Financial Administration PDF

UNIT 1 NATURE ANDSCOPE OF
FINANCIAL ADMINISTRATION
.,
' Structure
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
1.O 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
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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
i and a dynamic content to financial administration. In the changed context, it is
I 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
I 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
,A,:,:,r-,.r:-, :.. --------. .
Financial Administration : Basin Now let us get to know some more accurate definitions of Financial Administration.
and Objectives 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~cialaffairs 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 Private Finance

1) Adjustment of income to 1) Adjustment of expenditure to
expenditure income
la) Popular control la) Corporate control
2) Elastic resources 2) Limited resources
3) Resource mobilisation through 3) No such power
coercive power
4) Tendency towards deficit 4) Tendency towards balanced
budgets
5) Direction of expenditure towards 5) Towards profit maximisation
public service
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
eniialitv Ficral nnlirv o f the o n v e r n m ~ n thac hprnrnp a n n w p r f i ~ inctnirn~nt
l in
~nfluencingthe socio-economic life of the people. Defence and administrative Nabre and Scope of Financial
AdmlnistraUon
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.
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?
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Finmcid Adminls(ratIon :Basla

and Objectives .........................................................................................................
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~blemsof public
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
are bound to have some direct or indire~t'conse~uences of 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.
Nature and Seop of Financial
Thus, finmcial administration provides a framework of choices regarding ends and Administration
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.
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
I 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.
I 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.
Financial Administration : Basin It looks at a policy in the framework of long-term economic consequences. There is
and ObJectivcs 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
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?
Nature
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SCW Flkdal
4) Highlight the.comprehensiveview regarding the scope of financial'admin&ation.
1.6 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 b) Work and Structures
and Objeckives 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

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.
Planning-programming-budge* system (PPBS) : It is a technique for optirnising
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 : ! h e b p o l i t i d theory :This theory as advocated by Wagner laid emphasis on looking
and objecti'vcs 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,
n~ Fifth Edition, Henry Colt and Co.:
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:
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 ~dministrationfrom 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
*..--A 1,-LZ-
Nature and h p e of Financial
Check Ywr Progress 2 Administration
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.
Financial planning
Budgeting
Resource mobilisation
Investment decisions
Expenditure control
Accounting and auditing.

Financial planning
Financial organisation.
Financial personnel
e Financial advice
Coordination of income and expenditure
Financial reporting
Executive, legislative and audit control.
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
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. Objectives and Rindpks d
We shall also trace the evolution of financial administration in India and also highlight Flnaneial Administration
some of the emerging trends.
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.
' FinaRCI.l Admtnfstration: Basics 7) Facilitating smooth flow of parliamentary processes : The basic tenet of
and Objectlva
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
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 Objectives and Principles 01
Financial Administration
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) The principle of primacy of public interest, public choice and public policy
2) The principle of political direction and control
3) The principle of correspondence
4) The principle of unity of organisation and management
5) The principle of stability and balance
6) The principle of simplicity and flexibility
7) The principle of conduct, discipline and regularity
8) The principle of public trust and accountability.
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 : 4). The Principle of Unity of Organisation and Management
and Objectives
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 firm financial
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.
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.

Note : i) Use the space,given below for your answers.
ii) Check your answers with those.given at the end of the unif.
Objectives and Principles of
1) What are the important principles of financial administration? 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~atiJontax etc., constituted other direct taxes.
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
nt and
Procedures.
Period 111 (1919-1947) .. Demdcratisation and
Decentralisation
Period IV (1950-till date) .. Development orientation.
Financial Administration : Basics Period I : Creation of structure and concretisation thereof
and Objectives
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 i 1ndia in 1854. This
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
Objectives and Rind* of
supervised and controlled Provincial Finance Departments. The Finance Department FiluncW AdminLstnrion
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.
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 Governor-
general 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
I
I
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
1 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
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

7 7 - - -
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
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, 4) Application of contingency approach
and Objectives
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
I
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
of "national sector" in which publi~sectorand 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.
.16)
x*
Non-bureaucratic delivery of public goods and services
Following public choice theorists, the government is thinking in termsbf providing
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.
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 Objectives and Principles of
Financial AdminlsCration
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. ,
Check Your progress 4

'
ii) Check your answers with those givkn at the end of the unit.
1) Outline the emerging trends in financial administration of 1ndia.
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
muadd : Bslla inflation, the government had to take Wry radical steps in 1991. These include control
b b ~ v a
MIJ
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 f :
.3
W ~ n e of
firms, governmental units of all o t h q ,

between the residents of country a*' %&
terms of country's currency. <
'*
e Payments : It is a kind of i"..' statement that records all transactions
between individuals, firms and gover@&taf units of one nation and individuals,
ns. It gives a record of all transactions
: *ofthe world with payments expressed in
,-$-
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~troducedat the provincial level under the
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 Governor-
General.
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 Taxa- Enquiry Committee was constituted by the
Government of India under the C h a h @ h l p of L.K.Jha in 1974. It was set up w12h
the objectives of examining the role $>indirect taxation in promoting economic use
of scarce resources, in mobilising , its impact on prices and costs and to
suggest suitable reforms in the indkm%Fation system.
Manpower W i n g : It is the pro&S$t 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 sEnquiry Committee set up by the
Government of India in 1970 under f&&Pirmanship of Mr. Justice R.N. Wanchoo.
The Committee was to recommend cM&$He, effective measures for unearthing black
money, checking avoidance of tax, s M e s t improvements in tax assessment and
administration.
2.7 REFERENCES , .t.;_.

.,*
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.
rover.H.N. 1954. Financing ~ow&nr, Htnry Holt and Company: New York.
Hicks, u.K., 1951. Public Finance, Nisbet & Co. Ltd: London. Ob]ectlve~and Prlnclpla of
Flnanclal Admlnl~tratlon
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.

EXERCISES
Stability
Development
Self-reliance
Reduction of interpersonal inequalities in income and wealth
Balanced regional development.
Management of the finances of public household
Implementation of projects and programmes
Provision for public goods and social services
Growth, employment and price stability
I
Capital formation
Productive deployment of national funds
Facilitating smooth flow of parliamentary processes
1
Achieving equity and equality.
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.
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
i
The objectives and functions provide the basis for staffing and equipping of
the organisation.
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.
The financial administrative history of India can be divided into four
distinctive phases
FlnaneU Administration :Basks First period (1765-1858) was Characterised by Creation of Structure and its
and Objectives 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.
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.
The f o ~ u of
s financial administration is on welfare and growth rather than
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
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
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.
3.1 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 - CONCEPT AND SALIENT
FEATURES
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
both publi~sector and private sectors are present is the mixed economy of the
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, Mlxed Economy
employers, investors etc. This is achieved thmgh cost control, price cutting,
advertisements etc.
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
the market can usefully encourage and acca- - as it cannot put a man into
space so it cannot bring quickly into existencqi&bl industry where there was little
or no steel making capacity before. Nor can it-ly create an integrated industrial
plant. Above all no one can be certain that it'* do so in countries where
development has lagged and where there is n4 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."
'I
"Socialism is an economic organisation of in which the material means of

production are owned by the whole commuqjt$s:to a general economic plan, all
members being entitled to benefit from the of such aocialised planned
prodilction on the basis of equal rightsifPlAs *nst 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 au- 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. 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: Oemocratic socialism, which is a milder form of socialism shares with capitalism
and obWvca 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

n~ the two extremes of capitalism
anh socialism, it is now possible to define a mixed economy in functional terms. A
mixed economy is characterised by :
i) a balance between the market economy and the planning mechanism;
ii) 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 also acknowledged the
important role of village, cottage and small scale industries.
Flnenclei Admlnlstretion : Beslcs The resolution accorded a prominent role to the public sector. The apprehensions of
end ObJectlves 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 of 1 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.
I . r
Check Your Progrea~1

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 : Basics 1) to help in the rapid economic growth and industrialisation of the economy and
md Objectives
create the necessary infrastructure for economic development
2) to earn return on investment and thus generate resources for development
3) to promote redistribution of income and wealth
4) to create employment opportunities
5) to promote balanced regional development
6) to assist the development of small-scale and ancillary industries; and
7) 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 No. of

(Rs. in crores) enterprises
1 2 3
Aeoa 1.4.1951 29 5
Aeon 1.4.61 948 47
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 ethe third plan,
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. Mixed Econom:
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.
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: iii) Technology imports for priority industries are automatically approved for royalty
and ObJectlves
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.
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.
..........................................................................................................
.........................................................................................................
.........................................................................................................
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 The public sector was supposed to have control over the commanding heights of the
and Objectives 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.
Mixed Economy
EXERCISES
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
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.
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.
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.
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' Objectives
4.1 Introduction
4.2 Federalism - Meaning
4.3 Basic. Features of Federalism
4.4 Principles of Fiscal Federalism
4.5 Evolution of Fiscal Federalism in India
4.6 Let Us Sum Up
4.7 Key Words
4.8 References
4.9 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 ' nis blended with the essence of
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
financial rdlations need to be reviewed in this framework. ?

country. It breeds administrative inefficiency and local disconten The Centre-State
'
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 i
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.
Centre-State Financial Relations-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.
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 aspirations which may be rooted in culture, religion. race, language, internal or
and Objectives 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 collecting-
local 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~nicDeterminants
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 Centre-State Financial Relations-1
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.

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
: central government. Functions of a purely local character, confined to a unit in each
and Objectives instance, should generally be left to the Central Government. Normally, there should
d."
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.
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 i
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.
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.
Centre-State Finandd Relations-l
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.
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
A
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.
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 benefit distribution may not #ways match. When units which happen to be the bigger
and Objectives
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-Councilretained 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 nin 1870. The fiscal history of the next sixty
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,
Centre-State Financial RektioabI
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 :
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
foundations for a system of elaborate but flexible financial arrangements betwenenthe
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.

Note : i) Use the space given below for'your answers.
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.
~inancialautonomy 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 centre-State Financial Relations-i
on the one hand, and its relative cost of providing a standard range and quality of
services, on the other.
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.

EXERCISES
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.
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 of cooperation,
understanding and accommodation. Independence and coordination are,
therefore, both essential for the functioning of a federation.
3) USA, Commonwealth of Australia and Canada.

i) Independence and responsibility
ii) Adequacy and elasticity
iii) Efficiency
iv) Equity
v) Equalisation transfers
vi) Conflict resolution
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.
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

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~ of revenue transfers. The capital resources for planned development are.
now tra~sferredon 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~creature ot a tederation is that the powers are so divided that the central
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 Centre-StateFinancial
Relations-11
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;
". .. 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 Article 286 of the Constitution forbids taxation by states of
and Objeftlves
a) imports into or exports from the tercitory of India;
b) Inter-state trade; and
c) sale of goods dec1ared.b~the 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
.~
Centre-State Fin'ncid Re'ations-l?

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.
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
for such vital matters as the defence of the country and the stability of 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 The Ninth Finance Commission (Second Report) also observed :
sod ObJcetlva
"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) increase in the number of commodities taxed
b) increase in rates
c) rise in prices; and
d) 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
s 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 ;.action ;nil -r\linm nnrl ~ r w 4 ~ l n..-L
assprimary education, medical and public health, welfare of scheduld cistes, ccobc-st.tr ~ i a ~ cRelatkns-11
i d
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.
The seventh Finance Co-on twk'the view that grants-in-aid should only be a
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
b'inancial Administration : Basics Commission observed that "the importance of planned development is so great that
and Objectives 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

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: Centre-State Financial Relations-11
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
and assist them in resolving these in implementation of the plan. They are
thus expected to function as an active link between the Planning Commission and ihe
state governments.
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 those on account of central and centrally sponsored plan-scheme, the totality of the
and Objectives
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
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 Centre-State Financial Relations-I1
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
i 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.
I
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.
It
Agricultural Income Tax is not easy to administer. Large commercial losses have also
been incurred by the public sector enterprises year after year.
I
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.
I "We may conclude that there is a slightly higher degree of centralisation of
I revenues in India than is generally found in the economically developed
I
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
I
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
i of federal transfers cannot be said to be an indication of dependence"
Financial Administration : Basics Indebtedness of States : One of the major problem areas in Centre-State financial
and Objectives
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
borrowed funds efficiently and productively for capital expenditure instead of
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"

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?

Centre-state Financial Relations-11
3) What are the major sources of devolution of resources from the union to the
states?
4) Point out the areas of conflict in federal finance between the centre and states.
.........................................................................................................
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.........................................................................................................
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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
i 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
t assistance for the execution of the State Plans including Centrally Sponsored
Schemes. In spite of the criticism that the Planning Commission's recommendations
j 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.
Financial Administration : Basics
and Objectives 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. '
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.
Centre-State Financial Relations-11
EXERCISES
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.

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.

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
I
Planning Commission.
mmcial : 4) Your answer should include the following points:
ard Objectives
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 FISCAL POLICY, EQUITY AND
SOCIAL JUSTICE
Structure
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
6.0 OBJECTIVES
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 is their excessive
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.
Flscd PoUq, EquYy md
v) Control of inflation
Sodd Jurtkc
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 non-
inflationary 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

1) What is the central concern of fiscal policy? What are the major aspects of
government finance that fiscal policy is concerned with?
2) 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 Non-
Resident 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 macro-
economic 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.
I
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.
I
Can government expenditure be reduced? "The newly evolving analysis of
bureaucracy by economists provides more rigorous underpinning for an old
I
conclusion popularly known as 'Parkinsons Law' (Refer to Section 6.7 for
j
explanation). Bureaucrats maximise their own utility and the principal variable in
I their "utility function" is power. Power can be roughly measured by a proxy such as
I the size of the bureaucrat's budget, or the size of the department by the number of
'
I 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
I
will strongly resist any attempt to dismantle a government organisation. The
governments, even when they make genuine efforts to reduce expenditure, usually d o
iI
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 A N D SOCIAL

JUSTICE
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 41.2 38.2 .28.1 20.1

All India 51.5 48.3 37.4 29.9
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
L 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
li 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
reduced. Nor~mlprocess of industrial development always benefits the affluent
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 1991-
92. 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

I
'Note : i) Use the space given below for your answers.
ii) Check your answers with those given. at the end of the unit.
I
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.
Thavaraj, M J.K., 1978. Financial Administration in India, S u l t a n - C h d & Sons,
N-...naw;
ANSWERS TO CHECK YOUR PROGRESS
EXERCISES
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.
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

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.
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 Objectives
7.1 Introduction
7.2 Budget-Meaning
7.3 Characteristics of Budget
7.4 Functions of Budget
7.5 Classification of Budgets
7.6 Budget-An Illustration
7.7 Let Us Sum Up
7.8 Key Words
7.9 References
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 MP-Y i) plans, programmes, pro~ects,schemes and activities-current as well as new
sydwm-I 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 CHARACTERISTICS OF BUDGET

The basic characteristics of government budgeting are as follows :
i) 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

I) What are the components of a budget?
2) Discuss the characteristics of government hl~dget.

....................................................................................... Government Budgeting :Prhdplr
and Functbm
2
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 inter-
relationships 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
~conomicclassification
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) Salary
2) Wages
3) Travelling allowance
4) Office expenses
5) Machinery and equipment
6) Works
7) Grants-in-aid
8) Other charges
9) Suspense account
Merit8
i) 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 inter-
department 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.
ri) It shows clear allocation of funds. For example, what percentage of the Covannmt Bdgdhg :PrMpla
expenditure is on salaries, travelling allowances, etc. and Functbm
iii) In times of financial stringency, this classification enables across-the-board cuts

on specific heads such as travelling allowances, foreign travel etc.
I Deadta
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
I 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 1) Education

efforts which provides distinct 2) Health
services. 3) Defence
4) Agriculture
Propamme A segment of a function usually 1) Elementary
having an end identfible education
with a major organisation. Secondary education
Higher education
Technical] Vocational
education
National Malaria
Eradication Programme
Development of High
Yielding Crops
Activity/ A division of a prognmme I) Construction of echo01
RoPct into homopneour typa of buildings
work or rbcma Stmngihening of
kbonlories
2) Purchase of seeds/
fenilLcn
Another example of a functional classification of roads will classify the system as :
Funct~on : Roads
Programmes : 1) National Hi%ways
2) Roads of Economic or Inter-State importance
3) Strategic Roads
4) State Highways
5) Major District Roads
6) Rural Roads
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~onprovides 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,
has to be the same; as it is 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 Covult#lnmtB o d H n :Prhdpk
mod Functlom
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.
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.
WWE WW Budget at a Chnee

,.
(* m)(In crores of Rupees)
1-1-92 I ~ I - 9 2 192-93
rJrr mfh rJrr
=T- =T- =T-
Budget Revised ts
d&
I
Estimates Estimates Estimates
I. Revenue Receipts 54954
2. Tax Revenue
(Net to Centre) 42978
3. Non-Tax Revenue .I1976
4. Capital Receipts ,39015

5. Recoveries d Loano 5712
6. Other Receipts ...
7. Borrowings and other
liabilitica 33303
8. Total Receipts
(1 + 4) Y3%9
9. Non-Plan Expenditure 76198

10 On Revenue Account 60850
II. On Capital Account 1 5348
12. Plan Expenditure 291 18

13. On Revenue Account 12666
14 On Capital Account 16452
15. Total Expenditure

(9 + 12) 105316
16. Revenue Expenditure
( l o + 13) 73516
17. Capital Expenditure
(11 + 14) 31800
18. Revenue Dcfrit
(1-16) 18562
19. Budgetary Defic~t
(8- 15) 11347
20. Fiscal Deficit

[(I + 5 +6)-15= 7 + 191 44650
21. m-&rft*dk Increase in net
BPJ*tiWm RBI Credit
*@T to Central Government # 14745 7719 8800 5389##
mmif
# m - & r ~ b 3 m ~ U W K # Including other variations in Reserve Bank of
*
d h ~ W i T * @ ~
w-w l
India's credit to Central Government.
## e a ~ a ~ m a ~ l f t m ~ m n l ## Not independently estimated.

-
' \-

/ 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.
I
-
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. .
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
A budget essentially includes the information about :
plans, programmes, projects, schemes and activities, current as well as new
proposals for the c o m i n ~
.year,
.
resource position and .income from different sources including tax and non-
tax 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.
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 gand Budgauy
SyJ~ras-1
I ) Your answer should include the following points :
Accountability
Management
Control
Planning
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.
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 INDIAN BUDGETARY SYSTEM
Structure
8.0 Objectives
8.1 Introduction
8.2 Evolution of Budgeting System in India
8.3 Principles or Budgeting
8.4 Financial Year
8.5 The Budgetary Process
8.6 Budgetary Cycle
8.7 Let Us Sum Up
8.8 Key Words
8.9 References
8.0 OBJECTIVES
-- -
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 planning-
orientation 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~ngbalance 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 I!.
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-Councilaccountable to the Secretary-of-
State-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.
I
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. Indian Budgetry Syslem
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 Montague-
Chelmsford 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 of India Act, 1935, delivered a body blow to his powers. Except for
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.
8.3 PRINCIPLES OF BUDGETING

The essential principles generally observed in government budgeting in India are :
i) 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 ~ vi) The form of estimates should correspond to the accounting heads since the
system-I
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
year and any dislocation in this year will lead to statistical, accounting and lndim Budgauy system
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.
Cbeck Your Progress 1

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 Consolidated Fund of India
Systems-I
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 Indian Budgduy System
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.
. - -
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 V) Proposed estimates for the next financial year (which is the budget proper).
tern-1
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.
\\,,
~ 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 Indian Budgduy System
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.
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).

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.

I
These are the four stages in the budgetary cycle. viz; preparation, approval, Indian Budgetary System
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.
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
Remote control through Secretary of State.
Budgeting and Budgetary Delegated financial authority to Governor General in Council.
Systems-l
Centralised financial control in the Finance Department.
Complex rules, regulations and procedures.
Principle of annuality.
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.
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.

I ) Your answer should include the following points :
Revenue budget consists of the revenue receipts of government (tax and non-
tax 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.
Preparation and submission of budget estimates by ministriesldepartment.
Parliamentary approval.
Execution of the budget by government audit.
Collection of revenues.
Custody of the collected funds, and
Distribution of funds.
UNIT 9 CLASSIFICATION OF
GOVERNMENT EXPENDITURE
Structure
9.0 Objectives
9.1 Introduction
9.2 Classification of ~ o v k r n m e nExpenditure
t
9.3 Revenue and Capital Expenditure
9.4 Developmental and Non-Developmental Expenditure
9.5 Plan and Non-Plan Expenditure
9.6 An Evaluation of the System of Classification of Expenditure
9.7 Let Us Sum U p
9.8 Key Words
9.9 References
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 : Non-
developmental 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. Classilkationof Government
Expenditure
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
transactions and records government's influence on each sector of 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.
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 Non-
Developmental 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
expenditure; alternatively, the allocation may be based whether an expend~tureis
"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 (tax-
revenues 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
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.
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 "Non-
Developmental" expenditure. Developmental expenditure comprises expenditure
z-nm.--c.A -- c.Am.n-+:-- --A:n-l -m.Ll:n kc.-lth o n A f 0 m i 1 . 1 n l o n n i n m l ~ h n n - vQ n A
employment, agriculture, cooperation, irrigation, transport and communication and Clssslfica~ion
of Government
Expenditure
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.
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 'Non-
Developmental' 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 "Non-
Developmental", "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.
Riit i t i c r i i c t n m a r v tn m a k c = c n n ~ ha r l i c t i n r t ; n n fnr hrnarl analvtiral nllrnncpc
The classification of government expenditure into "Plan" and "Non-Plan", C I d Governmen1
~ ~
Expenditure
"Developmental" and "Non-Developmental" gives a distorted picture of the whole
classification pattern of government expenditure, because Developmental and Non-
Developmental 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.
' 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 "Non-
Developmental" 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
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.
~ e v e n u ereceipts 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.
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.

11 Y n i ~ rnnpwer shn~ildinrliide the fnllnwin~nnints:
C'BbSincatiOn OrGOVernment
Plan expenditure refers to the expenditure incurred by the Central government on Expenditure
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.
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.
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
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 Public Expenditure:
Theories and Growth
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.
Positive Approaches -Ic
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: -49 .noQ
,
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.
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
'q assured to all.
rstr
lent u. outlined above do throw light on the determinants
e in favc wssible to lay down a law which will explain the
)rough a t
behaviour of public expenditure in different environments. The factors that have so far Public Expenditure:
Theories and Growth
influenced public expenditure are environmental, technological, economic,
administrative and political in nature.

1) What are the practical problems involved in the marginal utility approach?
..........................................................................................................
2) Explain public choice theory as a determinant of public expenditure.
..........................................................................................................
3) Discuss Peacock-Wiseman hypothesis on public expenditure.
10.3 IMPACT OF PUBLIC EXPENDITURE

'
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.
Public Expenditure:
10.4 GROWTH OF PUBLIC EXPENDITURE IN INDIA Theories and Growth
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

(Rs. crores)
1950-51 1992-93 Growth over

(B.E.) 1950-51
Total Expenditure 529 1,19,087 Over225 times

Revenue Expenditure 347 89,570 Over 258 times
Capital Expenditure 183 29,517 Over 161 times
National Income (1991-92) 8,398 4,25,672 ,About 48 times
estimated
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 Expenditure of Col. (3) as

prices the Central per cent of (2)
Government
(Capital+Revenue)
(1) (2) (3) (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.
Another salient feature of the growth of government expenditure is the increase in the
i 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 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.
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
--1:+:-,.1 :-+.-... ..
Public expenditure diverts economic resources into channels determined by the Public Expenditure:
Theories and Growth
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.
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.

EXERCISES
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.
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.

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.
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.
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
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
7'
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.
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,
Performance Budgeting
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.
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.

1) Explain the concept of performance budgeting.
.. .
A
..........................................................................................................
2) List the objectives of performance budgeting.
..........................................................................................................
3) Describe the budgetary process involved in performance budgeting.
..........................................................................................................
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 efficiency-
of 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) The very basis of performance budgeting is classification of goverr~mentalwork
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.

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 object- Performance Budgeting
wise 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.
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.

EXERCISES
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
s more effective performance audit.
Measures progress towards long-term objectives as envisaged in the plan; and
Brings close annual budgets and developmental plans.
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.

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.
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 Objectives
12.1 Introduction
12.2 Concept and Meaning of Zero Base Budgeting
12.3 Zero Base Budgeting and Traditional Budgeting: A Comparison
12.4 Genesis of Zero Base Budgeting
12.5 StepsIElements of Zero Base Budgeting
,'12.6 Introduction of Zero Base Budgeting in India
12.7 Implementation of Zero Base Budgeting -Benefits and Problems
12.8 Let Us Sum Up
12.9 Key Words
12.10 References

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.
12.3 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:
- Last year's spending level is extrapolated into next year, Zero Base Budgeting
- Some growth factor is added on account of inflation, increase in prices of raw

material and wages etc.
- Spending level is further incremented for new projects and programmes.
ZBB attempts to shift the traditional management approach towards a new m ~ d of e
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 Zero Base Budgeting

Budgeting
Review & Justify
New Programmes
b
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.

1) Discuss the concept of ZBB highlighting its aims and objectives.
..........................................................................................................
! 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 cost-
benefit 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
~l nf 7RR
Zero Bare Budgeting .
- There must be a genuine need within the organisation.
- 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

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 Company Code Bank
Package
Objective of Activity Dept.
Level of: Discussion/Section
Desired Resources Current Budget Year % age of
Results Required Year current
Personnel
No.
Description of
Activity Wages
Salaries
Total staff
variable
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 Zero B ~ s Budgeting
e
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:
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 B~ B2 B3 B4
Middle level
consolidation CI c
2 c
3 c
4 c
5
Preliminary
ranking by "1 "2 "3 "4
"5
managers who
developed it
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 cost-
effective 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. \
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:
7tq-o Hase Hudgeting
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
i
I
programmes to high priority programmes.
iI 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 cost-
i effectiveness 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.
1 - 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.
I - It sharpens and quantifies objectives and formulates alternative methods of
operations.
- It promotes involvement of line managers in budget formulation.
C
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
I
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.
v) 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.
Check Yonr l'mgms 2

1) Trace the evolution of zero base budgeting system in India.
..........................................................................................................
2) Describe the stages in the implementation of zero base budgeting.
..........................................................................................................
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
Zero Base Budgeting
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
b
fact the system has failed to take off due to administrative problems.
I
12.9 KEY WORDS
B
..
Deer~lonUnit: 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.
, Decision m: A document that identifiesand describesfacts about an activity from
every possible angle.
PInnning Rogpmdqj Bodgding System (PPBS): It is a technique for optimising
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.
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.

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.
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.

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.
Identification of decision units and their objectivies.
Formulation and development of decision packages.
Ranking of decision packages.
Allocating resources to decision packages.
Identifies inefficient or obsolete duplication of activities.
\
Facilitates critical review of all programmes/activities in terms of their cost-
effectiveness 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 Non-tax. Revenue
13.4 Sharing of Receipts with States
13.5 Resource Mobilisation over the Years
13.6 Let Us Sum Up
13.7 Key Words
13.8 References
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.
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, :
Sources of Hrvcl~ue
building etc. when the price at which it is sold or transferred exceeds the price at Tax and Non-Tax
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.
13.2.2 Indirect Taxes

I
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
1 system a heavy reliance is laid on indirect taxes which amount to around 83%.
i
Indirect taxes include sales tax, excise duties, entertainment tax, customs duties etc.
i 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
Sources d Revenue :
Excise Duties can be specific or ad valorem. It is specific when levied at a specified Tax and Non-Tax
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) 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
I
other taxes and duties.
I
Notes : i) Use the space given below for your answers.
I ii) Check your answers with those given at the end of the unit.
I
II 1) What do you understand by direct taxes? State the types of direct taxes levied by
the Union Government.
2) What is Corporation Tax?
..........................................................................................................
3) What do you understand by Wealth tax?
.........................................................................................................
...........................................................................................................
4) Distinguish between specific and ad valorem excise duties.
.........................................................................................................
.........................................................................................................
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 Revised Budget
1990-91 1990-91 1991-92
a) Interest Receipts 9,519.09 9,572.74 11,008.82
b) Dividends and Profit 720.89 779.55 967.12
Sources : R.B.I. Report, ~ u d b e t1991-92and 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.
S w m of RLvcnw :
Other Interest Receipts : The estimates under 'other interest receipts' are in respect Tax and Non-Tax
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
I 1) International
Budget
1990-91
Receipts Discharge Net
Revised
1990-91
Receipts Discharge Net
Monetary Fund 509.40 0.05 509.35 549.98 326.18 223.80

2) International Bank for
Reconstruction and
Development 115.77 14.00 101.77 115.77 18.00 97.77
3) International Development
Association - 0.60 (-)0.60 0.00 0.60 -0.60
4) International Fund for
Agriculture 4.49 1.85 2.64 4.49 1.85 2.64
5) Asian Development Bank - 0.10 (-)O.lO - 0.40 (-) 0.40
6) African Development Fund
and African Development
Bank 7.44 4.80 2.64 7.44 4.70 2.74
Total 637.10 21.40 615.70 677.68 351.73 325.95

S.D. 1,250.17 1,033.73 216.44 2,736.26 2,562.35 173.91
Source : Budget 1991-92 .

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
grants-in-aid and other contributions. 1
13.4 SHARING OF RECEIPTS WITH STATES

-/
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
. . . . - - -.
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
Budget- Revised Budget

1990-91 1990-91 1991-92
Total Tax Revenue 59,778.57 58,916.01 66,217.73

Less states share:
Taxes on income 4,064.31 4,120.48 4,467.91
Union Excise Duties 10,361.44 10,414.00 11,175.47
Total States Share 14,425.75 14,534.91 15,643.38
Less :Transfer of Union territory taxes and 58.83 63.25 79.43
and duties to local bodies
Centre's Net Tax Revenue 45,293.99 44,317.85 50,494.92
Source : Budget 1991-92

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 :0
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.
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
t Product (NNP) ratio was as low as 6.4%;
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 Sourees of Revenw :
is remarkably good by any standard. In India all the major taxes, except personal Tax and Non-Tar
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.
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
i
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 nthe postal and telecommunication
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.
II 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
I measured by the ratio of net profits to capital employed, rises to 4.5% in 1989-90,
which is the highest achieved in the decade. Howeb~rthe 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
I 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
i 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
crore at 1984-85 prices for fii~ancingthe 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.

Notes : i) Use the space given below for your answers.
iih Check vour answers with those given at the end of the unit.
--- - - -
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 Sourap of Revenue :
it more equitable and sound. 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.

EXERCISES
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.
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.
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.
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.
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.
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
rL- n- _ A _ _ _-I a_.. r 1L- >_ --- I- L - >l-.-lL ..r - 3 r L - -A_.--
UNIT DEFICIT FINANCING
Structure
14.0 Objectives
14.1 Introduction '
14.2 Deficit Financing - Concept and Meaning
14.3 Role of Deficit Financing as an Aid t o Financing Economic Development
14.4 Deficit Financing and Inflation
14.5 Deficit Financing and Price Behaviour in India
14.6 Advantages of Deficit Financing
14.7 Limitations of Deficit Financing
14.8 Measures/Alternatives t o Control Deficit Financing
14.9 Let Us Sum U p
14.10 Key Words
14.11 References
14.12 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 Deficla Financing
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.
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
t 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
I
lies, therefore, in government spending in excess of the revenue it receives in the
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.
Deficit Financing
- 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.

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,
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, j
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.
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
of deficit financing will be inflationary and the safe limit of 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.

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

I P
Balance of Payments : It is a kind of income statement that records all transactions
I 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.

EXERCISES

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.
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
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.
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.
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.

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.
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.

,
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
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 Publk Deb1 Management and
Role of Reserve Bank of India
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
I
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
i , 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.
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
1
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.
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
ry Scheme' in 1971.
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.

1) State the causes for public borrowing
.........................................................................................................
.........................................................................................................
.........................................................................................................
2) Distinguish between reproductive and unproductive debt.
3) What are internal and external debts?

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,
the size and com~ositionof 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.
iii) 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.
PUBLIC DEBT AND ECONOMIC DEVELOPMENT

AND INFLATION
The existence of a laree ~ u b l i cdebt does Dose real and ootential ~roblems.Externallv
held debt is obviously a burden. The payment of interest and principal require the Public Debt Management and
Role of Reserve Bank of India
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
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 Internal Central Total Total Total

Debt. & Debt. to . Govt. Govt. Debt. Deficit
Obliga- GDP (%) External Debt. GDP (%)
tion Debt.
1990-91 R.E. 2796 0060 0318 31 14 0067 0 I06

1991-92(Bu) 3181 006 1 0356 3537 0074 -
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 a
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
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
Publk Debt Maaagtmcnt and
Indian households and business houses paying higher taxes and the government Rde of R r s n e Bank of India
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
consisting of 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
that a screening of imports be ca~riedout and non-essential imports slashed with an
t iron hand. The philosophy of import led growth should be abandoned in favour of
the philosophy of import substitution and self-reliance.
1
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.
-. . . . A. -
Another short-term measure may be to cajole the NIUs into investing in areas either
.* rL- n- -C.TT-.T 2 .A-
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
holder of Central government securities. It has undertaken considerable b u y i ~ gand
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.
Public Debt Management and
Large public debt imposes constraint upon effective monetary (interest rate) policy. Role of Reserve Bank of India
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.
1) What do you understand by the process of conversion of public debt?
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 ~M O ~ O ~ U ~ I I
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.
public Deb1 Management and
Time and demand liabilities : Time liabilities are fixed deposits which are Role of Reserve Bank of lndla
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.
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.

EXERCISES
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
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.
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.
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.

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
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 Financial Apprabrl
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 Real or Nominal 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). 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
I 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.
1 Internal Transport and Handling Costs
It is important to be clear about where inputs and outputs should be priced in a

I
project appraisal. In the case of a project's output, it could be valued at the
I
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
I the net incremental benefit of the project to the implementing agent that is of
li 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.

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.

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

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 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), ... (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:
(Bl -C1) (B2 4 2 ) (B3 -C3) ...,.......(Bn - cn

0 -0 +r )
' ( ~ + r ') (~ ~ + r ) ~ ( 1 + r)"
Financial Appraisal
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)
Total 1100 1550 4450 NPV=10.4
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
I should be rejected.
I
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 non-
discounted costs, benefits and net benefits (benefits-costs) of the railway project.
I Column (4) gives the discount factor, 1/(1+.08)t, by which the non-discounted
i
net benefits in column (3) are multiplied, to obtain the discounted value of these
i net benefits in each year, t, shown in column (5). These discounted net benefits
I 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,
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
Financial Appraisal
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)
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
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

1) Briefly discuss cash flow in financial analysis.
- - - -
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 ~roiectwill be financiallv ~rofitable.These
market prices usually contain many distortions such as taxes, tariffs and price Financial Appraisal
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.
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 of Projects: A Text in
Cost Benefit Analysis, Macmillan, London.
Perkins, Frances. 1952, Practical Cost-Benefit Analysis: Basic Concepts and
Applications, Macmillan, Australia.
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.

EXERCISES
Cbeck Your Progress 1

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.
1 Commercially oriented government agencies that are selling output
will usually undertake a financial as well as an economic analysis of
I
anv new ~roiectthey are considering.
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.

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.

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 ~roiectimvlementer.
Financial Appraisal
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.
* 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.
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
17.3 Financial Analysis and Economic Analysis: Distinction
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
17.0 OBJECTIVES
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.
When a 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:
Should a new bridge be built, or should the existing ferry service be Economic and Social
Appraisal
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.
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.

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 Economic and Social
expansion of activities the base case would represent a continuation of the Appraisal
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).
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 Economic and Social
due to the impact of noise levels to assess the cost of airport noise); and Appraisal
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
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, Economic and Social
machinery and other inputs are used for construction, or in the case of an Appraisal
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.
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 Economic and Social
range of independent projects and adequate resources, must accept or Appraisal
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:
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 2/C - L ' ~
1-0 (1 r)"
+ "-0 (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
30 NPV obtained from a limited capital works budget.
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 Economic and Social
rationale in welfare economics for the social analysis of projects is therefore Appraisal
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
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 Project B
Rich Poor Rich
Cost paid by
Benefits received by
If distributional weights, d: 1 1 1 1 1
Economic NPV +50 +80
Therefore do Project B
I
If distributional weights, d: 2 1 2 1
Cost paid by 0 100 160, 0
Benefits received by 300 0 0 160
social NPV +200 0

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 Economic and Social
correct view in the case of the developed, higher income countries, which have Appraisal
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.

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.

EXERCISES
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.
Economic and Social
Through pre-feasibility study financial and economic analysis of the Appraisal
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
P and operations procedures can benefit from the past experience.
v
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.

The steps involved in preparing a full economic evaluation are as
follows:
i
i) The specification of the objectives of the proposal and their
relation to the overall objectives of the agencies.
ii) To identify the widest possible range of action at the earliest
stage of the planning process.
1 iii) An attempt should be made to estimate the 'state of the world' as
it will exist with the project in existence.
I
iv) The next step will be valuation of cost and benefits.
v) There are certain things to be taken into consideration such as
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.
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.
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.
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
18.0 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
theory !i. 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
s , Legislative Committees-Public
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-to- I reiclative Control
day 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:
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~scussthe

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 ~ ai creation. The first step that waslaken in this direction
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 As per Article 107 (i) subject to the provisions of Articles 109 and 117 with respect Legislative Control
I to Money Bills and other financial bills, a bill may orginate in either House of
I Parliament and subject to the provisions of Articles 108 and 109 a Bill shall not be
I
deemed to have been passed by the House of Parliament unless it has been agreed
I
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
I 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 recommenda-
tions 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
t 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.
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
mo~ng an amkndment making provision for reduction or abolition of any tax.
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
hole : i) Use the space given below for your answers.

ii) Chek your answers with those given a t the end of the unit.
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.
- - - --
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
- . - ...
c) - A Money Bill must be returned by the Rajya Sabha to the Lok Sabha within Legislative Control
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.
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 ih this behalf in the Appropriation Act, or under rules framed by
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~amentexercises 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
r 3 Legislative Control
Vote. i) Use the space given below for your answers.

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.
.,
.......................................................................
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 yBill is a Bill certified t o be such by the Speaker of the Lok
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.

EXERCISES
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.

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
1 ) Your answer should include the following points:

I
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.
I 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
I
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.

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.

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
7
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.
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
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.
I The financial functions in Government are performed by the following agencies:

I
1) The Legislature
; 2) The Executive
1
3) The Treasury or the Finance Department
I
4) The Audit Department
I
i
Financial < ontrol Legislature has to determ~neby law the sources of government revenue. Executive
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,
Public Accounts ~ o m m i t k eand 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 sof the Governor General in Council and the report
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 System of Financial Committees
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.
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 sub-
committees 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 cexpenditure

Note : i) Use the space given below for your answers
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
Committee he automatically becomes the Chairman. Ministers cannot be system of Financial Committees
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;
ii) suggest alternative policies in order to bring out efficiency and economy in
administration;
iii) examine whether the money is well laid out within the limits of policy implied
k in the estimates; and
I 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.

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) Improving the organisation and working of the department;
ii) Securing economies, and
iii) Providing guidance in the presentation of the estimates.
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.
Note ; 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?
...................................................................
...................................................................
.....................................................................
2) Evaluate.the functioning of Estimates Committee in India.
.......................................................................
.......................................................................
.......................................................................
.......................... ............................................
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
r of India
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. System of Financial ('ommittee\

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.
19.6 FUNCTIONING OF COMMITTEES-AN .

APPRAISAL
I he working of,legislative committee seems to leave much'to be desired. Legislative

I ~nancialcontrol 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
~nquiriesare concerned with points which the Auditor-General raises." The PAC is
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
sl snA 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~onof
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.

1) Examine the functions of Committee on Public Undertakings.
.......................................................................
2) What are the weaknesses of parliamentary financial control in India?
.......................................................................
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
audited by an independent officer, who should submit this audit report to the I
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 System of Financial Committees
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.
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.
.
EXERCISES

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
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 I

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.

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
I
does not lay down any policy.
I
T h e basic function of the Committee is t o ensure efficiency and economy in 1
administration.
T h e Estimates Committee is performing a useful function in improving the
efficiency of administration in India.

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.

T h e I e o i c l a t i v ~finanrial cn"trn1 hna h ~ r n m emnre nnminal than real
The Estimates Committee deals more with economy and efficiency through system or kinnncinl Committees
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.
UNIT'20 EXECUTIVE CONTROL
Structure
Objectives
Introduction
~vol'utionof Executive Control Over Expenditure
Role of the Finance Ministry
Delegation of Financial Power
Let Us Sum Up
Key Words
References
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 policy-
making 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
----- 4
. ------
* - c: -c *L.. . -..-*--.
With,the emergence of new tasks after Independence and the launching elf Five-Ykar Executive Control
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.
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
responsibility with any other department of the government. ~he'resuk~,was delay in
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
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
nt the
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 require-
ments 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;

a t ~dministratibnof 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.
d) Controlli~gtheentire exknditure of the Government in cooperation with the
administrative ministries and departments conamed.
Check 'Your ~ r o g i e s s1 ,

I) 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 ~of an independent secretary, and for overall coordination of all the
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.
he Department of Expenditure
The department of expenditure is divided into the following divisions:
a) Establishment Division including Implementation Cell and Staff Inspection Unit

b) Defence Finance Division
c) . Cost Accounts Wing
d) Plan Finance Division and
e) Special Cell
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~essfor economy should be promoted in all the administrative departments.
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

ii)' Check Your answers with those given at the end of the unit.
I) Outline,the organisation and functions of Ministry of Finance.
.......................................................................
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
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.

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
of financ~aladministration has gone a long way towards putting the administration of
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~nanceDepartment 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
Institute of Public Administration, ~ e wel hi.

EXERCISES

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.

administration of the finances of the Central Government
handling of financial matters affecting the country as a whole 1
.
.
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 . . A . ->
- Check Your Progress 2 Executive Control

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
Budget, makes periodic 'assessment of foreign excha~geneeds and resources
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 long-
term financial institutions excluding LlC and UTI.
The Department of Expenditure is mainly concerned with the administration
of expenditure control.
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
resulted in concentration of authority in only one ~ e p a r t m e n of
t 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.
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
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 \
I
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,
I
accounting is an useful'aid to management in performing its various managerial
I
functions effectively.
i In this unit, the difference between commercial accounting and government
i accounting has been explained. The recent reforms in government accounting viz.,
I Departmentalisation of Accounts, Revised Accounting Structure, Management
i
Accounting have also been explained.
I ..
! .
ACCOUNTING : DEFINITION AND
i 21.2
IMPORTANCE
.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
- - _ - -> - --- >----:L-?J -- L-----A :^-^
Aeeountn md ~ u d i t 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 Accounting System in lndr
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.
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.
b) 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.
.c) 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.
d) 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.
i
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
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Accounts and Audlt c) 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.
d) 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.
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.
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
i
routine accounting duties. Moreover, accounting duties bring the Audit Department
partially under the control of the executive, whose accounts it compiles.
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.
>
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 1
an Additional Secretary, a Joint Secretary, and Under Secretaries supported by I
subordinate officers. Apart from the Headquarters set up, evely Ministry
P . .. . - . - -. -- - -.
ii) The Comptroller and Auditor General was relieved of the responsibility of Accounting system in India '
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
3 I?
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.
iii) 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.
I iv) 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.
b) Arranging payments to autonomous bodies, corporations, authorities, and
also grants-in-aid, loans etc.
'c) Arrangements for making payments through the Pay and Accounts offices
of pay and allowances, office contingencies and miscellaneous payments.
d) Consolidation of the accounts of the Ministry as a whole, in accordance
with the instructions issued by the Central Government.
e) Preparation of Appropriation Accounts for the grants controlled by the
Ministry.
f) Organising a sound system of internal check to ensure accuracy in
accounting and efficiency of operation as part of management.
g) Introduction of an efficient system of Management accounting best suited
to the functional requirements of the Ministry and its Departments.
v) 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.
'\
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.
\

1) 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~menta d o ~ t e dfor Plan DurDoses. The team submitted two reDorts on the
reforms in the structure of demand-for grants. In p a r n o r the report, it suggested Accountlng System in India
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/organisationsunder minor
, ,
heads.
-.A
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.
,-
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
Accounts and Audit
* P
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 eMinister, 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,
--
' Check Your Progress 2
1) Why was the accounting system introduced by the British revised?
Accounting Syrtem In Indh
2) Explain the concept of Management Accounting. \

\
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21.8 LET U S SUM CTP

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~intingand 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.
I
Capital ~ x ~ e h d i t u r Payments
e: in respect of which, services will be available for
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.
RamachandrantK.S., 191 1. Wutc-17ingover a Watch Dog, Ashish Publishing House:
New Delhi.

EXERCISES
I) Your answer should include the following points:
Advantages
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.
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.

I) Your answer should include the following points:
Change in the role of the government.
Extension of the government functions. *

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.
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 joint-
stock companies with limited liability, there is divorce between owners (share-
holders) 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
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Accounts md Audit
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.
4
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. ( ,
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 profit-
making.
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,
nt. it votes taxes which provide government the resources, necessary
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'
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2 2 3 EVOLUTION OF AUDITING IN INDIA
I
1
i
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
components of audit in the re-war era were (a) audit against budget provisions
(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
I 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
I
rules and regulations, could still be objected to on the ground that it breached broad\
concepts of financial ethics.
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 pre-
determined 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
--r---- -P r . ..--
A
:
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
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performance-cum-efficiency audit of an operation1 programme1 activity of an entity as AudltIIIg SW&I IIIl n d ~
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.

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
I
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
i the following paragrahps.
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

t regularity as specified in the Audit code, inter-alia,
are to ensure:
I *\
i) that there is provision of funds for the expenditure, duiy authorised by
competent authority;
ii) that the expenditure is in accordance with a sanction properly accorded and is
incurred by an officer competent t o incur it; , I
iii) that the claims are made in accordance with the rules and in proper form;
iv) 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 S t
' .e
disbursement of pay to a government servant;
V) that the expenditure sanctioned for a limited period is not admitted in audit
beyond that period without further sanction;
vi) that the rules regulating the method of payment have been duly observed by
the disbursing officer;
vii) that payment has been made to the person and. that it has been acknowledged
a n d recorded 50 t second claim against government o n the same account,
is not possible; a n
viii) that the payments have been correctly brought into account in the original
documents.
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.
Receipts Audit
Receipts audit involves the audit of income-tax and custom and excise receipts at
A 1 - . ., .
1 ,.. ,
' . .
A a . >A . ..A . - A & IA ~ A ~
level. From the late fifties, receipts audit has been conducted by the Indian Audit Auditing System in I?din
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 quasi-
judicial nature, audit should ensure that the discretion used has been exercised in a
judicious manner.
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 cost-
. .*
benefit analysis.
Thirdly, the objectives of investment are often a combination of financial and non-
financial 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
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
Lastly, the Constitution furtliir provides that thd conditions of service of persons Auditing System in Jndin
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.
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 non-
observance 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.
I
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
- - - -
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.
ii) Check your answers with those given at the end of.the unit.
1) Distinguish between Regularity Audit and Receipts Audit.
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2) Explain the meaning and scope of Performance Audit in India. Auditing System ~ Indla
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.' /, ,
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%.:.A"
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3) Discuss the importance of Audit Reports and their utility to administration.

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('
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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 . .
t h w~nrnrnenA~tinnr
~ n f thp r n r n r n i t t ~ ~
--- - - - ---- --
Accounts and Au& 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.
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.

EXERCISES
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.tax-
payer and also helps Parliament to exercise control over the Executive.
I
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 Auditing System in !ndia
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.
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.
- -
UNIT 23 ROLE OF THE COMPTROLLER

AND AUDITOR GENERAL
WAG)
Structure
23.0 Objectives
23.1 Introduction
23.2 Origin and Constitutional Position of CAG
23.3 Duties and Powers of the CAG in Regard t o Accounts and Audit
23.4 Other Duties of CAG
23.5 Role of C A G : An Appraisal
23.6 Let Us Sum Up
23.7 Key Words
23.8 References
23.9 Answers t o Check Your Progress Exercises
23.0 OBJECTIVES
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
Rok of the Comptrolkr
23.2 ORIGIN AND CONSTITUTIONAL POSITION md Auditor Cenad (CAC)
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
rr r.. ..... C.. -
Auditor General and made him, alongwith the Judges of the Supreme Court, an
.._.. 1 . . ...... " . . . P
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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 I,
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.
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
'
i .
Executive, whose tda sactions he is expected t o audit.
23.3 DUTIES AND POWERS OF THE CAG IN

REGARD TO ACCOUNTS AND AUDIT
i) Accounting Duties ,i
The duties and powers of ;he Comptroller and Auditor ~ e n e r a have l been prescribed
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
and receipts of the Government of India, the State ~ o v e r n m e n f and
s 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 Role of the Comptroller
Comptroller and Auditor General to compile the accounts of the Union and of each and Auditor General (CAG)
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;
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.
f) to audit account of bodies or authorities by request.
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
1
Indian Audit and Accounts Dep rtment. .
1
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.

Note : i) Use the slate given below for your answers.
ii) Check youqanswers with those given at the end of the unit.
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. ,
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~mptrollerand 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 Role of the Comptroller
~ u d o General,
r has argued in favour of autonomy to "maintain the dignity, and Audltor General (CAC)
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
s Appointment
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
I certain departments of Union Government, the Comptroller and Auditor General
had ceased to be responsible for maintaining the accounts of Food, Rehabilitation,
1 Supply Departments, Lok Sabha and Rajya Sabha Secretariats, since separate
I 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
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

1) Evaluate the role of the Comptroller and Auditor General in Indian Democracy.
23.6 LET US S U M UP
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
-
perform his/ her functions without any inteference from the Executive. His/ Her Role of the Comptroller
and Auditor General (CAG)
primary duty is to uphold'the Constitution and the laws in the field of financial
administration.
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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EXERCISES

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. 7
Constitution Act, 1950 redesignated the Auditor-General as Controller and
Auditor General and made him an officer of the Constitution.
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.
Thn PAc nracrrihac thn fnrmc in rvhir-h thn o~~nnnntc
n f thn 1Tn;nn nnrl nf thn
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.

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
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
school of 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&tratloaof the methods and instruments of raising finance. It presents the conventional view
Pubh: Enterprka
of financial administration in PEs. Today, financial administration goes far
beyond the task of raising finance and deciding about the mix 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 to be commensurate with the business risks. The business risks arise
'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 management. Investments in inventory can be regulated to ensure that excess
Pubk Enterprises 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 Systems
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 Systems
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
PEs are different from private sector enterprises in terms of their nature as well
c 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
I
of their profitability. PEs are composed of two terms, viz. 'public' and 'enterprise'.
5 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
Public Enterprises (SL~ES)run by state governments of the Indian Union and
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

. . ---. .-
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~btrntionof
~ 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
I
Chairman-cum-Managing Director
I
Direaor Director I Director
(Muction) (Marketing) I (Personnel)
I
I
Director (Finance)
1
Executive Director (Finance)
I
General Manager (Finance)
I
Deputy General Manager Deputy General Manager Chief (Fmance)
(CorporateF-CC) (Accounts) (One at each
I I UnitlRegion)
Finance Manager Senior Finance Manager
I I
~ e ~ F
u- & ~anqer Deputy Finance Manager
I
Senior ~ k u n t Officer
s
I
Accounts Officer
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,
c 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
i 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 Power to sanction capital expenditure

Gross Blocks of: without urior auuroval of Government
Less than Rs. 100 crore Rs. 5 crore
Between Rs. LOO crore and
Rs. 200 crore Rs. 1,O crore
Above Rs. 200 crore Rs. 20crore
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 Rs. 200 crore, the
I power to incur expenditure on additions, modifications and new investments will
b be raised from the existing limit of Rs. 20 more to Rs. 50 more without prior
1 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

I There are various sources of financing PEs. These mainly constitute equity and
I
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
i investment and cash credit advances.
i .
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 scheme of disinvestment of equity in PEs from 1991-92 in which year Rs. 3,000
Publk Enterprises
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 1985-861986.87 1987-881988-89 1989-90 1990-91
1 2 3 4 5 6 7 8 9 10 11
1. Number of
running Public
Enterprises Number 163 201 207 211 214 221 226 233 236
2. Crpital
Employed b.Crore 18207 29855 36382 42965 51835 55554 67629 84869 401797
3. Turnover b.Crore 28635 47272 54784 62360 69088 81271 93137 -1 118355
4. Gross Margin
(Rofit before
depruiation.
I intertn and
tax) . . b.Crore 2401 5771 7386 8230 9897 11134 13438 16412 18510
I
5. Dqmuuum*Rs.Crore 983 2205 2758 2983 3376 4150 4866 5790 7151
6. Gross profit
't before interest
and tax Rs.Cm 1418 3565 4628 5287 6521 6984 8572 10622 11359
7. Interest Rs.Crore 1399 20% 2529 3115 3420 3595 4167 5329 7539
8. Netpro6t
beforetax Rs.Cron 19 1480 2099 2172 3101 3389 4405 5293 3820
9. Tax b.Crore 222 1239 1190 Mob 1330 1329 1411 1504 1452
10.Net M t
after tax Rs.Crore -203 240 909 1172 1771 #)60 2994 3789 2368
11.Internal
Reso-
generated
(Grw Rs.Crore 1225 3278 4251 5068 6014 6947 8915 10774 llj72
12.Net M t
(after tax)
to capital
employed Percent -1.1 0.8 2.5 2.7 3.4 3.7 4.4 4.5 2.3
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 1986-87 1987-88 1988-89 1-90 1990-91 191-92

(R.E.) (B.E.)
1. Deport. Comm. Und&&np'

i. Forest 497.70 516.21 543.69 414.35 540.24 372.46 528.33
ii. Power Rojcas -75.04 -93.81 -116.40 -84.19 -34.83 -54.M -42.98
iu. Road & Water Tpt.
S e ~ a s -25.65 -36.59 -110.76 -56.51 -93.21 -75.78 -64.10
iv. Dairy Development -99.29 -40.45 -43.91 -52.38 -106.99 -72.23 -77.18
v. Industries -14.10 -16.46 -20.51 -10.09 -159.66 -112.91 -40.04
vi. Mines & Minerals 40.06 35.05 27.02 51.83 60.62 60.43 75.26
vii. Irrigation Rejects
(Commercial) -871.60 -1225.95 -1344.50 -1840.79 -1916.85 -2002.63 -22M.66
viii. Multipurpose River
Projects
2. RontdRontEmklng
-u 537.76 551.h 570.71 466.18 600.86 432.89 603.59
3. ld6sdld6smmkhg
-u -1068.68 -1413.26 -1636.08 -2043.96 -2311.54 -2318.11 -2430.96
4. Net FinMddR e d
-tdU- -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 However, there are PEs which have had an unblemished profit making record.
Public Enterprises
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.

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. 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 after tax has been paid) from an investment project to equal the initial sum
public Enterprises 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.
Value Analysis: It is the process of analysing the intrinsic value of the investments
1
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

. 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.
Investment management function
Financing function
Checking upon financlai performance
Planning systems
Operating decisions
Control systems.
1) Your answer shouM include the following pgints:

Boards of management of PEs
I ~dministrativeministry
16
. 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.
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
~inancialAutonomy and Accountability of Public Enterprises: Recent Trends
Let Us Sum Up
Key Words
References

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.
Financial Autonomy and
25.2 CONCEPT OF FINANCIAL AUTONOMY Aceountnbiiity d PuMe
AND ACCOUNTABILITY IN PUBLIC Enterprlscs
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.
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 of
financial business of PEs. The respect for the corporate status of these enterprises
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 exercising the financial controls on PEs. PEs may enjoy autonomy in the day-to-day
Public Enterprises 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 Fhund.IPokks: These are fundamental aspects of financial accountability.
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) Clear financial procedures.
b) Efficient internal audit.
c) Commercial audit by private auditors.
d) Proper internal organisation of the enterprise, based on optimal criteria and
decentralisation.
e) Appointment of a Financial Advisor of the enterprise by the government or
under governmental approval.
f) 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.
g) Reservation of certain financial matters for government approval, under the
Articles of Association or under the Act governing a public enterprise.
h) 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 1
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 d o you understand by financial autonomy of PE?
.......................................................................................................
2) List six institutions which can explicitly lay down policy relating to financial'
i autonomy of PEs.
I .......................................................................................................
i
i
.......................................................................................................
.......................................................................................................
i
.......................................................................................................
# .
3) Point out the areas of financial accountability of PEs.
Financial Administration of
Public Enterprises
4) Discuss the methods of ensuring financial accountability of PEs.

.......................................................................................................
.......................................................................................................
.......................................................................................................
.......................................................................................................
....................................................................................... ...............
i
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 Financial Autonomy and
account of time overruns and poor quality of financial disclosure. 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.
i 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.
25.7 SUGGESTIONS FOR ENSURING IMPROVED

AUTONOMY AND ACCOUNTABILITY OF
PUBLIC ENTERPRISES
A number of suggestions can be offered to ensure improved financial autonomy
and accountability in PEs. To begin with, these enterprises should be commercialised.
P 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
I
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 should instead of putting limits on investments, expenditure, borrowings, etc, issue
Public Enterprises 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, Financial Autonomy nod
managerial autonomy of PEs, financial powers in regard to their investments and AecoontaMUty of Public
Enterprises
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
I
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.
,' 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
tn thn -vtnnt nC 3fl n m r ,.ant Tlrn nnnmknr nF th- nn.mmm--t -nm;---r m- +
).
a
Financial Administration of board of directors of PEs will be reduced to 'one'. Multiple audits may be
Public Enterprises 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
I
the country are giving a top priority to streamlining the preparation of annual
accounts and annual reports in the State Level Public Enterprises. 1
j
Check Your Proeress 2 i
1) Highlight the problems pertaining to financial autonomy and accountability in PEs.
2) What suggestions would you offer to strike a balance between financial control
and financial autonomy in PEs?
..........................................................................................................
..........................................................................................................
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 t
they have in respect of the financial autonomy.
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.
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 Financial Autonomy and
lapse of time. Accountability of Public
Enterprises
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.
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.

EXERCISES
Check Your Pmgmw 1
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.

Parliament
Government
Comptroller and Auditor General of India
C o w of L;nu
Financial Administration of Mass Media
Public Enterprises
Citizen
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.
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.

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.
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.
1 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
I 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.
I
I 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~efor running higher
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 Y
financial year
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) 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,
,..n-nn n-rl ,.,liar+ +,van ..l,,, ..Art. ,..G,:,-b C-,,AA, r - C---..l,b, l-,:-l,c, -,A
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
~ n s h mrrn-h
l ~ 11rh-n a n v m m m m n t tn n r n v ; A m sn sApnamntn l r r r n l ~f -r.hl;r cr-Arc .u;+l.nmmt
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
I
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.
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.
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
1
taxation, enterprises, or the wealth of the citizens, located ikithin the limits of
municipal body. Direct taxation is common in municipal f d aeinistration. In
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 also provide financial assistance for projects of
urban development, such as, water supply, housing, roads etc.
Sources of income of urban governments may be grouped under:
i) Tax-revenue
ii) Non-tax revenue
iii) Orants-in-Aid, and
iv) Loans.
i
I
These sources are briefly discussed M below: Financial Adminhtntlon d
Urban Gover~~ments
I 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
I
bye-laws, rules, regulations etc. For example in Punjab and Haryana this source of
L
, revenue fetches about 30 per cent of revenue. The national average of the proceeds
from this source is a little above 30 per cent.
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.
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 -
----A_.-&:-- - m e - L..:ll:--
-C
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.

Note :i) Use the space given below for your answers.
1) Discuss the important factors which contribute for determining the ecology of
local finance.
...............................................................................................................................
2) Describe briefly the principles which should govern the local finance.
............................................................................................................................... Financial A d d d S U a h d
............................................................................................................................... Urban Covernmencs
...............................................................................................................................
3) Explain the sources of income of urban government.
...............................................................................................................................
...............................................................................................................................
...............................................................................................................................
. '
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.
1 Assessment and Collection of Revenues

I 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
I assessment list. An appeal against the assessment of taxes lies with the Deputy
I 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

In the Municipal Committees, the income received by different departments is
i credited every day into the Municipal Treasury. The power of withdrawal df the
i 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
I
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
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
Municipal Ac~ountsCode, 1930. The instructions of the Examiner, Local Fund
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 I
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.
-
26.7 STATE CONTROL AND SUPERVISION i
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 rrat- En- awn--1- :.. D..-:nL -bar-
instructed Ludhiana Municipal Corporation in 1986 to levy octroi on man-made Financial Adminisfrsfion of
fibres like nylon and terene and hand knitting yarn made out of nylon fibre at the rate Urban Governments
of rupees 2.10 per 100 rupees. II
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.
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 ,
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 municipal bodies in India. The state government ensures that the grants are properly
r l
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-in-
aid 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
t municipalities, audit is not conducted regularly. It is
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 Financial Admlnhlration of
Urban Governments
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 the-
administrative control thereof as in the case of education and f re-brigade but the
t
expenditure pertaining to these functions is largely borne by th municipal bodies.
This is wholly unfair and unbusinesslike.
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
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 and if accepted and implemented will surely hel# to bridge the gap
between the municipal services and resources. The sooner it is done, the better it
$wouldbe.
check Your P r 0 2 ~
ii) CheCJyxSr answers with those given at the end of the unit.
1) What are the steps involved urban fiscal management ?
........................................................................................
2) What are the various methods of state control over municipal finance ?
........................................................................................
.......................................................................................
3) critically evaluate the gap between municipal services and resources.
26.9 LET US SUM UP

In a democratic political system, local government means management of local affairs
by the elected representatives of a locality which stands for restricted area like a
village, a group of villages, a town, a city. It acts as a nursery for f u t u leaders.
~ It serves
as an ideal channel of communication between the local community and the higher
levels of the government. Knowledge of ecology and principles of local finance is
essential for managing the financial operations of urban local bodies. The major task
of financial administration in local bodies is to make the best use of the available
resources and channelling them into proper fields of expenditure. To meet their
expenditure on different heads or services, the urban local bodies have been
empowered to defive their incbme from several sources such as tax revenue, non-tax
revenue, government grants, share of government taxes and tbe loans. Budgeting
offers an opportunity for an assessment of the matching of functions and resources.
The Executive Officer is responsible for preparing and placing the budget before the F i d dA d m ~ t b mof
municipal committee for approval. He is also responsible for the proper assessment Urban Covcrnaeatr
and collection of taxes, safe custody and disbursement of fund etc. Apart from this,
proper maintenance and timely submission of accounts to audit is another important
function of the Executive Officer. Urban local bodies in India do not have adequate
automony. The state government exercises a considerable degree of control over
municipal fund, budget, taxation, borrowing, accounts, audit and grants-in-aid. The
working of the urban local bodies in India shows that they do not have adequate
municipal financial resources to provide sewices to the community. The more
prominent causes for the insufficient municipal financial resources may be identified
as the faulty system of devolution of funds, limited financial autonomy, political
I
reluctance to impose taxes, defective tax administration, ineffective audit,
t limited borrowing powers, faulty grants system, undeveloped trading enterprises,
increased population pressure and so on. After Independence in India, a number of
commissions and committees have been set up at the centre and the states t o examine
I the finances of urban local bodies. These committees and commissions have made
innumerable suggestions t o enhance the municipal financial resources. All these
suggestions if implemented will definitely augment the finances of these bodies which
in turn may make sincere efforts to narrow the gap between the municipal services
and resources.
26.10 KEY WORDS

.
Cantonment Boards:These are set up under the Cantonments Act 1924, which is a
Central government legislation. These Boards are set up for the administration of the
civic affairs of the Cantonment areas, which are delimited areas where the military
forces and troops are permanently stationed. The board looks after the health,
medical affairs, education, electricity, water supply etc. of these areas.
Deconcentrated Pattern
In a deconcentrated pattern, a government o r an organisation unit o r a superior
delegates t o another, the power t o act in its o r his o r her name without transferring
the authority. It resewes its authority to withdraw it a t any time, o r issue directions
and even t o reverse the decisions. In fact, the delegated authority is not a right but a
derived concession that also can be exercised at the pleasure of the delegating
authority. Thus, in this type of pattern, the local authorities merely act as agents of
Central or State Government.
Decentralised Pattern
In a decentralised pattern, there is devolution of powers from one government t o
another by means of either a statute o r Constitution. It is just an extension of the
-
democratic principle extension of people's right t o manage their own affairs in a
local area without any undue interference from central o r state government. Thus, in
this pattern, local authorities have a right and not a concession of independent
existence .and functions.
Ecology
The word 'ecology' is borrowed from biology where it suggests the interdependence
between an animal species and its natural environment. In public administration, the
concept of ecology means the study of interdependence or interaction between public
administration and its environment. Since, local government'is a part of the public
administration, it cannot escape from theeffectsof environment in which it develops.
Notifled Area Committees: These are set up to meet the civic needs of the developing
towns, which do not fulfil the statutory conditions for the constitution of a
municipality. These are entirely nominated bodies and such provisions of the State
Municipal Act apply todhem as are specified by the state through a notification. ' 5
Octroi Tax
It is a tax on go6ds which are brought into the municipal limitsfor consumption, use
nr pale therein
Local Finance Terminal Tax
It is imposed on goods arriving in a city or town by rail. It is realised by the railway
on behalf of the municipality, on commission basis.
Town Area Committees : These Committees are of smaller size. These exist in smaller
towns and are entrusted with limited civic functions. These are governed under special
statute.
26.11 REFERENCES
Maheshwari, Shriram, 1984. Local Government in India, Lakshmi Narain Aggarwal:
Agra.
Sharma, S.K. and V.N. Chawla, 1975. Municipal Administration in India: Some
Reflections, International Book Company.
Singh, S.N., 1991. Local Government: A Comparative Perspective, Uppal Publishing
House: New Delhi.
Thavaraj, M.J.K. 1978. Financial Administration of lndia, Sultan Chand and Sons :
New Delhi.

EXERCISES
Form of local polity,
Size and level of local units,
Financial control exercised by the government,
Responsibilities given to the local government,
Economic conditions of the local inhabitants.
Independence and responsibility,
Adequacy and elasticity,
Integration and coordination
Public accountability
Simplicity
Effective municipal personnel management
Fiscal access
Tax-revenue
Non-tax revenue
Grants-in-Aid
Loans

Budgetary process and authorisation
Procedure for assessing and collecting revenues
Custody and disbursement of funds
Stores
Accounting and auditing
The control exercised by the State Government over municipal finances extends to
the following activities:
Taxation
Municipal expenditure and fund
Budget
a 1 An.."
Grants-in-Aid Financial A d m i b t i w of
Accounts and audit Urban Governmats

In elastic sources of taxation
Elaborate, cumbersome, time consuming rules and procedures governing the
imposition of taxes
Limited borrowing powers of the urban local bodies
Inadequate, irregular, unsystematic, uncertain grants-in-aid provided by the
goomnrnent
Ineffective, inefficient system of audit
Unwillingness, reluctance on part of local bodies to mobilise their resources to
the admissible limit and exploit their limited powers of taxation.
UNIT 27 FINANCIAL ADMINISTRATION
OF RURAL GOVERNMENTS
Structure
27.0 Objectives
27.1 Introduction
27.2 Concept of Rural Development
27.3 Principles of Rural Local Finance
27.4 Rural Government: Sources of Revenue
27.5 Rural Government: Expenditure Pattern
27.6 Rural Fiscal Management
27.7 State Control and Supervision
27.8 Gap between Rural Services and Resources
27.9 Let Us Sum Up
27.10 Key Words
27.11 References
27.0 OBJECTIVES
describe the machinery concerned with financial administration in rural
governments
discuss the concept of rural development and the principles of rural local finance
examine the sources of revenue and expenditure pattern of rural local authorities
explain the various aspects of rural fiscal management
evaluate the forms of state control and supervision over Panchayati Raj finances;
and
highlight the gap between the rural services and resources and-suggest remedial
measures to narrow the gap.
27.1 INTRODUCTION
In India, Rural Local Government covers the rural population. It is created,
sustained, regulated and even abolished by the State Government. It consists of three-
tier structure, namely, Village Panchayat at the village level, the Panchayat Samiti at
the block level, and the Zila Parishad at the district level. It was recommended by the
Balwantrai Mehta Committee and is based on the concept of democratic
decentralisation which was later on termed as Panchayati Raj in preference to Rural
Government.
Keeping in view the importance of local self-government in free India, a provision was
made in the Constitution for the growth and development of Gram Panchayats.
Article 40 lays down: "The state shall take steps to organise village Panchayats and
endow them with such powers and authority as may be necessary to enable them to
function as units of self-government". Apart from this, Article 246 also empowers the
State Legislatures to make laws with respect to any matter pertaining to local self-
government. The extent and form of democratic decentralisation, therefore, varies
from State to State. At present, there are various models of Panchayati Raj operating
in the country. Some states like for example, Andhra Pradesh (from 1959 to 1983),
Rajasthan had adopted the three-tier structure of Panchayati Raj as recommended by
Balwantrai Mehta Committee. But in Andhra Pradesh, on the basis of Asoka Mehta
Committee recommendations, a four-tier structure came into existence since 1983,
with Mandal Praja parishads coming in place of Panchayat Samitis. In Maharashtra
too, the pattern of Panchayati Raj is unique, wherein instead of block, district has
been made the unit of planning and development, while Panchayat Samiti acts as a Financial Administration of
Rural Covmments
statutory committee of the Zila Parishad. In Karnataka since 1985, changes were
brought about in the earlier prevailing three-tier structure. Now there are Village
~ a n c h a ~ a t s / ~ oPanchayats
wn at the base, the Taluka Development Boards in the
middle and the District Development Council for each district at the top.
The 1980s saw the resurgence of rural local bodies in India, particularly in Andhra
> Pradesh, Karnataka and West Bengal. The Union Government had also come up in
May 1989, with a bill in favour of aConstitutiona1.amendmentfor the resurrection of
Panchayati Raj, backed by the slogan "Power to people" and got it passed in the Lok
Sabha. The bill could not become an act as the sponsors failed to muster the required
support in the Rajya Sabha. Again in 1990, the 74th Constitutional amendment was
introduced by the National Front government which lapsed due to the dissolution of
Lok Sabha.
Financial administration in Rural Local Government involves operations designed to
. generate, regulate and distribute the financial resources needed to provide services to
the community. These operations are performed by the following agencies:
i) The Executive Wing which prepares the budget
ii) The Legislative Wing which alone can grant funds
iii) The executive, which controls the expenditure of funds sanctioned by the I
Legislative Wing
iv) The Audit Department
v) Standing Committees especially the Standing Committee for Finance and
Taxation.
27.2 CONCEPT b~RURAL DEVELOPMENT

The term 'rural' means an area characterised by non-urban style of living, greater
inter-dependence among people, more deeply rooted community life and a slow
moving, rhythm of life based on faith and conviction in religious ethics and themes.
Occupationally it is based on crop farming, tree crops and related activities like
plantation, agriculture, modern dairying, fish farming, sheep rearing etc. The growth
and development of urban areas has been at the expense of rural areas and with the
emergence of city centres, the rural areas ,were neglected. This was much more true so
far as the rural population in developing countries was concerned. When the umbrella
of colonial regime was lifted from the third world nations, most of the planners and
administrators of these newly independent nations, got concerned with the
development of the rural areas of their nations. This concern was largely because a
majority of the population was living in rural areas under abject poverty, malnutrition
and insanitary living conditions. Ignorance and poverty were two stumbling blocks in
their development and their removal was the main objective of the independent
nations. The commitment of the leaders of these nations was to bring in prosperity
and improve the quality of life of the people in rural areas, constituting a big resource
for them as electorates in the elections. Invariably, this commitment becomes a prime
mover with them at the time of elections and its tempo gets diminished in due course
of time. Some piece-meal programmes or projects on rural development are brought
to the people in the rural areas and these are in many cases not in consistence with
their need structure. The adhocism in the planning of these programmes and half-
baked implementation strategies have raised the basic issue of what is required to be
developed in these areas. This brings in the problem of conceptualising rural
development.
A comprehensive concept and method of rural development has been suggested by the
World Bank. Rural development has been defined as a "strategy to improve the
economic and social life of a specific group of people that is the rural poor including
small and marginal farmers, tenants and the landless". A national programme of rural
develoqment should include a mix of activities including projects to raise agricultural
-output, create new employment, improve health and education, expand
communications and improve housing ...... The nature and content of any rural
development programme or project will reflect the political, social and economic
Local Finance
circumstances of the particular country or region......" Since Independence, rural
development has been the main thrust of national development effort. The guiding
principles of planning are growth, equity, social justice, self-reliance, improved
efficiency and productivity. A number of development programmes from Community
Development Programme to Jawahar Rozgar Yojna were started to change the
scenario in the rural areas in India. These programmes have been of some help in
solving the problem of migration of people to urban areas to some extent. This is
evident from the fact that the percentage of rural population to total population
dropped only moderately from 82.7 per cent in 1951 to 80.09 per cent in 1971. Green
Revolution of the sixties and White Revolution of the early seventies seem to have
changed the gloomy outlook of a large chunk of rural population. However, it is an
irony of fate that because of the population growth and rising expectations not much
of development is visible.
27.3 PRINCIPLES OF RURAL LOCAL FINANCE

The principles of urban local finance mentioned in Unit 26 are also applicable to rural
local finance. (Refer to Section 26.3.)
27.4 RURAL GOVERNMENT: SOURCES OF REVENUE
All governmental programmes would remain mere paper items in the absence of
adequate financial resources. As a matter of fact, government cannot achieve any of
its social and economic goals without requisite finances. Thus, it can safely be
concluded that finances are sine qua non for the success of Panchayati Raj. The
pattern of revenues of Panchayati Raj varies from State to State. But the sources of
revenue of Panchayati Raj Institutions, in general, may be grouped under: (i) Tax
Revenue, (ii) Non-Tax Revenue, (iii) Grants-in-aid, (iv) Loans, (v) Share of State
Taxes, and (vi) Donations and Contributions.
Every unit of Panchayati Raj is empowered to impose obligatory or discretionary

taxes under the authority of law. These are the following:
i) Chula or House Tax
ii) Local rate
iii) Tax on profession or trade, or employment
iv) Tax on animals and vehicles.
,I .* .
v) Pilgrimage Tax
vi) Tax on public entertainments
vii) Toll (on new bridges)
viii) Lighting T a x
ix) WaterTax
Non-tax revenue
The non-tax revenue of Panchayati Raj consists of:
a) fees at fairs, agricultural shows etc.,
b) fees for use or benefits derived from public hospitals, dispensaries, markets etc.,
c) licence fees
d) Judicial fines .
e) remunerative assets
f) rents and profits accruing from property vested in or managed by Panchayati Raj
Institutions and
g) income from trusts, endownments, gifts.
Grants-in-aid
In Zlll the States, the Panchayati Raj Institutions depend heavily upon the grants from
the state governments. Grants-in-aid given by the States are ad hoc and discretionary
in nature depending largely on the availability of funds with the States. These can
Financial Administratiom of
broadly be divided into two categories-general purpose grant and specific purpose Rural Governments
grant. The former is released to Panchayati Raj Institutions to meet their general
expenditure. The latter grant is earmarked for certain specific purposes such as water
supply, flush type latrines, sewerage system etc. In India, the pattern of grants-in-aid
varies from state to state. In Punjab, the Panchayat Samitis receive the following
grants from the State Government:
1) Compensatory grants in lieu of abolition of tax on profession, country liquor,
cattle pounds.
2) Grants for implementing Community Development programmes.
3) Grants for the performance of agency functions.
4) Ad hoc and matching grants.
5 ) Grants from other departments such as animal husbandary, education, health and
family welfare.
Panchayati Raj Institutions raise loans to meet the capital expenditure involved in
satisfying the increasing local needs which are developmental in character. In India,
local borrowings are regulated by an ~ll-1ndiaAct known as the Local Authorities
Loan Act of 1914. The State governments may impose different forms of restrictions
on Panchayati Raj Institutions to raise loans which vary from State to State.
Share of State Taxes

Some of the state governments share the proceeds of some specified taxes such as land
revenue, local cess, sales tax etc., with the Panchayati Raj Institutions. For example,
40 per cent of the total land revenue collected in the village is given to Gram
Panchayats in Punjab.
Donations and Contributions

Apart from the above sources of revenue, Panchayati Raj Institutions also derive
income from other sources. For example, Gram Panchayat earns income from
Shamlat (common) Land given on rent for cultivation or grazing purposes. Besides,
they also receive donations and contributions from All-India bodies and institutions
for specific purposes like adult literacy, cottage, village and small scale industries. The
income from these sources is negligible now.
27.5 RURAL GOVERNMENT: EXPENDITURE PATTERN

Ananalysis of the expenditure pattern of Panchayati Raj Institutions shows that it is
on the increase. Population growth, inflation, and the involvement of these
institutions with the nation-building activities on agency basis are some of the factors
.responsible for rapid increase in expenditure. A look at the budget of Panchayat
Samiti shows that the expenditure is divided under two heads i.e. plan and non-plan.
The plan expenditure involves the expenditure for which the provision is made in the
State Plan Schemes, Centrally Sponsored Schemes and Central Plan Schemes. The
Panchayati Raj Institutions generally depend upon grants, borrowings, subsidies etc.,
' . ' to finance this type of expenditure. The non-plan expenditure includes salaries, travel
expenses, office expenses, medical reimbursement, contingency etc. The major heads
, of expenditure shown in the budget are: health and rural sanitation, educatioi.,
communications, animal husbandry, family welfare, salaries of the staff, audit fee, law,
charges, repayment of loans etc. Table given below shows the expenditure on different
heads, incurred by the Panchayat Samiti in Chandigarh during the year 1987-88.
'
Local Finance Expenditure Pattern of Pmcbayat Samiti in Chmdigarb
Head of Account
Establishment
* 1987-88
Rupees)
Health and Rural Sanitation

Schemes purely executed from Panchayat Samiti
Fund-Family Planning, Family Welfare
Education
Social Education
Grants-in-aid to Panchayats for
Law charges
Fairs and shows
House Building Advance to Staff
Repayment of loans
Refund of Interest to Bank

1) What operations are involved in financial administration of rural local
government? How are these performed?
..........................
........................................................................................
........................................................................................
........................................................................................
........................................................................................
2) Discuss the irrponant principles that govern rural local finance.
........................................................................................
................................................................... ./. .................
........................................................................................
........................................................................................
............................
3) Point out the sources of revenue of Panchayati Raj Institutions.
..........................
..........................
........................................................................................
..........................
...........................
27.6 RURAL FISCAL MANAGEMENT

Since governments spend publie money for public purposes, economical and efficient
use of public money is a very important task of fiscal management. It is suggested that a
government which has worked out a satisfactory system of fiscal management has
gone a long way towards putting the administration of its affairs upon an efficient
basis. The fscal management involves a continuous chain of operations such as
budget preparation and its app
collection of revenues, custody a
accounts and their audit. These are described briefly as under:
.. --
Finamid Administration of
Budget preparation and its approval Rmrl Gorcranwats
In Panchayati Raj Institutions, budgeting is one of the major processes by which the
use of the public resources is planned and controlled. The budget plays a very
important role in the social and economic life of a community. In India, the long-term
objectives of the Five Year Plans of the Government influence the revenue and
expenditure pattern of Panchayati Raj Institutions as shown in the annual budget.
Every year, the Gram Panchayat prepares its budget towards the year-end. The
Sarpanch and the Panchayat Secretary in consultation with Panchayat members
attempt to frame the budget which is placed before the Gram Sabha at its Sawani
meeting for consideration and suggestions. In case, a Gram Panchayat fails to prepare
the budget, the respective Panchayat Samiti prepares the budget and places it before a
specially convened meeting of the Gram Sabha concerned for necessary action. it may
be clearly noted that Gram Sabha has only to consider the budgetary proposals
placed before it. It does not have the power to formally pass them. Generally it is
passed in the form of a resolution and sent to the respective Panchayat Samiti for its
sanction. Thus, it can be said that if Gram Panchayat defaults, the respective
Panchayat samiti is the formal authority to frame and finalise its own budget.
The budget estimates of receipts and expenditure of Panchayat Samiti are drawn up
by the Executive Officer (B.D.P.O.). These estimates contain the (a) actuals of the
previous year, (b) budget estimates for the current year, (c) revised estimates of the
current year, and (d) budget estimates of the next year. The Executive Officer
endeavours to prepare the estimates as accurate and realistic as possible and keeps in
view amounts which are expected to be received by the Panchayat Samiti from the
Government by way of grants-in-aid for Community Development Programme and
schemes transferred by other departments of the State Government. After careful
scrutiny of the budget estimates by the Executive Officer, it is submitted to the
Standing Committee on Finance and Taxation for its close scrutiny or any
modification as it may consider fit. After the scrutiny by the Committee, the budget is
again submitted to the Panchayat Samiti for consideration, which may approve the
budget with or without any modification. The budget so approved is sent to the Zila
Parishad which may or may not suggest any alteration in the budget. In Punjab, in
case of difference of opinion, the decision of the Zila Parishad is final and binding on
the Panchayat Samiti. But the situation differs from state-to-state. Even in the case of
Punjab, the differences are generally resolved at the political level.
The Secretary of the Zila Parishad prepares the budget every year and places it before
the Standing Committee for finance and taxation. After having considered the
estimates of receipts and expenditure, the standing committee submits the budget to
the Zila Parishad for approval. As soon as it is passed by the Zila Parishad, it is sent
to the government so that it can be scrutinised with a view to pointing out any misuse
or abuse of funds placed at the disposal of the Zila Parishad. Thus, it is clear that the
budget as passed by the Parishad is final.
Apart from this, it is important to note that the departments cancerned prepare the
District-wise statement of funds to be placed at the disposal of the Zila Parishads and
the Panchayat Samitis and pass on the same to the State Government before the
prescribed date each year. The Government communicates to each Zila Parishad the
allocation af funds for schemes earmarked to the Zila Parishad as well as Panchayat
Samitis. The Zila Parishad then meets immediately and decides block-wise allocation
of funds and conveys its recommendations to the government. Keeping in view the
recon'mendations of the Zila Parishad, the government communicates to each
Panchayat Samiti the allocation of funds allotted to it for the schemes to be executed
by it during the next financial year. On receipt of the intimation of the allocation of
funds, the Panchayat Samiti prepares its budget and submits it to Zila Parishad for
approval as mentioned earlier.
Assessment and collection of taxes

Assessment of taxes involves the preparation of a list of persons liable to pay the tax,
and determining the amount of tax that has to be paid by them. The procedure for the
assessment and collection of taxes varies from State to State. In Punjab, the Sarpanch
assisted hv Panchavat w r r r t a r v the F r e n l t ; v m fitXrrr nf Pnnchavnt Samiti nr t h ~
Local Finance secretary of Zila Parishad is primarily responsible to ensure that all taxes are
collectively, promptly and regularly assessed and realised. He has also to see that
taxes collected are brought to account and there is no leakage.
In order to collect taxes, a fresh Demand Register is prepared every year. The nature
of demand, name and address of persons by whom tax is payable etc. are entered in
the register. If an assessee feels that an assessment of his liability to a tax is not
correctly and fairly made, he is entitled to make objections within a prescribed period,
usually before the assessing officer himself. If he is not satisfied with the decisions on
his objections, he is usually entitled to appeal to some higher officer. The detailed .
procedure in regard to arrears, refund of taxes, receipt of payment by cheque etc. is
laid down in rules framed by the State Government.

All taxes realised by the Panchayati Raj officials are credited to the account of the
fund of Gram Panchayat, Panchayat Samiti and Zila Parishad. The drawing and
disbursing officer while incurring or authorising expenditure out of the fund shall
observe the cannons of financial propriety which are given below:
1) Every officer incurring or authorising expenditure on behalf of the Panchayat
Samiti or Zila Parishad should be guided by cannons of financial propriety. He is
responsible for enforcing financial order of strict economy at every step.
2) Every officer is expected to exercise the same vigilance in respect of expenditure
incurred out of the fund as a person of ordinary prudence would exercise in
respect of expenditure of his own money.
3) The expenditure should not prima facie be more than the occasion demands.
4) No authority should exercise its power of sanctioning expenditure to pass an order
which will be directly or indirectly to its own advantage.
5) Money out of the fund should not be utilised for the benefit of a particular person
or section of the community unless:
a) the amount of expenditure involved is insignificant, or
b) a claim for the amount could be enforced in a court of law, or
c) the expenditure is in pursuance of a recognised policy or custom.
6) The amount of allowances granted to meet expenditure of a particular type should
be so regulated that the allowances are not on the whole a source of profit to the
recipients. Money indisputably payable should not, as far as possible, be left
unpaid.
Stores
The term 'Stores' includes all articles and materials purchased or otherwise required
for the use of or in the service of Panchayat Samiti or Zila Parishad, whether these are
,consumable like articles of stationery etc., or non-consumable like instruments,
furniture etc. Detailed rules have been framed for the procurement, custody and issue
of stores.
Accounts and audit

After the budget has been approved by each unit of Panchayat Raj, the process of
public expenditure and revenue collection starts. Since a lot of public money is spent
by the Panchayati Raj officials, maintenance of proper accounts and audit of
expenditure aisume great importance. It is only through systematic accounts
supported by vouchers and receipts that the legality and honesty of the transactions
can be determined.
In Gram Panchayats, Sarpanch helped by Panchayat secretary is responsible for the
maintenance of accounts. Similarly, the accounts of the Panchayat Samiti are
maintained by the Executive officer and that of the Zila Parishad by the Secretary. All
the accounts of receipts and expenditure have to be kept in a manner and form
determined by the State Government from-time to time.
The Secretary to Government, Finance Department and Examiner Local Fund

Accounts are responsible for the examination and audit of the accounts of receipts Financial Administration of
Rural Governments
and expenditure of Gram Panchayats, Panchayat Samitis and Zila Parishads who in
I turn make suitable arrangements to enable the auditor for conducting audit. The
purpose of the audit is to ensure that the money has been spent with honesty,
I efficiency and economy. Further it has to see that the money has been spent according
I to the rules, regulations and sanction of the concerned authority. It has also to point
t out whether budgetary grants have been exceeded or whether there was any case of
misappropriation or waste of public funds.
The Examiner, Local Fund Accounts prepares an audit report on the annual accounts
of Panchayat Samitis and Zila Parishads. This report brings out the true financial
picture as on the last working day of the financial year to which it pertains. The audit
F
report along with the annual accounts is placed before the Panchayat Samiti and Zila
i Parishad for necessary action. Further, the annual accounts along with the audit
report of Panchayat Samitis is examined and discussed by the Public Accounts
Committee of Zila Parishad. Similarly, the audit report of the accounts of Zila
Parishad is also examined and discussed by the Public Accounts Committee
I
separately constituted at the divisional level. The recommendations of these
L committees are of binding nature.
The Government has the power t o determine a system of pre-audit or test check in
consultation with the Examiner, Local Fund Accounts in respect of the accounts of
Panchayat Samitis or Zila Parishads. The decision of the government in this respect is
final.
27.7 STATE CONTROL AND SUPERVISION
Panchayati Raj Institutions like urban local bodies are non-sovereign entities. Though
authority and responsibility have been transferred to these institutions, under
democratic decentralisation, they do not enjoy absolute autonomy to manage their
own affairs. They function under varied forms and degrees of control exercised by the
respective state governments. Had they not been under any control, they would not
have been local authorities, but sovereign states. The main purpose of the government
control is to assist, guide and direct these institutions so that they do not make
mistakes. This is what Mehta Committee observed. "It must not be cramped by too
much control by the government or government agencies. It must have the power ro
make mistakes and to learn by making mistakes, but it must also receive guidance
which will help it to avoid making mistakes" State Legislature exercises legislative
control government departments, exercise administrative control, and the courts,
exercise judicial control. In his Section, we will examine the financial control
exercised by the government or government agencies over these institutions.
Financial control is one of the most effective instruments of government control over
Panchayati Raj Institutions. This type of control is more or less similar in almost all
the states and is exercised in matters relating to taxes, budget, grants-in-aid, loans,
accounts and audit. The taxation powers of the Panchayati Raj Institutions are
strictly controlled by the government. Every resolution of each unit of Panchayati Raj
to increase or decrease the rate or even to abolish an existing tax needs the approval
of State Government. In Punjab, the government is empowered to permit Panchayat
Samitis to impose tax on any subject of the state list. The government may even
suspend or abolish a tax which it considers to be unfair in its incidence or injurious to
public interest.
In all the states, detailed accounting procedures have been laid down in matters
pertaining to itemisation of receipts and expenditure, custody and disbursement of
funds, stores, periodical scrutiny of accounts by the appropriate authorities, and so
on. Besides, the accounts are also subject to government audit which is an important
instrument through which control and supervision is exercised, deficiencies located
and loop'holes plugged to ensure financial discipline. As mentioned in the preceding
section, there is also a provision for pre-audit or test check of the accounts of
Panchayati Raj Institutions by the auditors appointed by the State Government.
The State Government has a financial stake in Panchayati Raj Institutions. It provides
Local Finance natural that the provider or guarantor of funds has a responsibility to ensure that they
are not misused or diverted to unapproved schemes. Thus one who pays the piper
calls the tune. Besides, every proposal to raise loan requires approval by the state
government. Before government gives the green signal t o borrow, it examines the
scheme in detail, reviews the entire financial position of the unit of Panchayati Raj
concerned, fmes the period of repayment, determines the mode of borrowing etc.
Budgets are to be prepared by the Panchayati Raj Institutions in the manner and form
as prescribed by the state government, which may also frame rules in regard to the
time schedule for the submission of budget to higher authorities. In some states, it is
'
the superior tier of the Panchayati Raj that has the power to sanction the budget. For
instance, the budget of the Gram Panchayat is approved by the Panchayat Samiti and
Samiti's budget by the Zila Parishad. The system of supervision within the three-tier
structure is an important feature of democratic decentralisation envisaged by the
Balwantrai Mehta Committee which also recommended that village panchayats
should be supervised by the Panchayat Samitis, the Samitis by the Zila Parishad and
the Zila Parishads by the State Government. All this was to be in addition to the
powers of the Deputy Commissioner and other State officials who exercise similar
powers of supervision. Last but not the least, the state government is empowered to
either supersede or dissolve the Panchayati Raj Institutions on the grounds of
persistent maladministration, corruption, misappropriation of funds etc. It is the
ultimate weapon in the armoury of the state government to put the Panchayati Raj on
rails.
27.8 GAP BETWEEN RURAL SERVICES AND

RESOURCES
A review of the working of Panchayati Raj shows that it has not come up to the
expectations of the people. There are many problems that have made Panchayati Raj
Institutions ineffective in accomplishing their basic purpose. It is generally the view
that part of the inability of these institutions in performing their functions
satisfactorily lay in their weak financial resources. The problems of Panchayati Raj
finance are of varied character. In the first place, it has been noticed that in spite of
wide taxation powers, Panchayati Raj Institutions have not utilised them fully. The
Asoka Mehta Committee's findings reveal that these institutions have rarely utilised
their taxation powers. It observes : "In spite of all the exhortations on the need to raise
their own resources 5y way of taxation, there is a general resistance by the Panchayati
Raj Institutions to imposing taxes. This reluctance is visible not only in the case of
Panchayats which are in face-to-face contact with the people but also in the case of
the Zila Parishads even in such states as Maharashtra where they are performing a
variety of developmental functions and need additional resources". This unwillingness
to rnobilise the resources is due to the unpopularity of the measure and the
representatives fear of their being unseated at the next election. There is no
exaggeration that the minimum that an elective body can do to alienate the
sympathies of its constituents and to ensure the defeat of its sitting members at the
next polls is to give the people heavier doses of taxation. Various committees which
have examined, from time to time, the problem of local finance, have drawn pointtd
attention to this factor. Hence, the Asoka Mehta Committee recommended that some
of the local taxes should be made compulsory. It observed, "The thesis 'no taxation,
only representation' should be discouraged. Representation involves inescapable
responsibility of raising resources for development and welfare work". Further, the
borrowing facilities available to Panchayati Raj units are too restrictive. The Local
Authorities Loans Act, 1914 under which these units can raise loans is not much
suited to the needs of the modern times and requires a complete overhaul. It has been
suggested that the scope of the purposes for which loans can be raised, the period and
other conditipns of repayment should be liberalised keeping in view the rural poverty.
The establishment of a new financing body like a Panchayati Raj Finance
Corporation in the states of Uttar Pradesh and Bihar to provide loans to Panchayati
Raj Institutions to enable them to take up different types of remunerative enterprises
has not been favoured by Asoka Mehta Committee. The Committee was of the
28 opinion that it is not likely to add to the total availability of the credit. What is
required in this context is a greater rural orientation to all the financial institutions to
Finaminl Admlnbbltion of
Apart from this, the present system of grants-in-aid suffers from certain shortcomings. R d Conruncltl
The grants are unrelated to the needs, these are irregular, uncertain and their release is
sometimes based on political considerations. To fill up the gap between revenue and
expenditure, the grants should be made available to these institutions on time and
their release on political considerations should be avoided.
Though there is a provision for government audit of Panchayati Raj Institutions, yet
there are serious gaps in actual practice. It has been noticed that the accounts,
especially, of Village Panchayats, have remained unaudited for years at times.
Panchayati Raj units have not cared to consider or remove the audit objections within
the stipulated period. Hence, audit should be conducted regularly and the impression
of its dispensibility should not be allowed to gain ground. The persons found guilty of
misuse of funds should be given exemplary punishment and shown no leniency. In
order to ensure that weaker sections of the society derive maximum benefits from the
various plans, the Asoka Mehta Committee suggested that there should be an
independent authority to carry out 'Social Audit' of the funds and programmes
earmarked for the Scheduled Castes and Scheduled Tribes and to ensure that projects
designed for them are implemented in a way that the desired impact is not diluted.
Improper distribution of sources of income between the state and rural local bodies,
limited financial autonomy, undeveloped trading enterprises, increased population
pressure and functions etc., are some of the reasons for inadequate financial resources
of Panchayati Raj Institutions. TOimprove the financial conditions of local bodies,
creation of a separate tax-zone was strongly recommended by the Local Finance
Enquiry Committee (1949-5 1) and the Taxation Enquiry Commission (1953-54).
There is nothing new in this arrangement. It was practised during the period 1921-37
under the Government of India Act, 1919. The committees and commissions set up at
the centre and the states have also suggested simplification of tax-imposing
procedures, development of trading enterprises, appointment of State Finance
Commission on the pattern of Central Finance Commission. Centralised purchasing,
streamlining of financial management etc. are some of the remedial measures to
augment finances of local bodies in India. If the suggestions described above are given
a serious and fair trial, there is no reason why the shape of Panchayati Raj finances
will not improve. These suggestions, when pursued, will go a long way in bridging the
gap between needs and present supply of funds, putting Panchayati Raj finances on an
even keel.

1) Highlight the steps involved in rural fiscal management.
........................................................................................
........................................................................................
2) Examine the financial control exercised by the government or governmefit

agencies over Panchayati Raj Institutions.
.........................................................................................
........................................................................................
3) The problems of Panchayati Raj finance are varied in nature-Discuss.
........................................................................................
........................................................................................
........................................................................................
27.9 LET US SUM UP

The existing set-up of rural government in India is based on the concept of democratic
decentralisation as envisaged by Balwantrai Mehta Committee. The major purpose of
rural development is to improve the social and economic life of those residing in the
rural areas. In fact, the focus of development is the 'Rural Poor'. The revenue and
expenditure pattern of Panchayati Raj Institutions is described in the Act under which I
these institutions are created. The system of fiscal management differs from state to
state. In case of Gram Panc
budget. The budget of the P
that of the Zila Parishad by
the assessment and collection of taxes, safe custody and disbursement of funds
maintenance of accounts and their audit. Like urban bodies, Panchayati Raj
Institutions are also regularly controlled and supervised by State Government. A
review of the functiow and
and commissions reveals that there is a wide gap between the revenue and local
expenditure. These committees and commissions have made a number of suggestions
to bridge the gap between the two . If these suggestions are sincerely pursued and
given a fair trial, they will definitely help the Panchayati Raj in improving its financial
position which in turn will help in fulfilling their obligations towards rural
community.
27.10 KEY WORDS

Centrally Sponsored Schemes :Plan schemes sponsored by the Central Ministries on
subjects falling in the State list with usually fifty per cent financing by the Centre.
Community Development Programme :The programme was started in 1952 under
the first five year plan. It aimed at changing the outlook of villagers, making them self
reliant, inculcating among them a feeling of cooperation through better utilisation of
resources.
Gram Sabha : It is the lowest administrative body at the village level, consisting of all
persons residing in the area whose names are included in the voters list. It meets
atleast twice a year to review and scrutinise the work done by the Panchayats.
Green Revolution :The strategy, adopted in the 1960s for rapid growth in agricultural
production through intensive use of high-yielding variety of seeds, water and
fertilisers.
Mandala Praja Parishad : The new structure of Panchayati Raj introduced in Andhra
Pradesh since 1986 consists of four-tiers. Gram Panchayat is the lowest tier. The
Mandala Praja Parishads cover population of 35 to 50,000. Above it is the district
peoples council or Zila Praja Parishad. The fourth-tier is the District Development
Review Soard or Zila Abhivrudhi Sameeksha Mandal.
Toll : Money paid for the use of a road, bridge, harbour etc.
White Revolution : Efforts made in the 1970s for increasing milk production in the
country through adoption of improved dairying practices.
27.11, REFERENCES
Bhatnagar, S., 1978. Rural Government in India, Light and Life: New Delhi.
Durgesh Nandini, 1992. Rural Development Administration, Rawat Publications:
Jaipur.
Financial Administration of
Maheshwari, Shriram, 1971. Local Government in India, Orient Longman: New Rural Covemment~
Delhi.
Muttalib, M.A., and Mohd. Akbar Alikhan, 1982. Theory of Local Government,
Sterling Publishers Private Limited: New Delhi.
Reddy, G. Ram, 1977. Patterns of Panchayati Raj in India, Macmillan: Delhi.

EXERCISES
Operations in financial administration in rural local government are those
designed to generate, regulate and distribute the financial resources needed to
provide services to the community. These operations are performed by :
The executive wing which prepares the budget.
The legislative wing which alone can grant funds.
The executive controls the expenditure of funds sanctioned by the legislative
wing.
Audit department
Standing Committee

Independence and responsibility
Adequacy and elasticity
Integration and coordination
Public accountability
Simplicity
Effective personnel management
'
Fiscal access
Tax revenue
Non-tax revenue
Grants-in-Aid
Loans
Share of State Taxes
Donations and contributions

Budget preparation and its approval
Assessment and collection of taxes
Procurement, custody and issue of stores
Accounts and audit
Strict control exercised by the government on the taxation powers of the
Panchayati Raj Institutions.
Centralised accounting procedures
Accounts subjected to government audit
Pre-audithest check of the a ~ u p t of
s Panchhyati Raj Institutions by the
auditors appointed by the state/government.
Control exercised by the government with regard to grants-in-aid, loans
'
provided to the Panchayati Raj Institutions, by way of approval, review etc.
Powers of supersession or dissolution of Panchay~fi&ij Institutions, vested with
the government.
3) Your answer should include the following points: I
Improper utilisation of taxation powers
a TTnx&ll;nnnnao en +ha rmr, IIE :-d:t..t:r\nr ~ I rI n ~ ~ l r : l : thn
~a -am-..--am
Restricted borrowing facilities of Panchayati Raj Institutions
Present system of grants-in-aid which is uncertain, irregular and unrelated to the
needs of the institutions
Irregularities in the system of audit.

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UNIT 1 NATURE ANDSCOPE OF

1.2 FINANCIAL ADMINISTRATION : MEANING

The Distinction between Public Finance and Private Fiance

Publk Finance Private Finance

With the advent of democracy, as a popular social institution, the concept of

The concept of planned development has enabled public administrators to play an

Finmcid Adminls(ratIon :Basla

1.4 NATURE OF FINANCIAL ADMINISTRATION

1.5 SCOPE OF FINANCIAL ADMINISTRATION

2) Discuss any two roles of financial administration as propounded by modem

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

1.6 COMPONENTS OF FINANCIAL ADMINISTRATION

Check Your Progress 3

2) Identify the elements of an organisational system.

1.7 LET US SUM UP

System :An arrangement of interrelated and interdependent elements of a

1.10 ANSWERS TO CHECK YOUR PROGRESS

fl -Your answer should include the following points :

1) Your answer should include the following points :

FINANCIAL ADMINISTRATION : OBJECTIVES

2.3 PRINCIPLES OF FINANCIAL ADMINISTRATION

2) The principle ofpolitical direction a d c m t d

Check Your Progress 2

2.4 FINANCIAL ADMINISTRATION IN INDIA

2.4.1 Historical Perspective

Period II : Development of systems end procedures

Period 111 :Democratisation and deceptralisation

Paiod IV :Development orientation

Independence brought basic changes in the political context of financial

Check Your Fmgress 3

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

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

Development efforts in India are characterised by an order of investment much

3) Development of zero base perspective

Check Your progress 4

2.5 LET US SUM UP

2.6 KEY WORDS f :

firms, governmental units of all o t h q ,

Integrated Financial Advice : This s&m was introduced in 1975-76 in Indian

2.7 REFERENCES , .t.;_.

2.8 ANSWERS TO CHECK YOUR PROGRESS

The Second period (1860-1919) saw the efforts to develop budgetary

therefore, no need for planning or a pre-detennined framework tor guiding the

"Socialism is an economic organisation of in which the material means of

1) It is based on social and economic plan*, collective ownership of facton of

4) Equity or equitable distribution of incomcr is central to aocialism.

Salient Features of Mixed Economy :~ a v i described

Industrial Policy Resolution, 1956 -

Check Your Progrea~1

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

Total Investment No. of

iv) Under utilisation of capacity.

3.5 MIXED ECONOMY - RECENT TRENDS AND AN

3.7 KEY WORDS

After going through this unit, you should be able to :

financial rdlations need to be reviewed in this framework. ?

4.3 BASIC FEATURES OF FEDERALISM

Rationale for coming together

i) Federation by disaggregation, that is, by a process of decentralisation - a

Check Your Progress 1

2) In a federation, what is emphasised more -the independence of the constituent