National Rural Employment Programme and the Rural Landless Employment Gaurantee Programme. In addition to the budgetary allocation for Rural Development programmes, an additional allocation (1992-93) is to be made available from the corpus of the National Renewal Fund for employment generation schemes to supplement the normal employment generation through the Jawahar Rozgar Yojana. An additional allocation of foodgrains, through the Public Distribution System, in the 1700 most backward blocks at a subsidised rate, is another step for protecting these vulnerable sections of society from the pressure on prices. Another important way in which fiscal policy can contribute to the reduction of poverty is to encourage rapid economic growth and fast expansion of productive employment opportunities. Taxation has significant effects on savings and investment in the economy,on the allocation and uses of resources between alternative sectors, and on the efficiency with which resources are utilised. A progressive tax structure becomes inevitable if inequalities of income are to be process of industrial development always benefits the affluent reduced. Nor~ml sections of society. It is from them that resources can be mobilised for financing poverty alleviation programmes. Such a tax structure would rely heavily on direct taxes on income and wealth. Our tax structure, unfortunately, relies largely on indirect taxes. The time is ripe to have a look at the tax system which has evolved over a long period and has become extremely complex. The taxation system has to be simplified, made more progressive so that none of our basic objectives of growth and social justice are compromised. Food subsidy is a pan of the system of food security for the poorer and weaker sections of the population and is a basic element in the social policy. This is being continued. Fertiliser subsidy has become the largest single subsidy in the fiscal system. There is no doubt that fertiliser is an essential ingredient for agricultural production. Agricultural development is vital not only for economic growth in general, but also to ensure rising levels of income and employment in rural areas. In 1980-81, fertiliser subsidy was just 12 per cent of the total allocation in the Central and State Plans taken together, for Agricultural Rural Development Special Area Programmes and Irrigation and Flood Control. It increased to 33 per cent in 199192. Measures for better targeting and containing it are under investigation. For the present, this is being continued. Thus ends of social justice and equity are being served by the fiscal policy. Once the economy goes through the macro-economic stabilisation and structural reforms come to fruition, it should be possible to do much more in programmes of poverty alleviation, employment generation, public distribution systems, etc.
peck Your Progress 2

*

'Note : i) Use the space given below for your answers.
I

I

ii) Check your answers with those given. at the end of the unit. riefly describe the contribution made by fiscal policy in defusing the recent balance of payments crisis in India.

......................................................................................... ......................................................................................... ......................................................................................... .........................................................................................
2) How has fiscal policy helped in reducing inequalities of income?

......................................................................................... ......................................................................................... .........................................................................................

6.6

LET US SUM UP

Fiscal policy is concerned withi(l) raising financial resources and spending them and

(2) public debt operations to influence the economic activities of the community in
desired ways. It is also concerned with the allocation of resources between the public and private sectors and their use in accordance with national objectives and priorities. The objectives of fiscal policy are (i) to increase the rate of capital formation for promoting and sustaining a high rate of growth; (ii) reduction in economic inequalities of income and wealth through poverty alleviation programmes, generation of employment opportunities, a progressive tax structure and a system of subsidies which benefit the poor; (iii) balanced growth; (iv) provision of economic and social overheads; (v) control of inflation; and (vi) a progressive tax structure. How has fiscal policy contributed to the attainment of the objectives it is credited with? As we have discussed in the unit, three of the most important aspects are: control of inflation, balance of payments and reduction in public expenditure. The economy is an integrated whole. The best contribution that fiscal policy has made is in helping to pull the country away from the brink of an economic disaster. The balance of payments crisis could be defused through a series of policy measures which included fiscal corrections, trade policy reforms and industrial policy reforms. The excess demand pressures in the economy were generated by expansionary fiscal policies of central and state governments. The government had to cut down on its fiscal deficit. The reckless increase in the fiscal deficit had spilled over to the external sector and triggered the balance of payments crisis. Several measures were, therefore, taken to introduce fiscal discipline in the country. A serious effort was made to (i) contain nonplan expenditure; (ii) undertake disinvestment in the public enterprises; (iii) increase some administered prices to generate revenues; (iv) bring about devaluation of the rupee so that exports could be encouraged; and (v) introduce structural reforms in trade. industrial policy, public sector etc. In order to tide over the crisis, massive credits were negotiated with the International Monetary Fund and the World Bank. The crisis has blown over. But fiscal discipline will need to be observed for many years before the economy can turn the corner.

6.7

KEY WORDS

Budget Deficit : It is the difference between all receipts and expenditure, both revenue and capital. This difference is met by the net addition to the treasury bills issued by the central government and drawing down of cash balances kept with the Reserve Bank of India. .

Cost-Push Inflation : It is a situation in which consumer and industrial prices keep rising owing to a cantinuing demand for higher wages.

Gross Domestic Product :The total value of goods and services that are produced within a country over a specified period. usually one year, excluding all those goods and services used during that period to produce further goods and-services.

G n a FLpd Dclldt :It refers to the total resource gap in terms of excess of total ~ government expenditure over revenue receipts and grants. This concept fully reflects the indebtedness of the government.
Integrated R u n l Development Programme (IRDP) :This is an antipoverty programme introduced in the sixth five year plan period during 1978-79 with the objective of bringing about economic, social and cultural transformation of rural. sector by generating additional employment opportunities and reducing the number of those living below the poverty line. The programme aimed at raising income and employment opportunities of landless, marginal farmers, poor rural artisans, scheduled castes and tribes through agricultural, and animal husbandry practices, village craft and services etc. J a m b Rozgar Yojam : This is an employment programme announced during the seventh five year plan in 1989. The earlier existing two rural wage employment programmes i.e. NREP and RLEGP got merged into this scheme. The intention of this scheme is to provide employment to atleast one person in every family living below the poverty line in rural area for atleast 50-100 days in a year.
'

Market Economy : An economic system in which the question of what to produce, how much to produce and for whom to produce are decided in an open market through the free operation of supply and demand.

Monethcd Deficit : It is the increase in the net Reserve Bank of India credit to the central government. It is the part of fiscal deficit which leads to an increase in money supply. N a t i o d R u n l Employment P r q n m m e (NREP) :This was started in 1980, with the objective of generating additional employment opportunities for the rural people, particularly to that segment which is without assets.
Natiolul Renewal Fund : It was set up by the government recently with the aim of taking care of workers, who go out of employment by the proposed closure of terminally sick public sector units in the country. It will be used to provide a safety net to workers in sick enterprises and to finance their retraining and redeployment. Revenue Ddidt :It denotes the difference between revenue receipts and revenue expenditure. Rrkhmn's Law :This gives Cyril Northcote Parkinson's satirical view of the effectiveness of human beings and their organisations. The law holds that 'work expands so as to fill the time available for its completion'. It was then formulated to apply to government redtape and bureaucratic inefficiency in Britain. R u n l Landless Employment Guuantee Programme (RLEGP) :This was initiated in 1983 with the objective of providing gainful employment for the rural landless labourers by creation of productive assets, strengthening rural socioeconomic infrastructure and thereby improving the overall quality of life in the rural areas.

REFERENCES
Government of India, 1985. Long Term Fiscal Policy, New Delhi. Government of India, 1991. Economic Survey 1991-92, Manager. Government of India Press, h e w Dclhi. Government of India, 1992. Annual Budget 1992-93, Manager, Government of India Press, New Delhi. Gowda, Venktatagiri K.. 1987. Fiscal Revolution in India, Indus Publishing Company, New Dewi.

N..naw; -.

Thavaraj, M J.K., 1978. Financial Administration in India, S u l t a n - C h d & Sons,

ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1

I)

Your answer should include the following points : Fiscal policy is concerned with (I) raising financial resources and spending them and (2) public debt operations to influence the economic activities of the community in desired ways. It is also concerned with the allocation of resouras between the public and private sectors and their use in accordance with national objectives and priorities. It aims at using its three major instruments-taxes, public expenditure and public debt as balancing factors in the development of the economy.

2) Your answer should include the following points : The important objectives of fiscal policy include'the following : To increase the rate of capital formation. reduction in economic inequalities of income and wealth. help in achieving balanced growth. emphasise on the provision of economic and social overheads. guidance in designing d progressive tax structure.
Check Your Progras 2

I) Your answer should include the following points : Fiscal deficit had to be reduced substantially so that the primary cause of inflation could be eliminated. Balance of payments crisis had to be defused through several policy measures including fiscal corrections.
A significant reduction in total government expenditure was achieved through a series of measures.

2) Your answer should include the following points : Poverty alleviation programmes such as rural development programmes, rural implement generation schemes etc., have been financed by the government. Pressures on prices in respect of essential commodities have been softened through public distribution system. System of taxes and subsidieu which benefit the poor has been put in place.

UNIT 7 -GOVERNMENT BUDGETING :PRINCIPLES A N D FUNCTIONS
Structure
7.0 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 Objectives Introduction Budget-Meaning Characteristics of Budget Functions of Budget Classification of Budgets Budget-An Illustration Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

7.0

OBJECTIVES

After studying this unit. you should be able to : state the meaning and components of budget explain the general characteristics of budgeting systems identify the important functions which budgets usually perform; and describe the classification system according to which budgeted expenditures are classified.

7.1

INTRODUCTION

A single item of public expenditure or that of public revenue cannot be judged in isolation. Whereas public expenditure is designed to promote welfare, the taxes impose costs on the tax payers. The welfare and costs, utility and disutility of government financial transactions, need to be balanced. The demands for expenditure have to be balanced against the available resources. A b-udget is, therefore, a financial plan for rationing scarce resources amongst various demands for expenditure. Over the last few decades, however, budgets have become extremely complex and pervasive. According to Gladstone "they are no longer affairs of arithmetic but in a thousand ways go to the root of prosperity of individuals, the relations of classes and strength of kingdomsw.Thus the concerns of budget makers are not just financial, that is, producing a balance between expenditure and revenues; rather these are economic, political, social and administrative in nature. In this unit, we will discuss the meaning, characteristics and functions of budget. The three-fold classification of budget shall also be examined.

7.2

BUDGET-MEANING

qrbudget is a statement containing a forecast of revenues and expenditures for a period of time, usually a year. It is a comprehensive plan of action designed to achieve the policy objectives set by the government for the coming year. A budget is a plan and a budget document is a reflection of what the government expects to do in future. While any plan need not be a budget, a budget has to be necessarily a plan. It shows detailed &location of resources and p r o p o d taxation or other measures for their realisation. More specifically, a budget contains information about :

-8 sydwm-I

M PY

i)

plans, programmes, pro~ects, schemes and activities-current as well as new proposals for the coming year;

ii) resource position and income from different sources, including tax and non-tax revenues; iii) actual receipts and expenditure for the previous year; and iv) economic, statistical and accounting data regarding financial and physical performance of the various agencies and organs of the government.
A budget is, however, not a balance sheet (exhibiting total assets and liabilities) of the government on a particular date but refers only to information explained above. It is a financial blueprint for action and is, therefore, of great advantage to government departments, legislatures and citizens.

7.3
i)

CHARACTERISTICS OF BUDGET

The basic characteristics of government budgeting are as follows : There is a strong emphasis on expenditure control with itemised ceilings and sanctions. The French system of budgeting is largely based on this principle, viz. : a strong financial control system. For historical and administrative reasons, Indian budgetary system is also set in a framework of strong financial control. Although, after Independence, this feature has become diluted through various schemes of delegation of powers and decentralisation.

ii) Another characteristic is the tendency towards incrementalism. The bulk of ongoing activities is left untouched. Only marginal adjustments are made in raising and allocating resources from one year to the other. In spite of various budgetary innovations, budgetary systems the world over are essentially incremental in nature. iii) There is usually no attempt to relate inputs to outputs or expenditure to performance and benefits. Any such attempt, if at all it is made, is limited to the economic function and the largest component of government activities, perse, are mainly expenditure-oriented. iv) Generally budgets are prepared for a time span of one year. Since budgeting presupposes planning it must, therefore, adopt a longer time frame. v) Some of the budgetary systems (Netherlands) reflect application of commercial principles t o budget, including provision of depreciation allowances and in some systems, accrual-based aqounting. The Italian budgetary system shows the availability of funds beyond the financial year with parallel operation of the preceding and current year's budgets. vi) In some countries, special accounts are maintained (Japan) and these are outside the budgetary process. In other countries, extra-budgetary devices of various types are resorted to

Check Your Progress 1 Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.
I) What are the components of a budget?

2) Discuss the characteristics of government hl~dget.

.......................................................................................
2

Government Budgeting :Prhdplr and Functbm

7.4

FUNCTIONS OF BUDGET

A budget is a powerful instrument in the hands of government. It has manifold objectives. Some of these are as follows:

Aecount.bility In the early phase, legislative control and accountability were the primary functions of the government budget. This arose from the legislature's desire to control (impose, amend and approve) tax proposals and spending. The executive was accountable to the legislature for spending-within limits approved by the latter, under several heads of expenditure, and only for approved purposes. Similar accountability was to exist within the executive on the part of each subordinate authority to the one immediately above in the hierarchy of delegation. Accountability continues to be an important function of the government budget even today owing to its usefulness in budget execution and plan implementation. Management Budgeting is an executive or managerial function. As an effective.tool of management, budgeting involves planning, coordination, control, evaluation, reporting and review. Many of the budgetary innovations such as :
functional classification, performance measurement through norms and standards, accounting classsification to correspond to functional classification, costing and performance audit and use of quantitative techniques have become important aids to management. Various budgetary systems like performance budgeting and zero base budgeting are specifically management-oriented systems.

Coatml Control essentially implies a hierarchy of responsibility, embracing the entire range of executive agencies, for the money collected and expenditure, within the framework of overall accountability to the legislature. In a democracy, control assumes new dimensions and gives rise to exceedingly difficult problems. The basic concern in a truly representative government is to bring about suitable modifcations in the uesign and operation of the financial system so as to ensure executive responsibility to the legislature which is the law-making, revenue determining and fund-granting authority.
Legislative control would mean that the legislature can meaningfully, and not merely formally, participate in the formulation of broad policies and programmes, their scrutiny, approval and implementation through the annual budget. It also means that the legislature can effectively relate performance and achievement of the executive to the objectives and policies as laid down by it. Members of the legislature are not always adequately acquainted with the complexities of financial administration, nor can they always understand the enormity of the vast scale of operations and therefore the level of funds required. Various devices are, therefore, used to assist legislatures in exercising their legitimate powers over the executive. The Congressional committees of the United States and the Parliamentary Select committees of the United Kingdom and India help the legislature in exercising their control over the public purse. We shall be discussing in detail about the role of financial Committees in Unit 19 of Block 6 of this course. Statutory audit also examines the accounts and other relevant records to ensure that the moneys granted by the legislature are spent strictly in accordance with law. Also, audit tries to ensure that the government obtains value for the tax-payers' money and that the norms of economy, efficiency and effectiveness are observed.

Planning Budgeting provides a plan of action for the next financial year. Planning, however, involves the (i) determination of long term and short term objectives,

6udg&al and Budgetary
Sy*1111-l

($determination of quantified targets, and (iii) fixation of priorities. Planning also spans a whole range of government policies keeping the time factor and interrelationships between policies in view. Planning envisages broad policy choices. At the level of projects and programmes, the choice is between alternative courses of action so as to optimise the resource utilisation. The goals of public sector, viz., (i) optimal allocation of resources, (ii) stabilisation of economic activity. (iii) an equitable distribution of income, and (iv) the promotion of economic growth are all pursued in an organisational context. In the short-run, achievement of these goals has to be co-ordinated by means of administrative and legal instruments among which budget policy and procedure are the most important. Planning in the budget process reflects political pressures as well as financial pressures and financial analysis.

7.5

CLASSIFICATION OF BUDGETS

Information on the working of the budgetary process is obtained from the systems of classification. Since such a process has a multitude of functions and objectives, different types of classification are needed, either singly or in combination to serve the purpose of appropriation, programme management and review, evaluation of plan implementation and financial and economic analysis. Transactions of the government can be classified by objects such as salaries, wages etc.; organisation or department; functions such as defence, education, agriculture, etc.; their economic character such as consumption expenditure, capital formation, etc. The system of classification of expenditure is a very important aspect of the budget for the fulfilment of budgetary functions. It is through the classification system that the managerial potential of budgeting process may be realised. Let us now discuss some of the most important classification systems. They are : Object-wise or line-item or traditional classification Functional classification ~conomic classification
Object-whe CLurllication Traditional budgeting ensures control of expenditure and the need t o ensure accountability of the executive to the legislature as well as that of the subordinate formations of the executive to the higher echelons. The budget is divided into sections according to organisational units, departments, divisions and expenditure is detailed by each category such as salary, wages, etc. A typical classification would be as follows :

I) 2) 3) 4) 5)
6)

7) 8) 9)

Salary Wages Travelling allowance Office expenses Machinery and equipment Works Grants-in-aid Other charges Suspense account
As a l m d y stated, the rationale for this type of classification was the need to facilitate control and accountability. Inter-agency, inter-organiation and interdepartment comparison of expenditure could easily be made. This information would also be available on a time-aeries basis, that is, from year to year, so that the departments conarned could be pulled up if the expenditure trends, as revealed through this classification, were not satisfactory.

Mrt ei8
i)

ri) It shows clear allocation of funds. For example, what percentage of the expenditure is on salaries, travelling allowances, etc. iii) In times of financial stringency, this classification enables across-the-board cuts on specific heads such as travelling allowances, foreign travel etc.
I

Covannmt Bdgdhg :PrMpla and Functbm

Deadta

i)
I

!

The basic philosophy of budgets with this type of classification is that spending the budgetary allocation is in itself a virtue. Whatever the amount allocated to a particular object it has to be spent, without emphasis on the likely outcome of that expenditure. Since control is not related to performance, it easily degenerates into wastefulness and extravagence. Performance thus takes a back seat.

ii) Emphasis is laid on procedural considerations, legality and regularity of expenditure and all the complex rules that are framed to satisfy regularity audit. Evaluation, justification for expenditure and obtaining value for money become only incidental. iii) Inadequate information is available about the government's objectives and programmes. The emphasis on control and accountability exerts an influence on the criteria which govern budget decisions. Programme control, contribution to development, programme co-ordination and efficient resource allocation are neglected. iv) Any duplication, redundant activities and expenditure are hard to detect and avoid. v) It is only the most pressing demands which receive attention of the budget makers. Policies, programmes and projects which have only long term benefits, usually get postponed year after year.

Functional Claesificrtion
Performance budgeting is based on a "conviction that the way in which revenue and expenditure are grouped for decision making is the most important aspect of budgeting''. A functional classification of the budget is necessary under the system of performance budgeting. The presentation of budgeted expenditure should, therefore, be in t e r n of functions, programmes, activities and projects. Such a classification is an aid to the managerial function of performance measurement relative to the costs incurred. The output of a prograrnmelactivity in terms of physical targets has to be related to the inputs required. These are translated into financial terms and shown as the budget provision asked for the implementation of the programmelactivity. The scheme of functional classification is outlined below :

FUNCTIONAL CLASSIFICATION
Fuaction A major division of governmental efforts which provides distinct services. A segment of a function usually having an end identfible with a major organisation. 1)
2) 3) 4)

Education Health Defence Agriculture Elementary education Secondary education Higher education Technical] Vocational education National Malaria Eradication Programme Development of High Yielding Crops

Propamme

1)

Activity/

RoPct

A division of a prognmme into homopneour typa of work or rbcma

I)

Construction of echo01 buildings Stmngihening of kbonlories Purchase of seeds/ fenilLcn

2)

Another example of a functional classification of roads will classify the system as :
Funct~on Programmes
: Roads : 1)

National Hi%ways Roads of Economic or Inter-State importance Strategic Roads State Highways Major District Roads Rural Roads

2) 3)

4)

5)
6)

Activity/(under the Programme : National Highways) Project : 1) Maintenance of Roads 2) Construction of Bridges on the National Highways Km x I .................to .................x 10

3) Restoration of Missing Links

4) Widening of Roads

5) Construction of Bye-pass
6) Grade Improvement etc.
The terms function, programme, activity and project have definite connotations; in practice, however, these can be quite flexible, the only requirement being that these terms should be used in a consistent manner over the entire span of a departmental budget and also as between different departments of the government. This type of classificat~on provides information about the nature of sources of the government and the share of public expenditure directed towards that particular budgetary control-administrative accountability. An important point to be noted is that the total budget provision, however classified, s has to be the same; as it i the same budget which is submitted to the legislature for approval. Economic Clasification The budget of the government has an impact on the economy as a whole. Because of its sheer magnitude, receipts and expenditure of the government and various policies that are articulated through the budget, are easily the most significant factors that can and do change the very nature, content and direction of the economy. It is, therefore, important to group the budgetary provisions in terms of economic magnitudes, for example, how much is set aside for capital formation, how much is spent directly by the government and how much is transferred by government to other sectors of the economy by way of grants, loans, etc. Economic classification categorises government's total expenditure into meaningful economic heads like investment, consumption, generation of income, capital formation etc. According to the Economic and Social Council of the United Nations (Economic classification provides) "an analysis of the transaction of Government bodies according to homogenous economlc categories of transactions with the other sectors of the economy directly affected by them". This analysis is contained in a separate document called Economic and Functional Classification of the Central Government Budget, and is brought out by the Ministry of Finance. A broad categorisation is as follows : Economic Classification of Total Expenditure
1)

Consumption Expendir'ure

a) Defence b) Other Government Administration 2) Transfer Payments (current) a ) Interest Payments b) Subsidies c) Grants to States and Union Territories d ) Others
3) Gross capital formation of budgetary resources

a) Physical Assets b) Financial Assets

4) Others 5) Total Expenditure
An annual comparison would show whether the expenditure on capital formation is increasing or declining. A decline would be due to increase either in consumption expenditure or in the transfer payments, say interest.

Covult#lnmtB o d H n :Prhdpk mod Functlom

7.6

BUDGET-AN ILLUSTRATION

The Budget 1992-93 of the Government of India is reproduced below. It indicates brief receipts and disbursements along with broad details of tax revenues and other receipts. A broad break-up of expenditure-plan and nonplan, capital and revenue is also given. The excess of government's menue expenditure over revenue receipts constitutes revenue deficit of government. Taking into account the capital expenditure and the capital receipts also, there is a gap of a year between receipts and expenditure. This total borrowing requirement of the government from all sources equals the fiscal deficit. This is the difference between the total expenditure of Government by way of menue, capital and loans (net of repayments) on the one hand and revenue receipts of governments and capital receipts which are not in the nature of borrowing but which finally accrue to the government, on the other.

W E WW W

Budget at a Chnee
,.
(*

m)(In crores of Rupees)
I ~ I - 9 2 192-93 rJrr

1-1-92 rJrr

mfh
=T-

=TBudget Estimates

=Tt& s d I Estimates

Revised Estimates

I. Revenue Receipts 2. Tax Revenue

54954 42978 .I1976 ,39015 5712

3.
4. 5. 6. 7.

(Net to Centre) Non-Tax Revenue Capital Receipts Recoveries d Loano Other Receipts Borrowings and other liabilitica Total Receipts (1 + 4)

...

33303

8.

Y3%9 76198 60850 1 5348 291 18 12666 16452

9. Non-Plan Expenditure 10 On Revenue Account II. On Capital Account 12. Plan Expenditure 13. On Revenue Account 14 On Capital Account 15. Total Expenditure (9 + 12) 16. Revenue Expenditure ( l o + 13) 17. Capital Expenditure (11 + 14) 18. Revenue Dcfrit (1-16) 19. Budgetary Defic~t (8- 15) 20. Fiscal Deficit [(I + 5 +6)-15= 7 + 191

105316 73516 31800 18562 11347

44650

21. m-&rft*dk BPJ*tiWm

*@T mmif
#

Increase in net RBI Credit to Central Government #

14745

7719

8800

5389##

m - & r ~ b 3 m ~ U W K

#

d h ~ W i T * @ ~

w-w
'

*

Including other variations in Reserve Bank of India's credit to Central Government.

l

##

e a ~ a ~ m a ~ l f t m ~ m n l

##

Not independently estimated.

\Check Your Progress 2 / Note : i) Use the space given below for your answers.

1 '

ii) Check your answers with those given at the end of the unit. 1) What are the functions of a budget?
,

.

.......................................................................................... .........................................................................................
2)

What is object-wise classification of budget? Discuss its demerits.

.........................................................................................
......................................................................................... ......................................................................................... .........................................................................................
3) Explain economic classification of budget.

......................................................................................... ......................................................................................... ............................................................................................

7.7

LET US SUM UP

4 budget is an annual financial statement containing a forecast of revenues and expenditures of the government for a financial year. It shows a break up of expenditure, proposed taxation or other measures for raising resources. Budget is usually for one year, is incremental in nature and expenditure-oriented. As discussed in the unit, budget is a powerful instrument with manifold objectives in the hands of government. Primarily it was viewed as an instrument of legislative control and accountability. In the modern times, however, budgeting has become management-oriented and various budgetary innovations have specific managerial objectives. Budget also serves as a vehicle for implementing the developmental plans of the nation.
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Information on the working of the budgetary process is obtained from the systems of classification. Transactions of the government can be classified by objects such as salaries, wages etc; by function as defence, agriculture, industry etc., or by their economic character such as consumption, capital formation etc. These are respectively known as object-wise classification, functional classification and economic classification.

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7.8

KEY WORDS

Accrual-baaed Accountin# : An accounting system where a system of charging income and expenditure to the period in which they are earned or incurred is followed, rathei than to the period in which they are actually received or paid. Accountability : Responsibility of the various agencies of the government for the proper management of funds allocated. Depreciation AUowmce : Allowance provided for the dimunition or reduction in the value of an asset due to use and/or lapse of time. Economic C l d c a t i o n :Grouping the budgetary provisions in terms of economic magnitudes such as consumption expenditure, transfer payments, capital formation, etc. Functional Clursification : Presentation of the budgeted expenditure in terms of functions, programmes, activities and projects. InmmenW Budgetin# :A system of budgeting in which the bulk of expenditure on the on-going activities of the government is left untouched, only marginal adjustments (incremental) are made in raising and allocating revenues. Line-item CLesiiication :The system of classifying expenditure by organisations (Ministries and departments of the government) and objects of expenditure such as salary, transport, material contingencies etc.

7.9

REFERENCES

Burkhead jesse, 1956. Government Budgeting, John Wiley & Sons: New York Premchand A, 1983. Ciovernrnerit Budgeting and Expenditure Control: Theory and Practice, JMF: Washington DC Thavaraj, M. J. K., 1978. Financial Administration of India, Sultan Chand & Sons : Delhi

7.10 ANSWERS TO CHECK YOUR PROGKESS EXE.RCISES
Check Your Progress 1 I) Your answer should include the following points : A budget essentially includes the information about : plans, programmes, projects, schemes and activities, current as well as new .year, proposals for the c o m i n ~. resource position and .income from different sources including tax and nontax revenues.
actuil receipts and expenditure for the previous year, and -economic, siatistical, and accounting data regarding financial and physical performance of the various agencies and organs of the government.

2) Your answer should include the following points : Strong emphasis on expenditure control with itemised ceilings and sanctions.
Tendency towards incrementalism. No attempt to relate inputsto outputs or expenditure to performance benefits. Short time-span of one year.

I

~ u d g a h g Budgauy and
SyJ~ras-1

Check Your Progress 2 I ) Your answer should include the following points : Accountability Management Control Planning
2)

Your answer should include the following points : Object-wise classification of budget is one where the budget is divided into sections according to organisational units, departments, divisions etc. and expenditure is indicated by each category like salary, wages, travelling allowances etc. Demerits of classification are : Control is not related to performance. Procedural considerations, legality and regularity of expenditures, complex rules are given importance; evaluation and justification for expenditure become incidental. Inadequate information is available about objectives and performance of government. Duplicate, redundant activities and expenditure are hard to detect and avoid.

3) Your answer should include the following points : Economic provisions in terms of economic magnitudes should for example, indicate how much is set aside for capital formation, how much is spent directly by the government and how much is transferred by government to other sectors of economy by way of grants, loans dc. It categorises government expenditure into meaningful economic heads like investment, consumption, generation of income, capital formation.

UNIT 8
Structure
8.0 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10

INDIAN BUDGETARY SYSTEM

Objectives Introduction Evolution of Budgeting System in India Principles or Budgeting Financial Year The Budgetary Process Budgetary Cycle Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

8.0

OBJECTIVES
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After studying this Unit you should be able to: explain the evolution of budgeting system in lndia state the principles underlying the budgetary process discuss the rationale for the financial year identify the various dimensions of practical budget making; and describe budget cycle.

INTRODUCTION
Even though budgetingin ancient and medieval lndia was known not only in its essentials but in fairly great detail, modern budgetary practices started taking shape with the governance of the country being taken over directly by the British Crown. Broadly, the evolution of budgeting has passed through three stages. Firstly, the budgeting system was a sub-system of the British administration. The financial objectives were subordinate to the limited objectives of the colonial power. Control of expenditure and accountability were the hallmarks of this period. Secondly, with the attainment of Independence, the developmental priorities of the nation superseded the limited objectives of the British Raj. In the third phase, a planningorientation has been sought to be imparted to the budgetary exercises. These three phases correspond to the systems known as incremental budgeting, performance budgeting and zero base budgeting respectively. The system described in the following sections is that which is currently practised and is the end result of all the budgetary innovations introduced with varying degrees of success. In this unit, we Will discuss the evolution of budgeting system in India, principles of budgeting and rationale of the financial year. The various steps of budget making and budgetary cycle shall also be focused in the unit.

8.2

EVOLUTION OF BUDGETING SYSTEM IN INDIA

Kautilya's Arthashastra, which describes the administration during Mauryan period makes reference to an excellent budget system with very detailed, minute rules about the maintenance, preparation, submission and scrutiny of accounts. Every year, the Finance Minister made a note of the opening balance in the Treasury, of all current . expenditure, including capital projects in hand (Karaniya) as well as those which had been completed (Siddham). Along with this there was a detailed statement of receipts

from all sources; and also a statement of the clos~ng balance anticipated at the end of the year. Full and precise accounts were kept of all receipts and outgoings, on Revenue and Capital accounts; plans were also prepared and included in the budget of all proposed new and profitable expenditure for investment. The accounts included estimates for the coming year, and the actual results of the year just ended. The entire Cabinet sat in a conclave, so to say, to scrutinise them and to pronounce upon their accuracy, fullness and satisfactory nature in all respects. And their business was not only to verify the actual figures, to tally expenditure with outlay by vouchers and receipts, they also had to see that full valuc was received for every pie spent; that the clerks, officers and departmental heads hac done their duty honestly and efficiently. A system of fines or rewards helped t o mak the system very effective. The rewards a s well as punishments fell a? much upon clerks as upon the superior officers, inspectors o r even the Auditor-General. The rulers of the Delhi Sultanate and the Mughal empire also continued a financial system not very different from the Mauryan system. With the advent of the British rule, the lndian financial administration came effectively under the control of the East lndia Company. Till 1833, the presidencies of Bengal, Bombay and Madras were quite independent in finance and there was hardly any centralised financial system. This position changed with the Charter Act of 1833 which vested the superintendence, direction and control of all the revenues in the Governor General of India-in-Council. The main activity of the East lndia Company being territorial expansion, expenditure on costly wars mounted. Huge sums were remitted to England on account of interest payable on lndian debt, interest on investment on Railways, civil and military charges supposed to have been incurred in England on behalf of India, including the expenses on the maintenance of the O f f i e of East lndia Company in India. That the Governors of the three presidencies hardly had any powers can be seen from the fact that no governor could create a permanent post carrying a princely salary of more than Rs. ten per month. Following the first war of Independence, in 1857, there was chaos in financial administration. With the takeover of the Indian administration by the Crown, the financial system came t o be fashioned on the lines of the system prevailing in England. lmperial objectives dictated a highly centralised system of financial and administrative control. As we have discussed in Unit 2, the first budget was formally introduced in lndia in 1860 by Sir James Wilson, the then Finance Member of the Governor-Generak-in-Council. There was a t that time no elected legislature in India. The budget was also not presented to the British Parliament. The budget, however, made the Viceroy/Governor-General-in-Council accountable to the Secretary-ofState-in-Council in London who, as a member of the British Cabinet, looked after lndian affairs. The Secretary of State became the fountainhead of all authority. He delegated powers to the Governor-General of India. The powers had to be exercised within the ambit of rules and regulations which had to be strictly followed. According to Thavaraj, the basic features of the financial system in India during the period 1858- 1935 were : i) The Secretary-of-State-in-Council was the chief regulator of the financial system; ii) Governor-General-in-Council exercised delegated financial authority; iii) Finance Department was the custodian of Indian finance8 and iv) Controller General had combined responsibility for lndian Audit and Accounts. The Secretary of State controlled Indian finances through : a) acceptance of the lndian budget; b) regulation and control of expenditure through voluminous rules, regulations and codes; and c) through numerous executive orders.
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The budgetary system, more or less, retained these features in spite of the reforms introduced by Lord Mayo in 1870, Lord Lytton in 1877, Lord Rippon's Quinquennial Settlements of 1882 and Lord Curzon's Reforms, 1904. The scene,

however, changed significantly following Montague-Chelmsford Reforms of 19 19. From 1921 onwards, the Central Legislative Assembly, with a non-official majority, was for the first time given the right to discuss and pass the annual budget of the Government of lndia in respect of 'non-reserved' subjects, as also to pass the Finance Bill embodying taxation proposals. The Governor-General was, however, empowered to "certify" the financial proposals in the event of their rejection by the legislature. Before these reforms were introduced, the provincial governments had to seek the approval of the Central Government for every rupee spent. The MontagueChelmsford Reforms for the first time introduced realistic provincial autonomy. Central and provincial heads of revenue were clearly demarcated. Consequently, the importance of the supervisory role of Finance Member over the provincial finance departments declined considerably and vanished altogether after 1935. The Secretary of State, however, did not suffer any diminution in his supreme authority after the 1919 d o r m s . Nothing of significance could happen without his knowledge. But he intervened only when the imperial interests were in jeopardy. The Government o India Act, 1935, delivered a body blow to his powers. Except for f the control over the services, the Secretary of State gave up direct exercise of most of his powers. The Governor General and the Governors exercised special powers and prerogatives over what were called reserved subjects which together with charged items were outside the purview of legislative financial control. They could also restore a demand rejected or reduced by the legislatures. Again, no expenditure could be incurred even if it was duly authorised by the legislature unless it was included in a schedule of expenditure authenticated by the Governor-General or the Governor. Thus the system of financial control, both at the tlme of budget formulation and approval for incurring expenditure, turned out to be very rigid, rule-oriented and complex. This system naturally inhibited and suppressed any popular initiative towards change and development. Understandably, the control over financial administration was a necessary adjunct of the fundamental imperial objectives. It was never meant to facilitating solutions to national problems. It was this system, with all its distortions and rigidities, which India inherited from the British.

Indian Budgetry Syslem

8.3
i)

PRINCIPLES OF BUDGETING

The essential principles generally observed in government budgeting in India are : Principle of annuality. The budget should be on an annual basis; this leads to another rule "the rule of lapse". The operation of this rule leads to a rush of expenditure towards the end of the year. However it has the merit of enforcing parliamentary sanction-which is always for an amount for a specific period after which it must be obtained again. This implies that if the funds voted are not used by the end of the financial year, the unspent balance lapses.

ii) The government budgets are on cash basis. iii) There should be one budget for all financial transactions of the government. In the absence of one common budget it would be difficult to assess the true financial position of the government. Railways and other public enterprises, however, have separate budgets. In the case of railways, total receipts and expenditure are incorporated in the Central Government Budget. The estimates of capital and loan disbursement and also the extra budgetary resources for financing the plans of public enterprises are also shown in the Central Budget. iv) The budgeting should be gross and not net. Gross transactions, both in the case of receipts and expenditure of each department, should be shown. It is not permissible to deduct any receipt accruing to the department from the charges of collection or any other expenditure. This is intended to ensure that the parliamentary control over expenditure is meaningful. In the absence of this provision, the budget coming up before the Parliament would be reduced only to the net deficit, if any. v) Budgeting should be close. It should not be guess work or guess estimates which result in wide fluctuations and can lead to improper allocation of funds. supplementary grants.

Budnctlnn .nd B u d l a u ~ system-I

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vi) The form of estimates should correspond to the accounting heads since the estimates eventually get converted into actual accounts of receipts and expenditure.

FINANCIAL YEAR
When the first modern budget was presented in 1860, the financial year adopted by the government was from 1st May to 30th April. Beginning with the year 1866, however, the financial year was changed to April-March, in conformity with the practice in England. This practice has been the subject of debate and various committees and commissions which examined the issue have been critical of it. The Administrative Reforms Commission in its Report on Finance, Accounts and Audit observed. "The financial year starting from the 1st of April is not based on custom and needs of our nation. Our economy is still predominantly agricultural and is dependent on the behaviour of the principal monsoon. A realistic financial year should enable a correct assessment of revenue, should also synchronise with a maximum continuous spell of working season and facilitate an even spread of expenditure. For centuries, people in India have become accustomed to commence their financial year on the Diwali day. This practice has its roots in their way of life. The business community and other sections of society start the Diwali day with the feeling that they have finished with the old period of activity and have embarked upon a new one. It is, therefore, appropriate that the commencement of the financial year should be related to Diwali and in order to prescribe it in terms of a date, we have recommended that the 1st November should be the beginning of financial year." The commission also thought that a budget year commencing on the 1st November would be better suited for the transaction of Parliamentary business. It is normally argued that the effect of south-west monsoon, which is responsible for over 90 per cent of the total annual rainfall in India, would be known by September, and the likely agricultural production during the year can be estimated fairly accurately. The commercial and industrial activities are also largely dependent on the performance in the agricultural sector. Besides, the monsoon months can be utilised for budget formulation and the critical fiscal parameters can be decided upon in the light of anticipated level of economic activity in the ensuing year. Under the present arrangements, soon after the expenditure sanctions reach the executing agencies, the onset of monsoon renders it difficult to start construction of the budgeted works. These works have to wait till the rains are over. The speed of works is affected because of the intervention of monsoons when barely the preparatory work of projects has been completed. The delayed execution of works results in the rush of expenditure towards the end of the year leading to surrender of funds at the close of the financial year. Essentially a budget year should help in performing the following functions: i) making a fairly accurate estimates of revenue; ii) making a fairly accurate estimates of expenditure; iii) it should facilitate an efficient execution of projects; and iv) the budget calendar should be convenient to the legislators and administrators. Different dates have been suggested by the various experts who have examlned the question of fina-ncial year. These are 1st July, 1st October, 1st November or 1st January. While there is a merit in each one of these suggestions, none of these can reconcile the conflicting criteria proposed. Considering only the criterion of better predictability of revenues, no single budget year provides enough scope for the various states to make a realistic assessment for both Kharif and Rabi crops. Rabi crops are very important for some of the states. The estimation of total agricultural production would, therefore, remain a guess work. It has, therefore, been argued that the balance of advantage lies in not disturbing the present fiscal year. The database of the economy relates to the existing financial
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year and any dislocation in this year will lead to statistical, accounting and administrative problems. One has to weigh the advantages of changing over to a different fiscal year against the disadvantages inherent in such a switchover. And one has to remember that there is no general agreement on the alternative fiscal year. The only practical appioach, therefore, is to continue with the present financial year.

lndim Budgauy system

Cbeck Your Progress 1 Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.
I) Highlight the basic features of the financial system in lndia during the period 1858-1935.

2) State the essential principles of government budgeting in India.

3) What are the functions of a budget year?

8.5

THE BUDGETARY PROCESS

With the attainment of Independence, the objectives, the policy framework and the environment of financial administration underwent a radical change. The conflict between popular will and aspirations and the policy and procedures which had characterised financial administration in the country disappeared overnight. Even though the basic features of the Government of lndia Act, 1935, with regard to financial administration, were retained, there was no fundamental disharmony between these instruments and the national priorities. These instruments could be and were refashioned according to the changed objectives. The budgetary processes in India follow the procedure laid down in Articles 112 to 117 of the Constitution. Accordingly, annual budget of the Union, called the Annual Financial Statement of estimated receipts and expenditure, is to be laid before both Houses of the Parliament in respect of every financial year. The Budget shows the receipts and payments of government under three parts in which government accounts are kept : i) Consolidated Fund, ii) Contingency Fund, and iii) Public Account.

Budgdlng and Budgduy Systems-I

Consolidated Fund of India

All revenues received by government, loans raised by it, and also its receipts from recoveries of loans granted by it form the Consolidated Fund. All expenditure of government is incurred from the Consolidated Fund and no amount 'can be withdrawn from the fund without authorisation from the Parliament.
Contingency Fund

Occasions may arise when government may have to meet urgent unforeseen expenditure pending authorisation from the Parliament. The Contingency Fund is an Imprest placed at the disposal of the President to incur such expenditure. Parliamentary approval for such expenditure and for withdrawal of an equivalent amount from the Consolidated Fund is subsequently obtained and the amount spent from Contingency Fund is recouped to the lund. The corpus of the fund authorised by the Parliament, at present, is Rs. 50 crore.
Public Account

Besides the normal receipts and expenditure of government which relate to the Consolidated Fund, certain other transactions enter government accounts, in respect of which government acts more as a banker; for example, transactions relating to Provident Funds, small savings collections, other deposits etc. The moneys thus received are kept in the Public Account and the connected disbursements are also made therefrom. Generally speaking, Public Account funds d o not belong to government and have to be paid back some time or the other to the persons and authorities who deposited them. Parliamentary authorisation for payments from the Public Account is, therefore, not required.
Charged Expenditure

Under the Constitution, certain items of expenditure like emoluments of the President, salaries and allowances of the Chairman and the Deputy Chairman of the Rajya Sabha and the Speaker and Deputy Speaker of the Lok Sabha, salaries, allowances and pensions of Judges of the Supreme Court and the Comptroller and Auditor-General of India, interest on and repayment of loans raised by government and payments made to satisfy decrees of courts etc; are charged on the Consolidated Fund. These are not subject to the vote of Parliament. The budget shows the charged expenditure separately in the Consolidated Fund. Government budget comprises : i) Revenue budget; and ii) Capital budget
Revenue Budget

It consists of the revenue receipts of government (tax and non-tax revenues) and the expenditure met from these revenues. The estimates of revenue receipts shown in the budget take into account the effect of the taxation proposals made in the Finance Bill. Other receipts of government mainly consist of interest and dividend on investments made by government, fees, and other receipts for services rendered by government.
Capital Budget

It consists of capital receipts and payments. The main items of capital receipts are loans raised by government from public which are called Market Loans, borrowings by government from Reserve Bank and other parties through sale of Treasury bills, loans received from foreign governments and bodies and recoveries of loans granted by Central Government to State and Union Territory governments and other parties. Capital payments consist of capital expenditure on acquisition of assets like land, buildings, machinery, equipment, as also investments in shares etc. and loans and advances granted by Central government to State and Union Territory governments, government companies, corporations and other parties. Capital budget also incorporates transactions in the Public Account.
Demands for Grants

The estimates of expenditure from the Consolidated Fund included in the budget and required to be voted by the Lok Sabha are submitted in the form of Demands

for Grants. Generally, one Demand for Grant is presented in respect of each ministry or department. However, in respect of large ministries or departments, more than one demand is presented. Each demand normally includes the total provisions required for a service, that is, provisions on account of revenue expenditure, capital expenditure, grants to State and Union Territory governments and also loans and advances relating to the service. Where the provision for a service is entirely for expenditure charged on the Consolidated Fund, for example, interest payments, a separate appropriation, as distinct from a demand. is presented for that expenditure and it is not required to be voted by Parliament. Where. however, expenditure on a service includes both 'voted' and 'charged' items of expenditure, the latter are also included in the demand presented for that service but the 'voted' and 'charged' provisions are shown separately in that demand. Plan expenditure forms a sizeable proportion of the total expenditure of the central government. The Demands for Grants of the various ministries show the plan expenditure under each head separately from the non-plan expenditure. The document also gives the total plan provisions for each of the ministries arranged under the various heads of development and highlights the budget provisions for the more important plan programmes and schemes. A large part of the plan expenditure incurred by the central government is through public sector enterprises. Budgetary support for financing outlays of these enterprises is provided by government either through investment in share capital or through loans. The budget shows the estimates of capital and loan disbursements to public sector enterprises in the current and the budget years for plan and non-plan purposes and also the extra-budgetary resources available for financing their plans, The Railways and Telecommunication services are the principal departmentally-run commercial undertakings of government. The budget of the Railways and the demands for grants relating to Railway expenditure are presented to parliament separately. However, the total receipts and expenditure of the Railways are incorporated in the Central Budget. The demands for grants of the Department of Telecommunications are presented along with other demands of the central government.
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Indian Budgduy System

8.6

BUDGETARY CYCLE

In order to allow time for the executive and legislative processes to go through, budgeting is geared to a cycle. The process of approval is very significant in a responsible form of government. The cycle consists of four phases: Preparation and submission; Approval; Execution; and Audit At any given point of time, several cycles would be in operation and would be overlapping.'Nevertheless, various segments of a cycle have different operational life. Budget Preparation In India, budget preparation formally begins on the receipt of a circular from the Ministry of Finance sometime during September/October, that is, about six months before the budget presentation. The circular prescribes the time-schedule for sending final estimates separately for plan and non-plan, and the guidelines to be followed in the examination of budget estimates to be prepared by the department concerned The general rule is that the person who spends money should also prepare the budget estimates. Budget proposals normally contain the following information: i) Accounts classification ii) Budget estimates of the current year iii) Revised estimates of the current year iv) Actuals for the previous year; and

.geting and Budgetary tern-1

V)

Proposed estimates for the next financial year (which is the budget proper).

Budget estimates normally involve : a ) Standing charges or committed expenditure on the existing level of service. Thiis can easily be provided for in the budget, as it is more or less based on a projection of the existing trends. b) New expenditure which may be due to : i) expansion of programmes involving expenditure in addition to an existing service or facility; and

i ) new service for which provision has not been previously included in the grants.
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~ h i l e \ W (i) can be estimated with reference to progress made and the likely ) expenditure during the next financial year, budget provision for (b) (i) and (ii) cannot be made unless the scheme relating to it is finally approved. The budget estimates prepared by the ministries/depanments according to budget and accounts classification are scrutinised by the Financial Advisors concerned. The plan items of the Central Budget are finalised in consultation with the Planning Commission and are based on the Annual Plan. Parlinmentary Approval The estimates of expenditure prepared by ministries/departments are transmitted to the Ministry of Finance by December where these are scrutinised, modified where necessary and consolidated. The estimates of revenue are also prepared by the Finance Ministry and thus the budget is finalised. The budget is presented to the Parliament generally on the last working day of February. In the first stage, there is a general discussion on the broad economic and fiscal policies of the government as reflected in the budget and the Finance Minister's speech. This lasts about 20-25 hours. In the second stage, there is a detailed discussion on the demands for grants, usually in respect of specific ministries or departments. Each demand for grant is voted separately. At this stage members of parliament may move motions of various kinds. Generally these are policy cuts, economy cuts, and token cuts. The policy cut motion seeks to reduce the demand to rupee one and is indicative of the disapproval of general or specific policy underlying the service to which the demand pertains. The motion for economy cut is to reduce the proposed expenditure by a specified amount. A token cut in a demand is moved to reduce it by a nominal amount say Rs. 100 and may be used as an occasion to ventilate a specific grievance. Since it is never possible to accommodate a detailed discussion on each demand for grant separately, the demands that cannot be so discussed are clubbed together and put to the vote of the Parliament at the end of the period allotted for discussion. Though the budget is presented before both Houses of Parliament, the demands for grants are submitted only to the lower house. Demands for grants, are the executive's requisitions for sanction to spend, and only the lower house can have a say in the matter. While the legislature can object to a demand for grant, reject it or reduce it, it cannot increase the same. It may also be mentioned here that since no demand for a grant can be made except on the recommendations of the President or the Governor (in the case of State), private members cannot propose any fresh items of expenditure. If this were allowed it would necessitate revision of receipts and consequently the budget and sometimes may lead to improper appropriation of public funds. Even after the demands for grants have been voted by the Parliament, the executive cannot draw the money and spend it. According to the Constitutional provisions, after the demands for grants are voted by the Lok Sabha, Parliament's approval to the withdrgwal from the Consolidated Fund of the amount so voted and of the amount required to meet the expenditure charged on the Consolidated Fund is sought through the Appropriation Bill. The Appropriation Bill after it receives the assent of the President becomes the Appropriation Act. Thus, without the enactment of an Appropriation Act, no amount can be withdrawn from the Consolidated Fund. Since the financial year of the government is from 1st April to 31st March, it follows that no expenditure can be incurred by the government after 31st March unless the

Appropriation Act has heen passed by the close of the financial year. This is generally not possible as the process of discussion of the budget usually goes on up to the end of April or the first week of May. Thus, in order to enable the government to carry on its normal activities from 1st April till such time as the Appropriation Bill is enacted, a Vote on Account is obtained from Parliament through an Appropriation (Vote on Account) Bill. The proposals of government for levy of new taxes, modification of the existing tax structure or continuance of the existing tax structure beyond the period approved by Parliament are submitted to Parliament through the Finance Bill. The members can utilise the occasion of discussion on the Finance Bill to criticise government policies, more specifically the proposals regarding the taxation and tax laws. In certain cases, taxation proposals take effect immediately. Since, however, passing of the Finance Bill may entail a time lag, a mechanism under which the taxation proposals take effect immediately pending the prissing of the Finance Bill exists in the form of Provisional Collection of Tax Act, 1931, which empowers the government to collect taxes for a period of 75 days till the Finance Bill is passed and comes into effect. The budget of the Central Government is not merely a statement of receipts and expenditure. Since Independence, with the launching of five year plans, it has also become a significant statement of government policy. The budget reflects and shapes, and is in turn shaped by, the country's economic life. A background of the economic trends in the country during the current year enables a better appreciation of the mobilkation of resources and their allocation as reflected in the budget. A document, Economic Survey, is prepared by the government and circulated to the members of Parliament a couple of days before the budget is presented. The Survey analyses the trends in agricultural and industrial production, money supply, prices, imports and exports and other relevant economic factors having a bearing on the budget.
Indian Budgduy System

Execution of the budget The execution of the budget is the responsibility of the executive government. The procedures for execution of the budget depend on the distribution anddelegation of powers to the various operating levels. As soon as the Appropriation Act is passed, the Ministry of Finance advises spending Ministries/ Departments about their respective allocation of funds. The controlling officers in each ministryldepartment then allocate and advise the various disbursing officers. The expenditure is monitored to ensure that the amounts placed at the disposal of the spending authorities are not exceeded without additional funds being obtained in time.
Thus the financial system broadly consists of the following levels : a) controlling officers; normally the head of the ministry/department acts as the
controlling officer;

b) a system of competent authorities who issue financial sanction; c) a system of drawing and disbursing officers; and d) a system of payments, receipts and accounts. The Department of Revenue in the Ministry of Finance is in overall control and supervision over the machinery charged with the collection of direct and indirect taxes. Such control is exercised through the Central Board of Direct Taxes and the Central Board of Indirect Taxes. These Boards exercise supervision and control over the various operational levels which implement different taxation laws. The Reserve Bank of India is the central banker of the government. The nationalised banks and the network of treasuries are also performing the service of collection (receipts) and disbursement of funds.

Audit The executive spends public funds as authorised by the legislature. In order to ensure accountability of the executive to the legislature, public expenditure has to be audited by an independent agency. The Constitution provides for the position of the Comptroller and Auditor General of India to perform this function. It is his/ her duty to ensure that the funds allocated to various agencies of the government have been made available in accordance with law; that the expenditure incurred has the sanction of the competent authority; that rules, orders & procedures governing such

expenditure have been duly observed; that value for money spent has been obtained and that records of all such transactions are maintained, compiled and submitted to the competent authority. This is the last stage in completing the budgetary cycle (for details see units no. 22 and 23).
Check Your Progress 2 Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.

1 ) Distinguish between revenue and capital budget.

2) State the phases of the budgetary cycle.

3) What are the main functions involved in the execution of the budget?

8.7

LET US SUM UP

Although, in ancient India, a fairly developed budgetary system was prevalent, it is only after the British Crown took over from the East lndia Company in I860 that a modern budget was introduced. The Secretary of State in the Council was the chief regulator of the financial system in lndia and the Governor General in the Council exercised delegated financial authority. Finance Department was the custodian of lndian finances. As we have discussed in the unit many reforms were introduced, particularly in 1919 and later in 1935. The system of financial control which lndia inherited in 1947, turned out to be very rigid, rule-oriented and complex. Necessarily it was an adjunct of the fundamental imperial objectives rather than an instrument to solve national problems. The budgetary process under the Constitution follows the procedure laid down in Articles 112 to 117. The budget shows receipts and payments under three parts in which government accounts are kept; these are Consolidated Fund, Contingency Fund and Public Account. The budget comprises Revenue Budget and Capital Budget. The budget estimates of expenditure which are to be voted by the Lok Sabha are submitted in the form of Demands for Grants. Generally, one Demand for Grant is presented in respect of each ministry or department. The budgeted expenditure is also classified as plan and non-plan. Bulk of the expenditure represents standing charges or committed expenditure and is non-plan. X large part of the plan expenditure incurred by the Central Government is through public sector enterprises.

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I

These are the four stages in the budgetary cycle. viz; preparation, approval, execution of the budget and audit. Preparation of ihe budget usually begins on the receipt of a circular from the Ministry of Finance during Se?tember/October. It contains iriformation relating to the budget estimates of the current year, revised estimates, actuals for the previous year and the proposed budget estimates for the next financial year. The budget is presented to the Parliament on the last working day of February. A general discussion is followed by a detailed discussion on each demand for grant. The Parliament may reduce or reject but may not increase any budgetary provision which is subject to its vote. After the Parliament has voted the demand for grants, an Appropriation Act has to be passed by it to enable the government to withdraw money from the Consolidated Fund of India. The executive spends the money in accordance with the powers delegated to the operational levels. Finally, the expenditure is audited by the Statutory Audit to ensure that the public funds have been used as authorised and that rules and regulations have been observed.

Indian Budgetary System

KEY WORDS
Resaved Subjects : The Montague-Chelmsford Reforms introduced the division of subjects at the provincial level into reserved and transferred subjects. The resewed subjects included important departments which were in charge of councillors who along with the Governor were responsible to the Secretary of State and British Parliament. The transferred subjects were in charge of ministers who were responsible to the provincial legislature.
Rule of h p a e : This is a budgetary principle which implies that no part of the grant which is unspent by any departmentlministry in any year can be carried forward to the next year. Secretary of State :The Act of 1858 ended the rule of East India Company and Indian administration was brought directly under the British Crown. This Act created the Office of the Secretary of State who was a Cabinet minister in the British Cabinet entrusted with the responsibility of managing affairs in India on behalf of the Crown. Supplementary Crrrntr : If original estimates in budget are insufficient to carry on any activity, additional funds are sought by the government from the Parliament in the course of the financial year through supplementary grants. Vote-on-Account : Even though the financial year starts on 1st April, the budget takes some time to be passed. So, to meet the expenditure that will be incurred in the first few months of financial year till the budget is passed, the Parliament/legislature is required to pass vote on account which is an advance grant.

8.9

REFERENCES

Burkhead, Jesse, 1956. Government Budgeting, John Wiley & Sons : New York. Premchand A, 1983. Government Budgeting and Expenditure Control: 7'heory and Practice, IMF : Washington DC. Thavaraj, M.J.K., 1978. Financial Administration of India, Sultan Chand and Sons : Delhi.

ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress I 1) Your answer should include the following points :

Remote control through Secretary of State.

Budgeting and Budgetary

Delegated financial authority to Governor General in Council. Centralised financial control in the Finance Department. Complex rules, regulations and procedures. 2) Your answer should include the following points : Principle of annuality.

Systems-l

r Rule of Lapse.
The government budgets are on cash basis. Principle of one budget for all financial transactions of the government. Budgeting should be gross and not net. Budgeting should be close. The form of estimates should correspond to the accounting heads. 3) Your answer should include the following points : Making a fairly accurate estimates of revenue and expenditure. Facilitate an efficient execution of projects. Budget calendar should be convenient to the legislators and administrators.

Check Your Progress 2 I ) Your answer should include the following points :
Revenue budget consists of the revenue receipts of government (tax and nontax revenues) and the expenditure met from these revenues. Revenue receipts include interest and dividend on investments made by government, fees and other receipts for services rendered by government. Revenue expenditure is for normal running of government departments and various services, interest charges on debts incurred etc. It does not result in creation of any assets. Capital budget consists of capital receipts and payments. Capital receipts include loan raised by government from public, borrowings, extirnal loans etc. Capital pay;nn:,ts comprise capital expenditure on acquisition of assets like land, building etc., loans and advances given by central government to states and union territories etc. 2) Your answer should include the following points : Preparation and submission of budget estimates by ministriesldepartment. Parliamentary approval. Execution of the budget by government audit. 3) Your answer should include the following points : Collection of revenues. Custody of the collected funds, and Distribution of funds.

UNIT 9 CLASSIFICATION OF GOVERNMENT EXPENDITURE
Structure
9.0 9.1 9.2 9.3 9.4

9.5 9.6 9.7 9.8 9.9 9.10

Objectives Introduction Classification of ~ o v k r n m e nExpenditure t Revenue and Capital Expenditure Developmental and Non-Developmental Expenditure Plan and Non-Plan Expenditure An Evaluation of the System of Classification of Expenditure Let Us Sum U p Key Words References Answers to Check Your Progress Exercises

9.0 OBJECTIVES
After reading this unit, you should be able to: explain the various classifications of government expenditure differentiate between revenue and capital expenditure distinguish between developmental and non-developmental expenditure differentiate between plan and non-plan expenditure; and evaluate the present system of classification of government expenditure.

9.1 INTRODUCTION
This unit deals with one of the important issues in Financial Administration i.e. the classification of government expenditure. The economy of a country is greatly influenced by the level of government o r public expenditure. It is one of the major processes by which the welfare of the people is ensured and it is a vital aspect of a government's budget. It is an important instrument in the hands of government that can be utiIised for the maximisation of public satisfaction. Again, it helps in overcoming the inefficiencies of the market system in the allocation of economic resources. It also helps in smoothing out cyclical fluctuations in the economy and ensures a high level of employment and price stability. Thus, government expenditure plays a crucial role in the economic growth of a country. Government expenditure covers all the expenditure incurred by government under the account heads of "Revenue", "Capital" and "loans". Revenue expenditure can be classified into two categories : Nondevelopmental expenditure and Developmental expenditure. Classification of government expenditure is closely related to the objectives of the government i.e. economic growth, financial control, price stability etc. For instance, the accounting classification of expenditure into 'Plan' and 'Non-plan', 'Capital' and 'Revenue' enables the Parliament to exercise financial control over expenditure and within the government, to exercise financial control over the spending departments. Similarly, the economic classification of government expenditure helps the government in determining how much of the economic resources are allocated by government to various economic activities and their contribution to the economic growth of the nation. Again, the cross classification of expenditure (i.e. Functional-cum-Economic classification) serves the social objectives of the government by determining the expenditure incurred on consumption and non-consumption. Thus, each classification of government expenditure serves one or other objectives of the government viz., financial control, economic growth, price stability etc.

.

Financial Administration

In this unit, we shall deal with the various classifications of government expenditure, points of distinction between capital and revenue, developmental and non. developmental, plan and non-plan expenditure.

9.2 CLASSIFICATION OF GOVERNMENT EXPENDITURE
Since the latter part of the 19th century and earlier part of the 20th century, most of the capitalistic and socialistic countries switched over to the concept of welfare state. During this period, most governments of independent countries concentrated their energy on economic development. T o achieve speedy economic development, governments had stepped up their expenditures.

Nature of Government Expenditure: Public expenditure is incurred in the form of purchases of goods and services, transfer payments and lending. Purchase of goods and services is intended to carry out governmental activities by the direct utilisation of economic resources for example, purchase of articles from the market right from paper clips to military aircraft. Transfer payments and lending are intended to provide enterprises and households with purchasing power to enable them to buy goods and services in the market. In many developed countries, transfer payments for social welfare constitute a sizeable portion of government budgets. In developing countries, some of the functions of transfer payments are performed by subsidies to consuiners in the form of below cost sales by state enterprises. Examples of such subsidies are supply of bread, foodgrains, cooking oils, sugar and tea to public below the normal cost. ' Classification of Expenditure: Government expenditure can be broadly classified into four categories: (i) Functional Classification or Budget Classification (ii) Economic Classification (iii) Cross Classification and (iv) Accounting Classification. As already mentioned, each classification of expenditure in government serves one objective or other i.e. financial control, economic growth, price stability etc. i) Functional or Budget Classification: In India, the classification of accounts was structured so as to correspond to the organisation in which the transaction occurred and within the organisation to the inputs on which expenditure was incurred. For example, construction of a hospital would be classified and displayed in accounts as "public works expenditure" and not as expenditure on a programme like "Medical Relief" under social services. The classification indicated the nature of expenditure but not its purpose. It did not enable identification of expenditure with functions, programmes, activities and projects. It lacked management approach in accounting in as much as it did not provide the facility for monitoring and analysis of expenditure on functions, programmes, activities and projects.
The Government of lndia introduced in April, 1974 a revised accounting structure, which attempts to serve the purposes of management as well as the requirement of financial control and accountability. Under this scheme, a five-tier classification has been adopted i.e. sectoral, major head, minor head. subhead, and detailed heads of account. Sectoral classification has grouped the functions of government into three sectors, namely, General Services, Social and Community services and Economic services. In the new scheme of accounts, a major head is assigned to each function and minor head is allotted to each programme. Under each minor head. there would be subheads assigned to activities/schemes/organisations covered by the programme Under the new system, the object classification has been retained and placed at the last tier. It is meant to provide item-wise control over expenditure and ensure financial control and accountability. Functional classification established adequate links between budget and account heads and the plan heads of development. This has facilitated obtaining information of progressive expenditure on plan programmes and projects. The principle adopted in the new accounting classification is that all expenditures on a function. programme or

.

.'

activity should be recorded under the appropriate major, minor or subhead. Functional classification has provided the necessary facility for monitoring and analysis of expenditure on functions, programmes and activities to aid the management function. (For further details, please refer to Unit 21 of Block 7 of this Course.)
ii) Economic Classification:Economic classification refers to the resources allocated by government to various economic activities. It involves arranging the public expenditures and receipts by significant economic categories, distinguishing current expenditure from capital outlays, spending for goods and services from transfers to individuals and institutions, tax receipts by kind from other receipts and from borrowing and inter-governmental loans, grants etc. This classification brings out such important aggregates as public expenditure of the consumption kind, public investment and the draft of public authorities on public savings for financing the development oulays in the public sector. In short, this classification analyses the total governmental f transactions and records government's influence on each sector o the economy. iii) Cross Classification or Economic-cum-Functional Classification: Cross classification provides the breakup of government expenditure not only-by economic categories but also by functional heads. For instance, expenditure on medical facilities (a functional head) is split between economic categories such as current expenditure, capital expenditure, and various types of transfers and loans. Conversely, cross classification shows how expenditure on a particular economic category, say capital formation, is divided according to different public activities like education, labour welfare, family planning etc.

Classilkationof Government Expenditure

.

Under a scheme of cross classification, functional classification of expenditure can be analysed according t o its economic character and economic classification of expenditure can be analysed according to the functions performed by it. The two types of classification therefore supplement each other and give a clear picture of the total transactions of government.
iv) Accounting Classification: Accounting classification of government expenditure can be analysed under (i) Revenue and Capital (ii) Developmental and NonDevelopmental and (iii) Plan and Non-Plan. Each classification of expenditure serves one objective or other of the government. For instance, Revenue and Capital expenditure classification indicates how much government expenditure results in creation of assets in the economy and how much expenditure is unproductive. Again, developmental and non-developmental classification indicates how much government expenditure is spent on social and community services and economic services as against general services. Similarly, the Plan and Non-Plan expenditure classification helps the Planning Commission and Finance Commission in determining the pattern of central assistance on plan schemes to state governments, and union territories. Thus, each classification of government expenditure serves one objective or other in government.

9.3 REVENUE AND CAPITAL EXPENDITURE
The difference between Revenue and Capital expenditure is the difference between expenditures that result in the creation of new assets and those which do not. Goods and services consumed within the accounting period may be included in the current is expenditure; alternatively, the allocation may be based whether an expend~ture "revenue producing or not". The main purpose of the capital account is to show the gross and net capital formation in the public sector during the accounting period (i.e. say from 1st April to 31st March). Under the Indian Constitution, budget has to distinguish expenditure on Revenue account from other expenditures. Government budget comprises Revenue Budget and Capital Budget. Revenue budget consists of revenue receipts of government (taxrevenues and other revenues) and the expenditure met from these revenues. Tax revenues comprise proceeds of taxes and other duties levied by the Union. Revenue expenditure is for the normal running of government departments and various services, interest charges on debt incurred by government etc. Broadly speaking, expenditure which does not- result in creation of assets is treated as 'Revenue expenditure'. All -

. %

.

7

Financial Administration

grants given to state governments and other parties are also treated as revenue expenditure. Capital budget consists of capital receipts and payments. The main items of capital receipts are loans raised by government from public which are called market loans, borrowings from Reserve Bank of India and other parties through sale of Treasury Bills, loans received from foreign governments and loans granted by Central government to state and union territory governments and other parties. A Capital expenditure may be defined as any expenditure other than operating expenditure, the benefits of which extend over a period of time exceeding one year. The main characteristic of capital expenditure is that atleast a major portion of the expenditure is made at one point in time and the benefits are realised at different points in time in the ensuing years. In other words, Capital expenditure is the expenditure which is intended for creating concrete assets of a material character in the economy. Examples of Capital expenditure are the aquisition of assets like land, buildings machinery, equipment and also investment in shares and loans and advances granted by Central government to state and union territory governments, government companies etc. With the advent of planning in India in 1951, Capital expenditure incurred on plan account has assumed an enormous significance. It has also its economic effects depending on whether the projects financed by capital expenditure are quick yielding or long yielding in economic benefits. Also, it has its impact on the revenue budgets of the Centre. In brief, the difference between revenue and capital expenditure is the difference between expenditures which result in creation of new assets and those which do not. Revenue expenditure is for the normal running of government departments and various services, interest charges etc. On the other hand, capital expenditure or at least some portion of it results in creation of assets in the economy.
check Your Progress 1

Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.

1) Explain the meaning of Government expenditure. Distinguish between 'revenue' and 'capital' expenditure.

2) Explain the significance of Economic and Cross Classification of government
expenditure.

DEVELOPMENTAL AND NON-DEVELOPMENTAL EXPENDITURE
Government expenditure can be classified into e eve lop mental" and "NonDevelopmental" expenditure. Developmental expenditure comprises expenditure
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employment, agriculture, cooperation, irrigation, transport and communication and other miscellaneous services. Expenditure incurred on these items both on Revenue and Capital accounts is also treated as development expenditure. Non-Developmental expenditure, on the other hand, comprises expenditure incurred on items like defence, collection of taxes and duties, administrative services, interest on debt and other services, stationery and printing and other expenditure on general services. Developmental expenditure is an accounting concept that has grown in conjunction with economic plans. It constitutes the main target of the plan. It enables planners to specify a measurable level of achievement that the economy may attain within the planning period. By providing a target for developmental expenditure in the plans, the economic aspirations of citizens are focused. Certain classes of public expenditure are treated as developmental by fiat and they are treated as component of plan expenditure or government contribution to economic growth. Developmental expenditure is said to be directly related to the promotion of backward economy; non-developmental expenditure does not help development. But in reality, capital expenditure on administration, rehabilitation, relief does help directly or indirectly the economic development of the country. Hence, it is difficult to follow a rigid distinction between developmental and non-developmental expenditure, though it is customary to make such a distinction for broad analytical purposes. 1tiswell-known that no developmental expenditure is "developmental" indefinitely or advantageous to the economy, irrespective of the amounts being spent by government departments. T o the best of government's knowledge, each item of expenditure (i.e. Developmental and Non-Developmental) must contribute equally on the margin to economic welfare. ,Too much emphasis on "Developmental" and "Plan expenditure" will ultimately lead to a reduction in "Non-Developmental" expenditure and thereby indirectly affects the growth of the economy. In brief, Developmental expenditure leads to economic growth whereas Non-Developmental expenditure does not. Developmental expenditure comprises the expenditure incurred on social and community services and economic services. Non-Developmental expenditure comprises the expenditure incurred on general services. The distinction between "Developmental" and "Non-Developmental" expenditure beyond a certain point, gives a distorted picture of the whole government expenditure, as Non-Developmental expenditure also contributes to economic growth indirectly and as such it is not totally unproductive. For example expenditure on defence, though it is non-developmental, is very much required for establishing defence preparedness of the country which cannot be weakened.

Clssslfica~ion Government of Expenditure

9.5 PLAN AND NON-PLAN EXPENDITURE
Government expenditure can also be classified into "Plan" and "Non-Plan" expenditure. Plan expenditure refers to the expenditure incurred by the Central Government on Programmes/Projects, which are recommended by the Planning Commission. Non-Plan expenditure, on the contrary, is a generic term used to cover all expenditure of government, not included in the plan. Non-Plan expenditure consists of many items of expenditure, which are obligatory in ndture and also essential obligations of a state. Items of expenditure, such as interest payments, pensionary charges, statutory transfer to states come under the obligatory nature. Defence, internal security are essential obligations of a state. Any neglect of these activities can lead to collapse of government. Besides, there are special responsibilities of the Central Government like external affairs, currency and mint, cooperation with other countries and the expenditure incurred in this connection are treated as "non-plan" expenditure. Of all the major items of Non-plan expenditure of the Central Government, interest payments, defence, subsidies take the lion's share of expenditure. The distinction between 'plan expenditure' and non-plan expenditure' is purely an administrative classification and is in no way related to economic or national accounting principles. For instance, in many cases 'plan expenditure' becomes non-plan expenditure, after the plan is over. Again, an item of plan expenditure during a

Financial Administration

particular five year plan becomes "non-plan" in the following plan, if its responsibility is shifted on to the state governments, as in the case of centrally sponsored and central sector schemes or if the expenditure spills over from one plan to the next or the expenditure is agreed to be incurred outside the plan outlay of the state governments approved by the Planning Commission. The classification of expenditure between "Plan" and "Non-Plan", "Developmental" and "Non-Developmental" of certain schemes/projects in government gives a distorted view of government's classification of expenditure. After all, the test of public expenditure is the amount of satisfaction it gives to the public by the quantity or quality of services it makes possible. But classification like 'Developmental' and 'NonDevelopmental' expenditure may ignore the point, unless a sense of proportion is maintained. For instance, maintenance expenditure of a building is likely to suffer, whereas a plan scheme, even if it is not important, acquires a priority and urgency, out of its proportion, because it is a 'plan' item of expenditure. Again, it is possible to create posts under plan schemes, even if a ban exists on creation of posts. Thus, the classification of expenditure into 'Plan' and 'Non-Plan', sometimes, endows certain schemes with more than necessary legitimacy and thereby acts to distort one's view of public expenditure.

9.6 AN EVALUATION OF THE SYSTEM OF CLASSIFICATION OF EXPENDITURE
The classification of government expenditure is done mainly to achieve the objectives of government i.e. financial control, estimation of revenues and expenditures of government, allocation of funds to the various sectors of the economy, economic growth etc. In order to achieve these objectives, public expenditure has been classified into four categories, viz., Functional classification, Accounting classification, Economic classification, and Cross classification. Accounting classification classifies government expenditure into "Revenue" and "Capital", 'Developmental" and "NonDevelopmental", "Plan" and "Non-Plan" expenditure. Developmental expenditure is said to be directly related to the promotion of the backward economy, whereas non-developmental expenditure does not. However, in actual practice, non-developmental expenditure in the form of the capital outlay on rehabilitation, administration and relief does contribute directly or icdirectly to the economic development of the country. The classification of government expenditure into "Plan" and "Non-Plan" is purely an administrative classification and is not related to economic or national accounting principles. Also, the "Plan" and "Non-Plan" do not correspond exactly to "Developmental" and "Non-developmental" categories respectively because we find both these types of expenditure under "Plan" and "Non-plan" heads. For example, the expenditure related to new projects/programmes becomes 'Plan' expenditure during the period of a five year plan. If the projects/programmes are completed within the five year plan period, then their maintenance will be brought under 'non-plan' expenditure, during the next plan period. Again, the 'plan' expenditure, during a particular five year plan, becomes 'non-plan' in the following plan, if the responsibility is shifted on to the state governments, as in the case of centrally sponsored and central sector schemes. Thus,4y classifying expenditure into "Plan" and "Non-Plan", undue influence is given to 'plan' expenditure at the expense of non-plan in government, even though non-plan expenditure also includes capital expenditure and contributes to the economic development of the country. However, this classification is found useful by the Planning .Commission and Finance Commission for determining the central assistance tostates for plan schemes from time to time. The classification of expenditure into "Developmental" and "Non-Developmental" is also not based on any rational principle. Developmental expenditure is said to be directly related to the economic growth of the country, whereas non-developmental expenditure does not. In practice, non-developmental expenditure, in the form of capital outlay on rehabilitation, administration and relief, does help directly o r indirectly in the economic development of the country. Hence, it is difficult to follow a rigid distinction between "Developmental" and "Non-Developmental" expenditure.
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The classification of government expenditure into "Plan" and "Non-Plan", "Developmental" and "Non-Developmental" gives a distorted picture of the whole classification pattern of government expenditure, because Developmental and NonDevelopmental heads are also part of "Non-Plan" expenditure. After all, the test of public expenditure is the amount of satisfaction it gives to the public by the quantity or quality of the services it makes possible. But classifications like the "Developmental" and "Non-Developmental" may ignore this point, unless a sense of proportion is maintained. However, all the three classifications, viz., Accounting, Economic and Cross classification of government expenditure are essential to determine the allocation of expenditure to various sectors, capital formation, employment opportunities, price stability, economic growth and also for ensuring financial control by Parliament and by government within the departments.
'

C

I d Governmen1 ~
Expenditure

~

Check Your Progress 2 Note: i) Use the space given below for the answers. ii) Check your answers with thosegiven at the end of the unit.

1) What are the basic differences between 'Plan' and 'Non-plan' expenditure?

2) Distinguish between 'Developmental and Non-developmental' expenditure

3) Comment on the usefulness of distinction between 'plan' and 'non-plan' and 'developmental' and 'non-developmental' expenditure in government.

9.7

LET US SUM UP

We have seen that the classification of government expenditure serves a number of purposes i.e. parliamentary control over expenditure, economic development, price stability etc. Today, government expenditure has become a part of the life of the citizens. In this unit an attempt has been made to explain the differences between "Plan" and "Non-plan", "Revenue" and "Capital" as well as "Developmental7' and "NonDevelopmental" expenditure. Also. the meaning and usefulness of Economic and Cross classification of government expenditure, has been discussed.

9.8 KEY WORDS
Revenue Budget: It consists of the revenue receipts of government and the expenditure met from these revenues.

Financlal Administration

Revenue Expenditure: It is for the normal running of government departments. Capital Budget: It consists of capital receipts and payments. Capital Receipts: These are loans raised by government from public, which are called market loans, borrowings from the Reserve Bank of India etc. Capital Expenditure: Expenditure incurred on acquisition of assets like land, buildings, machinery, equipment etc. Plan Expenditure: Plan expenditure forms a sizeable proportion of the total expenditure of the Central government. It refers to the expenditure incurred by the Central Government on programmes/projects on the recommendations of the Planning Commission.

9.9. REFERENCES
Chelliah R.J. 1969. Fiscal Policy in Underdeveloped Countries with Special Reference to India, 2nd Edn, George Allen & Unwin: London. Peacock A.T. and J. Wiseman, 1967. The Growth of Public Expenditure in the United Kingdom, George Allen and Unwin Ltd. : London. Reddy K.N., J.V.H. Sarma, and N. Sinha, 1984. Central Government Expenditure, Growth, Structureand Impact, 1950-51to 1977-78, National Institute of PublicFinance and Policy: New Delhi. Singh M.P., 1988. Economics of Government Expenditure and Growth, Reliance Publishing House: New Delhi. Sury M.M., 1990. Government Budgeting in India, Commonwealth Publishers: New Delhi.

EXERCISES
Check Your Progress 1

1) Your answer should include the following points: Government expenditure covers all the expenditure incurred by government under the accounting heads of "Revenue", "Capital" and "Loans". Revenue expenditure is the expenditure incurred for running the government departments, payment to various services and interest charges etc. Revenue expenditure does not result in creation of any assets. ~evenue receipts comprise taxes and other duties levied by the Union. Capital Receipts are loans raised by government from public, which are called market loans, borrowings from R.B.I. etc. Capital expenditure is the expenditure intended for creating concrete assets of a material character in the economy. 2) Your answer should include the following points: Economic classification refers to the resources allotted by government to various economic activities. It divides government expenditure into meaningful economic aggregates like public consumption, investment, generation of income, etc. It enables policy makers to step up expenditures in those sectors, which contribute to the economic development of the country. Cross classification or Economic-cum-Functional classification helps in analysing expenditure, according to its economic character as well as functions. It is found useful in drawing up a programme of projected expenditure covering a period of years and in evaluating the progress of actual expenditure against budget provisions.
Check Your Progress 2
11 Y n i ~ r nnpwer shn~ild inrliide the fnllnwin~ nnints:

Plan expenditure refers to the expenditure incurred by the Central government on programmedprojects, on the recommendations of the Planning Commission. Non-plan expenditure is a generic term used to cover all the expenditure of government, not included in the plan. Examples are expenditure on defence, interest payments, subsidies etc.

C'BbSincatiOn OrGOVernment

Expenditure

2) Your answer should include the following points: Developmental expenditure is an accounting concept that has grown in conjunction with economic plans. It constitutes the main target of the plan. Developmental expenditure covers the expenditure incurred on social and community services and economic services. Non-developmental expenditure is an unproductive expenditure, even though some portion of it contributes indirectly to economic growth.
3) Your answer should include the following points: Classification of expenditure into "Plan" and "Non-Plan" is purely administrative and has nothing to d o with economic o r national accounting principles. Similarly, the classification of expenditure into "Developmental" and "Non-developmental'', beyond a certain point, distorts the whole classification of government expenditure, as Non-developmental expenditure also includes Plan and Non-plan expenditure. Notwithstanding these limitations, these classifications of government expenditure are essential for achieving the objectives of government.

UNIT 10 PUBLIC EXPENDITURE: THEORIES AND GROWTH
Structure
Objectives Introduction Determinants of Public Expenditure Impact of Public Expenditure Growth of Public Expenditure in India Let Us Sum U p Key Words References Answers to Check Your Progress Exercises

10.0 OBJECTIVES
After studying this unit you should be able to: evaluate the various theories and approaches by different schools of thought regarding the determination of public expenditure; explain how public expenditure policies and measures affect different aspects of the economy; trace the growth of public expenditure in India and analyse it with the help of theories discussed; and highlight the recent trends in public expenditure policies in India.

1 0 1 INTRODUCTION
Consistent with the earlier concept of state as a police state, minimum expenditure by it was considered to be the best level of expenditure. The analysis of public expenditure was not, therefore, recognised as a worthwhile field of economic research. Public finance concentrated on the study of public revenue and issues relating to taxation rather than the expenditure therefrom. In the post Second World War period, there has been a phenomenal increase in the level of government or public expenditure both in absolute terms and also in relation to the national income. There has, therefore, been a great amount of scholarly interest in understanding the causes of public expenditure, and its incidence, that is, who benefits from the various components of public expenditure. The major area of concern has been to channelise public expenditure into those areas of the economy where its effects will be optional in terms of growth, consumption and distribution. More recently, however, serious concern has been voiced regarding the effective utilisation of government funds and the paramount need. to avoid wasteful expenditure. A correct perspective on Central Government expenditure, reasons for its massive growth, pattern and direction of its increase, effects on the economy, recent trends and the need to control it, are issues which are central to the understanding of financial administration. These are precisely the issues which will be examined in this unit.

10.2 DETERMINANTS OF PUBLIC EXPENDITURE
Various theories have been formulated during the last three decades to explain different aspects of public expenditure. As said in Section 10.1 the analysis of trends in public expenditure and its determinants caught the attention of researchers for the past few years. In spite of all these attempts, no comprehensive theory of expenditure has been developed. 'Let us now discuss some of the important theories which seek to explain the factors that determine increasing public expenditure.

Marginal Utility Approach This is one of the important theories developed in the 1920s which suggested an economic approach to determine the composition of expenditure and budgeting. According to this theory, the government spends its limited income on alternative services in such a way that the marginal benefit is the same on all items. Just as an individual, in order to satisfy hisher wants, spends in a manner to achieve a certain balance among different types of expenditure which would ensure, some marginal return of satisfaction from all of these. According to Pigou, "Expenditure should be so distributed between battleships and poor relief in such wise that the last shilling devoted to each of them yields the same real return." The same principle has been restated by Dalton thus "Public expenditure should be carried just so far that the marginal social advantages of expenditure in all directions are equal and just balance thc marginal social disadvantages of all methods of raising additional public income". Though the principle of maximum social advantage is quite attractive in theory, there are practical problems in making it operational. Firstly, it is not easy to quantitatively measure the benefits flowing from diverse.items of public expenditure for instance, expenditure incurred on defence and social security. Secondly, this theory cannot be subjected to a test. Evaluation of activities of the government is difficult due to the vast a'rray of services and goals of the government and absence of an acceptable measure. Thirdly, it is not only the level of present satisfactions of the 'Community' that a government will be concerned with. The future interests of the community are also important. Fourthly, what the community can afford also depends on how the money is raised and how it is spent. Expenditure on unnecessary wars or departments of the government may result in social disadvantages. Expenditure on sustaining loss-making public enterprises with a social service content may, on the other hand, be easily justified. This principle is thus, at best, applicable to the use or distribution of a fixed sum rather than as a standard for determining the total size of public expenditure. Public Goods Approach Public goods are those for which no private mechanism exists for providing themand which are consumed in equal amounts by all. People who have not paid for them cannot be excluded from their enjoyment, e.g. public parks or security. Public goods usually correspond to all goods and services provided by government and include a wide variety of goods and services. The demand for such public goods becomes an important element in the determination of public expenditure. Public Choice The recognition of the importance of the political processes in revealing public preferences has, in due course, contributed to the growth of "public choice" theories. Anthony Downs offered useful analysis of these political processes. Downs' theory, which was based primarily on the US systems, provided a general framework for explanation of public expenditure. In democratic societies, it is held, governments determine revenues and expenditure to maximise their chances for winning the election. The budgeted expenditure is determined not with reference to overall spending and taxation but through a series of separate policy decisions based on estimates of gains and losses of votes. According to Downs, government will provide what voters want and not necessarily what is beneficial. Thus the central reality for governments is the citizen's vote and not his welfare. In order to fulfil voters' demands, promises made at election time, their aspirations for projects or services, the expenditure has to expand making for larger government, larger bureaucracies, bigger budgets and more problems in trying to find resources for financing the budgeted expenditure.
-Ic Positive Approaches The positive approaches are concerned with the actual growth of public expf over a period of time and deal with the formulation and verification @F'~~* hypothesis. These include: Q -49 .no,

Public Expenditure:

Theories and Growth

Financial Administration

Wagner's Law The earliest theory advanced is that of Adolph Wagner in 1876 which came to be known as "Wagner's law". He propounded the "Law of increasing expansion of public and particularly state activities" which is referred to as the "law of increasing expansion of fiscal requirements". The law suggests that the share of the publicsector in the economy will rise as economic growth proceeds, owing to the intensification of existing activities and extension of new activities. According t o Wagner, social progress has led to increasing state activity with resultant increase in public expenditure. He predicted an increase in the ratio of government expenditure to national income as per capita income rises. It is the result of growing administrative and protective actionsof government in response to more complex legal and economic relations, increased urbanisation, and rising cultural and welfare expenditures. Another reason is the decentralisation of administration and the increase in the expenditure of local bodies. According to Musgrave, however, it is not fruitful to seek an explanation for the total expenditure. Tests carried out by various researchers have shown that the increase in expenditures is far more complex than is evident from the tests carried out on empirical data. Therefore, according to Musgrave, it may be far more rewarding to adopt a desegregated approach (an approach which divides the study of expenditures of government) through a study of expenditures of government on capital formation, consumption and transfer payments. Displacement Effect Hypothesis of Peacock and Wiseman Peacock and Wiseman based on a study entitled "The Growth of Public Expenditure in the UK, 1961", provided an explanation to fluctuations in public expenditure over time. The hypothesis put forward is that public expenditure grows due to growth in revenue. During settled times, people call be expected to develop notions of acceptable rates of taxation. This can be known as the tolerable level of taxation and this level cannot be high. With real economic growth, the more or less stable level of taxation will produce increasing amounts of revenues as well as expenditure. This, however, does not explain the relative increasing growth in public expenditure. Large scale social disturbances, like wars, influx of refugees change the tolerance limit of people to the burden of taxation which arises as a result of increased spending. The result is called a "displacement effect" which shifts expenditures and revenues to new higher levels. So a displacement effect is created when the earlier lower tax and expenditure levels are displaced by new and higher budgetary levels. Even after the event is over, new levels of tax tolerance change and the society feels capable'of carrying a heavier tax burden. The level of public expenditure does not return to the low level it was before the event. According to Buchanan "the single best explanation for tremendous growth in the jublic sector of the economy and also for the increased concentration of expenditure in . federal government is provided by the predominant importance of expenditures, : :ct or indirect made necessary by wars and threats of war". While war and military atures are the most important factors responsible for an increase in public jditure, other "social upheavals" and natural calamities like droughts, famine and cause a substantial upward shift in public expenditure. These events create new xgency demands on government -new social welfare schemes, war pensions, affordable previously all leading to maintaining the level of expenditure fter social upheavals.

rstr lent u. e in favc )rough a t

sually has the important policy objective of securing better distribution of the less fortunate citizens. A reduction in inequalities of income *tthrough a progressive tax structure, public distribution system, programme, large scale transfer payments e.g., pensions, ooverty alleviation programmes aimed at reducing rural and *rammes involve large scale outlays atleast till such time as a ' assured to all. q outlined above do throw light on the determinants wssible to lay down a law which will explain the

behaviour of public expenditure in different environments. The factors that have so far influenced public expenditure are environmental, technological, economic, administrative and political in nature.
Check Your Progress 1 Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.

Public Expenditure: Theories and Growth

1) What are the practical problems involved in the marginal utility approach?

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2) Explain public choice theory as a determinant of public expenditure.

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3) Discuss Peacock-Wiseman hypothesis on public expenditure.

10.3 IMPACT OF PUBLIC EXPENDITURE
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Public expenditure diverts economic resources into channels determined by the government in accordance with national objecti4es and public policy. As a . consequence, the scale and direction of public expenditure may affect the pattern and levels of consumption of the community volume of production allocation of resources distribution of incomes levels of prices and employment. These effects are discussed below:
Consumption

Public expenditure enhances the quality of life of people by providing recreational, cultural, educational and public health facilities, such as public parks, playgrounds, libraries, educational institutions, hospitals and dispensaries and scientific, cultural and commercial exhibitions. Consumption, after all, is the end objective of economic activity of individuals. By promoting the level of economic activity and a more equitable distribution of income, the state can bring about a greater sense of social and economic security in the lives of individuals. The government enables them to live a fuller and richer life.
Allocation of Resources

Public expenditure allocates resources in accordance with national priorities. The priorities may be defence, agricultural production and self-sufficiency in food, industrial development, generation of employment opportunities, an equitable distribution of income, balanced regional development, population control, a better ecological

Financial Administration

balance etc. Public expenditure in these areas is bound to raise the community's productive power. According to Dalton "increased public expenditure in many of these directions is desirable in order to bring about that distribution of the community's resources between different uses, which will give the best results, balancing without bias the present and future". Changes in national priorities, from time to time, will be reflected in the pattern of public expenditure. Again, resource allocation has to take into account the balance between present needs and future requirements. Apart from imparting a sense of fairness as between generations, projects with long gestation periods can be undertaken only by the state. Hence allocation has to keep in view the fact that market economy cannot always take care of social needs. These can be taken care of only by the state.
Production The roles of private and the public sectors are complementary. The public sector provides the infrastructure, transport and communications, power, education and public health programmes. In the absence of goods and services provided by the government sector, private sector can hardly make any meaningful contribution towards production and development: According to Dalton, other things being equal, taxation should not adversely affect production and public expenditure should increase it as much as possible. Public expenditure can affect (i) the ability to work, save and invest, (ii) the desire to work, save and invest, and (iii) allocation of resources as between different uses. Public expenditure can influence these factors either favourably o r unfavourably.

The economies of ,developing countries cannot make significant progress unless they concentrate on development of investment goods sector. This may not result in production in the immediate future, as in education and health programmes, infrastructural projects and projects with long gestation periods. This would, however, certainly build up growth potential in the economy, and help take the economy to a self-generating level.
Distribution In Dalton's words, "other things being equal, that system of public expenditure is best, which has the strongest tendency to reduce the inequality of incomes." A system of grants and subsidies is equitable in the measure in which it is progressive. This leads to maximum social benefit. An approximation to this principle would be provided by a system of grants which would bring all incomes below a certain level to that level (say, above the poverty line), without adding anything to incomes above that level. A public distribution system which makes available essential commodities at subsidised prices to the poor, will also achieve the same result. Free provision of services to all members of the society e.g., free health service o r free education, "narrows the area of inequality". Social security measures and social insurance schemes, which are helped partly or wholly from public funds, e.g. oldage pensions, sickness and maternity benefits, unemployment relief, industrial injury compensation, widows pension etc., improve distribution by reducing inequality of incomes. Economic S tabilisation Business activity in an economy is usually characterised by fluctuations of a cyclical nature. A boom in the economy may burst and lead to a depression. While during boom, prices rise beyond the reach of common person, spelling misery. During depression, employment and production levels fall drastically causing colossal damage. During depression, when employment, production and national income start declining, government can undertake compensatory spending. This may imply heavy public works programmes so that employment and incomes may pick up leading to economic recovery. During boom, public expenditure should be strictly curtailed, leading to surplus budgets. During depression, public expenditurepolicy would lead to heavy outlays on public works; expenditure would thus be in excess of revenues, leading to deficit budgets. Thus public expenditure, if properly planned and conscientiously undertaken, will have the favourable effect of raising employment, production and national income, after pulling the economy ont of depression and thus bringing about ereater economic stabilitv.

10.4 GROWTH OF PUBLIC EXPENDITURE IN INDIA
The total expenditure of the Central government has grown from Rs. 529 crore in 1950-51to Rs. 1,19,087crore in 1992-93 (budget estimates) (225 times). Of this revenue expenditure grew even faster. It went up from 347 crore in 1950-51to Rs. 89,570 crore in 1992-93(B.E.) (258 times). But capital expenditure grew at a slower rate. It increased from Rs. 183crore in 1950-51to Rs. 29,517 crore (161 times). It is, however, clear that the total expenditure of the Central government has grown at a much faster rate than the growth rate in national income which went up from Rs. 8,938 crore in 1950-51to Rs. 4,25,672 crore (estimated) in 1991-92 (48 times). One can say, that the total expenditure has been increasing at a rate about 5 times higher than the growth rate of national income (Gross National'Product).
Table 10.1: Growth in Central Government Expenditure

Public Expenditure: Theories and Growth

(Rs. crores) 1950-51 1992-93 Growth over (B.E.) 1950-51 1,19,087 89,570 29,517 4,25,672 Over225 times Over 258 times Over 161 times ,About 48 times

Total Expenditure Revenue Expenditure Capital Expenditure National Income (1991-92) estimated

529 347 183 8,398

Source: Annual Budgets and Economic Survey 1991-92. Another way of looking at this absolute and relative increase would be to relate the expenditure to GNP, as shown in the table below.
Table 10.2: Growth of Central Government Expenditure

(Rs. crores) Year GNP at current prices Expenditure of the Central Government (Capital+Revenue) (3) Col. (3) as per cent of (2)

(1)

(2)

(4)

The trends of the Central government expenditure seem to support two of the most widely discussed approaches to the behaviour of public expenditure. First, there has been an increase in public expenditure that conforms to Wagner's law of increasing state activity. This is obviously the result of the planned economic development undertaken in India since 1950-51. Second, there have been several discontinuities in the trend, suggesting the pressure of Peacocli-Wiseman "displacement effect". As already stated, this effect hypothesizes that government spending rises by discrete stages in response to the periodic occurrence of "social upheavals". Some of the discontinuities in Indian government spending, however, can be attributed to events that may not qualify as "social upheavals". It has been shown that the "displacement effect" was a factor responsible for increase in spending during and after the Indo, Chinese hostilities of 1962. Other factors are: rehabilitation of displaced persons from Pakistan, oil price hike in 1973 and the inflation that followed, and Indo-Pak war in 1971.
i

Another salient feature of the growth of government expenditure is the increase in the relative share of revenue expenditure in the total expenditure. This share was 65.5 per cent in 1950-51. When planning got underway and gathered momentum in the first two

Financial Adminidration

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decades, revenue expenditure always stood at less than 50 per cent of the total outlay of the Central government. The balance, over 50 per cent, was accounted for by capital expenditure. Since the seventies, however, the rate of growth of revenue expenditure has far exceeded that of capital expenditure. In the eighties, revenue expenditure has increased at twice the rate of increase in capital expenditure. Recent Trends: During the two years (1991-92 & 1992-93) (BE) the pace and direction of expenditure have changed radically. The revenue expenditure in 1991-92 increased by 13.8 per cent over that in 1990-91 whereas capital expenditure actually declined by seven per cent. In 1992-93(BE), while the revenue expenditure increased by only seven per cent (down from 13.8 per cent increase in 1991-921, there was a standstill in respect of the capital expenditure. There are two reasons responsible for the downward trend in the rate of increase in government expenditure. Firstly, the fiscal crisis faced by the country beginning with the year 1990-91, deepened in 1991-92. The government initiated corrective measures to restore fiscal discipline in the economy. Some of the key elements in this structural adjustment were containment of non-plan expenditure including defence expenditure and subsidies. Secondly, the economic philosophy of the government has undergone a revolutionary change. The investment programme of the government is no longer aimed at increasing investment in public sector enterprises. With the iiberalisation of the economy -changes in industrial and trade policy, financial sector reforms etc., are all aimed at less government intervention rather than more. Hence, the relative decline in government expenditure. This is every reason to believe that this trend will continue in the foreseable future. Check Your Progress 2 Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit. 1) Examine the impact of public expenditure on distribution.

2) Analyse the increase in Central government expenditure in the light of Wagner's Law & Peacock-Wiseman Hypothesis.

3) Indicate broadly how the various components of the Central government expenditure have been registering an increase since 1950-51.

10.5 LET US SUM UP
The study of public expenditure has become worthwhile because the role of state has been expanding. There has been a phenomenal increase in public expenditure consistent with the welfare functions assumed by governments. As we have discussed in the unit, various theories and approaches have sought to explain the factors determining the growth in public expenditure. Among them, Wagner's Law of increasing state activities and the Peacock-Wiseman Hypothesis are more important. The factors are mainly environmental, technological, economic, administrative and
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Public expenditure diverts economic resources into channels determined by the government in accordance with national objectives and priorities and public policy. A s a consequence, the scale and direction of public expenditure may affect the pattern and levels of consumption of the community, volume of production, allocation of resources, distribution of incomes, levels of prices and employment. There has been a phenomenal growth in public expenditure both in absolute terms and also in relation to growth in national income. This growth is a consequence of the state taking over the function of economic development. Other factors influencing rise in public expenditure have been wars, rehabilitation of displaced persons, oil price hike, and natural calamities. The government is now making a conscious and vigorous effort to reduce the magnitude of public expenditure.

Public Expenditure: Theories and Growth

10.6 KEY WORDS
Economic Stabilisation: Smoothing out business fluctuations of cyclical nature..These fluctuations are boom conditions and depression which affect prices, production and employment. Maximum Social Advantage: Net social advantage of an additional unit of expenditure on all items should be equal to the net social cost of raising additional revenue. Public Goods: Public goods are those for which no private mechanism exists for providing them and which are consumed in equal amounts by all. Individuals cannot be excluded from consuming them even if they d o not pay for them. Also, consumption by one individual does not preclude others from enjoying it.

Gowda Venkatagiri K , 1987. Fiscal Revolution in India, Indus: New Delhi. Jain, P.C., 1989, Economics of Public Finance, Vol. I , Atlantic: New Delhi. Prem Chand, A . 1983. Government Budgeting and Expenditure Controls: Theory and Practice, IMF: Washington.

10.8 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1 1) Your answer should include the following points: Quantitative measurement of benefits flowing from diverse items of public expenditure becomes difficult. The level of present satisfactionsof the community are mainly kept in view by the government whereas the future interests of the community are equally important. The principle is applicable to the use or distribution of a fixed sum rather than for determining the total size of public expenditure. 2) Your answer should include the following points: Public choice theory as propounded by Anthony Downs based primarily on the system of USA, provided a general framework for explanation of public expenditure. According to this theory, public expenditure is determined by the governments desire to maximise their chances for winning the election. 9 Bzdgeted expenditure is determined not with reference to overall spending and taxation but through a series of separate policy decisions based on gains and losses of votes. Citizen's vote is the determining factor in public expenditure. The expansion in expenditure is to fulfil voter's demands - promises made at election time.

Financlai Administration

3) Your answer should include the following points: The increase in public expenditure is due to growth in revenue. During settled times, ;,eople can be expected to develop notions of acceptable rates of taxation which is known as the tolerable level of taxation. Large scale social disturbances, like wars change the tolerance limit of people to bear the burden of taxation to meet the expenditure. This is called a "displacement effect". This effect shifts revenues and expenditures to new higher levels, which continues after the completion of the event. The new levels of tolerance which emerge make the society feel capable of carrying a heavier tax burden.

Check Your Progress 2 1) Your answer should include the following points: Introduction of a system of grants and subsidies which lead to maximum social benefit. Public distribution system which makes available essential commodities at subsidised prices to the poor. Social security measures and social insurance schemes like oldage pensions, unemployment relief etc. to improve distribution by reducing inequality of incomes.
2) Your answer should include the following points: The increase in expenditure of the Central government due to planned economic development undertaken since 1950-51,conforms to Wagner's law of increasing state activity. Events which may not be called 'Social upheavals' like Indo-China war of 1962, rehabilitation of displaced persons from Pakistan, oil price hike in 1973, etc. resulted in "displacement effect" leading to increased spending by the government. This effect hypothesizes that government spending rises by discrete stages in response to periodic occurrence of social upheavals. 3) Your answer should include the following points: Total expenditure of the Central government from 1950-51till 1992-93 (B.E:) has increased about 225 times. Revenue expenditure has gone up 258 times during the same period. Similarly, capital expenditure has risen 161 times. National income, during the same period went up only about 48 times.

UNIT 11 PERFORMANCE BUDGETING
Structure
Objectives Introduction Performance Budgeting : Concept and Objectives Steps in Performance Budgeting Performance Budgeting System in India Performance Budgeting System -A Critical Evaluation Let Us Sum U p Key Words References Answers to Check Your Progress Exercises

11.0 OBJECTIVES
After studying this unit, you should be able to: explain the concept and objectives of performance budgeting describe the steps in performance budgeting discuss the performance budgeting system in India; and evaluate the performance budgeting system.

11.1 INTRODUCTION
In a planned economy, it is logical to think in terms of budgeting both as the nearest link in a well-integrated system of planning, programming and budgeting and as a tool of management. It provides a system of information for decision-making, coordination, evaluation and control to the appropriate levels of the organisation. During recent years, there has been a significant increase in public expenditure. Government's. involvement in the stabilisation of the economy, equitable distribution of wealth, stimulating forces leading to economic growth and increase in the price levels are some of the factors that have contributed to the increasing public expenditures. The increasing public expenditures which brought with them a good deal of complexity, led to two significant questions: i) how to control and regulate the increasing public expenditures; and ii) how to introduce efficiency into the public expenditures. In this unit an attempt has been made to explain the concept of performance budgeting and its genesis in Indian administration. A critical review of the system has also been done in the unit.

11.2 PERFORMANCE BUDGETING :CONCEPT AND
As we have discussed in Unit 2 of Block 1 of this course, the financial system of our country during the British period was characterised by high degree of centralisation, adh2rence to rigid financial rules and procedures, integration of accounts and audit etc. After independence, attempts have been made to make the financial administration performance-oriented, with a view to bringing about efficiency and economy in the implementation of plans, programmes and activities. Efforts were made to make the budget an efficient tool of plan implementation. The result has been the introduction o f the performance budgeting system in the government. We shall discuss in detail itbout the evolution of performance budgeting system in India in Section 11.4 of this unit.

Financial Administration

Performance budgeting is generally understood as a system of presentation of public expenditure terms of functions, programmes, performance units, viz. activities1 projects, etc., reflecting primarily, the governmental output and its cost. It is essentially a process which brings out the total governmental operations through a classification by functions, programmes and activities. Through suitable narrative statements and workload data that form an integral part of the presentation, it indicates the work done, proposed to be done and the cost of carrying these out. The main thrust of performance budgeting has been on providing output-oriented budget information within a long range perspective so that resources could be allocated more efficiently and effectively. Its emphasis is on accomplishment rather than on the means of accomplishment. The purpose of government expenditure is more important than the object of expenditure under performance budgeting. Thus performance budgeting is a programme of action for any given year with specific indicators regarding tasks, the means of achieving them and the cost of achieving them. It tries to define the physical and financial aspects of each programme and activity and thereby establish the relationship between output and inputs. Performance budgeting has to operate within the framework of clearly defined objectives which are to be achieved through successful implementation of various programmes and activities undertaken by the concerned agency. Performance budgeting, therefore, involves the development of more refined management tools, such as work measurement, performance standards, unit costs, etc.

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Objectives: Performance budgeting seeks to: i) correlate the physical and financial aspects of programmes and activities; ii) improve budget formulation, review and decision-making at all levels of management in the government machinery; iii) facilitate better appreciation and review by the legislature; iv) make possible more effective performance audit; v) measure progress towards long-term objectives as envisaged in the plan; and vi) bring annual budgets and developmental plans together through a common language. Components of Performance Budget The performance budgets have certain vital ingredients that need to be constantly kept in view: i) a programme and activity classification that represents the range of work of each organisation;

ii) a framework of specified objectives for each programme; iii) a stipulation of the targets of work or achievement; and iv) suitable workload factors, productivity and performance ratios that justify financial requirements of each programme. Formulation of Performance Budget Each performance budget will in the first instance indicate the organisational structure and the broad objectives that govern the approaches and work of the administrative agency. This is followed by a Financial Requirements Table. This Table is the most important part of the performance budget and has three basic elements: - a programme and activity classification indicating the range of work of the agency in meaningful categories - object-wise classification showing the same amount distributed among the different objects of expenditure such as establishment charges; and - sources of financing indicating the budgetary and account heads under which the funds are being provided in the budget.

11.3 STEPS IN PERFORMANCE BUDGETING
Four basic steps are involved in the introduction of performance budgeting: i) Establishing a meaningful classification of public expenditure in terms of functions,

ii) the establishment, improvement and extension of activity schedules for all measurable activities of the government; iii) the establishment of work output, employee utilisation, standard or unit costs by objective methods, i.e. bringing the system of accounting and financial management into accord with the classification; and iv) the creation of related cost and performance recording and reporting system. The important requirement for performance budgeting is a programme of action for any given year with specific indications regarding the tasks, the means of achieving them and the costs of achieving them. This is important even in traditional budgeting process. The distinction, however, is that under performance budgeting the organisations are compelled to think of their future activities not merely in terms of financial plans but in terms of the results, work assignment and organisational responsibilities. It isnormally held that in the context of planningfor economic growth, planning is a thinking process and budgeting is a doing process. Since the physical and financial aspects go together and the programme structure is expected to be the same, performance budgeting facilitates the functional integration of the thinking and doing process. The formulation of programmes for achieving the organisationuLgoals is an important task in the budgetary process. A programme is a segment of an important function and represents a homogeneous type of work. These programmes of work need to be developed for meeting the short-term plans, medium-term plans and long-term plans and involve formulation of schemes, laying down their targets, measuring the financial costs and benefits. The programme has to be assessed in the light of financial and economic factors i.e. ensuring adequate resources for the programme so chosen and examination of the impact of the proposed outlays on the economy as a whole through cost-benefit analysis. Complex programmes are divided into sub-programmes to facilitate execution in specific areas. Each programme or sub-programme further consists of many activities which are shown in the respective budgets. For example immunization programme is a programme under the function 'health'. As each programme has many activities, provision for storage of vaccines could be an activity under the programme. The real commencing point in the budgetary process is allocation of resources. In the conventional system primary emphasis is laid on the previous level of allocations and spendings and no emphasis is laid on its performance in terms of its objectives and the programme of action that it has set out for itself for the next year. Under performance budgeting the primary agency prepares the budget, submits its requirements as per programme classification. It indicates its past activities, their costs, the activities to be taken up during the next year, the results expected and the pattern of assignment of responsibilities. The very basis of the performance budgeting is commitment to achievement and the awareness of accountability. The budget so prepared is reviewed at higher level and resources are allocated keeping in view the priorities of the proposal. Some times due to financial constraints resources may not be available in full and a cut has to be imposed. However, this may be done in full awareness of the implications of the cut on the programme. Under performance budgeting, the programme classification and the rationale behind it indicate a group of choices with their priorities, already'made. This minimises the dislocational effect of cuts and ensures a better identification of their impact on programme achievement. Resource allocation is followed by budget execution. Budget execution must ensure achievement of objectives and for that the following budgetary and managerial considerations must be kept in view: i) Communication of the grants to the various subordinate agencies well in time ii) Ensuring the initiation of action for implementing the schemes provided for in the budget iii) Overseeing the regular flow of expenditures iv) Prevention of cost over-runs; and v) Time phased plan for expenditure and work. The final stage in the performance budgeting process is appraisal and evaluation.

Performance Budgeting

l Administration

Under the existing system evaluation of the physical achievements in certain sectors is being undertaken by the Programme Evaluation Organisation. Under performance , budgeting, each programme would lend itself to an evaluation by the agency concerned, even before it is undertaken by an outside organisation. The important ,aspect is that evaluation should, as far as possible, follow the completion of a programme and the administration should be enabled t o formulate its future course of action in the light of results obtained.

Check Your Progress 1 Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.
1) Explain the concept of performance budgeting.

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2) List the objectives of performance budgeting.

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3) Describe the budgetary process involved in performance budgeting.

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11.4 PERFORMANCE BUDGETING SYSTEM IN INDIA
The need for performance budgeting in India was felt ever since India entered into planning era. The then existing budgeting and control system was found inadequate as no input-output relationship could be established between financial outlays and physical targets. The first study regarding the relevance of performance budgeting to our institutional set-up and needs was made by Dean Appleby in 1953. At that stage, however, the system of performance budgeting was still incipient in the federal government and Dean Appleby was not very certain of the outcome of the system. The Estimates Committee of the Lok Sabha, in its 20th report recommended that "... the Performance-cum-Programme System of budgeting would be ideal for a proper appreciation of the schemes and outlays included in the budget, especially in the case of large scale developmental activities. The Performance Budgeting should be the goal which should be reached gradually and by progressive stages without any serious budgeting dislocation." The recommendation was primarily made to strengthen the parliamentary control over expenditure. The Estimates Committee raised the issue again in their 73rd report in 1960 and suggested that the recommendation regarding performance budgeting be implemented at the earliest possible. These recommendations brought results. In 1961, the Union Finance Ministry accepted the recommendations of the 73rd report of the Estimates Committee and issued instructions exhorting the public enterprises to adopt performance budgeting. However due to operational problems, no undertaking implemented the instructions. In 1964 performance budgeting again became a focus of attention when the Planning

Commission held that "the stage has reached when appropriate methods of Performance Budgetingshould be evolved, so that these become an integral part of the machinery for planning and supervision over plan fulfilment." As a part of the implementation of this suggeston, the planning commission formed a Performance Budgeting unit in the Committee on Plan Projects in 1965. In order to identify the benefits this unit conducted a number of studies which provided the database for Administrative Reforms Commission. When Administrative Reforms Commission was set up, a working group on performance budgeting was established by the Commission. The working group recommended the introduction of performance budgeting in India in the developmental departments both at the Centre and in the States, in a phased. manner. The Administrative Reforms Commission further recommended that the introduction of Performance budgetingshould be initiated with the budget of 1969-70and completed by 1970-71. In view of this, the Union Finance Ministry submitted a document known as "Performance Budgets of Selected Organisations 1968-69'' to the Lok Sabha in April 1968. The Government of India, on the recommendation of A R C (Administrative Reforms Commission) issued guidelines for the adoption of Performance Budgeting in all ministries, departments and State Governments w.e.f. 1973-74. American budget experts were also invited to advise the Government of India on the introduction of performance budgeting.

11.5

PERFORMANCE BUDGETING SYSTEM -A CRITICAL EVALUATION

The government accepted performance budgeting and initiated the process of change, gradually and cautiously, almost two decades ago. The system has since been introduced in all development departments at the centre. Some of the states like Maharashtra, Punjab, Rajasthan, Tamil Nadu and Uttar Pradesh have introduced performance budgeting in a large number of departments. The progress has, however, been very slow in most of them, it is, therefore, necessary to take stock of the gains and limitations relating to performance budgeting. This shall help in consolidating gains and tackling problems and making performance budget an effective tool of internal financial management at all levels of government. Performance Budgeting improves legislative review by presenting a comprehensive view of the various departments and agencies of the government. In fact this system ensures all the advantages that are likely to accrue from an organic integration of the process of planning and budgeting. Performance Budgeting helps to improve public relations by providing clearer information for a rational public appraisal of responsible government. The welfare content of a progressive budget on an activity basis would strengthen the democratic process and evoke meaningful participation of the citizens in the implementation of the tasks set out in the budget. In any organisation decision-making with regard to allocation of resources, determining order of priorities and the structure of responsibilities, is dependent upon the efficiencyof the system of information and communication. Only performance budgeting , accompanied by decentralised accounting and systematic reporting could provide such informational support. Functional classification (about which we have discussed in Unit 7 of Block 2) facilitates integration of the process of planning, programming and budgeting. If annual budget is essentially a part of the long-term development plan relating to the public sector, the traditional budget does not facilitate the interweaving of the physical and financial aspects. The advantages of performance budgeting in such a situation is that it brings the financialand physical aspects together right from the beginning of the proposal to the final stage of the scheme.

Finanrial Administration

In brief, performance budgcting provides for more effective controls, makes legislative control more meaningful, helps to gear the process of decentralisation of authority in conformity with responsibility and improves public relations. Having considered the different aspects of the technique it shall be in the fitness of things to briefly enlist some of its limitations as well. Important among these are as under: i) work The very basis of performance budgeting is classification of goverr~mental into functions, programmes and activities. But in practice it may not be possible to have such well-organised categories.

ii) The programme and activity classifications developed are sometimes too broad to reveal the significant activities of the department to serve as a basis for budgetary decisions and management. iii) This technique focuses on quantitative than a qualitative evaluation. iv) The process of allocation of cost estimates over programme elements is difficult and often these estimates may not be as meaningful as they should be. v) Performance budget aids but does not solve the greatest problem in budget decision making, viz., the comparative evaluation of projects, functions or activities, unless it is supported by cost-benefit analysis which itself is far from perfect especially when the indirect and intangible costs and utilities are involved in a big way.

Check Your Progress 2 Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.
1) Trace the events which led to the adoption of performance budgeting in India.

2) Critically evaluate the suitability of performance budgeting.

11.6 LET US SUM UP
Performance budgeting is a system of presenting public expenditure in terms of functions and programmes reflecting the govemment output and its cost. It is designed to serve the purposes of long range planning. If it is to be of operational significance, it must be built from operating levels of responsibility and summarised suitably for higher level of management. It must be remembered that performance budgeting is a tool. Whether it is manageable or unwieldy depends largely on the skill of the toolmaker. Efficacy of its application depends on the skill, imagination, energy and strength of purpose of the user. All it can provide is meaningful basis for administrative planning, executive coordination, legislative scrutiny and administrative accountability at all levels of government.

11.7 KEY WORDS
Cost Benefit Analysis: A systematic comparison between the cost of carrying out a n y service or activity and the value or the benefit of that service or activity. An attempt is made to quantify as far as possible all costs and benefits arising from that activity.

Financial Requirements Table: It refers to the table indicating programme and objectwise classification of activities indicating budgetary and account-heads under which the funds are provided. Performance Budget: An output-oriented budget emphasising the accomplishment rather than means to accomplishment. Performance Audit: Assessment of the performance of an organisation with a view to know that the results achieved have been commensurate with the expenditure of resources. Work Measurement: It is a method of establishing the time taken by a qualified worker to carry out a specified job at a defined level of performance.

Performance Budgeting

11.8 REFERENCES
I

Prem Chand A , 1969. Performance Budgeting, Academic Book: Bombay. Thavaraj M.J.K., 1979. Performance Budgeting in India in B.C. Mathur et. al., ed. Management in Government, Publications Division, Ministry of Information and Broadcasting, Government of India: New Delhi. Thavaraj, M.J .K., 1978. Financial Administration of India, Sultan Chand & Sons :New Delhi. United Nations, 1966. A Manual for Programme and Performance Budgeting, U.N. Publications : New York.

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11.9 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1 1) Your answer should include the following points: It is a system of presentation of public expenditure in terms of functions, programmes and performance units.
I

Output-oriented budget information. Accomplishment based.

2) Your answer should includi the following points:
b

Correlating the physical and financial aspects of programmes and activities. Improves budget formulation, review and decision-making at all levels of management in the government machinery.

#

Facilitates better appreciation and review by the legislature. ~ a k e possible more effective performance audit. s Measures progress towards long-term objectives as envisaged in the plan; and Brings close annual budgets and developmental plans.
3) Your answer should include the following points:

Formulation of programmes and establishment of meaningful classification in terms of functions, sub-functions, programmes, sub-programmes, activities, etc. Allocation of resources. Budget Execution. Appraisal and Evaluation. Check Your Progress 2 1) Your answer should include the following points: Inadequacy of budgeting and control system in the early era of planning. Suggestions of Estimates Committee of Lok Sabha in its 20th report.

Setting up of Administrative Reforms Commission and its recommendations. Implementation of performance budgeting in India.

2) Your answer should include the following points: Improves legislative review. Meaningful participation of the masses. Provides informational support. Integration of process of planning, programming and budgeting. Some of the limitations of performance budgeting include: - Classification of work difficult and broad. - No qualitative evaluation. - Dependent upon support from other techniques.

CTNIT 12 ZERO BASE BUDGETING
Structure
12.0 12.1 12.2 12.3 12.4 12.5 ,'12.6 12.7 12.8 12.9 12.10 12.11 Objectives Introduction Concept and Meaning of Zero Base Budgeting Zero Base Budgeting and Traditional Budgeting: A Comparison Genesis of Zero Base Budgeting StepsIElements of Zero Base Budgeting Introduction of Zero Base Budgeting in India Implementation of Zero Base Budgeting -Benefits and Problems Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

After studying this unit, you should be able to: explain the concept and meaning of zero base budgeting distinguish zero base budgeting from traditional budgeting trace the developments which necessitated the introduction of zero base budgeting describe the process involved in implementation of zero base budgeting; and discuss the problems and benefits in implementation of zero base budgeting system.

12.1 INTRODUCTION
India has been passing through a tight financial position. The budgetary deficit over the years has been increasing and as a result strict financial control became an urgency. The Government has taken a number of steps to reduce the budgetary deficit through control of expenditure. However, it is a well-known fact that financial management can be toned up through budgetary reforms on the lines of Zero Base Budgeting. Zero Base Budgeting (ZBB) is a control technique which requires that an organisation while preparing its budget should not take earlier year's expenditure for granted but should start afresh. This concept implies that a complete re-examination of the ongoing programmes and activities should be carried out to assess their continued utility. In this unit an attempt has been made to explain the concept of Zero Base Budgeting, its objectives, historical background and the process followed for its implementation. It also discusses the benefits and problems arising from the implementation of zero base budgeting.

BUDGETING
Zero Base Budgeting is a management process that provides for systematic consideration of all programmes and activities in conjunction with the formulation of budget requests. It is a system whereby each governmental programme, regardless of whether it is new or existing programme must be justified in its entirety each time a new budget is formulated. It implies that, in defence of its budget request no department shall make reference to the level of previous appropriation. The analytical definition of Peter Sarant holds that "Zero Base Budgeting is a technique which complements and links the existing planning, budgeting and review process. It identifies alternative and efficient methods of utilising limited resources in the effective attainment of selected

-

Financial Administration

benefits. It is a flexible management approach which provides a credible rationale for re-allocating resources by focusing on the systematic review and justification of the funding and performance levels of current programmes or activities." The objectives of Zero Base Budgeting according to the Department of Expenditure, Ministry of Finance, Government of India are: "Zero base budgeting requires identification and sharpening of objectives, examination of various alternative ways of achieving these objectkes, selecting the best alternatives through cost-benefit and cost-effectiveness analysis, prioritisation of objectives and programmes, switching of resources from programmes with lower priority to those with higher priority and identification and elimination of programmes which have outlived their utility." Zero Base Budgeting, thus, is an operating, planning and budgeting process which requires each manager to justify entire budget requests in detail from scratch, and shifts the burden of proof to each manager to justify why any money should be spent at all, as well as how the job can be done better. This approach requires that (i) all activities be identified in decision packages (or programmes) that relate inputs (costs) with outputs (benefits), (ii) each one be evaluated by systematic analysis, and (iii) all programmes be ranked in order of performance. Zero Base Budgeting aims at achieving a state of affairs whereby the whole of the budget needs to be justified in order to (a) combat waste and complacency (b) ensure that the relative tasks and activities remain under constant watch and review alternative levels of action in each sector periodically. The concept of zero base budgeting is as old as the concept of budgeting. Since the first budget of any organisation is always prepared from zero, all the organisations experience this approach at least once. However, in zero base budgeting the idea is proposed to experience it year after year i.e. every time the budget for the next period is prepared. This does not mean that efforts made earlier are not taken into consideration at all. What it exactly means is that one must re-evaluate all activities to find out the level to which such activity should be funded; i.e. whether it should be eliminated or shall be funded at reduced level or increased level or similar level? It shall be determined by the priorities established by top management and by the availability of funds.

1. 23

ZERO BASE BUDGETING AND TRADITIONAL BUDGETING: A COMPARISON

Zero Base Budgetineis more or less a self-defining term. As we have discussed earlier. in zero base budgeting all expenditures are thoroughly analysed from zero base, such that the current expenditure levels are justified. In contrast, traditional budgeting usually begins with estimation of current costs. These estimates serve as the starting point to which management will add data corresponding to price changes, estimated inflationary uplifts and planned additions, deletions or alternatives. The assumption is customarily made that current expenditure is justified, such that only the large budgeted increments from current expenditure levels need to be investigated. Failure to investigate current expenditure regarding its necessity and effectiveness will lead to funding of activities for which no increase, or perhaps a decrease in spending is warranted. Traditional budgeting has not proved to be a suitable tool for shifting resources from low to high priority areas. It does not involve the same rigorous approach as zero base budgeting and does not answer the question as to whether we are getting value for the money being spent. Zero Base Budgeting is a decision-oriented approach and focuses on old and new activities and connects short and long range goals by monitoring the achievements of objectives. On the other hand, traditional budgeting is accounting-oriented and focuses on increments and monitors expenditures. The logic behind traditional budgeting techniques stresses on three points:

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Last year's spending level is extrapolated into next year, - Some growth factor is added on account of inflation, increase in prices of raw material and wages etc.

Zero Base Budgeting

- Spending level is further incremented for new projects and programmes.
e ZBB attempts to shift the traditional management approach towards a new m ~ d of thinking and operation whereby the managers not only justify the new proposals and the funds required, but also have to justify the ongoing activities and the funds required for them. In other words, in the conventional budgethg no review of ongoing activities is undertaken. It can be shown through the following diagram: Traditional Budgeting New Programmes
b

Zero Base Budgeting Review & Justify On-going Activities ------ - _-

Thus ZBB helps managements to evaluate the claims on scarce resources in terms of organisation's objectives and to make trade-offs among current operations, development needs and profits, and allocate the financial and other scarce resources for the achievement of the objectives or goals of the organisation.
Check Your Progress 1

Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.
1) Discuss the concept of ZBB highlighting its aims and objectives.

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2) Distinguish between ZBB and traditional budgeting.

12.4

GENESIS OF ZERO BASE BUDGETING

The origin of the concept of ZBB can be traced back to the year 1924 when Hilton Young, the noted English budget authority stressed the need for annual re-justification of budget programmes. Later in 1960 the US Defence department introduced the Programme, Planning and Budgeting System (PPBS). It was based on cost-benefit analysis and was very much similar to ZBB. But the final attempt to introduce ZBB was made by the US Department of Agriculture in 1962,when the budget director suggested that each programme be justified from zero and in 1964, this department prepared the budget. This experiment however proved unsuccessful due to various reasons. The various agencies proceeded on the assumption that their programmes were necessary and formulated them accordingly. The new technique was taken as an additional exercise enhancing the volume of paper work, time and energy and as such it could not be

Financial Administration

managed properly by the concerned agencies However, it was Peter Pyhrr who designed its logical framework and implemented it successfully in the private industry in 1969 while working as a staff control manager in Texas Instruments USA. In 1968, Pyhrr reviewed the speech given by Authur F. Burns on the control of government expenditure which advocated that government agencies should start from ground zero, as it were, with each year's budget and present their appropriation in such a manner that all funds can be allocated on the basis of costbenefit analysis, resulting in substantial cost savings. Thus Pyhrr formulated this concept in order to reduce staff costs. He developed this system as a tool for planning budgeting and control. H e first applied it to research and development divisions of the company. Finding it successful, he extended it to other divisions of Texas Instruments. Based on this experience he published an article which caught the attention of the then Governor of Georgia -Jimmy Carter who invited Pyhrr to apply the approach to the State of Georgia. ZBB was introduced for the first time in a government system and was adopted for the formulation of the budget for the fiscal year 1973-74. Jimmy Carter was so much. influenced with its success that when he was elected President of the USA, he introduced the concept of ZBB in Federal Budgeting Control Systems and also made it mandatory through the legislation for the year 1979. President Carter claimed that an effective ZBB system will benefit the Federal Government in several ways e.g. it will:
- Focus the budget process in a comprehensive analysis of objectives and needs. - Combine planning and budgeting into a single process.

- Cause managers to evaluate in detail the cost-effectiveness of their operations.
- Expand management participation in planning and budgeting at all levels of the

federal government. Following the memo, the office of Management and Budget (OMB) issued Bulletin No. 779 on April 18,1977 providing budget guidelines and instructions to the agencies on the use of ZBB for the preparation and justification of 1979 budget requests. It stated ZBB as a management process that provides for systematic consideration of all programmes and activities in conjunction with the formulation of budget requests and programme planning. The principal objectives of ZBB were to:

- Involve managers at all levels in the budget process.
- Justify the resource requirements for existing activities as well as the new activities. - Focus the justification of the evaluation of discrete programmes or activities of each

decision unit.
- Establish, for all managerial levels in an agency, objectives against which

accomplishments can be identified and measured.
- Assess alternative methods of accomplishing the objectives. - Analyse the probable effects of different budget amounts or performance levels on

the achievement of objectives; and

- To provide a credible rationale for re-allocating resources, especially from old
activities to new activities. Though the conversion from conventional budgeting to ZBB did pose some problems, yet the implementation process proceeded smoothly. Thus in the USA ZBB achieved an unprecedented goal without going for a pilot experiment and the Federal government agencies became the experimental laboratory of ZBB. Since 1973, in the USA ZBB has become apopular management tool in both public and private organisations. A dozen states, 36 municipalities and 500 corporations have used it with a great degree of success as compared to government agencies.

12.5

STEPSIELEMENTS OF ZERO BASE BUDGETING

ZBB is a four step budgeting process which can be applied in a relatively simple way in any organisation. However, there are a number of conditions which must be fulfilled
fnr
9

c n n r r ~ c c f i irnnlement9tinn nf ~l

7RR

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There must be a genuine need within the organisation.

Zero Bare Budgeting .

- Thc: management environment of an organisation should be objectively assessed. - A competent management accountant should,occupy a senior budgeting position

within the organisation.

- A ZBB programme must have the unqualified support and involvement of top
management.
- ZBB must be tailored to the technical requirements of the organisation intending to

implement it.
- A budget should be prepared for the organisation. - The implementation of ZBB programme will be aided by a commitment to post-

implementation review and maintenance of the programmes. The basic four steps are: 1) Review of organisational structure, and identification of decision units and their objectives.

2) Analysing the decision units, working and evolving documented decision packages. 3) Reviewing and ranking the decision packages on the basis of chosen criteria. 4) Allocation of organisation resources to rank decision packages and preparing detailed operating budgets.
Step 1. Decision Units

The first starting step in ZBB is the analytical review of the organisational structure and activities conducted. In every organisation there are meaningful interrelated hierarchical parts which are separated in order to verify the reporting relationships and functional responsibilities. This stage is intended to isolate key decision points in the organisation's hierarchy commencing with the lowest level and progressing to the top. The identification of the organisational entities (decision units) which will prepare budget requests for the organisation are accomplished through selection by higher level management. Selections are based on relationship to organisation, special analysis and re-organisation. Other factors are that units are not too low nor too high in the organisation to prevent meaningful review or analysis and the managers of these units make significant decisions on the amount of spending and the scope, direction, or quality of work to be performed. A decision unit is a distinct segment of an organisation for which budget is prepared. Decision units are identified by segmenting the organisation into discrete functions, operations or activities for review and analysis. These are the lowest units in the organisational hierarchy which are headed by responsible managers having authority to make decisions on the activities under their control. These should be capable of carrying out different programmes or activities to achieve an objective. The identifica.ion helps in deciding the levels in the organisation at which budgets should be formulated o r ZBB ought to start first. Instead of considering the whole department as decision units, individual sections or performing units of each of these departments should be treated as separate decision unit. The location of decision unit often is a difficult exercise. It is imperative that in the identification there should be a complete knowledge about the organisational structure, its management and objectives. Once the decision units have been identified, each of these must be analysed keeping in view (a) the functions of the department (b) whether any of the tasks are being performed due to some abnormal situations such as expansion, consolidation, (c) whether any of the tasks being performed be reduced or eliminated completely (d) the minimum staffing required to accomplish the normal functions of the decision units.
Step 2. Formulation and Development of Decision Package

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Top level management completes two functions in the zero base budgeting process before decision packages (budget requests) are prepared. It decides as to which level of management develops the initial budget requests and budget guidance it needs to prepare the requests (decision packages). These two functions illustrate why ZBB is

first a "top-down" process before becoming a "bottom up" management process. A decision package includes comprehensive justification for budget estimates of an activity. Such a justification is built up by answering a number of questions. The first question to be answered is in regard to the need for the proposed expenditure as to what specific purpose it is serving. This would necessitate sharpening the objectives of the expenditure so that it could be evaluated by using the relevant evaluative techniques or measures of performance. In case the proposed expenditure is justified in the context of its objectives, a further question may be asked to know if there is a better alternative of incurring expenditure to achieve the specified objectives. To quote from Government of India's letter issued in 1986on the subject of "Introduction of zero base budgeting in the Government of India" a decision package is a budget request which should contain the following:

- A description of the functions or activities of the decision unit. - The goals and objectives of the various functions/activities of the unit. - Benefits to be derived from financing the activityJproject. - Relevance of the activityJproject to the overall objectives of the organisation/
department in the present context. - The consequences of its non-funding. - The projectedJestimated cost.

- The yearly phasing of the proposed expenditure. - Alternative ways of performing the same activity or same objective
As Pyhrr defines it "the decision package is a document that identifies and describes a specific activity in such a manner that management can (a) evaluate it and rank it against other activities competing for the same or similar limited resources and (b) decide whether to approve or disapprove it. One of the significant aspects of the decision packages is that it is used by a manager to define his or her objectives and responsibilities and how best to meet them at various levels of effectiveness. The manager also defines the methods for achieving the objectives. The manager can recommend elimination of some of the activities.

ZBB Decision Package Format
Decision Package Company Code Bank

Objective of Activity Level of: Resources Desired Results Required Personnel No. Description of Activity Wages Salaries Total staff variable

Dept. Discussion/Section Current Budget Year Year

% age of current

Total How and when accomplished Alternatives to achieve result Advantages of retaining activity Consequences if activity is eliminated Prepared by Date Approved by Date

Step 3. Ranking of decision packages After the construction of decision packages the next important step is to rank the decision packages. Ranking is the process of arranging the various service levels (decision packages) and benefits to be gained from the additional funds to be allocated. These are ranked in order of priority or decreasing benefits to the organisation. The process allows management to allocate scarce resources by concentrating on the following three key questions:

Zero B ~ s Budgeting e

1) Where to spend the money first?
2) How much should be spent in pursuing these goals and objettives? 3) What are the consequences of non-implementing those decision packages which are not going to be approved? The ranking is done on an ordinal scale (i.e. lst, 2nd and 3rd etc.) in order of priority. Because of the huge numbers involved the ranking process takes place at a number of levels depending on the size, geographical dispersion, levelsof management, volume of decision packages, unit managers, budget staff o r by ranking committee.

Cut off level of funding Ranking of decision packages in large organisations is more problematic as compared to smaller organisations. In large organisations identifying each discrete activity with several levels of effort could create a number of problems. If management has to review in detail and rank every decision package with conflicting needs, it may take valuable time and effort of the top management.
This problem could be reduced to some extent by: i) Concentrating management review on lower priority discretionary packages around which the funding levels o r cut off levels will be determined.

ii) Limiting the number of consolidation levels through which the packages will be processed. All packages presented for funding generally would fall into three categories i) Those with higher priority and high probability of funding. ii) Those with marginal priority and which may be funded or not funded dependingon the resources available; and iii) Those with low priority and low probability of funding. The cut off level of funding is usually established arbitrarily as a percentage of current year budget or actual expenditure level or in absolute rupee value. It is important to note that cut off level has nothing to do with the ultimate allocation of resources. It is only a means to help the ranking managers to cut down the time and effort needed to review and rank packages.

Ranking Process
Top level review A Senior level consolidation and ranking Middle level consolidation Preliminary ranking by managers who developed it

B~

B2

B3

B4

CI

c 2

c 3

c 4

c 5

"1

"2

"3

"4

"5

Each subordinate review level prepares a ranking sheet to submit to thenext higher review level. This sheet serves primarily as a summary sheet to identify the order of

Financial Administration

priority placed on each decision package. Each time a ranking sheet is filled out by the ranking manager who sends it to the next ranking manager. It serves the following purposes:

1) It identifies cumulative funding level which helps top management to know whether the total budget request has exceeded the total available resources or is still below it. 2) It allows top management to decide which package it wants to review in detail. 3) It provides a work sheet to top management to make funding decisions among several rankings readily, adjust the funding levels etc.
The ZBB can be adopted by any organisation willing to aggressively eliminate its budgetary deficit. But only managers intimately acquainted with the organisation culture can make it work effectively. Although the process is ideally suited for costeffective planned growth, most managers probably will be initially interested in its enduring cost-reduction aspects and the capability it provides for responding flexibility to sudden shifts in an operating environment.

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12.6

INTRODUCTION OF ZERO BASE BUDGETING IN INDIA

The concept of ZBB has been in use in Indian private industry since long. For example Britannia Industries Ltd. and Union Carbide have been using it since 1977-78 without calling it Zero base budgeting. However in government context, it is of recent origin. The first application of the system was in the Department of Science and Technology in 1983. In view of the severe resource crunch for the seventh plan, several alternative steps were recommended to the government by the Eighth Finance Commission and the Planning Commission to prune the wasteful public expenditure and inefficiencies in implementation of government programmes. The Finance Ministry decided to introduce the system of ZBB in all departments of the Union Government in 1986-87, as it was important to control the government expenditure of the seventh plan which was showing a negative contribution. Unless the situation was remedied, the only alternative was to cut the plan outlay or to resort to more deficit financing than was envisaged in the plan document. Neither alternative was desirable and therefore the government, had launched a massive economy drive. On 10th July 1986, the Ministry of Finance issued a circular-cum-budget guidelines to all ministry departments, and State Governments and Public Sector Undertakings, impressing upon them the need to apply ZBB to all schemes and programmes with over Rs. One Crore outlay from the fiscal year 1987-88. For this purpose, a Central monitoring cell was formed. The Finance Ministry had identified around 150 redundant and low priority schemes with the estimated outlays over Rs. 1000 Crore which the Ministry wanted to eliminate. Among the State governments, Maharashtra has .been implementing ZBB in 42 departments. The budget for 1987-88 reflected a saving of Rs. 50 crore. Several , redundant and duplicative and low priority schemes have either been eliminated or merged. Similarly Karnataka Government experimented with ZBB in Public Health and Agriculture Sections and also had plans to apply it to all 45 departments. Among the public sector undertakings, Madras Refineries Ltd., HMT, BHEL, BEL, Indian Telephone Industries, Indian Oil, Neyveli Lignite Corp., a few steel plants and nationalised banks have planned to implement ZBB.

12.7

IMPLEMENTATION OF ZERO BASE BUDGETING - BENEFITS AND PROBLEMS

The implementation of ZBB has certain benefits and some problems too. Let us now discuss these:

Benefits of Zero Base Budgeting The major benefits of the use of zero base budgeting can be the following: i) Zero base budgeting examines all existing and new programmes and activities. It also makes the managers analyse their functions, establish priorities and rank them. This exercise helps in identifying inefficient or obsolete functions within the area of responsibility. In this way resources are allocated from low priority programmes to high priority programmes.

7tq-o Hase Hudgeting

i
I

iI
i

ii) This system facilitates identification of duplication of effortsamong organisational units. Such inefficient activities are eliminated and some other activities are merged. iii) All expenditures, under this system are critically reviewed and justified and all operationslactivities are evaluated in greater detail in terms of their costeffectiveness and cost-benefits. This requires managers to find alternative ways of performing their activities which may result in more efficient procedures. iv) ZBB promotes the tendency to initiate studies and improvements during the period of operation as the persons at the helm of affairs know that the process would be exercised next year and their knowledge and training would enhance efficiency and cost-effectiveness. v) ZBB provides for quick budget adjustments during the year. If revenue falls short in this process, it offers the capability to quickly and rationally modify goals and expectations to correspond to a realistic and affordable plan of operations.

.

vi) ZBB ensures greater participation of personnel in formulation and ranking processes. This helps in promoting level of job satisfaction and thus resulting in better control and operational efficiency in the organisation. vii) Zero base budgeting is a flexible tool that can be applied on a selective basis. It does not have to be applied throughout the entire organisation or even in all the service departments. Keeping in view the limitations of time, money and persons available to instal, operate and monitor it the management thus can select priority areas to which zero base budgeting may be applied. The benefits of ZBB thus can be summed up as follows:
I

- It eliminates redundant activities and those which are being duplicated.
- It identifies low and high priority activities for resource deployment. - It justifies budget requests on cost-benefit and cost-effectiveness basis. - It allocates scarce resources rationally.
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1

I

It sharpens and quantifies objectives and formulates alternative methods of operations.

- It promotes involvement of line managers in budget formulation.
C

I

Problems in Implementatioo i) Managementfactors: Whenever any cost control technique like zero base budgeting is adopted there is resistance from certain individuals and groups having interest in the organisation. Since goals, objectives and targets are achieved through the actions of responsible people whose behaviour makes the system work or fail, it is essential for the organisation to examine the effects of adoption of new techniques on the people and the effects of people on techniques. This is very important for the adoption of ZBB as it challenges the past practices, methods, performance, attitudes, habits etc., of the people working in the organisation. As such it becomes very important for the management to effectively manage its internal organisation before taking any step towards implementation of the zero base budgeting. Thus effective management of the organisation is the primary requisite in implementation of the programme.
ii) ZBB is time consuming and is a more complicated process than the conventional budgeting. It requires more staff, a great deal of time and effort as compared to conventional budgeting system. For managers at all levels to understand the system thoroughly there is need for proper communication system. iii) ZBB involves voluminous paper work. Each d d s i o n unit is supposed to prepare decision packages and rjve prover iustification. In government de~artments.

Finnncinl Adminislrntion

where there are thousands of programmes and activities, the number of decision packages may run into several thousands. This is bound to create handling problems and confusion. iv) There is no standard formula for identifying the minimum level of funding. Generally minimum level of funding is identified on arbitrary basis which comes from top management as budget guidelines. But the viability of this procedure is questionable. v) The ranking of decision packages, particularly when the number of such packages is large, creates a big problem. The ranking may become an unwieldy process. vi) Zero base budgeting decision and the p v of fixing priorities become a political nightmare. Conflict may arise on ranking as managers have a tendency to assign a higher priority, to their own projects. Problems of ZBB can be summed up as: i) It challenges the past practices, performance, attitudes, of people. ii) It requires more time and effort. iii) Detailed costs and necessary information for decision packages often are not made available. iv) It increases paper work to unmanageable proportions. Ranking a large number of decision packages becomes an unwieldy process. vi) Identifying various levels of funding, particularly the minimum level is a difficult task.
v)

Check Yonr l'mgms 2 N t : i) Use the space given below for your answers. oe ii) Check your answers with those given at the end of the unit.

1) Trace the evolution of zero base budgeting system in India.

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2) Describe the stages in the implementation of zero base budgeting.

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3) What are the benefits of this technique?

LET US SUM UP
The ZBB is a technique which helps in achieving the goals of an organisation through better resource allocation. It is a system of helping managers at all levels to evaluate in

b

I
B

detail the Cost-effectiveness of their operations and specific activities. It permits the executives to better establish their priorities and allocate scarce resources. Under this system, new expenditure proposals are to compete on the same footing with the ongoing expenditure based on their respective merits so as to claim a share of the available resources. In India ZBB was formally introduced in 1986 but so far it has failed to take off. It has been implementedin the true sense only in the department of space. For the rest of the ministries the success is negligible. However, the economic crisis through which India is passing, makes it imperative that ZBB is implemented in true spirit. In fact the system has failed to take off due to administrative problems.

Zero Base Budgeting

12.9 KEY WORDS
Deer~lon Unit: It is a distinct segment of an organisation for which budget is prepared. It is identified on the basis of functions, operations or activities of the organisation. Dcso eiin A document that identifiesand describesfacts about an activity from every possible angle.

..

,

m:

PInnning Rogpmdqj Bodgding System ( P S : It is a technique for optimising PB) allocation of fundsin the budget through exercise of proper choice among programmes which compete for limited resources. This technique requires that the identification of goals or objectives to be achieved by the organisation be clear and specific. The next step is to search for alternative programmes for achieving these objectives most . effectively and at least cost. The costs of each programme should be related to the corresponding output from them. Ranking: Procxs of arraaging activities in the order of their priority.
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12.10 REFERENCES
Austin Allan, Cheek Logan, 1979. Zero Base Budgeting: A Deckion Package Manual, Amaclom: New York. Handa, K.L. 1991. Expenditwe Control and Zero Base Budgeting, Indian Institute of Finance: New Delhi. Joshi, P.L. & V.P. Raja, 1988. Techniques of Zero Base Budgeting: Text and Cases, Himalaya Publishing House: Bombay. Pyhrr A. Peter;1973. Base Budgeting, John Wiley and Sons: New York. Sarant Peter C.,1978. L o &irc Budgeting in Public Sector, Westley Publishing Company: Addison. Stonica Paul J., 1977.'Zero Base Planning and Budgeting, Don Jones: Home Wood.

12.11 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
1) Youranswer should include the following points: Zero base budgeting is a system whereby each governmental programme, regardless of whether it is a new or existing programme must be justified in entirety each time a new budget is formulated. Whole of the budget must be annually justified from scratch in order to combat waste and complacency. It requires identification, examination, selection of the best alternatives through cost-benefit and cost-effective analysis.

2) Your answer should include the following points: in zero base budgeting all expenditures are thoroughly analysed from base zero while traditional budgeting usually begins with the estimation of current cost.

Financial-Administration

Zero base budgeting facilitates shifting of resources from low to high priority areas while it is not possible with traditional budgeting. While zero base budgeting is decision-oriented approach which focuses on old and new activities, traditional budgeting is accounting-oriented which monitors expenditure.

Check Your Progress 2

1) Your answer should include the following points: Introduction of ZBB in all departments of the Union Government in 1986-87 with a view to controlling government expenditure. Issue of budge guidelines by the Ministry of Finance to all ministry departments, state governments, public sector undertakings to apply ZBB to all schemes and programmes with over Rs. one crore outlay for the fiscal year 1987-88. Introduction of ZBB in some states like Maharashtra and Karnataka.
2) Your answer should include the following points:

Identification of decision units and their objectivies. Formulation and development of decision packages. Ranking of decision packages. Allocating resources to decision packages.

3) Your answer should include the following points: Identifies inefficient or obsolete duplication of activities. \ Facilitates critical review of all programmes/activities in terms of their costeffectiveness and cost-benefits. Ensures greater participation of personnel in formulation and ranking process. Provides for quick budget adjustments during the year. Allocates scarce resources rationally.

UNIT 13 SOURCES OF REVENUE: TAX AND NON-TAX
Structure
13.0 Objectives 13.1 Introduction 13.2 Tax Revenue - Concepts and Classification
13.2.1 Direct Taxes 13.2.2. Indirect Taxes

13.3 13.4 13.5 13.6 13.7 13.8 13.9

Non-tax. Revenue Sharing of Receipts with States Resource Mobilisation over the Years Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

13.0 OBJECTIVES
After reading this unit, you should be able to : state the concepts and classification of tax revenue discuss the components of non-tax revenue describe the sharing of receipts with states; and explain trends in resdrce mobilisation over the years.

13.1 INTRODUCTION
Mobilisation of resources is a sine-qua-non for planned economic development of the economy. It becomes the means to the attainment of growth. The term resource mobilisation covers much more than taxation. It covers the income from public services, public enterprises and public utilities. A development plan, in order to be ,uccessful, should accord the highest priority to the generation of sufficient surplus from the ccrrent revenues of the government, its departmental units and the public enterprises. As development proceeds and the level of income in the economy rises, it should be able to mop up additional resources in the form of public borrowings and small savings. It may also be necessary to resort to deficit financing (about which we will discuss in detail in Unit 15) primarily to provide money for increasing transactions in the wake of rising incomes and growing monetisation of the economy. But at the same time care should be taken to ensure that it does not become inflationary. Similarly external assistance may be necessary as long as domestic resources do not prove adequate to finance the developmental programmes. In this unit, we are concentrating mainly on two sources of revenue-tax and non-tax for resource mobilisation. The compdnents of tax and non-tax revenue will be discussed and as an example provisions in regard to Budget of 1991-92 relating to resource mobilisation will be given.

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13.2 TAX REVENUE - CONCEPTS AND CLASSIFICATION
The income of the government may be defined either in a broad or narrow sense. In a broad sense it includes all 'incomings' or 'receipts' and in the narrow sense only those receipts which are included in the ordinary concept of revenue. The, chief elements which are included in the concept of public receipts but excluded'from that of public revenue, are receipts from public borrowings hnd from the sale of public assets.

The most important source of government revenue is from taxes. A tax is a compulsory charge imposed by a public authority, like for example income tax. Sometimes description of taxes cover penalties for offences. The distinction between taxes and penalties is one of motive; a pubIic authority imposes taxes mainly to obtain revenue and resorts to penalties mainly to deter people from doing certain things. Therefore, a tax is a compulsory contribution imposed by a public authority, irrespective of the exact amount of service rendered to the tax payer in return, and not imposed as a penalty for any legal offence. The commonest classification of taxes is between direct and indirect taxes. Direct tax is imposed and collected directly from the person on whom it is legally imposed while an indirect tax is imposed on one person, but paid partly or wholly by others. Thus an indirect tax is conceived as one the incidence of which can be shifted or passed on to another person, while the incidence of the direct tax falls on the person concerned and cannot be shifted or passed on to another person. Now let us discuss in detail the types of direct and indirect taxes.

13.2.1 Direct Taxes
Income Tax, Corporation Tax, Capital Gains Tax, Estate Duty, Gift Tax, Wealth Tax come under the category of direct taxes. In the case of direct taxes the liability is determined with direct reference to the taxpayer's tax-paying ability, while in the case of indirect taxes, this ability is assessed indirectly. For instance, in case of incometax which is a direct tax, the amount of tax to be payable by a person, is determined on the basis of that person's income. Let us discuss in detail the various direct taxes. These form source of revenue for the Union Government. a) Income-Tax : This is the tax which is levied on the total income of the tax payer after reducing prescribed deductions. In India, the first Income Tax Act was passed in 1886. Later in 1922, a comprehensive act was passed. In 1961, this Act was repealed and a new Income Tax Act was passed. Under the Income Tax Act, income includes salaries, interest on securities, profits and gains of business and professions, capital gains, value of any benefit or perquisite., any winnings from lotteries, other games etc. But income derived from agricultural activities is exempted from income tax till date. There are changes made in the rates of income tax from year to year. Also under the Indian Income Tax Act certain incomes are totally exempt from tax. Some of these include, accumulated balance of recognised provident fund, death-cum-retirement gratuity, house-rent allowance upto a certain limit, scholarships granted to meet educational costs, post-office savings etc. The budget 1991-92 proposed certain major changes in the rate structure of income-tax. The exemption limit for personal income tax was raised from Rs. 18,000 to Rs. 22,000 i.e. income tax will be levied only on annual incomes exceeding Rs. 22,000. Any person getting an annual income upto Rs. 22,000 need not pay any income tax. The lowest tax rate of 20% has been extended from the existing limit of Rs. 25,000 to Rs. 30,000. Under the new system introduced for 1991-92, a person contributing to provident fund, Life Insurance Corporation etc., can now be entitled only to a tax rebate calculated at the rate of 20% on such savings. b) Corporation tax : In India, the companies are subjected to tax on their incomes which is called Corporation tax. Apart from this, the companies deduct tax at source from the dividends of shareholders and deposit them with the authorities. Hence whatever dividend a shareholder gets is the amount received after deduction of tax. The Corporation tax which is levied on the income of the Company is different from this. This is levied at a flat rate and subject to a number of rebates and exemptions. These rebates and exemptions vary according to activities, criteria, types of corporate income. The Budget of 1991-92 reduced the tax rate for widely held domestic companies from the existing rate of 50% to 40%. As a measure of relief the deduction for setting up new industries was raised from 25% to 30% in the case of companies and from 20% to 25% in the case of others. This benefit can now be availed-of for 10 years as against 8 years.

c) Tax on Capital Gains : This is the tax levied on the sale of any asset like land, building etc. when the price at which it is sold or transferred exceeds the price at which it was purchased or acquired. In India. any profits or gains arising from the transfer of a capital asset are taxed under the head 'capital gains'. However, certain capital assets have been excluded from the purview of this tax, like consumable stores, raw materials, furniture etc. d) Expenditure Tax : Thi$ tax was introduced in 1958 in India. The tax was levied on persons and Hindu Undivided Families whose income from all sources during the relevant previous year, after deducting all taxes on such income, exceeded Rs. 36.000. It was introduced on the recommendation of Prof. Kaldor who felt that expenditure was easily definable than income as the basis of taxation and it was a better index of taxable capacity. But later in 1962, it was abolished, as it failed in curtailing extravagant consumption or checking the evasion of other taxes. Again in 1987, the Expenditure Tax Act was introduced which provides for levy of a tax on expenditure incurred in hotels where the room charge for any unit of accon?modation is Rs. 400 or more per day per individual. The rates of expenditure tax have been raised w.e.f. 1.6.1989 from 10% to 20% of expenditure incurred in connection with provision of any accommodation, food, drinks and certain other categorics of services. It will not apply to expenditure incurred in foreign exchange or in the case of persons enjoying diplomatic privileges. e ) Wealth Tax : The Wealth Tax Act, 1957 provides for levy of a tax on the net wealth of every individual, Hindu Undivided Families and companies which are closcly hcld. Agricultural property is not included in the net wealth of an individual. But possession of amount of wealth to a certain limit is exempted from wealth tax. The Finance Act of 1985 enhanced the basic exemption under the Wealth Tax Act from Rs. 1.5 lakhs to Rs. 2.5 lakhs in respect of individuals and Hindu Undivided Families. The maximum rate of tax was also lowered' from 5% of the taxablewealth to 2% if the assessable wealth exceeds 30 lakhs in -respect of individuals and Hindu Undivided Families. f) Estate Duty : The estate duty was introduced in India in 1953. It was levied on the total property passing or deemed to pass on the death of a person. The duty was leviable on all property belonging to the deceased which included cash, jcwcllery. household goods etc. A slab system was fixed according to which tax was lev~cd. Later many changes were brought about under various acts in the rate of tax. The Estate Duty (Amendment) Act 1984, discontinued estate duty on agricultural land. The levy of estate duty in respect of property (other than agricultural land) passing on death occurring on or before 16 March, 1985 has also been abolished under the Estate Duty (Amendment) Act, 1985. g) Gift Tax : Gift tax was introduced in India in 1958. It is a tax imposed on gifts made by individuals, Hindu Undivided Families, Corporations, on the value of the taxable gifts made by them during the year. It is paid by the person giving the gift. Initially gifts upto Rs. 10,000 were exempted from the tax. Later changes were brought about in the exemption limits. According to the 1991-92 Budget, gift tax is levied on gifts exceeding a value of Rs. 20,000, subject to certain exemptions. These exemptions include gifts to charitable institutions, female dependents on the occasion of marriage, gifts to spouse etc. The direct taxes as discussed above are the sources of revenue to the Central Government. The proceeds of some of the above taxes though collected by the Union Government are distributed between the Union and states. We shall be discussing about these provisions in Section 13.4 of this unit. The direct tax revenues of the State governments include the State's share of income tax, estate duty, la'nd revenue, urban immovable property tax etc.

Sources of Hrvcl~ue Tax and Non-Tax

:

1 . . Indirect Taxes 322
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Having dealt with the various types of direct taxes, which form the source of revenue to the Central government let us now discuss about the indirect taxes. In our taxation system a heavy reliance is laid on indirect taxes which amount to around 83%. Indirect taxes include sales tax, excise duties, entertainment tax, customs duties etc. One of the important reasons for increasing revenue from indirect taxes is with

b u m Mobllisstion

increasing financial requirements of revenue, it is easier to impose and revise the indirect taxes than direct taxes. a) Customs Duty : These are taxes imposed on goods entering (import duties) or leaving (export duties) a customs area. Taxes imposed on goods imported from abroad are import duties while those levied on goods exported from the country are export duties. There are broadly three types of customs duties - import duties, export duties and cesses on exports. i)

Import duties : These are levied according to the rates of duty prescribed under Schedules I and I1 of the Indian. Tariff Act 1934. A commodity schedule prescribes the different rates of import duties leviable on different commodities. Generally luxury items are charged the highest with a view to discouraging their import while low rates are charged for essential items. The net customs revenue has been estimated at Rs. 20,800 crore during 1990-91 and Rs. 26,410 crore in 1991-92 after taking into account the changes brought under the Finance Act 1990. As against the original estimate of Rs. 21,213 crore, revised estimate for 1990-91 with regard ro import duties, is placed at Rs. 20,562.65 crore. The estimated decrease in gross revenue is mainly on account of less revenue realisation from project imports, electrical machinery, iron and non-alloy steel, stainless steel, non-ferrous metals, motor vehicles and parts thereof, organic and inorganic chemicals, glass and glassware etc. This decrease in estimated revenue realisation is likely to be balanced to a great extent by increased collection of import duties from crude oil and other petroleum products, machine tools, plastics, rubber products, railway locomotives and materials etc. Anticipated import duty realisation (net) in 1991-92 shows an increase of Rs. 5,508.79 crore as compared to the revised estimate of 1990-91. The increase in gross revenue is expected mainly from crude petroleum and other petroleum products, electrical and nonelectrical machinery, project imports, chemicals, transport equipment. Budget estimates for 1991-92 take into account the impact of adjustment of exchange rates effected in July 1991.

ii) Export duties : Export duties before World War 11, were levied with the prime objective of mobilising revenue. Later, during the post war period, they have been levied for other purposes. According to the Report of Taxation Enquiry Commission (1953-54), "several duties have been imposed for preventing the impact on domestic markets of inflationary conditions abroad, or for stabilising domestic prices, while other duties have been imposed for protective purposes." In the initial years of planning, the share of export duty in the total indirect taxes was quite high as during that time India had a foreign market monopoly for the staple products. But later, due to decline in India's monopoly in staple products, it became essential to reduce the rates of duties on many commodities like jute, tea, textiles and by the end of the third plan, these duties had to be practically abolished. Later again in 1966, these export duties were reimposed on many items due to competitive position of goods in international market. Export duties are increased, reduced or abolished by the government from time to time keeping in view various factors like the production of the commodity, its exportable surplus, its demand and prices in international market, etc. But the share of export duties in total indirect taxes is showing a downward trend, mainly due to expansion in revenue from the union excise duties. The revised estimate of net collections from export duties in 1990-91 is placed at Rs. 1.00 crore as against the original estimate of Rs. 6.15 crore. The budget estimate for 1991-92 has been placed at Rs. 0.10 crore. b) Union Excise Duties : These are taxes or duties imposed upon the domestic productjon of commodities for sale or consumption within the country. In India, under the Constitution, excise duty can be levied only by the Union Government, other than those on alcoholic liquor, opium, narcotic drugs etc. on which the state governments levy state excise duties. In recent years, excise duties have becom, an important source of revenue for the Government of India because of growing
indiopnen~~c nrndwtinn nf mmmndities

Excise Duties can be specific or ad valorem. It is specific when levied at a specified rate per unit of the physical product. 'Ad Valorem' duty is related to the monetary value of the commodity and levied at certain percentage of this value. Union excise duties are levied on commodities covered by the Central Excises and Salt Act 1944 and other special acts enacted from time to time. The commodities are grouped into 139 budget heads. A number of commodities are however exempted from duty. The receipts during 1990-91 are estimated at Rs. 24,500 crore as against the budget estimate of Rs. 25,125.03 crme (after taking into account the effect of changes made in the Finance Act 1990) showing a decrease of Rs. 625.03 crore. The decrease in basic and special excise duties in the revised estimate of 1990-91 as compared to the budget estimate is mainly on account of less revenue realisation from cess on crude oil, petroleum products, iron and steel, rubber products, etc. c) Other Taxes and Duties : In addition to the above taxes there are other taxes such as foreign travel tax, inland air travel tax, foreign exchange conservation tax, water cess etc. These taxes do not fall directly in any of the categories. These taxes are classified under the head 'other taxes'. i)

Sources d Revenue : Tax and Non-Tax

Foreign Exchange Conservation (Travel) Tax : In terms of this Act, a person drawing exchange for travel abroad is required to pay, Foreign Exchange Conservation (Travel) Tax at the rate of fifteen per cent on the rupee equivalent of the foreign exchange released to them. This has been made effective from 5th October 1987. An authorised dealer or a money changer collects the tax from a traveller in respect of all foreign exchange released by himher. However, the following categories of foreign travel are exempted from payment of the tax : a) Medical treatment b) Studies abroad c) Haj and Ziarat pilgrimages d) Visits to Sikh shrines in Pakistan and Bangladesh e) Visits to Kailash Mansarover

ii) The Foreign Travel Tax Scheme was introduced with effect from 15 October, 1971 through Finance Act, 1971. This was further amended by the Finance Act 1989. The amended scheme provides for a levy of a tax of Rs. 300 per passenger for international journey, (Rs. 150 for journey to the neighbouring countries). One per cent of the collection made, less refund, is paid to the carrier as collection charges. iii) Inland Air Travel Tax was introduced through Finance Act 1989. The tax which was levied earlier at a rate of 10% of the basic fare is n'ow levied on the full fare. iv) Water (Prevention and Control of Pollution) CesS is levied on industries and local authorities on use of water, under the Wafer Cess Act, 1977. The receipts are initially credited to the Consolidated Fund of India. The net proceeds are distributed to the state water pollution boards under a prescribed formula. The indirect revenues of state governments include state's share of union excise, state excise, general sales tax, motor vehicles tax, entertainment tax, electricity duties and other taxes and duties.

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Check Your Progress 1 Notes : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.
1) What do you understand by direct taxes? State the types of direct taxes levied by the Union Government.

II

2)

What is Corporation Tax?

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3) What do you understand by Wealth tax?

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4) Distinguish between specific and ad valorem excise duties.

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13.3 NON-TAX REVENUE
The non-tax revenues of the Union Government include (A) Administrative receipts (B) net contribution of public sector undertakings; (i) Railways (ii3 Posts and Telegraphs (iii) Currency and mint and (iv) others. (C) Other revenues which include revenue from forests, opium, irrigation, electricity and dividends due from commercial and other undertakings. Administrative receipts include state plan loans advanced to states by the Centre. In pursuance of the recommendations of the Ninth Finance Commission as accepted by the government, the state plan loans advanced to states during 1984-89 and outstanding as at the end of 1989-90 have been consolidated for 15 years with-9% rate of interest. The interest receipts from the state governments are estimated at Rs. 5,576.53 crore in the revised estimate of 1990-91 and Rs. 6,789.5 crore in the budget estimate of 1991-92.
Table 1

Interest receipts, Dividends and Profits (in Rs.'Crores) Budget a) Interest Receipts b) Dividends and Profit Revised Budget

1990-91 9,519.09 720.89

1990-91 9,572.74 779.55

1991-92 11,008.82 967.12

Sources : R.B.I. Report, ~ u d b e t 1991-92and Economic Survey 1991

Interest on Ldans to Union Territory Governments : The interest receipts during 1990-91 is estimated at Rs. 16 crores and Rs. 18.71 crore in budget estimates of 1991-92 on loans advanced to Union Territory of Pondicherry. Interest payable by Railways : In terms of the recommendations of the successive Railway Convention Committees (RCC) o f Parliament, the Railways paid a fixed dividend to General Revenues on the capital invested in the Railways as computed annually.

Other Interest Receipts : The estimates under 'other interest receipts' are in respect of interest on loans advanced to public sector enterprises, port trusts and other statutory bodies, cooperatives etc. and on capital outlays on departmental commercial undertakings.
Table 2 International Financial Institutions

S w m of RLvcnw : Tax and Non-Tax

I
1) International

Budget
1990-91

Revised
1990-91

Receipts Discharge Monetary Fund 2) International Bank for Reconstruction and Development 3) International Development Association 4) International Fund for Agriculture 5) Asian Development Bank 6) African Development Fund and African Development Bank Total S.D.
Source : Budget 1991-92

Net
509.35

Receipts Discharge
549.98

Net

509.40

0.05

326.18 223.80

115.77
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14.00

101.77

115.77 0.00 4.49
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18.00

97.77

0.60 (-)0.60 1.85 2.64 0.10 (-)O.lO

0.60 -0.60 1.85 2.64 0.40 (-) 0.40

4.49

7.44 637.10 1,250.17

4.80 21.40

2.64 615.70

7.44 677.68 2,736.26

4.70

2.74

351.73 325.95 2,562.35 173.91

1,033.73 216.44

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As a result of evaluation of Fund's holdings of Indian currency as on April 30,1991 the budget estimates for 1991-92 provide Rs. 1,805.03 crore as expenditure for this purpose with corresponding credit under securities account. India is a participant in the Special Drawing Rights (SDRs) Department of the IMF. During the year 1990-91 the net cumulative allocation of SDRs to India remained at SDR 327.00 million as there was no fresh allocativn of SDRs. As in the case of Union Government, the non-tax revenues of the state governments include administrative receipts, net contribution of the public sector undertakings 1 grants-in-aid and other contributions.

13.4

SHARING OF RECEIPTS WITH STATES
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Indian Constitution is quasi-federal and the country has a three-tier government, the central government, the state governments and the local governments. As the local public authorities are directly under the state government, no separate allocation of taxation rights has been done to them. T o avoid any dispute between the centre and states in the fields of taxation, the following constitutional provisions have b e v a d e . 1) There is no tax which can be levied by both the centre and the states. The Lustom duties and the corporation tax fall within the purview of the central government and they account for about 50% of its tax revenue. States have power to levy some other taxes to finance their activities. The important taxes falling in this category are sales tax, land revenue, state excise duties, entertainment tax etc. 2) Some taxes are levied by the central government but their proceeds are divided between the centre and the states. Union excise duties and taxes on income other than agricultural income belong to this category. The basis on which these taxes are divided between the centre and {he states is recommended by the Finance Commission. 3) The power to levy and collect certain taxes is vested in the centre, whereas their revenue proceeds are to be distributed among the states. Estate duty on property other than agricultural land, duty on railway freights and fares, terminal tax on goods and passengers carried by railways o r purchase of newspaper and

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Though some taxes are levied by the central government, the responsibility to collect them is on the state government. For instance, stamp duties other than those included in the Union list and excise duties on drugs and cosmetics have been included in this category. There is need for decentralisation of functions for encouraging local initiative, for securing promptness in decision-making and efficiency in its implementation, and for allowing for a variety of experiments to suit varying needs, tastes and temperaments - this is implied in the federal nature of the Constitution which ensures immediate effective resource mobilisation and maintenance of national perspective. According to 1991-92 budget, current situation of sharing of receipts with states is as follows :
Table 3 Tax Revenue

Budget1990-91

Revised
1990-91 58,916.01 4,120.48 10,414.00 14,534.91 63.25 44,317.85

Budget
1991-92 66,217.73 4,467.91 11,175.47 15,643.38 79.43 50,494.92

Total Tax Revenue Less states share: Taxes on income Union Excise Duties Total States Share Less :Transfer of Union territory taxes and and duties to local bodies Centre's Net Tax Revenue
Source : Budget 1991-92

59,778.57 4,064.31 10,361.44 14,425.75 58.83 45,293.99

There exists a conflict between the transfer of finances made in accordance with the Finance Commission's recommendations and that of Planning Commission. T o avoid this, Financ.e,Commission should be recognised as a permanent statutory body. Its scope and functions must be widened by suitable constitutional amendments. The devolution of revenues from centre to states should be in conformity with economy, administrative convenience and efficiency. It should be able to provide national minimum to people. The ideal way of achieving this is to transfer resources from richer to poorer states. While transferring resources to states, population, climate and rainfall, state of economic development should be kept in mind. Central Government should not make directly any loans to states. State Governments should be encouraged to borrow directly from the public as much as they can. An important development in the sphere of centre-state financial relations in the recent years relates to the states taking recourse to unauthorised overdrafts with the RBI. Two factors, namely, temporary difficulties because of the uneven flow of receipts and expenditures and chronic imbalances between their functions and resources have been behind this trend. Of late repayment of and interest on debts falling due every year are Causing a great drain on the state governments' budgetary resources. Most of the projects on which the state governments invested capital by borrowing from the centre are not yielding the desired rate of returns. This calls for more determined efforts to improve the performance of public sector projects. But some of the non-plan loans have become dead weight debts which need to be remitted. Centre-state financial relations need review and readjustment. States should learn to live within their means and should exploit their resources fully.

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India has done extremely well in terms of tax effort. In 1950-51 when the planning process was initiated, t h ; ~ a x - ~ e National Product (NNP) ratio was as low as 6.4%; t since then it has been risiqg steadily and s t a n d a t 25% (approximately) today. For a developing country like Itidia which started its development effort with a very low per capita income and has recorded an extremely modesyrate of growth (i.e. around

1.370 per annum increase in NNP per capita), this record in mobilising tax revenue is remarkably good by any standard. In India all the major taxes, except personal income tax and land revenue, have recorded buoyancy greater than unity. In recent years buoyancy of excise duty and sales tax has been as high as 1.51 and 1.41 per cent respectively. This has enabled far greater mobilisation of resources through taxation. There still remains some scope for raising additional tax revenue in the country. This can be done if the government decides to show the required political will to tax agricultural incomes which presently remain outside the taxation net.

Sourees of Revenw : Tax and Non-Tar

I

Apart from tax revenue other important aspects of resource mobilisation are generation of non-tax revenues, restricting of current government expenditure and raising of surpluses of public sector enterprises. Additional resource mobilisation measures undertaken in the 1990-91 budget were expected to yield Rs. 1,790 crore. Out of this Rs. 550 crore were to be raised through direct taxes and Rs. 1240 crore through indirect taxes. The states' share in centre's additional resource mobilisation after making adjustment for the loss of Rs. 170 crore on account of concessions in income tax was estimated at Rs. 3 crore. The Railway Budget for 1990-91 proposed hikes in the rates of goods traffic, passenger fares, parcel and luggage rates. These proposals are estimated to yield additional revenue of Rs. 892 crore. ~ e v i s i o h i n postal and telecommunication the tariffs were estimated to result in an additional revenue of Rs. 645 crore. The total additional revenue changes in tax rates, through revisions in railway fares and freights and through revisions in postal and telecommunication tariffs was thus estimated at Rs. 3327 crore in 1990-91. Net profits (after tax) of central government public enterprises increased substantially from Rs. 2994 crore in 1988-89 to Rs. 3782 crore in 1989-90. The rate of return, as measured by the ratio of net profits to capital employed, rises to 4.5% in 1989-90, the which is the highest achieved in the decade. Howeb~r petroleum sector accounted for the bulk of these profits, i.e. Rs. 2,900 crore out of the total Rs. 3,782 crore in 1989-90. The non-petroleum sector enterprises numbering about 200 contributed a meagre sum of Rs. 882 crore. While this reflects an improvement over the net profit of Rs. 430 crore made in 1988-89, the ratio of the net profits to capital employed in non-petroleum sector enterprises was only 1.3% in 1989-90. It indicates that there is a substantial scope for improving the financial performance of non-petroleum central government public enterprises. The overall working results of Central Government public enterprises for the first half of 1990-91showed a net profit of Rs. 481 crore as against Rs. 1,103 crore during the corresponding period of 1989-90. The seventh plan envisaged generation of internal resources to the ex'tent of Rs. 23,013 crore and additional resource mobilisation to the extent of Rs. 11,490 the crore at 1984-85 prices for fii~ancing plan outlays. Against this during the seventh plan, the public enterprises have generated gross internal resources of Rs. 37,715 crore at current market prices. About 32% of plan investment in central public enterprises during the seventh plan was financed by generating net internal resources - 28% by extra-budgetary resources and 40Yo by the budgetary support. The outlook on the resource mobilisation front is serious but not unmanageable. The resource imbalances accumulated over several years cannot be eliminated in a short period. In the present context soft options have either a limited effect or no effect at all in the correction of macro-economic imbalances. The measures introduced during 1990-91, which aimed at better revenue collections and containment of public expenditure have had a limited effect as evidenced by the revised budget deficit which is estimated to be considerably higher than the budget estimate. It is essential that a serious effort be made to introduce corrective measures through hard decisions and difficult choices. Any beginning should aim at strict control over government expenditure, particularly the revenue and non-plan expenditure, rationalisation of subsidies so that they are better directed towards the poor and improvement in revenue collections. Continued effort on the part of the government may provide the basis for a transition to a sustainable resource regime over the next few years.
Check Your Progress 2 Notes : i) Use the space given below for your answers. iih Check vour answers with those given at the end of the unit.

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Resource Mobilipptioll

1) What are the non tax revenue sources of the union government?

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2) Discuss the Constitutional provisions relating to sharing of tax receipts between the Centre and States.

13.6 LET US SUM UP
Resource mobilisation includes not only taxation but also income from public services, public enterprises and public utilities. In this unit, we have discussed the two main sources o f revenue-tax and non-tax. Taxation is a very important source of revenue. Taxes are of two types--direct and indirect. We have examined the important direct taxes which form the source of revenue for Union Government. This includes incometax, corporation tax, tax on capital gains, expenditure tax, wealth tax, estate duty, gift tax. Indirect taxes form a very important source of revenue to the government. Import duties, export duties, union excise duties, other taxes like foreign travel tax, foreign exchange etc. are included under indirect taxes. which have been dealt with in the unit. The norl-tax revenues of the union government consist of administrative receipts, net contribution of public sector undertakings and other revenues. We have discussed the Constitutional provisions regarding sharing of proceeds of revenue between the Centre and state governments, and resource mobilisation over the years.

KEY WORDS
Closely held Companies : These are companies in which more than fifty per cent shares are held by five or less than five persons. Dividend : It is the share of profits earned from a company, either by the government or any individual as holder of shares in that company. Finance Commission : Article 280 of the Indian Constitution provides for the setting up of Finance Commission once in every five years, to recommend to the President measures relating to th& distribution of financial resources between the centre and the states. It is entrusted with the task of distribution between the union and the states of the net proceeds of the taxes which are to be or may be divided between them and the allocation between the states of respective shares of such proceeds. Per capita income : Average income per member of the population of a particular country. Special Drawing Rights (SDR's) :It is an international reserve currency system which was created by the International Monetary Fund (IMF) in 1969. SDR's are used along with goldand dollars as monetary reserves and accepted and used by any member of the IMF as a means of payments between central banks in exchange for existing currencies. SDR's which supplement gold and convertible currencies are created annually and are apportioned to members according to their (the countries) size, importance and requirements. Taxation Enquiry Commission :This Commission was set up in 1953 under the

chairmanship of Dr. John Mathai to review the whole Indian tax structure to make it more equitable and sound.

Sourap of Revenue :

Tax and Non-Tax

13.8 REFERENCES
Bhatia, H.L., 1992. Public Finance (Revised Edition), Vikas Publishing House : New Delhi. Bishnoi Usha, 1980. Union Taxes in India, Chugh Publications : Allahabad. Chelliah Raja J. 1969. Fiscal Policy in Under-Developed Cbuntries with special reference to India, George Allen and Unwim Ltd : London. Jain, Inu, 1988. Resource Mobilization and Fiscal Policy in India, Deep and Deep Publications : New Delhi. Jha, S.M., 1990. Taxation and the Indian Economy, Deep and Deep Publications : New Delhi. Lall, G.S., 1969. Financial Administration in India, H.P.J. Kapoor : Delhi.

13.9 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1 1) Your answer should include the following points : Direct tax is a tax imposed and collected directly from the person on whom it is legally imposed. It is a tax the incidence of which falls on the person concerned and cannot be shifted or passed on to another person. The direct taxes comprise income tax, corporation tax, capital gains tax, estate duty, gift tax, wealth tax.

2) Your answer should include the following points : It is the tax levied on the incomes of the companies. It is levied at a flat rate and subject to a number of rebates and exemptions. Corporation tax does not include the tax deducted by the companies from the dividends of the share holders.

3) Your answer should include the following points

:

The Wealth Tax Act 1957 provides for levy of a tax on the net wealth of every individual, Hindu Undivided families and closely held companies. Agricultural property is not included in the net wealth of an individual.

4) Your answer should include the following points : Specific excise duties are those which are levied at a specified rate per unit of the physical product. Ad valorem duty is that which is related to the monetary value of the commodity and levied at certain % of this value.
Check Your Progress 2 1) Your answer should include the following points : The non tax revenue sources of the Union Government include (A) 'administrative receipts (B) net contribution of public sector undertakings (i) Railways (ii) Posts and Telegraphs (iii) Currency and mint and,( iv) others. (C) Other revenues which include revenue from forests, opium, irrigation, elektricity and dividends due from commercial and other undertakings. 2) Your answer should include the following points : There is no tax which can be levied by both the Centre and the states. The custom duties and the Corporation tax fall within the purview of the Central Government. The states also have power to levy some other taxes to finance their activities. This include sales tax, land revenue, entertainment tax etc. Some taxes are levied by the Central Government but their proceeds are divided between the Centre and the states like Union excise duties. There are certain taxes like estate duty on property other than agricultural land, duty on railway freights and fares etc., which are levied and collected by
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UNIT
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14.0 14.1 14.2 14.3 14.4 14.5 14.6 14.7 14.8 14.9 14.10 14.11 14.12

DEFICIT FINANCING

Objectives Introduction ' Deficit Financing - Concept and Meaning Role of Deficit Financing as an Aid t o Financing Economic Development Deficit Financing and Inflation Deficit Financing and Price Behaviour in India Advantages of Deficit Financing Limitations of Deficit Financing Measures/Alternatives t o Control Deficit Financing Let Us Sum U p Key Words References Answers t o Check Your Progress Exercises

14.0 OBJECTIVES
After reading this unit you should b e able t o : explain the meaning of deficit financing discuss the role of deficit financing as an aid t o financing economic development describe the relationship between deficit financing and inflation state the impact of deficit financing on price behaviour in India point out the advantages and limitations of deficit financing; and suggest measures to control deficit financing.

14.1 INTRODUCTION
The government is committed t o socio-economic responsibilities for breaking the vicious circle of poverty and uplifting the economic conditions of the masses and developing the economy into a self-reliant one. In 1950, it was thought that these objectives could be achieved through the process of planned economic development. Throughout the period of planned economic development in the country one basic problem has been that of mobilisation of resources. Sources of financing economic development are broadly divided into domestic and foreign sources. Domestic sources of finance at the disposal of the government consist of taxation, public borrowing, government savings which include surpluses of public enterprises and deficit financing. The foreign finances consist of loans, grants and private investments. All these sources of finance have their social costs and benefits o n the basis of which an upper limit can be determined for the use of any one method of financing development. Since the financial requirements of development are enormous and all various sources have their own limitations, it becomes almost essential t o make use of all the sources as far as possible. The choice is not between which one is t o be used but between the various combinations of using all of them. Thus both the domestic and foreign sources of finance have their own place and importance in a developing country. It is essential to formulate appropriate policies for different sources of finance and successful implementation of these policies is required for achieving the desired objectives of rapid economic development. Taxation is an old source of government revenue. Not only that, it is also regarded as the most desirable method of financing public investment in developing countries. But it is a well known fact that taxation has a narrow coverage in developing countries and the tax revenuetnational income ratio isnot only low but the increase in this ratio is also very slow during the process of development. Public borrowing is considered a better method of collecting public revenue than

taxation (on the one hand government will get sources for development programmes and, on the other, conspicuous consumption will be reduced). But it cannot substitute taxation completely because there are certain limitations to the use of this source of financing development. Firstly public borrowing depends on the credit worthiness of the government. Secondly, people do not want to lend to the government because the rates of interest offered by the government are lower than those offered by the borrowers in the private sector. And thirdly, if the prices are rising, people will not be interested in saving and lending because of depreciation in the value of money. We shall be discussing about public borrowing as a source of resource mobilisation in detail in the next Unit i.e. 15. Domestic sources of financing economic development are sure to fall short of the huge financial requirements for rapid economic development in developing economies. So external sources of finance have become almost essential for the developing economy. In spite of the necessity of foreign assistance, it remains only a subordinate source of financing development in a developing economy. In the early stages of development a substantial foreign assistance may be needed but gradually foreign assistance as a percentage of development expenditure goes on diminishing as the developing nations must learn gradually to become self reliant. Hence various conventional sources of finance, such as taxation. public borrowing, having been found to be inadequate, deficit financing has been resorted to for meeting the resource gap. The idea of resorting to deficit financing for economic development, which is of relatively recent origin, has remained very controversial. But there are no two opinions regarding the evil consequences of deficit financing, when adopted carelessely for capital formation and economic development. But the problem before the country is to choose between the two evils i.e. to adopt deficit financing for capital formation and face inflation or to go without development programmes due to paucity of funds. In this unit we will discuss the meaning of deficit financing and its role as an aid to financing ec'onomic development. We shall also highlight the relationship between deficit financing and inflation and its impact on price behaviour in India. The advantages and limitations of deficit financing are also dealt with.

Deficla Financing

14.2

DEFICIT FINANCING -CONCEPT AND MEANING

Deficit financing refers to means of financing the deliberate excess of expenditure over income through printing of currency notes or through borrowings. The term is also generally used to refer to the financing of a planned deficit whether operated by a government in its domestic affairs or with reference to balance of payment deficit. In the West, the phrase "Deficit financing" has been used to describe the financing of a deliberately created gap between public revenue and expenditure or a budgetary deficit. This gap is filled up by government borrowings which include all the sources of public borrowings viz., from people, commercial banks and the Central Bank. In this manner idle savings in the country are made active. This increases employment and output. But according to Indian budgetary documents government resorting to borrowing from the public and the commercial banks does not come under deficit financing. These are included under the head of 'Market Borrowings' and government spending to the extent of its market borrowings does not result in or lead to deficit financing. In the Indian context, public expenditure, which is financed by borrowing from the public, commercial banks are excluded from deficit financing. While borrowing from the central bank of the country, withdrawal of accumulated cash balances and issue of new currency are included within its purview. Deficit financing in Indian context occurs when there'are budgetary deficits. Let us now discuss the meaning of budgetary deficit. Budgetary deficit refers to the excess of total expenditure (both revenue and capital) over total receipts (both revenue and capital). In the words of the First Plan document, the term 'deficit financing' is used to denote the direct addition to gross national expenditure through budget deficits, whether the deficits are on revenue or on capital account. The essence of such a policy lies, therefore, in government spending in excess of the revenue it receives in the

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pesource Mobilisation

shape of taxes, earnings of state enterprises, loans from the public, deposits and funds and other miscellaneous sources. The government may cover the deficit either by running down its accumulated balances or by borrowing from the banking system (mainly from the Central Bank of the country) and thus 'creating money'. Thus, the government tackles the deficit financing through approaching the Central Bank of the country i.e. Reserve Bank of India, and commercial banks for credit and also by withdrawing its cash balances from the Central Bank. The magnitude of actual budget deficit during the seventh plan had been of the order of Rs. 29,503 crore (at 1984-85 prices) which was more than double the estimate of Rs. 14,000 crore. The Budget for 1990-91 laid stress on limiting the size of the budget deficit through containment of expenditure growth and better tax compliance. The budget programmed a deficit of Rs. 1,10,592 crore in 1989-90. The revised estimates for the year 1990-91 placed the budgetary deficit at Rs. 10,772 crore which is nearly 50% higher than the budget estimate. Proper financial management demands that the revenue receipts of the government, which are in the shape of taxes, loans from the public, earnings of the state enterprises etc., should not only meet the revenue expenditure but also leave a surplus for financing the plan. Contrary to this deficits on revenue account are growing year after year. For example the revised estimates place the deficit on revenue account during 1990-91 at Rs. 17,585 crore as against the budget deficit of Rs. 10,772 crore. A higher revenue deficit implies higher borrowed resources to cover the deficit leading to higher interest payments thus creating a sort of vicious circle.

FINANCING ECONOMIC DEVELOPMENT
Deficit financing has been resorted to during three different situations in which objectives and impact of deficit financing are quite different. These three situations are war, depression and economic development. Deficit financing during war Deficit financing has its historical origin in wlr finance. At the time of war, almost every government has to spend more than its revenue receipts from taxes and borrowings. Government has to create new money (printed notes or borrowing from the Central Bank) in order to meet the requirements of war finance. Deficit financing during war is always inflationary because monetary incomes and demand for consumption goods rise but usually there is shortage of supply of consumption goods. Deficit financing during depression The use of deficit financing during times of depression to boost the economy got impetus during the great depression of the thirties. It was Keynes who established a Xgositive role for deficit financing in industrial economy during the period of ,depression. It was advocated that during depression, government should resort to construction of public works wherein purchasing power would go into the hands of people and thereby demand would be stimulated. This will help in fuller utilisation of already existing but temporarily idle plants and machinery. Deficit spending by the government during depression helps to start the stagnant wheels of productive machinery and thus promotes prosperity. Deficit financing and economic development Deficit financing for development, like depression deficit financing, provides stimulus to economic growth by financing investment, employment and output in the economy. On the other hand "development deficit financing7'resembles "war deficit financing" in its effect on the economy. Both are inflationary though the reasons for price rise in both the cases are quite different. When government resorts to deficit financing for development, large sums are invested in basic heavy industries with long gestation periods and in economic and social overheads. This leads to immediate rise in monetary incomes while production of consumption goods cannot be increased immediately with the result that prices go up. It is also called the inflationary way of financing development. However, it helps rapid capital formation for economic development.

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Deficit Financing
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14.4

DEFICIT FINANCING AND INFLATION

Deficit financing in a developing country is inflationary while it is not so in an advanced country. In an advanced country the government resorts to deficit financing for boosting up the economy. There is alround unemployment of resources which can be employed by raising government investment through deficit financing. The result will be an increase in output, income and employment and there is no danger of inflation. The increase in money supply leading to demand brings about a corresponding increase in the supply of commodities and hence there is no increase in price level. But, when, in a developing economy, the government resorts to deficit financing for financing economic development the effects of this on the economy are quite different. Public outlays financed by newly-created money immediately create monetary incomes and, due to low standards of living and high marginal propensity to consume in general, the demand for consumption of goods and services increases. But if the public investment is on capital goods, then the increased demand for the consumer goods will not be satisfied and prices will rise. Even if the outlay is on the production of consumption goods the prices may rise because the monetary incomes will rise immediately while the production of consumer goods will take time and in the meanwhile prices will rise. Though investment is being continuously raised (through taxation, borrowing and external assistance), most of it goes to industrieq with long gestation period and for providing basic infrastructure. Though there is effective demand, resource5 lie under or unemployed. Lack of capital, technical skill, entrepreneurial skills etc. are responsible in many cases for unemployment or underemployment of resources in a developing economy. Under such conditions, when deficit financing is resortea to, it is sure to lead to inflationary conditions. Besides, in a developing economy, during the process of economic development, the velocity of circulation of money increases through the operation of the multiplier effect. This factor is also inflationary in character because, on balance, effective demand increases more than the initial increases in money supply. Deficit financing gives rise to credit creation by commercial banks because their liquidity is increased by the creation of new money. This shows that in a developing economy total money supply tends to increase much more than the amount of deficit financing, which also aggravates inflationary conditions. The use of deficit financing being expansionary becomes inflationary also on the basis of quantity theory of money.
Check Your Progress 1 Note : i) Use the space given below for your answers.

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ii) Check your answer with those given at the end of the unit.

1) Explain the meaning of deficit financing.

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2) How does the concept of deficit financing, as existing in the West, differ from that in the Indian context?

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3) Deficit financing in a developing country is inflationary while it is not so in an advanced country. Discuss.

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Resource Mobilkation

14.5

DEFICIT FINANCING AND PRICE BEHAVIOUR IN INDIA

Price stability is an essential condition for stability in economic life as well as economic growth. On the contrary, fluctuations in prices create an atmosphere of uncertainty which is not conducive to development activity. When we examine the price mcvements during the planning period in India, there are three clear trends. First during the first plan period (i.e. 1951 to 1956) the general price level had fallen. From 1955-56 to 1965-66. the prices rose steadily at an annual rate of 6%. Finally. from 1966-67 onwards (except 1975-76 and 1977-78) prices rose at the rate of about 0% per annum and now it is in the double digit range. Deficit financing as a tool for covering the financial gap in India was introduced at the time of formulation of first five year plan. During the first plan deficit financing was of the order of Rs. 333 crore and the money supply with the public increased by about 22 per cent. Since this expansion in the supply of money fell short of the increase in output, the general price level came down by about 18 per cent. During second plan. actual deficit financing was less than the targeted amount,
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The third plan was very abnormal (adverse weather conditions. 1962 Chinese aggression. 1965 Pakistan war). Deficit financing during the third plan amounted to Rs. 1333 crore - more than double the target. Money supply with the public increased more rapidly.

In the fourth plan (1969-71), the amount of deficit financing stood at Rs. 2060 crorc -about two-and-a-half times the target. Money supply increased from 6387 crore to Rs. 11,172 crore at the end of 1973-74. Prices increased by 47% approximately. No doubt there were certain factors beyond the control of the government such as war with Pakistan in 1971, substantial expenditure on account of Bangladesh refugees, oil price hike etc. Besides, the reluctance on the part of the states to mobilise adequate resources, their general financial indiscipline and overdrafts from the Reserve Bank also compelled the government to take resort to deficit financing.
111 view of severe inflationary pressures in the economy since 1972-73. the draft fifth plan 1974-79 laid utmost stress on non-inflationary methods of financing. But. as against the target of Rs. 1354 crore for the fifth five year plan, the actual amount of deficit financing was much more.

During this period, although the money supply increased by about 50 per cent, the overall increase in wholesale prices was 33% because of the imposition of emergency in 1975 resulting in comfortable position in regard to the availability of sever:~l commodities through the effective management of supplies. During the sixth plan (1980-8.5) deficit financing was o f the order of Rs. 15.681 crore as against the estimated target of Rs. 5000 crore. During this period money supply increased from Rs. 23,117 crore-in 1980-81 to Rs. 39,380 crore in 1984-85. Seventh plan paper indicated a cautious approach towards deficit financing and stated that "The required resources have to be mobilised in a manner which minimise dependence on external sources or on deficit financing which has a high inflationary potential." Still the target for deficit financing was placed at Rs, l1,OOU crore and according to the latest estimates the actual deficit financing has been of the order of Rs. 34,182 crore i.e. more than 2.4 times the target. Money supply with the public has increased from Rs. 43.599 crore in 1985-86 to Rs. 76.259 crore in 1988-89 and index of..wholesale prices has gone up from 357.8 to 435.8 during the same period. There were many other factors like mismanagement of the war economy. excessive dependence on monsoon, power shortagz, labour strikes, increase in the rates of commodity taxation, rise in wage rates, black money, rise in the international price

of petroleum products which have been responsible for price rise in India. However, experience shows that the increase in money supply has led to a rise in prices. There has been a close relationship between the rate of increase in prices and the rate of growth in money supply and prices have a tendency to rise to new heights at every successive increase in money supply resulting from deficit financing. When deficit financing is inflationary, i t will go against the very purpose for which it is used because it will simply lead to continuous inflation and no development. Inflation creates uncertainty, labour unrest, work stoppages and decline in production because of the demand for higher wages and salarieh to compensate for higher cost of living. Inflation reduces the real income and the real consumption of all classes of people in the society except the rich. This is objectionable on grounds of economic efficiency, labour productivity and social justice. Moreover, there is no certainty that higher levels of income accruing to profit earners will be invested in1 productive enterprises, for the rich may waste windfall gains in con'spicuous consumption or indulge in speculative activities. Besides, inflation is a sort of invisible tax on all incomes and cash balances. Their value is automatically reduced with every rise in prices. Inflation leads to balance of payments difficulties because due to rising prices the country loses export market and people prefer imported goods. which appear cheaper as compared to domestic goods. Inflation is charged with distorting the pattern of investment and production in the economy. Inflation is beset with the danger of channelising economic resources into less urgent and speculative fields where the scope for profits to private enterprises is Illore and such fields are generally of little importance to the nation. Inflationary deficit financing increases the administrative expenditure of the government because whenever government resorts to large doses of deficit financing, it has to neutralise its effects by sanctioning new dearness allowances, revision of controlled prices. distribution of essentials through fair price shops, compulsory requisition of foodstuffs etc. All these measures lead to an increase in the administrative burden of the government in order to ward off inflation caused by the use of deficit financing.

14.6 ADVANTAGES OF DEFICIT FINANCING
Uptill now, we have seen that deficit financing is inflationary and it destroys its own purpose of aiding economic development. But it is not always so. Secondly inflation 13not always harmful for economic development. On the contrary, to a certain extent inflation is conducive to economic development and hence deficit financing is beneficial. During the process of development, increase in national production is bound to give rise to the demand for increased money supply for transactions. This can be met by injecting new money in the economy through deficit financing. If deficit financing is resorted to for productive purposes especially for the production of consumer goods and that too for quick results then deficit financing is not that inflationary. For example, if any land reclamation activity is to be undertaken which would lead to agricultural production, resort to deficit financing for this activity will not be inflationary. Even if there is a moderate price increase of 4 to 5% per annum, its impact on the economy will not be too severe. Besides, deficit financing will not be inflationary if it is matched by a balance of payment deficit. To the extent to which past savings of foreign balances can be used to pay for such imports, it would be deflationary. But much reliance cannot be put on balance of payments deficit because balance of payments deficit depends on our foreign exchange reserves and our credlt worthiness in the world market. Moreover, a developing country aims at reducing this deficit by increasing exports and reducing imports. Deficit financing will be non-inflationary if the government is able to mop up the additional money incomes, created by deficit financing, through taxation and saving schemes. Properly controlled and efficiently managed programme of deficit financing may help the process of economic development. In fact a certain measure of deficit financing is inevitable under planned economic development to activate unutilised or dormant resources especially when one of the objectives of planning is to step up the

Inflationary impact of deficit financing is helpful for economic development to a certain extent and under certain circumstances like : a) Under developed countries, with their low incomes, low or negative savings, inadequate investment and traditional resistance to change and modernisation, will remain stagnant or develop at an intolerably slow pace unless they are restructured and activised. This can be done with the stimulus of inflation. b) Inflation stimulates economic activities and rising prices induce more ' investments. In a developing economy the major goal is rapid economic development through speedy capital formation. The additional income that is earned through inflation can be ploughed back and if the same process is repeated there is every possibility of a rapid rate of capital formation in the country. For this, inflation may be tolerated to a certain extent. c) Inflation is said to be a useful method of increasing saving in a forced way. There will be redistribution within the private sector of the economy, from the personal sector to corporate sector. Inflation reduces real consumption and provides resources for investment purposes.
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Thus, deficit financing is a necessary and positive instrument to accelerate the rate of economic growth in countries suffering from acute shortage of capital. But any deficit financing has to be undertaken in the context of an efficient and well executed plan for economic development.

14.7 LIMITATIONS OF DEFICIT FINANCING
Deficit financing (as we have examined uptill now) can be regarded as a necessary evil which has to be tolerated, at least in the developing economies, only to the extent it can promote capital formation and economic development. This extent of tolerance is called the safe limit of deficit financing. This safe limit shows the amount of deficit financing that the economy can absorb and beyond which inflationary forces may be set in motion. Though it is not possible to quantify it, yet it is desirable to identify the factors that affect it. Factors that affect deficit financing, can be put under two categories : (a) factors related to demand for money and (b) factors related to supply of money. If the demand for money is low in the economy, the safe limit of deficit financing will be low. Then creation of new money o r deficit financing must be kept at a low level otherwise evil consequences will follow. Reverse will be the case when demand for money is high. On the supply side of money, if due to some factors the supply of money or purchasing power with the public increases, other things being equal, it will have an inflationary tendency and the safe limit of deficit financing will be low. However, safe limit will be high in the opposite situation. The concept of 'safe limit' of deficit financing can be reduced to the age old theory of demand and supply. The point at which demand for and supply of money are equal is the point of safe limit of,deficit financing. Unfortunately conditions in a developing country are not so simple. Various factors simultaneously exert contradictory effects on each side.
Factors Affecting Safe Limit

i)

The safe limit of deficit financing depends on the supply elasticity of consumption goods in the country. Usually, the supply of consumption goods, specially foodgrains, cannot be increased to any extent for a long time due to many constraints in a developing economy. Under such circumstances even a little deficit financing would be inflationary and the safe limit of deficit financing will be very low.

ii) Safe limit of deficit financing also depends on the nature of government expenditure for which new money is created, i.e., the purpose of deficit financing. If the newly created money is used for unproductive purposes, the use f of deficit financing will be inflationary and the safe limit o deficit financing will be lower than if the newly created money is to be used for industrial development or for intensive farming.

iii) If the foreign exchange reserves are increasing the scope of using deficit financing will increase because that way the country will be able to import more goods which will have deflationary effect. iv) Time lag between the initial investment and the flow of final products also determines the safe limit of deficit financing. If this time lag is long, then inflation will set in from the very initial stage of investment and it will not be possible to control the rapidly rising prices. v) Low safe limit of deficit financing is required if the economy consists of large speculative business community. vi) If government is not in position to implement successfully its economic policies accompanying the policy of deficit financing, low safe limit of deficit financing is prescribed. vii) If a country is already passing through inflationary phase, low deficit financing is advised. viii) If the rate of growth of population is high then low deficit financing is good and vice versa. ix) Safe limit deficit financing also depends on a country's tax structure and the borrowing schemes through which the government can take away at least a portion of additional incomes thereby reducing the purchasing power with the public. But all this is not easy in a developing economy where there are rigidities in the tax system. There is large scale tax evasion so that government is not able to take away any substantial part of additionalincomes. The country is, therefore, more prone to inflation and the safe limit of deficit financing is low In a developing economy, all the aforesaid factors exert their influence simultaneously. The effect of each factor may be favourable or unfavourable for the use of deficit financing and sometimes the effects of some factors may counter effect each other and, thus, be cancelled out. This safe limit of deficit financing will be different for different countries because conditions vary from country to country. The safe limit of deficit financing also depends on the measure of popular cooperation which the government gets and the willingness of the people to submit to austerity. Even if this limit is calculated, it will go on changing with every change in the economic conditions of the country. With efforts in the right direction this limit can be shifted upwards so that a larger amount of deficit financing\ can be resorted to by a government which is conducive to economic development and not inflation.

14.8 MEASURES/ALTERNATIVES TO CONTROL DEFICIT FINANCING
Besides open deficit financing undertaken by the goyernment, there is concealed deficit financing in developing economies. In all government departments, in a developing country most of the expenditure is incurred recklessly in the last few weeks of the financial year so that the amount sanctioned may not lapse. This reckless expenditure is largely a waste and is not accompanied by expected results. This expenditure is fairly large every year. It is not productive and it leads to price rise and operates in the economy in a manner similar to deficit financing. Most of the havoc created in the economy is actually created by this concealed deficit financing. If, by efficient and honest administratithi, this vast wasteful expenditure can be avoided, the officially acknowledged deficit financing will not be so inflationary. Anti-social acts such as evasion of taxes, black marketing, cash transactions to supplement recorded cheque transactions, under invoicing and over invoicing of export and imports, and a variety of such forms of corruption on the part of the private parties lead to large volume of 'unaccounted money'. This money is to be spent recklessly and it leads to inflationary rise in prices. Government must try to remove reckless expenditure in public and private sectors caused by 'concealed deficit financing' and 'unrecorded gains' instead of stopping the use of deficit financing which is likely to be spent productively and therefore help in the economic development of the country. In order to minimise the inflationary effects of deficit financing during the process of

Resource .Mobilisation

development the government will have to keep a vigilant and constant watch on changing economic situations, study the repercussions of measures adopted in several spheres and, above all, take effective action on following lines : a) Government should try to drain off a larger proportion of funds resulting from deficit financing through saving campaign and higher taxation. b) The policy of deficit financing should be adopted as a last resort, after exhausting all other possible sources of development finance. c) Investment should be channelled into those areas where capital output ratio is low so that returns are quick and price rise is not provoked. d) Along with deficit financing, government should adopt policies of physical controls like price control and rationing etc. e) Import policy should allow import of necessary capital equipment for economic development and consumer goods required by the masses alone. Import of luxury and semi-luxury goods should be discouraged. f) Deficit financing and credit creation policies should be integrated in such a way that neither of the two sectors (public or private) is handicapped due to shortage of financial resources and, at the same time, inflation is also kept in check in the economy.

Above all these policies, what is more required is that the government should try to seek full public cooperation and people should have full faith in the policies of the government so that government policies can be successfully implemented. Deficit financing or no deficit financing, the process of economic development itself is inflationary. Whenever new investment is financed by taxation or borrowing, the result is an increase in monetary incomes, increase in demand for consumption goods, and price rise. With this background the important question, in a developing country, is not whether deficit financing should be resorted to or not for economic development, but, rather, how far inflation can be pushed without upsetting the productive process. Thus deficit financing is a necessary and positive instrument to accelerate the rate of economic growth in countries suffering from acute shortage of the capital, though it is necessary to emphasise here that it must be undertaken with an efficient and well executed plan for economic development.

Check Your Progress 2 Note : i ) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.
1) When deficit financing is inflationary, it will go against the very purpose for which it is used because it will simply lead to continuous inflation and no development. In the light of the statement, comment on the negative effects of inflation on the economy.

2) What do you understand by safe limit of deficit financing? List atleast three factors affecting safe limit.

3) Discuss a few alternatives to control deficit financing.

Deficit Financing

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14.9 LET US SUM UP
Deficit financing as a method of resource mobilisation has assumed an important place in public finance in recent times. It refers to the means of financing the deliberate excess of expenditure over income through printing of currency notes or through borrowing. In this unit, we have discussed the meaning of deficit financing, its role as an aid to financing economic development in various situations. Deficit financing in a developing country becomes inflationary and it has varied effects on economic development which have been highlighted in the unit. We have also examined the impact of deficit financing on price behaviour in India during the plan period. It shows that, apart from other factors, there has been a close relationship between rate of growth of money supply resulting from deficit financing and rate of increase in prices. But to a certain reasonable extent, deficit financing has proved to be conducive to economic development, especially in countries with acute shortage of capital. The advantages of deficit financing in this context have been dealt with in the unit. As we have discussed in the unit deficit financing in developing economies can be regarded as a necessary evil which can be tolerated only to the extent it promotes capital formation and economic development. This extent of tolerance is known as safe limit of deficit financing. T o minimise the inflationary effects of deficit financing during the process of development, certain measures have to be taken like proper channelising of investment in areas with low capital output ratio, adoption of policies of physical control like rationing, import of only necessary capital equipment etc. In economies with low capital formation, deficit financing becomes a necessary and positive instrument if used with efficient and well executed plan of economic development.

14.10 KEY WORDS
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Balance of Payments : It is a kind of income statement that records all transactions between individuals, firms and governmental units of one nation and individuals, firms, governmental units of all other nations. It gives a record of all transactions between the residents of country and rest of the world with payments expressed in terms of the country's currency. Capital-Output Ratio : It refers to the economy's total stock of real capital divided by the level of its income or output. Capital account : The section of the national income accounts which record investment expenditure incurred by government on infrastructure such as roads, hospitals and schools and investment expenditure by the private sector on plant and machinery. Credit creation : It refers to the process in which the group of deposit taking and lending institutions on the basis of an increase in their reserve assets produce an increase in the volume of their lending and of the associated deposit liabilities. Deflation : In contrast to inflation, deflation refers to a decline in the general price lcvel of all goods and services equivalent to a rise in purchasing power of money. While in the state of inflation, there is a fall in the value of money with increasing prices, during deflation, with fall in the prices, there is increase in the value of money. Gestation period : It refers to the period taken from the conception or initiation of thc project till its final completion or prodllitior. stage. For example, while cottage industries may need less gestation period, say h few munths, an industrial steel or

Resource Mobilisation

energy plant may require quite a few years gestation period. Invoicing : An itemised statement of goods or services brought or sold usually including a request for payment. Marginal propensity to consume : The relationship between the community's income and what it can be expected to spend on consumption will depend on the psychological characteristics of the community which is called its propensity to consume. Multiplier effect : The doctrine of multiplier states that any given increase in investment (private or government) will result in an increase in national income as a. multiple of the increase in investment. For example, money spent in building a new plant, sets off a chain reaction. It increases the income of the workers directly engaged in its construction, the incomes of the merchants with whom the workers trade and so on. Multiplier effect implies that an original excess of investment over savings may over a longer period of time increase money income by several times the primary excess. Overdraft : Borrowing money in excess of what one is entitled to, tdl the balance in the account becomes negative. Quantity theory of money : The theory states that the level of prices in an economy varies directly with the quantity of money in circulation provided the velocity of circulation of that money and the volume of trade which it is obliged to perform are not changed. Revenue account : It means the total income of a business or government, generated by the sale of goods only or income generated from sources other than sales. Velocity of circulation of money : The average number of times a unit of money is spent during the period under consideration, a year for instance.

14.11 REFERENCES
Bandhopadhyay Asis, 1978, 'Deficit Financing as a Strategy for Economic Development', in Commerce Guide. Chelliah R.J., 1973. 'Significance of Alternative Concepts of Budget Deficit', I . M.F. Staff Papers. Jain Inu, 1991. 'Deficit Financing, Money Supply and Price Behaviour in Ivdia', Finance India, Vol. V. No. 3. Karadia, V.C., 1979. 'Deficit Financing, Money Supply and Price Behaviour ifiladia', Indian Journal of Economics. Tripathy , R.N. & M. Tripathy , 1985. Public Finance and Economic Development in India, Mittal Publications : Delhi.

14.12 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1 1) Your answer should include the following points : Deficit financing refers to the means of financing the deliberate excess of expenditure over income through printing of currency notes or through borrowing. It is resorted to for financing a planned deficit incurred by the government in management of its domestic affairs or with reference to balance of payment deficit. 2) Your answer should include the following points : The concept of deficit financing in the West implies financing of a deliberately created gap between public revenue and expenditure. T h ~ gap s is filled by government borrowings from all the sources i.e. from people, commercial banks and the central bank.

Deficit financing as used in the Indian context is resorted to when there are budgetary deficits. Government borrowing from public and commercial banks does not come under deficit financing as in the West. In Indian context, borrowing from the Central Bank of the country, withdrawal of accumulated cash balances and issue of new currency are included within the purview of deficit financing.
3) Your answer should include the following points : Deficit financing in a developing country gives rise to various effects in the economy. Public outlays financed by newly created money immediately create monetary incomes and, due to low standards of living and high marginal propensity to consume, demand for consumption goods and services increases.

Deficit Financing

The production of consumption goods being time consuming, with immediate rise in monetary income, there is increase in prices. Most of the investment that is raised goes to industries with long gestation period. Resort to deficit financing in a developing economy where there is lack of capital, technical skill, entrepreneurial skills etc. leads to inflationary conditions.
Check Your Progress 2

1) Your answer should include the following points : Inflation creates uncertainty, labour unrest, work stoppages, decline in production due to demand for higher wages and salaries.

Reduction in the real income and real consumption of all classes of people in the society except the rich. Investment in unproductive, speculative activities by the profit earners. Reduction in value of incomes and cash balances. Balance of payments difficulties, with losing export market and increase in imports.

2) Your answer should include the following points : The extent to which deficit financing has to be tolerated in developing economies, so that it can promote capital formation and economic development, is known as the safe limit of deficit financing. Your answer regarding the factors affecting the safe limit can include any three of the factors discussed in Section 14.7.
3) Your answer should include the following points : Effective saving campaign and higher taxation to divert a larger proportion of funds resulting from deficit financing. Channellising of investment into those areas where capital output ratio is low.
,

Adoption of policies of physical control like price control, rationing etc. Import of necessary capital equipment for economic development and consumer goods required by masses. Proper integration of deficit financing and credit creation policies.

UNIT 15 PUBLIC DEBT MANAGEMENT AND ROLE OF RESERVE BANK OF INDIA
Structure
Objectives Introduction Public Debt - Meaning and Causes Classification of Public Debt Public Debt Management Public Debt and Economic Development and Inflation Trends and Structure of Public Debt in India Role of Reserve Bank of India in Public Debt Management Let Us Sum U p Key Words References Answers to Check Your Progress Exercises

15.9 OBJECTIVES
After going through this unit, you should be able t o : state the meaning and causes of public debt list various types of public debt explain the important elements of public debt management discuss the relationship between public debt, economic dcvclopment and inflation describe the trends and structure of public debt in India; and discuss the role of the Reserve Bank of India in public debt management.

15.1 INTRODUCTION
We have discussed in the previous unit on Deficit financing that the problem of resource mobilisation is causing a concern in present times in achieving a self-reliant economy. A s said earlier, the government finances its expenditure through conventional sources like taxes. public borrowing o r printing money. With the government undertaking programmes of planned economic development on a large scale, it is not possible to meet the related expenditure either entirely through taxation o r creation of new money. There is a certain limit beyond which revenue from taxation cannot be raised as it would affect the level of investment, production in the country and people's paying capacity. Also financing the programmes through creation of new money beyond a certain level becomes inflationary. Hence resort to public borrowing as a method of resource mobilisation has become an increasing phenomenon in present times. Public borrowing helps in discouraging unproductive expenditure and diverts the savings of the people for capital formation, financing new developmental projects etc. In this unit, we shall discuss the meaning of public debt. reasons for resorting to public borrowing and types of public debt. T h e unit highlights the elements of public debt management, trends and structure of public debt in India and the role of Reserve Bank of India in public debt management.
'
#,

15.2 PUBLIC DEBT - CONCEPT AND CAUSES
Modern fiscal policy endorses unbalanced government budgets for purposes of stimulating economic growth and stabilising economy, its application leading to a

growing public debt. Growth of public debt has been quite substantial in almost all developing economies in recent years. We shall be discussing this in detail with special reference to India in Section 15.6 of this unit. Public debt in simple words means debt incurred by the government in mobilising savings of the people in the form of loans, which are to be repaid at a future date with interest. Public debt can be both internal as well as external. According to Richard Musgrave and Peggy Musgrave, "(Public) borrowing involves a withdrawal made in return for the government's promise to repay at a future date and to pay interest at the interim". The concept of public borrowing as such was condemned earlier by classical economists like Hume and Adam Smith who considered that it would compel the government to tax the public and hence lead to disequilibrium in the economic system. Later the Great Depression of 1929 brought about a marked change in economic thinking of which J.M. Keynes was the pioneer. It was felt that public debt would raise the national income, lead to effective demand in the economy, increase the employment and output. hence it was after the second world war that public borrowings came to occupy a prominent place in the budgets of governments. Having discussed the concept of public debt, now let us highlight the causes for public borrowing. a) A considerable portion of the public debt is attributable to the sharp increases in government outlays in public sector projects. Building up the economic infrastructure like railways, roads, bridges, power plants etc. that provide the base for economic development, requires huge investments which the government cannot finance just through taxation. b) Another reason for the growth in public debt is due to both the Central and state governments lending significant amounts of capital funds to the private sector for investment in planned development projects. c) Public borrowing is resorted to for meeting temporary as well as long-term deficits. It is required to meet the current deficits in budget when the revenues are insufficient to meet the expenditure. Also in times of war, or economic crisis, or other unexpected emergencies, the increase in governmental activities result in increasing expenditure that make the government resort to public borrowing. In recent years, factors-like increase in prices, enlargement of administrative services, increasing expenditure on defence, wages and dearness allowances etc., have also contributed to increase in public debt.

Publk Deb1 Management and Role of Reserve Bank of India

I

i

,

15.3 CLASSIFICATION OF PUBLIC DEBT
As said earlier, one method by which a public authority may obtain income is by borrowing. The proceeds or whatever is collected from such borrowing form part of public receipts. On the other hand the payment of interest op and the repayment of the principal of the public debts thus created form part of public expenditure. Public debt car; be classified in many ways. Let us now discuss some important classifications :
1) Reproductive and Unproductive Debt A distinction is, often, drawn between 'reprodu tive debt' and dead weight debt or unproductive debt. The former is a debt w h i d s fully covered or balanced by the possession of assets of equal value. These debts are incurred generally for the construction of such capital assets which yield revenue t o the government. In case any debt is incurred to meet expenditure on irrigation, railways etc., the income derived from the creation of such assets can be used to repay the debt. With regard to reproductive debt, the interest and sinking fund on it (about whilch we will discuss later) is normally paid out of income derived by the public authority,from the ownership of its property or the conduct of its enterprises. And here it is a good working rule that the debt should be repaid within the physical lifetime of the corresponding asset.

1

Unproductive or dead weight debt is that debt which is incurred to cover any

Resource Mobillsstion

budgetary deficits or for such purposes as do not yield any income to the government in times of war for example. The interest and sinking fund, if any, on this type of debt must be obtained from some other source of public income, generally from taxation and, since there is no corresponding asset created, there is no rule regarding the period of repayment.
2) Voluntary and Compulsory Debt

Public debts are incurred through public loans. There are two types of loans voluntary and compulsory. Voluntary loans are those regarding which people are free to subscribe to government's securities whenever they are floated. The chief advantage of a voluntary load, as compared with taxation is, that, in the case of former, people are free, according to their circumstances and inclination, to subscribe as much or as little as they please. Compulsory loan is a rarity in modern public finance, though, in emergencies like war, famine etc., government enforces borrowing through legal compulsion to secure required amount of funds. This is also resorted to at times t o curb inflationary tendencies in the economy. With this purpose in view only the Government of lndia introduced the ' ~ o m ~ u l s o Deposit Scheme' in 1971. ry

3) Internal and External Debt Public debt may be internal or external. It is internal if subscribed by persons or institutions inside the country. An internal loan only involves transfers of wealth within the borrowing community which in this case is the same as the lending communi(y, In cage of external loan, it involves, firstly, a transfer of wealth from the lending to the borrowing community, when the loan is raised and secondly, a transfer in the reverse direction, when the interest is paid or principal is repaid.
4) Long-term and Short-term Debt

Public debt may either be for a long-term or for a short-term. This is adistinction of degree. The distinction often drawn between "funded" and "floating or unfunded" debt is roughly equivalent t o that between long and short-term debt. Funded or long-term debts are repayable after a year while unfunded debts are generally incurred for a short-term and must be repaid within a year. It includes the treasury bills which are issued for a currency of ninety-one-days, ways and means advances from the Reserve Bank of India (less than three months) etc.
Check Your Progress 1 Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit. 1) State the causes for public borrowing

......................................................................................................... ......................................................................................................... .........................................................................................................
2) Distinguish between reproductive and unproductive debt.

3) What are internal and external debts?

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Public Debt Management and Role of Reserve Bank of lndla

15.4 PUBLIC DEBT MANAGEMENT
Public debt occupies the minds of politicians, editorial writers, citizens and economists. Intuitions tell us that we would be better off without the debt just as we would wish to be free of personal debts. Yet to sort out the real burden from the fancied requires the most careful economic analysis. It is all the more important because the burden of public debt can be shifted wholly or in substantial part from the present to the future generation. The burden of public debt is not something which can be thrown backwards and forwards through time and made to fall, at will, wholly on one generation or wholly on another. Can large public debt lead to default or bankrupt the government? Default occurs when a borrower fails to meet its financial commitments. Bankruptcy exists when a borrower's debt far exceeds its ability to meet obligations. The government will neither default nor face bankruptcy since it has .the power to tax and print money. Suppose the government has no tax revenue to meet interest payment on its debt, it can secure whatever funds it needs by raising taxes. Alternatively, since it is the sole issuer of paper currency, it can print additional paper currency and use it to meet its interest payments. Thus with virtual unlimited sources of funds, the government is not prone to default or bankruptcy. In practice, as a portion of debt falls due each month, government does not usually cut expenditure or raise taxes to provide funds to retire or repay the maturing bonds. Rather, the government simply refinances the debt, i.e. it sells new bonds and uses the proceeds to pay off holders of the maturity bonds. Hence public debt management becomes a crucial task or responsibility of the government. Public debt management refers to the task of determining, by the fiscal and monetary authorities, of the size and com~osition debt, the maturity pattern, interest rates, redemption of debt etc. Keeping in view the increasing magnitude of public borrowing both internal and external, about which we will discuss in subsequent sections, the extent to which the government canmobilise funds from public depends upon the skilful public debt management. In this task, various aspects need to be kept in view like lowering the rate of interest, adjusting the length of the maturity of debt, providing adequate funds for economic development etc. For example, if both the central and state governments decide to go in for public borrowing, details need to be worked out regarding the amount, interest rates and other terms and conditions accompanying the loans. In India, this task of bringing about the coordination is achieved throughsthe Reserve Bank of India which is the central monetary authority. Elements of public debt management Let us now discuss some of the important methods usually adopted for the retirement of public debt. These include the following : i) Refunding ii) Conversion iii) Surplus Budget iv) Sinking Funds v) Terminable Annuitibti v) Additional Taxation vii) Capital levy viii) Surplus balance of payments i)

.

Refunding of debt implies the issue of new bonds and securities by the government in order t o repay the matured loans. In the refunding process, usually short-term securities are replaced by long-term securities. Under this method the money burden of debt is not relinquished but iS accumulated owing to the postponement of debt redemption.:

Resource Mobilisation

ii)

Conversion of public debt implies changing the existing loans, before maturity, into new loans at an advantage. In fact, the process of conversion consists generally in converting or altering a public debt from a higher to a lower rate of interest. Now, when the rate of interest falls, it may convert the old loans into new ones at a lower rate, in order to minimise the burden. Thus the obvious advantage of such conversion is that it reduces the burden of interest on the tax-payers. The success of conversion, however, depends upon (i) the credit worthiness of the government, (ii) the maintenance of adequate stock of securities, (iii) the efficiency in managing the public debt. The difference : between refunding and conversion is that in the case of the latter, there can be a change in rate of interest and other terms.

Quite often, surplus budget (i.e., by spending less than the public revenue obtained) may be utilised for clearing of public debts. But in recent years, due to ever-increasing public expenditure, surplus budget is a rare phenomenon. Moreover, heavy taxes have t o be imposed for realising a surplus budget, which may have adverse consequences. Or when public expenditure is reduced for creating surplus budget, a deflationary bias may develop in the economy. Hence this method is not considered suitable for retirement of any debt. iv) A sinking fund is created by the government and it is gradually accumulated every year by setting aside a part of current public revenue to be deposited in the fund in such a way that it would be sufficient to pay off the funded debt at the time of maturity. Perhaps, this is the most systematic and the best method of redemption. Under this method, the aggregate burden of public debt is least felt, as the burden of taxing the people to repay the debts is spread evenly over a period of time. Accumulation of the fund inspires confidence among the lenders and thereby the credit-worthiness of government increases. A sinking fund is however, a slow process of debt redemption. Moreover, during an emergency or financial stringency, the government is tempted to encroach upon such funds. v) Terminable Annuities of debt redemption is similar to that of sinking fund. Under this method, the fiscal authorities clear off or repay a part of the public debt every year by issuing terminable annuities to the bond holders which mature annually. This is the method of redeeming debt in instalments. By this method the burden of debt goes on diminishing annually and by the time of maturity, it is fully paid off. vi) The simple method of debt repayment is to impose new taxes and get the required revenue to repay the principal amount of the loan as well as interest. This method causes redistribution of income by transferring the resources from taxpayers to the hands of bond holders. It may also impose burden on future generation if new taxes are levied to repay the long-term debts. vii) Capital levy is strongly recommended by Dalton as a method of debt redemption with the least real burden on the society. Capital levy refers to a very heavy tax on property and wealth. It is a once for all tax on the capital assets and estates. It is generally imposed after a war to repay unproductive war debts. viii) The retirement of external debt, however, is possible only through an accumulation of foreign exchange reserves. This necessitates creation of a favourable balance of payments by the debtor country by augmenting its exports and curbing its imports, thereby improving the position of its trade balance. Thus the debtor country has to concentrate on the expansion of its export sector industry. Further, loans raised must be productively utilised, so that they may become self liquidating, posing no real burden to the country's e(conomy. In developing economies, where external debt has increased tremendously, it is necessary that its burden is reduced by changing the terms of repayment o r rescheduling the debt.

iii)

PUBLIC DEBT AND ECONOMIC DEVELOPMENT AND INFLATION
The existence of a laree ~ u b l i c debt does Dose real and ootential ~roblems. Externallv

held debt is obviously a burden. The payment of interest and principal require the transfer of a portion of real output to other nations. When a developing economy borrows abroad to build a dam or when a state issues bonds to build a school, it acquires an external debt that has to be repaid at some future date. Just as in the case of an individual, the borrowing increases the total resources available initially, but reduces the resources available in the future. To meet the interest and repayment charges owed to the outside world, the government must reduce future public spending or raise taxes and thereby reduce private spending. In each case, it cuts total internal resource use. In effect, the borrowing simply makes the resources that were available earlier in exchange for the commitment to pay interest. The initial increase in total available resources is made possible by borrowing done outside the community. Similarly, interest and repayment means that the community gives up resources to the outside world later. When government borrows within the country, total resources available to the country as a whole are not increased. The resources are simply transferred from bond payers i.e. people to the government. Similarly, the interest and repayment charges do not transfer resources outside the country but only transfer them from the taxpayer to the bondholders. One burden of a public debt is unambiguous. Extra taxes have to be imposed to finance the interest payments. These taxes lead to some loss of real output because of their distorting and disincentive effects. Even though the redistribution of income from the taxpayers to the bondholders is only a transfer payment, it does contribute to the negative effects of the tax system. Thus dead weight loss is borne year after year as the interest payments continue to be met. As the debt financing of public spending leads to the decline in investment, there would be another unambiguous loss of output. Future generation would inherit a small stock of capital, an economy with a smaller capacity to produce, hence a smaller output. Debt financing also reduces private investment. Firstly under conditions of full employment and with an unchanged monetary policy, when the government borrowing is competitive with private borrowing, interest rates will be raised by the deficit, and investment will be reduced. This is usually called "Crowding out Effect" (Government borrowing will increase the interest rate and reduce private investment). Secondly, investment may also be reduced by the presence of an existing public debt. Consumers may consider their bond holdings to be a part of their wealth which would make them feel wealthier, raise their consumption, and cut their saving. Further, the higher taxes to cover the interest must have some negative influence on investment. Finally, the existence of large debt may have psychological influence on business behaviour. If people really get alarmed over the national debt, the loss of confidence may curtail their investment. The significance of this psychologicai factor is difficult to evaluate. The average citizen fears the debt mainly as a source of inflation. The debt represents past outlays that were not matched by taxes, hence it measures past government claims to resources that it could not pay for. If government e'ngages in debt financing when the economy is already at full employment, existence of a large public debt tends to shift the consumption schedule upward. This shift will be inflationary. Furthermore, government bonds can be converted into money easily and will have little or no, risk of loss. Government bonds, therefore, constitute a potential backlog of purchasing power which can add materially to inflationary pressure_s. During periods of inflation, it is very tempting for consumers to utilise this reserve of purchasing power in an attempt to beat rising prices. Such an attempt to tackle inflation will cause more inflation. Uptil now we have seen only one side of the coin. There is another side to the public debt i.e., the positive role of public debt in economic development. Both public and private debts play a positive role in a prosperous and growing economy.'As economy expands, so does saving. Modern employment-theory and fiscal policy tell us that, if aggregate demand is to be sustained at a high level of employment, this expanding volume of saving or its equivalent must be obtained and spent by the consumers, business houses or government. The process by which savirrg is transferred to spenders is debt creation. Whenever government issues bonds, since these are highly liquid and risk free securities, they make an excellent purchase for small and

Public Debt Management and Role of Reserve Bank of India

Resource Moblllsstlon

conservative savers. To the extent that the availability of bonds encourage saving, more resources are freed for investment and economic growth tends to be enhanced,

15.6

TRENDS AND STRUCTURE OF PUBLIC DEBT IN INDIA

Modem fiscal policy endorses unbalanced government budgets for purposes of stimulating economic growth and stabilising the economy, its application leading to a public debt. At the time of Independence, India inherited from the British a dead weight debt of Rs. 300 crore. Since the government had undertaken various programmes of planned development the resources had to be mobilised through various sources including public borrowing. The increasing amount of resources that were mobilised by the government through domestic or internal borrowing resulted in significant growth of internal public debt. The internal debt which was 2054 crore in 1950-51 rose to Rs. 183,183 crore in 1990-91.
Table 15.1 Internal and External Debt Scenario (In Rs. hundred crows) Year Internal Debt. & Obligation Internal Debt. to . GDP (%) Central Govt. External Debt. Total Govt. Debt. Total Debt. GDP (%) Total Deficit

1990-91 R.E. 1991-92(Bu)

2796 3181

0060
006 1

0318 0356

31 14 3537

0067 0074

0 I06

-

Source : Financial Express, 1 1 th August, 1991.

According to Economic Survey 1991, the outstanding internal and external debt of Government of India at the end of 1991-92 is estimated to amount to Rs. 3,54,901.12 crore as against Rs. 3,11,059.21 crore at the end of 1990-91 (RE). Out of this total public debt, internal debt and other liabilities as on 31st March 1992 was 3,19,778.70 crore and external debt as on 31st March 1992 was of the order of 35,122.42 crore. A major portion i.e. over four-fifths of the public debt is internal. And if the focus in the c6ming year should be slashing the budget deficit and not fiscal deficit, it might grow further and assume alarming proportions. The bulk of the government bonds are held by Indian citizens and institutions - banks, business houses, insurance companies, governmental agencies and trust funds - within the Indian economy. While the internal public debt is a liability for the people (as tax payers), that same debt is simultan.eously an asset for the people as it is helping in undertaking many developmental projects. Retirement of the internal debt, therefore, calls for a gigantic transfer payment whereby Indian individuals and business houses would pay higher taxes and the government, in turn, would pay out those tax revenue to those individuals and institutions in the aggregate in redeeming the bonds which they hold. Although a redistribution of wealth would result from this gigantic financial transfer, it need not entail any immediate decline in the economy's aggregate wealth or standard of living. The repayment of the internally held public debt entails no leakage of purchasing powef from the economy of the country as a whole.
External debt

a

The economic implications of the external public debt are quite different. India owes this external public debt to foreign governments, foreign banks and international lending institutions such as the World Bank and the International Monetary Fund. External public debt is a liability for the Indian people as tax payers and an asset to

foreign lenders. Therefore, retirement of the external public debt would involve Indian households and business houses paying higher taxes and the government would then pay out these tax receipts to lenders abroad. This obvjously means a transfer of income and wealth from Indian families and business to foreigners. Thus, retirement of the external public debt would entail a leakage of real purchasing power out of the economy and a decline in the standard of living of the Indian people. According to Economic Survey 1991, India's medium and long-term external debt f consisting o external assistance on government and non government accounts, external commercial borrowings and International Monetary Fund (IMF) liabilities amount to Rs. 80,135 crore (about 18% of GDP) at the end of 1989-90, including outstahding Non-Resident Indian (NRI) deposits. The country's aggregate debt stock was Rs. 97,966 crore at the end of 1989-90amounting to over 22% of GDP. External debt obligations have increased more than three times during 1980-91. Growing debt servicing is a matter of immense concern, as it is eroding the aid inflow drastically. The compound growth rate of aggregate debt stock from 1980-81to 1989-90has been 20% in iupee terms and 10% in terms of U.S. Dollars. There has been a notable change in the composition of debt stock. At the beginning of Sixth Five Year Plan, external debt stock consisted mainly of external assistance which constituted almost 90% of debt stock. Since then, the share of external assistance in debt stock has declined to less than 70% in 1989-90. External commercial borrowing has registered the fastest growth and accounts for 27% of debt stock in 1989-90. The declining share of external assistance in inflow of external capital, hardening of terms of such assistance and rapidly rising rates of interest in the international capital markets contributed to indulgence in the debt service payments in the late 1980s. In the latter half of the decade debt stock grew at a compound rate of about 17.5?/0 while the growth in debt service amounted to about 28.5 per cent per annum. During the decade 1979 and 1989, as a proportion of GNP, external debt rose from 11.9% in 1979 to 24% in 1989. Not only this, the average rate of interest of external borrowings, which was 2.5% during 1979, rose to 6.4% in 1989. Obviously, it implies that the loans in recent years have been taken on high interest rates. World Bank's latest debt tables reveal that India's external debt which stood at $62.50 billion'in 1989 rose to an estimated $70.953 billion in 1990. It shows a rise of 13.5% during the year and thus India has become the third most indebted country in the world after Brazil and Mexico. This huge debt burden only underlines the fact that in future years interest payment burden is likely to be much larger and India may have to borrow further to fulfil its debt service obligations or we can say that our country is in serious debt trap. India faced a severe resource crunch in 1991 and contacted the IMF for a loan of $5-7 billion besides the loans contacted from other sources so that the country is bailed out of current foreign exchange crisis. The total debt burden will be in range of $76-78 billion. The basic factor responsible for debt trap is the deteriorating balance of payment (BOP) on current account. The deficit in balance of payments on current account which was of the order of Rs. 2852 crore in 1984-85 has risen to Rs. 10,410 crore in 1988-89. The purpose of the government's recent exercise of devaluing Indian Rupee in July '91 was to boost export and reduce imports, so that the trade gap is narrowed dowi. Although the government has been making serious efforts at promoting exports, all its efforts are getting a setback by the increasing imports. It is, therefore, imperative out that a screening of imports be ca~ried and non-essential imports slashed with an iron hand. The philosophy of import led growth should be abandoned in favour of the philosophy of import substitution and self-reliance. To relieve the situation, it became imperative for the country to secure a loan from the IMFMTorld Bank to tide over the present crisis. There is a need to convert commercial loans bearing high rates of interest into low interest bearing institutional loans. Such a rescheduling of loans can help to reduce the debt service burden. Another short-term measure may be to cajole the NIUs into investing in areas either
1

Publk Debt Maaagtmcnt and Rde of R r s n e Bank of India

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A.

-

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Resource MobUMon

certainly mitigate the present foreign exchange scarcity. Another suggestion is to permit direct foreign investment by multi-national corporations. But while permitting foreign private investment, vigilance has to be maintained to ensure that the investment helps to upgrade our technology and capability of production in the capital goods sector. However, devaluation, liberalisation or direct foreign investment cannot succeed unless domestic economy is improved. The external debt situation cannot be analysed effectively in isolation from the domestic debt situation. Consequently the policies aimed at correcting the balance of payment situation have to be linked with economic reforms to contain the fiscal deficit. There is, therefore, the need for evolving an overall strategy of development which should help to restore the macroeconomic balance within the country and also limit our dependence on external debt. Here comes the role of the Reserve Bank of India in managing public debt.

15.7

ROLE OF RESERVE BANK OF INDIA IN PUBLIC DEBT MANAGEMENT

The Reserve Bank of India and its various offices and representatives have the responsibility to assist the economy in achieving sustained economic growth without inflation through its monetary policy. Monetary policy consists of altering the economy's money supply for the purposes of attaining growing levels of output and employment on the one hand and stability in the price levels on the other. More specifically, monetary policy entails achieving two inter-related goals. First, it must expand the supply of money in the long run to meet the demand for money in a growing economy and, second, it must adjust the money supply to curb economic fluctuation, i.e., during recession to stimulate spending and, conversely, restrict the money supply during inflation to constrain spending. The Reserve Bank of India as the central monetary authority has an important role to play in public debt management. It helps the central and state governments to float new loans and manage public debt. The ownership pattern of public debt in India reveals that the Reserve Bank of India and other commercial banks continue to have the major ownership of the debt. The Reserve Bank continues to be the largest single and holder of Central government securities. It has undertaken considerable b u y i ~ g selling of government securities. Hence whenever government resorts to public borrowing, the Reserve Bank of India buys its securities. The readiness of the Reserve Bank of India to contribute to government loans, whenever they are floated, prevents the government from borrowing from other sources at a higher rate of interest. The Reserve Bank of India is entrusted with the responsibility of imposing credit control measures from time to time. The Banking Companies (Amendment) Act, 1962 requires the commercial banks to mairitain liquidity ratio of certain percentage of their time and demand liabilities with the Reserve Bank. This facilitates the commercial banks to borrow money from the Reserve Bank whenever required. This Statutory Liquidity Ratio (SLR) was raised from 38% to 38.5% of all demand and time liabilities of commercial banks. Another method of credit control is through the system of cash reserves where the commercial banks are required to maintain a minimum amount of liquid assets with the Reserve Bank of India. This Cash Reserve Ratio (CRR) was left unchanged at its existing legal maximum of 15% of all net demand and time liabilities of commercial banks. In times of need, the banks can borrow from the Reserve Bank of India on the basis of eligible securities. An important step towards rationalisation of the interest rates structure was taken by Reserve Bank of India when it introduced a new regime of lending rates for commercial banks with effect from 22nd September, 1990 and replaced the earlier programme specific, sector specific and region specific interest rates related to the size of adyances, except for export credit and the Differential Rate of Interest (DRI) scheme. The rates of interest were again revised on 9th October, 1991 in view of the changes made in Budget of 1991. The Reserve Bank of India thus regulates the banking structure through imposition of such liquidity restrictions regarding credit supply.

Large public debt imposes constraint upon effective monetary (interest rate) policy. The basic dilemma is between the government's desire for low interest costs, on the one hand and the goals of economic stability and growth on the other. More specifically, during periods of inflation, the monetary authority should restrict money supply which will raise interest rates and thereby tend to limit spending. Check Your Progress 2 Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.
1) What do you understand by the process of conversion of public debt?

Public Debt Management and Role of Reserve Bank of India

2) Explain the term Sinking Fund. What are its advantages?

..........................................................................................................

3) Discuss the negative consequences of public debt.

1 5 . 8 LET US SUM UP
Public borrowing apart from imposition of taxes and deficit financing, is one of the methods through which resources are mobilised for taking up developmental tasks in the country. In this unit we have discussed the meaning of public debt, causes for increasing public debt which include increasing government outlays in public sector projects, for meeting temporary and Short-term budget deficits etc. There are various types of public debt which can be categorised broadly into reproductive and unproductive, voluntary and compulsory, internal and external, short-term and

R W U ~ O~O~U~II M

long-term. We have also discussed the importance of public debt management, its elements which include refunding, conversion, surplus budget, sinking fund etc. The unit has also touched upon the aspect of public debt, its impact on economic development and inflation. There has been significant growth of internal debt from Rs. 2054 crores in 1950-51 to Rs. 183, 183 crores in 1990-91. Similar is the position with regard to India's external debt. These aspects relating to trends and structure of public debt in India have been discussed. The Reserve Bank of India as the central monetary authority in the country has a very important role to play in public debt management which has been dealt with in the unit.

15.9

KEY WORDS

Compulsory Deposit Scheme : This was introduced for the first time in India in 1963-64 and reintroduced again in 1974. The Act provided for compulsory deposit for a period of two years of 50% of the additional dearness allowance and for one year of additional wages and salaries. All the employees of Central and State governments, local bodies, companies, corporations, industrial, commercial establishments in the private and public sectors, besides salaried employees who are liable to pay income tax were covered under the scheme. Cash Reserve Ratio (CRR) : This is a general credit control method under which each commercial bank is statutorily required to maintain a certain minimum of cash (exclusive of the balances with the central bank of the country, viz., the Reserve Bank) a certain percentage of the bank's aggregate demand and time liabilities at the close of every business day. Crowding out effect : An increase in governpent expenditure that has the effect of reducing the level of private sector spending. In a broader sense, it denotes the effect of larger governmental expenditure, leaving less for private consumption, spending, private sector investment and exports. Debt sqvicing : In simple words it means payment of interest on debts that are due. It includes the cost of meeting interest payments, regular repayments of principal on a laan along with any other charges that are to be borne by the borrower. Debt trap : It is a situation when a country is unable to meet the instalments of debt repayments and interest charges and it is forced to borrow again to repay old debts. Differential Rate of Interest (DRI) : The scheme introduced by the Government of India in 1972 based upon the recommendations of a Committee appointed by the Reserve Bank of India under the Chairmanship of R.K. Hazari. This scheme was introduced to help the weaker sections of the society to raise their standard of living by undertaking productive self employment projects. Under the scheme, bank finances to the weaker sections are made available at rates lower than the general rate of interest. Devaluation : It is the action taken by government of any country, reducing the valuation of its currency in terms of other countries, either by fixing its exchange value at a lower level or by allowing it to be depreciated by market forces. It is mostly used to correct a serious balance of payments deficit i.e. when import values far exceed export values and there is an increasing shortage of foreign exchange to pay for the imports. Such deficit is reduced by undertaking devaluation which lowers the price of exports in terms of foreign currencies and raises the pri& of imports at home. Great Depression : The worldwide depression that started in 1929 and lasted till 1935. It was characterised by low economic activity and mass unemployment. Gross Domestic Product : The total value of goods and services that are produced within a country over a specified period, usually one year, excluding all those goods and services used during that period to produce further goods and services. Gross National Product : It refers to a comprehensive measure of a nation's output i.e. sum total of goods and services produced in the country during the year. Statutory Liquidity Ratio (SLR) : According to the Banking Companies(Amendment) Act, 1962, all commercial banks are required to maintain a certain percentage of their time and demand liabilities with the Reserve Bank of India which is called Statutory Liquidity Ratio.

.

Time and demand liabilities : Time liabilities are fixed deposits which are withdrawable after specified periods. This includes deposits which are made for three months, six months, one, three years or more. ema and liabilities include those deposits which can be withdrawn by the depositor without previous notice to the bank. Treasury bills : It is a financial security issued by the government as a means of borrowing money for short periods of time like three months. Ways and means advances : These are short-term loans made by the (central bank of the country to the government.

public Deb1 Management and Role of Reserve Bank of lndla

15.10 REFERENCES
Bhatia H.L., 1992. Public Finance, Revised Edition, Vikas Publishing House: New Delhi. Burman Kiran, 1978. India's Public Debt & Policy Since Independence, Chugh Publications: Allahabad. Jain, Inu, 1988. Resource Mobilization and Fiscal Policy in India, Deep & Deep Publications: New Delhi. Misra, B., 1980. Economics of Public Finance, Revised Edition, Macmillan: New Delhi. Sreekantaradhya, 1972. Public Debt and Economic Development in India. Sterling Publishers: New Delhi. Thavaraj, M.J.K., 1978. Financial Administration of India, Sultan Chand & Sons, New Delhi. Tripathy R.N. & M. Tripathy, 1985. Public Finance and Economic Development in India, Mittal Publications: Delhi.

15.11 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1

1) Your answer should include the following points : The causes for public debt include : Sharp increases in government outlays in public sector projects. Building up the economic infrastructure like railways, roads, power plants etc. which require huge investments. Lending of significant amounts of capital funds by the Central and State governments to the private sector for investment in planned development projects. For meeting temporary as well as long-term budgetary deficits. 2) Your answer should include the following points : , Reproductive debts are those which are incurred by the government for the construction of such capital assets that yield revenue to the government like railways, irrigation projects etc. Here the income derived from the creation of such assets is used to repay the debt. In case of unproductive debt, no asset is created. These debts are incurred to cover budgetary deficits or for such purposes as do not yield any income to the government like in case of wars.
3) Your answer should include the following points : 3 Internal debt comprises loans or securities floated by the government and subscribed by persons or institutions within the country.

External debts are those incurred when borrowing is resorted to ffom persons or institutions outside the country.

Check Your Progress 2

1) Your answer should include the following points : Conversion is one of the ways adopted for retirement of public debt. It implies changing the existing loans before maturity into new loans with change in rates of interest. This process generally alters a public debt from higher to a lower rate of interest.

2) Your answer should include the following points :
A sinking fund is a fund created by the government. Every year a part of the current public revenue is deposited in the fund with a view to paying off the funded debt at the time of maturity. Creation of sinking fund minimises the aggregate burden of public debt as the task of taxing the people for resources is spread evenly over a period of time. This inspires confidence among lenders and credit worthiness of the government increases.

3) Your answer should include the following points : Imposition of extra taxes to finance the interest payments. Decline in investment leading to loss of output. Crowding out effect with reduction in private investment. Possession of bonds by the people raises their consumption and reduces savings.

UNIT 16 FINANCIAL APPRAISAL
Structure
Objectives Introduction When to Undertake a Financial Analysis? How to Value Project Benefits and Costs in a Financial Analysis? The Cash Flow in the Financial Analysis Discounting in Project Analysis Let Us Sum Up Key Words References Answers to Check your Progress Exercises

16.0 OBJECTIVES
After reading this unit, you should be able to: understand the meaning of financial appraisal; highlight the need for a financial analysis; and explain the methodology of financial analysis.

16.1 INTRODUCTION
Financial appraisal is a method used to evaluate the viability of a proposed project by assessing the value of net cash flows that result from its implementation. Financial appraisals differ from economic appraisals in the scope of their investigation, the range of impacts analysed and the methodology used. A financial appraisal essentially views investment decisions from the perspective of the organization undertaking the investment. It therefore measures only the direct effects on the cash flow of the organisation of an investment ,decision. By contrast, an economic appraisal considers not only the impact of a project on the organisation sponsoring the project, but also considers the external benefits and costs of the project for other government agencies, private sector enterprises and individuals-regardless of whether or not such impacts are matched by monetary payments. Financial appraisals also differ from economic appraisals in that: market prices and valuations are used in.assessing benefits and costs, instead of measures such as willingness to pay and opportunity cost; the discount rate used represents the weighted average cost of debt and equity capital, rather than the estimated social opportunity cost of capital; and The discount rate and the cash flows to which it is applied are usually specified on a nominal basis as the cost of debt and cost of equity are observed only in nominal terms. A financial analysis of a project is undertaken to assess whether it will be commercially profitable for the enterprise implementing it. A private firm will undertake a financial analysis of a potential investment in order to determine its impact on the firm's balance sheet. Governments and international agencies will also routinely undertake a financial analysis, as well as an economic analysis, of any project in which the output will be sold and a financial analysis will therefore

Investment of Pubnc Funds

have some meaning. In this unit we will be discussing the meaning, the need and methodology of financial appraisals.

16.2 WHEN TO UNDERTAKE A FINANCIAL ANALYSIS?
A financial analysis must be undertaken if it is necessary to determine the financial profitability of a project to the project implementer. Normally it will only be worthwhile carrying out a financial analysis if the output of the project can be sold in the market, or otherwise valued in market prices. This will almost always be the case for a privately sponsored project, but will also apply to some government business undertakings. A private firm will primarily be interested in undertaking a financial analysis of any project it is considering, and only in some special circumstances will it wish to undertake an economic analysis. . Commercially oriented government authorities that are selling output, such as railway, electricity, telecommunications, or freeway authorities, will usually undertake a financial as well as an economic analysis of any new project they are considering. They need to assess the project's potential impact on their budget, as well as its impact on the country's welfare. For example, the Department of Telecommunication offers provision of telephone services at a reduced rate, it needs to examine the impact of the decision on their budget and overall public good. Another situation where a government will be interested in undertaking a financial analysis of a project is when the project is financially viable without the subsidy or other forms of assistance. In practice, governments and international agencies routinely undertake a financial as well as an economic analysis of any project where a financial analysis will have some meaning- essentially, if the output will be sold. It can then compare the results of the financial and economic evaluation, to determine the project's budgetary impact on the government, as the implementer, as well as its contribution to national welfare. Even non-commercial government institutions may sometimes wish to choose between alternative facilities on the basis of essentially financial objectives. For example, in the case of a hospital service, the management of hospital could well be required to select the cheapest method of providing a given standard of accommodation or care. A national defence force will often choose between available alternative methods of achieving a physical goal, such as airborne troop management capacity, on the basis of the, cheapest financial option. This procedure is called cost minimization or cost effectiveness. It differs from a full financial analysis in that only the cost of a project is estimated in market or conceivably in economic prices. The benefits are specified in terms of some quantitative target, such as the number of patient beds to be provided or number of troops that can be moved.

16.3 HOW TO VALUE PROJECT BENEFITS AND COSTS IN A FINANCIAL ANALYSIS?
The financial benefits of a project are just the revenues received and the financial costs are expenditures that are actually incurred by the implementing agency as a resulpof the project. If a project is producing some good or service for sale, the revenue that the project irnplementers expect to receive each year from these sales will be the benefits of the project. The costs incurred are the expenditures made to establish and operate the project. These include capital costs, the cost of purchasing land, equipment, factory building, vehicles and office machines, and working capital, as well as its ongoing operating costs, for labour, raw materials, fuel and utilities.

In a financial analysis, all these receipts and expenditures are' valued as they
appear in the financial balance sheet of the project, and are therefope measured in market prices. Market prices are just the prices in the local economt, and include all applicable taxes, tariffs, trade mark-ups and commissions. Since the project's implementers will have to pay market prices for inputs they use and will receive market prices of the output they produce, the financial costs and benefits of the project are measured in these market prices.
P

Financial Apprabrl

Real or Nominal Prices

I

It is obviously very important to know whether the input and output projections given by the proposing firm or agency are valued in current prices (normal) or constant prices (real). This is necessary to ensure that the analysis is carried out in a consistent set of prices, so that the total net value of the project ultimately calculated is a real figure. Often, constant (say 1990) prices, rather thin current prices, are used in a project's cash flow. A project's cash flow is merely the costs and benefits paid and produced by the project over its lifetime in the years that they occur. The use of constant prices simplifies the analysis, as it relieves the analyst of the need to make projections about the anticipated inflation rate in the country over the life of the project. This procedure is quite appropriate if input and output prices in domestic currency are expected to increase at approximately the same rate over the life of the project. However, there are several situations where the use of constant prices may not be appropriate. The first is when the analyst is drawing up project financing plans. In this situation, the analyst will need to estimate expenditures in nominal terms to ensure that planned sources of finance will be sufficient to cover all project costs. The second is a situation where the investment is privately operated and will pay company tax. The financial analysis will need to be carried out in both nominal and real terms because the rate of inflation will affect the interest payments, depreciation allowance and the cost of holding stocks. All these will influence the firm's tax liability. Working capital requirements will also be affected by the level of inflation. Finally, if input prices are expected to rise at different rates over the life of the project, and vary from year to year, it will usually be simpler to include all prices in current terms.

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Internal Transport and Handling Costs

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It is important to be clear about where inputs and outputs should be priced in a project appraisal. In the case of a project's output, it could be valued at the project gate or in the market for the project's output. In a case of project inputs, they could be valued at the project gate, at the gate of the input supplier's factory or mine or at the port of entry into the country. In order to determine which the appropriate price is, it is necessary to remember that in a 'financial appraisal it is the net incremental benefit of the project to the implementing agent that is of interest.
, In the case of project outputs, they should therefore be valued at the market price

received for them at the project gate. Transport costs from the project to market should be subtracted from the wholesale price received in the market. Project inputs should also be valued at their market cost at the project gate. This price will include the transport and handling cost of getting them there.

II

Local and Foreign Costs

II

Many a times project appraisals split costs (and sometimes benefits) between locally incurred and foreign exchange costs and benefits. This is useful if policy

Investment of Public Funds

makers wish to judge the impact of the project on the balance payments, or if foreign financing agents such as aid agencies or multilateral banks wish to see the distribution of items eligible for aid grants or loans. Usually, even if local and foreign costs are identified, in a financial analysis all costs and benefits are then expressed in local currency, converted at the official exchange rate. However, the foreign currency costs may in some instances be expressed in a common international currency like US Dollar, or in terms of the local currency of a bilateral aid donor country. In order to separate the cash flow into local and foreign prices, and also to predict the future price of a project's tradable inputs and outputs, it may be necessary to make projections about future exchange rates. To do this it will be necessary to assess, inter alia, if local inflation rates are likely to diverge from average international inflation rates, and particularly those of the host country's major trading patterns. If local inflation is expected to be higher than the average for major trading partners, devaluation of the local currency could be anticipated, increasing both the costs of imported inputs and the local currency value of exported outputs. If local inflation is expected to be lower than that of the country's major trading partners, it is likely that the local currency will appreciate over the life of the project. If this is a real appreciation, it will have the effect of lowering imported input prices as well as lowering the local currency receipts from exported outputs and/or reducing the international competitiveness of these exports. The following section paragraphs discusses about how the inputs and outputs of a project that are valued in market prices should be incorporated into a project's cash flow in order to undertake a financial analysis.

Check Your Progress 1 Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the Unit.
1) Discuss when to undertake the financial analysis.

2) Highlight how to value project benefits and cost in a financial analysis.

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16.4 THE CASH FLOW IN THE FINANCIAL ANALYSIS
It comprises the following input and output components:
The Financial Cash Flow

Financial Appraisal

I

The financial cash flow of a project is the stream of financial costs and benefits, or expenditures and receipts, which will be generated by the project over its economic life, and will not be produced in its absence. Before the cash flow of a project can be estimated, it will be necessary for the project sponsors to undertake detailed market research into product markets and prices. They must find out if there will be market for the project's output and what it can be sold for. Then the analyst will need to assess the sources, quantities and costs of required capital assets, raw materials and labour, to estimate the likely costs of the project. It may also be necessary to determine anticipated inflation rates and exchange rate movements, as they may affect the valuation of the project's expenditures and receipts.
Project Life

Early in the process of constructing a project's financial cash flow it will be necessary to determine the length of the project's economic life. This will be the optimal period over which the project should be run to maximise its return to the project implementer. The project's life is frequently set equal to the technical life of the equipment used. However, various factors, such as the technological obsolescence of equipment, changing tastes, international competitiveness or the extent of a natural resource or mineral deposit, may result in the economic life of the project being shorter than the technical life of the equipment employed. If the project is expected to have long term environment impacts, it may be necessary to extend the length of the cash flow so that these costs (or benefits) can be measured.
Capital Costs

The capital costs of a project can be divided into fixed capital costs, or the cost of acquiring fixed assets like plant and equipment, start-up costs, and working capital, which finances the operating expenses of the enterprise. In a financial analysis, all forms of capital expenditure should be entered in the financial cash flow in the years in which the project actually has to pay for them. For example, if the project receives a soft loan from the supplier of its equipment, which involves a grace period before repaying the loan, the cost of this equipment will not be included in the cash flow until it must be paid for by the project.
Operating Costs

The project's operating costs cover its recurrent outlays on labour services (wages and salaries), raw materials, energy, utilities (water, waste removal, etc,), marketing, transport, insurance, taxes and debt service over the life of the project. Each operating cost is entered in the cash flow in the year (month or quarter) in which it is incurred. Total operating costs may also be expressed in terms of costs per unit of output. As was mentioned previously, unit operating costs are likely to be somewhat higher in the first year or two of a project, so the difference between start-up costs under capital costs, and steady state operating

Investment of Public Funds

Treatment of Taxes

In addition to a financial analysis undertaken from the owner's point of view,.the company taxpaid on project profits can be calculated in order to determine the project's net present value after tax. A government may do this to determine whether a project seeking subsidies or concessions will be financially profitable after tax or not. A private firm may merely wish to know if a proposed investment will be profitable after tax, given the tax regime of the country concerned.
The taxable income of the project will be determined by subtracting all operating costs, interest payments and allowable depreciation on the capital assets from the firm's revenue earnings each year. The appropriate company income tax rate is then applied to this taxable income to determine the project's taxation liability. If the country gives incentives to new investments in the form of tax holidays or accelerated depreciation of assets, these should be taken into account in the project's taxable income and tax liability. The tax liability is subtracted from taxable income to obtain the project's net of tax income. Project Benefits In a financial analysis, the project's benefits equal the cash receipts actually received by the project from the sate of goods or services it produces, or the market value equivalent of home consumed output in the case of non-marketed output. This can be the revenue fi-om sales, rent or royalties, depending on the nature of the project. Other revenue earned from, for example, bank deposits, the sale of fixed assets or insurance claims, will also be included as separate items under project receipts or benefits.
a

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Net Benefits

The project's net benefit stream is calculated as the difference between the total revenue (or benefit) stream and its expenditure (costs) stream.

16.5 DISCOUNTING IN PROJECT ANALYSIS
In project analysis, any costs and benefits of a project that are received in future periods are discounted, or deflated by some factor, r, to reflect their lower value to the individual (or society) than currently available income. The factor used to discount future costs and benefits is called the discount rate and is usually expressed as a percentage. For example, suppose the project is expected to yield a stream of benefits equal to BO, Bl, B2, .... Bn and to incur a stream of costs equal to CO, C1, C2,. .... Cn in years 0, 1,2, ... n. Then in each period the net benefits (benefits minus costs) of the project will be: (BO-CO), (B 1-C I), (B2-C2),

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... (Bn-Cn)

This is simply the project's net benefit flow. Assuming that the discount rate, r, is constant, then the discounted cash flow of the project can be represented as:

0

-0

n (Bl -C1) (B2 4 2 ) (B3 -C3) ...,.......(Bn - c +r ) ( 1 + r)" ' ( ~ + r' ( ~ + r ) ~ ) ~

Once future net income streams have been discounted in this way, expenditures and revenues fiom all the different time periods will be valued in units of similar value - present day units of currency. They will then be directly comparable with each other and can be added together. Adding the discounted net benefits fiom each year of the project's life, its discounted net benefit flow, gives a single monetary value called the project's net present value, NPV. For, the previous example, the project's NPV is: Table 1: Manual Discounting of a Railway Project Cash Flow ($L Million)

Financial Appraisal

Total

1100

1550

4450

NPV=10.4

I

The net present value criterion of a project is the single most important measure of the project's worth. If a project's NPV is positive (i.e. its discounted benefits exceed its discounted costs), then the project should be accepted. If its NPV is negative (its discounted costs exceed its discounted benefits), then the project should be rejected. In the above table, an 8% discount rate is used to mechanically discount the net benefits of a railway project. The project's NPV can then be estimated by just adding up these discounted net benefits. Columns (I), (2) and (3) show the nondiscounted costs, benefits and net benefits (benefits-costs) of the railway project. Column (4) gives the discount factor, 1/(1+.08)t, by which the non-discounted net benefits in column (3) are multiplied, to obtain the discounted value of these net benefits in each year, t, shown in column (5). These discounted net benefits can then be added together to obtain the total discounted net benefits, or net present value, of the project. The bottom line of the table shows that the NPV comes to $L10.4 million if an 8%.discount rate is used. A NPV greater than zero indicates that the discounted benefits of the project are expected to be greater than its discounted costs and the project will therefore be worth undertaking. This example illustrates how crucially the estimation of a project's NPV depends on the discount rate employed. A lower discount rate would have deflated future income by less and increased NPV of the project. A higher discount rate would have deflated future income more heavily and decreased the NPV of the project,

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Investment of Public Funds

possibly changing it from positive to negative. The selection of the appropriate discount rate is therefore a very important issue in project appraisal. The Discount Rate in Financial Analysis

In a financial analysis market prices are used to value project inputs and outputs, even if these prices are distorted. Market prices are used so that the financial profitability of the project to its implementer can be determined. The market price of capital to the project implementer is the market interest rate, and this represents the cost to the implementer of investing capital in the project. The correct approach to determining the financial discount rate, the discount rate used in the financial analysis, is therefore to estimate the actual cost of capital to the project implementer This will vary depending on whether at the margin the implementer is a borrower or lender of investible funds.
If the project implementer is a net borrower, the interest rate at which the enterprise can borrow is the opportunity cost of funds employed. This market borrowing rate should be used as the financial discount rate for any project appraisal undertaken by the enterprise. If the project implementer intends to draw some funds from its own financial resources and some from market borrowings, the weighted cost of the capital it obtains from these different sources will be the appropriate financial discount rate. If the firm or the government Considering a project is a net lender, in the absence of the project it could invest these funds in the financial market and earn the market lending rate. The opportunity cost of the funds to be used for the project will therefore be the after tax market lending rate that it could earn on this capital. The project must earn at least this market lending rate for it to be worth doing and the after- tax lending rate should therefore be used as the financial discount rate for any project appraisals undertaken by this enterprise. In reality the enterprise will usually want to earn some margin above the market lending rate if the project is considered a riskier use of the firm's funds than available financial investments. Discounted Project Assessment Criteria The two most commonly used discounted measures of a project's net benefit are its net present value and internal rate of return. The domestic resource cost ratio, benefit cost ratio and net benefit investment ratio are also be discussed below: a) Project Net Present Value (NPV) The NPV measure of project worth is the most useful and one of the most commonly used criteria for determining whether a project should be accepted.The net present value of a project is simply the present value, PV, of its net benefit stream. It is obtained by discounting the stream of net benefits produced by the project over its lifetime, back to its value in the chosen base period, usually the present. The net present value formula is:

Where, Bt are project benefits in period t Ct are project costs in period t r is the appropriate financial or economic discount rate n is the number of years for which the project will operate

In Table .I, the NPV of a railway project was estimated mechanically. The net benefits of the project each year were deflated by a factor equal to I/(l+r)t, where r ,was the discount rate and t the year in which the net benefits of the project were received. These discounted net benefits were then added together for the 'n' years of the project. Under this decision rule a project is potentially worthwhile or viable if the NPV is greater than zero; i.e. the discounted value of benefits is greater than the discounted costs. If projects are mutually exclusive, the project which yields the highest NPV would be chosen.
b) The Internal Rate of Return of a Project (IRR)

Financial Appraisal

The internal rate of return, IRR, of a project is probably the most commonly used assessment criterion in project appraisal. This is primarily because the concept of an IRR is in some ways comparable to the profit rate of a project and is therefore easy for non-economists to understand. Furthermore, it does not rely on the selection of a predetermined discount rate. The internal rate of return is the discount rate that, if used to discount a project's costs and benefits, will just make the project's net present value equal to zero. Thus the internal rate of return is the discount rate, r*, at which:

Since the internal rate of return is the discount rate internal to the project, its calculation does not depend on prior selection of a discount rate. A project's internal rate of return can therefore be thought of as the discount rate at which it would be just worthwhile doing the project. For a financial analysis, it would be the maximum interest rate that the project could afford to pay on its funds and still recover all its investment and operating costs.
A project is potentially worthwhile if the IRR is greater than the test discount rate. If projects are mutually exclusive, this rule would suggest that the project with the highest IRR should be chosen.

c) The Net Benefit Investment Ratio (NBIR) The net benefit investment ratio, NBIR, is the most convenient selection criterion to use when there is a single period budget constraint. NBIR'of a project is the ratio of the present value of the project's benefits, net of operating costs, to the present value of its investment cost. Its formula is given by:

2
Where OCt are the project's operating costs in period t ICt are the project's investment costs in period t Bt are the benefits in period t r is the appropriate discdunt rate

/

The NBIR therefore shows the value of the project's discounted benefits, net of

Investment of Public Funds

The decision rule for the net benefit investment ratio is that all projects that have a net benefit investment ratio greater than unity should be selected. This selection criterion is completely compatible with those for the net present value and the internal rate of return of a project. d) The Benefit Cost Ratio (BCR) The benefit cost ratio was the earliest discounted project assessment criterion to be employed. However, due to problems associated with its applied use, it is rarely used in project appraisal today. The benefit cost ratio is simply the ratio of the sum of the project's discounted benefits to the sum of its discounted investment and operating costs. This can be expressed mathematically as:

BCR = '=O (1 + r)' ct

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A project should be accepted if its BCR is greater than or equal to 1, that is, if its discounted benefits exceed its discounted costs.

Check Your Progreas 2 Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the Unit.

1) Briefly discuss cash flow in financial analysis.

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2) In order to appraise a project by NPV, what are the methods to be followed?

16.6 LET US SUM UP
Governments and individuals can usually pursue only limited objectives when they choose projects on the basis of a financial appraisal. In most circumstances, a financial analysis using market prices to value a project's inputs and outputs will merelv tell the analvst whether a ~roiect will be financiallv ~rofitable. These

market prices usually contain many distortions such as taxes, tariffs and price controls and do not reflect the true costs and benefits to the economy of a project's use of particular inputs and production of various outputs. Therefore a financial analysis will only rarely measure a project's contribution to the community's welfare.

Financial Appraisal

16.7 KEY WORDS
Economic or Social Appraisal: A process of judging the economic or social profitability of a project. Financial Appraisal: A process of judging the commercial viabilitylprofitability of a project. Managerial Appraisal: A ptocess of judging the integrity and competence of promotion and management team behind the project. Project Appraisal: A process of judging the acceptability or otherwise of an investment project. Tecbnical Appraisal: A process of judging the technical feasibility of a project.

16.8 REFERENCES
Dasgupta, A.K. and Pearce, D.W., 1972, Cost-Benefit Analysis-Theory and Practice, Macmillan, London. Layard, R (ed.), 1972, Cost-Benefit Analysis, Penguin, Harmonsworth. Little, I.M.D. and Mirrlees, J.A., 1990. Project Appraisal and Planning for Developing Countries, Heinemann Educational Books, London. Pearce, D.W. and Nash, C.A., 1981. The Social Appraisal o Projects: A Text in f Cost Benefit Analysis, Macmillan, London. Perkins, Frances. 1952, Practical Cost-Benefit Analysis: Basic Concepts and Applications, Macmillan, Australia. f Squire, L. and Van der Tak, H.G., 1975, Economic Analysis o Projects, Johns Hopkins University Press, Baltimore.
UNIDO, 1972. Guidelinesfor Project Evaluation, United Nations, New York.

16.9 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Cbeck Your Progress 1 1) Your answer should include the following points:
A financial analysis must be undertaken if it is necessary to determine

the financial profitability of a project to the project implementer. Financial analysis can be cany out if the output of the project can be sold in the market, or otherwise valued in market prices. This analysis can be canyout if the output of the project can be sold in the market, or otherwise valued in market prices. This analysis can be applied for a private sponsored project, and to a extent it can be also apply to some government business undertaking. Commercially oriented government agencies that are selling output will usually undertake a financial as well as an economic analysis of anv new ~roiect they are considering.

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Investment of Public Funds

Another situation where a government will be interested in undertaking a financial analysis of a project is when the project is financially viable without the subsidy. 2) Your answer should include the following points: The financial benefits of a project are just the revenues received and the financial costs are expenditures that are actually incurred by the implementing agency as a result of the project. If a project is producing some good or service for sale, the revenue that the project implementers expect to receive each year from these sales will be the benefits of the project.
1

The costs incurred are the expenditures made to establish and operate the project. In a financial analysis, all these receipts and expenditures are valued as they appear in the financial balance sheet of the project, and are therefore measured in market prices. It is obviously very important to know whether the input and output projections given by the proposing firm or agency are valued in current prices (normal) or constant prices (real). It is important to be clear about where inputs and outputs should be priced in a project appraisal. Some project appraisals split costs (and sometimes benefits) between locally incurred and foreign exchange costs and benefits. This is useful if policy makers wish to judge the impact of the project on the balance payments, or if foreign financing agents such as aid agencies or multilateral banks wish to see the distribution of items eligible for aid grants or loans.

Check Your Progress 2
1) Your answer should include the following points: The financial cash flow of a project is the stream of financial costs and benefits, or expenditures and receipts, which will be generated by the project over its economic life, and will not be produced in its absence. Before the cash flow of a project can be estimated, it will be necessary for the project sponsors to undertake detailed market research into product markets and prices. They must find out if there will be market for the project's output and what it can be sold for. Then the analyst will need to assess the sources, quantities and costs of required capital assets, raw materials and labour, to estimate the likely costs of the project. It may also be necessary to determine anticipated inflation rates and exchange rate movements, as they may affect the valuation of the project's expenditures and receipts. Early in the process of constructing a project's financial cash flow it will be necessary to determine the length of the project's economic life. This will be the optimal period over which the project should be run to maximiSe its return to the ~roiect imvlementer.

The capital costs of a project can be divided into fixed capital costs, or the cost of acquiring fixed assets like plant and equipment, start-up costs, and working capital, which finances the operating expenses of the enterprise. The project's operating costs cover its recurrent outlays on labour services (wages and salaries), raw materials, energy, utilities (water, waste removal, etc,), marketing, transport, insurance, taxes and debt service over the life of the project.

Financial Appraisal

*

In addition to a financial analysis undertaken from the owner's point of view, the company tax paid on project profits can be calculated in order to determine the project's net present value after tax. The project's net benefit stream is calculated as the difference between the total revenue (or benefit) stream and its expenditure (costs) stream.

2) Your answer should include the following points: The two most commonly used discounted measures of a project's net benefit are its Net Present Value (NPV) and Internal Rate of Return The NPV measure of project worth is the most useful and one of the most commonly used criteria for determining whether a project should be accepted. The net present value of a project is simply the present value, PV, of its net benefit stream. It is obtained by discounting the stream of net benefits produced by the project over its lifetime, back to its value in the chosen base period, usually the present. The net present value formula is:

Bt are project benefits in period t; Ct are project costs in period t; r is the appropriate financial or economic discount rate; and n is the number of years for which the project will operate.

UNIT 17 ECONOMIC AND SOCIAL APPRAISAL
Structure
17.0 Objectives 17.1 Introduction 17.2. Role of Cost Benefit Analysis in Project Development, Evaluation and Implementation Financial Analysis and Economic Analysis: Distinction 17.3 17.4 Steps in Preparing a Full Economic Evaluation 17.5 Social Cost Benefit Analysis 17.6 Let Us Sum Up 17.7 Key Words 17.8 References 17.9 Answers to Check Your Progress Exercises

17.0 OBJECTIVES
After reading this unit, you should be able to: highlight the need for an economic analysis by governments; discuss the role of Cost Benefit Analysis in project development, evaluation and implementation; bring out the differences between financial and economic analysis; explain the steps in preparing a full economic evaluation; and discuss the purpose of social cost benefit analysis.

17.1 INTRODUCTION
An economic analysis, also called a cost benefit analysis, is an extension of a financial analysis. An economic analysis is employed mainly by governments and international agencies to determine whether or not particular projects or policies will improve a community's welfare and should therefore be supported. As cost benefit analysis enables the analyst to determine if a project will make a positive contribution to the welfare of a country, it should routinely be undertaken to evaluate major government-funded projects and policies. The government should also undertake a cost benefit analysis of any private project seeking government subsidies or policy support, such as tariff protection. While a financial analysis is concerned only with the interests of the implementing agency or firm, cost benefit analysis is concemed with welfare of all the firms, consumers and government in a particular country. An economic analysis is not, however, concerned about the welfare of foreigners. The methodology of cost benefit analysis, or CBA, was first developed in the 1930s in the United States when the Federal government had to decide whether to undertake many large, publicly funded irrigation, hydroelectricity and water supply projects in the dry central and western states of the United States. However, modem cost benefit analysis theory and practice h e evolved largely from path-breaking work by Little and Mirrlees, Dasgupta, Marglin and Sen in their UNIDO Guidelines, Harberger , Corden , Squire and Van Der Tak and other work collected in Layard . Many other useful contributions have been made by various authors.
cost benefi analysis is undertaken, micro economic, macro economic and international trade theory is applied to real world situations in order to answer questions such as these:

When a

Should a new bridge be built, or should the existing ferry service be upgraded? Should an export-oriented aluminum refinery be established, or should the unprocessed bauxite and coal be exported? Should computers be imported or assembled locally? Will this irrigation project be a better use of resources and lead to a greater increase in community welfare than that highway project? What fuel should be used to generate electricity? For the government to answer these questions, it is necessary that it goes beyond a financial appraisal, which determines how commercially profitable these alternative policies and potential investments would be. This is essential for a number of reasons. The first is that governments typically have broader and more complex objectives, which they wish to achieve from public gdod and social service provision and policymaking generally, than mere profit maximisation. If governments only wished to maximise profits from the operation of state enterprises, they would be well advised to privatise them, as the private sector is likely to be more efficient at pursuing this goal. Government objectives fall broadly under the heading of "optimisation of community welfare". The most straightforward economic objective is the optimisation of the level of GNP per capita. Other objectives may include preserving the environment, redistributing income to particular target groups or regions and enhancing national security. Even from this short list it is obvious that there may be conflict between some of these objectives. One of the major reasons that governments use cost benefit analysis is to determine the impact of various competing projects on community welfare, defined in terms of all these different criteria. The other major reason for the use of cost benefit analysis lies in the many distortions and imperfections that affect prices in factor and goods markets. In many countries market prices, that is, prices quoted in domestic markets, reflect a range of distortions, including taxes, subsidies, controlled prices, tariffs, and monopoly or monopsony rents. These factors distort market prices so that they no longer reflect the true economic value that people place on consuming such goods and services (their demand price), or the true cost to the economy of producing them (their supply price). If a government wishes to determine which projects will make a positive contribution to community welfare, it will not necessarily be able to use the market prices of the projects' inputs and outputs to calculate their true costs and benefits to society. When undertaking a cost benefit analysis, the project analyst will try to correct for such distortions by calculating economic, or shadow, prices. The shadow prices of the project's inputs and outputs, like labour and capital, goods that enter international trade, traded goods, and those that do not, non-traded goods, will reflect the true economic value of these inputs and outputs to the economy concerned. In a cost benefit analysis shadow prices for projects' inputs and outputs are substituted for market prices.

Economic and Social Appraisal

17.2 ROLE OF COST BENEFIT ANALYSIS IN PROJECT DEVELOPMENT, EVALUATION AND IMPLEMENTATION
The techniques of financial and cost benefit analysis are employed in three of the six identifiable stages of project formulation and evaluation viz., 2, 3 and 6 given below:

- - - - -

-

-

-- -

-

Investment of Public Funds

Project Identification
At this stage, the initiating agency, such as a government department or utility, defines the initial concept of project and outlines the objectives that the government wishes it to achieve. These may include the provision of health, transport or education services, for example. The first major issue that must be investigated is the existence of market opportunities. In the case of social services, the analyst must determine the anticipated demand for the project's output and the benefits that the public is expected to derive from these services. An initial assessment of the best technology to employ, given local factor prices, as well as the appropriate scale and timing of the project is also necessary. Engineers, health specialists, educationalists, environmental scientists, agricultural specialists, market analyst and many other professionals will contribute to this stage of the project's development. Economists may also be involved in a preliminary assessment of the viability of alternative technology given the relative prices of capital and labour in the country concerned. This process yields the basis concept of the project and background information, which enables the government to progress to the pre-feasibility study stage.

Pre-feasibility Study
At this stage, the analyst obtains approximate valuations of the major components of the project's costs and benefits: input and output quantities and prices. More precise estimates must be made of the demand for the project's output, the technical capacity and cost of the plant or technology envisaged, and the project's manpower requirements. In many cases this data will be provided by the technical professionals involved in the original project identification stage. Using this preliminary data, financial and economic analyses of the project will

. then be undertaken by the economic analyst, to determine whether the project
appears to be financially and economically viable. A preliminary financing schedule may also be drawn up to identi@ the source and costs of funds. If the project appears viable from this preliminary investigation, it will be worthwhile proceeding to the full feasibility study stage.

Feasibility Study
At this stage, more accurate data must be obtained on all project costs and benefits, but particularly those that risk analysis indicates are crucial to the project's viability. The financial and economic viability of the project is then assessed again. If the project is still found to be viable, approval should be sought to proceed to the project design phase.

Project Design
This involves undertaking the detailed engineering design work of the project, based on the technology envisaged at the feasibility stage. Manpower requirements, administration and marketing procedure are all finalised at this point.

Implementation
At this stage, tenders are let and contracts signed to facilitate the appointment of the project manager, who will oversee the construction and possibly the operation of the project.

Ex-post Evaluation

Economic and Social Appraisal

The final stage of a project is essential, yet frequently overlooked in project appraisal and implementation. This evaluation is designed to determine the actual contribution that the project has made to national welfare, after several years of project operation. Its primary purpose is to help to identify the major sources of project success and failure, so that future project development, analysis and operation procedures can benefit from past experience.

17.3 FINANCIAL ANALYSIS AND ECONOMIC ANALYSIS: DISTINCTION
The economic analysis technique outlined above have much in common with financial analysis. However there are significant points of distinction.
Firstly, a traditional financial analysis examines a project from the narrow perspective of the entity undertaking the project. It does not take account of effects on other enterprises or individuals. Thus, a proposal put forward by one government agency may inflict costs (or confer benefits) on other government agencies, on private sector enterprises or on individuals. These external costs and benefits must be taken into account. Similarly, a strictly financial analysis does not consider the opportunity cost of using resources in the case where the actual price paid by or to the entity is not a good indcator of the real value in terms of alternative uses. Secondly, economic evaluation does not consider directly the payment of interest. Rather real resource flows are shown and time preference is taken into account by the use of a discount rate. Thirdly, in economic analysis capital expenditure is recognised as a resource cost at the time it is incurred whereas in financial analysis it may be shown amortised over the life of the project for taxation and other purposes.

In the public sector the fundamental requirement is for an economic appraisal. However it should be noted that the undertaking of an economic appraisal does not remove the need for a financial analysis. The financial analysis will show the demands on cash flow which will result from the project- an important factor when managing the State's finances. It will also show the rate of return from the project which is important for commercial agencies. There is an important distinction between the costs and benefits involved in a financial analysis and those included in an economic analysis. Financial analysis whether used in the public or the private sector, implies the notion of the agency maximising its net financial surplus over time. This will generally differ from the maximisation of the economic surplus generated for the community as a whole whenever prices do not reflect the benefits or costs associated with an activity (in some case there may not even be any prices because benefits and costs are not traded). In the case of the more commercial agencies the differences between financial appraisal and economic evaluation will commonly be comparatively small. However for agencies with significant community service obligations, fmancial appraisal can be suitably applied only in a narrow range of decision choices. Thus in the economic evaluation of a public road not subject to a toll, financial appraisal will not be of much assistance. Similarly, in choosing between two sites for a hospital, not only should the costs of building on the two sites be

Investment of Public Funds

considered, but also the level of transport costs and length of travel time incurred by patients and visitors to the hospital. Thus in estimating the economic costs and benefits of a project, the analyst will have to estimate values where no direct price is charged and will generally have to consider a wider range of costs and benefits than occurs in a financial appraisal.

check Your Progress 1 Note: i) Use the space given below for your answers. ii) -Checkyour answers with those given at the end of the Unit.
1) Highlight the role of cost benefit analysis in the project development, evaluation and implementation.

2) Discuss the differences between financial analysis and economic analysis?

17.4 STEPS IN PREPARING A FULL ECONOMIC EVALUATION
The steps in preparing a standard economic evaluation are outlined below:

Definition Objectives: The starting point and in many ways the most crucial aspect for the evaluation of an investment proposal is the specification of the objectives of the proposal and their relation'to the overall objectives of the agency. No appraisal of the project can be meaningful unless the objectives are clearly defined. Identification Options: It is necessary to identify the widest possible range of options at the earliest stage of the planning process. One alternative that should be considered is the possibility of the objective being met by the private sector. In developing various options the first option to be considered is the base case of "do nothing" i.e. retain the status quo. This is not to say the base case will not involve costs; in many cases doing nothing (for example continuing with a low maintenance programme) will result in cost penalties. One benefit of doing something may be the avoidance of these costs. In the case of asset replacement decisions it may involve deferral of replacement and continued maintenance and or eventual replacement with a

.

- . . .

new asset of comparable standard to that being replaced. In the case of an expansion of activities the base case would represent a continuation of the existing system or policies. Identification of Costs and Benefits-The With-Without Principle: This is the basic principle of any type of project evaluation. In practice, it means that an attempt should be made to estimate the "the state of the world" as it will exist with the project in existence. This should be contrasted with the "state of the world" that would have existed in the absence of the project (the "do nothing" option). This principle has two important implications: First, economic evaluation must not simply be a comparison of before project conditions with after project conditions because such comparison would attribute the contribution of all pre-existing trends and external factors to the project itself For example, reductions in on-going costs due to changed work practices should not be attributed to savings from an investment in new plant if the changes in work practices would have been introduced regardless of the investment decision. Second, the analysis should include all impacts, both beneficial and otherwise, of the proposal being evaluated. In particular, not only should the intended effects or benefits which are the objectives of the project be included, but also the subsidiary or indirect effects. There are a range of types of benefits and costs which must be considered, and they accrue to different people: some accrue directly to the user or provider of the service; while others accrue to outsiders (these are known as externalities). The case of the evaluation of a dam whose primary purpose is the provision of irrigation for commercial crops can be used as an example. The impacts to be included in the analysis would be: the provision of irrigation water for cropping (the rrimary objective and a traded benefit); the provision of urban water (a traded benefit) flood mitigation benefits (a quantifiable non-traded benefit which is external to the users and providers of water); recreational benefits offered by the dam (a quantifiable non- traded benefit external to the consumers of water); and environmental effects on native flora and fauna (an external effect which may be difficult to quantify even in physical terms). The importance of the with-without principle cannot be overstated. Failure to adopt it may lead to meaningless results. Valuation of Costs and Benefits: When considering how impacts should be valued in practice, it may be convenient to classify impacts into three categories. i) Costs and benefits which can be readily identified and valued in money terms (e.g. Value of additional electricity supplies to users, travel time savings).

Economic and Social Appraisal

Investment of Public Funds

ii) Effects which can be identified and measured in physical terms but which cannot be easily valued in money terms because of the absence of market signals and consequential disagreement as to the rate of valuation (e.g. museums, reduction in pollution). iii) Impacts which are known to exist but cannot be precisely identified and accurately quantified, let alone valued (e.g. Crime prevention effects of police programs, comfort improvements in new trains, aesthetic effects of beautification programs). When considering benefits and costs which either cannot be valued or cannot be quantified there can be a tendency to concentrate on the benefits and ignore the costs. This should be resisted. Where valuation is possible, two key concepts need to be kept in mind. a) The Opportunity Cost Principle: The use of resources (manpower, finance or land) in one particular area will preclude their use in any other. Hence the basis for valuing the resources used is the "opportunity cost" of committing resources; i.e. the value these resources would have in the most attractive alternative use. The adoption of this principle reflects the fact that the economic evaluation of public sector projects should be conducted from the perspective of society as a whole and not from the point of view of a single agency. Commonly, the price paid for new capital, labour or inputs will reflect the opportunity cost of the resources. The position may be less clear in the case of the existing land owned by the agency. However, in general it is considered that a cost equivalent to its maximum market value or likely land use zoning should be placed on such land. The general principle applies even where the public sector may have access to an input at a cost different from its market value. For example, coal supplied from an electricity generator's own collieries should be priced at the market price for comparable coal rather than the costs of supply, reflecting the fact that the coal has an alternative use. b) Willingness-to-pay Principle: In valuing the benefits of a project the aim is to place a monetary value on the various outputs of the project. Typically such outputs will include: i) benefits for which a price is paid; and ii) benefits for which no price is paid. Where the services are bought and sold it is generally presumed that the price paid is a reasonable proxy for the values of the service to the consumer. This principle will hold most closely where the changes in output and price levels associated with the investment are relatively small. Where output changes are significant then it may be desirable to take account of changes in consumer surplus (an excess over the market price which the consumer would have been willing to pay). This will require knowledge of the price elasticity of demand (i.e. sensitivity of demand to changes in price). However, where the service is not freely traded or there is no price charged, or where the benefits fall broadly on the community rather than individual users, more indirect measures of the willingness to pay for the benefits need to be derived. A variety of techniques are available including:
1

i) the use of data on expenditure by consumers in seeking to participate in benefits (e.g. costs incurred in visiting a national park);

I

ii) price data from related goods and services (e.g. variations in house prices due to the impact of noise levels to assess the cost of airport noise); and iii) choice experiments (e.g. experimental choice between a 'variety of existing and new amusement/recreation amenities to infer a value for a new amenity). Where no established fiamework exists, valuation of non-traded outputs will have to be approached on a case by case basis. Some government services have been provided at subsidised prices and this introduces distortions in the market. Therefore the imposition of customer charges to value benefits is likely to understate benefits. As with services for which no price is charged, additional effort is needed in the appraisal to estimate the additional benefits, either from externalities or consumer surplus.
Specific Issues

Economic and Social Appraisal

a) Avoidance of Double Counting or Overstating of Benefits In enumerating the costs and benefits of a proposal, care should be taken to avoid double counting. For example, the construction of a dam may increase the value of the land which is to be irrigated as a result of the increased ability of the land to grow crops. The increased value of the land merely reflects the market's capitalisation of the increased output stream. Inclusion of the net value of the increased output and the increased land value would count the same benefit twice. Another danger is the overstatement of benefits by attributing the total output of a process to a single input. In the above example, the total value of the crops made available by the water irrigation project should not be attributed to the project. Rather the net value of the additional production should be derived by deducting all additional input costs fiom the value of the additional output, i.e. the costs of labour, capital and other inputs such as fertiliser and fuel should be deducted fiom the value of the output. Measured in this way the value of net output, subject to provision for a normal profit provides a measure of the willingness to pay for water. Hence, the inclusion of this benefit would also require adjustment for actual payments made for water provided.

b) Treatment of Inflation
Due to inflation, costs and benefits which occur later will be higher in cash terms than similar costs or benefits which occur earlier. .There are two different ways to tackle this issue. Either nominal values can be used for each time period and then discounted with a nominal discount rate, or real cash flows can be used discounted by a real discount rate. In practice it is considered that the use of real cash flows and discount rates may simplify the forecasting and calculation processes. c) Use of Shadow Prices A shadow or accounting price is the price that economists attribute to a good or factor on the argument that it is more appropriate for the purpose of economic calculation than its existing price, if any. In evaluating any project, the economist may effectively correct a number of market prices and also attribute prices to unpriced gains and losses that it is expected to

Investment of Public Funds

generate. He will, for example, add to the cost of a factor or subtract from the cost of a good, in making allowance for some external diseconomy. Wherever the amounts of a good, to be added to or subtracted from the existing consumption are large enough, the economist will substitute for price the more discriminating measure of benefit, consumer surplus. Certain gains or losses to an enterprise he will value as zero, since for the economy at large they are only transfer payments. The cost of labour that would otherwise remain idle, he must value at its opportunity cost; not at its wage; and so on. d) Valuation of Specific Cost Items i) Land and Pre-existing BuildingsIPlant While a project may use land, buildings or plant already owned by an agency for which no payment will be made, the opportunity costs of these assets should be included. ii) Labour In assessing labour costs, the value of existing labour resources transferred to the project, as well as additional labour required, should be included. iii) Overheads Labour related overheads such as supervision, transport costs, administrative costs, printing and stationery etc., are also included. iv) Residual Values At the end of the planning horizon or project life, some assets may still have some value. Such assets may not have reached the end of their economic life and may still be of use to the agency or may be resale able. In this case the value of an asset may be assessed at a level pro rata to its remaining economic life. Alternatively the asset may have reached the end of its economic life but have a scrap value. This value is a benefit to the project and should,be included in the evaluation. Certain assets are nondepreciable, such as land and can be valued at opportunity cost.

Costs to be Excluded from Analysis
A number of items which are included as costs in accounting reports or financial appraisals should not be included in an economic evaluation of an investment proposal. a) Sunk Costs In an evaluation, all costs must relate to future expenditures only. The price paid 10 years ago for a piece of land or a plant item is of no relevance; it is the opportunity cost in terms of today's value (or price) which must be included. All past or sunk costs are irrelevant and should be excluded. b) Depreciation Depreciation is an accounting means of allocating the cost of a capital asset over the years of its estimated useful life. It does not directly reflect anv oaoortunitv cost of caaital.

The economic capital cost of a project is incurred at the time that labour, machinery and other inputs are used for construction, or in the case of an existing asset, when it diverted from its current use to use in the project being evaluated. These project inputs are valued at their opportunity cost. Hence, depreciation should not be included in the economic evaluation. c) Interest As future cash flows are discounted to present value terms in economic evaluations, the choice of the discount rate is based on various factors which include the rate of interest. The discounting process removes the need to include interest rate in the cash flows. Discounting of Future Costs and Benefits a) The Concept of Discounting The costs and benefits flowing from an investment decision are spread over time. Initial investment costs are borne up front while benefits or operating zcosts may extend far into the future. Even in the absence of inflation, a rupee received now is worth more than a rupee received at some time in the future. Conversely, a rupee's cost incurred now is more onerous than a rupee's cost accruing at some future time. This reflects the concept of timze preference which can be seen in the fact that people normally prefer to receive cash sooner rather than later and pay bills later rather than sooner. The existence of real interest rates reflects this time preference. In order to compare the costs and benefits flowing from a project it is necessary to bring them back to a common time dimension. This is done by discounting the value of future costs and benefits in order to determine their present value. The process of discounting is simply compound interest worked backwards. b) The Recommended Discount Rate Private sector entities sometimes require that the rate of return on a particular project exceeds the return expected on an alternative project which might otherwise be undertaken. Or they might stipulate a return somewhat in excess of the cost of borrowed funds. Public sector decision-makers will be encouraged to invest in projects which generate returns greater than the government's test discount rates. Three alternative bases for the setting of the discount rate have been proposed: social time preference; opportunity cost of capital; and cost of funds. The first two concepts of the discount rate relate to the opportunity cost of the resources used in the public sector investment projects. Resources could be used elsewhere and the discount rate attempts to measure such opportunities foregone. In principle the social time preference rate and the opportunity cost of capital should be the same. However, for various reasons such as private sector profit and capital constraints in the public sector, the two will differ. Typically the opportunity cost of capital will be greater than the social time preference rate.

Economic and Social Appraisal

Investment of Public Funds

Resources devoted to public investment will be at the expense of current consumption or private sector investment. In a growing economy with rising living standards, a rupee's consumption today will be more valued than a rupee's consumption at some future time for, in the latter case, the rupee will be subtracted from a higher income level. This so-called marginal social rate of time preference is, of course, not easy to measure. If alternatively, public investment takes place at the expense of private investment then, from an economic efficiency viewpoint, public investments of an economic nature should not be sanctioned if they are expected to earn significantly lower rates of return than those same resources might earn (before tax) in the private sector (the so-called marginal social opportunity cost). This concept is also difficult to measure accurately. The concern is not with the average rate of return in the private sector, but with the marginal rate - that is with the rate which would be earned by the private sector if additional capital allowed further private investment to occur. In theory a perfectly competitive capital market will see equality of the consumer's marginal rate of time preference, the investor's rate of return on the marginal project and the market rate of interest. In practice interest rates provide limited guidance to the estimation of discount rates on these bases. In the face of the difficulty of measuring discount rates on these bases, it has sometimes been argued that the appropriate rate of return or discount rate should be derived from the interest rate at which government borrows funds in the market. But given the dominant position of government in the capital market, the variability of interest rates and the wide range of factors which impact on interest rates this is quite an inadequate way of deriving the appropriate discount rate. c) Impact of Discount Rates on Project Ranking It should be noted that the choice of the discount rate is an important issue as it can have a significant impact on the ranking of options/projects and hence their choice. In general, as the discount rate rises projects with larger initial outlays and lower ongoing outlays become relatively less attractive compared with projects with lower initial outlays and higher ongoing outlays. Thus, a higher discount rate would favour maintenance options as against asset replacement. Similarly in the case when net benefits are spread far into the future, the higher the discount rate, the more net benefits far in the future are downgraded in present value terms relative to net benefits closer to hand. Thus, short lived options are favoured by higher discount rates relative to long-lived options. d) Decision Criteria Once all the costs and benefits over the life of the programme have been identified and quantified, they are expressed in present value terms. Using the discounted stream of costs and benefits, the following decision measures should be calculated. Investment decision making is primarily concerned with three types of processes:

The screening process, whereby the decision maker, faced with a range of independent projects and adequate resources, must accept or reject the individual projects. The choice process between mutually exclusive projects, whereby the decision makers must choose from a range of mutually exclusive projects (commonly directed at similar objectives): The ranking process, whereby the decision maker is faced with resource constraints which prevent all acceptable projects from being preceded with- hence the projects must be ranked in an objective manner. Various investment criteria are available in reaching decisions in these circumstances. Commonly used criteria are the Net Present value (NPV); Internal Rate of Return (IRR), Benefit Cost Ratio (BCR) and Net Present Value per constrained unit of input (NPVII). i) Net Present Value Net Present Value is the sum of the discounted project benefits less discounted project costs. Formally it can be expressed as follows:

Economic and Social Appraisal

Where Bn = project benefits in year n expressed in constant rupees
Cn= project costs in year n expressed in constant rupees

r = real discount rate N'= number of years that costs and/or benefits are produced Under this decision rule, a project is potentially worthwhile (or viable) if the NPV is greater than zero; ie the total discounted value of benefits is greater than the total discounted costs. If projects are mutually exclusive, the project which yields the highest NPV would be chosen. ii) Benefit-Cost Ratio The Benefit-Cost Ratio (BCR) is the ratio of the present value of benefits to the present value of costs. In algebraic terms it can be expressed as follows:

BCR-C
1-0

2/C
(1 r)"
+

"-0

L ' ~ (1+ r)"

A project is potentially worthwhile if the BCR is greater than 1; ie, the present value of benefits exceeds the present value of costs. If projects are mutually exclusive, this rule would indicate that the project with the highest BCR should be chosen.

It has become conventional to split costs into two types when calculating BCRs: initial capital costs and ongoing costs. Ongoing costs are normally deducted from benefits in the year incurred to make a net benefit stream, while initial capital costs are used as the denominator. iii) Internal Rate of Return The Internal Rate of Return (IRR) is the discount rate at which the net present value of a project is equal to zero, ie discounted benefits equal

Investment of Public Funds

discounted costs. In algebraic terms the IRR is the value of r which solves the equation:

A project is potentially worthwhile if the IRR is greater than the test discount rate. If projects are mutually exclusive, this rule would suggest that the project with the highest IRR should be chosen. iv) Evaluation of Decision Rules The NPV and BCR provide equally acceptable criteria for showing whether an individual project is worthwhile, when taken in isolation. Both clearly show when, for a given discount rate, the project benefits exceed costs and the results of the rules will not conflict with each other. While in many cases the IRR will also yield simple and unambiguous results, care needs to be exercised in the use of IRR. In cases of non-conventional cost-benefit streams (i.e. where there are substantial discontinuities or breaks in the net benefits stream over time) more than one quite different IRR may be calculated. An example of a non-conventional cost-benefit stream is where a project incurs net costs initially followed by net benefits over a number of years and then net costs again. v) Choice between Mutually Exclusive Projects A simple use of NPV, BCR and IRR will not yield the same results for the more complex choice between mutually exclusive projects. The project with the highest NPV may not have the highest IRR or the highest BCR. In the latter case this is because the ratio can be affected by the inclusion of costs as negative benefits, or different balances between initial costs and ongoing costs. This makes it difficult to compare across projects. Where there are no constraints on inputs, such as capital resources, the choice between projects should be made on the basis of maximization of NPV; i.e. the project with the highest NPV should be preferred. This will ensure that the project which provides the largest potential contribution to welfare is adopted. vi) Ranking Under Constraints In practice decision-makers operate in environments where constraints are commonplace. Indeed constraints on capital funds are almost universal. In order to ensure the Government's budgetary objectives are met, such constraints will clearly heavily influence decision making on projects. The problem facing decision-makers is to rank projects in terms of return to the constrained input and then choose projects so as to maximise the NPV of the total program. None of the three decision criteria discussed above take capital constraints explicitly into account, although the BCR calculation as indicated above implicitly does so. However, use of the NPV per rupee of total capital would result in the choice of that combination of projects which maximizes the total NPV obtained from a limited capital works budget.

30

It can be readily calculated as follows:

Economic and Social Appraisal

Where I = capital investment in the project in year n , C, = I, + Operating costs in year n Note that the capital investment is discounted to its present value in the same way as are the net benefits. Using this measure, projects with the highest NPV per dollar of total capital are selected until the budget is exhausted. This means that the expenditure constraint may be a factor in the choice of an investment option which does not have the highest NPV, if the option with the highest NPV requires very high expenditure. In such circumstances the return on the incremental expenditure may be relatively low. This procedure seeks to maximize aggregate NPV from the available funds. Sensitivity Analysis Sensitivity Analysis is used to assess the possible impact of uncertainty. It illustrates what would happen if the assumptions made about some or all of the key variables proved to be wrong and shows how changes in the values of various factors affect the overall cost or benefit of a given investment project. A key practical role of sensitivity analysis is to incorporate different views about one or more key assumptions which can reasonably be held by the different people involved in the assessment process. It is a useful means of indicating the critical elements on which the outcome of the project depends. This allows management to focus on these areas during project implementation or to divert further resources to the improvement of cost and benefit estimates and the reduction of uncertainty. (It is a necessary part of any investment appraisal.) The steps in undertaking appropriate sensitivity tests are outlined below. i) Decide plausible range of values for factors subject to uncertainty: e.g.

-

-

real energy cost + or - 20 per cent real wages + 4 to +12 per cent exchange rate + 50 to -30 per cent

ii) Determine relationships between the sensitivities for the various variables (e.g. nominal wages and inflation). If correlations exist these may be tackled by: moving to a higher level of aggregation (e.g. consider the movement of real wages rather than nominal wages and inflation). looking at the underlying source of uncertainty. specifying a set of mutually consistent assumptions for relevant factors under a number of different scenarios.

Investment of Public Funds

iii) Calculate the effect of plausible changes on the decision criterion (the NPV). The range of values taken by many variables may not be large enough to alter the decision and may therefore be eliminated, thus reducing the number of variables under consideration. If sensitivity analysis is to be usehl to decision-makers it needs to be undertaken systematically and presented clearly.
Post-Implementation Review

A selection of the major projects undertaken by an agency should be subject to ex-post evaluations. In addition, major ongoing programs which may involve a series of smaller projects should be subject to such ex-post evaluations. These evaluations would involve: i) re-evaluation of the benefits and costs of the selected option to assess whether the anticipated benefits were realised and the forecast costs kept to; ii) reconsideration of alternative options; and iii) examination of the project design and implementation to assess the scope for improvement to the option adopted. By examining these issues ex post evaluations will assist in the development and evaluation of future projects. In addition, public sector agencies should implement procedures for ongoing asset management and assessment.

17.5 SOCIAL COST BENEFIT ANALYSIS
The financial or traditional economic project appraisals implicitly assumed that income distribution issues are beyond the concern of the project analyst or that the distribution of income in the country is considered appropriate. However, in many, if not most, developing and developed countries governments are not only interested in increasing efficiency but also in promoting greater equity. In most countries the existing distribution of income is clearly not considered to be ideal by the government or the population. Social cost benefit analysis or the social appraisal of project has evolved to respond to this need. A social appraisal of a project goes beyond an economic appraisal to determine which projects will increase welfare once their distribution impact is considered. The project analyst is not only concerned to determine the level of a project's benefits and costs but also who receives the benefits and pays the costs. Social appraisal therefore tackles the moral and theoretical dilemma-that a project is worth undertaking if it has the potential to produce a Pareto improvement in welfare. In an economic analysis of a project it is implicitly assumed that a dollar received by any individual will increase the community's welfare by the same amount as a dollar received by any other individual. However, an extra dollar given to a very poor person, with an annual income of say only USD300, will usually increase that person's welfare by much more than would a dollar given to the same person if he or she became very rich, with an annual income of USD 100000. As a society we may be prepared to undertake a project, A, which increases the consumption of poor people by USDlOO per annum even if it reduces t h e consumption of rich people by USDSO. On the other hand, the community may not be prepared to undertake another project, Bywhich increases the consumption

of the rich by USDlOO and reduces that of the poor by USDSO. The theoretical rationale in welfare economics for the social analysis of projects is therefore quite strong, as the marginal utility of income of a person who receives a low income is expected to be greater than the marginal utility of income of the same person if she or he receives a high income. An economic analysis of projects A and B would not capture these differences and would merely indicate that both had the same positive impact on community welfare.
Distributional Weights

Economic and Social Appraisal

One of the most commonly used methods of undertaking a social cost benefit analysis is to introduce distributional weights in to the cash flow. Distributional weights are attached to changes in income, costs and benefits, received by different income groups, ensuring that a project's impact on the income of low income groups receives a higher weight than the same dollar impact on the income of high income groups. The introduction of these distributional weights enables projects to be assessed on the basis of distributional as well as efficiency objectives.
The Introduction of Distributional Weights into the Cash Flow

- In an economic analysis, project generated changes in consumption enjoyed by all income groups are weighted at unity, d=l. In a social analysis income accruing to (or being taken from) lower income groups would typically be given a distributional weight greater than one (d>l). On the other hand, income accruing to (or being taken from) a high income group would be given a weight less than one (d<l). A project that benefits a low income group would therefore have a higher social net present value than one that benefits a high income group, if all other, un-weighted costs and benefits remain the same.
*

In the example shown below the government of a country with a highly skewed income distribution is considering two mutually exclusive projects, A and B.
Table 1 The Use of Distributional Weights in Social Analysis of Projects ($L Million) Project A Rich Poor Project B Rich

Cost paid by Benefits received by If distributional weights, d: Economic NPV
Therefore do Project B

1 +50

1

1 +80

1

1

I
2 0 300 +200 1 100 0 2 160, 0 0 1 0 160

If distributional weights, d: Cost paid by Benefits received by social NPV
Therefore do Project A

Investment of Public Funds

Project A's costs are borne by the rich and its benefits are received by the poor, while project B is the opposite. Its costs are borne by the poor and its benefits are received by the wealthy. Since the two projects are mutually exclusive the project wit the highest NPV should be selected. If an economic analysis were undertaken and distributional weights of unity were applied to the costs and benefits of the two projects, project B would have an NPV of $L80 and project A an NPV of $L50. Hence, project B should be selected. However, if the government decides that it values income going to the poor more highly than income going to the rich and applies a distributional weight of, for example, d=2 to the low income group's income, project A would have a social NPV of $L200 and project B would have a social NPV of $LO. Project A would then be selected on the basis of a social cost benefit analysis.
Arguments for and Against the Use of Distributional Weights

There are several problems for analyst wishing to use this approach. The first is the difficulty of tracing the net income changes accruing to different income groups as a result of the project, even in the case of relatively straightforward project. It may be very time consuming and expensive to identify who will bear the costs of a project, who will reap its benefits; and what the income levels of these different groups are. It has therefore been argued that the introduction of distributional issues into project appraisal will so increase the complexity of undertaking a cost benefit analysis that serious inaccuracies could become more common. This argument is very persuasive and may be conclusive for large projects with a diverse group of beneficiaries and whose income levels may be difficult to determine. The counter argument put by those supporting social analysis of projects is that, as distributional:issues will be implicitly introduced into project analysis in any case, it is much better that they are treated in a consistent and rigorous way. The second problem with the use of distributional weights relates to how the government or project analyst can objectively determine the appropriate set of weights to employ. Even if the distributional impacts of a large project can be traced, the marginal utility of income of these different groups may be very hard to determine. Economists such as Harberger and Amin have opposed the formal inclusion of distributional objectives into cost benefit analysis. They claim that, by necessitating comparisons of the welfare that individuals receive from increasing their income by a fixed amount, say $1, social cost benefit analysis compromises the objectivity of project appraisal. Instead, Jenkins and Harberger recommend merely documenting which groups benefit and which lose from a project, leaving it to decision-makers to determine implicit, rather than explicit, distributional weights. Supporters of social benefit analysis argue that failure to explicitly compare the utility received by different income groups within the framework of the project appraisal implies that the analyst gives equal weight to gains in consumption by all income groups, from the poorest and most destitute to the wealthiest groups in society. This would only be justified if it were assumed that the marginal utility of income, the change in utility experienced from a given increase in consumption, of all individuals was equal irrespective of their income levels. Another argument advanced by those opposed to the introduction of distributional issues into cost benefit analysis is that project should be selected in order to maximise national income and that the taxation and welfare systems

should then be used to redistribute this 'income. This is very reasonable and correct view in the case of the developed, higher income countries, which have well developed fiscal and social welfare systems. In many developing countries, however, the fiscal system is weak and even re@essive. Large proportions of the population, rich and poor, pay no tax at all and there are few social welfare payments. Corruption and the power of economic elites often ensure that the wealthy evade taxation and wield sufficient political resistance to making direct transfers to target groups through the fiscal system. The only acceptable method of making transfers may be via public sector projects to provide social infrastructure, such as schools and hospitals or economic infrastructure, such as roads and irrigation facilities. If economy-wide mechanisms for promoting income redistribution are not available there may well be a justification for employing social appraisal of such projects. In relation to distributional weights, Harberger points out that even if quite moderate distributional weights are employed, it would be possible to sanction acceptance of scandalously inefficient projects. For example, in Australia it may appear reasonable that changes in consumption enjoyed by families on an income of less than $A15000 should be given an income distributional weight of 2, and consumption changes by those on an income of more than $A90000 should be given a distributional weight of 0.5. However, this would imply that a project would be acceptable if it extracted $1 from the wealthy, which would then have a social value of $0.50 and gave only $0.25 to the poor, as the latter would then have a social value of $0.50 also. The use of such distributional weights could therefore result in projects being accepted that entail efficiency losses of 75 percent of costs. Harberger argues that such inefficiency would be quite unacceptable to the electorate and he recommends that, if distributional weights are used, a caveat should be added limiting the extent of acceptable efficiency losses.
Check Your Progress 2 Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the Unit.

Economic and Social Appraisal

1) Briefly explain the steps in preparing a full economic evaluation.

2) Highlight the purpose of social cost benefit analysis.

Investment of Public Funds

17.6 LET US SUM UP
Financial, economic and social analyses are flexible tools for assessing alternative uses of resources in order to achieve welfare objectives determined by the government. A financial analysis indicates whether a project will be profitable to its implementer, by 'using market prices for inputs and outputs. An economic analysis, using shadow prices, reveals which projects will make a positive contribution to economic welfare. Finally, a social analysis extends an economic analysis, and includes an examination of the distributional impact of the project.

17.7 KEY WORDS
Capital Market: refers to various institutions and arrangements concerned with the purchase, sale and transfer of stock and bonds. Labour Economics: Labour economics studies the demand and supply for the most important factor of production, human beings. Since the days of Marshall and indeed of Smith, if not earlier, economists have recognised that one cannot analyse the market of labour, without taking account of such issues as social relations of production, long term contractual arrangements, problems of effort and motivation, as well as institutions like unions and internal labour markets, which differentiate the labour market from a bourse. For many years recognition of these factors made labour economics an area in which economic theory was applied sparingly and in which institutional analyses dominated. Subsidies: A payment made by a government to one or more firms to prevent an increase in the price of a product or to prevent the decline of a firm of industry. Tarifti: A tax applied to imports either as a percentage of their value or on a unit basis.

17.8 REFERENCES
Amin, G.A.,1978, Project Appraisal and Income Distributional Weights in Social Cost Benefit Analysis, World development, 6. Corden,W .M., 1974, Trade Policy and Economic Welfare, Oxford University press, London. Harberger, A.C., 1972, Project Evaluation, Collected Papers, Macmillan, New York. Layard, R. (Ed), 1972, Cost Benefit Analysis, Penguin, Harmonsworth. Little, I.M.D. and Mirrlees, J.A.,1974, Project Appraisal and Planning for Developing Countries, Heinemann Educational Books, London. Squire, L. and Van der Tak, H.G.,1975, Economic Analysis of Projects, Johns Hopkins University Press, Baltimore. UNIDO, 1972, Guidelinesfor Project Evaluation, United Nations, New York.

17.9 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1 1) Your answer should include the following points: The initiating agency, such as government department or utility, defines the initial concept of project and outlines the objectives that government wishes it to achieve.

Through pre-feasibility study financial and economic analysis of the project will be undertaken by the economic analyst, to determine whether the project appears to be financially and economically viable. The next stage of the study is the feasibility study. Here the financial and economic viability of the project is assessed again. If the project is still found to be viable, approval should be sought to proceed to the project design phase. The final stage of the project is ex-post evaluation. The primary purpose of this evaluation is to help to identify the major sources of project success and failure, so that future project development, analysis and operations procedures can benefit from the past experience. 2) Your answer should include the following points:
v

Economic and Social Appraisal

P

The traditional financial analysis examines a project from the narrow prospective of the entity undertaking the project. In public sector the fundamental requirement is for an economic appraisal. The financial analysis will show the demand on cash flow which will result from the project an important factor when managing the states finances. The financial analysis will also show the rate of return from the project which is important for commercial agencies. Financial analysis whether used in public or private sector implies the notion of the agency maximising its net financial surplus over time. This will generally differ from the maximisation of the economic surplus generated for the community as a whole. In case of -commercial agencies the difference between financial appraisal and economic evaluation will commonly be comparatively small. Agencies with significant community service obligations, financial appraisal can be suitably applied only in a narrow range of decision choices. For example the economic evaluation of a public road not subject to a toll, financial appraisal will not be of much assistance.

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Check Your Progress 2
1) Your answer should include the following points:
The steps involved in preparing a full economic evaluation are as follows: The specification of the objectives of the proposal and their i) relation to the overall objectives of the agencies. To identify the widest possible range of action at the earliest ii) stage of the planning process. iii) An attempt should be made to estimate the 'state of the world' as it will exist with the project in existence. iv) The next step will be valuation of cost and benefits. There are certain things to be taken into consideration such as v) while enumerating the cost and benefits of a proposal, care should be taken to avoid double counting. vi) Items which are included as costs in accounting reports or financial appraisals should not be included in an economic evaluation of an investment proposal.

i

1
I

Investment of Public Funds

vii) The next step is the discounting of future cost and benefits. This is done by discounting the value of future cost and benefits in order to determine there present value. viii) Sensitive analysis is used to assess the possible impact of uncertainty. ix) A selection of major project undertaken by an agency should be subjected to ex-post evaluation.

2) Your answer should include the following points:
Developing and developed countries are not only interested in increasing efficiency but also in promoting greater equity. Social cost benefits analysis or the social appraisal of the project as evolved to respond to this need. Social appraisal of a project goes beyond an economic appraisal to determine which project will increase welfare once there distribution impact is considered. The social appraisal tackles the moral and theoretical dilemma - that a project is worth undertaking if it has the potential to produce a pare to improvement in welfare.

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UNIT 18 LEGISLATIVE CONTROL
Structure
L

18.0 Objectives 18.1 Introduction 18.2 Concept of Legislative Control 18.3 Historical Background of Legislative Control 18.4 Provision in the ~onstitution,'l950 18.5 Control over Taxation 18.6 Control Over Public Expenditure-An Evaluation 18.7 Let Us Sum Up 18.8 Key Words . 18.9 . References 18.10 Answers to Check Your Progress Exercises

18.0 OBJECTIVES
After reading this unit, you should be able t o explain the concept of legislative control describe the historical background and constitutional provisions of legislative control
,

examine the extent of control exercised over taxation; and explain and evaluate the legislative control over public expenditure.

18.1 INTRODUCTION
Financial administration of a country is executed through (a) the legislature, (b) the Executive, (c) the Finance ~ e p a r t m e n t(d) the Audit and (e) the Parliamentary , committees. Legislature is the on1.y competent organ of government in democracies which authorises the government to collect taxes and also t o spend them in a particular manner. Without legislative approval neither the amounts can be appropriated nor taxes collected. It can also abolish or decrease or levy taxes. In i . theory ! is the executive which demands and the legislature approves. Therefore, . before the government can work on its budget plan, it has to get it passed by the Parliament. This is known as enactment of the budget. The discussion on the budget in Parliament provides the members with opportunity to review, the working of various Departments and Ministries. It also enables them to elicit information on the progress achieved in the implementation of various programmes undertaken by the Government. The members get an opportunity of. examining the worthwhileness and the social and economic implications of the new expenditure proposals included in the budget. After the budget is approved, the Appropriation Act is passed by Parliament authorising the executive to incur expenditure against the allotments included in vdrious grants. Through the delegation of financial powers, the Ministry of Finance shares its responsibility for financial control with the administrative ministries during the implementation of the budget. The Legislative Control is exercised through the operation of the committees of Parliament, namely, the Public Accounts Committee, the Estimates Committee, the Committee on Public Undertakings, the Committee on Subordinate Legislation and the Committee on Assuradces. The Comptroller and Auditor General of India-a statutory authority under the Constitution-acts as a watch dog of the Parliament and conducts audit to see that

Financial Control

the expenditure incurred by the Executive is for the purpose voted by the Parliament and is within the sanctioned grants. The cases of default, financial irregularities misappropriation of funds and neglect of financial propriety are reported by the Comptroller and Auditor General of India to the Public Accounts Committee for such action as it may deem necessary. While examining the appropriation of accounts and the reports of the Comptroller and Auditor General of India thereon, the Committee conducts an elaborate system of investigations. The review of the Audit Report by the Public Accounts Committee completes the cycle of Parliamentary financial control over appropriation grants to the Executive.
. The entire administrative machinery comes under the potential control of the legislature. This is because every action may provide a question; every question, an adjournment debate, and 'every adjournment debate a fulldress debate'. Besides, the Parliamentary Committees too, exercise control over the Government of the day.

18.2 CONCEPT OF LEGISLATIVE CONTROL
Parliament exercises control over revenue, expenditure, borrowing and accounts. Legislative sanction is required for the levy of new taxes or for the increase in the rates of existing taxes, for the withdrawal of money from the Consolidated Fund for public expenditure. and for raising of loans. Public Accounts are scrutinised by the Public Accounts Committee and are audited by a statutory authority which is independent of the executive: In Indian context, the following four principles of financial controi are being followed:
'

,

i)

The executive, acting through Ministers cannot raise money by taxation, borrowing or otherwise without the authority of Parliament; proposals for expenditure requiring additional funds must emanate from the cabinet.

ii) The second principle is the Control that vests in the Lok Sabha which has the exclusive control of the Money bills. These must orginate in the Lok Sabha which has the sole power to grant money by way of taxes or loans and to authorise expenditure. The Rajya Sabha may reject a grant but not add to it. iii) The demand for grants must come from the Government. Neither the Lok Sabha nor a State Assembly may vote a grant except on a demand for grant from the Government. iv) Likewise, the proposal for a new tax or for an increase in the rate of an existing tax must come from the Government. In India the instruments of legislative control are: Questions, Adjournment motions, Resolutions, Votes, ~ u d ~ e tand Legislative Committees-Public s, Accounts Committee, Estimates Committee, Committee on subordinate legislation and the Committee on Assurances. These tools of exercising legislative control are described here briefly.

1) Question Hour :The first hour of every Parliamentary day is reserved for questions, which provide an effective form of control. Questions asked can keep the entire administration on its toes. A question is an effective device of focusing public attention, in a striking manner, on different aspects of administration's policies and activities. Any administrative action can provoke a question, though the member cannot compel the Minister to give the answer. The Speaker, too, may disallow certain questions. A question is asked with a view to getting information, obtaining ministerial opinion on a subject or simply hammering the government on alleged weak points. Many of the questions, may be trivial, but some d o cause tremendous harm to the Government-the Life Insurance Corporation episode of 1956 resulting in the resignation of Finance Minister arose from an answer t o a question.
This is a widely known, popular and commonly employed method of ensuring accountability. From time to time members have been raising matters of great importance through their questions.

2) Adjournment Debates :The device of adjournment motion is a tool of day-today control, and may be utilised for raising a discussion in the House on any specific question of urgent nature and of public importance. If allowed by the presiding officer, an immediate debate takes place on the matter raised, thus suspending the normal business of the House. In practice, it has been seen that the Speaker has shown a consistent tendency not to Interpret the term 'urgent nature and of Public importance' liberally.
3) Debates on Enactment of Acts and Amendments : The various readings of a bill provide opportunities t o the members of Parliament to criticise the entire policy underlying the bill. The criticism may even make the Government change its mind. The Government, for instance, withdrew the highly controversial Hindu Code Bill In 1951. Similarly, whenever Parliament is approached for the amendment in the Act, the members again get an opportunity t o discuss the same.
4) Budget Discussion : Since the introduction of the Budget on Account Parliament has greater opportunity of discussion on the budget proposals. The members of Parliament have various opportunities of discussing the budget, on the following occasions:

I reiclative Control

a) After the presentation of the budget, general discussion takes place. On -this occasion the discussion relates to the budget as a whole o r any question of principles involved therein. b) Voting on grants provides the second opportuni'ty. Discussion at this stage is confined to each head of the Demand, and, if cut motions are moved to the specific points raised therein, the discussion is sufficiently pointed and may be focused on specific points.
C)

Discussion on the Finance Bill provides an endless opportunity to d~scuss the entire administration. In the words of G.V. Mavlanker, "It is an acknowledged principle that any subject can be discussed on the Finance Bill and any grievance ventilated. The principle being that the citizen should not be called upon to pay, unless he is given, through Parliament the fullest latitude of representing his views and conveying his grievances."

5) President's Speech :The President addresses both the Houses of Parliament assembled together at the commencement of the Budget session. The address is prepared by the Government and each Ministry is responsible for the portion pertaining to it. The President's Speech broadly spells out the major policies and activities with which the executive would be pre-occupied in the period Immediately ahead. The members of Parliament have an opportunity to criticise the entire realm of administration for its alleged acts of ommission and commission.
6) Parliamentary Committees : Parliamentary Committees-Public Accounts Committees, Estimates Committee, Committee on Public Undertakings, Committee on subordinate legislation and Committee on assurances-are als'o tools of control over administration. The first three committees exercise detailed and substantial control, and the Committee o'n assurances undertake a scrutiny, of promises, assurances, undertakings, etc., given by the Ministers from time t o time, on thc' floor of the House and it reports on:

i) the extent to which such assurances, promises etc., have been implemented and ii) where implemented, whether such implementation has taken place within the minimum time necessary for the purpose. The existence of such a committee make4 Ministers more careful in making promises.

7) Audit :Parliament exercise control over Public expenditure through the Comptroller and Auditor General who audits a!l Government accounts to ensure t h a t t h e money granted by Parliament has not been exceeded without a supplementary vote and money expknded conforms to rules. The accountability of

Financial Control

through the reports of the Comptroller and Auditor General who has rightly been de\cribed as the guide, philospher and friend of the Parliament.
(

heck Your Progress 1

\c~te :

i) Use the space gives below for your answers: ii) Check your answers with those given at the end .of the unit.

I

I 4 hat is legislative control? Discuss the principles of financial control.

2) What are the various instruments of exercising legislative control? Explain.

18.3

HISTORICAL BACKGROUND OF LEGISLATIVE CONTROL

Though full legislative control over the budget is a concept of this countly, historically the concept of budget began to develop in the late middle ages when the revenue was to be collected from the king's domain. Hence the budget was a statement of revenue and expenditure. During the wars and other emergencies when the King required a lot of money for running the affairs of the state, he had t o consult the nobility to know their views on the taxes. The expenditure still remained a prerogative of the king. Only after the 1688 revolution, the Principle of 'No revenue without representation' got established. The control over expenditure had still not acquired the conventions of legislative approval. .The system of legislative control over Public finance first arose in England and it was more a growth t h a ~ a creation. The first step that waslaken in this direction i . during the reign of King John was towards the control of receipts and revenues rather that of expenditure. The Stuart autocracy made the Parliamentarians more exacting and they began to claim a share in the control of Public expenditure as well. But this did not come'about suddenly or according t o any concerted plan or design it was a very gradual development. The establishment of the accounting and reporting system in 1787, the audit system under the Exchequer and Audit Department Act of 1866, and the constitution of a Standing Committee of Public Accounts in the House of Commons in 1866 were significant historical developments in the arena of Legislative Control. Thus was built up the modern system of Audit and Report through which the Legislature controls the finances of the state. The system of legislative control in India is more or less based on the system prevailing, in England.

18.4

PROVISIONS IN THE CONSTITUTION, 1950

The Constitution of India provides in its various articles the legislative procedure and procedure in financial matters. The main provisions of Indian Constitution are given below:

1

I
I
I

I

As per Article 107 (i) subject to the provisions of Articles 109 and 117 with respect to Money Bills and other financial bills, a bill may orginate in either House of Parliament and subject to the provisions of Articles 108 and 109 a Bill shall not be deemed to have been passed by the House of Parliament unless it has been agreed to by both Houses, either without amendment or with such amendments only as are agreed to by both Houses. Article 109 (1) provides that a Money Bill shall not be introduced in the Council of States. As,per Article 109 (2), after a Money Bill has been passed by the House of the People ;it shall be transmitied to the Council of States for its recommendations and the council of States shall within a period of fourteen days from the date of its receipt of the Bill return the Bill to the House of the People with its recommendations and the House of the people may there upon either accept or reject all or any of the recommendation of the Council of State's. As per Article 109 (3), if the House of the People accepts any of the recommendations of the Council of States, the Money Bill shall be deemed to have been passed by both the Houses with the amendments recommended by the Council of State and accepted by the House of the People. Article 112 (1) provides that the President shall in respect of every financial year cause'to belaid before both the Houses of the Parliament statement of the estimated receipts and expenditure of the Government of India for the year. Such a statement is called "Annual Financial Statement". As per Article 113 (1). so much of the estimate as related t o the expenditure charged u t o n the Consolidated Fund of India shall not be submitted to the vote of the Parliament. Butpothing in this clause shall be construed as preventing the discussion in either House of Parliament of any of those estimates. Article 114 (1) provides that as soon as the grants under Article 113 have been made by the House of the People, there shall be introduced a Bill t o provide for the appropriation out of the Consolidated Fund of lndia of all moneys required to meet: a) the grants so made by the House of the People, and b) the expenditure charged on the Consolidated Fund of India but not exceeding in any case the amount shown in the statement previously laid before Parliament.
,

Legislative Control

I

t

.

.

As per Article 116 (I), the House of the People shall have power: a) to make any grant in advance in respect of the estimated expenditure for a part of any financial year pending the completion of the procedure prescribed in Article 113 for the voting of such grant and the passing of the law in accordance with the provisions of Article 114 in relation to that expenditure. b) to make a grant' for meeting an unexpected demand upon the resources of India when on account of the magnitude or the indefinite character of the Service, the demand cannot be stated with the detail ordinarily given in an annual financial statement; c) to make an exceptional grant which forms no part of the current service of any financial year, and the Parliament shall hiive power to authorise by law the withdrawal of moneys from the Consolidated Fund of India for purposes for which the said grants are made.

As per Article 117 (1) A BiJl or amendment making provision for any of the matters specified under Article 110 shall not be introduced:,or moved except on the recommendation, of the President and a Bill making such provision shall not be introduced in the Council of States. No such recommendation shall be required for m o ~ n g amkndment making provision for reduction or abolition of any tax. an Article 117 (b) also provides that a Bill which, if enacted and brought into operation, would involve expenditure from the Consolidated Fund of India shall not be passed by either House of Parliament unless the President has recommended t o that House the consideration of the Bill.

t inancial Control

(

hpck

Your Progress 2
i) Use the space given below for your answers. ii) Chek your answers with those given a t the end of the unit.

hole :

I) Trace the historical background of legislature control.

2)

Explain the various provisions as contained in the Indian Constitution as to legislative control over financial matters.

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18.5

CONTROL OVER TAXATION

Legislation of the Budget is by no means complete until a provision has been made for collecting the required money from the people. For this purpose a ~ i n a n c ; Hill is placed before the House. This bill embodies the taxation or revenue proposals for the financial year that is, it includes all the existing taxation schemes with modification or without modification. This practice is quite in consonance with the well known principle of democracy that "no tax shall be levied or collected except by authority of law". as embodied in Article 265 of our Constitution. S o while the passage of the Appropriation Bill authorises the Government t o appropriate money from the Consolidated Fund, the passage of the Finance Bill authorises it t o collect taxes. The Finance Bill is the bil). embodying the Government's Financial (Taxation) prbposals for the ensuing financial year which has t o be passed by the Parliament every year. It is open t o general and clause by clause discussion. Amendments may propose the abolition or the reduction of any'tax but may not propose new tax or an increase in the rate of any existing tax. The Bill as amended I \ passed by the Lok Sabha and after consideration by the Rajya Sabha it goes to I he President for his signature after which it becomes an Act. Money Bill is one dealing with taxation, borrowing, or expenditure. Budget proposals are placed before both the Houses of Parliament at the opening of the budget session. The authority for money bills is with I ok Sabha and it is. therefore, the Lok Sabha that proceeds with Bill. The Finance Minister presents his annual financial statement t o the Lok Sabha and the presentation is foilowed by a general discussion of the financial statement as a whole in both the Houses separately. No item of expenditure is exempted from general discussion. But the discussion is to be only of a general character relating to policy and involving a review and the criticism of the administration of the Department concerned and members may give vent t o the grievances of the people.
A Money Bill, however, differs from the Finance Bill in the following respects:

a) A Money Bill deals exclusively with taxation, borrowing or expenditure. Whereas Finance Bill has a broader coverage in that it deals with other matters as well. b) A Money Bill is a Bill certified to be such by the Speaker of the Lok Sabha

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...

c) - A Money Bill must be returned by the Rajya Sabha to the Lok Sabha within 14 days of its receipt with its recommendations. if any, which the Lok Sabha is not bound to accept. Disagreement over a Finance Bill.however, is resolved at a joint sitting by a majority of the total number of members present and voting.

Legislative Control

18.6 CONTROL OVER PUBLIC EXPENDITURE-AN EVALUATION
The function of the legislature does not end with the voting of grants for public expenditure. Is has also to see that the funds granted are spent faithfully and economically according to its direction. The Parliament has to satisfy itself that the (1) funds have been applied to purposes approved (2) within the amounts appropriated and (3) that waste and extrayagance have been avoided. For this purpose, there is an independent audit of all the departmental accounts by the Comptroller and Auditor General of India followed by an examination of his report by a Parliamentary sub Committee. Joint responsibility of the political executive to the Parliament is an essential feature of Parliamentary democracy. The most important control exercised by the Parliament over the executive is its control on the pursestrings. The executive can not spend any money without authorisation from the Parliament. Audit by Comptroller apd Auditor General of India The control of Parliament over expenditure is complete only when it can assure itself that the funds were spent by the executive for the purposes for which they were granted. This is ensured by the provision of audit of the accounts by an independent-authority, viz. the Comptroller and Auditor General of India. He audits all expenditures of the union and the States and ascertains whether moneys shown in the accolints as having been disbursed were legally available for and applicable to the purposes for which they have been used. He audits all other accounts of the Centre and the States. He submhs his audit report to the President and the Governors to be placed beforq Parliament and the State ~ e ~ i s l ' a t u rHe e. reports on any waste and inefficiency. ~e comments clearly on matters of accounting or financial principle which are in dispute, transactions where heavy losses have occurred or.might occur, expenditure on new services and departure from settled precedents and procedures. T o ensure a thorough audit and full report to the Parliament the Comptroller and Auditor General of India has been given an independent status by the Constitution. Since the Parliament is too unwieldy a body for a serious technical discussion on the.C.A.G.'s'reports, it sends the reports for detailed examination to certain committees of the Parliament. Some important committees of this type are discussed below: The Public Accounts Committee (P.A.C.) The audit report of the Comptroller and Auditor General is presented to the Parliament. The examination of the audit report is entrusted to a special committee of the Parliament known as the Public Accounts Committee. Rule 143 relating to Control of Committee on Public Accounts provides:

I)

In scrutinising the appropriation accomts of the Government of India and the report of the Comptroller and Auditor General thereon, it shall be the duty of the Committee on Public Accounts to satisfy itself: a) that the money shown in the accounts as having been disbursed were legally available and applicable to the service or purpose to which they have been applied or charged b) that the expenditure conformes to the authority which governs it, and c) that every re-appropriation has been made in accordance with the provisions made i this behalf in the Appropriation Act, or under rules framed by h

Financial

(

untrol

2) It shall be the duty of the Committee on Public Accounts;
a).to examine such trading. manufacturing and profit and loss accounts and balance sheets as the President may have required to be prepared and the C.A.G.'s reports thereon.

6) t o consider the report of C.A.G. in cases where the president may have
required him to conduct aud.it of any receipt or to examine the accounts of .stores and stock. The conclusions of the Public Accounts Committee on the audit report of the C.A.G. are submitted t o the Parliament with recommendations for action by Government wherever necessary. Thus the Public Accounts Committee is the mechanism to secure the accountability of the executive in respect of expenditure voted by the Parliament. The Estimates Committee Through the mechanism of the Public Accounts Committee, the Parliament has been able t o secure the accountability of the executive in respect of expenditure voted by it. It is through the mechanism of the Estimates Committee that the Parliament subjects the estimates of the Finance Ministry t o a detailed scrutiny before they are submitted to the Parliament. The functions of the Committee are to:
1) report what economies, improvements in organisational efficiency o r administrative reform, copsistent with the policy underlying the estimates may be effected,

2) suggest alternative policies in order t o bring about efficiency'and economy in administration,

3) examine whether the money is well-laid out within the limits of the policy implied in the estimates, .
4) suggest the forms in which the estimates shall be presented to the Parliament.

The Committee selects some departments each year, examines their working in great detail and makes the suggestions on organisations, economy etc. including policy matters. 'The Committee on Public Undertakings The examination of Pujlic Undertakings by the COPU is in the nature bf the evaluation of the performance of Public Undertakings covering important aspects such as implementation of policies, programmes, management, financial success etc. The Committee considers the part of the C.A.G.3 report 06 Public Undertakings transferred t o it. After examinatidn of the report, COPU sends it to the Parliament alongwith its own comments. The reports of this committee alongwith C.A.G.'s reports provide a very effective instrument of control of Parliament over Public expenditure. Parliament's Direct Control The Parl~ament exercises direct control over Public expenditure by examining the reports of the committee on Public Accounts and Estimates Committee. A general discussion is held on the reports submitted by the Committees and the Auditor General's reports. The Government has to reply to the charges made, if any. Hence from the foregoing discussion it is clear that the Parliament sanction funds to Government for spending but it takes appropriate steps t o see that: a) expenditure is according to the rules prescribed b) there- is e&nomy in expenditure, and

,

. c ) there is no fraud, embezzlement or misappropriation.

Check ~ o u Progress 3 r Vote. i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.

Legislative Control

I)

Whv is it considered necessary t o control Public expenditure? Discuss the functions of Parliamentary Committees which control the budget.

2) Discuss the role of Comptroller and Auditor General of India in controlling Public expenditure.

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18.7. LET U S S U M UP
Need for sound financial administration has become imperative because government expenditure has greatly increased. Financial administration is becoming complex day-by-day: It includes raising, spending and accounting of funds collected from the tax payers. T h e funds are needed by the executive, granted. by the legislature, spent by the administrative ministries and audited by the Comptroller and Auditor General. According t o democratic principles, n o t a x can'be levied o r collected and no expenditure can be incurred by the government except with the prior consent of the Parliament. It is often argued that the control of the Parliament over thq financial administration is more nominal than real. Requests for grants cannot be revised because they are presented by the executive, which represents the majority in the Parliament. However, it must be realised that the power of modifying the budget proposals of the Government may not be exercised but the very fact that the Parliament has this power gives it a great deal of authority over the executive. Even if the budget proposals of the Government are not normally modified by the Parliament the budgetary process gives the members a number of opportunities t o discuss the policy of the Government. During the general discussion on the budget the members can criticise the general policy of the Government and can suggest alternatives. During discussion over the grants of different departments, the Parliament can examine in detail the working of particular departments and make suggestions about improving their working. Similarly opportunities are also provided by discussions on the Appropriation Bill and the Finance Bill.

KEY WORDS
Finance Bill : The Finance Bill is the Bill embodying the Government's Financial (Taxation) proposals for the ensuing financial year which has t o be passed by Parliament every year. It has a broader coverage in that it deals with other matters well.

Financial Control

expenditure. A ~ o n e y is a Bill certified t o be such by the Speaker of the Lok Bill Sabha.

Agarwala, R.N. 1966. Financial Committees o f Indian Parliament, S . Chand & C o Delhi. Bhambri, C.P. 1959. Parliamentary Control Over Finance in India, Jaiprakash Nath: Meerut. Gadhok, D.N. 1976. Parliam'entary Control a v e r Government Expenditure, Sterling Publishers Pvt. Ltd. Delhi. Morris, Jones, 1957. Parliament in India, London. Plowden Committee Report,Control of Public Expenditure U.K., 1961 Premchand, A, 1961. "Parliamentary Control Over Expenditure: How t o make it more effective ", Economic and Political Weekly. Thavaraj, M.J.K. 1964, "Essential of Financial Administration", Indian Journal of Public Administration, Vol 2 Issue No. New Delhi Wattal, P.K. 1963 Parliamentary Financial Control o f India, Minerva Book Shop: Bombay.

18.10 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1 1) Your chapter should include the following points : l Financial administration of a country is executed through (a) the legislature (b) the Executive (c) the Finance Department (d) the Audit and (e) the Parliamehtary Committee. l Legislature is the only competent organ of government in democracies which authorises the government t o collect taxes and also t o spend them in a particular manner. l T h e Legislative control is exercised through the operations of the Committees of Parliament. l T h e Comptroller and Auditor General of India-a statutory authority under the Constitution acts as a watch d o g of the Parliament and conducts audit t o see that the expenditure incurred by the Executive is for the proposes voted by the Parliament and is within the sanctioned grants. l The executive acting through ministers cannot raise money by taxation. borrowing o r otherwise without the authority of Parliament a n d proposals for expenditure requiring additional funds must emanates from the cabinet. l T h e second ptinciple that vests in the L Q Sabha the exclusive control of the ~ money bills, which must originate in the Lok Sabha which has the sole power t o grant money by way of taxes o r loans and t o authorise expenditure. The Rajya Sabha may reject a grant but not add t o it. l The demand for grants must come from the Government. Neither the Lok S a b h a nor a State Assembly may vote a grant except on a demand for grant from the Government. l The proposal for a new t a x o r for an increase in the rate of a n existing tax must come from the Government. 2) Your answer should include the following points: 0.Ouestion Hour

Votes Budget discussions President Speech Legislature Committees- Public Accounts Committee. Estimates Committee. Committee on Subordinate legislation and the Committee o n Assurances.
I

Check Your Progress 2
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1 ) Your answer should include the following points: Historically the concept of budget began to devetop in the late middle ages when the revenue was supposed t o the collected from the King's domain. After 1688 resolution the principle of 'No revenue without representation' got established The system of legislature control over Public Finance first arose in England and it was more a growth than a creation. The first step that was taken in this direction during the reign of King John was towards the control of receipts and revenues rather than of expenditure. The Stuart autocracy made the Parliamentarians more exacting and they began t o claim a share in the control of Public expenditure as well. The establishment of the accounting and reporting system in 1787. the audit system under the exchequer and Audit Department Act of 1866, and the Constitution of a Standing Committee of Public Accounts in the House of Commons in 1866 were significant historical developments in tHe arena of Legislative Control.

'*

2) Your answer should include the following points: Article 107 (i) subject t o the provisions of Articles 109 and 117, with respect t o Money Bills and other Financial Bills, a Bill may originate in either House of Parliament and subject t o the provisions of Articles 108 and 109, a Bill shall not be deemed t o have been passed by the House of Parliament. Articles 109 (i) provides that a Money Bill shall not be introduced in the Council of States. Article 112 (i) provides that the President shall in respect of every financial year cause t o be laid before both the Houses of the Pailiament a statement of the estimated receipts and expenditure of the Government of India for that year. As per Article 113'(i), so much of the estimates as relates t o the expenditure charged upon the Consolidated Fund of India shall not be submitted t o the Vote of the Parliament. And also Article 114 (i), 116 (i), 117 (i) provides legislature procedures in financial matter.

Check Your Progress 3
1) Your answer should include the following points: The function of the legislature does not end with the Voting of grants for Public expenditure. It has also t o see that the funds granted are spent faithfully and economically according t o its direction. The Parliament has t o satisfy itself that the funds have been applied t o purposes approved, for this purpose, there is an independent audit of all the departmental accounts by the Cemptroller and Auditor General of .India' followed by an examination of his report by a Parliamentary Committee. Public Accounts Committee scrutinises the .appropriation accounts of the Government of India and the report of the Comptroller and Auditor General thereon. Estimates Committee is t o report what economies, improvements in organisational efficiency o r administrative reform, consistent with the policy uqderlying the estimates may be effected. The 'Committee on Public Undertakings considers the part of the C.A.G.3 report on Public Undertakings transferred to it, after examination of the report, COPU sends it t o the Parliament alongwith its own comments.

7

Financial Control

Union and the States and ascertains whether moneys shown in the accounts as having been disbursed were legally available for and applicable t o the purposes for which they have been used. He audits all other accounts of the cantre and the States. He submits his audit report t o the President and the Governors to be placed before Parliament and the State legislature. He reports on any waste and inefficiency, comments clearly on matters of accounting or financial principle which are in dispute, transactions where heavy losses have occurred o r might occur, expenditure on new services and departure from settled precedents and procedures.

UNIT 19 SYSTEM OF FINANCIAL COMMITTEES
Structure
Objectives Introduction Need for Committees Public Accounts Committee Estimates Committee Committee on Public Undertakings Functioning of Committees-An Appraisal Let Us Sum up Key Words References Answers to Check Your Progress Exercises

19.0 OBJECTIVES
After reading the unit, you should be able to: explain the concept of Financial committees describe and discuss the composition and functions of public Accounts Committee, Estimates Committees and the Committee on Public Undertakings; and debate the various dimensions and issues involved in financial control

The term financial administration is used in a broad sense to include all the processes involved in collecting, budgeting, appropriating and expending public money, auditing income and expenditures, auditing receipts and disbursements; accounting for assets and liabilities and accounting for the financial transactions of the government and reporting upon income and expenditures, reporting upon receipts and disbursements, and the condition's 'of funds and appropriations. Government like any other organisation, can achieve little without finance. Therefore, the efficiency of financial administration is an important aspect of Government's effectiveness. A government which has worked out a satisfactory system of financial administration has gone a long way towards putting the administration of its affairs upon an efficient basis.

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The financial functions in Government are performed by the following agencies: 1) 2) 3) 4) The Legislature The Executive The Treasury or the Finance Department The Audit Department

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Financial

< ontrol

Legislature has to determ~ne law the sources of government revenue. Executive by has to provide the machinery and lay down the procedure of the collection of the revenue. Proper records or accounts of these revenues are to be m'aintained so that the accounts may be audited by an independent officer, who should submit an audit report to the legislature. In financial administration , legislature plays the key rok. All other agencies of financial administration act on behalf of the legislature, and are responsible to the legislature for all their activities. Hence legislative control over the finances and financial administration of the country is direct and pervasive. In order to exercise proper control, the Parliament and legislature setup certain committees. Three such committees set up in India, namely, Estimates Committee, and Public Accounts ~ o m m i t k e the Committee on Public Undertakings, which exercise financial control on behalf of the legislature. The purpose of financial control is to secure honesty and economy in expenditure. These agencies have to see that the tax payers money is rightly and properly used.

19.2 NEED FOR COMMITTEES
a

Effective legislative control over the expenditure of the government requires the Parliament to satisfy itself that the appropriations have been utilised economically for the approved purposes within the framework of the grants. It should also undertake a detailed examination of the annual budget estimates of the government to suggest possible economies in the implementation of plans and programmes embodied therein. Both these functions are of pivotal importance in making the parliamentary control over governmental expenditure comprehensive. The legislature as such has neither the energy not the time to perform these functions. It; therefore, constituted three committees, composed of members belonging to it. to devote themselves to these functions. These three committees are: a) Public Accounts Committee b) Estimates Committee c) and the Committee on Public Undertakings. State legislatures also have similar committees though all of them do not have separate committees on public undertakings.

19.3 PUBLIC ACCOUNTS COMMITTBE
Historically, the Webly commission of 1896 indicated the need for an accounts committee to highlight financial irregularities. The Montague Chelmsford reforms suggested the creation of such committees out of the provincial legislatures. The first such committee on Public Accounts was created at the centre to deal with the appropriation of ~ c c o u n t s the Governor General in Council and the report of of the Auditor General thereon. The British Parliament acquired power to grant appropriation with the Revolution of 1688. The power to ascertain how the money had been spent was conferred only in 1861, when the House of Commons created the committe on Public Accounts. In India, the Public Accounts Committee was first created at the centre in 1923 with the coming into force of the Montford reforms in 1921. It became a major force in the legislative control of Public expenditure. Despite the limitations of its constitution and the restrictions on its authority, it exercised erlormous influence in bringing to bear upon government the need to enforce economy in the expknditure of public money.

committee of Parliament, called the Public Accounts Committee. A committee of Parliament is preferred because the Parliament does not have the time to undertake detailed examination of the report. Secondly, the scrutlny being technical, can best be done by a committee and, lastly. the non-party character of the examination is possible only in a committee but not in the house.

System of Financial Committees

Composition Under the provisions of the Constitution, the Public Accounts Committee at the Centre is constituted of members from both the Houses of Parliament; it is composed of 22 members, 15 &om the Lok Sabha and 7 from the Rajya Sabha. The members are elected through a system of proportional representation by single transferable vote. Almost every sizeable party or group is represented on the Committee. Although the committee is elected annually, there is a convention that there should be a two year tenure of the membership to ensure continuity. The Chairman of the Committee is nominated by the Speaker from amongst the members of the Committee. Till 1966-67, the chairman belonged to the ruling party. Since then, a member of the opposition has been named the chairman. Functions of the Committee The ,func\ions of the Committee are to satisfy itself that
a) the moneys shown in the accounts as having been disbursed were legally available for and applicable to the service or purpose to which they have been applied or charged; b) the expenditure conforms t o the authority which governs it; and c) every reappropriation has been made in accordance with provisions made in this behalf under the rules framed by the competent authority. It shall also be the duty of the Public Accounts Committee: a) to examine, in the light of the report of the Comptroller and Auditor General, the Statement of accounts showing the income and expenditure of state corporations, trading and manufacturing schemes and projects, together with the balance sheets and statements of Profit and Loss accounts which the President may have required to be prepared, or are prepared, under the provisions of the statutory rules regulating the financing of a particular corporation, trading concern, or project; b) to examine the statements of accounts showing the income and expenditure of Autonomous and Semi-autonomous bodies, the audit of which may be conducted by the Comptroller and Auditor General of India either under the direction of President or by a statute of Parliament; and to consider the report of the Comptroller and Auditor General in cases where the President may have required him to conduct an audit. The committee also reviews the form and details in which the estimates are prepared in order to arrest any tendency t o reduce the number of votes or to include large lump-sum provisions since these are regarded as diminishing the control of Parliament over the estimates. It goes into the technical accounting procedure, in order to find out its adequacy or otherwise to control departmental extravagance.

Working of the Committee The Public Accounts Committee can organise itself into sub-committees and working groups. When.approved by the committee, the reports of the subcommittees are deemed to be the reports of the Public Accounts committee.
The Committee may send for persons, papers and records. The conclusions of the Committee are submitted to Parliament in the form of a report. T o make the work of the committee more effictive, the Comptroller and Auditor General now submits interim reports to it. The committee is thus able to reach the conclusions and finalise its recommendations. It has at its disposal the services of the Comptroller and Auditor General. who is the guide. vhilosovher and friend of the committee.

A convention has evolved that the recommendations of the Committee are accepted by the Government. But sometimes these arc sent back for reconsideration Mo\t 01 the issues are thus settled through mutual diseussion and free and frank exchanrc o f views. The Public Accounts Committee probes into the transactions carried out It conducts a post-mortem examination of the Public Accounts. To quote the first Speaker of the Lok S a W a (inlhe speeches and writings of G.V. Matalan har. Speaker t o PAC, p. 97)-'The very fact of consciousness that there is someone wh will scrutinize what has been done. is a great check on the slackness or ncgiigence oJ the executive." The examination, if it is properly carried out. thus. leads to general efficiency of the administration. The examination by the committee may also be useful as a guide for both future estimates and policies The control exercised by the Public Accounts Committee is quite signrficant. I he controls relate to financial matters and are quasi-judicial in nature As a watchdog it acts as a deterrent on excesses committed by the executive I t is hoped that the committee will emerge as an effective force in the control of Pu b ~ i c expenditure
Check Your Progress 1

Note :

i) Use the space given below for your answers
ii) Check your answers with those given at the end of the Unit.

1) When did the idea of Public Accounts Committee originate in India? What was
its rationale?

2) What are the basic functions of Public Accounts Committee?

ESTIMATES COMMITTEE
.. The Estimates Committee was first created in April, 1950 and its functions were

enlarged in 1953. There had been a predecessor or Estimates Committee. called the Standing Finance Committee, which was first constituted in 1921 and attached to the Finance Department of the Government of India. This committee depended on the will of the executive. It had no statutory status. Its functions were not clearly defined and its deliberations were not satisfying to the elected representatives of the legislative assembly. Composition The Estimates Committee, constituted in 1950 had 25 members; in 1956 the . membership was revised t o 30. It is a select committee elected by the members of' the Lok Sabha from amongst themselves according to the principle of proportionate representation based on single transferable vote. The term of office of the menibers is one year. But according to conventions, two-thirds of the members are re-elected for another year. The Chairman of the Committee is nominated by the Speaker. If, however, the Deputy Speaker is a member of the

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Committee he automatically becomes the Chairman. Ministers cannot be appointed on the Estimates Committee. Its functions, methods'of appointments and other relevant matters are laid down in the Rules of Procedure and conducting of Business in the Lok Sabha. Functions The committee examines such of the estimates as it may deem fit or are specifically referred to it by the Lok Sabha o r the Speaker to: i) report what economies, improvements in organisation, efficiency and administrative refoims, consistent with the policy undkrlying the estimates, may be affected;

system of Financial Committees

ii) suggest alternative policies in order to bring out efficiency and economy in administration; k iii) examine whether the money is well laid out within the limits of policy implied in the estimates; and iv) suggest the form in which the estimates shall be presented to the Parliament. While examining the policies of the government the Estimates Committee does not lay down tny policy. It can only see whether the policies laid down by Parliament are carried out. The basic functions of the committee are to ensure efficiency and economy in administration. The Estimates Committee can constitute one or more . sub-committees. The reports of the sub-committees are deemed to be the reports of the whole committee. Working of the Committee The tenure of mdmbers is one year but continuity is maintained by re-electing members. Once a decision is taken as to the estimates to be examined, the Committee collects and collates material required for an adequate examination of the expenditure. The papers are put before the committee for preliminary scrutiny and further information, if needed, is collected. It may constitute a sub-committee which issues a questionnaiie to the concerned ministries for furnishing full and complete answers to the points raised. The Committee has power to send for papers, persons, and records. Sometimes study groups are appointed to undertake as on the spot study of the projects under examination. After completing the examination of the witnesses, the committee formulates its recommendations. The Committee submits its report to the House. The recommendations of the Estimates Committee relate to: i) ii) iii) Improving the organisation and working of the department; Securing economies, and Providing guidance in the presentation of the estimates.

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The Committee has always interpreted its terms of reference in a liberal way. It takes the view that economy, efficiency and organisation are interconnected. The Estimates Committee is thus performing a useful work. Majority of its recommendations are accepted by the Government, as is revealed from the reports on the implementation of recommendations submitted by the Estimates Committee from time to time. Functional and Economic Classification of budget, introduction of performance budgeting, and so on are someof the far reaching recommendations of the Committee. The Estimates Committee is performing a useful function in improving the efficiency of administration in India. The work of the Committee can be improved by having sub-committees. T h e ultimate success of the Committee, however, rests on the influence it exercises on the Government in its long-term thinking and planning. Check Your Progress 2 Note
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i ) Use the space given below for your answers. i i b Check your answers with those given at the end of the U n ~ t .

Financial Cont--1

W%en and why was the Estimates Committee set up in India?

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2) Evaluate.the functioning of Estimates Committee in India.

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19.5

COMMITTEE ON PUBLIC UNDERTAKINGS

Till April 1964 the affairs of Public Enterprises in India used t o be looked after by the two Committees: namely the Estimates Committee and Public Accounts Committee. But in view of huge investments and manifold increase in the activities of public enterprises it was felt that there should be a separate agency which should look into the working of public enterprises in detail and report to the Parliament. In 1964, on the recommendation of the Krishna Menon Committee, a separate committee on Public Undertakings was constituted. This committee, which started functioning from May 1, 1964 took over the work relating to autonomous Public Enterprises from thd other two Committees viz the Estimates Committee and the Public Accounts Committee.

Composition Earlier there used to be ]%members in the Committee, with 10 members from the Lok Sabha and 5 members from the Rajya Sabha. With effect from April 1974, the number of members has been increased to 22 ....15 members of COPU are drawn from the Lok Sabha and 7 members are drawn from the Rajya Sabha. The . members of COPU are elected every year in accordance with the principles of proportional representation by means of single transferable vote. Functions of COPU The Principal functions of COPU are:
a) to examine the reports and accounts of Public Undertakings as specified in the fourth schedule of the Rules of procedure and conduct of Business in Lok Sabha; b) to examine the reports, if any, of the Comptroller a n d ' ~ u d i t o General of India r on the Public Undertakings; c) to examine, in the context of autonomy and efficiency of the public undertakings, whether the affairs'of the Public Undertakings are being managed in accordance with sound business principles and prudent commercial practice; d) to exercise such other functions vested in the Public Accounts Committee and the Estimates Committee in relation t o the Public Undertakings as are not covered by clauses (a), (b) and (c) above and as may be allotted to the committee from time t o time. The COPU shall not examine: i) Matters of major Government policy as distinct from business or commercial functions of Public enterprises;

ii) matters of day-to-day administration,
;i;l m s t t m r c fnr r n m c i r l m r s t i n n fnr w h i r h m s r h i n m r v i c s l r m s A v e c t s h l i c h m r l hv r n v

special statute under which a particular Public Enterprises is established. Working of the Committee Ihe COPU has been doing commendable work since its inception in 1964. In the bery first year (1964-65) it submitted I I reports. During the third Lok Sabha it \ubmitted 40 reports. During 5th Lok Sabha it submitted 56 repocts. The COPU undertakes horizontal studies also. So far it has prepared nine horizontal reports. I hey are, township and factory buildings; management and administration; Materials Management, Financial Management, Public relation and publicity, Production Management, Personnel Policies and Labour Management relations; Role and achievement of Public Sector Undertakings and Foreign Collaborations. rhese horizontal reports are very useful as they contain valuable information about one particular aspects of all enterprises taken together. The Committee asks the ministry and the enterprises to fivnish necessary material relating to chosen subjects. The committee often visits chosen enterprises for informal discussions. After the study tours, and after receiving formal memorandum and other information from concerned parties, non-official and official witnesses are invited to give evidence at formal sittings of the committee held at Parliament House. .All evidence given before the Committee is treated as confidential. r h e committee provides a whole lot of real and useful information on Public Enterprises operations. The enterprises are studied in some detail covering important aspects of their working with a view to making a n evaluation of their performance.

System o Financial ('ommittee\ f

19.6

FUNCTIONING OF COMMITTEES-AN APPRAISAL

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I he working of,legislative committee seems to leave much'to be desired. Legislative I ~nancial control has become more nominal than real. The Estimates Committee

deals more with then economy and efficiency through administrative retorms and reorganisation of various departments keeping in view direct reduction in , xpenditure. The PAC deliberations are based on a post-mortem examination of reports produced by the audit, sometimes relating to some distant past rather than with matters which could create an impact on the current financial performance. S o I r is a check rather than a n effective control. Ashok Chanda who himself had been India's Comptroller and Auditor General, observed. "The effectiveness of the C ommittee is largely determined by the thoroughness with which the audit examination has been conducted, likewise the value of audit criticism depends on the support it receives from the committee. Not only are the functions of these two authorities interrelated, but there is a measure even of interdependence in their relations. This is emphasized by'the fact, that by far, the bulk of the committee's ~nquiries concerned with points which the Auditor-General raises." The PAC is are not vested with any executive power, and its function is limited t o a scrutiny of public expenditure. The Estimates Committee is seized with the question of suggesting possible economies consistent with the policies underlying the estimates presented to the Parliament. The ultimate success of the committee, however, rests on the influence it exercises on the government in its long-term thinking and planning. This, in turn, demands that the committee makes constructive and farsighted suggestions. According to Ashok Chanda, "The emphasis on a review of the policies of government and of the structure of departmental organizations, to the relative exclusion of a detailed scrutiny of estimates, has substantially altered the character and purpose of the committee." The committee is arrogating to itself a role, which constitutionally is that of the house. The committee makes many recommendations o n matters of administrative reorganisation, reconstitution of departments and
rdictrihnltinn n f fnnnrt;nnc

Thir hrr hardlv a h v n r a ~ t i ~ ~.til;t\r snA sl

mp-v

I ~ T ;tc

recommendations are rejected by the government.
A thorough examination of working of the public enterprises by the COPU is the best

available device of control over these enterprises by the Parliament. The COPU keeps the Parliament duly informed about their performance and how monies voted by rt are, intact, appropriated. Through the COPU the administration comes in direct contact with the Parliament. The COPU has done some usefyl work. In its tone. temper and manner of working, it is not different from the Estimates Comm~ttee-and the Public Accounts Committee. But the advantage lies in the fact that it ha< been able to give sufficient time to the study of Public Undertakings because it is concerned exclusively with them. In the course of examination of causes and investigat~on of problems and issues the Committee has, from time to time, made some specific suggestions to the government and they have been found to be quite useful. It has, hence, contributed towards improving the performance and profitability of the\e enterprises. Check Your Progress 3 Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the Unit.
1) Examine the functions of Committee on Public Undertakings.

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2) What are the weaknesses of parliamentary financial control in India?

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19.7 LET US SUM UP
Legislature has to determine the sources of government revcnue,Exccutivc has to provide the machinery and lay down the procedure for the collection of the revenue. Proper accounts of these revenues are to be maintained so that the accounts may be I audited by an independent officer, who should submit this audit report to the legislature. i Effective Parliamentary control over the governmental expenditure requires that the Parliament should satisfy itself that (I) the appropriations'have been utilised economically for the approved purposes within the framework of the grants and (2) it should undertake a detailed examination of the annual budget estimates of the government t o suggest possible economies in the implementation of plans and programmes embodied therein. Both these functions are important in making the legislative control over expenditure complete. Parliament performs these functions through three committees composed its members viz. Public Accounts Corn ~ ~ t t e e , Estimates Committee and the Committee on Public Undertakings.

, 1 9 3 KEY WORDS
Public Accounts Committee : Parliament exer&ses its control over expenditure, first by the provision o i audi! nf Public Accounts by an independent and statutory

authority, the Comptroller and Auditor General of India and thereafter and examination of his report by PAC. Estimates Committee : It examines in detail the estimates after they have been voted by Parliament with a view to securing possible economies in the execution of plans and programmes consistent with the policy implied in those estimates, and make suggestions and recommendations which may, to the extent acceptable:, be incorporated in the estimates for the subsequent years. Committee on Public Undertakings: COPU has been set up specially for an indepth examination of the working of the Public Enterprises.

System of Financial Committees

19.9 REFERENCES
I
AggarwaIa, R.N. 1966. Financial Committees of Indian Parliament, S. Chand and Co., Delhi. Bhambri, C.P. 1959. Parliamentary Control over Finances in India, Jai Prakash Nath: Meerut. Chanda, Asok, 1959. Indian Administration, George Allen and Unwin: London. Gadhok, D.N. 1976. Parliamentary Control over Government Expenditure, Sterling Publishers Pvt. Ltd. Delhi: Morris, Jones 1957. Parliament in India, London. Plowden Committee Report, 1961. Control over Public Expenditure. Prem Chand, A. 1961. Parliamentary Control over Expenditure-How to make it effective.Economic and Political Weekly. Ramanathan, V.V. 1964. Control o f Public Enterprises in India. Asia Publishing House: Delhi. Thavaraj, M.J.K. 1964. "Essential of financial Administration", Indian Journal of Public Administration. Wattal, P.K. 1963. Parliamentary Financial Control in India. Minerva Book Shop: Bombay.

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19.10

ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress 1
1)

Your answer should include the following points: The Webly Commission of I896 indicated the need for an account committee to highlight financial irregularities. The Montague Chelmsford reforms suggested the creation of such Committee out of the provincial legislatures.
d

In India, the Public Accounts Committee was first created at the Centre in 1923. Parliamentary control over finances of the government is assured through a special Committee of Parliament, called Public Accounts Committee. A Committee of Parliament is preferred because the Parliament does not have the time to undertake a detailed examination of the report. The Scrutiny being tedhnical, can best be done by a Committee. The non-party character of the examination is possible only in a Committee

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Financial Control

2)

Your answer should include the following points: The functions of the Committee is t o satisfy itself that money shown in the accounts as having been disbursed were legally availabe for and applicable t o the service o r purpose t o which they have been applied o r charged. expenditure conforms t o the authority which governs it. every reappropriation has been made in accordance with provlslons framed by the competent authority. I t shall also be the duty of the Committee. t o examine, in the light of the report of the Comptroller and Auditor General. t o examine the statements of accounts showing the income and expenditure of autonomous and Semi autonomous bodies.

Check Your Progress 2 1) Your answer should include the following points: T h e Estimates Committee was first created in April, 1950. Its functions were enlarged in 1953. There had been a predecessor of Estimates Committee, called the Standing Finance Committee, which was first constituted in 1921. It was attached t o the Finance Department o n the will of the executive; it had n o statutory status. Its functions were not clearly defined. 2) Your answer should include the following points: I t examines the estimates as it may deem fit o r specially referred t o it by the L o k S a b h a o r the Speaker to: Report what economies, improvements in organisation efficiency and administrative reforms, consistent with the policy underlying the estimates, may be affected. Suggest alternative policies in order t o bring out efficiency and economy in administration. Examine whether the money is well laid o u t within the limits of policy implied in the estimates. Suggest the form i n which the estimates shall be presented t o the Parliament. While examining the policies of the government the Estimates Committee does not lay down any policy. T h e basic function of the Committee is t o ensure efficiency and economy in administration. T h e Estimates Committee is performing a useful function in improving the efficiency of administration in India.

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I

Check Your Progress 3
1)

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Your answer should include the following points: t o examine the reports and accounts of Public Undertakings. t o examine the reports, if any, of the Comptroller and Auditor General of India o n the Public Undertakings. t o examine, in the context of autonomy and efficiency of the Public Undertakings, whether the affairs of the Public Undertakings are being managed in accordance with sound business principles and prudent commercial practices. t o exercise such other functions vested in the Public Accounts Committee and the Estimates Committee in relation t o the Public undertakings as arf not covered by clauses (a), (b) and (c) above and a s may be allotted t o thc . Committee from time t o time. Your answer should include the following points:
T h e Ieoiclativ~ finanrial cn"trn1 hna h ~ r n m e mnre nnminal than real

2)

The Estimates Committee deals more with economy and efficiency through administrative reforms and reorganisation of various departments, keeping in view direct reduction in expenditure. The PAC deliberations are based on a post-mortem examination of reports produced by the audit, sometimes relating to some distant past rather than with matters which could create an impact on the linent financial performance. So it is a check rather than an effective control. The PAC is not vested with any executive power, and its function is limited to a scrutiny of Public expenditure.

system

or kinnncinl

Committees

UNIT'20 EXECUTIVE CONTROL
Structure
Objectives Introduction ~vol'ution Executive Control Over Expenditure of Role of the Finance Ministry Delegation of Financial Power Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

20.0 OBJECTIVES
After reading the unit, you should be able to: explain the evolution of Executive Control over expenditure and the developments in the'area of financial administration discuss the organisation of Ministry of Finance critically analyse the role of the Ministry of Finance, and briefly sketch the progress made towards delegation of financial powers and analyse the vario_us problems in financial delegation.

INTRODUCTION

The effectiveness of financial administration, in a democratic country, largely depends on the ability of the system to set up a smooth hierarchy of controls consistent with the unity of organisation on the one hand and decentralisation of political power on the other. If the financial machinery is to work smoothly and give good results, the principles of responsibility, accountability and control must find expression throughout the entire chain of operations. Maximum economy consistent with efficiency can be ensured only when waste, fraud, misappropriation, inadequate allocation for essential purposes, inefficient exercise of power, etc., are minimised through improved programming, supervision and control. In order to ensure proper financial control, both the legislature and the executive have to play an important role. Legislature has to determine by law the sources of government revenue; whereas Executive has to provide the machinery and lay down thd procedure for the collection of revenue. Executive control is one of the most important instruments of financial administration. Control in matters of policy concerning finance vests in the government as a whole. Government decides the policy of expenditure. Questions like pay, pension and provident fund to the officials are all determined by the government. The executive performs the policymaking function concerning finance, and then it is subject to the approval of the legislature. The Finance Department is always responsible for the entire financial administration of the country. The department performs a variety of functions with

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With,the emergence of new tasks after Independence and the launching elf Five-Ykar Plans, the implementation of the various programmes of economic ind sqcial ,development placed larger responsibilities on the administrative authorities and executing agencies. In order to achieve their goals realistically efficiently and economically the operating agencies need adequate facilities. Their prime requirement is control of their financial resources. This is only possible through delegation bf financial powers.

Executive Control

20.2

EVOLUTION OF EXECUTIVE CONTROL OVER EXPENDITURE

Certain fundamental changes have been made in the environment of fmancial administration in India since Independence. An important upshot of the changed political and constitutional environment has been the formal acceptance of executive accountability to the legislature as the base of financial administration in India. The basic features of the federal structure introduced in 1935 continued. Attempts were made to capture the spirit of legislature financial control along with the institutional ingredients imbued with this democratice spirit. Before Independence, Government of India Act of 1919 which embodied the recommendations of Montford Reforms was an important milestone on the road to decentralisation. The cent'ral point in financial control was not firmly set in getting the money's worth of results. The financial rules and procedures as well as the orientation of those who manned the machinery for financial control were heavily accented on regularity and legality. The.financial control has continued to be too slow, too specific and to4detailed. Financial and Audit Controls have been more meticulous about enforcing the obserVance of rules and procedures than to encourage people to prompt and speedy decisions. Major steps towards more delegation of financial powers were made in 1958, 1962, 1968 and 1975. Thus the high degree of centralisation which characterised the system of financial control in' British India has been restructured over the 30 years of Independence. The procedures, approaches and the tools of nil& a control have undergone much change. The broad functions and structure of finance department at the centre and in the states have remained more or less the same even after Independence. Legislative control over the executive, especially in financial matters, is sought to be achieved through (1) its approval of the detailed expenditure and tax proposals and (2) as well as through its scrutiny of executive's irresponsibility and irregularities committed in the course of impiementation of the budgets. The formal aspect of accountability to the legislature requires that the executive conducts its affairs in such a way that it is not exposed to adverse criticism. Hence the executive as well as the top layers of the administrative hierarchy are interested in exercising such control over the various levels of administration to prevent irregularities and ensure efficiency and economy in operations. Like the pre-British Treasury, the Ministry of Finance exercised stringent,bqgetary control and expenditure control. The Ministry of Finance did not share this delay in responsibility with any other department of the government. ~he'resuk~,was the execution of projects and lapse of funds. The Administrative Reforms Commission in its report on "Finance Accounts and Audit" in January 1968 highlighted this problem and observed that: The Control of the Finance Ministr,' 1 over public expenditure is exercised, in the main, three stages: i) Approval of programmes or policies in principle, ii) Acceptance of provision in the budget estimates, and iii) Prior sanction to incurring of expenditure subject to such power as have been delegated to the administrative ministries. It is the control at the first and the third stages that generally engages much of the time of the Finance Ministrv and that im~ineeson the dav-to-dav workinn of the
79

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Financial Control

administrative ministries. A 'control at these stages, if too rigid or detailed involving much time and effort,'can slow down the pace of work, delay the implementation of projects-particularly developmental, commercial or industrial and thereby cause loss of national effort or income. While the need for control or scrutiny is n i t denied, ~t must be constructive, purposeful, imaginahve and not narrow in outlpok or cramping in effect. In all responsible governments, control essentially implies the iccountability and responsibility of lower t o the higher organs in the administrative hierarchy for the money collected and expenditure incurred. In this context the treasury of the Finance Department of the Bureau of the Budget is likely to occupy a ktrategic position. The Executive control could be exercised when the estimates are prepared or when expenditure is incurred. The units of a department are not generally interested, except in the most incidental or indireci way in the general financial problems of the service or of the government or of the economy as a whole. Their main interest lies in their work. It becomes necessary that the head of various services should scrutinise estimates in terms of their needs and spending capacity. This process moves upwards to heads of departments who are expected to moderate the estimates in the light of . accepted policies of the government. Under a cabinet system, The Treasury is entrusted with the responsibility to aggregate and consolidate the estimates of the different departments. In discharging this function the Treasury may be able to influence the departmenial estimates through scrutiny and advice. The Finance Department controls and coordinates various spending departnients. The framing of general financial and economic policies and programmes of Government is the responsibility of the Finance Department. The Finance ~ e ~ a r t m eprepares the nt estimates of income and expenditure and submits them to the Parliament for approval. After the Parliament has approved the Budget, the Finance Department plays the most important part in theaexecution of tbe Budget. Thus it is.a department of control and supervision whose main duty is to manage the finances of the state. Grants are voted and appropriations are made by the Parliament to the executive. It is the duty of the executive to spend the money as voted by the Parliament. The maxims of honesty, efficiency, and economy should guide the conduct of the Executive officials while they spend public money. Parliament is the sole authority ' under the Constitution empowered to sanction funds to the executive for all expenditures. It is the duty of the Parliament to ensure that an adequate machinery exists to see that no money is spent out of the consolidated funds by the executive beyond the appropriations provided by law or the Parliament. Under the traditional system, the Treasury, down to the heads of the units, assumes responsibility for the efficient and economical expenditure of the funds entrusted to them as soon as the budget is approved by the fund-granting authority. But in the modern times financial administration defines budgetary control as the establishment of departmental budgets ;elating to the responsibilities of executives, to the requirements of a policy and the continuous comparison of actuals with budgeted results. This comparison aims at securing, through individual or collective action, the objectives of the policy or to provide a basis for its revision. Such a control would, however, involve the establishmem of a pre-determined standard or target of performance, measurement of the actual performance, comparison with the predetermined standards, the disclosure of deviation between the actual and standard performance and reasons for these deviations, and taking suitable corrective action where examination of the deviations indicates that this is necessary. The execution of the budget means: a) Proper collection of funds b) Proper custody of the collected funds

Executive Control

20.3

ROLE OF THE FINANCE MINISTRY

Tlhe Finance Department of the government exercises great control over items of expenditure pertaining to estimates which have been approved by the Parliament, and for which resources have been duly appropriated. The finance department is always responsible for the entire financial administration of the country. The department performs a variety of functions with regard to finance of the country. It has control over expenditure of money. It controls and coordinates various spending departments of the government. It is responsible for the collection of taxes. 1t.exercises vital control and supervision over the expenditure of the government departments. The main duties of the Finance Departments are; of a t ~dministratibn the finance of the Central Government and handling of financial matters affecting the country as a whole. b) Riiising the necessary revenues for carrying on the administration and regulating the taxation and borrowing policies of the Government. c) Admini%trationof problems relating t o banking and currency and in consultation with the ministries concerned, arranging the proper utilisation of the country's foreign exchange resources. administrative ministries and departments conamed.

d) Controlli~g theentire exknditure of the Government in cooperation with the

Check 'Your ~ r o g i e s s 1 Note:
I)

,

i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.

Trace the evolution and development'of executive control over expenditure in India.

2)

Discuss the duties of the Finance Ministry.

Organisation of the Ministry of Finance The Finance Minister, assisted by a Minister of State in the department of Finance and the Deputy Minister of ~ i n a n c emanages this most important department of the , Government of India. The Ministry is at present divided into the Departments of Economic Affairs, Revenue and Banking and Expenditure. Each department is under the c h a r g ~ an independent secretary, and for overall coordination of all the of departments, there is a Finanpe Secretary. Department of Economic Affairs The D$partment,of Economic Affairs prepares the central government Budget, makes periodic assessment of foreign exchange needs and resources and takes steps to mobilise and allokate resources, internal as well as external, in keeping with developmental and other needs. The department is also responsible for policies

relating to insurance, currency and coinage, capital issue and foreign investments, administration of securities contracts (Regulation Act) and regulation of stock exchanges. The Department comprises six main divisions viz: a) Budget b) Planning c) Internal Finance d) External Finance e) Economic and f ) Insurance The Budget division of the Department of Economic Affairs is responsible for the preparation and presentation to Parliament the Budget of the Central Government. This division performs the whole function of coordination, collection and consolidation of data relating to receipts and expenditure of Government. The Internal Finance divisi6n is concerned with all matters connected with currency and coinage, Reserve Bank of India, Price control etc. The Planning division is concerned with the work connected with the preparation of the capital Budget and the allocation of ceilings of capital expenditure of the various ministries. External Finance division is responsible for matters relating to foreign exchange, budget foreign investments etc. The Economic division is an advisory wing of the department of Economic Affairs. Its main function is to examine trends in the economy and to carry out studies and research with a view to advising the Ministry on questions of economic developments abroad, particularly those which have a bearing on the Indian economy. Insurance division deals with the administration of the Life Insurance Corporation.

The Department of Revenue and Banking The Revenue wing of the department, deals with the following subjects: Income tax, Wealth tax, Expenditure tax, Customs, Central. Excise, Opium and Narcotics and central functions under the Indian Stamps Act.
The Banking wing of the Department of Revenue and Banking is concerned with the formulation and implementation of Government policies having a bearing on the commercial banks and long-term financial institutions excluding LIC and UTI.

Department of Expenditure The department of expenditure is divided into the following divisions:
a) b) c) d) e) Establishment Division including Implementation Cell and Staff Inspection Unit Defence Finance Division Cost Accounts Wing Plan Finance Division and Special Cell

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The Department of Expenditure is mainly concerned with the administration 01 expenditure control.

Evaluation of the Role of Ministry of Finance The Control of Finance Department extends to the practice.of requiring specific authority by the Finance Department for every item of expenditure even after the general policy has been accepted as a result of sanction by the Parliament. Such an excessive control of the Finance Department over the finances of the country resulted in concentration of authority in only one Department of the Government. The result of the centralisation of such powers is that there is no delegation of financial authority even to the high ranking and responsible officers of the various administrative ministries.
The scrutiny of expenditure by Ministry of Finance after Budget has been approved by the Parliament is due to the fact that often Administrative Ministries submit their schemes to the Finance Ministry during the last moments of the preparation of the estimates. There is generally inadequate prebudget scrutiny for want of'

details in the case of @any schemes. Since often schemes are included in the Budget without prior scrutiny it becomes necessary for the Ministry of Finance to undertab the examination after the Budget has been approved and before they are actually executed. Therefore, unless the expenditure sanctions are issued with the concurrence of the Finance Ministry, no part of the expenditure can be incurred. To avoid such a delay, prebudget scrutiny of the schemes by the administrative ministries and the Finance Ministry should be complete and detailed. The Estimates Committee in its ninth Report, concerning Administrative, Financial and other rdorms has probed the problem in detail. The committee also observed that there should be coordination between the Finance Ministry and the Administrative Ministries. There should be more delegation of financial authority to the administrative Ministries. The committee observed that concrete steps should be taken to establish perfect cordiality between the administrative Ministries and the Ministry of Finance and to see that one is complementary to the other and helps in the ultimate objectives. The committee made the following recommendations. 1) Before a scheme is embarked upon, it should be properly planned and it should also be ascertained, whether the money required for it is available or can be made available at the proper time. Detailed plans and estimates should be worked out to enable the Ministry of Finance to approve the schemes and accord, financial concurrence.
2) After the scheme is approved from the financial point of view by the Ministry of . Finance, detailed execution of the scheme and spending of money thereon should be the responsibility of the administrative Ministry concerned which should also be given power to vary or alter amounts under the sub-heads of the scheme so long as the total outlay is not affected.

Thus, on the basis of recommendations of the Estimates Committee, procedures and methods ought to be developed which should remove delay and bring efficiency to financial control. Delegation of financial responsibility to the administrative ministries is necessary. Although the ov.eral1 control has to be exercised by the Ministry of Finance, administrative ministries should be given more powers to incur expenditure on various schemes and plans: The financial responsibility and conscious~ess economy should be promoted in all the administrative departments. for Each ministry should prepare its Budget in as detailed a manner as possible and work out the details of all schemes to be executed by the ministry in the ensuing financial year

Check Your Progress 2

Note :
I)

i) Use the space given below for your answers. ii)' Check Your answers with those given at the end of the unit.

Outline,the organisation and functions of Ministry of Finance.

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2)

Critically analyse the role of the Ministry of Finance.

..-20.4 DELEGATION OF FINANCIAL POWER

Financial Control

respect of creation of.posts and contingent expenditure. These powers were further enhanced in 1954 and 1955. A.K. Chanda, the then Comptroller and Auditor General of India, who undertook the task of preparing a plan for delegation of financial powers and for a reorganisation of the system of financial control, submitted his proposals for the consideration of the Public Accounts Committee gf Parliament While pinpointing the defects in the existing system, he recommended that, to avoid delays in the issue of expenditure sanction$, the particulars of the proposals referred by the adniinistrative ministry to the Ministry of Finance at the prebudget review stage should be furnished in greater detail to enable the Finance Ministry to carry out a better and more systematic prebudget scrutiny. A breakthrough, of key importance, came in 1958, when the Government of India sought to delegate financial powers to the administrative Ministries. However, the Ministry of Finance continues to be responsible for making a reasonable and fair distributiofi of the total suni determined by its ways and means position amongst the various programmes and activities of the government within the framework of the plan. The Government has recognised the need for rationalising the procedures for expenditure sanctions and delegation of powers to the administrative ministries in their various delegation schemes. The main objectives of these delegation schemes has been to improve the procedure for prebudget scrutiny and to delegate within broad limits powers of post-budget expenditure sanctions to the administrative departments

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The delegation schemes have exhorted the administrative ministries to redelegate, in their turn, administrative and finahcial powers to heads of departments and to other subordinate authorities with due regard to their respective levels of responsibility. It is .well recognised that for a system of delegation to be effective, the powers delegated should step down the line and be commensurate with the responsibilities to be discharged at the various official levels. The need for delegation would vary in the case of different organisations depending on their respective programme requirements and on whether they are to exercise'such powers in normal times or in times of crisis. For a meaningful operation of a scheme of delegation the exercise of powers by the delegate should be insisted upon. The Ministry of Finance should send back a case without expressing its views if the matter falls within the delegated powers of an administrative ministry. In the same way, the administrative ministries and heads of departments should insist upon the decisions being taken at levels vested with adequate powers. The need for speedy and efficient despatch of the public business makes it imperative that the functionaries at different levels should make full use of the powers delegated to them. The Estimates Committee in its Ninetyeighth report in 1975-76 observed that there is a need for further redelegation of powers t o the field agencies which have the primary responsibility for execution of schemes and attaining set targets. The Committee endorsed the view that it is essential that they should have adequate powers commensurate with the responsibilities to be discharged by them. The Committee suggested that one of the ways to ensure that delegated powers are actually exercised is to create proper atmosphere to it. The officers should be consciously encouraged to develop initiative and take decisions. It should also be ensured that methodical and conscious work and exercise of powers entrusted to officers is recognised and appreciated while bonafide ommissions and commissions are not held against them. The A.R.C. study team on Financial Administration observed that-"A scheme of delegation of financial powers which does not become operative until1 the last detail is approved by the Finance Ministry is unsatisfactory. Once the preliminary feasibility report has been prepared and accepted by the government, the administrative ministry should be permitted to sanction expenditure on essential preliminary items, subject to a certain limit, in a fixed preparation or percentage of the estimated costs." "If the project is to be implemented without delay, the need for delegating some powers to the administrative ministries for incurring expenditure on the essential preliminary items becomes important. It is, therefore, suggested that after the

preliminary feasibility report has been examined and approved by the government, the administrative ministries should have powers to incur expenditure within certain limits on the essential preparatory items pertaining the project." UMer the latest delegatiqn schemes the administrative ministries have W n given full powers of reappropriation within a grant, provided there'is no diversion of funds from plan schemes to non-plan activities and there is no augmentation of the total proyision made for administrative expenses under a particular grant. In actual practice. the administrative ministries,enjoy enough freedom in the matter of reappropriation of funds, even in these cases where reappropriation of funds could, under the rules. be done only withthe prior sanction of the Ministry of Finance. Check Your Progress 3 Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.

I ) What steps have been taken towards delegation of financial powers in India since Independence'?

2 ) Discuss the observation of Estates Commjttee, ARC on the need for delegation of

financial powers.

20.5 LET U S S U M U P
Finance being so vital to any organisation, especially Government, its administration is alw an important study. A government which has worked ouf a satisfactory system administration has gone a long way towards putting the administration of of financ~al its affair5 on an efficient basir. Thus. financial administration, involving the machinery and methods by which funds for the support of public services are raised, Spent and accounted tor. is at the very core of modern government. The financial functions are performed by leglrlature, the executive branch of the Government, the Finance Department and by the Audit Department. Control In matters of policy concerning finance rests in the government as a whole. F~nance Department is always responsible for the entire financial administration of thc country. r'his department performs a variety of functions with regard to financial adyini\tration of a country.
I rom time to time the Government has recognised the need for rationalising the procedures for expenditure sanctions and has delegated enhanced powers to the administrative ministries in their various delegation schemes. The purpose is to improve the procedures for prebudget scrutiny and to delegate powers of post-budget expenditure sanctions to the administrative departments, within broad limits. There have been various issues in Executive Control over expenditure, control by Finance Ministry and the delegation of firiancial powers in the Government'of India

b inanrial Control

KEY WORDS
Treasury or Finance Department : First and foremost amongst the departments of administration stands the Department of Finance or Treasury. This department performs a variety of functions with regard to finances of the country. Executive :'One of the important agencies in financial administration is the Executive. The Executive performs the policy-making function concerning finance and then tries to get the approval of the legislature.

Chanda, A.K. 1959. Aspects o f Audit Control, Asia: Bombay. Chatterjee, B.M. 1963. Financial Control in Go?. and Pvt. Sector Mangt. Review. Dutt, R.C., 1968. Financial Control in Public Enterprises, Lok Udyog. Ghosh, C.K. 1966. Expenditure Control in Development Admn. Indian J1. of Public . Admn. New Delhi. Govt. of India, 1968. Administrative Reforms Commission, Report of the study team on financial administration. , Panandiker, V.A. 1975. Development Administration o f India, Macmillan. Shakdhar, S.L. 1957. Budgetary System in Various Countries, New Delhi. Thavaraj, M.J.K. & Handa, R.L. 1973. Financial Control and Delegation, Indian el Institute of Public Administration, ~ e w hi.

20.8 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1 1) Your answer should include the following points: certain fundamental changes have been made in the environment of financial administration in India since Independence. formal acceptance of executive accountability to the legislature as the base of financial administration in India. major steps towards more delegation of financial powers were made in 1958, 1962, 1968 and 1975. high degree of centralisation which characterised the system of financial control in British India has been restructured over the 30 years of independence. the procedures approvals and the tools of such a contfol have undergone much change. 2) Your answer should include the following points: administration of the finances of the Central Government 1 . . handling of financial matters affecting the country as a whole raising the necessary revenues for carrying on the administration - e regulating the taxation and borrowing policies of the Government administration of problems relating to banking and currency arranging the proper, utilisation of the countries in foreign exchange resources controlling the entire expenditure of the Government in cooperation with the . . _. . . t . . . ->
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Check Your Progress 2 1) Your answer should include the following points: The Finance Ministry at presents divided into: Department of Economic Affairs Department of Revenue and Banking Department of Expenditure Each department is under the charge of an independent Secretary, and for overall coordination of all the departments, there is a Finance Secretary The department of Economic Affairs prepares the Central Government needs and resources Budget, makes periodic 'assessment of foreign excha~ge takes steps to mobilise and allocate resources, internal as well as external, in keeping with developmental and other needs. Department of Revenue and Banking deal with, lncome tax, Wealth tax, Expenditure tax, Customs, Central Excise. Formulation and lmplementation of Goveinment policies having a bearing on the Commercial banks and longterm financial institutions excluding LlC and UTI. The Department of Expenditure is mainly concerned with the administration of expenditure control.

Executive Control

2) Your answer should include the following points: The control of Finance department extends to the practice of requiring specific authority by the finance department for every item of expenditure Executive control of the Finance department over finances of the country t resulted in concentration of authority in only one ~ e p a r t m e n of the Government. T'he resultaf the centralisation of such powers is that there is no delegation of financial authority to the high ranking and responsible officers of the various administiative ministries. There is generally inadequate pre-budget scrutiny for want of details in the case of many schemes. Unless the expenditure sanctions are issued wjth the concurrence of the finance ministry, no part of expenditure can be incurred. There should be mdre delegation of financial authority to the administrative ministries. Administrative ministries should be given more powers to incur expenditure on various schemes and plans.
Cheek Your Progress 3 1) Your answer should include the following points:. Greater financial power were delegated, in 1953: in respect of creation of posts and contingent expenditure. These powers were further enhanced in 1954 and 1955. A breakthrough, of key importance, came in 1958, when the Government of India sought to delegate financial power to the administrative ministries. The Government has recognised the need for rationalising the procedures for expenditure sanctions and delegation of powers to the administrative ministries in their various delegation schemes. The main objectives of these delegation schemes has been to improve the procedure for prebudget scrutiny Delegating within broad limits powers of post budget expenditure sanctions to the administrative departments.
2) Your answer should include the following points: The Estimates Committee in its Ninetycight report in 1975-76 observed that there is a need for further redelegation of powers t o the field agencies. It endorsed the view that it is essential that they should have adequate powers commensurate with the responsibilities t o be discharged by them. It s u d s t e d that one of the ways to ensure that delegated powers are actually exercisedais to create p;oper atmosphere for it. . The officers should be consciously encouraged to develop initiative and take
,I..-m -.,;: *

Financial Control

It should alsdbe ensured that methodical and conscious work and exercise of powers entrusted to officer is recognised and appreciated while bonafide omissions and commissions are not held against them. The A.R.C. observed that a scheme of delegation of financial powers which does not become operative until the last detail is approved by the finance ministry is unsatisfactory. It has been suggested that once the preliminary feasibility report has been prepared and accepted by the Government, the administrative ministry sh&d be permitted to sanction expenditure on essential preliminary items.

UNIT 21 ACCOUNTING SYSTEM IN INDIA
Structure
Objectives Introduction Accounting : Definition and Importance Principles and Methods of Government Accounting Separation of Accounts from Audit Departmentalisation of Accounts Revised Accounting Structure Management Accounting in Government Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

21 .O

OBJECTIVES

After studying this unit, you should be able to : explain the differences between Commercial and Government Accounting discuss the advantages and disadvantages of the separation of accounts from Audit and its present position in Government explain the main features of Departmentalisation of Accounts describe the essentials of the Revised Accounting Structure; and analyse the concept of Management Accounting and its limitations in Government.

21.1 INTRODUCTION
Accounting, whether in a commercial organisation or in Government, is a tool of management, In a manufacturing organisation, it provides information to management about the cost of manufacturing a product, the cost of performing a job, the cost of sales and the profit earned or loss incurred etc. Similarly, in a commercial organisation, it provides information about the profit or loss and also the increase or decrease in the assets and liabilities of the organisation. It also provides data for proper budgetary control. In the case of government, accounting helps the various levels of management, in the preparation of plans and exercise of proper financial control. By providing data about the expenditure incurred on various activities, it helps budget planners to determine in advance, the taxes to be levied and also the areas, where the cut in expenditure is possible. Again, it helps the management in proper monitoring and implementation of plans, schemes. Thus, accounting is an useful'aid to management in performing its various managerial functions effectively. In this unit, the difference between commercial accounting and government accounting has been explained. The recent reforms in government accounting viz., Departmentalisation of Accounts, Revised Accounting Structure, Management Accounting have also been explained.

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ACCOUNTING : DEFINITION AND IMPORTANCE
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.The word accounts in the financial sense, has been defined as statements of facts relating to money or things having money value. The facts that are incorporated in
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In the early stages of civilisation, the number of transactions to be recorded was so small that each businessman was able to record and check for himself/ herself all the transactions. But with the growth of trade, it became difficult for him/ her to know from the records, how she/ he stood in relation to his/ her customers and whether her/ his business was profitable or not. This gave rise to the maintenance of accounts on a doubleentry basis, which was helpful in the preparation of profit and loss account and balance sheet of the business. The process through which these ends are effected is called "accounting." Accounting is a discipline which records, classifies and summarises data and presents it in a convenient form to various levels of management in an organisation for decision-making purposes. It helps managers to prepare their budget plans realistically so that the expenditure could be watched against the budget allocation, and corrective action could be taken, wherever necessary. It also helps outsiders i.e. shareholders/ government, to know the working of the business firm, by presenting data about its activities, profit or loss and its assets and liabilities. In government, accounting provides information for the preparation of annual budgets. It helps budget planners to determine, in advance, the taxes to be levied for meeting the committed expenditure, or to reduce the expenditure, wherever possible. It provides information to managers about the expenditure involved annually, on pay, allowances, materials etc. and also the expenditure incurred on Plan Schemes. It also provides information regarding expenditure incurred on functions, programmes, activities, for the speedy development of performance budgeting in all departments of government. It further helps in exercising proper financial control and observance of rules and regulations by the various authorities. Its main purpose is to provide timely information to various levels of management, for taking proper decisions in respect of their areas of operations and for monitoring the performance of activities against their physical targets and also the expenditure against the budget, so as to enable the government to take corrective action, wherever considered necessary.

21.3

PRINCIPLES A N D METHODS OF GOVERNMENT ACCOUNTING .

The principles of commercial and government accounting differ in certain essential points. The main function of a commercial concern is to produce goods and sell them to earn a profit. On the other hand, the main function of government, is not to make profit but to govern the country and administer the various functions in the best way possible in the interests of the society at large. A commercial concern deals primarily with the utilisation of capital for the purpose of making a profit. It is interested in seeing at intervals, how it stands in relation to its debtors and creditors, whether it is gaining or losing, what are the sources of its gain or loss. In order to obtain ready answers to these questions, the concern has to keep a system of detailed accounts. In respect of each person dealt with, and each department of its activities, it maintains a separate accourit, so that the result of the transactions in each case may be ascertained. By preparing the manufacturing, trading and profit and loss accounts and balance sheet, the concern is able to know the profit earned or loss incurred during the year. It is a generally accepted practice in the commercial world to m9intain account books on the double entry system. The double entry system is based on the fact that in every transaction, two parties or accounts are involved-one giving and the other receiving. Under that system, every transaction requires two entries in the books, one against the party or account giving and the other against the party or account which is receiving. The activities of a government, on the other hand, are determined by the needs of the country. If the activities to be carried out, during the coming years, are known, it becomes easier to determine the funds required to carry out those activities. Government accounts are, therefore, designed to enable the government to

determine, how much money it needs to collect from the tax-payers in order to maintain its activities. The classification of transactions in government accounts is determined firstly by the administrative classification of the activities and secondly by the classification of the nature of the transactions. The government accounting is, therefore, quite elaborate and is kept on a single entry basis.

Accounting System in lndr

21.4

SEPARATION OF ACCOUNTS FROM AUDIT

i) Introduction
Accounting and auditing are interrelated but have independent functions. For reasons mainly of economy, these have been traditionally combined under one authority. From time to'time, however, attempts have been made to separate accounting from auditing as in the case of railways, defence, food, rehabilitation and supply. In 1971, the Comptroller and Auditor General's (Duties, Powers and Conditions of Service) Act was passed, which visualised the need for separating accounts from audit. Section 10 of the Act empowered the President, after consultatiorl with the CAG. to relieve the Comptroller and Auditor General from the responsibility of compiling the accounts of any department of the Union Government. A scheme for the separation of accounts from audit was approved by the Government of India in June 1975. An ordinance was issued by the President, which was followed by passing an Act, which amended the Comptroller and Auditor General's (DPC) Act 1971, thereby relieving him from the responsibility of compiling accounts of Ministries1 Departments of Government of India. He, however, still performs the accounts and audit functions in each state.

ii) Advantages of Combined Audit and Accounts
Continuance of combined audit and accounts under one functionary has been justified on the following considerations: a) Accounting and audit functions are interrelated. The preaudit of claims before admission for payment, the examination of contract documents, etc. with reference to the financial principles and rules is essentially an audit process. Therefore, the combination of the two functions is not wrong. An accounts organisation, independent of the administration, is a must to ensure that the internal accounting organisation is not coerced by the administration to admit questionable claims, overlooking irregular practices. Under the existing practice, certain accounting responsibilities have been imposed on the Comptroller and Auditor General. Consequently, arrangements will have to be made by him for the consolidation of departmental accounts and the compilation of Finance Accounts of the Central and State Governments as a whole. The co-ordinating role will imply that the uniformity in accounting principles and processes in the units has to be maintained. The Constitution has provided for a single Comptroller and Auditor General, unlike other Federal Constitutions. Hence, it would be better to keep accounts and audit with the Comptroller and Auditor General.
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iii) Dis\qdvantages of Combined Audit and Accounts
The basic disadvantages of the combined system are as follows : a) It violates the fundamental spirit behind the provisions of the Constitution and of the CAG Act of 1971, which expects that the duties of Comptroller and Auditor General should essentially be auditorial. b) Combination of audit functions with payment and account functions brings the Comptroller and Auditor General under the indirect control of the Finance Minister. Questions tabled in the Houses of Parliament pertaining to his . ---.. -*:-.. .. : 4, + thn ~ 4 E;..o..nn a . . . .
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Federal structure has been prescribed by the Constitution with autonomy to the states. With the state accounts handled by a functionary directly under the President, entrusting accounting duties to the' Comptroller and Auditor General would lead to the loss of the accounting autonomy of the states. The combined accounts and audit dffices function with less speed in the performance of their accounting duties, i.e. in the timely payments of dues, such as salary, pension, provident fund, gratuity etc.

d)

The disadvantages listed out above are not so great as to justify opposition to the separation for all times to come. The mere fact that separate accounts organisations of Defence, Railways, Lok Sabhal Rajya Sabha Secretariat and the separated Ministeries of Works, Housing and Supply etc. are functioning with efficiency, it dispel - the fears enumerated. In fact, the disadvantages arising out of combined accounts and audit organisations are more than the advantages accruing out of it.

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iv) Advantages of Separation or Departmentalisation of Accounts
Departmentalisation of accounts has many advantagp. It establishes a definite accountability on the decision-making departments for the expenditure incurred by them, out of the approved budget. He, who spends, should account for the expenditure. But an executive without administrative control over its accounting machinery, will hardly be able to discharge effectively its financial and accounting responsibility. Departmentalisation of accounts enables the audit department to confine its attention to audit matters in greater depth. The activity of higher audit (i.e. Efficiency-cum-Peformance Audit) may g e y r r e d , when audit is involved with routine accounting duties. Moreover, accounting duties bring the Audit Department partially under the control of the executive, whose accounts it compiles.

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v) Separation of Accounts
Realising the increasing need for separation of accounts from audit, the Government of India decided to departmentalise the accounts of the Central1 Ministries1 Departments, which had been with the Comptroller and Auditor General of India. All Ministries of the Government of India including the Posts and Telegraphs Department were brought under the Scheme of departmentalisation of accounts between 1st &I to 31st December, 1976.
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he scheme of Departmentalisation of accounts introduced from 1st April. 1976. is in character and method different from the earlier attempts made in this regard. The main objective behind this scheme was that in view of the manifold increase in Government expenditure and the need to implement effectively the developmental plans, management accounting should be properly developed as an integral part of each Ministry1 Department It was realised that to achieve this objective, the externality of the accounting system should be eliminated and there should be a vertical functional integration, coupled with horizontal administrative integration at each level of management. Accordingly, the Departmentalisation df accounts involved not only relieving the Comptroller and Accountant General of the responsibility of compilation of accounts but also taking over most of the payment and reciept functions from the Treasuries.
The broad features of the Scheme of Departmentalisation are detailed below: i) Each Ministry functions administratively under a Secretary, who is assisted by an Additional Secretary, a Joint Secretary, and Under Secretaries supported by subordinate officers. Apart from the Headquarters set up, evely Ministry
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The Comptroller and Auditor General was relieved of the responsibility of compiling and keeping the accounts of transactions relating to the Departments of the Ministries. Payment functions discharged by the treasuries were also taken over by the Departments. According to the practice, prior to departmentalisation of cc unts, the main Ministry and the subordinate offices used to draw funds by means of presenting bills in treasuries. The treasuries used to render accounts to the respective Accountant Generals, who compiled the monthly accounts. Each Accountant General rendered a monthly account of Central Gover ment transactions to the Accountant General, Central Revenues in Delhi! for consolidation and preparation of civil accounts.

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The Secretary of each Ministry is designated as the Chief Accounting Authority responsible for all transactions of the Ministry and its Departments. This responsibility is discharged through the Integrated Financial Advisor (IFA) of the Ministry. The Secretary has the over-all responsibility for the functioning of the accounting and payment set-up and is responsible for certification of monthly accounts. The Integrated Financial Advisor performs the following duties, on behalf of the Chief Accounting Authority. He/She will be responsible for: a) The preparation of the budget of the Ministry and its Departments in coordination with the Heads of Departments concerned and distribution of the budget allotment among the various wings/ departments of the Ministry. Control of expenditure will also form a part of his/ her responsibility. Arranging payments to autonomous bodies, corporations, authorities, and also grants-in-aid, loans etc. Arrangements for making payments through the Pay and Accounts offices of pay and allowances, office contingencies and miscellaneous payments. Consolidation of the accounts of the Ministry as a whole, in accordance with the instructions issued by the Central Government. Preparation of Appropriation Accounts for the grants controlled by the Ministry. Organising a sound system of internal check to ensure accuracy in accounting and efficiency of operation as part of management. Introduction of an efficient system of Management accounting best suited to the functional requirements of the Ministry and its Departments.

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The payments relating to the Ministries/Departments which are now made by the Bank and non-Bank treasuries, Accountant General and State Pay and &counts Officers, will be made by the Departmental Pay and Accounts Offices.
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In brief, departmentalisation of accounts was done mainly with a view to enable the Ministries to exercise direct control over their expenditure and to introduce a management accounting system, so as to provide relevant information to various levels of.management for taking proper decisions.
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Check Your Progress 1 Note :
1)

i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.

Explain the advantages of the separation of accounts from audit.

Accounts md Audit

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2)
Explain the disadvantages of the separ-&n of accounts from audit.

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3) Explain the salient features of departmentalisation of accounts.

21.6

REVISED ACCOUNTING STRUCTURE

The accounting system introduced by the British in the early years of this century remained more or less unchanged till April 1974. The classification in the accounting system introduced by the British, was mainly to facilitate financial and legal accountability of the Executive t o the Legislature and within the Executive. of the spending agencies t o the sanctioning authorities. Again. the classification had close relationship to the department in which the expenditure occurred than to the p d o s e s for which thermoney was spent. The basic concern was the item on which money was spent rather than the purposes served by it. This system served well so long as the functions of the Government were limited. But with a change in the role of Government, i.e. undertaking developmental programmes for the socio-economic development of the country under the successive Five Year Plans, need was felt for bringing in necessary reforms in the system of accounts, so as t o meet the challenges of development administration. The Administrative Reforms Commission set up by the Government in 1966, to bring about reforms in administration examined the existing system of accounts and recommended in their Report o n " Firiume, Acc.ounts and Audit", some changes in the system. This was done mainly in the context of introduction of performance budgeting in India. The Commission recommended that the structure of major heads of accounts should be recast to reflect broad functions and major programmes of Government. Also, the programmes, activities and projects of the varlous departments and organisations should be clearly identified and the minor heads connected with these programmes suitably recast, so as to reflect these activities. T h e Commission also suggested that the heads df development adopted for Plan purposes should be reviewed with a view t o establish a direct correlation between these heads and the general accounting heads. The Commission also recommended that the Government should constitute a team composed of representativei of the Comptroller and Auditor General, the Planning Commission, the Ministry of Finance, and the Administrative Ministry concerned which should be assigned the task of drawing up a programme for the implementation of the commission's recommendations. The Government of India accepted the suggestions of the Commission. I t appointed a team of officers composed of the Deputy Comptroller and Auditor General, the Joint Secretary (Budget) of the Ministry of Finance, and a representative of the Planning Commission, to undertake a review of the Heads of acounts and the Heads of dewelo~ment d o ~ t e d Plan DurDoses. The team submitted two reDorts on the a for

reforms in the structure of demand-for grants. In p a r n o r the report, it suggested that a Ministry/ Department in charge of a number of distinct services may present a separate demand for each of the major activities. In part I1 of the Demands, details of expenditure upto the level of major and minor heads of account may be included. In part 11i of the Demands, further details may be given about the provisions made in part 11 for minor heads and for activities/schemes/organisations under minor heads. The team submitted the second report in November 1972. It proposed a five tier classification structure. The team mentioned that the new classification would facilitate a link between budget outlays and functions, programmes-and activities. It would also ensure itemised control of expenditure. Also, the classification would facilitate introduction of performance budgeting. The Government of India accepted the recommendations of the team on reforms in the structure of Budget and Accounts. A revised accounting.structure was introduced by :he Government of India from April, 1974. Under this scheme, a five-tier classification has been adopted, namely Sectoral Major Head, Minor Head, Sub-Head and Detailed Heads of account. Sectoral classification has grouped the functions of government into three sectors, namely, General Services, Social and Community Services and Economic Services. General Services Sector includes services indispensable to the existence of an organised state, such as Police. Defence, External Affairs, Fire protection etc. This sector includes Organs of State (Parliament), Head of State, Judiciary, Fiscal and Administrative Services and Defence Services. Social and Community services sector covers programmes and activities relating to provision of basic social services to consumers, such as Education, Medical Relief, Housing, Social security and Welfare and Services required for community living such as Public Health. Urban Development, Broadcasting etc. Economic Services Sector includes programmes and acthities in the fields of Production. Distribution, Trade, Regulation ctc.
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In the new scheme of accounts, a Major Head is assigned to each function, and a Minor Head is allottcd to each Programme. Under each Minor Head, there would be sub-heads assigned to activities/schemes/ organisations covered by the progra*me. Major and Minor Heads classification is common to Union, States and Union territories Govclmments. Under the new scheme, the object classification has been retained and placed as the last tier. I t is meant to provide item-wise control over expenditure and to ensure financial control. The revised accounting structure in terms of programmes, activities, and projects establishes adequate links between Budget and Account HeadQi.e. Major Head. Minor Head and Sub-Head) and the Plan Heads of developmeqr. It helps in obtaining information of the progressive expenditure incurred inflplan programmes /? and projects. I t also helps in the speedy implementation of performance budgeting. Further. i t also helps in monitoring and analysis of expenditure on progl-am'mes~activities,' projects to perform the management functions effectively.

21.7

MANAGEMENT ACCOUNTING IN GOVERNMENT

According to Amerlcan Accounting Association "Management Accounting is the application of appropriate techniques and concepts in processing historical and projected economic data of an entity to assist management in establishing plans for ieasonable economic objectives and in mqking of rational decisions with a view toward those objectives." Management accounting involves collection and presentation of all such information which can be of help to management in the

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preparation of budget plans for the organisation. It helps in proper monitoring and evaluation of performance of the activities,'as compared to the budget plan in terms of financial expenditure and the corresponding physical accomplishments. Its purpose is to provide timely information to various levels of managements to facilitate decision-making, for efficient and economical achievement of their tasks. Management accounting encompasses financial accounting, cost accounting and all aspects of financial management. It involves not only colltction of information from financial records but also from cost records. In a system of management accounting, information has to be collected from various sources inside and outside the organisation and presented to management for taking decisions. A good management accounting system should provide timely accounting information to various levels of management, for a continuous review of the progress. of expenditure as related to the budgeted funds and the planned tasks. It should also facilitate the working of the scheme of performance budgeting. Management accounting varies from organisation to organisation depending on its objectives, organisational structure, and the information requirements at various levels etc. In Government, it is difficult to prescribe a standard system of management accounting, applicable to all departments of Government, as the functions of each department vary from one another. It is necessary, therefore, to evolve a management accounting system suited to the department, keeping in view its objectives, organisational structure, information requirements etc. Again; management accounting system, once introduced, should be reviewed periodically to cope with the changing requirements of that particular department. An Advisory Committee had been appointed, in 1976, by the Government of India under the Chairmanship of the F i ~ a n c e Minister, to consider and recommend management accountancy concept1 to suit the requirements of different Ministries/ Departments. The Committee was also required to make recommendations regarding management information system necessary to be developed for the purpose. Very little progress has, however, been in this dir~ction due to various constraints. The constraints in developing a system of management accounting in government have to be recognised. Government accounting, is c(one on a cash basis (not double entry basis) which makes it difficult to know the entire cost assignable to an activity. Again, the present structure of financial accounting is not conducive to serve the purposes of management accounting. The existing classification of accounts does not allocate cost to a 'cost-centre' or responsibility centre so as to evaluate actual cost against standard cost. Although the new classification structure developed for performance budgeting in terms of functions, programmes, activities had helped in monitoring expenditure on a programme or activity, the classification still needs to be linked with cost-centres or responsibility-centres for speedy development of management accounting in Government. It may be concluded that the. recent financial reforms introduced in the Government of India, namely, revised accounting structure, departmentalisation of accounts, performance budgeting, Integrated Financial Advisor Scheme etc. are all intended to facilitate the early introduction of management accounting in government. The reforms already started should be carried forward, so that the management accounting system developed in a Ministry/ Department, could provide timely information to various levels at management for speedy decision-making,

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' Check Your Progress 2
Note :
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Use the space given below for your answers. Check your answers with those given at the end of the unit. ii)

i)

Why was the accounting system introduced by the British revised?

Accounting Syrtem I Indh n

2)

Explain the concept of Management Accounting.

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21.8

LET U S SUM C P T

Thus, in this unit, the developments in the area of Government accounting right from the beginning of this century to the present, have been explained. The importance of management acco~inting and its limitations in Government, has also been explained.

21.9

KEY WORDS

Cost Accounting: Analysis of accounting and other information to determine the cost of each activity/ product/job.
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Capital ~ x ~ e h d i t u r Payments in respect of which, services will be available for e: many years to come e.g. machines. Financial Accounting : Art of recording, classifying and summarising transactions, which are of a financial nature. Revenue Expenditure : Payment in respect of which services have already been obtained e.g. wages, salaries, rent etc.

21.10 REFERENCES
Chandrasekharan R.K., 1990. The Comptroller and Auditor General of India (Vol. I ) , Ashish Publishing House : New Delhi.

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RamachandrantK.S., 191 1. Wutc-17ingover a Watch Dog, Ashish Publishing House: New Delhi.

21.11 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1

I)

Your answer should include the following points: Accounting and audit functions are interrelated An Accounting organisation, independent of the administration, is necessary to prevent irregular practices ih administration. There is a need to maintain uniformitv in accounts.

Advantages

2) Your answer should include the following points:

Disadvantages
The Combined system of audit and Accounts violates tile fundamental spirit behind the provisions of the Constitution and of the CAG (DPC's) Act 1971. It brings the Comptroller and Auditor General, under the indirect control of the Finance Ministry. It does not help in speedy performance of accounting duties. Departmentalisation of accounts was done in all Ministries of Government in 1976.

3) Your answer should include the following points
The c o m p t r d l e r and Auditor General was relieved of the responsibility of compiIing the accounts of the Ministries1 Departments. Each Ministry functions administratively under a Secretary, who is designated a s the Chief Accounting Authority. He/ She is responsible for the accounting transactions of his/ her Ministry/ Department. The Integrated. Financial Advisor assists the Secretary of the MinistrylDepartment in the performance of his/ her accounting duties, by preparing the Budget of the Ministry and watching the expenditure from time to time. The scheme helps in speedy introduction of Management Accounting in Government.

Check Your Progress 2 Your answer should include the following points: I) Change in the role of the government.
Extension of the government functions.
2)
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Your answer should include the following points : Management accounting encompasses Financial Accounting, Cost Accounting and all aspects of Financial Management. Government accounting is done on a cash-basis. Classification in Government accounts is not in terms of Cost Centres or Responsibility Centres, which are essential for allocation of expenses and providing timely information to management.

UNIT 22 AUDITING SYSTEM IN INDIA
Structure
Objectives Introduction Auditing: Definition and Importance Evolution of Auditing in India Statutory and Internal Audit Types of Audit Independence of Audit Results of Audit-Audit Reports and their Follow-up with Administration Let Us S u m Up Key Words References Answers t o Check Your Progress Exercises

22.0 OBJECTIVES
After studying this unit, you should be able to: explain the meaning and importance of audit describe the differences between Internal and Statutory audit analyse the features of Regularity audit and Performance audit understand the utility of audit reports and their impact on administration.

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22.1 INTRODUCTION
Audit deals with papers and figures. I t is in the nature of a post-mortem examination of accounting and financial transactions of a firm or a company or a department of Government. An auditor has a vital role to play in modern economy. With the growth of jointstock companies with limited liability, there is divorce between owners (shareholders) and managers (Board of Directors). This has made it important that there should be an independent auditor to check the correctness of the financial transactions of a limited liability company on behalf of the shareholders, as a means of managerial accountability to thc owners. Likewise, on the basis of audited accounls, certified by a n auditor. the tax authorities can be reasonably certain that the profit or loss, disclosed by a n assessee, is reasonably true and correct, instead of * undertaking a check of accounts of the assessees. In the case of governmental activities, audit acts a s a 'watchdog' oE the nation's financial interests. The administrative structure of the State is so vast and its operations so complex that it is impossible for an ordinary tax payer to know that the money contributed by him/ her t o the running of the state is being misused. Audit helps to highlight losses, waste and under-utilisation of capacity, due to improper decisions at the appropriate levels. Above all, ParliamentIState Legislatures vote supplies but they have no means t o know that the moneys' have been spent for the purposes for which they were voted and also not in excess thereof. It is for the proper exercise of these important aspects of control that Parliament L-- L--- ----A ...:L - ----.:....:---I . -A. -: -...L--:... :- .L,.r
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In this unit, you will study the meaning a n d impo;tance of audit and the evolutio@,, of auditing in India. You will know the various types of audit conducted by the Comptroller and Auditor General for effecting economy and efficiency in administration. This unit will also explain the importance of audit reports and their examination by the Public Accounts Committee of the Lok Sabha.
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22.2 AUDITING : DEFINITION A N D IMPORTANCE
The world Audit is derived from the Latin word Audire t o hear. Originally, the accounting parties were required to attend before the auditor, who heard the accounts. I n the early stages of civilisation, the methods of accounts were so crude and the number of transactions t o be recorded so few that each individual was able t o check for himself/ herself all his/ her transactions. But soon with the establishment of empires, a system was established t o record account transactions and audit them. The person whose duty, it was to check such accounts came to be known a s the Auditor. An audit is a n examination of accounting records undertaken with a view to establishing, yhether o r not they correctly and completely reflect the transactions t o which they purport to relate. Its purpose is t o see that expenditure has been incurred with the sanctions of the competent authority and applied for the purpose for which it was sanctioned. It should be duly supported by vouchers, a s a safeguard against fraud and misappropriation. Audit is a n instrument of financial control. In its relation t o commercial transactions, it acts a$ a safeguard, on behalf of the proprietor, against extravagance, carelessness o r fraud o n the part of the proprietor's employees in the realisation and utilisation of his/ her moeny or other assets. It ensures on proprietor's behalf, that the accounts maintained truly, represent facts and that expenditure has been incurred , with due regularity and propriety.
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The financial transactions of a government need to be similarly 'watched. The agency employed for the purpose should be independent from the employees of Government, who are entrusted with the realisation and utilisation of public money or other assets, This task is entrusted, in India, t o the Indian Audit and Accounts Department. S o far a s its audit duties are concerned, the position of the Indian Audit and Accounts Department in relation to government transactions, is to a large extent. similar t o that of a n auditor. In this context, Parliament1 Legislatures may be regarded i s the shareholders of the Government concern and the Executive Government as its directors. The object of this concern is. however. not profitmaking. Audit is one of the four pillars of democracy viz.. (i) Parliament (ii) Judiciary (iii) Press and (iv)'Audit. Firstly, Parliament is the most important organ of democracy. It is composed of people's representatives, elected on the basis of adult franchise. The members belonging to the majority party in Parliament form the Government. All laws necessary for the running of the Government have to be passed by the ~ a r ~ ~ d m eAgain, it votes taxes which provide government the resources, necessary nt. for running the administrative machinery and also votes funds for meeting the expenses. Secondly, judiciary and the press are the other two pillars which are necessary for administration of justice and functioning of a healthy democracy. Lastly, a F i t is a vital instrument of ensuring effective supremacy of Parliament over the executive. Parliamentary control consists not only in voting suppliers and approving the imposition of taxes but also in ensuring that actually the funds have been applied to the purpose for which these werc voted. Audit is a valuable aid t o administration. 1nBH countries, audit is not just tolerated as a necessary evil but is looked upon a s a valued ally, which brings t o notice procedural and technical irregularities and lapses on the part of individuals, whether they may be errors of judgment, negligence or acts and intents of dishonesty. The -1 complementary roles of audit and administration are now accepted a s a fact, being essential for toning up the machinery of government-In the ultimate ana!ysis, audit' ..-A ..A-:-:-.-...:..--- .L.-s &- ,..:-. ,F ~,..,+..-~..t' I . ..L,L ~t := ALii;:

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2 2 3 EVOLUTION OF AUDITING IN INDIA

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The evolution of auditing in India, as well as in other countries, has been a gradual process. It has been closely related to the activities undertaken by the government, the internal control and management systems available in government departments. In the pre-war era, the main functions of government were collection of revenue, maintenance of law and order, defence and execution of public works of certain kinds. Few governments undertook commercial activities. In such a situation, the functioh of audit was largely one of regularity and compliance audit. The principal era were (a) audit against budget provisions components of audit in the (b) audit against sanctions (c) audit of accounts and appropriations (d) expenditure aud'it and (e) propriety audit. Audit against budget provisions and against sanctions constituted what was known as complhnce.or regularity audit [See Section 22.5 (i)]. The highest form of audit within the traditional framework. was considered to be propriety audit. A transaction. which was otherwise in order and in conformity with rules and regulations, could still be objected to on the ground that it breached broad\ concepts of financial ethics.

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In the post-war era, the welfare state had to undertake several socioeconomic, commercial and industrial programmes to speed up development and improve the quality of life of the people. Correspondingly. audit had to shift its emphasis so that it was io a position to report to Parliament. whether or not these programmesiactivities had achieved their objectives. New areas of audit had to be covered and new techniques had to be developed. With increasing activity. government departments and agencies had to build up their own systems of internal control. The transition from the traditional type of audit to the audit of economy, efficiency and effectiveness of activities (the three E's audit) was achieled. through an intermediate stage of value for money audit. which covered the economy and efficiency aspects. Broadly. it can be said that economy audit is aimed at ensuring that the activities are undertaken and completed at the lowest possible cost. Efficiency audit is concerned with ascertaining that an activity is completed according to a pre-determined output to input ratio and according to a predetermined time table. In the audit of effectiveness of programmes, it is necessary to determine whether the objectives for which the-programmes were undertaken, have been achieved and whether the programmes had the intended effect on the social and economic life of the people. Thus, broadly, it can be stated, that in the earlier stage. traditional audit was concerned with economy. at the intermediate stage. it Was concesned with economy and efficiency and that today it is concerned with economy, efficiency and effectiveness. As already mentioned. the evolution of government auditing in India has been a gradual process. coinciding with the changes in the functions of government. Until 1950. government audit was mairJy expenditure oriented. Appropriarion audit; regularity audit, sanction audit, propriety audit etc. were conducted by the Indian Audit and Accounts Department, in so far as they related to individual transactions of government. The techniques and procedures prescribed for conducting audit, by and large. fulfilled the task of transaction audit of government expenditure. The concept and practice of audit of expenditure has undergone radical changes in the post-independent era (after 1950). Following the development of parliamentary democracy and introduction of successive Five Year Plans for national development-social, economic and industrial-massive investments have been made by the government at the centre and in the states. .When the pattern of government ex&dituredimension underwent a radical and rapid transformation in the wake of successive national plans, it was felt that the scrutiny of individual transactions was. inadequate, as it tended to mistake the tree for the woods. It became. therefore, essential for audit to ascertain whether the various developmeilt programmes and welfare activities were being properly executed and their operations conducted economically, whether they were producing the results expected of them. Hence she concept of efficiency audit was introduced to meet the changing requirements in the -P A ..-: .
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Accounts iunl Audit

Introduction of performance budgeting and functional classification in government accounting gave a new dimension to efficiency-cum-performance audit. Since 1962, when the technique of efficiency-cum-performance audit was develcped, it has been applied to the transactions connected with the development programmes. The introduction of comprehensive appraisal of the public sector undertakings and evolution of the mechanism of Audit Boards with built-in external expertise, saw yet another extension of the technique of efficiency-~um~performance audit. In addition, audit also covered new areas i.e. audit of tax receipts, audit of scientific departments etc. With the shift in approaches in audit, changes have been introduced in the content and presentation of audit reports. Thus, the evolution of auditing in India has been a gradual process, matching with the changes in the functions of government.

22.4 STATUTORY AND INTERNAL AUDIT
Statutory Audit
Statutory audit refers to the audit conducted by the Comptroller and Auditor General, through the agency of the Indian Audit'and Accounts Department. As per the Constitution as well as by the CAG CDPC) Act, 1971, it is the function of the Comptroller and Auditor General to (i) audit all expenditure from the Consolidated Fund of India of the Union, of each State and of each Union Territory, having a Legislative Assembly and to ascertain whether the money shown in the accounts a s having been disbursed were legally available and applicable to the service or purpose to which they have been applied of charged and whether the expenditure conforms to the authority who governs it and (ii) to audit all transactions of the Union and of the states relating to the contingency functs and public accounts. The Comptroller and Auditor General has been given, under the Constitution, access to the accounts of expenditure incurred against appropriations granted by Parliament. The CAG is empowered to inspect any office connected with the t r a n s a c t i v to which his/ her authority extends. Statutory audit has a three-fold purpose. First, it is an accountancy audit to check the accuracy of arithmetical calculations and to see that all payments are sttpported by receipted vouchers. In its essence, it is no different from the limited audit of private auditors. Its objects are (i) detection of fraud (ii) the detection of technical errors and (iii) the detection of errors of principles. It is usually a continuous audit. but of a small percentage of transactions. Secondly, it is a n appropriation audit to check the classification of expenditure, in order to make sure that the items have been charged to the proper heads of accounts and further that the apprcpriation for these heads have not been exceeded. Thirdly it is an administrative audU or audit of sanctions to check that expenditure has been incurred according to the rules and regulations or where not so covered, it has been sanctioned by the competent authority. Statutory audit, can assure the Parliament, that appropriations have been utilised in accordance with the rules and regulations and within limits specified. I t can vouch for the accuracy of ac,tounts and detect misapplication of funds, frauds, and defalcations. I

Internal Audit
lnternaiaudit, on the other hand, is internal to the organisation. Internal audit is conducted by an agency or departmeyt created by the management of the organisation. It is an integral part of the organisation and functions directly under the Chief Executive. It is in the nature of an internal service to the Executive for smooth and efficient functioning and for reviewing and improving its performance. The common objectives of an internal audit. inter-alia are to ( i ) check the adequacy, soundness and applicability of the systems of internal controls (Accounting, financial and other operating controls); (ii) prevent and detect frauds (iii) check on the - 2 --..--.. --A ..-1:-L:I:... . .L.. ,.---..- .:-.. A . P ,.---,.-. ,., :. A.., . I:.,\.,.,.,,, +A .
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performance-cum-efficiency audit of an operation1 programme1 activity of an entity as a whole, or its parts designed to different levels for any of the objective, set by the management. Internal audit, in any organisation, does not possess the same kind of independence as is available to the external audit, conducted by the Indian Audit and Accounts Department. There is, however, no conflict between internal and external or statutory audit. Where internal audit is adequate, the extent of statutory audit is limited to test checking of internal audit work.
Check Your Progress 1

AudltIIIg SW&I I l n d ~ I I

Note:

i) ii)

Use the space given below for your answers. Check your answers with those given at the end of the unit.

1) Explain the meaning and importance of audit in a democracy.

2)

Explain the difference between Statutory audit and Internal audit.

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22.5 TYPES OF AUDIT
The broad aim of audit is to safeguard the financial interests of the tax payer and to assist the Parliament1 Statel Union territory legislatures in exercising financial control over the executive. It is the function of the Comptroller and Auditor General to ensure that the various authorities set up by or under the Constitution, act in regard to all financial matters, in accordance with the Constitution and the laws of Parliament and appropriate legislatures and rules and orders issued thereunder. In order to discharge the auditorial duties entrusted by the Constitution to him/ her, the Comptroller and Auditor General (CAG) conducts various types of audit viz., Financial audit, Regularity audit, Receipts audit, Commercial audit, Audit of stores and stock, Petformance audit etc. In the performance of this stupenqous task, the CAG is assisted by the accounting authorities in various ministries and by the Principal Accounts Officers functioning in various states. Some of the features of Financial audit, Regularity audit, Receipts aadit, Performance audit are explained in the following paragrahps.

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Financial Audit
Financial audit is the audit conducted by the Indian Audit and Accounts Department to see whether the administrative action of the executive is not only in conformity with prescribed law, financial rules and procedures, but it is also proper and does not result in any extravagance. Finaircia1 audit does not concern itself with the audit of administrative organisations and procedures and is different from administrative audit. It is the duty or the function of the executive government to frame rules. regulations and orders. which are to be observed bv its subordinate

Accounts and Audit

in waste. extravagance o r !mproper expenditure. it is certainly the duty o l audit to call specific attention to matters of that kind and to bring the lacts to the notice of Parliament. For instance, in a canal project construction. audit would not concern itself with the administrative set-up for the actual construction of the canal and whether it should pass through a particular part of the country or not. These are matters of administration a n d no scrutiny of these processes will be done by the audit. But if it is found that the alignments had been drawn up on insufficient data. necessitating a subsequent change involving additional expenditure o r that the financial results were less than what had been anticipated, then it is the duty of audit to examine the circumstances which resulted in the wrong alignments resulting in loss o r avoidable expenditure to the tax payer. Audit interferes only when administrative action has serious financial implications and is not in comformity with prescribed law, financial rules and procedures. Financial audit also includes audit against propriety o r broad principles of orthodox finance. Thus, financial audit safeguards the interests of tax-payer by bringing to the notice of Parliament, wastage in government expenditure.

Regularity Audit
Regularity audit consists mainly In checking that the payments have been duly authorised and are supported by proper vouchers in the prescribed form. Its main purpose has been t o ensure conformity with the relevant administrative, financial budgetary and accounting rules and regulations provided for in the Constitution or the laws made by Parliament. The objectives of a u d ~ against regularity as specified in the Audit code, inter-alia, t are to ensure:
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that there is provision of funds for the expenditure, duiy authorised by competent authority; that the expenditure is in accordance with a sanction properly accorded and is , incurred by an officer competent t o incur it; that the claims are made in accordance with the rules and in proper form; that all prescribed preliminaries t o expenditure a r e observed, such a s proper estimateq framed and approved by competent authority for works e x p e n d i t h e , a health certificate obtained, where necessary, before disbursement of pay to a government servant; that the expenditure sanctioned for a limited period is not admitted in audit beyond that period without further sanction; that the rules regulating the method of payment have been duly observed by the disbursing officer; that payment has been made to the person and. that it has been acknowledged second claim against government o n the same account, a n d recorded 50 t is not possible; a n that the payments have been correctly brought into account in the original documents.

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Audit against provision of funds, aims at determining that the expenditure incurred has been o n the purpose for which the grant and appropriation had been provided a n d that the amount of such expenditure does not exceed the appropriation made. Audit, in relation t o audit'of expenditure, is t o ensure that each item of expenditure is covered by a sanction of the competent authority. Audit against rules a n d orders is a n important aspect of regularity audit. It ensures that the expenditure conforms t o the relevant provisions of the Constitution and of the laws and rules made thereunder. Audit of expenditure against regularity is a quasi-judicial type of work, performed by the audit authorities. It involves interpretation of the Constitution, , rules and orders.

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Receipts Audit
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Receipts audit involves the audit of income-tax and custom and excise receipts at 1 . ., . ,.. , . a . > . .. . -

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level. From the late fifties, receipts audit has been conducted by the Indian Audit and Accounts Department, In receipts audit, the function of audit department is to ensdre that adequate regulations and procedures have been framed and are being observed by the revenue department, to secure an effective check on assessment, collection and proper allocation of revenue. Since the assessments in a revenue department are of a quasijudicial nature, audit should ensure that the discretion used has been exercised in a judicious manner.

Auditing System in I?din

Performance Audit
Financial audit and Regularity audit generally involve scrutiny of individual transactions. They do not focus on the evaluation of a scheme or a programme to which these transactions relate. Therefore, both types of audits have been found inadequate for an evaluation of the performance of an organisation in terms of its goals or objectives. Ever since the Government launched Five-Year Plans, investment on a large scale has been made on developmental activities for acceleration of socio-economic development of the country. In many cases, the investments did not give the expected returns. Therefore, public has a right to know whether the results achieved had been commensurate with the resources invested. The public concern has found expression in the introduction of performance budgeting in government. The change in the thinking of government, In recent tunes, about the need to relate expenditure to corresponding physical accomplishments made it also t o think about the functions of audit. It has been accepted that Regularity audit/Propriety audit is essential for parliamentary control of expenditure. However, in view of the increasing developmental expenditure, under the successive Five Year Plans, a%dit should examine the achievements of specific programmes, activities and projects in terms of their goals or objectives. It has been felt that audit should bring out those cases where utilisation of resources has been sub-optimal. This has resulted in a serious thought being given to the need for performance audit which is also called efficiency unit. Performance audit seeks to find out whether the resources have been utilised efficiently by deploying them in an optimum manner. It highlights the extent to which resources are put to productive uses. It also highlights as to what extent quantified benefits could be expected from such deployment of resources. Although the technique of performance audit is sound and useful, there are many problems in conducting such an audit. Firstly, performance evaluation of an activity can be made only in the light of the objectives, which is expected to achieve. Objectives spell out the results desired from an activity. Whereas inputs are easy to measure for an activity, tremendous effort is required to quantify and measure the resulting output, particularly when this output has a social context. Secondly, according to the concept of Net Welfare, the utilisation of resources has to be optimised not only at the point where they are deployed but also at other points, where the effects of such investments are carried. In other words, investment decisions need to be justified by the application of the technique of social costbenefit analysis. Thirdly, the objectives of investment are often a combination of financial and nonfinancial factors. There may be situations, when these objectives of public investment which are otherwise considered socially desirable, are found incompatible with .immediate financial objectives. For instance, a public undertaking engaged in the hoduction of fertilisers, may have to sell its output a t a low price fixed by the government to support agricultural programmes. If the undertaking does not get adequate subsidy from government, its financial results may present a discouraging picture. The undertaking may have served a long-range national objective of achieving self-sufficiency in food production. But in the process, its profits get reduced considerably or it may incur losses. In situations, where the objectives act against financial performance of a public undertaking, it would not be proper to

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Fourthly, performance audit presupposes a good information system. A good information system is necessary, to furnish information about what has been actually achieved and at what cost, as against what was planned to be accomplished at a particular cost. Lastly, effectiveness of performance audit would depend onthow best the yardsticks of performance have been evolved. The technique of performance audit can be applied successfully in cases, where normslstandards are available for application. It is easier to apply in manufacturing organisations, than in the case of governmental organisat ions. In India, the concept of performance audit is of recent origin. Its scope is unlimited. T o conduct performance audit of public undertakings, Audit Boards have been set up. These Boards have been functioning, under the Comptroller and Auditor General, since April, 1969. The utility of Performance audit can hardly be over-emphasised. It, however, requires expertise in identifying quantifiable objectives in government. It also necessitates framing of precise yardsticks against which the use of resources can be evaluated. In view of these problems, the scope of performance audit in government ,appears to be at present limited.

22.6

INDEPENDENCE OF AUDIT

In India, independence of the audit has been ensured by the Constitution in many ways. Firstly, the Constitution had made audit of the accounts of the Union and of the States a Union subject, by virtue of Entry 76 in the Union List under Article 246 of the Constitution. There is, thus, a common auditor of both the Union Government as well as the States and this is a unique feature of the Indian Constitution. Secondly, the Constitution provides that the Parliament shall have exclusive power to make laws on the subject of audit of the accounts of the Union and of the States. At the same time, the Constitution has not made the Comptroller and Auditor General of India a n officer of Parliament or of the House of the People. In practice also, the States do not regard him as a n officer of the Union but a functionary created by the Constitution for purposes of both the States and the Union Government. Thus, the Comptroller and Auditor General of India occupies a unique place. He certifies the share of the States of the taxes collected by the Union and the amoults so certified are accepted by the State Governments without demur. He certifies the expenditure incurred by the States on public expenditure programmes initiated and financed by the Union and the Union Government accepts the figures without question. The Comptroller and Auditor General of India, thus plays a fiduciary role in the sensitive Union-State relations. Thirdly, the Constitution guarantees the independence of the Comptroller and Auditor General of India by prescribing that he shall be appointed by the President of India by warrant, under his hand and seal, and cannot be removed from office except on the ground of proved misbehaviour or incapacity. Fourthly, while Parliament will be competent to make laws to determine his salary and other conditions of service, they cannot be varied to his disadvantage, after his appointment. Fifthly, on retirement, resignation or removal, the Comptroller and Auditor General is prohibited from holding any further office either under the Government of India or under the Government of any State. % Sixthly, the salary and allowances of the Comptroller and Auditor General, the pension etc., payable to retired Auditors General and the administrative expenses of Comptroller and Auditor General's personal office, shall be charged on the Consolidated Fund of India. That is, they will not be subjected to the vote of ..

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Lastly, the Constitution furtliir provides that thd conditions of service of persons serving in the Indian-Audit and Accounts General shall be determined by the President after consultation with him. The Constitution, thus, provides adequate safeguards to the Comptroller and Auditor General to enable him/ her perform his'/ her constitutional functions, without any fear from the Executive. (These issues are dealj-with in detail in assessing the role of Comptroller and Auditor General in Unit 23.) An independent judiciary and an independent audit are two of the more important elements of democracy. On them, devolves in varying degrees, the responsibility of protecting democracy from authoritarian trends and executive excesses. Our Constitution has taken, therefore, reasonable care to safeguard their independence.

Auditing System in Jndin

22.7

RESULTS OF AUDIT-AUDIT REPORTS AND THEIR FOLLOW UP WITH ADMINISTRATION

Audit conducted by the Indian Audit and Accounts Department is in the nature of ex-post facto examination. In some cases, certain classes of payments are made after the claims have been audited and passed by audit. But these payments comprise a negligible percentage of the total expenditure of government. Since audit is conducted after the events have occurred, it cannot prevent an overpayment or nonobservance of the financial rules and regulations. Also, it cannot stop the executive authorities from the commission of any irregularity or impropriety during the course of t'ransactions. But the effectiveness of audit depends upon its right to report the results of audit to the proper authorities, which may be a departmental authority, the Government itself, or Parliament through the Public AccoOnts Committee. These bodies can then take appropriate action to rectify the irregularity or impropriety. The results of audit are required to be reported by the Audit Officer to the administrative authorities concerned at the earliest opportunity. These authorities then become responsible for the settlement of objections raised by audit authorities. It is also the responsibility of the administrative authorities to effect recovery of any amount disbursed wrongly. The Audit officers keep pursuing the objections raised by them till these are settled to their satisfaction by the administration. Finally, after completion of a year's accounts, the results of audit are reported to the concerned Government and their legislatures through the instrument of Audit Reports. Though Audit Reports appear post mortem, they serve many purposes: They are a n aid to administration/management to ensure that irregularities are not repeated in future. They help the planning process in not conceiving faulty schemes. They give the right signals for mid-course corrections in on-going schemes. They also serve the basis for taking appropriate disciplinary action by the administrative authorities concerned against the persons who have caused loss to the exchequer by their acts of omission and commission to act as a deterrent. Audit Reports should, however, be largely current and should be able to bring out the failures, drawbacks or the deficiencies as quickly as possible, so that prompt remedial measures can be taken by the administration. The Constitution has prescribed the procedure to be followed by the Comptroller and Auditor General for presentation pf the audit reports. The reports of the CAG in regard to the Union Government accounts shall be submitted t o the president and the State Government accounts, shall be submitted to Governor of the State. At present, the Comptroller and Auditor General submits three reports viz., i) Audit Report on the Appropriation Accounts, ii) Audit Report on the Finance Accounts and iii) Audit Report on the commercial and public sector enterprises and revenue receipts on Union and state governments. The responsibility of the Comptroller and Auditor General ceases with the submission of the audit reports to the President/Governor who causes them to be laid before the ParliamentlState legislatures respectively. In actual practice, the audit renorts of various novernments are received hv the Ministrv nf Finance on hehalf of

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the President. The Finance Minister lays them on the table of each House of Parliament. Regarding Audit Reports of states, similar procedure is followed generally. The authority of Parliament and state legislature to grant supplies to be effective, will require that Parliament and legislature should assure itself thdt the money is spent by the executive on purposes for which it was granted. And that the expenditure incurred does not exceed the amount sanctioned by them. The details of these are contained in the accounts and audit reports presented by the Comptroller and Auditor General for both Union and State governments. It is impossible for parliament and legislatures to examine in detail. the accounts and audit reports thereon which are technical and voluminous documents. The Houses are unable to spare the time that a proper examination requires. Parliament (Lok Sabha) and state legislatures have, therefore, set up a Committee known as the Committee on Public Accounts and have entrusted t~ it the detailed examination of accounts (appropriation and Finance) and audit reports thereon. An important function of the Public Accounts Committee is to ascertain that the money granted by Parliament has been spent by the government within the scope of the demand. This implies that the money recorded as spent against the grant, must not be more than the amount granted and the grant should be spent on purposes, which are set out in detailed demand. The functions of the committee extend, however, beyond the formality of expenditure to its wisdom, faithfulness and economy. When any case of proven negligence, resulting in loss or extravagance, is brought to the notice of the committee, it calls upon the Ministry/Department concerned to explain what action, it has taken to prevent a recurrence. In such cases, it might record its opinion in the form of disapproval or pass strictures against the extravagance or lack of proper control by the Ministry/ Department concerned. The Committee is, however, not concerned with questions of policy in the broad sense. The efficient functioning of the Public Accounts Committtee depends largely on the assistance given to it by the Comptroller and Auditor General and other officers. Apart from providing the basic material, audit assists the Committee in many ways. It provides notes to the members of the Committee which explain the significance of an irregularity or impropriety commented upon in the Audit report. Also, the auditors brief the members orally so that they can seek clarification and additional information in the course of oral examination of departmental witnesses. They also assist the committees in drafting reports, after considering the oral and documentary evidence. They also help the Committee in keeping a watch over implementation of those recommendations, which have been accepted by Government. The Public Accounts Committee of ParliamentIState submits its report embodying the findings on the audit reports of the Comptroller and Auditor General to Ministry/Department for implementation. The ministries are required to inform the Committee of the action taken by them on these recommendations within a period of six months from the date of the presentation of the Report. The Committee's recommendations are generally accepted by the Government. In cases, where the recommendations of the Committee are not acceptable to the Government, the reasons for Government's disagreement are placed before the Committee.

check Your Progress 2 Note :
1) i) Use the space given below for your answers. ii) Check your answers with those given at the end of.the unit.

Distinguish between Regularity Audit and Receipts Audit.

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Explain the meaning and scope of Performance Audit in India.

Auditing System ~ Indla

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Discuss the importance of Audit Reports and their utility to administration.

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Audit is an examination of accounting records, undertaken with a view to establishing whether they correctly and completely reflect the transactions to which they purport to relate. Its purpose is to see that expenditure has been incurred with the sanction of the competent authority, applied for the purpose for which it was sanctioned, and is duly supported by vouchers, as a safeguard against fraud and misappropriation. Audit is one of the four pillars of democracy. It is a vital instrument of ensuring effective supremacy of Parliament over the Executive. It is also a valuable ally to administration. The evolution of auditing in India has been a gradual process, coinciding with the growth in the functions of Government. Initially, auditing was primarily expenditure oriented. Gradually, audit of receipts was taken up. With the growth of public enterprises, commercial audit came into being. Recently, audit has gone into the evaluation of the performance of organisations, activities, projects etc. The Comptroller and Auditor General of India is responsible for conducting audit of the accounts of the Union, states and union territories with legislature. He/ She conducts regularity audit, receipts audit, commercial audit, performance audit etc. The Constitution has provided adequate safeguards to protect the independence of the Comptroller and Auditor General from the Executive. He/ She will be appointed by the President but can be removed only by the Parliament. His/ Her tenure, conditions of service cannot be varied to his/ her disadvantage, after his/ her appointment. He/ She cannot accept employment after retirement or dismissal, either under the Union Government or under the state government. His/ Her salary, allowances and pension as well as his/ her establishment will be charged upon the Consolidated Fund of India and not voted. Audit Report is the final destination of audit. The Comptroller and Auditor General submits three reports i.e. Audit report on appropriation accounts, auditreport on finance accounts, and audit report on the commercial and public sector enterprises and revenue receipts on Union and State Governments, to the President/Governor of ry with legisla\turs, who causes them to be e legislatures resp'ectively. The Audit reports ommittee. Besides providing the material, the s the committee, by preparing memos-on ommittee to conduct oral e,xamination and also ittee. In fact, the Comptroller and Auditor d guide of the committee. The Public Accounts stry on the basis of the findings made in
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are accepted By the Government. In case some recommendations are not acceptable to Government, the Committee examines the same and submits Adion-taken Report to the Parliament. To sum up, audit is not an inquisition and its mission is not one of fault-finding. Its purpose is to bring to the notice of the administration lacunae in the rules and regulations, irregularities and lapses and to suggest wherever possible, ways and means for the execution of plans and projects with greater expedition, efficiency and economy.

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22.9

KEY WORDS

Audit Reports: Comments on the regularity and propriety of expenditure as deemed necessary and proper on the results of audit investigation. Corporation Audit: Audit of the accounts of corporation either by or under law made by Parliament.

22.10 REFERENCES
Chanda, Asok, 1958. Indian Administration. George Allen Unwin Ltd.: London. Chanda, Asok, 1960. Aspects of Audir Control, Asia Publishing House: om bay. Handa, K.L., 1979. Programme and Performance Budgeting, Uppal Publishing House: New Delhi. Krishan Y., 1990. Audit in India's Democracy, Clarion Books: New Delhi. Mookerjee Sameer C., 1989. Role of Comptroller and Auditor General in Indian Democracy, Ashish Publishing House: New Delhi. Ramayyar M.S., 1967. Indian Audir and Accounts Department, The Indian Institute of Public Administration: New Delhi.

22.11 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1 1) Your answer should include the following points Audit is an examination of accounting records with a view to establishing whether they correctly and completely reflect the transaction to which they purport to relate. Audit is an instrument of financial control. .Audit is an aid to administration. Audit is one of the four pillars of democracy. It watches the interests of.taxpayer and also helps Parliament to exercise control over the Executive.

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Your answer should include the following points : Statutory audit is an audit conducted by the CAG of the transaktions of the Government of the Union and of each state and Union territory with legislature. St;(tutdry audit serves a three-fold purpose. It is an accountancy audit, appropriation audit as well as admidistrative audit. Internal audit is conducted by an agency within the organisation and% integral to management. Internal audit concerns itself with the examination of accounting, financial and other operations within the organisation. There is no conflict between internal and external audit.

Check Your Progress 2

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Auditing System in !ndia

1)

Your answer should include the following points : Regularity audit consists in checking that payments have been duly authorised and supported by proper vouchers. It ensures conformity with the relevant rules and regulations provided in the Constitution or the laws made by Parliament. Receipts audit involves t'he audit of income-tax and customs receipts. P.urpose of receipts audit is to ensure that adequate regulations and procedures have been framed and are being observed by the revenue departments to secure an effective check on assessment and collection of revenue.

2)

Your answer should include the following points: Regularity audit involves the audit of individual transaction. It is not an evaluation of performance of an organisation, in terms of its goals or objectives. . The change in thinking of Government to link expenditure to accomplishments led audit also to examine the performance of an organisation in terms of its goals or objectives. This is done by the performance audit. There are difficulties in the application of Performance audit viz., difficulties in determination of objectives at micro-level, difficulties in assessing performance in the case of public undertakings, where there are financial as well as non-financial objectives, difficulties in evolving norms/standards for Governmental activities etc.

3).

Your answer should include the following points : Results of audit find expression in Audit Reports. Audit Reports are examined by the Public Accounts Committee and the CAG assists the Committee. The CAG is the friend, philosopher and guide of the Committee. The Public Accounts Committee forwards Report to Government for implementation of its recommendations. Where there is disagreement with the recommendations of the Committee, the Government should forward its views to the Committee within a period of six months which will, after examination, submit an Action-taken Reportto the House.

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UNIT 23 ROLE OF THE COMPTROLLER AND AUDITOR GENERAL WAG)
Structure
23.0 23.1 23.2 23.3 23.4 23.5 23.6 23.7 23.8 23.9 Objectives Introduction Origin and Constitutional Position of CAG Duties and Powers of the CAG in Regard t o Accounts and Audit Other Duties of CAG Role of C A G : An Appraisal Let Us Sum Up Key Words References Answers t o Check Your Progress Exercises

23.0 OBJECTIVES
After studying this unit, you should be able to: understand the origin and constitutional position of CAG; describe the duties of CAG in respect of Accounts and Audit; and analyse the role of CAG in Indian Democracy.

23.1

INTRODUCTION

Exercise of financial control is one of the principal responsibilities of the legislature. Parliamentary financial control on government spending is implemented in two stages: primarily at the time of policy making and subsequently by controlling the implementation of the policy. Budget or the Annual Financial Statement showing the estimated receipts and expenditure of the Government for the ensuing financial year is presented and discussed in the Parliament or Legislature. The initial parliamentary financial control is exercised through the AnnuaI Budget Estimates of the Government for the ensuing financial year, which is presented to the House for approval. The second stage of control o\er the implementation of poIicies is exercised by examining that the funds voted by the Parliament1 Legislhture have been utilised f o r the purpose and in the manner in which the ParliamentlLegislature had desired. The control is exercised through the Financial Committees in Parliament and States Legislatures. During the second stage, the Comptroller and Auditor General of India (CAG) comes t o the aid cjf Parliament and State Legislatures. Audit is the principal instrument to ensure the financial accountability of the Executive to the Legislature of the Union and State. The Comptroller and Auditor Genera1 in India, has been, made responsible by the Constitution. to conduct the audit of the transactions of the Union and the States and Union Territories with Legislature. In this unit, you will study the origin of the office of Comptroller and Auditor General (CAG), the constitutional position and also the powers and duties of the CAG in relation t o accounts and audit. This unit will also make an appraisal of the
role nf C A G in Indian demnrrarv

23.2 ORIGIN AND CONSTITUTIONAL POSITION OF CAG
i) Origin Finance, Accounts and Audit are as old as history itself. History bqars out that a good accounts and audit organisation existed in ancient India. Kautilya in his famous Arthasastra gives an elaborate account of the accounting system that existed in the Mauryan period. According to the Arthasastra, "In the Mauryan policy, the final authority, in the matter of Finance, was the King; one of whose daily duties was to attend to the accounts of receipts and expenditure. Each Minister was responsible for the finance of his department and each department had its own accountant, treasurer and others. The Collector General was the head of the Finance Department. Below him was the special commissioner (Pradeshtara), who was a kind of Government Auditor checking District and Village group account, in addition to being in charge of collecting certain kinds of revenue. The accounting and financial, year closed on the last day of Ashadha". Similarly, Gupta rulers introduced more elaborate and orderly system of accounts and audit during their rule. According to Ramachandra Dikshitar "The accounts were maintained, as during the days of their predecessors, the Mauryas, and were submitted periodically for audit and approval. This is made clear to us by th'e term PATYUPARIKA. This may be translated broadly as corresponding to the modern Accountant General. The Accountant General who presided over the accounts department was responsible to the Council of Minister for his acts. I t is evident that there was an elaborate Department of Accounts in the Gupta time." Likewise, the medieval rulers, viz. Sultans and Moghuls, laid proper stress on collection of revenue and conduct of audit. The Moghuls vested greater authority in their financial chief. by naming him as the Vnrir or Dewan. Although the ancient and medie\,al administrations estahlishcd a coherent account and audit organisations, it \vent illlo decay, during the period of later Moghuls. Subsequently, it was the British. \\ho introduced a proper system of accounting and auditing. This system is hcing l'ollo\ved. by and large. in oui country toda!.. In 1858. when the East lndia Company's administration was taken o\vr by the Crown, a comptementary post ol Accountant-General at the India office was created \ to prepare the accounts of the expenditure incurred in England. Simultaneously, an independent Auditor was appointed by the Crown for the audit of these accounts. This arrangement was, however, shortlived. In 1860, both accounting and auditing f u n a o n s were amalga.mated and placed in charge of the Accountant-General to the Government of India. who was designated as 'Auditor General'. The statutory recognition of the Auditor General came, however, only in 1919, with the introduction of Constitutional Reforms. He was made independent of the Government af lndia and was appointed by the Secretary of State and held office as the administrative head of the Indian Audit Department. during his Majesty's pleasure. The Government of lndia Act 1935 gave further recognition to the importance and status of this office. Thereafter, his appointment was made by His Britannic Majesty and the conditions of his service were also determined by His Majesty-in-Council. His duties and powers were prescribed by rules made under the order of His Majesty-in-Council. His salary, allowances. and pension were made chargeable on the revenues of the Federation. He could be removed from office only in the same manner and on the same grounds, as a Judge of the Federal Court. With the incorporation of the Government of lndia Act 1935 in the Independence Act 1947, the authority of the Auditor-General was further enhanced and the auditor of the Indian accounts in United Kingdom was placed under his administrative control. With the subsequent integration of the princely states in the federal structure of the Indian Union, his audit responsibility was extended to the whole of India. The Constitution Act, 1950, redesignated the Auditor General as Comptroller and Auditor General and made him, alongwith the Judges of the Supreme Court, an rr r.. ..... .._.. . " . . . P
C..

Rok of the Comptrolkr md Auditor Cenad (CAC)

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financial administration of India, whether in the States o r the Union, should come under the coordinating authority of a single officer of Constitution, the Comptroller and Auditor General. ii) Constitutional Position of CAG The Constitution has installed the Comptroller and Auditor General (CAG) as a high independent statutory authority. The CAG is the one dignitary, who sees on behalf of the Legislatures that the expenses voted by them are not exceeded or varied and that the money expended was legally available for and applicable t o the purposes t o which it has been applied. Nothing can fetter the CAG's discretio o r judgement in any manner on matters which helshe may bring t o the notice of the Legislatures in the discharge of his/ her duties. The oath of office under the Constitution requires him/her to uphold the Constitution and the laws and to discharge the duties without fear or favour, affection o r ill-will.

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For the purpose of securing the highest standards of financial integrity of the administration and watching the interest of the tax-payer and also for purposes of Legislative control, the Constitution safeguards the independence and freedom of the Comptroller and Auditor General in the following ways. / , \ 1) Article 148 of the Constitution lays down that the Comptroller and Auditor General of lndia would be appointed by the President by warrant under his hand and seal. The CAG will hold office for a period of six years o r till he attains the age of 65, whichever is earlier. And he can be removed from office only in the same manner and on the same grounds as a Judge of the Supreme Court i.e. by impeachment in Parliament.

2) T o further ensure that the Comptroller and Auditor General cannot be influenced by the Executive, the Constitution provides, as per Article 148(3) that the salary and other conditions of service of the Comptroller and Auditor General are such as determined by law and cannot be varied to his disadvantages, after his appointment.
3) The Comptroller and Auditor General is debarred by Article 148(4) from holding any office either under the Government of India o r the State Governments, after he retires from the office of the Comptroller and Auditor General. 4) Furthermore, as per Article 148(6) all salaries, allowances and pensions payable to o r in respect of persons servihg in t p t office, shall be charged upon the Consolidated Fund of India.

5) The Comptroller and Auditor General is the Administrative Head of the Indian Audit and Accounts Department. His administrative power will be governed by rules made by the ?resident, in consultation with the former. Thus, the Constituti n/assures to the Comptroller and Auditor General. ? constitutional indepdnpence and has also placed him beyond fear o r favour of the ' Executive, whose tda sactions he is expected t o audit.

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23.3

DUTIES AND POWERS OF THE CAG IN REGARD TO ACCOUNTS AND AUDIT
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i) Accounting Duties

The duties and powers of ;he Comptroller and Auditor ~ e n e r a have been prescribed l by the Comptroller and Auditor General's (Duties, Powers and Conditions Service) Act 1971 as required by Article 149 of the Constitution of India. nder the Act, it is the responsibility of the Comptroller and Auditor General to a 4 1 1 expenditure s and receipts of the Government of India, the State ~ o v e r n m e n f and of the Union Territories. H e is also empowered to audit the expenditure and receipts of bodies or authorities substantially financed from Union o r State r e v e n u e s h t h e form of grants
or Inam

As per Section 10 of the CAG (DPC) Act 1971, it is the responsibility of the Comptroller and Auditor General to compile the accounts of the Union and of each State, and prepare the Finance Accounts. Again, it is the duty of the Comptroller and Auditor General to prepare, from the accounts, Appropriate Accounts, showing under the respective heads, the annual receipts and disbursements for the purpose of the Union, of each State and of each Union Territory having a Legislative Assembly. These accounts (i.e. Finance Accounts and Appropriation Accounts) are to be submitted to the President or Governor of a State or Administrator of the Union Territory, as the case may be. He also provides the necessary information to the Union and States in the preparation of their Budgets (i.e. knnual Financial Statement). The functions of the Comptroller and Auditor General, in brief, in so far as accounts are concerned, are mainly: 1) the prescription of forms in which accounts are to be kept in the Union and of the States;

Role of the Comptroller and Auditor General (CAG)

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2) preparation and submission of Finance Accounts and Appropriation Accounts to the President/Governor/Administrator of Union Territory as the case may be, and 33
providing information to UnionlState Governments for preparation of their annual budgets.

ii) Auditing Duties The real duty of the Comptroller and Auditor General is that of an auditor. The primary audit function is to verify the accuracy and completeness of accounts; to secure that all financial transactions viz., receipts and payments are properly recorded in the accounts, correctly classified and that all expenditure and disbursements are authorised and vouched and that all sums due, are recorded regularly in accordance with the demands and brought into account. He/ She acts as a watchdog to see that the various authorities under the Constitution function in regard to financial matters, in accordance with the Constitution and the laws of Parliament and appropriate Legislatures and Rules and Orders issued thereunder. As per the CAG (DPC's) Act, 1971 the auditorial functions of the Comptroller and Auditor General are as follows : a) to audit all receipts into and expenditure from the Consolidated Fund of India and of each State and of each Union territory, having a Legislative Assembly and to ascertain whether the money shown in the accounts as having been disbursed were legally available for and applicable to the service or purpose for which they have been applied. b) to audit all transactions of the Union and of the States relating to Contingency Funds, and Public Accounts. c) to audit all trading, manufacturing, profit and loss accounts and balance sheets and other subsidiary accounts kept in any department of the Union or of a State; and in each case to report on the expenditure, transactions or accou?ts so audited by him.

d) to audit receipts and expenditure of bodies or authorities substantially financed from Union or State revenues. e) to audit the accounts of Government, Companies and Corporaions established by or under the Law of Parliament, or in accordance with the provisions of respective Legislations. to audit account of bodies or authorities by request.

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In connection with the discharge of the auditorial duties,, the Comptroller and Auditor General can inspect any office of accounts under the control of the Union or a State, including treasuries and offices responsible for keeping initial or subsidiary accounts. In short, the Comptroller and Auditor General is responsible for the audit of the accounts of the Union and of the States and of bodies substantially financed '
f r n m ITninn n r C t a t e reveniiec Flirther h e l c h ~ aiiditc t h e arrniintc n f r n m n a n i p c nnrl

corporations and of autonomous autpor/ities, whose audit has been entrusted by law to him/her public interest. In the per/fo#mance of the duties, he/she is assisted by the Indian Audit and Accounts Dep rtment.

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23.4 OTHER DUTIES OF T A ~

, Besides the duties and functions relating to the auditing and reporting upon the
accounts of the Union, of the States and of the Union territories with Legislature, the Comptroller and Auditor General may be entrusted with duties and functions in relation to thegccounts of any other authority or body, as may be prescribed by or under any law made by Parliament. The Comptroller and Auditor General's additional duty a t present, is to undertake audit of companies, the Comptroller and Government companies. In the case of Government companies, the Comptroller and Auditor General may comment upon or supplement the report of the professional auditors. Also, his/her duty involves rendering assistance to the Public Accounts Committee in its functions.
Check Your Progress 1 Note : i) Use the slate given below for your answers. Check youqanswers with those given at the end of the unit. ii)

1) Explain the histodal development of Audit in India and the constitutional position of the Comptroller and Auditor General.

2).< Describe the Accounting and Auditing duties of the Comptroller and Auditor
General.
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23.5

ROLE OF CAG: AN APPRAISAL

The Constitution of India assigns an independent and.important position t o the Comptroller and Auditor General to perform the duties without fear or favour. It has provided adequate safeguards for his/ her independence from the Executive. The office of the Comptroller and Auditor General of India is created by the Constitution itself. I t has perpetual existence like other Constitutional organs of the State viz., the Supreme Court, the High Courts and the Election Commission. The Comptroller and Auditor General is an officer of the Constitution and not an officer of Parliament, even though he/she exclusively serves Parliament and State Legislatures. Thus, the Comptroller and Auditor General occupies a unique place in Indian democracy. i) Appointment, Tenure and Removal of CAG The Constitution guarantees the independence of the C~mptroller and Auditor 4 General by prescribing that he/she shall be appointed by the President of India by warrant, under his hand and seal and shall not be removed from office except on the ground of proved misbehaviour or incapacity. In a democratic set-up, independence in adequate measure is an indispensable necessity for this constitutional functionary

to perform his/her duties undeterred. A.K. Chanda, a former Comptroller and ~ u d o General, has argued in favour of autonomy to "maintain the dignity, r independence, detachment of outlook and fearlessness necessary for a fair, impartial and dispassionate assessment of the actions of the Executive in the financial field". As in the case of a Judge of the Supreme Court, the Comptroller and Auditor General can be removed from office only on two grounds-proved misbehaviour or incapacity. The address must be presented by both houses in the same session, and special majority is obligatory in each house for the passing of the resolution. The procedure for presentation of the address, investigation, and proof of the mihbehaviour and incapacity is to be decided by Parliamentary legislation. Thus, the removal procedure appears to be ji very difficult procedure and service as an effective safeguard against executive interference. ii) ~ e r m of Appointment s The Constitution guarantees his/her salary and other conditions of service, which cannot be varied to his/ her disadvantage after his/ her appointment. Also, the salary, and allowances of the Comptroller and Auditor General, shall be charged on the Consolidated Fund of India. Interference with the Comptroller and Auditor General's function is likely, if the salary and terms of conditions of service are left to the discretion of the Executive. Again, even in the event of Parliamentary displeasure with a Comptroller and Auditor General, his/ her salary, pension or age of retirement will not remain within the competence of Parliament to change, if it so wishes to penalise him/ her. On his/ her retirement, resignation or removal, the Comptroller and Auditor General is prohibited from holding any office under the Government of India or under the Government of the State. The purpose is to keep the incumbents immune from allurement of receiving favours from executive, which in turn might influence his/ her actions or decisions in office, prior to retirement. Indirectly, this provision strengthens the hands of the incumbents in making fearless assessment of executive actions. In actual practice, the spirit of this provision does not appear to have been strictly followed. The Constitution has provided that salaries, allowances and administrative expenses of the Comptroller and Auditor General be charged upon the Consolidated Fund of India. Unlike the other expenses of the Government, his/her expenses will not be votable in the budget. Hence, his/her action and official conduct is intended to be excluded from the scope of Parliamentary discussion and vote. The Constitution has thus accorded a very strong protection against Parliamentary interference with the working of the Comptroller and Auditor General's organisation. iii) Duties and Powers Parliament has prescribed the duties and powers of the Comptroller and Auditor General by enacting the Comptroller and Auditor General's (Duties, Powers and Conditions of Service) Act 1971. With the separation of accounts from audit in certain departments of Union Government, the Comptroller and Auditor General had ceased to be responsible for maintaining the accounts of Food, Rehabilitation, Supply Departments, Lok Sabha and Rajya Sabha Secretariats, since separate accounts offices were in existence for them. In 1976, the Government of India took on accounting functions under its own administrative Ministry/ Department with the result that separation of accounts from aylit in Central Government became complete. But the responsibility for preparing annual accounts separately for each of the State Governments and Union territories havirig Legislative Assemblies and to submit them to the Governor or Administrator respectively remains with the Comptroller and Auditor General. The combination of auditing functions in one authority, though justified on grounds of economy, is contrary to the pdnciples of independence of Audit. It amounts to making the Comptroller and Auditor General '4 partly responsible to the Executive and Legislature. He/She becomes answerablefa, Parliament and Legislature for his/ her accounting duties, which is an executive responsibility. Moreover, the accounting.authority will hesitate in publishing in its Audit Reports, major instances of accounting irregularity arising out of the accounts compiled by itself. T o that extent, auditing functions would suffer. The Constitution prescribes that the Comptroller and Auditor General is the authority to prescribe the forms in which the accounts of the Union and of the States shall be kept. The purpose of having a centralised system of accounts is primarily to ensure uniformity and economy. Moreover,the technical expertise of

Role of the Comptroller and Audltor General (CAC)

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Accounta and Audit

Comptroller and Auditor General in accounting matters of the Union and States is to be taken advantage of by the Government in the preparation and presentation of Annual Budget. So, the provision has its own advantgges. It entrusts the Comptroller and Auditor General with a very important responsibility. iv) Audit Reports The Constitution has prescribed the procedure to be followed by the Comptroller and Auditor General for presentation of his/ her reports. His/ her reports, in regard to the Union Government accounts, shall be submitted to the President. And the accounts of the State Government shall be submitted to the Governor of the State. His/ Her responsibility thereafter ceases. But it becomes obligatory for the President/ Governor to cause them to be laid before the House of Parliament/ State Legislature respectively. He/ She submits three Reports viz., Audit Report pp- ' Finance Accounts, Audit Report on the Appropriation Accounts, and ~ u d Report t on the Commercial and Public Sector Enterprises and Revenue Receipts on'U&n and State Governments respectively. The Constitution does not prescribe any form or guidelines for the contents of the Audit Report of the Comptroller and Audit General. It has thus been left with the Comptroller and Auditor General, the complete freedom and discretion to decide the form, the materials and the contents of the reports. v) Limitations Inspite of the various safeguards provided by the Constitution to maintain the independence of Comptroller and Auditor General from the Executive and Parliament, his/ her independence appears to be limited by four factors viz., (a) restraint of the Executive on his/ her budgetary autonomy (b) block of control over staff (c) indirect accountability to the Finance Ministry of the Union and the Finance Department of the State Government for handling accounting duties (d) absence of direct access to Parliament (unlike the Attorney General) in defence of his/ her official conduct, if and when questioned on the floors of Parliament. To conclude, notwithstanding these limitations, the Comptroller and Auditor General plays a unique role in rndian democracy, by upholding the Constitution and the laws in the field of financial administration. He/She is neither an officer of Parliament nor a functionary of Government. He/ She is one of the most important officers of the Constitution and his/ her functions are as important as that of Judiciary.
Lheck Your Progress 2 Note : i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.

1) Evaluate the role of the Comptroller and Auditor General in Indian Democracy.

2 . LET US S U M UP 36
As already mentioned, the Comptroller and Auditor General of India ensures the supremacy of the Parliament over the Executive in financial matters. He/She is an officer of the Constitution and not a n officer of the Parliament. The independence of the CAG is guaranteed by the Constitution in many ways to enable him/ her to

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perform his/ her functions without any inteference from the Executive. His/ Her primary duty is to uphold'the Constitution and the laws in the field of financial administration.

Role of the Comptroller and Auditor General (CAG)

23.7 KEY WORDS
Compilation of Accounts: T o compile is to compose and arrange materials collected from other records. The initial accounts of Government transactions in India are prepared by the authorities through whom the transactions occur; these authorities being unconnected with the Indian Audit and Accounts Department. Stores and Stock: The term "stores" applies generally t o all articles and materials purchased or otherwise acquired for the use of Government. The term "stock" refers to plant, machinery, furniture, equipment etc.

23.8 REFERENCES
Chanda, Asok; 1968. Indian Administration, G. Allen and Unwin: London. Chanda, Asok; 1960. Aspects of Audit Control, Asia Publishing House: New Delhi. Chandrasekhar R.K., 1990. The Comptroller and Auditor General of India, Ashish Publishing House : New Delhi. Ramayyar A.S., 1967. Indian Audit and Accounts Department, The Indian Institute of Public Administration : New Delhi. Sameer C. Mookejee, 1989. Role of the.Comptroller and Auditor General in Indian Democracy. Ashish Publishing House: New Delhi.

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23.9 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress 1
1) Your answer should include the following points : Accounting system in the ancient and medieval period. Amalgamation of Independent Accounting system in 1857 by Lord Canning. In 1860, auditing and accounting functions were amalgamated and placed in charge of an Accountant-General. Statutory recognition to the Auditor General in 1919. Government of India Act of 1935 gave further recognitlion to the impo ance and status of the office of CAG. Constitution Act, 1950 redesignated the Auditor-General as Controller and Auditor General and made him an officer of the Constitution.

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Comptroller and Auditor General is an independent statutory authority. The CAG is appointed by the President and can be removed only by the Parliament. The CAG's tenure is fixed for six years o r age of sixty five, whichever is earlier. The CAG's salary, allowances and pension are charged a n d n o t voted. The CAG' is debarred from accepting employment either under the Union Government or State Government, after demitting the office, of CAG.
2)

Your answer should include the following points:
Thn

PAc

nracrrihac thn fnrmc

i n

rvhir-h thn o~~nnnntc thn 1Tn;nn nnrl nf thn nf

The C A G prepares the Appropriation and Finance Accounts and submits them to the President and Governor in respect of the Union and of the States respectively. The CAG renders assistance to the Union/ States in the preparation of their budgets. The CAG audits the accounts, expenditure and receipt of the Union/ States. The CAG audits the bodies substantially financed from UnionlStates resources. Check Your Progress 2

1)

Your answer shoud include the following points: Independence of the Comptroller and Auditor General is assured by the Constitution in many ways viz., Appointment, Removal, Fixed tenure, salary and terms and conditions of service. Limitations in regard t o control over staff, budget and direct access t o Parliament. The CAG upholds the Constitution and the laws in the field of Financial Administration.

UNIT 24 FINANCIAL ADMINISTRATION OF PUBLIC ENTERPRISES
Structure
Objectives Introduction Meaning and Importance of Financial Administration in Public Enterprises Functions of Financial Administration in Public Enterprises Financial Objectives for Public Enterprises Financial Organisation of Public Enterprises Investment Management in Public Enterprises Public Enterprises-Sources of Finance Financial Performance of Public Enterprises Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

24.0 OBJECTIVES
After going through this unit, you should be able to: explain the meaning 'and importance of financial administration in public enterprises (PEs) discuss the functions of financial administration in PEs describe the financial objectives and organisation of PEs explain the investment management and financing of PEs; and evaluate the financial performance of PEs.

24.1 INTRODUCTION
Financial administration is the key functional area in the management of PEs. The financial administrators of PEs have to interact continuously with the other operating administrators in the enterprise to achieve the financial objectives. Finance is a service function and, therefore, the counterparts of financial administrators in other operating departments approach them to receive the requisite decisional inputs to execute their responsibilities. In all the stages of operations, finance function occupies the place of primacy. Under gestation, finance is required for the implementation of projects. In the normal run of the business, finance provides capital for meeting the day-to-day needs i.e., working .capital. In expansion, finance provides resources both for current operations and execution of new projects. In this unit we shall discuss the meaning, importance, functions of financial administration in PEs. The financial objectives and organisation of PEs shall be dealt with. Various aspects of investment management and financing of PEs shall be described. The financial performance of PEs in India shall be evaluated.

24.2 MEANING AND IMPORTANCE OF FINANCIAL ADMINISTRATION IN PUBLIC ENTERPRISES
Financial administration in PEs has been defined variously. According to one f school o thought, financialadministration in PEs means raising the funds to fulfil
the firrlmeino n&.
This &finitinn limits the m n e nf financial adminiahatinn i n

Financial Admin&tratloao f Pubh: Enterprka

the methods and instruments of raising finance. It presents the conventional view of financial administration in PEs. Today, financial administration goes far i beyond the task of raising finance and deciding about the m x of financial instruments. According to another view, financial administration in PEs deals with the management of cash. This definition implies that all such activities which affect the cash flow in PEs can be considered as financial administration. This is a very broad definition of financial administration as there cannot be many activities which do not influence the cash flow in PEs and as such it lacks operational validity. Some experts conceptualise financial administration in PEs , as that group of activities which deal with raising of finance, its allocation among different purposes and monitoring their financial performance. This definition possesses conceptual claiity and also combines operational validity.
As noted earlier, financial administration is one of the major functions in PEs. It has to frequently interface with other business finctions. A healthy interaction between finance and nonfinance administrators is a pre-requisite for a successful functioning of PEs. In reality, however this interaction hardly exists. Despite the usefulness of financial input in operating decisions, the operating administrators refrain from interacting with the financial administrators. There is a popular belief that finance function is disliked by the various functionaries in PEs. However, a study on the audit practices camed out by the Institute of Public Enterprise reveals that about 85 per cent of functionaries at all levels and in the different age groups preferred the continuation of audit. The financial administrators have brought this important function to disrepute because they try to control the performance of their counterparts in the operating departments more in terms of means and procedures than ends. In terms of the help provided to the non-finance exehtives, the financial administrators are found mostly indifferent. The ideal situation is one of providing active help. The exercise of the preparation and execution of budgets can be cited as a case in point. The budget should not be reduced to a game of numbers by financial administrators. It should be transformed into an exercise that may enlist the support and cooperation of all functionaries in PEs. On the part of the non-finance functionaries, they will do well to inculcate a positive approach to finance function and overcome the inertia of consulting the financial administrators as and when required from time to time.

24.3 FUNCTIONS OF FINANCIAL ADMINISTRATION IN PUBLIC ENTERPRISES
The financial policy of PEs is designed to achieve an optimal output at the lowest cost. It further aims to arramge to provide the financial inputs in a manner that may contribute to smooth functioning of PEs. In the effort to achieve this end, financial administrators have to execute the following functions:

Acquisition of Long-Term Sources of Funds
The financial administrator has a dual responsibility with regard to the acquisition of funds. HeIShe advises on the choice of appropriate sources of funds and then takes steps to procure the funds from the chosen sources. The funds employed in the enterprise may be classified into two groups long-term funds and short-term funds. The long-term sources of funds are further classified as debt and equity. Successful enterprises seek debt in preference to equity for reasons of cost, convenience and control. Debt is a less expensive source, since tax savings are poesible on intereat paid. Servicing equity, on the other hand, entails payment of tax. The overall cost of capital, therefore, varies in an inverse proportion to the debt component in the capital structure of the enterprise. Secondly, debt is relatively more convenient to obtain when needed and to redeem when not required. Debt does not also result in any dilution of control over the affairs of the enterprises since lenders do not acquire any voting rights. Lastly, low-cost debt provides a leverage which helps in achieving a higher rate of return on equity. There are,however, definite limits to debt financing.Debt involves financial risks which need t be commensurate with the business risks. The business risks arise o

'from likely changes in demand for the product, emergence of competition or imposition of controls over prices, imports, exports etc. The financial risk grows in proportion to the debt component in the capital structure. It is essential to set definite limits to debt financing. Limits to debts are fixed keeping in mind three interrelated standards, namely, industrial norms, debt servicing capacity and the cash adequacy during recession. 1) Each industry adheres to certain norms of capitalisation on the basis of its asset structure and magnitude as well as volatility of its earnings in the long run. Industries whose earnings are subject to high risks of obsolescence prefer self-financingand go in for a large equity base which can withstand the shocks.

2) The second factor, namely, the debt servicing capacity is taken as a fraction
of the annual cash accruals. Conservative bankers insist on debt service coverage ranging from 200 to 300 per cent. 3) The cash adequacy standard is a variant of debt service capacity standard and is based on cash flows expected during the recession period. The objective is to ensure the required capacity to service the debt even under the worst circumstances. The three norms together guide the management in deciding the limits upto which it can seek funds in the form of debt. It may be relevant to have a closer look at the equity-debt proportion in the capital structure of the central PEs. There are very few instances where the debt is more than the equity and even in these cases, the excess is due to the erosion of net worth because of accumulated deficits. The overall position is more or less in confirmity with the age-old policy of the government to maintain a 1:l ratio for debt and equity.
Acquisitlaa of Short-Term

Souras

The current assets held by one enterprise are financed mainly from short-term sources. However, the long-term sources are supposed to provide the margin money and also take care of investments in the core current assets. Bank borrowings in the form of overdrafts or cash credit, suppliers' credit and other current liabilities constitute the major sources of short-term finance available to an enterprise. Bank borrowings have become so expensive now-a-days that they are exerting a restraining influence on the enterprises. They are trying to manage their current assets more efficiently and are at the same time, looking for alternative and less expensive sources of short-term finance. The government follows the policy of asking PEs to obtain their credit requirements from the nationalised banks. In those cases where the enterprises are short of margin money, the government extends a guarantee to cover the deficit. When they find it impossible to obtain their total requirements of working capital from the banks, the government provides, short-term loans for a specific period.

Investments In Loag-Term Assets
The enterprises employ their capital partly in fixed assets and partly in current assets. The financial administrators have to ensure that funds at the disposal of the enterprise are judiciously employed and that the proposals for further investments are economically viable. The investments in fixed assets involve substantial long-term commitments in terms of finance as well as technology. The proposal far each investment is to be, therefore, subjected to a cost benefit analysis.
A professionalanalyst makes use of a number of techniques like average rate of

return, internal rate of return, pay back period, net present value (NPV) etc., for carrying out the cost benefit analysis. All these techniques help financial administrators in choosing the best project. (Refer to Section 24.10 on Key Words for explanation of these terms.)

Major investment decisions may be subject to external pressures on the enterprise. But the decisions on current asset-holdings fall well within the scope of internal

Financial Adrninbtrationof
Pubk Enterprises

management. Investments in inventory can be regulated to ensure that excess stocks and stock-outs are avoided. Similarly, efficient management of trade credit helps in keeping the investments in sundry debtors to the absolute minimum. Better management of cash offers scope for reducing the interest burden on the enterprise. The techniques of ABC analysis, economic order quantity, re-ordering level, value analysis, etc., help managing the current assets more efficiently.

Planning S s e s ytm
The planning process in the enterprise includes strategic planning, long-term corporate planning and annual performance budgeting. It also covers economic and financial analysis needed for short-term decisions. Strategic planning refers to planning of major strategies concerning expansion, diversification, taking up manufacture of new products, entering new markets, etc. The financial administrator plays a crucial role in marshalling the relevant costs and benefits and in advising the management on the long-term financial implications in terms of outlays and cashflows expected. HeIShe works closely with the team engaged in the stratesic planning process. The criteria for investment decisions mentioned earlier are integral to the process of strategic planning. Long Range Corporate Planning is the process of developing a time bound plan for achieving the objectives of an enterprise over a period of five or more years. It takes into account all the on-going activities as well as the new projects being taken up and prepares an integrated total plan for the enterprise as a whole. Here again the financial administrator plays a major role in assimilating the data, appraising the alternatives and developing master budgets and financial forecasts for covering the plan period. The Nrformance budget is an extension of the corporate plan. It is prepared in greater detail and sets physical and financial targets for each responsibility centre and builds the efficiency norms into them. The budget thus serves as an instrument of planning and control. Since profitability is not the guiding index of efficient performance, what is needed is a system for review and target setting for each segment of the enterprise. The Management by Objectives (MBO) may also provide a framework for formulating and implementing the performance budget. These budgets enable decentralisation of authority and centralisation of wntrol. Budgets also help management-by-exception.
Operating Decisions

There are very few decisions at the enterprise level which do not affect its funds. It is, therefore, logical for the financial administrators to have a say in those decisions. Leaving aside the investment decisions mentioned earlier the operating decisions cover a wide range of problems such as capacity utilisntion, pricing, overtime working,' shift-working, product-mix, credit policy and incentives.
Control S s e s ytm

Budgetary control and standard costing systems provide the basis for monitoring enterprise performance at all levels. They introduce a participative element in the target-setting exercise.
,

The financial administrator is expected to develop an integrated system which incorporatesfinancial accounting as well as management accounting systems. The system has to be so designed as to generate data for compiling periodical reports to be sent to the administrative ministry, Finance Ministry and Planning Commission etc. It should also provide information to enterprise managers at all levels about their achievements vis-a-vis plans and targets. These managers need assistance in identijlng and analysing cost variance as well as profit variance. Internal Audit is considered to be an integral part of finance function in most of the PEs. It is internal appraisal and is mainly concerned with the evaluation of the effectiveness of managerial controls including systems and procedures. The external'auditors rely very much on the internal audit for ensuring the credibility of basic records.

The financial executive coordinates with statutory auditors in carrying out the external audit. PEs are audited directly by the Comptroller and Auditor General of India (CAG) or by chartered accountants appointed by ,him as auditors. In the latter case, he has powers to carry out a supplementary test audit. There is an audit board which coordinates the external audit work in respect of central PEs in India.

24.4 FINANCIAL OBJECTIVES FOR PUBLIC ENTERPRISES
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PEs are different from private sector enterprises in terms of their nature as well as their obligations to the nation. The private sector enterprises possess a great deal of clarity in terms of their objectives which is essentially the maximisation of their profitability. PEs are composed of two terms, viz. 'public' and 'enterprise'. By being 'public' these enterprises stand accountable to the government. Their management and ownership also rests with the government on account of this characteristic. The term 'enterprise' meansthat PEs have to produce certain goods or render certain services at a price resulting in excess of income over expenses which should be duly reflected in the profit and loss account and balance sheet. Further, these enterprises operate in diverse sectors including manufachuing, financial, promotional and welfare activities. There are about 1100 State Level run by state governments of the Indian Union and Public Enterprises (SL~ES) 240 central PEs. However, these enterprises can still have uniform financial objectives which may range from the retention of the net worth to its maximisation implying the fact that enterprises at the bottom of the scale will have to keep their net worth intact whereas enterprises at the other point of the scale can multiply their net worth in a business like manner. The welfare enterprises engaged ' in serving the needs of the weaker sections of the society are not suited for profit maximisation. However, in order to maintain their present level of operations and their likely expansion, they must keep their net worth intact. On the other hand, the manufacturing enterprises operating in competitive sectors can maximise their net worth based on the market leads.
Check Yow Progress 1

Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.

. .

---. .-

1)

Why is financial administration the key functional area in the management of PEs?

.......................................................................................................

2)

Summarise the functions of financial administration in PEs.

F i i d Admi~btrntion of ~ u ~Enterprim l e

24.5 FINANCIAL ORGANISATION OF PUBLIC ENTERPRISES
Organisation for finance has undergone a radical transformation in PEs with the changes in the environment governing PEs and their structures. The financial organisation has acquired sophistication and complexity with the marketisation and partial privatisation of PEs. Diagram 1shows a typical organisation chart of the Financial Management Division in PEs.
Board of Directors Chairman-cum-Managing Director

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Direaor (Muction)

Director (Marketing)

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Director (Personnel)

Director (Finance)
Executive Director (Finance)

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General Manager (Finance)

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Deputy General Manager (CorporateF-CC) Finance Manager Deputy General Manager (Accounts) Senior Finance Manager Deputy Finance Manager

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Chief (Fmance) (One at each UnitlRegion)

~ e ~ F & u -

~anqer

Senior ~ k u n t Officer s Accounts Officer

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As the diagram shows, the Finance Division is headed normally by the Director (Finance) who holds a board level position. He advises the Chairman-cum-Managing Director (CMD) on all matters pertaining to finance and accounts. He is responsible for formulating and coordinating the financial plans. He executes a staff function and at the same time happens to be a line authority for the executive in the finance department. He is assisted in his task by Executive Director (Finance) and General Manager (Finance). The Executive Director is assigned some specific tasks besides helping the Director (Finance) fi the formulation of financial policy. These may include responsibility for audit and preparation of budget. The General Manager (Finance) is saddled with routine affairs such as the preparation and finalisation of accounts, compilation of budgets, handling of cash credit and arranging corporate finance. In most of the PEs, the Director (Finance) is recruited by the Public Enterprise Selection Board. The earlier convention of deputing the officer from the Finance Ministry or the Indian Audit and Accounts Department has been abolished by the government. Diagram 1shows that in case an enterprise is a multi-unitlmulti-productconcern, the financial organisations provide for a functionary (normally of the level of General Manager) to head this function at the various locations or product groups.

24.6 INVESTMENT MANAGEMENT IN PUBLIC ENTERPRISES
Investment proposals for esiablishmefit of new units or expansion of existing units emanate either from ministriesldepartments of the government or from the

enterprises desiring expansion and growth. The broad nature of investment is determined by the priorities indicated in the National Plan. Individual investment proposals are required to be within the overall programmes outlined in the plan document. The government exercises a measure of control over the size and pattern of investments in the PEs by reserving to itself the power to approve capital outlay exceeding certain financial limits. The government also exercises control over such investments through the mechanism of scrutiny and approval of the annual capital budgets of the concerned enterprises. The investment proposals are examined by various agencies of the government including the Projects Appraisal Division of the Planning Commission and the Plan Finance Division from financial, technical, economic and management viability angles. Their relevance to the overall plan objectives, availability of resources, social cost-benefit, etc., are also assessed. All investment proposals costi~lg Rs. 20 crore and above require approval of the government at the highest level after these are cleared by the Public Investment Board. The Public Investment Board is constituted with the Secretary (Expenditure) in the Ministry of Finance as Chairman. Its other members include Secretary, Planning Commission, Secretary, Department of Economic Affairs, Secretary, Industrial Development, Secretary, Department of Public Enterprises, Secretary to the Prime Minister and Secretary of the Administrative Ministry which has made the investment proposal to the Board. As per the delegation of financial powers effective from 8th June 1988, the powers of the ministryldepartments with integrated finance system, for sanctioning projectslschemes, was enhanced upto Rs. 20 crore but this power can be exercised after following usual Expenditure Finance Committee (EFCYprocedure and after obtaining the comments of the Planning Commission and other appraising agencies. Projects costing Rs. 20 crore and above continue to be considered by the Pqblic Investment Board, and Cabinet Approval is also obtained where expenditure is Rs. 20 crore or more. The powers of the Board of Directors of PEs to sanction capital expenditure were also enhanced in August 1986. As per the revised delegations, the powers of the Board of Directors are as indicated below:
Public Enterprises with Gross Blocks of: Less than Rs. 100 crore Between Rs. LOO crore and Rs. 200 crore Above Rs. 200 crore Power to sanction capital expenditure without urior auuroval of Government Rs. 5 crore Rs. 1,O crore Rs. 20crore

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In addition to the above delegation, Government (vide O.M. dated 7.11.88 and 29.8.1990) has further delegated enhanced powers to Board of Directors of Memorandum of Understanding (MOU) signing companies'to incur capital expenditure. As per the revised delegation, it has been decided that in respect of companies signing MOUs and .having gross block of w e r R . 200 crore, the s power to incur expenditure on additions, modifications and new investments will be raised from the existing limit of Rs. 20 more to Rs. 50 more without prior approval of the government. Further, the power to incur expenditure on replacement renewal of assets from the present limit of Rs. 50 crore to Rs. 100 more is provided subject to certain conditions.

24.7 PUBLIC ENTERPRISES-SOURCES OF FINANCE
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There are various sources of financing PEs. These mainly constitute equity and grants received from the government, public participation in equity, borrowings from the open market in the form of public deposits and issue of bonds, foreign investment and cash credit advances. The governmknt is the main provider of funds to PEs. It finances PEs through equity grants and borrowings. The borrowings are provided at a ratcof interest of 14-16 per cent per annum for long-term funding. The equity #isprovided for long-term funding at no cost. Thus, the equity represents the perpetual interest-free capital. To check the misuse of cost-free funds, the government has initiated a
.

Financial Administration of
Publk Enterprises

scheme of disinvestment of equity in PEs from 1991-92 in which year Rs. 3,000 crore was received from the sale of PE shares through mutual funds. The government's total equity in the Central PEs was of the order of Rs. 38,634 crore as on March 1,1990. The long-term loans provided by the Government to PEs amounted to Rs. 24,585 crore as on the same date. The central government provided about 68 per cent of the total financing needs to these enterprises in 1989-90. The foreign participation in terms of equity and debt amounted to Rs. 14,221 crore as on the same date which amounted to about 14 per cent of the total financing needs in 1989-90. The equity and loans provided by the financial institutions amounted to Rs. 5,213 crore and constituted about 5 per cent of the total financing needs as on March 31,1990. The private participation by way of bonds, equity and public deposits amounted to Rs. 60,496 crore which represented roughly 16 per cent of the total financing needs as on March 31, 1990. The working capital requirement of PEs are generally met through cash credits and advances arranged with the State Bank of India and nationalised banks. The total amount of outstanding cash credit drawn by the central PEs stood at Rs. 13,973 crore as on March 31, 1990. In special cases nonplan loans also are arranged by the central government to some enterprises to meet their working capital requirements. As on 31 March'1990 an amount of Rs. 14.40 crore was due from these enterprises under this head. Despite the recommendations made by several expert committees/commissions such as the Krishna Menon Committee (1959), Administrative Reforms Commission (1967) and Committee on Public Undertakings (1971), these enterprises did allow public participation in their equity. The internal financing through generation of internal funds by way of depreciation, write-offs and retained profits constitute another important source of financing PEs. Internal financing is a cost free source of finance. Between 1985-86 and 1989-90 internal resources generated by these enterprises stood at Rs. 37,677 crore. Not only the volume of internal generation of resources increased between 1985-86 and 1989-90 from Rs. 5,067 crore to Rs. 10,779 crore, respectively, but the number of PEs generating internal resources also increased from 126 to 150 during the same period. The generation of internal resources reduces the dependence of PEs on the government and thereby acts as an important measure of autonomy.

24.8 FINANCIAL PERFORMANCE OF PUBLIC ENTERPRISES
Financial performance of the Public Sector has assumed critical importance in the present context of severe resource crunch faced by the Indian economy. The public sector in India contributes 25 per cent to the country's Gross National Product. It holds a position of great strength in several economic activities despite the present move about privatisation. It is expected that PEs in India will double their size in terms of the investment from Rs. 3 lakh crore at the end of Seventh Plan to Rs.6 lakh crore at the end of the Eighth Plan. These enterprises contribute substantially to our foreign trade. About 20 per cent of the foreign trade is transacted through these enterprises. Table 1 shows that the central PEs with an investment of over Rs. 1,10,000 crore as on March 31,1991 had earned profits of less than Rs. 3,000 crore. The table also shows that the profitability of the central PEs declined by 40 per cent during 1990-91 over the previous financial year.

Units.

1980-81 1983-841984-85 1985-861 8 . 7 1987-881988-89 1989-90 1 9 - 1 968 909 3 4 5 6 7 8 9 10
11

1

2

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1. Number of running Public Enterprises Number 2. Crpital Employed b.Crore 3 Turnover . b.Crore 4. Gross Margin (Rofit before depruiation. intertn and b.Crore tax) . . 5. Dqmuuum*Rs.Crore 6. Gross profit before interest and tax Rs.Cm Rs.Crore 7. Interest 8. Netpro6t beforetax Rs.Cron 9. Tax b.Crore 1 .Net M t 0 after tax Rs.Crore 1 .Internal 1

163

21 0

207

211

214

21 2

26 2

233

236

18207 29855 36382 42965 51835 55554 67629 84869 401797 28635 47272 54784 62360 69088 81271 93137 1 118355

2401 983 1418 1399 1 9
222

5771 2205 3565
20%

7386 2758
4628

83 20 2983
5287

9897 11134 13438 16412 18510 3376 4150 4866 5790 7151 6521 3420 3101 1330 1771
6984

2529

3115 2172 Mob 1172

3595 3389 1329
#)60

8572 10622 11359 4167 5329 7539

1480 1239
240

2099 1190
909

4405 1411
2994

5293 1504 3789

3820
1452 26 38

-203

Resogenerated (Grw 12.Net M t (after tax) to capital employed Rs.Crore

1225

3278

4251

5068

6014

6947

8915 10774 llj72

Percent

-1.1

0.8

25 .

2.7

34 .

37 .

44 .

45 .

23 .

I n d u b deferred revenue expenditure.
(Swra: Financial Express, Economic Survery: 1991-92,Bombay. March 1 1992. p. vii).

Table 2 shows that the position of the state level PEs was none too good. These enterprises incurred losses continuously.
T.bb2:PLudrl-d-CouaeblU-dSt.baPrUTs
[profit(+)(Loss(-)I (Rs. more)

1985-86 1 8 - 7 1987-88 1988-89 19 968 -0
1. Deport. Comm. Und&&np'

1990-91
(R.E.)

191-92
(B.E.)

i. Forest
ii. Power Rojcas i . Road & Water Tpt. u

497.70 516.21 543.69 -75.04 -93.81 -116.40 -25.65 -99.29 -14.10
40.06

414.35 540.24 -84.19 -34.83

324 7.6 -54.M

528.33 -42.98

S e ~ a s iv. Dairy Development v. Industries vi. Mines & Minerals vii. Irrigation Rejects (Commercial) viii. Multipurpose River Projects
2. RontdRontEmklng

-36.59 -110.76 -40.45 -43.91 -16.46 -20.51 35.05 27.02

-56.51 -93.21 -75.78 -64.10 -52.38 -106.99 -72.23 -77.18 -10.09 -159.66 - 1 . 1 -40.04 129 51.83 60.62 60.43 75.26

-871.60 -1225.95 -1344.50 -1840.79 -1916.85 -2002.63 -22M.66

3. ld6sdld6smmkhg

-u u

537.76

551.h

570.71

466.18

600.86

432.89

603.59

-1068.68 -1413.26 -1636.08 -2043.96 -2311.54 -2318.11 -2430.96

4 Net FinMddR e d .
-d tU

-547.92 -862.00 -1065.37 -1577.78 -1710.68 -1885.22 -2430.96

These do not include'state Electricity Boards and Road Transport Corporations. (Source: Financial Express, Economic Survey: 1991-92,Bombay, March 1, 1992, p. vii)

Financial Administration of Public Enterprises

However, there are PEs which have had an unblemished profit making record. Some of these enterprises include the Oil and Natural Gas Commission, Bharat Heavy Electricals Ltd., Electronics Corporation of India Ltd., Air India, Hindustan Petroleum Corporation Ltd., Indian Petro Chemicals Ltd., Indian Oil Corporation Ltd., National Thermal Power Corporation Ltd., Steel Authority of India Ltd., Oil India Ltd. The top ten loss making enterprises as on March 31,1990 included Hindustan Fertiliser Ltd., Fertiliser Corporation of India Ltd., Indian Iron and Steel Company Ltd., Delhi Transport Corporation Ltd., Engineering Projects Ltd., Hindustan Ship Yard Ltd., Hindustan Steel Works Construction Corporation Ltd., Cement Corporation of India Ltd., National Jute Manufacturers Corporation Ltd., and Hindustan Cables Ltd. The dismal financial performance of PEs has resulted from sub-optimal project planning, under utilisation of capacities, lack of aggressive marketing, poor production and planning and control, unsuitable product mix and over-staffing. Externally, the failure of PEs in managing the environment to their advantage has also contributed a lot to this phenomenon. An efficient and effective financial administration can turn the corner of the ailing PEs. One way of turning the PEs around is to resort to the introduction of the OPTIMA (optimum performance through internal management action) in PEs. This will resultin commercialisation, corporatisation, restructuring and privatisation of PEs. The PEs will do well to adopt the private sector style of management. Externally, the government-PE interface needs to be made harmonious. The introduction of Memorandum of Understanding (MOU) is a step in the right direction. The financial administration in the PEs in 1990s is expected to proceed along new lines. In the field of financing, PEs will resort increasingly to capital market. They will also make forays into international capital markets. They are likely t o get listed on various stock exchanges in the country and their shares will be available for trading. The function of financial administration is expected to acquire participating orientation. The use of electronic data processing systems is likely to replace the hunch-driven decisions in the realm of finance administration. The cost of capital is expected to assume primacy in the area of financial decision making in PEs.

Check Your Progress 2
Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.
1) State the names of various institutions involved in the appraisal of investment decisions in PEs.

2)

How do PEs arrange their working capital?

....................................................................................................... .......................................................................................................

3)

List the various sources of financing long-term needs in .PEs.

4)

Give reasons for dismal performance of PEs in India.

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Financial Admioistratlon of Public Enterprises

LET US SUM UP
PEs constitute an important segment of the economic system in India. Their contribution to the national economy is phenomenal. Their effective functioning is crucial for the success of the planned economic efforts. The effectiveness of financial administration, measured in terms of profitability, points out that these enterprises have lagged far behind the expectations. They can make significant improvements in respect of the three components of financial administration viz., investment management, financing and checking upon their financial performance. The function of financial administration is undergoing a sea change in PEs. These enterprises have started organising their financial organisation in a businesslike manner. They have commenced efforts to reduce their dependence on the government through the capital market. They have initiated exercises to review their investment portfolio to weed out non-operating assets. There is a great scope for toning up, further the activities pertaining to financial administration in PEs.

24.10 KEY WORDS
Assets: These are the resources owned by PEs. ABC Analysis: It is the analysis of range of items in an organisation on cost criteria. A items are considered very important which represent high cost centre; hence need tight controls, strict and close watch, rigid estimates of requirements. B items are of intermediate cost centre which require moderate control while C items are low cost centre. .Disinvestment: Refer to Section 3.7 of Unit 3. Economic Order Quantity: It is a method of comparing cost of keeping a certain inventory level with cost of frequency of re-ordering. Inventory: It represents part of an enterprise's working assets consisting of raw materials to be used in manufacturing of a product, goods in process of manufacture and finished goods ready for delivery to the customers.
Internal Rate of Return: It is the yield rate or investment rate or earning power of the project. .

Line Authority: An authority concerned directly with the execution or fulfilment of the objectives of the government. The line authority is responsible for controlling, regulating, directing the administration.
Net Present Value (NPV): It is the yardstick for the assessment of a project or enterprise based on discounted cashflow techniques. A positive NPV indicates a better return while a negative NPV indicates a worse return. A zero NPV indicates that the project repays the capital invested plus the minimum acceptable return. Optimal Performance through Internal Management Action (OPTIMA): It is based on the belief that while external problems and constraints might exist, a great deal could be done through internal management, response and action (Reference: Iyer, Ramaswamy R. 1991. A Grammar of Public Enterprise: Exercises in Clarification, Rawat Publications; New Delhi). Pay-back Period: The length of time necessary for the returns (usually measured

Finmclal Administration of
public Enterprises

after tax has been paid) from an investment project to equal the initial sum invested in the project.

PublicInvestment Board (PIB): This was set up in 1972 to speed up approval of public sector projects. All proposals for investment in public sector enterprises involving one crore or more are referred to PIB. Privatisation: It is th6 transfer of PE activities partially or fully through management, ownership and financing modes. Re-ordering Level: A stock level at which more of the stock keeping unit must order to replenish the stock.
Staff Function: It is the function of rendering advice, assistance to the line

authority. For example, the U.P.S.C. in India is a staff agency which advises the government on matters of recruitment of personnel.
1

Value Analysis: It is the process of analysing the intrinsic value of the investments for achieving the objectives of the organisation.

24.11 REFERENCES
Department of Public Enterprises, 1991. Public Enterprises Survey, 1990-91, Vol. I, Government of India, New Delhi. Mishra R.K. 1992. Finance Function in Public Enterprise, Institute of Public Enterprise, Hyderabad. Mishra R.K. 1975. Problems of Working Cdpital in Public Enterprise, Sornaiah: Bombay. Mishra R.K. Nandagopal and N.C. Kar, 1987. Financing of Public Enterprises, Institute of Public Enterprise, Hyderabad.

24.12 ANSWERS TO CHECK YOUR . PROGRESS EXERCISES
Check Your Pmgres 1

1) Your answer should include the following points: . Finance is a service function which requires the counterparts of financial administrators in other operating departments approach them to receive the requisite decisional inputs to execute the responsibilities. Finance occupies the place of primacy in all stages of operation. Finance is required for the implementation of projects under gestation for : normal day to day running of the enterprise. Finance provides resources both for current operations and execution of new projects.

2) Your answer should include the following points:
Investment management function Financing function Checking upon financlai performance Planning systems Operating decisions Control systems.
Check Your Progress 2

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1) Your answer shouM include the following pgints: Boards of management of PEs ~dministrativeministry

.

Finance expenditure committee Public investment board Cabinet committee on economic affairs.

2) Your answer shodd include the following points: Cash-credits from nationalised banks Internal generation of resources Non-plan loans from the government.
3) Your answer should include the following points: Equity from the government

Debt from the government Grants from the government Resources from financial institutions Foreign participation in equity and debt Public participation in equity Extra budgetary resources including public sector bonds, deep discount bonds and commercial paper, etc. Internal generation of resources.
4) Your answer should include the follo.wing points: Sub-optimal project planning Under utilisation of capacities Lack of aggressive marketing Poor production and planning and control Overstaffing Unsuitable product mix.

UNIT 25 FINANCIAL AUTONOMY AND

ACCOUNTABILITY OF PUBLIC ENTERPRISES
Structure Objectives Introduction Concept of Financial ,Autonomy and Accountability in Public Enterprises Tiers of Financial Autonomy and Accountability in Public Enterprises The Methods of Ensuring Financial Autonomy and Accountability in Public Enterprises Status of Financial Autonomy and Accountability in Public Enterprises Problems Pertaining to Financial Autonomy and Accountability in Public Enterprises Suggestionsfor Ensuring Improved Autonomy and Accountability of Public Enterprises ~inancial Autonomy and Accountability of Public Enterprises: Recent Trends Let Us Sum Up Key Words References Answers to Check Your Progress Exercises

After reading this unit, you should be able to: explain the concept of financial autonomy and accountability in Publi6 Enterprises (PEs) describe various tiers of financial autonomy and accountability in PEs, discuss the methods of ensuring financial autonomy and accountability in PEs examine problems pertaining to financial autonomy and accountability in PEs provide suggestions for improved autonomy and accountability of PEs; and highlight recent trends pertaining to financial autonomy and accountability of PEs

25.1 INTRODUCTION
The extent of financial autonomy and accountability has been at the heart of discussions about improving the performance of PEs. There have been conflicting views about the right mix of financial autonomy and accountability which can ensure an efficient and effective performance from these enterprises. It goes without saying that there is no well-defined formula available in this respect which can be suggested to the principals (government) and the agents (PEs). What is required is to inculcate an awareness about striking the golden mean between financial accountability and financial control among those who hold the reins of the government and PEs in their hands. The right mix will emerge as a result of the mutualgnderstanding of the needs on the part of the principals and agents and the restraints that both will impose on each other to find an agreeable solution to the problem.
I

In this unit, we shall discuss the concept, various tiers and methods of financial autonomy end accountability of PEs. The problems pertaining to this aspect will be examined and suitable suggestions for improved autonomy and accountability of P E s shall be nrovided.

25.2 CONCEPT OF FINANCIAL AUTONOMY AND ACCOUNTABILITY IN PUBLIC ENTERPRISES
Public Enterprises (PEs) as we all know are set up wholly o r substantially owned by the government for the purpose of undertaking activities of industrial, manufacturing, trading or allied nature. They are government owned enterprises functioning under both central and state governments. The PEs are corporate bodies, set up either under specific acts of Parliament or under Companies Act. The PEs since they are established with public funds, are accountable to the public i.e. through thq parliament. Autonomy in simple terms means freedom to take decisions and function accordingly while accountability refers to rendering of accounts to some higher authority. The financial autonomy given to PEs means empowering them to take decisions on their own in the areas of investment management, financing of investments and monitoring the financial performance of respective enterprises based on sound business principles and the wisdom of the financial administrators. Insofar as investments are concerned, other things remaining the same, PEs should have freedom in identifying the projects, preparing the detailed feasibility project reports, appraising the projects, making investment choices, and implementing and monitoring them. They should also be free to decide the optimal level of investments in the various items of inventory book debts and floating stock of cash. By the same principle they should be free to peg the level of current liabilities to any proportion of the current assets. The financial decisions in the normal run may be made by these enterprises as guided by the cost of capital. They should possess the freedom t o choose among the various debt-equity propositions. They should be at liberty to select bankers, financial institutions and the channels of money and capital markets for financing their working fund requirements. Subject to the social constraints imposed on them by the government, these enterprises should be vested with the autonomy to develop their own costing and pricing systems, norms of profitability .and monitoring mechanism to ensure the desired financial status alike any business firm in the private sector. Prof. V. V. Ramanadham in his treatise entitled "The Control of PEs in India" discusses the concept of financial accountability. Primarily it implies the accountability of PEs to parliament in financial matters. So expressed, it is part of the general problem of amenability of PEs to parliamentary control and calls for a compromise between the democratic rights of parliament and the autonomy of the enterprises. The other aspect of financial accountability is that the maximum good tesults ought to be secured from the PEs. So expressed, it borders on the concept of efficiency in financial terms. The maximisation is not tantamount to an insistence on the highest possible profit from every public enterprise. The concept suggests that, subject to any set criterion of profit and social benefit, the enterprise ought to record the best possible results.

Financial Autonomy and Aceountnbiiity d PuMe Enterprlscs

25.3 TIERS OF FINANCIAL AUTONOMY AND ACCOUNTABILITY IN PUBLIC ENTERPRISES
Financial autonomy is a phenomenon external to the organisation. In other words, it flows from the environment governing the functioning of PEs. Thus there are six tiers of financial autonomy. These include the parliament, the government, the Comptroller and Auditor General (CAG) of India, the Courts of Law i.e. . the Supreme Court of India and the High Court, the mass media and the citizen. All these six institutions can have an explicit policy about the financial autonomy they may like to provide to PEs in order to enable them to operate efficiently and effectively. As the enterprises under discussion are both 'public' and 'enterprise', these institutions cannot be overjealous in controlling each and every aspect o f financial business of PEs. The respect for the corporate status o these enterprises f will have to be maintained by these institutions. While saying so we do not deny the need for exercising checks and balances on the financial decision making in these entemrises. The main mint is that these institutions should be selective in

Financial Administration of Public Enterprises

exercising the financial controls on PEs. PEs may enjoy autonomy in the day-to-day financial decision making which in its ambit may include matters such as normal purchases, cost allocations, evolving suitable price structures, selection of suitable sources and mix of finance, installation and operation of the financial information systems, and preparation and finalisation of accounts, etc. On the other hand, the six institutions may however intervene in the policy aspects of the financial decision making. For instance, if the parliament so desires, it may discuss the financial performance, financial position, pricing, financial aspects of foreign collaborations and the position of internal financing in PEs, etc. The government may reserve the right to approve the appointments of execiltives drawing salaries above certain levels and issue directives to PEs to provide certain services at particular prices, even if they are not economical. The CAG can give directions to PEs to follow a specific format for the presentation of their accounts and disclosure of the financial information. The various courts of law may direct PEs to alter their financial decisions if the fundamental rights of the citizens are affected. The mass media and the citizens may criticise certain financial decisions by PEs and as a result the PEs may have to reconsider the matter. Such decisions may include matters relating to pricing, and selection of suppliers of plant and materials which may attract public resentment. At times public enquiry can be camed out on certain decisions taken by the management of P.E.'s. For instance in 1970, on the recommendations made by the Committee of Public Undertakings, a one man commission was set up to enquire into award of contract for laying some pipelines to an American firm by the Indian Oil Corporation. The financial accountability of P.E.'s pertain to:

Major Accounting Decisions: These include: an increase in depreciation, changes in tender procedures, stores valuation and replacements.
Matters of Internal organbation: These include internal audit, procedures for ordering materials, delegation of powers, watch and ward supervision over financial transactions, provisions relating to disciplinary matters etc. These ark examples of matters which may be left to be properly evolved within the enterprise itself.
Broad F u dIPokks: These are fundamental aspects of financial accountability. h n . They require plans between those evolved by the board and the socioeconomic aims set by the parliament. These may include matters pertaining to self-financing, outlines of capital expansion programmes and the rates of dividend, repatriation of foreign funds or consultancy fees and so on.
PEs may owe an accountability to various institutions in respect of finankial results, productivity and growth. The memorandum of understanding (MOU) is emerging as an important instrumentality whereby PEs are required to spell out their objectives and the targets they are expected to achieve-during a given financial year.

25.4 THE METHODS OF ENSURING FINANCIAL AUTONOMY AND ACCOUNTABILITY IN PUBLIC ENTERPRISES
To ensure financial autonomy, both external and internal methods have been resorted to. Externally the government spells out the financial freedom of the PEs in regard to several aspects in their articles of association. The limits for investment, commercial borrowings, working capital borrowings, salaries offered to employees and powers of recruitment, etc., are specified in the articles of association of PEs. The provisions regarding business budgeting, costing and pricing etc. are also contained therein. The government indicates the extent of autonomy to PEs in respect of pricing, investment and profitability, in the MOU. In the articles of association as well as the enabling acts under which public corporations have been set up the government exercises self-restraint on itself not to interfere in the day to day working of PEs including matters pertaining to financial functioning. Internally PEs ensure autonomy at different levels of functioning by enforcing

delegation and decentralisation of financial powers. In many a PE, there is a healthy tradition to hold group meetings which are also known as communicarion meetings. In these meetings the departmental heads are the invitees. The workers' representatives are also invited. The problems are discussed and decisions are taken then and there. These meetings deal with the decisions regarding procurement, : plant acquisition, investment of funds and acceptance of tender. This instrument provides a great deal of financial autonomy to the executives and work force. The methods of ensuring financial accountability may be divided broadly into two categories: organisational methods and the external methods. The former may take the shape of arrangements which may enable a PE to give a good financial account of itself. The external means may be a sequel to the autonomous organisation of a PE, created for ensuring that the managers, to whom it does not belong, behave responsibly vis-a-vis the parliament. The organisational means of financial accountability are as follows: a) b) c) d) e)
f)

g) h)

Clear financial procedures. Efficient internal audit. Commercial audit by private auditors. Proper internal organisation of the enterprise, based on optimal criteria and decentralisation. Appointment of a Financial Advisor of the enterprise by the government or under governmental approval. Governmental control is exercised through the Board of Directors of the PE. The Chief Executives and full-time Directors of the PEs are appointed by the government. In most of the enterprises government's representatives on the boards in the form of nominee directors are present. They are from the concerned Administrative Ministry and Ministry of Finance serving in an ex-officio capacity on the board. Reservation of certain financial matters for government approval, under the Articles of Association or under the Act governing a public enterprise. Audit of PEs by the Comptroller and Auditor General is another means of financial accountability. In PEs there is a system of double audit. The accounts of PEs are first audited by the statutory auditors of the enterprise. After this is passed by the Board of Directors of the enterprise, then the supplementary audit is conducted by the office of the C & AG.

Check

Y w Regress

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Note: i) Use the space given below for'your answers.
ii) Check your answers with those given at the end of the unit.

1)

What d o you understand by financial autonomy of PE?

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2)
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List six institutions which can explicitly lay down policy relating to financial' autonomy of PEs.

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3)
Point out the areas of financial accountability of PEs.
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Financial Administration of Public Enterprises

4)

Discuss the methods of ensuring financial accountability of PEs.

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25.5

STATUS OF FINANCIAL AUTONOMY AND ACCOUNTABILITY IN PUBLIC ENTERPRISES

Though financial autonomy is a much talked about phenomenon, there are a number of constraints on PEs imposed by the diktats from the parliament and the administrative ministry. For example the DVC Act makes it obligatory on the Damodar Valley Corporation to report on ten financial matters, obtain approval on fifteen financial matters and receive directions from the Minister on five financial matters. As discussed earlier, in the guise of serving the public interest, a minister can always issue a formal directive to PEs. There have been cases of frequent lunch-table directives to PEs by the government. One of the reasons as to why PEs have missed linking costs with prices can be found in the undue interference by the government in their working. The guidelines issued by the Department of Public Enterprise (then Bureau of Public Enterprises) corroborate this assertion. There are more than 200 guidelines on financial matters. ~ h e s e guidelines range from the rate of interest which PEs should pay on their borrowings to the dividend pay-out ratio which they must maintain while deciding about the retention of profits. Though these are said to be guidelines, they are in a sense virtually the orders of the government. Parliament directly exercises control in as much as its prior approval is required for certain investments in PEs and in certain cases periodic reports are to be submitted to it. This however applies only to new services, that is, for new activities, taken up for the first time. Further, such approvals are only financial and not administrative. If the parliament is not in session, the money may, in case of emergency be provided out of the contingency fund and the sanction of parliament is obtained at a later date. The systems and procedures designed to ensure the financial accountability in PEs are very detailed and elaborate. The parliament debates the financial issues relating to PEs at the time of the budget discussions and the question hour. Further, to look into the financial performance of PEs and to check upon their commercial and business prudence, the Committee on Public Undertakings (COPU) a standing committee on PEs set up by the parliament, also helps PEs on a continuing basis to develop a proper perspective in relation to the financial matters of these enterprises. We have already discussed the role of this committee in Unit-19 of Block 6 of this course. The COPU has, submitted to the parliament about 600 reports. It has also camed out a number of horizontal studies. Some of these studies have been on financial aspects the prominent of which include "Financial Management in PEs", "Role and Achievements of PEs", "Inventory Management in PEs", "Project Management in PEs", and "Galloping Expenditure on foreign travels in PEs" etc. Government controls on PEs make the financial accountability a very painful task. The reports and returns submitted on financial aspects are monthly, quarterly and annual in nature. If these enterprises incur losses, then they have to get even their revenue budget approved by the administrative ministry. The CAG cames out not only financial but also efficiency and propriety audits for these enterprises. The annual reports place these enterprises

in a disadvantageous position vis-a-vis their counterparts in the private sector on account of time overruns and poor quality of financial disclosure.

Financial Autonomy and Accountnbillty of Public
Enterprises

24.6 PROBLEMS PERTAINING TO FINANCIAL AUTONOMY AND ACCOUNTABILITY IN PUBLIC ENTERPRISES
The financial autonomy and accountability of PEs occupy an important place in a democratic country such as ours. However, as things stand, these are treated as two separate facets of the personality of PEs and often the perceptions of the government and PEs on the issues relating to autonomy and accountability differ. An important problem in this context is the government's insistence to get matters referred to it on the various financial issues and the aversion of PEs to disclose the requisite financial information to their principals i.e. the respective administrative ministries. Whereas the government continues to treat these enterprises as its extensions, the PEs do not or cannot make concerted efforts to come out of the gravitational pull of the government. The parliament, the administrative ministry, the CAG and the Courts are considered as the trustees of public funds and are prompted, therefore, to impose a variety of controls on these enterprises. They do not want to take any risk with the public money, but prefer safety and security. Prof. Ramaswamy Iyer in his book "A Grammar of Public EnterprisesExercises in Clarification" has identified some frequently heard complaints regarding government's interference in public enterprise managements. The circulars issued by the Bureau of Public Enterprises at times relate to certain unimportant and even trivial matters. Excessive monitoring by the government is also another problem. Also during the course of the annual plan discussions, the entire investment programme of a PE comes under review and questions are raised about investment decisions which are within the corporate powers of the public enterprise. And the economy instructions which are issued from time to time by the government applies to PEs abridging their powers. There is a gap between the powers that are formally possessed by PEs and those that are actually exercised by them.

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25.7

SUGGESTIONS FOR ENSURING IMPROVED AUTONOMY AND ACCOUNTABILITY OF PUBLIC ENTERPRISES

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A number of suggestions can be offered to ensure improved financial autonomy and accountability in PEs. To begin with, these enterprises should be commercialised. This will enable PEs to charge economic rates for the goods and services provided to their users. This will result in the generation of adequate internal resources and consequent reduction of financial support from the government to fund their operation and expansion needs. In turn, the government control on financial matters will decline drastically. Corporatisation of these enterprises is another suggestion. This will transform the systems, structure and strategy of PEs and resolve many thorny problems with regard to financial autonomy and accountability. A large number of PEs have been complaining about lack of autonomy to them as they do not have adequate powers to procure the requisite amount of materials, stores and supplies etc. On the contrary, the government is of the view that the inventories in these enterprises should be rigorously controlled as there is a heavy over-investment in this component of assets in PEs. The government's suspicion cannot be questioned as many a PE do not have materials management manual. The absence of such a manual has encouraged them to procure materials disproportionate to their needs. The CAG in his various audit reports has commented upon the non-preparatiun of the budget, cost, internal audit, Research and Development and capital expenditure manuals. Many PEs do not have even the budget manual. The enhanced delegation and decentralisation of financial powers within PEs is a must. In order to achieve this objective well defined structures must be developed. The boards of management in PEs should specify the financial powers vested in each functionary. Similarly, the various executives in PEs should be encouraged to delegate financial powers to their junior colleagues. The government, on its part

Financial Administration of Public Enterprises

should instead of putting limits on investments, expenditure, borrowings, etc, issue only suggestive guidelines. In case a PE exceeds the suggested ceiling, it may be required to report the matter to the government. The principle of management-by-exception should be followed. The government should intervene only in such cases where it is necessary to do so in the larger public interest. PEs should formulate clearly financial strategies and goals which should be both unambiguous and quantifiable. For instance, PEs could specify proposed rate of return on their capital employed, declare a specified dividend on their equity, finance their expansion programmes largely through internal generation of resources and approach the capital market to finance the rest of their expansion needs. A clarity in financial objectives will enable PEs to acquire the necessary financial autonomy from the government. It will also lead to self-imposed controls. This will eliminate the need for the government to clamp ,financial controls on them. There must also be a sincere application of the Management by Objectives (MBO) for attaining financial objectives. It is desirable to eliminate the multiple audits in PEs which are mostly unproductive. It has to be noted that the counterparts of PEs in the private sector are not required to undergo so many audits. The audit approach needs to undergo a change in order to yield the desired results. The auditors must be made conversant with the operations and philosophy of PEs. The annual reports can serve as an important medium to satisfy the autonomy and accountability needs. They can be a good instrument to win greater autonomy for PEs and fulfil, at the same time, the control needs of the parliament, CAG and the Courts. An analysis of the annual reports of PEs shows that they are not brought out in time. The time lag in their finalisation and presentation to the parliament ranges from one year to ten years. Secondly, in many cases they are either sketchy or lack important information relating to the trerids in output, productivity, prices, profitability, comparative performance and so on. Necessary steps must be taken to improve the practices pertaining to the preparation ' and presentation of the annual reports by PEs. Articles 12 and 14 of the Indian Constitution have been extended to PEs whereby these enterprises have been considered as State. The 'State' as defined in Article 12 of the Constitution, is to include "the government and Parliament of India and the government and legislature of each of the states and all local or other authorities within the territory of India or under the control of the government of India". Though originally PEs were excluded from the purview of the 'State' as defined in Article 12 of the Constitution, slowly, bodies performing quasi-governmental functions, statutory corporations, government companies, have been brought within the purview of the state. The High Courts and the Supreme Court have accepted many writ petitions which have a financial impact on PEs. Some of these relate to the procurement of materials and payment of pension etc. As discussed earlier, PEs contain not only 'public' but the 'enterprise' element. Thus to enable PEs function without any handicaps in the present competitive atmosphere, there is a need to introduce an amendment in the Indian Constitution to take PEs out of the purview of Articles 12 and 14.

25.8 FINANCIAL AUTONOMY AND ACCOUNTABILITY OF PUBLIC ENTERPRISES: RECENT TRENDS
The PEs in India have been set up to speeden up the process of i n d k r i a l development. It goes without saying that, they will be able to achieve efficiency, contribute towards maximum production of goods and services with minimum wastage of resources, only if sufficient functional autonomy is provided. They should have freedom of decision-making within broad guidelines or policies. A suitable balance needs to be struck between autonomy and accountability. There has of late, been a lot of discussion about the question of autonomy and accountability of PEs, its relationship with the government. The Arjun Sengupta Committee set up by the Government of India in 1984, went into various aspects

of public enterprise management like relations ,between government and PEs, managerial autonomy of PEs, financial powers in regard to their investments and capital budget and so on. It recommended that the government should be primarily concerned with overall strategic planning and policy rather than day-to-day functioning of PEs which should be left to the enterprises concerned. The responsibility of the government is to ensure that public money invested in the enterprises earns an appropriate rate of return and that their functioning is consistent ,with plan objectives including those related to employment, fair pricing, efficient use of scarce resources etc. The Committee was of the opinion that enterprises functioning in the core sectors like power, steel coal and lignite etc. have to interact with the ministries with regard to matters like investment planning, price fixation and financial management. Their plans will have to be integrated with the national plans. But financially viable non-core public enterprises can finance their requirements, by raising funds from the public through deposits or debentures or borrowing from ,the financial institutions, without being subjected to any process of governmental clearance. Regarding accountability of PEs to Parliament, the Committee recommended that Parliament questions on day-to-day operation and management may be avoided. The debate on the Demands for Grants of the concerned Administrative Ministry could be used for the purpose of a debate on the performance of PEs under the control of the Ministry. The Economic Administration Reforms Commission which was set up in 1981 headed by late L.K. Jha, also went into this aspect of autonomy and accountability of PEs. According to the Committee, in the name of public accountability numerous checks and controls are introduced at every stage which hinder executive action, concentrates decision-making powers in the Ministry and infact dilutes the accountability of the management. The accountability concepts and ,instrumentalities which have come to prevail over the years are in need of careful reconsideration with a view to ensuring that (a) they do not erode the autonomy of PEs and thus hamper the very objectives and purposes for which they ought to be accountable and (b) that what is sought to be secured is accountability in the wider sense of answerability for the performance of tasks and the achievement of results, rather than in the narrow sense of responsibility for the correctness and propriety or individual actions or decisions or confirmity to rules and procedures. The Committee recommended, apart from certain statutory controls which apply to both public and private sector units, they should not be subject to any other constraints on their autonomy. Also once the investment decisions of PEs have been approved and necessary funding provided for, the management should be allowed to go ahead without seeking any further clearances except those which apply to all undertakings like those relating to industrial licensing, foreign exchange releases etc. Also the number, scope and coverage of the governmental guidelines and instructions to PEs should be thoroughly reviewed and drastically reduced and only those concerned with major objectives and/or performance parameters can be retained. There is no denying the fact that the government is convinced about providing more autonomy to PEs and reducing the wide-randing financial controls on them. The approach outlined in the budget speeches of the Finance Minister in 1991-92 and 1992-93, the observations made in the economic survey of 1991-92 and the letter on development policy sent by the Finance Minister to the World Bank President describe the various steps the government proposes to take ,in this regard.

Financial Autonomy nod AecoontaMUty of Public
Enterprises

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The government proposes to classify PEs as competitive and non-competitive units. About 140 units at the central level have been identified as competitive PEs. These enterprises will be guided by the market forces in their financial matters. The government proposes to refrain from issuing guidelines or directives. The PEs may be allowed a free hand to decide their financing, pricing and costing policies. They will be at liberty to develop suitable systems and structures to achieve the overall financial objectives. The enterprises which are non-core in nature will not receive any budgetary support. They will have to finance their needs through the internal generation of resources and mobilisation of money from capital markets. There will be a disinvestment of equity in tliese enterprises
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Financial Administration of

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board of directors of PEs will be reduced to 'one'. Multiple audits may be eliminated or scaled down. The government is taking appropriate steps to improve the quality of financial reporting in PEs through their annual reports. The various state governments in the country are giving a top priority to streamlining the preparation of annual accounts and annual reports in the State Level Public Enterprises. Check Your Proeress 2 Note: i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.
1) Highlight the problems pertaining to financial autonomy and accountability in PEs.

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2) What suggestions would you offer to strike a balance between financial control and financial autonomy in PEs?

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3) Discuss the measures taken by the government in recent times to provide financial autonomy to PEs.

LET US SUM UP
Adequate financial autonomy is a necessary condition for the successful working of PEs. This autonomy should not only flow from the government but it should further percolate from the top to the bottom in the PEs themselves. The financial controls are an important phenomenon in a democratic set up. These controls should not, however, be regressive. Whereas there is an over emphasis on financial accountability, PEs have failed in using whatever little leverage they have in respect of the financial autonomy.

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KEY WORDS
- . Articka of bmdatlon: These are regulations tor the managenlent, .internal . . arrangement of a company. It lays down the terms and conditions on wnicn tne shareholders, agree amongst themselves, as t o how the business of the company shall be camed.

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Capital Market: It refers to various institutions, arrangements concernea witn tne

purchase, sale and transfer of stock, bonds etc.

Depreciation: Dimunition or reduction in the value of an asset due to use and/or lapse of time. Debt-Equity Ratio: This ratio measures a company's financial leverage. It is calculated by dividing debt of the company (both short and long term) by the entire equity capital. Contingency Fund: Refer to Section 8.5 of Unit 8. Dividend: It is share of profits earned from a company either by the government or any individual as holder of shares in that company. Manuals: Documents in respect of the various subjects detailing the process and the duties of the executives in carrying out various activities. Management by Exception: It involves concentrating on those areas that are not functioning according to plan rather than on areas of operation which are running smoothly. Management by Objectives: It involves managers and subordinates in jointly establishing specific objectives and periodically reviewing progress towards meeting those targets. Marketisation: It denotes the governance of PEs by market forces in respect of demand, supply and investment.
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Financial Autonomy and Accountability of Public
Enterprises

25.11 REFERENCES
Bureau of Public Enterprises and Bharat Heavy Electricals Ltd., 1988. Government Policy on Public Enterprises Vol. I & 11, New Delhi. Economic Administration Reforms Commission, 1985. Report on Autonomy and Accountability in PEs, Government of India: New Delhi. Iyer, Ramaswamy R, 1991. A Grammar of Public Enterprises, Exercises in Clarification, Rawat Publications: Jaipur. Nigam Raj K, 1986. Towards a viable and vibrant Public Sector in India, Documentation Centre for Corporate and Business Policy Research: New Delhi. Sankar, T.L., R.K. Mishra, S. Ravisankar, 1983. Public Enterprises in India, Himalaya: Bombay. Sankar, T.L., R.K. Mishra, S. Ravisankar, 1984. Leading Issues in Public Enr~rpnst'sManagement, Himalaya: Bombay. Sankar, T.L., D.J. Chambers et.al, 1986. Public Enterprises Policy in India and UK in 1980s, Himalaya: Bombay.

25.12 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Pmgmw 1

1) Your answer should include the following points:
Financial autonomy of PEs means: financing decisions laying down financial objectives investment decisions developing costing a d pricing systems, norms of profitability and monitoring mechanism.

2) Your answer should include the following points:
Parliament Government Comptroller and Auditor General of India C o w of L;nu

Financial Administration of Public Enterprises

Mass Media Citizen
3) Your answer should include the following points:

Major accounting decisions like increase in depreciation, changes in tender procedures, stores valuation etc. Matters of internal organisation like internal'audit, delegation of powers, disciplinary matters etc. Broad financial policies pertaining to self-financing, capital expansion programmes, rates of dividend etc.
4) Your answer should include the following points:

Clear financial procedures Efficient internal audit Commercial audit by private auditors Appointment of a Financial Adviser of the enterprise by the government or under government approval Exercise of government control through Board of Directors of the enterprise Audit by the C & AG. Check Your Progress 2 1) Your answer should include the following points: Detailed and elaborate systems and procedures to ensure financial accountability of PEs Government's insistence' to get matters referred to it on various financial issues and the aversion of PEs to disclose the requisite financial information to the respective administrative ministries Frequent guidelines issued by the Bureau of Public Enterprises pertaining to unimportant, trivial matters Review of investment programmes of PEs during annual plan discussions.
2) Your answer shoulu include the following points:

Corporation, Commercialising and restructuring of PEs Enhanced delegation, decentralisation of financial powers within PEs through well defined structures evolved within the organisation Clarity in financial objectives Application of Management by objectives for attaining financial objectives Elimination of multiple audits in PEs Government intervention only in larger public interest.
3) Your answer should include the following points:

Proposal to classify PEs as competitive and non competitive units PEs to be allowed a free hand to decide their financing, pricing and costing policies Enterprises in non-core sectors to finance their needs through internal generation of resources and mobilisation of money from capital markets Multiple audits to be scaled down or eliminated Improvements in quality of financial reporting of PEs Autonomy in investment decisions Autonomy in day-to-day matters pertaining to financial functioning.

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UNIT 26 FINANCIAL ADMINISTRATION OF URBAN GOVERNMENTS
Structure
Objectives Introduction Ecology of Urban Local Finance Principles of Urban Local Finance Municipal Government: Sources of Revenue Municipal Government: Expenditure Pattern Urban Fiscal Management State Control and Supervision Gap between Municipal Services and Resources Let Us Sum Up Key Words References Answers to Check Your Prwress Exercises

26.0 OBJECTIVES
After studying this Unit, you should be able to:

. explain the major divisions and the machinery concerned with financial
administration discuss the ecology and principles of urban local finance explain the sources of municipal revenue and expenditure pattern describe the budgetary process and the system of accounting and auditing highlight the methods of state control over municipal finance; and evaluate the causes of gap between the municipal services and resources and make suggestions to bridge the gap.

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26.1 INTRODUCTION
Local Government means the management of local affairs by the representatives of the locality itself. It deals with the problems, chiefly of local concern. It plays an important role in solving the local problems of the people. It provides the foundation on which the democratic structure of a country stands. It is in and through these institutions that the citizens get training and necessary experien~e running higher for representative institutions such as the State Legislatures and the Union Parliament. De Tocquaville, a noted French writer pronounced "A nation may establish a system of self-government, but without the spirit of municipal institution it cannot have the spirit of liberty". Former Prime Minister of India, the late Jawahar La1 Nehru remarked "Local self government is and must be the basis of any true system of democracy. We have got rather into the habit of thinking of democracy at the top and not so much below. Democracy at the top will not be a success unless you build on its foundation from below." Thus local institutions constitute the strength of a free nation. At the local level, India is governed by two different sets.of institutions, namely, the Rural Governments and the Urban Local Governments. The former covering the rural population, comprises a three-tier structure from the village to the district. It was recommended by Balwantrai Mehta Committee. It is formed on democratic principles and organically linked. The urban local governments cover urban population. The requirements for an urban area are:

Local Finance

a) a minimum population of 5,000 b) a population density of not less than 400 per sq. km., and c) three-fourth (75%) of the occupations of the working population should be outside agriculiure. The urban local governments are of mainly six types, namely: a) Municipal Corporation b) Municipalities c) Notified Area Committee d) Town Area Committee e) Improvement Trust f) The Cantonment Board The first five are created under state Municipal laws while the Cantonment Boards are established under central Act, called Cantonment Act, 1924. Since local government is a state subject (entry 5, state list, seventh schedule of the Constitution of India), local bodies are created by the respective state governments. The pattern of local governments, therefore, varies from state to state. Even within the state all the six types are not found in every state. But municipalities are found everywhere. Financial administration in urban governments is as important as finance. It consists of those operations the object of which is to make the best use of available resources and channelling them into proper fields of expenditure. Under democratic government, the elected institutions (i.e., Municipal councils in case of Municipalities) vote the taxes and authorise expenditure. It has to ensure that these representative institutions do not place more tax burden on the people and the money voted by them for expenditure is used according to their wishes with due regard to economy and efficiency. An ill-organised financial administration can be a handicap resulting in inadequate finances. Financial administration in urban governments falls into the following divisions: i) Preparation of the budget i.e., estimates of revenue and expenditure for ensuing financial year
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ii) Getting budget passed by the Municipal council or other competent authority iii) Regulation of the expenditure and raising resources according to it iv) Custody of funds raised and their disbursement v) Rendering of the accounts by the Executive Officer and the audit of these accounts The machinery concerned with financial administration in urban governments varies from state to state. But generally it comprises the following components:
i)
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The Municipal council

ii) Executive Officer along with the departments concerned mainly with financial administration iii) The main financial officers in the administrative departments iv) Examiner, Local Fund Accounts (Audit Department) v) The committees of the municipalities particularly the committee on Finance and Taxation We shall be discussing the functions of each of these in the subsequent sections.

26.2

ECOLOGY OF URBAN LOCAL FINANCE

The form of local polity, size and level of local units, local functions, government control and the economic conditions of local inhabitants are important factors which contribute to determining the ecology of local finance. The financial position of the local government is significantly determined by the form of local polity. A decentralised pattern of local government helps the local authority to determine its financial position because it enjoys greater degree of financial independence to levy,
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execute budgetary proposals. Whereas, a deconcentrated pattern of local government may not help the local government to augment its financial resources because it allows a lesser degree of financial autonomy in regard to various facets of its financial activities. In this type of local polity, local government heavily depends on the government-for finances. It may also not command better public image and enjoy better position in relatio'n to government when compared with local government in a decentralised polity. Another important factor which determines the adequacy of local finance is the size of the local authority. A local unit, big in terms of its area and population, has a better financial position in comparison to the one that is comparatively small in terms of physiography and human settlement. Take for example, in comparison to.a Municipal Corporation, a Notified Area Committee has limited sources of income because of its small area and population. Such types of local authorities look to upper levels of government for help to keep themselves financially in a viable condition. Responsibilities given to the local government are yet another prominent factor for determining the local finance. The government allocates resources to the local governments commensurate with their functions. Where the local government fails to carry out its responsibilities within the available resources, the government has to either provide extra revenue or withdraw such responsibilities. In India, for example primary education is a local function. But sometimes inadequate local finance does not permit most of the local authorities to perform this function inviting government intervention. Moreover, when new responsibilities are assigned to local bodies, adequate funds are made available to the local government in the form of government grants. The financial contrd exercised by the government is also an important factor in determining the scope and scale of local finance. The government provides a broad base for local finance through local government Act in respect of sources of income, pattern of expenditure (compulsory and optional), mode of preparation, enactment, and execution of budgetary proposals, custody of funds, accounts and audit. At times, the government comes to the rescue of the local governments for the performance of their responsibilities, in case of insufficient local resources as well as for their involvement in national obligations. Besides, government also helps the local authority to raise loans, to meet their needs of capital expenditure such as land and heavy machinery. Last but not least the general poverty of our people is undoubtedly a potent factor in the matter of local finance. People in our country have very little taxable capacity. A simple study of the annul national per capita incomes of countries like - UK, USA, Canada and Japan and that of India will amply prove the point. Thus, general poverty\of people may not help to contribute much towards local revenues.

26.3 PRINCIPLES OF URBAN LOCAL FINANCE
The principles which should govern urban local finance are discussed briefly as under:

Independence and Responsibility
The principle of independence means that urban governments must have freedom of financial operations for fulfilling their obligations. The cannon of responsibility which flows from independence implies that the responsibility for raising and spending money should be with the same authority. The authority which has the pleasing job of spending money should also do the unpleasant job of raising it. Taxing autonomy and spending autonomy must go hand in hand.

Adequacy and Elasticity
The principle of adequacy means that the resources of the urban governments should be sufficient for discharging the assigned duties. Elasticity means that the resources should expand in proportionate t o their ability to pay taxes. By uniformity, we understand that the financial system in urban governments should be such as to
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resort to rats of taxation substantially higher than those of other urban governments.

The entire financial system of urban governments should be well-integrated and all fiscal arrangements should combine into a consistent whole. The integration of central, state and local revenue and expenditure should be done in such a way that promotes development. The coordination of central, state and local finance should not only be in taxation but should also cover the current budget, capital outlay programmes, credit operations of the various authorities and should be accompanied with a coordination of their administrative activities as well.

In a democratic system, the principle of public accountability means that government should be a ountable to the elected representatives who represent the citizens of the country, or e state or the locality as the case may be, for its taxing and spending decisions. After executing the budget, there should be an audit of it by an independent authority and all acts of omissions and commissions by administrative agencies or the executive, if there be any, should also be dealt with severely.

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It means procedures concerning preparation, enactment, execution, custody and disbursement of funds, accounts, audit, etc., should be simple and understandable for taking timely action which is essential for efficiency and economy. The absence of simplicity, promptness with caution, regularity of working affectsthe vitality of financial administration.

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Effective Mtmicipal Persoanel Management
It means that personnel policies in matters of recruitment, traqng, promotion, conditions of service, security of service, conduct and discipline, political neutrality etc., should help on toning up the efficiency of personnel which is essential for managing financial operations.

Fiscal Access
The fiscal arrangements should be such that they give to urban governments an access to new financial resources. There should be no bar: in developing new sources of income within their own prescribed fields to meet the growing financial needs. The resources should grow as the responsibilities increase, hence, the need for exploiting new sources of revenue.

26.4 MUNICIPAL GOVERNMENT: SOURCES OF REVENUE
In India, f m c e is the basic problem of urban governments. Adequate finances constitute the life-blood of the whole system of local government. Without sufficient f~nances, urban governments become mere subordinate units of state government and fail to cater to the civic needs of the community. Their incqme is derived from local taxation, enterprises, or the wealth of the citizens, located ikithin the limits of m n c p l body. Direct taxation is common in municipal f d aeinistration. In uiia addition, they impose special levies, commonly termed as "betterment levies" charged for improvements on property made by them. Besides, they receive assistance from state and central governments for dischar&ng their obligatory duties. International agencies through state governments a s provide financial assistance for projects of lo urban development, such as, water supply, housing, roads etc. Sources of income of urban governments may be grouped under:

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Tax-revenue Non-tax revenue Orants-in-Aid, and Loans.

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These sources are briefly discussed M below: Tax-Revenue The major proportion of income of urban governments flows from taxes. It ranges between two-fifths and three-fourths of total income. The main taxes are: a) Octroi or terminal tax b) House tax c) Tax on trades, professions , d) Tax on dogs e) Tax on advertisements other than those published in the newspaper f) Bazar tax g) Tax on vehicles h). Tax on theatres i) Toll tax. NOR-taxRevenue It includes receipts from rents of municipal property, interest on investments, profit from public utility undertakings like-water supply, passenger transport, electricity supply, fee for issuing licences or permits, fmes realised for offences against municipal bye-laws, rules, regulations etc. For example in Punjab and Haryana this source of revenue fetches about 30 per cent of revenue. The national average of the proceeds from this source is a little above 30 per cent.

Financial Adminhtntlon d Urban Gover~~ments

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It is another important source of income of urban governments in India. Grants represent subsidies @en by the state government in aid of certain services rendered by urban governments. Grants can broadly be divided into two categories, namely, recurring and non-recurring. The former are provided by the State Government to meet the gap in their recurring expenditure. The latter are glven to municipalities to meet the initial cost of some specific projects such as water supply, school buildings, health centre etc. The amount of grant is determined on the basis of the matching formula, per capita income and expenditure etc. Loans Urban governments also meet their needs of capital expenditure such as purchase of land, heavy machinery and long-term projects by raising loans. Borrowings are regulated by the central law known as Local Authorities Loans Act, 1914. Loans are raised with prior sanction from the state government. In certain cases, the permission of the central government is also needed. The urban governments are permitted to borrow loans from banks, Life Insurance Corporation and other financial institutions. All proposals concerning loans from open market or LIC are required to be cleared by the Reserve Bank of India. For all practical purposes, urban governments except municipal corporations have to depend largely upon loans from their respective state governments. Every loan has its own rate of interest, term, mode of repayment, measures of utilisation etc.

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26.5 MUNICIPAL GOVERNMENT: EXPENDITURE PATTERN
A municipality can spend on the services permitted to it under the law which may be contained in a public Act of Parliament or State Legislature in a local Act. Besides, the state government may, in the name of public interest, declare any other expendituqe to be a legitimate charge on municipal funds. Though the responsibilities of municipal bodies in our country are more or less similar, yet there are wide variations among the states in the matter of per capita expenditure on different heads or services. The important heads of municipal expenditure are as under: General Administration, Establishment and Collection Clnuges This expenditure includes charges like salaries of employees, maintenance of the _ H - - -L ----- C-- r L - - - l f - - r l - -C --A r L - m e - L.l:.:l----A_.-&:--

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Loenl Finance

and octroi. The other charges which fall under this head also include litigation expenditure such as lawyer's fee, court and witness fee, election expenses for preparing voters list, ballot papers, audit fee for auditing accounts etc. Public Education The responsibility of providing free and compulsory education for children until they complete the age of fourteen years is as a matter of fact to be borne by the state governments. (Article 45 of the Constitution of India). But in some states, like Punjab, Bihar, Haryana, Uttar Pradesh, this is being shared by urban governments. These states extend financial aid to urban governments to meet the expenditure. The expenditure on public education falls under two heads, viz., (1) running schools, and (2) setting up and operating public libraries and reading rooms. Medical and Public Health Protection of public health is one of the primary functions of urban governments. The public health activities are divided into two parts: i) provision for medical relief and administration of preventive.medicines and ii) maintenance of public health. Water Supply Pure drinking water is essential for good health. The provision of pure, clean and adequate water supply is, therefore, an important function of urban governments. Expenditure on this head is usually quite heavy because tanks, reservoirs, engines, pipes, taps and other works may have to be constructed and maintained. Besides, the water is supplied at no-profit no-loss basis, in other words, the water is supplied at a less rate than the cost of production. Municipal Works It is one of the important items of the municipal budget. Under this head, the urban government's maintenance of roads, bridges, markets, slaughter-houses, lanes and bye-lanes and any such other works concerning with the physical beautification and development of the city or a town, are covered. Maintenance and Reserve for Unforeseen Emergency Maintenance expenditure covers property repairs, dismantling unauthorised structures etc. Reserve for unforeseen emergency includes expenditure on public safety such as fire services, protecting public against stray and dangerous dogs, and any such other emergency which is un~~edictable.

Check Your Progress 1
Note :i) Use the space given below for your answers. ii) Check your answers with those given at the end of the unit.

1) Discuss the important factors which contribute for determining the ecology of local finance.

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2) Describe briefly the principles which should govern the local finance.

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Financial A d d d S U a h d Urban Covernmencs

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3) Explain the sources of income of urban government.

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URBAN FISCAL MANAGEMENT
It includes budgetary process, procedure for assessing and collecting revenues, custody and disbursement of funds, stores, accounting and auditing. These are discussed a s under: Budgetary Process and Authorisation A budget is not nearly a statement of revenue and expenditure, it is something more than that. The whole policy of the municipal body is reflected in the budget. It is a tool of management. In Punjab, the Executive Officer is responsible for preparing the municipal budget. In the month of December, the spending and earning departments send to the Accountant their annual estimates containing the (a) actuals of the previous year; (b) actuals of the current year; (c) revised estimates of the current year; (a)estimates of the ensuing year. After receiving the estimates from the different departments, the Accountant consolidates them and sends the consolidated budget to the Executive Officer for examination. After careful scrutiny of the estimates, the Executive Officer submits proposal to the Finance Sub-committee. After receiving the recommendations from the Finance Sub-committee, the budget is placed before the Committee of the whole houscfardWussion and approval.
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Assessment and Collection of Revenues The Executive Officer is responsible for the assessment and collection of taxes. But in actual practice, the Tax Sqerintendent assisted by the Tax Inspector prepares the assessment list. An appeal against the assessment of taxes lies with the Deputy Commissioner. The Jurisdiction of the Civil Courts is debarred in matters of assessment. But on points of law the Deputy Commissioner may make a reference to the High Court. Custody and Disbursement of Funds

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In the Municipal Committees, the income received by different departments is credited every day into the Municipal Treasury. The power of withdrawal df the money rests with the Executive Officer. At the end of each day, the balance is drawn in cash book which must tally with the day's transactions entered in the cash book and the balance of amount in hand. This means practice of the singleentry system, that is, the revenue side is credited when any amount is received and debited when paid out. Stores Urban Government's stores are divided into two parts, namely, (a) Special stores and (b) General Stores. Special stores consist of article required by a particular department. These are purchased directly according to the requirements of the department. General stores consist of articles which are of general bse and are required by general departments. Such stores are purchased through the central stores department. In this way the purchase of wholesale quantity is made at the lowest rate

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Local Finance

and much saving is effected in cost as well as in establishment charges. Municipal Accounts and Audit Accounts mean a record of money transactions. It may be described as a procedure by which a local body puts all its business transactions on record to coordinate the data in these records, so that they may be used intelligently. Accounts not only enable the local bodies to regularise its administration but also help them in the exercise of proper control over the finances. In Punjab the general methods, the structure of accounts and the manner in which the accounts are to be kept are prescribed in the Code, 1930. The instructions of the Examiner, Local Fund Municipal Ac~ounts Accounts are to be complied with, in respect of details to be furnished by the urban government. Inseparable from the maintenance of proper accounts of the municipalities is the necessity of their audit. It is of two types, namely, pre-audit and post-audit. The former is conducted before the expenditure is incurred on any item. The latter is done after the financial transaction has already been made. In India both types of audit are in operation in Municipalities. As a mattersf fact it is the municipality which decides the mode of audit in a municipality. The accounts of the municipalities are audited annually by the Examiner, Local Fund Accounts. The cannons of financial propriety are clearly laid down in the Municikal Accounts Code. The main purpose of audit is as under: a) To ensure that the same amount has been spent which was sanctioned in budget. b) To see that the amount has been spent according to rules and regulations. c) To confirm that the amount has been spent for the purpose for which it was granted i.e. the amount sanctioned for the purpose of education has not been spent for public works. d) Check the financial propriety i.e. money has been spent economically and efficiently. e) To see that the amount has been spent with the prior sanction of the competent authority.
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26.7 STATE CONTROL AND SUPERVISION
Urban local bodies are not sovereign bodies. As mentioned earlier, local government is a state subject and as such state government is empowered to legislate on various aspects of local bodies. It determines their structure, powers, functions, financial resources etc. In fact, urban local bodies are regularly controlled, supervised, directed and occasionally penalised by the State Government for their acts of omission and commission. In India, the forms of government control over urban bodies are many and varied. Such control is of four broad varieties, namely, (a) legislative, (b) judicial, (c) administrative, and (d) financial. In this unit, we are mainly concerned with financial control. Government control over the finances of urban governments may be grouped under the following heads. Control over Taxation The government is empowered to exempt any person or property from the payment of any tax. Every resolution of a municipality increasing or decreasing or abolishing an existihg tax, requires the approval of the state government and in certain cases, of central government as well. For example, in case of tax on profession, the Constitution of India had prescribed a limit of Rs. 250 per annum in 1949. In view of the price rise and other factors some state governments when demanded by local bodies, had to request the centre to revise the ceiling. The rate was, therefore, enhanced to Rs. 2,500 per annum in 1988 by the Sixtieth Amendment Bill of the Constitution. The state government is empowered to suspend or prohibit, or remedy a tax unfair in incidence or injurious to the interests of the general public. Besides, the state government can direct a municipal body to impose octroi on a
narticiilar itpm a t a n a r t i r n ~ l a r rat-

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instructed Ludhiana Municipal Corporation in 1986 to levy octroi on man-made fibres like nylon and terene and hand knitting yarn made out of nylon fibre at the rate of rupees 2.10 per 100 rupees. State government may allow urban bodies to add supplementary rates to the existing government taxes. For example, in India, when state governments had abolished octroi, they permitted the urban governments to impose a surcharge on the sales tax which is a state tax: Besides, a local tax may be administered by the government, although it is actually enjoyed by the urban governments. For instance, in Andhra Pradesh entertainment tax which is basically a local tax is imposed by the government but the entire proceeds are given to urban governments after retaining the collection charges amounting to Rs. 5 per unit of the collections. Similarly, from motor vehicle tax, which was formerly a local tax in India, certain percentage of the collections are made over to the urban authorities by the state governments.

Financial Adminisfrsfion of Urban Governments
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Control over Municipal Expenditure and Fund
The state government is empowered to regulate municipal expenditure by fixing limits on expenditure to be incurred on various items, laying down regulations and procedures for incurring expeniliture. If the work involved exceeds a particular limit of expenditure, the urban bodies are required to obtain administrative and technical sanction from the competent authorities as determined by the state government. It can also require a municipal body to pay for any service. The purposes to which municipal fund can be applied are specified by the State Government through an Act and its application to any other purpose requires the government approval.

Control over Budget

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The urban bodies are required to prepare their budgets in the manner and form as determined by the state government from time to time. The budget approved by the municipality canriot be executed without the prior sanction of the state government which in turn has the power to make alterations in budgetary proposals. As mentioned in the preceding section if municipality does not agree with the modifications made, the decision of the state government is final'and binding on the municipality. In some states, the budget is not subject to the sanction of the state government. In such states the approval is needed only in those cases where municipalities are indebted. Besides, prior sanction of the state government is also needed for re-appropriation from one head to another head of the budget, that is, the money granted for education can be put to use for public works with government approval.

Control over Loans
As mentioned earlier, the borrowing powers of urban bodies are regulated by the central law known as the Local Authorities Loans Act, 1914. Before approving any proposal to borrow, the state government thoroughly examines the scheme, reviews the entire financial position of the urban local body, fixes the period of repayment, determines the mode of borrowing etc. For example, the Uttar Pradesh Na.gar Mahapalika Adhiniyam, 1959, lays down the following restrictions: a) No loan can be raised unless the state government has approved.the purpose, amount, rate of interest, date of floatation, period of repayment and method of repayment of loans. b) The period within which the loan is to be repaid shall, in no case exceed 30 ykars. c) Without theprior sanction of the Government no part of the amount borrowed shall be applied to any purpose other than that for which it was borrowed. d) No portion of the sum borrowed shall be applied to the payment of salaries or allowances of any municipal officer or servant other than those who are exclusively employed on the work for construction for which the money was borrowed. e) No loan can be raised for the execution of any work other than a permanent work.

Control over Grants
Grants-in-aid are the most effective instrument of state control over the finances of

Local Finance
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municipal bodies in India. The state government ensures that the grants are properly utilised and not misappropriated or diverted to unapproved purpdses. The grants can be reduced, suspended, and withheld if the accompanying conditions are not fulfilled by a municipal body. Control over Accounts and Audit Accounting and auditing are important instruments of state control over municipal finances. The municipal bodies maintain accounts in the form and manner as prescribed by state government. As stated earlier, in Punjab, the municipal bodies are required to follow the Punjab Municipal Accounts Code, 1930, which lays down detailed procedures for all sorts of financial transactions. Any departure from the form and manner requires the sanction of the state government. Besides, the state government may at any time direct special examination and conduct audit of municipal bodies by Auditors appointed by the state government. The main aim of the state government control through an audit is to ensure that public money is properly utilised and no amount is paid for any expenditure without the proper authority and provisions of the funds in the budget.

26.8 GAP B E T ~ E N MUNICIPAL SERVICES AND RESOURCES
The municipal resources are mainly based on the distribution of functions between the State Government and the Local Government. The functions of the urban governments are specified in the Act under which they are established. The municipal functions are categorised as compulsory and optional. In order to discharge obligatory functions budgetary provision is made for them. If urban bodies fail to perform obligatory functions, the state government helps them either by providing grants-inaid or arranging long-term loans to meet the needs, subject to their repayment. Howtver, an analysis of the mnnicipal resources shows that there is a wide gap between the municipal services and resources. In India, the entire field of municipal resources, remarks one commentator "is replete with outmoded principles of political economy, with stultifying checks and with consequential discouragement." There is an overall lack of appreciation of the fact ihat adequacy of financial resources and efficiency of financial management are determinants of the tone of municipal administration. The causes of inadequate municipal resources are of varied character. The entire machinery of municipal tax administration suffers from serious defects such as poor collection, heavy arrears, leakage of revenue, corruption, evasion in taxes, improper assessment of taxes etc. Further, the municipal personnel are low-paid and lack necessary training and experience. It has been observed that the local staff concerned with the assessment of taxes is generally not fair and the principle of equity is often disregarded. For instance, the Tax Superintendent being responsible to the members of the municipal committee is generally inclined to assess the houses of influential persons and the members at a low rate. In spite of the audit of municipal accounts, the audit has remained ineffective and inefficient. ~ x c e in big municipalities, audit is not conducted regularly. It is ~t generally in the nature of post-mortem examination which is sometimes dubbed as "locking the stable after the horse is stolen." Again audit objections and reports remain uncared for, at year's end. Thus the very purpose of the audit is frustrated. The borrowing powers of the urban local bodies in India are also limited. The term of re-payment and the rate of interest on loans are unfavourable in comparison to developed countries of the World. Further, most of the sources assigned to municipal bodies for taxation are inelastic and cannot provide the required services for the growing activities of these bodies. For exampie, taxes like octroi, terminal and property which constitute the backbone of municipal finance are quite inelastic as the proceeds from them do not grow in proportion t o the growth in financial mquirctan&ts. Tbe rules and procedures governing the imposition of taxes etc. are very elaborate, cumbersome, time consuming and leave very little financial independence to municipal bodies. Besides, the powers of the Indian local bodies to levy is limited by the Constitution of India.

For instance, Art. 285(2) of the Constitution exempts the Central Government properties from the levy of local tax by municipalities. One of the contributing factors to the poor municipal resources is that the government grants are utterly inadequate, unrelated to needs, irregular, unsystematic and uncertain in their release to municipal bodies. In some states, like Punjab and Haryana, government has taken over some of the municipal functions or theadministrative control thereof as in the case of education and f re-brigade but the expenditure pertaining to these functions is largely borne by th municipal bodies. This is wholly unfair and unbusinesslike.

Financial Admlnhlration of Urban Governments

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Another significant reason for inadequate financial resources is the unwillingness of municipal bodies to mobilise their resources to the admissible limit and to exploit even the limited powers of taxation that they have. They have, generally, shown utmost reluctance in increasing the existing taxes or in imposing new ones even where advisable and feasible, especially the direct taxes, for fear of people's anger and resentment. Apart from the above mentioned causes for the unsatisfactory position of municipal resources the other reasons are: underdeveloped trading enterprises, increased population pressure, general poverty in India, increased responsibilities, increased cost of municipal services because of eversoaring prices of the material and enhanced wages of the municipal personnel, and so on. If the municipal government is to play its role commensurate with the expectations and aspirations of the people, a serious effort is to be made to ensure its financial soundness so that the gap between the municipal services and resources is reduced. A number of committees and commissions have examined the question of the adequacy of municipal resources in India since independence. It has been suggested that the prevalent reluctance of municipalities to introduce taxes has to be overcome. The local Finance Enquiry Committee (1949-5 1) rightly recommended "Local bodies which do not utilise their existing power of taxation can have no claim on the financial resources of the state, where a local body is unwilling to impose tax at an adequate rate, the state government should have the right, in first instance, to give friendly advice and if the local body fails to carry it out, the state government should in the last resort, have the power to impose or raise the taxes. To augment the resources of municipalities, the financial management of these bodies needs to be streamlined, by selecting municipal personnel on merit, imparting them adequate training, paying them competitive salaries etc. Apart from this, there should be a strict check on the corrupt and defaulting employees. Efforts should also be made for the proper assessment and collection of taxes. Incentives may be offered for prompt payment of taxes and heavy fines may be imposed on the tax defaulters. Besides, audit should be conducted more regularly and special provisions even punitive in nature should be made for the speedy disposal of audit objections. The suggestion of the Rural-urban relationship Committee (1963-66) to set up a Municipal Finance Corporation in each state to provide loans to the municipal bodies for developing municipal enterprises such as city transport, milk supply etc., needs serious consideration by the State Government. Keeping in view the suggestion of Central Council of Local Self Government it is in the fitness of things to appoint a Municipal Financial Commission on the pattern of Finance Commission at the national level to examine in detail the financial requirements of municipal bodies, laying down the principles of sharing certain taxes between the state and municipal bodies. The financial obligations arising from the recommendations of the Municipal Finance Commission may be placed before Central Finance Commission, appointed by the President under Art 280 of the Constitution. A number of State Governments have set up Municipal Finance Commissions, Maharashtra (1973) being the first followed by Orissa (1975). A state where such a commission has not been set up should consider this suggestion as early as possible. To improve the financial position of municipal bodies, government grants should be adequate, related to needs, regular, systematic, certain and be made available to them over the next five years or over the plan period. The borrowing conditions should be liberalised in certain ways such as longer terms of repayment, cheaper interest rates, extension in Dumoses and aermission with adeouate safermards tn hnrrnw in the enen

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market. This will go a long way to mwt most of the pressing needs of the capital nature for funding long-term and costly projects like water works, slum clearance etc. Last but not the least, the other suggestions such as a centralised purchasing, simplification of tax-imposing procedures, over-handling taxation structure, development of municipal enterprises, eradication of general poverty, and the proposal of the late Mr. Rajiv Gandhi, former Prime Minister of India to grant ~onstitut~onal status to municipalities should also:be kept in mind. All the above mentioned suggestions need the sincere and serious considerations of the State Government