What is Ability-To-Pay Taxation

Ability-to-pay taxation is a progressive taxation principle that maintains

that taxes should be levied according to a taxpayer's ability to pay. This
progressive taxation approach places an increased tax burden on
individuals, partnerships, companies, corporations, trusts, and certain
estates with higher incomes. 

The ability-to-pay taxation theory is that individuals who earn more money
can afford to pay more in taxes.

BREAKING DOWN Ability-To-Pay Taxation

Ability-to-pay taxation requires higher-earning individuals to pay a greater
percentage of their income towards taxes, compared to individuals with
lower incomes. The tax rate increases as a percentage along with income.
For example, as of 2018 for individuals in the United States,
taxable income up to $9,525 incurs a 10% income tax, while earnings over
$500,000 face a 37% income tax rate. Earnings between those amounts face
tax rates as set by income brackets.

Pros and Cons of Ability-to-Pay Taxation

Advocates of ability-to-pay taxation argue that it allows those with the most
resources the ability to pool together the fund required to provide services
needed by many. People and businesses rely on these services, either
indirectly or directly, such as snow removal, schools, scientific research,
police, and libraries. 

Additionally, using ability-to-pay taxation has the potential to increase a

government's revenues. Arguably, if a government uses a flat tax instead of
the ability-to-pay taxation, it must use relatively low tax rates to
accommodate low-wage earners. Following the theory of deadweight loss of
taxation, if the same rate applies to everyone, it will cause a loss of revenue
due to a lack of fund remaining after paying taxes. Also, as low-wage
earners are more likely to need all their earnings, allowing them to keep a
larger percentage of it helps to stimulate the economy.

Critics of ability-to-pay taxation state that progressive tax systems reduce

the incentive to climb the earnings ladder. It penalizes those who through
hard work and ingenuity have risen into higher incomes. These critics claim
ability-to-pay taxation is not fair for wealthy individuals.

Other critics prefer a benefit-received taxation method. Rather than basing

taxes on what an individual can afford to pay, benefit-received taxation
levies taxes on the people who receive the benefits of the tax. For example,
the government earmarks taxes collected from gasoline sales for roads.
Essentially, when drivers pay tax on gasoline, they receive the benefit of
well-maintained roads. Conversely, people who don't drive also don't have
to buy gas and do not end up paying that tax.

How the Internal Revenue Service Determines Ability-to-Pay

The phrase "ability to pay" refers to a taxation principle which supports
progressive taxation systems. It does not necessarily ensure that an
individual can afford their taxes, as affordability can be subjective.
However, lawmakers work on modifying the tax code or revising deductions
and credits to make taxes more affordable.

If an individual owes back taxes to the Internal Revenue Service (IRS), they
may apply for a payment plan or a reduced payment. At that point, the IRS
looks at their ability to pay. Based on their personal finances and assets, it
decides whether to accept the payment plan.

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What Is a Progressive Tax?

A progressive tax is a tax that imposes a lower tax rate on low-income
earners compared to those with a higher income, making it based on
the taxpayer's ability to pay. That means it takes a larger percentage from
high-income earners than it does from low-income individuals.

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1:37
Progressive Tax
Breaking Down Progressive Tax
A progressive tax is one that charges a higher tax rate for people who earn a
higher income. The rationale is that people with a lower income will usually
spend a greater percentage of their income to maintain their standard of
living. Those who are richer can typically afford the basic necessities in life
(and then some). 

The income tax system in the United States is considered a progressive

system.

The degree to how progressive a tax structure depends on how quickly the
tax rates rise in relation to increases in income. For example, if one tax
code has a low rate of 10 percent and a high rate of 30 percent, and another
tax code has income tax rates ranging from 10 to 80 percent, the latter is
more progressive.

The Advantages of a Progressive Tax

Progressive tax systems reduce the (tax) burdens on people who can least
afford to pay them, and these systems leave more money in the pockets of
low-wage earners, who are likely to spend all of their money and stimulate
the economy. Progressive tax systems also have the ability to collect more
taxes than flat taxes or regressive taxes, as tax rates are indexed to increase
as income climbs. Progressive taxes allow people with the greatest amount of
resources to fund a greater portion of the services all people and businesses
rely on, such as roads, first responders and snow removal.

The current tax system in the United States, which was signed into law in
December 2017 and went into effect as of January 2018, has seven different
tax rates or tax brackets based on income and filing status (single, married
filing jointly or heads of households). These tax rates are 10 percent, 12
percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent. 

Disadvantages of Progressive Taxes

Critics of progressive taxes consider them to be discriminatory against
wealthy people or high-income earners. These critics believe the U.S.
progressive income tax is effectively a means of income redistribution, based
on the myth most taxes are used to fund social welfare programs. However,
only a small portion of government spending is devoted to welfare payments.

Progressive Tax vs. Regressive Tax

The opposite of a progressive tax, a regressive tax, takes a larger percentage
of income from low-wage earners than from high-wage earners. A sales
tax is an example of a regressive tax because if two individuals buy the same
amount of goods or services, the sales tax constitutes a higher percentage of
the lower-earning individual's wages and a lower percentage of the higher-
earning individual's wages.
Progressive Tax vs. Flat Tax
Unlike progressive and regressive tax systems, a flat tax system does not
impose different tax rates on people with different income levels. Instead,
flat taxation imposes the same percentage tax on everyone regardless of
income. For example, if everyone is taxed at 10 percent, regardless of
income, this is a flat tax.

The U.S. payroll tax is often considered a flat tax because it taxes all wage
earners at the same percentage. However, as of 2016, this tax is not applied
on earnings over $118,500, and as a result, it is only a flat tax for people
earning less than that amount. Taxpayers earning more than that amount
pay a lower percentage of their total income in the payroll tax, making the
tax regressive.

DIRECT AND INDIRECT TAX: MERITS AND DEMERITS | ECONOMICS

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In this article we will discuss the merits and demerits of direct and indirect
taxes on an economy.

Taxes may be classified as direct and indirect. Direct taxes are levied on a
person’s or a firm’s income or wealth and indirect taxes on spending on
goods and services. Thus, direct taxes are paid directly by the person or firm
on whom the assessment is made, while indirect taxes are paid indirectly by
consumers in the form of higher prices. Direct taxes cannot be legally
evaded but in direct taxes can be avoided because people can reduce their
purchases of the taxed goods and services.

Direct Taxes:
Examples of direct taxation include income tax, corporation tax (on
companies’ profits), capital gains tax (a tax on the profits of sales of certain
assets), wealth tax (which is a tax on ownership of property or wealth) and a
capital transfer tax (a tax on gifts to replace death duties). Direct taxes are
mainly collected by the central government.

Advantages:
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(i) It is easy to determine the incidence of the tax – a person or institution
who actually pays and suffers the burden of tax.

(ii) Direct taxes tend to be progressive – people in the higher income group
pay a greater percentage than poorer people, e.g., income tax is graduated
so that high income earners pay a larger percentage; also a selective wealth
tax would only apply to those owning more than a certain level of wealth.

(iii) Direct taxes are easy to collect. Consider, for example, the PAYE system
which is used to collect income tax from most wage and salary earners.

(iv) Direct taxes are important to the government’s economic policy. If the
government is fighting inflation it can impose, for example, high levels of
income tax to restrict consumer demand. If the government is concerned
about unemployment it can reduce the levels of income tax to increase
consumer demand and increase production.

Disadvantages:
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(i) Direct taxation may be a disincentive to hard work. High rates of income
tax, for example, may discourage people from working overtime or trying to
gain promotion at work. Some economists blame the ‘brain drain’ (i.e., the
emigration of highly qualified persons, such as scientists and doctors) on
India’s high levels of taxation.

(ii) Direct taxation discourage savings because, after paying tax, individuals
and companies have less income available to save. This means that
investment, which relies on the level of savings, is low and this could cause
less production and employment.

(iii) This type of taxation encourages tax evasion – to avoid paying so much
tax.

(iv) There is no element of choice about paying the tax – it is unavoidable.

Indirect taxes:
Examples of indirect taxation include customs duties, motor vehicles tax,
excise duty, octroi and sales tax. Indirect taxes are collected both by the
central and state governments but mainly by the central government.

Advantages:
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(i) Indirect tax is fairly easy to collect.

(ii) It is easy to determine the incidence of an indirect tax.

(iii) The government can use it to discourage certain types of consumption.

A high rate of tax on tobacco can, for example, affect smoking habits.

(iv) Indirect taxation is a good way of raising revenue when levied on goods
with an inelastic demand, such as necessities.

(v) Tourists do not pay income tax. But they spend money on goods and
services. This adds to the tax revenue of the government.

(vi) Consumers have a choice as to whether they pay the tax. They can avoid
paying the tax by not consuming the goods which are being taxed.

(vii) Indirect taxes do not have a discentive effect on work.

Disadvantages:
(i) Indirect taxes are regressive. A regressive tax is one which causes a poor
person to pay a higher percentage of his or her income as tax than a rich
person. For instance, the tax ingredient of the price of a new television set
would be the same for the poor and the rich person, but as a percentage of
the poor person’s income, it is far greater.

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(ii) These taxes are not impartial. In recent years, certain groups of
consumers have complained that they are being heavily penalised by
taxation, e.g., drinkers, smokers and drivers.

(iii) Indirect taxes may contribute to inflation. The imposition of an indirect

tax on an item like petrol will increase its price. Since petrol is an essential
input in a large number of industries, this may set off an inflationary spiral.
Moreover, trade unions demand higher wages to maintain the real incomes
of workers.

The advantages and disadvantages of two types are listed in Table 4.

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Conclusion:
So, the conclusion is that, in a good tax system there should be a proper
balance between direct and indirect taxes. The revenue will be optimum and
loss of incentives minimum.

3 MAIN EFFECTS OF TAXATION ON PRODUCTION | TAXATION

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Main effects of taxation on production are: 1. Effects on Ability to work,

2.Effect on the Ability to Save, 3. Effect on Ability to Invest

1. Effects on Ability to work:

Taxes reduce disposable income. As such, the buying capacity and
consumption expenditure are curtailed. These cause the standard of living to
deteriorate. Consequently, efficiency and ability to work is adversely
affected.

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This happens in the case of low income group people. For the rich, however,
the ability to work is not so much affected by taxation. To avoid the ill-
effects of taxation, it is essential to grant exemption limits in income tax for
the benefit of poor and middle income groups. In India, now an annual
income up to Rs. 40,000 is exempted from income tax. Similarly, it is also
necessary to avoid indirect taxes on essential commodities of mass
consumption.

Again, there are some taxes which carry a beneficial impact on the ability to
work. For instance, taxes on goods like liquor, cigarettes, opium, etc. which
prohibit their consumption will lead to an improvement in general health
and efficiency of those who are now addicted to them.

2. Effect on the Ability to Save:

All taxes always have an adverse effect on one’s saving capacity.

Ability to save is adversely affected by taxation as taxes fall on income and

saving is the function of disposable income. As disposable income declines,
savings tend to decline.

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Though normally, taxation is on the surplus income (the income which is in

excess of the minimum standard of consumption level), the ability to save
will be reduced proportionally to the amount of taxation, as it will adversely
affect the marginal propensity to save by reducing the surplus income out of
which saving is generated.

Hence, taxation would cause a reduction in the saving potentiality.

Especially, the rich, having a high marginal propensity to save, are affected
most due to progressive taxation based on the ability to pay criterion. A
progressive taxation substantially reduces the ability to save of the rich
class.
Ability to save is also reduced by indirect or commodity taxation, because
these taxes cause a rise in prices which induces a higher spending from a
given income, thus, resulting in less saving.

Similarly, the corporate savings (that of business firms), too, are reduced by
corporate taxation. Corporate ability to save is, however, less affected than a
wealthy individual’s ability to save since equity does not demand
progression generally in the taxation of corporate income.

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But, when government spends the tax income for the benefit of the poor,
then their ability to save is enhanced. So, while evaluating the effects of a
tax, the effects of public expenditure should also be taken into consideration
to appraise the correct position in the economic system.

It is equally true that when direct taxes are imposed, they absorb the
excessive purchasing power of the commodity, cause a deflationary effect
which in turn enhances the real income of the common people and their
capacity to save.

3. Effect on Ability to Invest:

Ability to invest in the private sector evidently falls on account of the
reduced saving ability caused by the tax imposition. Hence, all taxes have
the immediate effect of reducing the amount of resources available for
investment in the private sector.

In fact, taxation leads to a vicious circle in that when a tax is imposed, ability
to save is reduced, less saving resources are available for investment in
capital formation of the private sector, so there will be reduction in capital
which in turn would lead to low productivity and low income, causing a
further reduction in the ability of the people to save. As such, it may be
stressed that to maintain and improve the investment function in a free
economy, it is necessary to ensure that the rate of savings is not discouraged
by taxation.

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This gloomy picture of effect of taxation is, however, painted without taking
into account the beneficial effects of public expenditure. In fact, public
spending compensates and tends to surmount the adverse effects of taxation.
The reduction in ability to work and save caused by taxation is more than
mitigated by the amenities of life provided by State expenditure.

When the overall social benefits of expenditure exceed the social sacrifice
involved in taxation, the net benefits of public spending will produce a
favourable effect on the ability to save and work. Similarly, the reduction in
private investment caused by taxation is more than offset by the public
investment programmes.

In fact, the public sector investment may fill the investment gap of effective
demand of the community and with due capital formation, can accelerate
the tempo of economic development. Public investment may be designed to
break the vicious circle of poverty in an underdeveloped economy. Thus,
though analytically, the effects of taxation are discussed separately from
those of public expenditure, in practice economic consequences of a fiscal
policy can hardly be segregated.

WHAT ARE THE OBJECTIVES OF PUBLIC ENTERPRISES?

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In India, public enterprises have been assigned the task of realising the
objectives laid down in the Directive Principles of State Policy.

Public sector as a whole seeks: (a) to gain control of the commanding heights
of the economy, (b) to promote critical development in terms of social gain
or strategic value rather than on consideration of profit, and (c) to provide
commercial surplus with which to finance further economic development.

The main objectives of public enterprises in India are as follows:

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1. Economic development:
Public enterprises were set up to accelerate the rate of economic growth in a
planned manner. These enterprises have created a sound industrial base for
rapid industrialisation of the country.

They are expected to provide infrastructure facilities for promoting

balanced and diversified economic structure of development.

2. Self-reliance:
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Another aim of public enterprises is to promote self-reliance in strategic

sectors of the national economy. For this purpose, public enterprises have
been set up in transportation, communication, energy, petro-chemicals, and
other key and basic industries.

3. Development of backward Areas:

Several public enterprises were established in backward areas to reduce
regional imbalances in development. Balanced development of different
parts of the country is necessary for social as well as strategic reasons.

4. Employment generation:
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Unemployment has become a serious problem in India. Public enterprises

seek to offer gainful employment to millions. In order to protect jobs,
several sick units in the private sector have been nationalised.

5. Economic surplus:
Public enterprises seek to generate and mobilise surplus for reinvestment.
These enterprises earn money and mobilise public savings for industrial
development.

6. Egalitarian society:
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An important objective of public enterprises is to prevent concentration of

economic power and growth of private monopolies. Public sector helps the
Government to enforce social control on trade and industry for ensuring
equitable distribution of goods and services. Public enterprises protect and
promote small scale industries.

7. Consumer welfare:
Public enterprises seek to protect consumers from exploitation and
profiteering by ensuring supply of essential commodities at cheaper prices.
They aim at stabilising prices.

8. Public utilities:
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Private sector is guided by profit motive. Therefore, it is reluctant to invest

money in public utility services like water supply, gas, electricity, public
transport. Therefore, the Government has to assume responsibility for
providing such services.

9. Defence:
Government has to set up public enterprises for production of defence
equipment. Supply of such equipment cannot be entrusted for private sector
due to the need for utmost secrecy.

10. Labour welfare:
Public enterprises serve as model employers. They ensure welfare and social
security of employees. Many public enterprises have developed townships,
schools, college and hospitals for their workers.

Role and Rationale of Public Enterprises

The public sector has been playing a vital role in the economic development
of the country. In fact the public sector has come to occupy such an
important place in our economy that on its effective performance depends
largely the achievement of the country’s economic and social goals.

Public sector is considered a powerful engine of economic development and

an important instrument of self-reliance. The main contributions of public
enterprises to the country’s economy may be described as follows:

1. Filling of gaps:
At the time of independence, there existed serious gaps in the industrial
structure of the country, particularly in the field of heavy industries. Basic
and key industries require huge capital investment, involve considerable
risk and suffer from long gestation periods.

Private sector concerns do not come forward to establish such industries.

Public sector has helped to fill up these gaps. The basic infrastructure
required for rapid industrialisation has been built up, through the
production of strategic capital goods.

The public sector has considerably widened the industrial base of the
country and speeded up the pace of industrialisation.

2. Employment:
Public sector has created millions of jobs to tackle the unemployment
problem in the country. Public sector accounts for about two-third of the
total employment in the organised industrial sector in India.
By taking over many sick units, the public sector has protected the
employment of millions. Public sector has also contributed a lot towards the
improvement of working and living conditions of workers by serving as a
model employer.

3. Balanced regional development:

Private industries tend to concentrate in certain regions while other regions
remain backward. Public sector undertakings have located their plants in
backward and untraded parts of the country.

These areas lacked basic industrial and civic facilities like electricity, water
supply, township and manpower. Public enterprises have developed these
facilities thereby bringing about complete transformation in the social-
economic life of the people in these regions.

Steel plants of Bhilai, Rourkela and Durgapur; fertilizer factory at Sindri,

machine tool plants in Rajasthan, precision instruments plants in Kerala
and Rajasthan, etc., are a few examples of the development of backward
regions by the public sector.

4. Optimum utilisation of resources:

Public enterprises make better utilisation of scarce resources of the country.
They are big in size and able to enjoy the benefits of large scale operations.

They help to eliminate wasteful completion and ensure full use of installed
capacity. Optimum utilisation of resources results in better and cheaper
production.

5. Mobilisation of surplus:
The profits earned by public enterprises are reinvested for expansion and
diversification. Moreover, public sector concerns like banks and financial
institutions mobilise scattered public savings thereby helping the process of
capital formation in the country. Public enterprises earn considerable
foreign exchange through exports.
6. Self reliance:
Public enterprises have reduced considerably the need for imports by
producing new and better products within the country. These enterprises
are also earning considerable amount of foreign exchange through exports.

7. Socialistic pattern of society:

Public sector is an instrument for realising social objectives. Public
enterprises help to check concentration of wealth and private monopolies.
These enterprises can serve as powerful means of economic and social
change.

8. Public welfare:
Public enterprises help in the establishment of a welfare state in the country.
These enterprises supply essential commodities at cheaper rates.

A proper balance between demand and supply is created to protect

consumers against exploitation by profit hungry businessmen. Public
enterprises also protect and promote the interests of workers.

Criticism of Public Enterprises [Arguments against Public Enterprises]

Public enterprises are opposed on account of weaknesses in their
organisation and working. These enterprises generally suffer from the
following problems:

1. Delay in completion:
Often a very long time is taken in the establishment and completion of
public enterprises. Delay in completion leads to increase in the cost of
establishment and benefits extracted from them are delayed.

2. Faulty evaluation:
Public enterprises are in some cases set upon political considerations. There
is no proper evaluation of demand and supply and expected costs and
benefits. There are no clear cut objectives and guidelines.
In the absence of proper project planning there is under- utilisation of
capacity and wastage of national resources.

3. Heavy overhead costs:

Public enterprises often spend huge amounts on providing housing and
other amenities to employees. Though such investment is useful for
employees but it takes away a large part of capital and the project suffers
from financial difficulties.

4. Poor returns:
Majority of the public enterprises in India are incurring loss. In some of
them the profits earned do not yield a reasonable return on huge investment.
Lack of effective financial controls, wasteful expenditure and dogmatic
pricing policy result in losses

5. Inefficient management:
Due to excessive centralisation of authority and lack of motivation public
enterprises are managed inefficiently. High level posts are often occupied by
persons lacking necessary expertise but enjoying political support.

6. Political interference:
There is frequent interference from politicians and civil servants in the
working of public enterprises. Such interference leaves little scope for
initiative and freedom of action. Public enterprises enjoy little autonomy
and flexibility of operations.

7. Labour problems:
In the absence of proper manpower planning public enterprises suffer from
over-staffing. Jobs are created to fulfil employment goals of the
Government. Guarantee of job in these enterprises encourages trade unions
to be militant in pursuing their aims.

Growth of Public Enterprises in India

At the time of independence, public sector in India was confined mainly to
railways, communications, defence production and public utility services.
Since then the growth of public enterprises has been very rapid.

PRICING POLICIES OF PUBLIC ENTERPRISES | ECONOMICS

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In this article we will discuss about:- 1. Principles of Pricing in the Case of

Public Enterprises 2. Machinery for Price Fixation 3. Guidelines.

Principles of Pricing in the Case of Public Enterprises:

What pricing policy should a Public Enterprise (PE) adopt? It is a complex
problem and is not possible to lays down, general principle of pricing that
should be followed by all the PEs. The complexity of pricing problem arises
because of the fact that some PEs are industrial and commercial
undertakings; some PEs are promotional and developmental; and some PEs
provide basic and essential infrastructure facilities.

Also, competitive environment—domestic and international—has got to be

taken into account in the case of goods produced by some PEs. There is also
to be considered the need for financial resources for investment purposes in
a developing country like India. From all these considerations; it should
follow that there cannot be just a single, principle of guiding of pricing that
can be prescribed for or that should be followed by all PEs.

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The following are some of the important principles of pricing which are
suggested in the case of PEs:
1. Marginal Cost Basis:
Marginal cost is the cost of producing an additional unit of a product. The
reasoning behind the ‘marginal cost basis’ of pricing policy, is that, if a
consumer is willing to pay for an extra unit of a product, welfare of the
community gets maximised when that extra or additional unit of product is
made available to him.
It is argued that if a consumer is not willing to pay the cost of the additional
unit (i.e. marginal cost), that additional unit should not be produced in the
interest of maximising welfare of the community. It is also argued that if
marginal cost basis is followed in pricing policy of PEs, resources of the
community will automatically be allocated to the production of different
goods that will lead to maximisation of the welfare of the community.

Marginal Cost:
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While considering ‘marginal cost’ in the short run, capital cost is fixed and
only variable cost is taken into consideration therefore, called ‘short-term
marginal cost’. In the case of long-term marginal cost, even fixed capital
becomes variable capital and marginal cost has in that case to take note of
both fixed capital cost and variable cost.

Criticism:
One criticism against the marginal cost principle of pricing of products of
PEs is that, if strictly applied, it would result in deficit in the case of
industries experiencing increasing returns or decreasing costs. Such deficits
may have to be met by imposing taxes on other consumers who are not
purchasing that commodity and this could reduce their welfare.

Surplus Revenue:
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The principle of marginal cost would mean, in the case of industries which
are functioning under conditions of decreasing costs, an increase in the price
of commodity with every increase in production of that commodity. This
would result in large surplus revenue. This surplus revenue, apart from
inviting public protests, might also result in a demand for a rise in wages
and bonus by workers in that unit of the PE.

Practical Difficulties:
The marginal cost principle may also be found unworkable because of the
practical difficulties of calculating, with any degree of accuracy, the
marginal cost in public utilities such as electricity, State transport services,
post and telegraph and so on.

2. Pricing on the Basis of Average Cost:

‘Average cost pricing principle’ refers to fixing the price of a commodity on
the basis of the average cost of population of the commodity. In the case of
average cost pricing, total revenue obtained by selling a certain amount of
commodity will be equal to its total cost of production. Thus, average cost
pricing principle ensures that the entire cost of production is absorbed in to
the price of the commodity.

It may be noticed that while calculating total cost of production, along with
various other costs, normal profits is also included. On account of this, the
price of a commodity is a little higher than the price based on the principle
of ‘No profit, No loss’.

Calculation Problem:
It is claimed that it is easy to calculate total costs and therefore, also the
average cost of a commodity, whereas it is not always possible to accurately
calculate marginal cost, and sometime it is even impossible to-do that. Thus,
in the case of railways, electricity and other public utilities it is possible to
calculate total costs and therefore, also the average cost of production of a
commodity or service whereas it is not possible in their cases to calculate
marginal cost.

Merits:
The following merits are claimed for the principle of average cost pricing of
commodities or services of PEs:
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1. Every consumer pays the entire cost of production of a commodity that he

is consuming instead of only its marginal cost. This appears reasonable.
2. Since nobody pays more than the average cost of production of a
commodity or what it has cost the commodity to be produced and no more,
there is no question of anybody being exploited (by changing a price that is
higher than what on an average the commodity has cost).
3. ‘No Profit, No Loss’ or ‘Break-Even’ Principle:
‘No profit. No loss’ or ‘Break-even’ principle of pricing of products or
services of PEs maintains that the price should be fixed in such a way that
there will be neither any profit, nor any loss for the concerned PE. In simple
terms, price should just-cover all costs of production.

Marginal Cost Pricing:

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It is noted that in the case of marginal cost pricing, in the case of decreasing
cost condition, the concerned-PE will suffer a loss which will have to be
subsidized by taxing people to the extent of the deficit suffered by the PE.
There is thus cross subsidization.
In the case of No profit, No loss’ principle of pricing of products of PEs
there is no question of any loss and, therefore, no subsidizing the PE out of
the government treasury or by taxing the people.

This means that when ‘No profit, No loss’ principle of pricing is adopted by
a PE non-consumers of the commodity in question are not forced directly or
indirectly to bear a ‘burden for the benefit of those who consume the
product.

Arthur Lewis has advocated this principle of ‘No Profit No loss’ on the
ground that the principle will prevent either over- expansion or under-
expansion of a PE and will thus help avoid either inflationary or
deflationary tendencies.

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In India, the Damodar Valley Corporation (DVC) follows the principle of

‘No profit No loss’ in pricing. Other PEs which follow this principle of
pricing are Hindustan Antibiotics, Hindustan Insecticides, Export
Guarantee Corporation, etc.

4. Profit-Making Principle of Pricing:

Profit-making principle of pricing of the products or services of PEs
maintains that the price charged should be such as to get for the concerned
PE some surplus after absorbing all the cost elements, including normal
profit. It is maintained that in developing countries like India, PEs are
expected to generate as much surplus as possible so that these surplus funds
can be further invested in developmental projects.

In Developing Countries:
In many developing countries like India, PEs has been occupying a
prominent place in the economy. Huge amounts (amounting to more than
Rs. 1,13,234 crores on Central Government projects) have come to be
invested in PEs. In developing countries, people being poor with an
extremely low per capital income, there is limited scope for both direct and
indirect taxation.

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If the rates are raised abnormally, the yields might decline and people may
also develop tax-resistances. It is, therefore, suggested that PEs should
generate as much surpluses or profits as possible which will augment
government’s financial resources which can be invested for further
development purposes.

In countries, where PEs have come to occupy a commanding position, it

would be easier and also practicable that the country’s financial resources
for developmental purposes should be augmented by this way than by
raising financial resources by taxation or deficit financing or borrowing
from the public.

Pronouncements:
We observe the pronouncements of politicians and economists in India in
favour of this principle of pricing of the products of PEs. Thus, Mrs. Indira
Gandhi, then the Prime Minister of India, pronounced that Government
advocated expanding the public sector so that the PEs can “provide
surpluses with which to finance further economic development”.

Mr. T.A. Pai (once Union Minister for Industries) argued that 12 per cent
return on investment in the public sector should be regarded as equitable
Dr. V.K.R.V. Rao maintained that the pricing policy of PEs should be such
as to promote the growth of national income… public enterprises must make
profit and the larger the share of public enterprises in all enterprises, the
greater is the need for their making profits.

Profits constitute the surplus available for savings and investments, on the
one hand, and contribution to national social welfare programmes, on the
other, and if public enterprises do not make profits, the national surplus
available for stepping up the rate of investment and the increase of social
welfare will suffer a corresponding reduction.

Taxation Committees Report:

The Taxation Enquiry Committee (1952) observed, “…in certain age where
the State has made substantial investment a policy of regulating prices so as
to secure an adequate return on the capital invested is not only
unobjectionable but may indeed be desirable. This is particularly so, where
public enterprise itself, fostered at State expense, may in turn play a role in
financing the country’s development.”

The Industrial Policy Statement of 1948 observed. “It is to be expected that

public enterprises will augment revenues of the State and provide resources
for further development to fresh fields.”

Plans:
India’s Five Year Plans have also advocated the same principle. Thus, the
Third Five Year Plan maintained. Substantial investments have been made
in the public sector over the last ten years and every effort must be made to
ensure that they yield an adequate surplus on the basis of which to plan
further advance.

The Sixth Plan Observed:

“Almost all the Central and State enterprises would need to adopt
appropriate pricing policies in order to achieve an adequate rate of return
on capital employed.”

It is thus maintained that according to this principle, while particular PEs,

such as Hindustan Insecticides and the Hindustan Antibiotics may operate
on the principle of’ No profit, No loss.’ PEs which are essentially industrial
or commercial in nature (and not concerned with matters like education,
research, public health and so on) should generate surpluses and augment
the pool of investment funds.

Comment on Profit-Making Principle of Pricing for PEs:

The following points of criticism are brought against the profit making
principle of pricing for PEs:
1. It should be noted that a reasonable return on investment in a PE is not
the same thing as making maximum profit or mopping up Maximum
resources for further investment purposes. If PEs as a whole is considered,
there is ground for argument that on the whole, the public sector should
yield a ‘reasonable rate of return’ on investment by which we may say what
a similar investment in the private sector yields.
Adverse Effect:
But if the Government aims at a higher than reasonable rate of return or
profit, the State having an absolute monopoly in some of the essential
services and commodities, the State can do that; but that will have an
extremely adverse effect on the welfare of the people (as in the case of
railway travel and electricity) and on other sectors of production, because
many of the commodities produced by PEs (e.g. coal, electricity, iron and
steel, chemicals, fertilizers, etc.) happen to be important inputs of some
other industries.

2. Reasonable Rate:
In the case of PEs in India, it is possible to raise objection even against the
principle of reasonable rate of profit on the basis of investment. In India,
most PEs have an extremely long gestation period and that resulted in the
escalation of costs and amount of investment. All this was often due to faulty
project planning, wrong location of a project under political pressure,
employing too many workers again due to political reasons, etc.

To expect the PEs to cover a reasonable rate of profit on this unnecessary

heavy investment would only mean covering up inefficiency of the PEs. The
reasonable rate of profit should be based on the efficient running of PEs.

3. Welfare Point of View:

In some cases like fertilizers, antibiotics, milk for poor school children and
mothers, etc., from the welfare point of view, it is necessary to subsidise their
prices.

4. And therefore, the principle under discussion cannot be a general

criterion for all types of PEs.
5. Pricing Policies of Some of the PEs in India:
The PEs in India follows a number of practices while fixing prices of their
products or services.

Following some of the important practices adopted by PEs in India:

(a) Administered Prices:
Administered prices or controlled prices are fixed by the Government, as in
the case of steel, electricity, railways, cement, sugar, etc. While fixing their
prices, the Government may follow any principles mentioned above, namely
reasonable rate of return. ‘No profit, No loss’, subsidised prices and so on.

(b) Subsidised Prices:
As a matter of policy, some of the prices of products of the PEs charged by
the government are below their cost of production, the Subsidy being paid
by the Government. Government may do this to specially help a certain
section of the community.

Thus, in India, fertilisers are subsidised to boost agricultural production;

similarly certain sections of society are provided loans at lower rates of
interest by nationalised commercial banks as they are too poor to pay the
normal rate of interest charged for the public. With a view to reduce the
birth-rate in India, prices of contraceptives produced by the Hindustan
Latex are subsidised.

(c) Parity Prices:
In the case of products of some of the PEs that have to face competition in
the open market with imported goods of similar types or close substitutes,
party with the landed cost of the imported commodity is made the basis of
fixing the prices. In India, this happens in the case of the Hindustan
Shipyard which has a monopoly in shipbuilding. In this case, parity with
prices of similar goods imported from the United Kingdom is aimed at.

(d) Cost-Plus Prices:
Cost-plus prices is the price fixed by the Government in the case of the
products of certain PEs on the basis cost of production incurred plus a
margin (around 10 per cent for profit) in addition to that. In India this is
done in the case of PEs like the Indian Telephone Industry, Hindustan
Aircrafts and Bharat Electronics Limited, which fix prices on the cost-plus
basis.

The danger in following this principle is that since a margin over cost of
production is permitted, this may breed inefficiency in the PEs leaving no
incentive to increase efficiency and reduce cost of production.

In India, captive producers like Hindustan Aeronautics, Hindustan Cables,

Bharat Dynamics, etc., follow this principle.

(e) Discriminatory Prices:

In the case of discriminatory prices, the PEs charge different prices for the
same product of the PEs for different sections of the community. Thus,
nationalised commercial banks in India charge different rates of interest in
the case of the very poor, the agriculturists with small landholdings and big
industrialists.

(f) Following the Leaders:

In this case, prices are fixed by PEs taking into consideration the prices of
similar goods fixed by a leading undertaking in the same line of production.
For example, Kerala Soaps and Oils, while fixing the price of its product,
takes into account the prices fixed by Hindustan Lever, Tata Soap, and
Mysore Sandal, etc.

(g) Trade Association Pricing:

In India, the Air India International fixes the price (i.e. airfares) on the basis
of the recommendation, of the international Air Transport Association; and
the Shipping Corporation of India fixes prices or rates of its shipping
services on the basis of the recommendations of the Shipping Conference
which is an international organisation.

(h) Competitive Prices:
In India, certain PEs like the Ashok Hotel fix their prices on the basis of
competition Prevailing in the market (that is, prices or rates charged by
other similar Five Star Hotels in the private sector).
(i) Dual Pricing Policy:
In the case of Dual Pricing Policy, a public sector enterprise charges one
price for some sector of the economy and another price for other sectors of
the economy. The dual pricing policy may be illustrated by the public sector
steel units. In the case of public sector steel units, the Government has been
following a dual pricing policy since 15th October, 1977.

According to this policy, steel is sold to priority sectors at a lower price, and
in order to compensate for this loss Involved, the public sector steel plants
are empowered to sell the balance of their production at higher prices to
other sectors of the economy.

Machinery for Price Fixation:

By a resolution, Government setup in January 1970, the Bureau of
Industrial Costs and Prices, (BICP) on the, recommendation of the
Administrative Reforms Commission, the BICP undertakes investigations, if
and where necessary, regarding prices to be charged by PEs and gives its
advice in the matter. In this work, the BICP is assisted by the Bureau of
Public Enterprises (BPE).

PUBLIC DEBT: MEANING, CLASSIFICATION AND METHOD OF REDEMPTION

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Public Debt: Meaning, Classification and Method of Redemption!

Meaning of Public Debt:
Modern governments need to borrow from different sources when current
revenue falls short of public expenditures. Thus, public debt refers to loans
incurred by the government to finance its activities when other sources of
public income fail to meet the requirements. In this wider sense, the
proceeds of such public borrowing constitute public income.

However, since debt has to be repaid along with interest from whom it is
borrowed, it does not constitute income. Rather, it constitutes public
expenditure. Public debt is incurred when the government floats loans and
borrows either internally or externally from banks, individuals or countries
or international loan-giving institutions.
ADVERTISEMENTS:

What is true about public borrowing is that, like taxes, public borrowing is
not a compulsory source of public income. The word ‘compulsion’ is not
applied to public borrowing except in certain exceptional cases of
borrowing.
Classification of Public Debt:
The structure of public debt is not uniform in any country on account of
factors such as categories of markets in which loans are floated, the
conditions for repayment, the rate of interest offered on bonds, purposes of
borrowing, etc.

In view of these differences in criteria, public debt is classified into various

categories:
i. Internal and external debt

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ii. Short term and long term loans

iii. Funded and unfunded debt

iv. Voluntary and compulsory loans

v. Redeemable and irredeemable debt

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vi. Productive or reproductive and unproductive debt/deadweight debt

i. Internal and External Debt:

Sums owed to the citizens and institutions are called internal debt and sums
owed to foreigners comprise the external debt. Internal debt refers to the
government loans floated in the capital markets within the country. Such
debt is subscribed by individuals and institutions of the country.

On the other hand, if a public loan is floated in the foreign capital markets,
i.e., outside the country, by the government from foreign nationals, foreign
governments, international financial institutions, it is called external debt.

ii. Short term and Long Term Loans:

Loans are classified according to the duration of loans taken. Most
government debt is held in short term interest-bearing securities, such as
Treasury Bills or Ways and Means Advances (WMA). Maturity period of
Treasury bill is usually 90 days.

Government borrows money for such period from the central bank of the
country to cover temporary deficits in the budget. Only for long term loans,
government comes to the public. For development purposes, long period
loans are raised by the government usually for a period exceeding five years
or more.

iii. Funded and Unfunded or Floating Debt:

Funded debt is the loan repayable after a long period of time, usually more
than a year. Thus, funded debt is long term debt. Further, since for the
repayment of such debt government maintains a separate fund, the debt is
called funded debt. Floating or unfunded loans are those which are
repayable within a short period, usually less than a year.

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It is unfunded because no separate fund is maintained by the government

for the debt repayment. Since repayment of unfunded debt is made out of
public revenue, it is referred to as a floating debt. Thus, unfunded debt is a
short term debt.

iv. Voluntary and Compulsory Loans:

A democratic government raises loans for the nationals on a voluntary basis.
Thus, loans given to the government by the people on their own will and
ability are called voluntary loans. Normally, public debt, by nature, is
voluntary. But during emergencies (e.g., war, natural calamities, etc.,)
government may force the nationals to lend it. Such loans are called forced
or compulsory loans.

v. Redeemable and Irredeemable Debt:

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Redeemable public debt refers to that debt which the government promises
to pay off at some future date. After the maturity period, the government
pays the amount to the lenders. Thus, redeemable loans are called
terminable loans.

In the case of irredeemable debt, government does not make any promise
about the payment of the principal amount, although interest is paid
regularly to the lenders. For the most obvious reasons, redeemable public
debt is preferred. If irredeemable loans are taken by the government, the
society will have to face the consequence of burden of perpetual debt.

vi. Productive (or Reproductive) and Unproductive (or Deadweight) Debt:

On the criteria of purposes of loans, public debt may be classified as
productive or reproductive and unproductive or deadweight debt. Public
debt is productive when it is used in income-earning enterprises. Or
productive debt refers to that loan which is raised by the government for
increasing the productive power of the economy.

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A productive debt creates sufficient assets by which it is eventually repaid. If

loans taken by the government are spent on the building of railways,
development of mines and industries, irrigation works, education, etc.,
income of the government will increase ultimately.

Productive loans thus add to the total productive capacity of the country.
In the words of Findlay Shirras: “Productive or reproductive loans which
are fully covered by assets of equal or greater value, the source of the
interest is the income from the ownership of these as railways and irrigation
works.”
Public debt is unproductive when it is spent on purposes which do not yield
any income to the government, e.g., refugee rehabilitation or famine relief
work. Loans for financing war may be regarded as unproductive loans.
Instead of creating any productive assets in the economy, unproductive
loans do not add to the productive capacity of the economy. That is why
unproductive debts are called deadweight debts.

Methods of Redemption of Public Debt:

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Redemption of debt refers to the repayment of a public loan. Although

public debt should be paid, debt redemption is desirable too. In order to
save the government from bankruptcy and to raise the confidence of
lenders, the government has to redeem its debts from time to time.

Sometimes, the government may resort to an extreme step, such as

repudiation of debt. This extreme step is, of course, violation of the contract.
Use of repudiation of debt by the government is economically unsound.

Here, instead of concentrating on the repudiation of debt, we discuss below

other important methods for the retirement or redemption of public debt:
i. Refunding:
Refunding of debt implies issue of new bonds and securities for raising new
loans in order to pay off the matured loans (i.e., old debts).

When the government uses this method of refunding, there is no liquidation

of the money burden of public debt. Instead, the debt servicing (i.e.,
repayment of the interest along with the principal) burden gets accumulated
on account of postponement of the debt- repayment to save future debt.

ii. Conversion:
By debt conversion we mean reduction of interest burden by converting old
but high interest-bearing loans into new but low interest-bearing loans. This
method tends to reduce the burden of interest on the taxpayers. As the
government is enabled to reduce the burden of debt which falls, it is not
required to raise huge revenue through taxes to service the debt.

Instead, the government can cut down the tax liability and provide relief to
the taxpayers in the event of a reduction in the rate of interest payable on
public debt. It is assumed that since most taxpayers are poor people while
lenders are rich people, such conversion of public debt results in a less
unequal distribution of income.

iii. Sinking Fund:

One of the best methods of redemption of public debt is sinking fund. It is
the fund into which certain portion of revenue is put every year in such a
way that it would be sufficient to pay off the debt from the fund at the time
of maturity. In general, there are, in fact, two ways of crediting a portion of
revenue to this fund.

The usual procedure is to deposit a certain (fixed) percentage of its annual

income to the fund. Another procedure is to raise a new loan and credit the
proceeds to the sinking fund. However, there are some reservations against
the second method.

Dalton has opined that it is in the Tightness of things to accumulate sinking

fund out of the current revenue of the government, not out of new loans.
Although convenient, it is one of the slowest methods of redemption of debt.
That is why capital levy as a form of debt repudiation is often recommended
by economists.

iv. Capital Levy:

In times of war or emergencies, most governments follow the practice of
raising money necessary for the redemption of the public debt by imposing a
special tax on capital.

A capital levy is just like a wealth tax in as much as it is imposed on capital

assets. This method has certain decisive advantages. Firstly, it enables a
government to repay its (emergency) debt by collecting additional tax
revenues from the rich people (i.e., people who have huge properties).

This then reduces consumption spending of these people and the severity of
inflation is weakened. Secondly, progressive levy on capital helps to reduce
inequalities in income and wealth. But it has certain clear-cut disadvantages
too. Firstly, it hampers capital formation. Secondly, during normal time this
method is not suggested.

v. Terminal Annuity:
It is something similar to sinking fund. Under this method, the government
pays off its debt on the basis of terminal annuity. By using this method, the
government pays off the debt in equal annual instalments.

This method enables government to reduce the burden of debt annually and
at the time of maturity it is fully paid off. It is the method of redeeming
debts in instalments since the government is not required to make one huge
lump sum payment.

vi. Budget Surplus:

By making a surplus budget, the government can pay off its debt to the
people. As a general rule, the government makes use of the budgetary
surplus to buy back from the market its own bonds and securities. This
method is of little use since modern governments resort to deficit budget. A
surplus budget is usually not made.

vii. Additional Taxation:

Sometimes, the government imposes additional taxes on people to pay
interest on public debt. By levying new taxes—both direct and indirect— the
government can collect the necessary revenue so as to be able to pay off its
old debt. Although an easier means of repudiation, this method has certain
advantages since taxes have large distortionary effects.

viii. Compulsory Reduction in the Rate of Interest:

The government may pass an ordinance to reduce the rate of interest
payable on its debt. This happens when the government suffers from
financial crisis and when there is a huge deficit in its budget.
There are so many instances of such statutory reductions in the rate of
interest. However, such practice is not followed under normal situations.
Instead, the government is forced to adopt this method of debt repayment
when situation so demands.

MAIN CAUSES OF UNEMPLOYMENT IN INDIA

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The following are the main causes of unemployment:

(i) Caste System:
In India caste system is prevalent. The work is prohibited for specific castes
in some areas.

In many cases, the work is not given to the deserving candidates but given to
the person belonging to a particular community. So this gives rise to
unemployment.

(ii) Slow Economic Growth:

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Indian economy is underdeveloped and role of economic growth is very

slow. This slow growth fails to provide enough unemployment opportunities
to the increasing population.

(iii) Increase in Population:

Constant increase in population has been a big problem in India. It is one of
the main causes of unemployment. The rate of unemployment is 11.1% in
10th Plan.

(iv) Agriculture is a Seasonal Occupation:

Agriculture is underdeveloped in India. It provides seasonal employment.
Large part of population is dependent on agriculture. But agriculture being
seasonal provides work for a few months. So this gives rise to
unemployment.
(v) Joint Family System:
In big families having big business, many such persons will be available who
do not do any work and depend on the joint income of the family.

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Many of them seem to be working but they do not add anything to

production. So they encourage disguised unemployment.

(vi) Fall of Cottage and Small industries:

The industrial development had adverse effect on cottage and small
industries. The production of cottage industries began to fall and many
artisans became unemployed.

(vii) Slow Growth of Industrialisation:

The rate of industrial growth is slow. Though emphasis is laid on
industrialisation yet the avenues of employment created by industrialisation
are very few.

(viii) Less Savings and Investment:

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There is inadequate capital in India. Above all, this capital has been
judiciously invested. Investment depends on savings. Savings are
inadequate. Due to shortage of savings and investment, opportunities of
employment have not been created.

(ix) Causes of Under Employment:

Inadequate availability of means of production is the main cause of under
employment. People do not get employment for the whole year due to
shortage of electricity, coal and raw materials.

(x) Defective Planning:

Defective planning is the one of the cause of unemployment. There is wide
gap between supply and demand for labour. No Plan had formulated any
long term scheme for removal of unemployment.

(xi) Expansion of Universities:

The number of universities has increased manifold. There are 385
universities. As a result of this educated unemployment or white collar
unemployment has increased.
(xii) Inadequate Irrigation Facilities:
Even after the completion of 9th five plans, 39% of total cultivable area
could get irrigation facilities.

Due to lack of irrigation, large area of land can grow only one crop in a
year. Farmers remain unemployed for most time of the year.

(xiii) Immobility of labour:
Mobility of labour in India is low. Due to attachment to the family, people
do not go to far off areas for jobs. Factors like language, religion, and
climate are also responsible for low mobility. Immobility of labour adds to
unemployment.

POLICIES FOR REDUCING UNEMPLOYMENT

June 14, 2019 by Tejvan Pettinger

There are two main strategies for reducing unemployment –

 Demand side policies to reduce demand-deficient unemployment

(unemployment caused by recession)
 Supply side policies to reduce structural unemployment / (the natural
rate of unemployment)
A quick list of policies to reduce unemployment
1. Monetary policy – cutting interest rates to boost aggregate demand
(AD)
2. Fiscal policy – cutting taxes to boost AD.
3. Education and training to help reduce structural unemployment.
4. Geographical subsidies to encourage firms to invest in depressed areas.
5. Lower minimum wage to reduce real wage unemployment.
6. More flexible labour markets, to make it easier to hire and fire
workers.
Demand side policies
 US and
UK were more successful in reducing unemployment after 2008/09
recession.

Demand side policies are critical when there is a recession and rise in
cyclical unemployment. (e.g. after 1991 recession and after 2008 recession)

1. Fiscal Policy
Fiscal policy can decrease unemployment by helping to increase aggregate
demand and the rate of economic growth. The government will need to
pursue expansionary fiscal policy; this involves cutting taxes and increasing
government spending. Lower taxes increase disposable income (e.g. VAT cut
to 15% in 2008) and therefore help to increase consumption, leading to
higher aggregate demand (AD).

With an increase in AD, there will be an increase in Real GDP (as long as
there is spare capacity in the economy.) If firms produce more, there will be
an increase in demand for workers and therefore lower demand-deficient
unemployment. Also, with higher aggregate demand and strong economic
growth, fewer firms will go bankrupt meaning fewer job losses.
Keynes was an active advocate of expansionary fiscal policy during a
prolonged recession. He argues that in a recession, resources (both capital
and labour) are idle. Therefore the government should intervene and create
additional demand to reduce unemployment.

Impact of Higher AD on Economy

This shows an increase in AD causing higher real GDP. The increase in

output leads to firms needing more workers.

However,

1. It depends on other components of AD. e.g. if confidence is low, cutting

taxes may not increase consumer spending because people prefer to
save. Also, people may not spend tax cuts, if they will soon be reversed.
2. Fiscal policy may have time lags. E.g., a decision to increase
government spending may take a long time to affect aggregated
demand (AD).
 3. If the economy is close to full capacity, an increase in AD will only
cause inflation. Expansionary fiscal policy will only reduce
unemployment if there is an output gap.
4. Expansionary fiscal policy will require higher government borrowing –
this may not be possible for countries with high levels of debt, and
rising bond yields.
5. In the long run, expansionary fiscal policy may cause crowding out, i.e.
the government increase spending but because they borrow from the
private sector, they have less to spend, and therefore AD doesn’t
increase. However, Keynesians argue crowding out will not occur in
a liquidity trap.
2. Monetary policy

Monetary policy would involve cutting interest rates. Lower rates decrease
the cost of borrowing and encourage people to spend and invest. This
increases AD and should also help to increase GDP and reduce demand
deficient unemployment.

Also, lower interest rates will reduce exchange rate and make exports more
competitive.

In some cases, lower interest rates may be ineffective in boosting demand. In

this case, Central Banks may resort to Quantitative easing. This is an
attempt to increase the money supply and boost aggregate demand.
See: Quantitative easing.
Evaluation
 Similar problems to fiscal policy. e.g. it depends on other components
of AD.
 Lower interest rates may not help boost spending if banks are still
reluctant to lend.
 Demand side policies can contribute to reducing demand deficient
unemployment e.g. in a recession. However, they cannot reduce supply
side unemployment. Therefore, their effectiveness depends on the type
of unemployment that occurs.
Supply side policies for reducing unemployment

Supply side policies deal with more micro-economic issues. They don’t aim
to boost overall aggregate demand but seek to overcome imperfections in the
labour market and reduce unemployment caused by supply side factors.
Supply side unemployment includes:

 Frictional
  Structural
 Classical (real wage)
Policies to reduce supply side unemployment

1. Education and training. The aim is to give the long-term unemployed new
skills which enable them to find jobs in developing industries, e.g. retrain
unemployed steel workers to have basic I.T. skills which help them find
work in the service sector. – However, despite providing education and
training schemes, the unemployed may be unable or unwilling to learn new
skills. At best it will take several years to reduce unemployment.
2. Reduce the power of trades unions. If unions can bargain for wages above
the market clearing level, they will cause real wage unemployment. In this
case reducing the influence of trades unions (or reducing Minimum wages)
will help solve this real wage unemployment.
3. Employment subsidies. Firms could be given tax breaks or subsidies for
taking on long-term unemployed. This helps give them new confidence and
on the job training. However, it will be quite expensive, and it may
encourage firms to just replace current workers with the long-term
unemployment to benefit from the tax breaks.
4. Improve labour market flexibility. It is argued that higher structural rates
of unemployment in Europe is due to restrictive labour markets which
discourage firms from employing workers in the first place. For example,
abolishing maximum working weeks and making it easier to hire and fire
workers may encourage more job creation. However, increased labour
market flexibility could cause a rise in temporary employment and greater
job insecurity.
5. Stricter benefit requirements. Governments could take a more pro-active
role in making the unemployed accept a job or risk losing benefits. After a
certain period, the government could guarantee a public sector job (e.g.
cleaning streets). This could significantly reduce unemployment. However, it
may mean the government end up employing thousands of people in
unproductive tasks which is very expensive. Also, if you make it difficult to
claim benefits, you may reduce the claimant count, but not the International
Labour force survey. See: measures of unemployment
6. Improved geographical mobility. Often unemployed is more concentrated
in certain regions. To overcome this geographical unemployment, the
government could give tax breaks to firms who set up in depressed areas.
Alternatively, they can provide financial assistance to unemployed workers
who move to areas with high employment. (e.g. help with renting in London)
7. Maximum working week. It has been suggested a maximum working
week of (for example 35 hours) would lead to firms needing to hire more
workers and reduce unemployment.
 However, a maximum working week may increase a firms costs and
therefore they are not willing to hire more. Also, there is no certainty a
firm will respond to a cut in hours by employing more – they may try
to increase productivity. Those with wrong skills will still face same
problem

BURDEN OF PUBLIC DEBT AND ITS MEASUREMENT

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Burden of Public Debt and Its Measurement!

Burden of Internal Debt:
It is said that an internal debt has no direct money burden since the interest
payment on debt and the imposition of taxation to pay interest to the lenders
is simply a transfer of purchasing power from one to another. This means
that in case of internal debt, money is borrowed from individuals and
institutions within the country.

Repayment (raised from taxation) constitutes just a transfer of resources

from one group of persons to another. In other words, these are transfer
payments and do not affect the total resources of the community Truly
speaking, government collects money through taxation imposed on the
richer people who are also the buyers of government bonds.

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That is to say, government collects money from the left pocket and pays it
back to the right pocket. Thus, under internal debt, since all payments
cancel out each other in the community as a whole, there is no direct money
burden.

Above all, money collected from internal source of borrowing is usually

spent for various developmental activities. Such expenditure results in
transfer of resources in the community and, as a result, aggregate resources
of the country increase. Thus, there can be no direct money burden of
internal debt.
But there is no denying the fact that internal debt involves direct real
burden to the community according to the nature of the series of transfer of
incomes from taxpayers to the creditors. If we assume that the taxpayers
and bondholders are the same persons then there can be no direct real
burden of debt. But we know that the taxpayers and the bondholders belong
to different income groups in the community.

Usually, the bondholders are richer people compared to the taxpayers.

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Certainly, it is necessary to raise taxation to pay interest on the debt and, the
greater the debt, greater the amount of taxation required to provide the
interest on it. Ordinarily, taxpayers are poor people. When the government
pays interest with principal to the bondholders, it results in the transfer of
purchasing power from the poor people to the richer people.

Thus, the payment of internal debt involves redistribution of aggregate

income. This results in inequalities in the distribution of income and wealth.
This is the direct real burden of debt on the community.

Again, it is argued that taxpayers are generally active people while

bondholders are idle, old and inactive ones who live on accumulated wealth.
In case of repayment of internal debt, wealth thus gets transferred from the
active persons, i.e., taxpayers, to the inactive persons, i.e., bondholders. This
certainly adds to the real burden of debt.

Some economists argue that public debt is invariably a burden on the future
generation.

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They argue that when the government borrows, the present generation
escapes the burden. After the loan is repaid at a later date with interest, the
future generation has to suffer by being forced to pay additional taxes. In
other words, the future generation will suffer when the present generation
reduces its savings as disposable income declines following a rise in taxation.

However, there are some people who do not agree with this view. They argue
that there is no shifting of the basic burden to the future. According to
modern economists, the real burden of governmental activities must be
borne during the period in which expenditures are made, since, during this
period, only resources are diverted from private to public sector use.
Borrowing method affects the future generations in two ways only. To the
extent to which public debt reduces capital formation, the stock of capital
goods and the potential level of national income in future generations will be
less.

Further, the borrowing methods create some problems for the future
generations in the form of adverse effects on the economy from the taxes
necessary to pay interest and principal, inflationary or deflationary effects
of the existence of the debt, etc. Thus, there is no shifting of the basic burden
to the future.

According to J. M. Buchanan, during the period in which the governmental

activities and borrowing take place, no burden is created, because burden,
by nature, implies a compulsory sacrifice.

Individuals in most cases voluntarily exchange their liquid funds for

government bonds. Thus, the present generation does not feel any burden on
them. However, it is a burden on the future generations who pay taxes
(compulsorily) for the retirement of public debt.

So, we can conclude that the question of shifting the burden of public debt to
the posterity or future generation is still an unresolved phenomenon.

Burden of External Debt:

During a given period, the direct money burden of external debt is the
interest payment as well as the principal repayment (i.e., debt servicing) to
external creditors. The direct real burden of such external borrowing is
measured by the sacrifice of goods and services which these payments
involve to the members of the debtor country.

There is also indirect money burden of external debt. Loan repayment by

the debtor country implies more exports of goods and services to the
creditor country. Thus a debtor country experiences a fall in welfare of the
community.

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Indirect real burden of external borrowing is crucial. Usually, government

imposes taxes to finance external debt. But taxes have disincentive effects. It
discourages work- effort and saving. Lower the saving, lower is the capital
formation. Thus, external borrowing eats away economic growth since
growth largely depends on capital formation. This indirect real burden of
external debt is quite similar to internal debt.
Knowing fully well the dangers of borrowing, governments of LDCs are
compelled to public borrowing—both from internal and external sources.

Measurement of the Burden of Debt:

Usually, burden of debt refers to financial burden of the government.

But as it does not indicate true burden, we consider following ratios to

estimate the burden of debt:
i. Income-Debt Ratio:
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It is estimated as:
size of public debt/national income = D/Y

If Y remains at a very high level, the burden of debt, D, will be insignificant.

However, if the ratio becomes high, debt then poses a great burden.

ii. Debt-Service Ratio:

This ratio is measured as:
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Annual interest payments of borrowing/National income = i/Y

Increase in Y means lower debt-service ratio. However, taxes are collected

for the repayment of public debt. Thus, this ratio indicates the necessity of
imposing higher taxes.

iii. Debt Service-Tax Revenue Ratio:

It is worked out as:
Annual interest payments/Aggregate tax revenue = i/T

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An increase of this ratio indicates the financial weaknesses of the

government.

TAXABLE CAPACITY:
 
DEFINITION AND EXPLANATION OF TAXABLE CAPACITY:
 
The concept of taxable capacity has been defined differently by different
economists. In the words of Sir Josiah Stamp:
 
"Taxable capacity is that maximum amount which the community is in a
position to bear towards the expenses of public authorities without having a
really unhappy and! down-trodden existence and without dislocating the
economic, organization too much".
 
According to Findlay Shiraz:
 
"It is the optimum tax ability of a nation, the maximum amount of taxation
that can be raised and spent on the economic welfare in that community".
 
Dalton calls it a dim and "contused conception". He writes in his book
"Principles of Public Finance":
 
"Absolute taxable capacity is a myth and should be banished from all
serious discussions of public finance".
 
For the various definitions of taxable capacity given by eminent writers on
Public Finance, we gather that by taxable capacity is meant the maximum
amount which a nation can contribute towards the support of the
government without inflicting damage on the power and will to produce.
 
The amount of tax burden which the citizens of a country are ready to bear
is not rigidly fixed. It can increase or decrease with a change in the
distribution of wealth, the size of population, method of taxation, etc. etc.
 
In other words, we can say that the limit of taxable capacity is a relative and
not an absolute quantity.
 
FACTORS OF TAXABLE CAPACITY:
 
The main factors which determine the taxable capacity of a nation are:
 
(i) The size of population: Taxable capacity is very much affected by the
increase in national income and by the rate of growth in population. If the
increase in national income is greater than the growth in population, the par
capita income goes up. The taxable capacity of the individuals rises. If the
rate of growth of population is higher than the national income, the taxable
capacity decreases.
 
(ii) The distribution of national income: Taxable capacity is also influenced
by the distribution of national income within a country. If there is unequal
distribution of wealth in the country, the taxable capacity of the nation will
be high, but if the income is equally distributed, then the taxable capacity
will be low. A man earning an income of $50,000 a month is able to pay
more to the government than thirty persons earning $300 per month.
 
(iii) Character of taxation: If taxes are devised wisely, then they give less
resentment from people and bring forth a large yield.
 
(iv) Purpose of taxation: Purpose of taxation has a direct bearing on taxable
capacity of a nation. If citizens of country are satisfied with purpose. of
taxation i.e., the increase in welfare of people, then they show greater
willingness to pay taxes to government. Whereas, if they find that revenue
will be spent for unproductive purposes, they hesitate to pay taxes.
 
We conclude, therefore, that if state spends revenue for purposes such as
education, sanitation, fighting for famine, diseases, etc., then taxable
capacity of nation expands to its utmost and if revenue is spent for
unproductive purpose like war, then taxable capacity shrinks.
 
(v) Psychological factor: Psychological factor, is a very important factor in
determining taxable capacity of a nation. If people are satisfied that
government is doing its utmost to raise standard of living of masses and in
maintaining prestige of country, then they try to sacrifice their lives what to
say of money for the government. A simple approach to patriotism brings
forth tons of gold.
 
(vi) Standard of living of people: If standard of living of people is high, they
work more efficiently so that they may enjoy a still better standard of living.
When they work enthusiastically, they receive higher wages from their
employers. Taxable capacity tends to increase then.
 
(vii) Effect of inflation: If country is in grip of inflation, purchasing power of
people is reduced, taxable capacity of nation shrinks considerably. But if
value of money is high and country is not faced with unemployment, then
taxable capacity of people is quite high.
 
Conclusion:
 
We have discussed above various factor on which taxable capacity of a
nation depends. We cannot single out any factor and say that taxable
capacity is determined solely by this factor alone. The fact is that various
factors influence taxable capacity and we have to take them all into
consideration while judging maximum amount which citizens of a country
can pay. We cannot deny this fact that it is quite difficult to measure taxable
capacity. But this does not mean we should not make an attempt because it
is beset with many difficulties.
 
According to Findly Shiraz:
 
"A road leading to an important centre has often many crossings, signposts,
danger signals, but this does not lessen its value to cautions sojourner".

TAX SHIFT

Definition:
Tax shift is a kind of economic phenomenon in which the taxpayer transfers
the tax burden to the purchaser or supplier by increasing the sales price or
depressing the purchase price during the process of commodity exchange. [3]
1. Tax shift is the redistribution of tax burden. Its economic essence is the
redistribution of national income of everyone. The absence of redistribution
of national income does not constitute an active of tax shift.
2. Tax shift is an objective process of economic movement. It does not
include any emotional factors. Whether taxpayers take the initiative to raise
or lower prices or passively accept price fluctuations is not related to tax
shift. Whether the economic relationship between the taxpayer and the tax
bearer is a class opposition or the unity opposition, it is also unrelated to the
tax shift.
3.Tax shift is achieved through price changes. The price mentioned here
includes not only the price of the output but also the price of the element.
The price changes mentioned here include not only direct price increase and
price reduction, but also indirect price increase and price reduction. No
price change, no tax shift.
It has the following three characteristics:
(1) It is closely linked with price increase and decrease;
(2) It is the redistribution of tax burdens among economic entities, and it is
also a redistribution of economic interests. The result will inevitably lead to
inconsistency between taxpayers and tax bearer;
(3) It is the taxpayer's proactive behavior.
CONDITION[EDIT]

In general, the existence of tax shift mainly depends on the following two
conditions:
The existence of commodity economy
Tax shift is achieved through commodity price changes in commodity
exchange. Without the existence of commodity exchange, there would be no
tax burden. Therefore, the commodity economy is the economic prerequisite
for tax shift. Historically, in a natural economic society based on self-
sufficiency, products generally go directly from the production sector to the
consumer sector without market exchange. During this period, agriculture is
the main sector of the national economy. The state taxation is mainly a tax
on land and land production. This part of the tax can only be borne by the
landowner, and taxpayers cannot implement tax transfer. With the
development of productivity, there has been the production of goods and the
exchange of goods. In capitalist society, the commodity economy is highly
developed. Under the conditions of commodity economy, the value of all
commodities is expressed in the form of currency as the price. The exchange
of goods breaks through the limitations of time and area and develops on a
large scale. It opens up a vast space for the taxation of goods and commodity
circulation. It also makes it possible to pass on commodity taxation, and
commodity taxation is also passed back or indirectly through price changes.
The existence of a free pricing system
Tax shift is directly linked to the price movement, which is usually achieved
by increasing the selling rate of sales goods and lowering the purchase price
of the purchased good. Among them, the tax burden of some taxes can be
directly passed on by changes in prices; the tax burden on some taxes is
through changes in capital investment, which affects the supply and demand
of commodities indirectly through the changes in prices. Regardless of which
form of transfer is adopted, it depends on price changes. Therefore, the free
pricing system is the basic condition for tax shift.
The free pricing system refers to a price system in which producers or other
market entities can price themselves according to changes in market supply
and demand. There are mainly three types of price systems: the
government-instructed program price system, the floating price system, and
the free price system.
Under the government's mandatory plan price system, the
producers,operators and other market entities do not have their own pricing
power, prices are directly controlled by the government, and taxpayers
cannot pass tax burden through price changes.
Under the floating price system, the government determines the maximum
price or minimum price of a commodity. Within the range of fluctuations,
the producers,operators and other market entities have a certain amount of
freedom in pricing, and tax shift can be realized within a certain extent and
within a certain range.
Under the free pricing system, the producers,operators and other market
players can freely set prices according to changes in the market supply and
demand relationship, and the tax burden can be passed on.
Through the analysis of the conditions for the shift of tax burdens, we can
conclude that basically there is still an objective shift of tax burden even if
under the highly centralized program management system. After
implementing the market economy system, there is an objective shift in tax
burden. But the market economy is a highly developed commodity economy.
Under this system, the production and business operators of goods and other
market entities have their own independent material interests. Profitability
has become the fundamental motive for all production and business
activities, and the realization of tax burden transfer has become the
subjective motivation and desire of various taxpayers. At the same time,
with the continuous deepening of the reform of the economic system, the
government has liberalized most of the pricing power, and the enterprises
have a large amount of free pricing power. The free pricing system based on
free prices has basically taken shape, and the conditions for the transfer of
taxes have now been met. Therefore, the phenomenon of shifting the tax
burden objectively existing in the commodity economy.
CHANGES IN COSTS[EDIT]

The transfer of tax burdens is related to changes in costs. In the three

situations of fixed, increasing and declining costs, tax transfer has different
characteristics.
For goods with fixed costs, the tax burden may be all passed on to the buyer.
Because the fixed-cost commodity does not increase or decrease its unit cost
with the quantity of production. At this time, if the demand is inelastic, the
tax can be added to the price to realize the transfer.
For goods with increasing cost, tax burdens can only be partially passed on.
Because the unit cost of this commodity increases with the increase in
output, the increase in the price of goods after taxation will affect the
market. The seller has to reduce production to reduce the cost of products in
order to maintain marketability, and thus the tax amount cannot be all
passed on.
For goods with diminishing costs, the tax burden can be all passed on to the
buyer. Because the unit cost of such goods decreases with the increase in
output, if there is no demand elasticity for taxable goods, taxes can also be
added to the price and passed on. Under some certain circumstances, taxes
can not only be passed on entirely, but even more than the tax price benefit.

CHARACTERISTICS OF AN EFFECTIVE TAX SYSTEM

CHARACTERISTICS OF AN EFFECTIVE TAX SYSTEM

A good tax system should meet five basic conditions: fairness, adequacy,
simplicity, transparency, and administrative ease.

Although opinions about what makes a good tax system will vary, there is
general consensus that these five basic conditions should be maximized to
the greatest extent possible.

Fairness, or equity, means that everybody should pay a fair share of taxes.
There are two important concepts of equity: horizontal equity and vertical
equity.

Horizontal equity means that taxpayers in similar financial condition should

pay similar amounts in taxes.

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

taxpayers who are better off should pay at least the same proportion of
income in taxes as those who are less well off. Vertical equity involves
classifying taxes as regressive, proportional, or progressive.

 Regressive tax: A tax is regressive if those with low incomes pay a

larger share of income in taxes than those with higher incomes. Almost
any tax on necessities, such as food purchased at a grocery store, is
regressive because lower income people must spend a larger share of
their income on these necessities and thus in taxes. Oklahoma’s sales
 tax is one example; lower-income residents pay a much larger share of
their incomes for groceries and other necessities than higher income
ones, so the sales tax takes more of their income.
 Proportional tax: A tax is proportional if all taxpayers pay the same
share of income in taxes. No taxes are truly proportional. Property
taxes often come closest since there is typically a close relationship
between a household’s income and the value of the property in which
they live. Corporate income taxes often approach proportional because
one rate applies to most corporate income.
 Progressive tax: A progressive tax requires higher-income individuals
to pay a higher share of their income in taxes. The philosophy behind
progressive taxes is that higher income people can afford and should be
expected to provide a bigger share of public services than those who
are less able to pay. The federal income tax is the best example of a
progressive tax; the Internal RevenueMoney received by a government
entity.... Service reports that the top one percent of taxpayers by
income paid 38 percent of federal income taxes in 2012.

While no system of taxes is perfect, it is important to seek horizontal equity

because taxpayers must believe they are treated equally. It is just as
important to seek vertical equity so government does not become a burden
to low-income residents.

Adequacy means that taxes must provide enough revenue to meet the basic
needs of society. A tax system meets the test of adequacy if it provides
enough revenue to meet the demand for public services, if revenue growth
each year is enough to fundA self-balancing accounting structure with
revenues, expenditures, assets and liabilities used to track monies
flowing... the growth in cost of services, and if there is enough economic
activity of the type being taxed so rates can be kept relatively low.

Simplicity means that taxpayers can avoid a maze of taxes, forms and filing
requirements.  A simpler tax system helps taxpayers better understand the
system and reduces the costs of compliance.

Transparency means that taxpayers and leaders can easily find information

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

PROPORTIONAL, PROGRESSIVE, AND REGRESSIVE TAXES

Taxes can be distinguished by the effect they have on the distribution of

income and wealth. A proportional tax is one that imposes the same relative
burden on all taxpayers—i.e., where tax liability and income grow in equal
proportion. A progressive tax is characterized by a more than proportional
rise in the tax liability relative to the increase in income, and a regressive
tax is characterized by a less than proportional rise in the relative burden.
Thus, progressive taxes are seen as reducing inequalities in income
distribution, whereas regressive taxes can have the effect of increasing these
inequalities.

The taxes that are generally considered progressive include

individual income taxes and estate taxes. Income taxes that are nominally
progressive, however, may become less so in the upper-income categories—
especially if a taxpayer is allowed to reduce his tax base by declaring
deductions or by excluding certain income components from his taxable
income. Proportional tax rates that are applied to lower-income categories
will also be more progressive if personal exemptions are declared.
Income measured over the course of a given year does not necessarily
provide the best measure of taxpaying ability. For example, transitory
increases in income may be saved, and during temporary declines in income
a taxpayer may choose to finance consumption by reducing savings. Thus, if
taxation is compared with “permanent income,” it will be less regressive (or
more progressive) than if it is compared with annual income.
Sales taxes and excises (except those on luxuries) tend to be regressive,
because the share of personal income consumed or spent on a specific good
declines as the level of personal income rises. Poll taxes (also known as head
taxes), levied as a fixed amount per capita, obviously are regressive.
It is difficult to classify corporate income taxes and taxes on business as
progressive, regressive, or proportionate, because of uncertainty about the
ability of businesses to shift their tax expenses (see below Shifting and
incidence). This difficulty of determining who bears the tax burden depends
crucially on whether a national or a subnational (that is, provincial or state)
tax is being considered.
In considering the economic effects of taxation, it is important to distinguish
between several concepts of tax rates. The statutory rates are those specified
in the law; commonly these are marginal rates, but sometimes they are
average rates. Marginal income tax rates indicate the fraction
of incremental income that is taken by taxation when income rises by one
dollar. Thus, if tax liability rises by 45 cents when income rises by one
dollar, the marginal tax rate is 45 percent. Income tax statutes commonly
contain graduated marginal rates—i.e., rates that rise as income rises.
Careful analysis of marginal tax rates must consider provisions other than
the formal statutory rate structure. If, for example, a particular
tax credit (reduction in tax) falls by 20 cents for each one-dollar rise in
income, the marginal rate is 20 percentage points higher than indicated by
the statutory rates. Since marginal rates indicate how after-tax income
changes in response to changes in before-tax income, they are the relevant
ones for appraising incentive effects of taxation. It is even more difficult to
know the marginal effective tax rate applied to income from business
and capital, since it may depend on such considerations as the structure of
depreciation allowances, the deductibility of interest, and the provisions
for inflation adjustment. A basic economic theorem holds that the marginal
effective tax rate in income from capital is zero under a consumption-based
tax.
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Average income tax rates indicate the fraction of total income that is paid in
taxation. The pattern of average rates is the one that is relevant for
appraising the distributional equity of taxation. Under a progressive income
tax the average income tax rate rises with income. Average income tax rates
commonly rise with income, both because personal allowances are provided
for the taxpayer and dependents and because marginal tax rates are
graduated; on the other hand, preferential treatment of income received
predominantly by high-income households may swamp these effects,
producing regressivity, as indicated by average tax rates that fall as income
rises.
HISTORY OF TAXATION

ADMINISTRATION OF TAXATION

Although views on what is appropriate in tax policy influence the choice and
structure of tax codes, patterns of taxation throughout history can be
explained largely by administrative considerations. For example, because
imported products are easier to tax than domestic output, import duties
were among the earliest taxes. Similarly, the simple turnover tax (levied on
gross sales) long held sway before the invention of the economically superior
but administratively more demanding VAT (which allows credit for tax paid
on purchases). It is easier to identify, and thus tax, real property than other
assets; and a head (poll) tax is even easier to implement. It is not surprising,
therefore, that the first direct levies were head and land taxes.
Although taxation has a long history, it played a relatively minor role in the
ancient world. Taxes on consumption were levied in Greece and
Rome. Tariffs—taxes on imported goods—were often of considerably more
importance than internal excises so far as the production of revenue went.
As a means of raising additional funds in time of war, taxes
on property would be temporarily imposed. For a long time these taxes were
confined to real property, but later they were extended to other assets. Real
estate transactions also were taxed. In Greece free citizens had different tax
obligations from slaves, and the tax laws of the Roman Empire distinguished
between nationals and residents of conquered territories.
Early Roman forms of taxation included consumption taxes, customs duties,
and certain “direct” taxes. The principal of these was the tributum, paid by
citizens and usually levied as a head tax; later, when additional revenue was
required, the base of this tax was extended to real estate holdings. In the
time of Julius Caesar, a 1 percent general sales tax was introduced
(centesima rerum venalium). The provinces relied for their revenues on head
taxes and land taxes; the latter consisted initially of fixed liabilities
regardless of the return from the land, as in Persia and Egypt, but later the
land tax was modified to achieve a certain correspondence with the fertility
of the land, or, alternatively, a 10th of the produce was collected as a tax in
kind (the tithe). It is noteworthy that at a relatively early time Rome had
an inheritance tax of 5 percent, later 10 percent; however, close relatives of
the deceased were exempted. For a long time tax collection was left to
middlemen, or “tax farmers,” who contracted to collect the taxes for a share
of the proceeds; under Caesar collection was delegated to civil servants.
ROLES PLAYED BY PUBLIC SECTOR IN INDIAN ECONOMY
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Here we detail about the following nine important roles played by public
sector in Indian economy, i.e., (1) Generation of Income, (2) Capital
Formation, (3) Employment, (4) Infrastructure, (5) Strong Industrial Base,
(6) Export Promotion and Import Substitution, (7) Contribution to Central
Exchequer, (8) Checking Concentration of Income and Wealth, and (9)
Removal of Regional Disparities.

1. Generation of Income:
Public sector in India has been playing a definite positive role in generating
income in the economy. The share of public sector in net domestic product
(NDP) at current prices has increased from 7.5 per cent in 1950-51 to 21.7
per cent in 2003-04. Again the share of public sector enterprises only
(excluding public administration and defence) in NDP was also increased
from 3.5 per cent in 1950-51 to 11.12 per cent in 2005-06.

2. Capital Formation:
Public sector has been playing an important role in the gross domestic
capital formation of the country. The share of public sector in gross
domestic capital formation has increased from 3.5 per cent during the First
Plan to 9.2 per cent during the Eighth Plan. The comparative shares of
public sector in the gross capital formation of the country also recorded a
change from 33.67 per cent during the First Plan to 50 per cent during the,
Sixth Plan and then declined to 21.9 per cent in 2005-06.

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But the Public sector is not playing a significant role in respect of

mobilization of savings. The share of public sector in gross domestic savings
increased from 1.7 per cent of GNP during 1951-56 to only 3.6 per cent
during 1980-85. During 1980s, the share of public sector in gross domestic
savings declined from 16.2 per cent in 1980-81 to 7.7 per cent in 1988-89.

In this connection Narottam Shah observed, “The failure of the public sector
contributes only 21 per cent of the nation’s savings; that also in part,
through heavy taxation and semi-fictitious profits of the Reserve Bank. The
remaining 79 per cent of the nation’s savings came from the private sector.”
Again the share of public sector in gross domestic savings increased from
4.78 per cent in 1990-91 to 6.61 per cent in 2005-06.

3. Employment:
Public sector is playing an important role in generating employment in the
country.

Public sector employments are of two categories, i.e:

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(a) Public sector employment in government administration, defence and

other government services and

(b) Employment in public sector economic enterprises of both Centre, State

and Local bodies. In 1971, the public sector offered employment
opportunities to about 11 million persons but in 2003 their number rose to
18.6 million showing about 69 per cent increase during this period.

Again in 2003, the public sector offered employment opportunities to 18.6

million persons which was 69 per cent of the total employment generated in
the country as compared to 71 per cent employment generated in 1991.
However, there is considerable decline in the annual growth rate of
employment in the public sector from 1.53 per cent during 1983-1994 to 0.80
per cent during 1994- 2004.

Moreover, about 69.0 per cent of the total employments are generated in the
public sector. Moreover, at the end of March 2004, about 51.7 per cent of
the total employment (i.e. about 96 lakh) generated in public sector is from
Government administration, community, social and personal services and
the remaining 48.3 per cent (i.e., nearly 89.7 lakh) of the employment in
public sector is generated by economic enterprises run by the Centre, State
and Local Governments.

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The maximum number of employment is derived from transport, storage

and communications (28.1 lakh). The public sector manufacturing is the
next industry which generated employment to the extent of 11.1 lakh
persons.

4. Infrastructure:
Without the development of infrastructural facilities, economic development
is impossible. Public sector investment on infrastructure sector like power,
transportation, communication, basic and heavy industries, irrigation,
education and technical training etc. has paved the way for agricultural and
industrial development of the country leading to the overall development of
the economy as a whole. Private sector investments are also depending on
these infrastructural facilities developed by the public sector of the country.

5. Strong Industrial base:

Another important role of the public sector is that it has successfully build
the strong industrial base in the country. The industrial base of the economy
is now considerably strengthened with the development of public sector
industries in various fields like—iron and steel, coal, heavy engineering,
heavy electrical machinery, petroleum and natural gas, fertilizers,
chemicals, drugs etc.

The development of private sector industries is also solely depending on

these industries. Thus by developing a strong industrial base, the public
sector has developed a suitable base for rapid industrialization in the
country. Moreover, public sector has also been dominating in critical areas
such as petroleum products, coal, copper, lead, hydro and steam turbines
etc.

6. Export Promotion and Import Substitution:

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Public sector enterprises have been contributing a lot for the promotion of
India’s exports. The foreign exchange earning of the public enterprises rose
from Rs. 35 crore in 1965-66 to Rs. 5,831 crore in 1984-85 and then to Rs.
34,893 crore in 2003- 04. Thus, the export performance of the public sector
enterprises in India is quite satisfactory.

The public sector enterprises which played an important role in this regard
include—Hindustan Steel Limited, Hindustan Machine Tools (HMT)
Limited, Bharat Electronics Ltd., State Trading Corporation (STC) and
Metals and Minerals Trading Corporation.

Some public sector enterprises have shown creditable records in achieving

import substitution and thereby saved precious foreign exchange of the
country. In this regard mention may be made of Bharat Heavy Electricals
Limited (BHEL), Bharat Electronics Ltd., Indian Oil Corporations, Oil and
Natural Gas Commission (ONGC). Hindustan Antibiotics Ltd. (HAL) etc.
which have paved a successful way tor import substitution in the country.

7. Contribution to Central Exchequer:

The public sector enterprises are contributing a good amount of resources to
the central exchequer regularly in the form of dividend, excise duty, custom
duty, corporate taxes etc. During the Sixth Plan, the contribution of public
enterprises to the central exchequer was to the tune of Rs. 27,570 crore.

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Again this contribution has increased from Rs. 7,610 crore in 1980-81 to Rs.
18,264 crore in 1989-90 and then to Rs. 85,445 crore in 2003-04. Out of this
total contribution, the amount of dividend contributed only 2 to 3 per cent of
it.

8. Checking Concentration of Income and Wealth:

Expansion of public sector enterprises in India has been successfully
checking the concentration of economic power into the hands of a few and
thus are redressing the problem of inequalities of income and-wealth of the
economy. Thus, the public sector can reduce this problem of inequalities
through diversion of profits for the welfare of the poor people, undertaking
measures for labour welfare and also by producing commodities for mass
consumption.

9. Removal of Regional Disparities:

From the very beginning industrial development in India was very much
skewed towards certain big port cities like Mumbai, Kolkata and Chennai.
In order to remove regional disparities, the public sector tried to disperse
various units towards the backward states like Bihar, Orissa, and Madhya
Pradesh. Thus, considering all these foregoing aspects it can be observed
that in-spite of showing poor performance, the public sector is playing
dominant role in all-round development of the economy of the country.

PUBLIC DEBT: MEANING, OBJECTIVES AND PROBLEMS

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Public Debt: Meaning, Objectives and Problems!

Meaning:
In India, public debt refers to a part of the total borrowings by the Union
Government which includes such items as market loans, special bearer
bonds, treasury bills and special loans and securities issued by the Reserve
Bank. It also includes the outstanding external debt.

However, it does not include the following items of borrowings:

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(i) small savings,

(ii) provident funds,

(iii) other accounts, reserve funds and deposits.

The aggregate borrowings by the Union Government—comprising the

public debt and these other borrowings — are generally known as ‘net
liabilities of the Government’.

Objectives:
In India, most government debt is held in long-term interest bearing
securities such as national savings certificates, rural development bonds,
capital development bonds, etc. In industrially advanced countries like the
U.S.A., the term government or public debt refers to the accumulated
amount of what government has borrowed to finance past deficits.

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In such countries the government debt has a very simple relationship to the
government deficit the increase in debt over a period (say one year) is equal
to its current budgetary deficit. But, in India, the term is used in a different
sense.

The State generally borrows from the people to meet three kinds of
expenditure:
(a) to meet budget deficit,

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(b) to meet the expenses of war and other extraordinary situations and

(c) to finance development activity.

(a) Public Debt to Meet Budget Deficit:

It is not always proper to effect a change in the tax system whenever the
public expenditure exceeds the public revenue. It is to be seen whether the
transaction is casual or regular. If the budget deficit is casual, then it is
proper to raise loans to meet the deficit. But if the deficit happens to be a
regular feature every year, then the proper course for the State would be to
raise further revenue by taxation or reduce its expenditure.
(b) Public Debt to Meet Emergencies like War:
In many countries, the existing public debt is, to a great extent, on account
of war expenses. Especially after World War II, this type of public debt had
considerably increased. A large portion of public debt in India has been
incurred to defray the expenses of the last war.

(c) Public Debt for Development Purposes:

During British rule in India public debt had to be raised to construct
railways, irrigation projects and other works. In the post-independence era,
the government borrows from the public to meet the costs of development
work under the Five Year Plans and other projects. As a result the volume
of public debt is increasing day by day.

The Burden of Public Debt:

When a country borrows money from other countries (or foreigners) an
external debt is created. It owes its all to others. When a country borrows
money from others it has to pay interest on such debt along with the
principal. This payment is to be made in foreign exchange (or in gold). If the
debtor nation does not have sufficient stock of foreign exchange
(accumulated in the past) it will be forced to export its goods to the creditor
nation. To be able to export goods a debtor nation has to generate sufficient
exportable surplus by curtailing its domestic consumption.

Thus an external debt reduces society’s consumption possibilities since it

involves a net subtraction from the resources available to people in the
debtor nation to meet their current consumption needs. In the 1990s, many
developing countries such as Poland, Brazil, and Mexico faced severe
economic hardships after incurring large external debt. They were forced to
curtail domestic consumption to be able to generate export surplus (i.e.,
export more than they imported) in order to service their external debts, i.e.,
to pay the interest and principal on their past borrowings.

The burden of external debt is measured by the debt-service ratio which

returns to a country’s repayment obligations of principal and interest for a
particular year on its external debt as a percentage of its exports of goods
and services (i.e., its current receipt) in that year. In India it was 24% in
1999. An external debt imposes a burden on society because it represents a
reduction in the consumption possibilities of a nation. It causes an inward
shift of the society’s production possibilities curve.

Three Problems:
When we shift attention from external to internal debt we observe that the
story is different.

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It creates three problems:

(1) Distorting effects on incentives due to extra tax burden,

(2) Diversion of society’s limited capital from the productive private sector
to unproductive capital sector, and

(3) Showing the rate of growth of the economy.

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These three problems may now be briefly discussed:

1. Efficiency and Welfare Losses from Taxation:
When the government borrows money from its own citizens, it has to pay
interest on such debt. Interest is paid by imposing tax on people. If people
are required to pay more taxes simply because the government has to pay
interest on debt, there is likely to be adverse effects on incentives to work
and to save. It may be a happy coincidence if the same individual were tax-
payer and a bond-holder at the same time.

But even in this case one cannot avoid the distorting effects on incentives
that are inescapably present in the case of any taxes. If the government
imposes additional tax on Mr. X to pay him interest, he might work less and
save less. Either of the outcome — or both — must be reckoned a distortion
from efficiency and well-being. Moreover, if most bondholders are rich
people and most tax-payers are people of modest means repaying the debt
money redistributes income (welfare) from the poor to the rich.

2. Capital Displacement (Crowding-Out) Effect:

Secondly, if the government borrows money from the people by selling
bonds, there is diversion of society’s limited capital from the productive
private to unproductive public sector. The shortage of capital in the private
sector will push up the rate of interest.

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In fact, while selling bonds, the government competes for borrowed funds in
financial markets, driving up interest rates for all borrowers. With the large
deficits of recent years, many economists have been concerned in the
competition for funds; also higher interest rates have discouraged
borrowing for private investment, an effect known as crowding out.

This, in its turn, will lead to fall in the rate of growth of the economy. So,
decline in living standards is inevitable. This seems to be the most serious
consequence of a large public debt. As Paul Samuelson has put it: “Perhaps
the most serious consequence of a large public debt is that it displaces
capital from the nation’s Stock of wealth. As a result, the pace of economic
growth slows and future living standards will decline.”

3. Public Debt and Growth:

By diverting society’s limited capital from productive private to
unproductive public sector public debt acts as a growth-retarding factor.
Thus an economy grows much faster without public debt than with debt.

When we consider all the effects of government debt on the economy, we

observe that a large public debt can be detrimental to long-run economic
growth. Fig. 22.3 shows the relation between growth and debt. Let us
suppose an economy were to operate over time with no debt, in which case
the capital stock and potential output would follow the hypothetical path
indicated by the solid lines in the diagram.

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Now suppose the government increase a huge deficit and debt; with the
accumulation of debt over time, more and more capital is displaced, as
shown by the dashed capital line in the bottom of Fig. 22.3. As the
government imposes additional taxes on people to pay interest on debt, there
are greater inefficiencies and distortions — which reduce output further.

What is more serious is that an increase in external debt lowers national

income and raises the proportion of GNP that has to be set aside every year
for servicing the external debt. If we now consider all the effects of public
debt together, we see that output and consumption will grow more slowly
than in the absence of large government debt and deficit as is shown by
comparing the top lines in Fig. 22.3.

This seems to be the most important point about the long-run impact of
huge amount of public debt on economic growth. To conclude with Paul
Samuelson and W. D. Nordhaus: “A large government debt tends to reduce
a nation’s growth in potential output because it displaces private capital,
increases the inefficiency from taxation, and forces a nation to service the
external portion of the debt.”
Conclusion:
There is no doubt a feeling among some people that interest payment on the
national debt repayment is a drain on the nation’s limited economic
resources. It is pure waste of our resources to use them to pay interest on the
debt.

This argument is wrong because interest payment on the debt — if

domestically held —do not prevent a use of economic resources at all. It is,
of course, true that if our debt is held by foreigners, we will suffer a loss of
resources.

In the case of domestically held (internal) debt, internal payment on the debt
involves a transfer of income from Indian taxpayers to Indian bondholders
of the same generation. Since, in most cases, taxpayers and bondholders are
different entities, a large national debt inevitably involves income redistri-
bution effects. But internal debt does not involve any using up of the
nation’s real economic resources.

Limit to Public Debt:

Though there is no clear end limit to internal debt there should be a definite
limit to external debt. Moreover the upper limit to internal debt should be
set by the annual rate of growth of per capita GNP.
Assessing the Debt (Optional):
What kind of burden does the national debt impose on taxpayers and on
future generations?

One of the most obvious and significant burdens of the national debt is the
interest that must be paid to borrow and maintain a debt of this magnitude.
The interest burden of the national debt cumulates as additional debt is
incurred each year. Because the debt is not being retired, interest must be
paid year after year.

The rising burden of the debt service — or interest cost of maintaining the
debt — will be passed on to future generations who will have to pay the
interest on the current debt. At the same time, however, many of those to
whom interest will be paid will be Indian citizens who own government
securities.

Should we pay off the debt? First of all, it would be a huge, probably
impossible, burden, even over several years, to raise, through taxes and
other revenues, the amount needed to pay off the debt. Second, with
repayment of the debt, a significant income redistribution would occur as
the average taxpayer became poorer due to the increased tax burden and
the holders of government securities became richer with their newly
redeemed funds.

Also, some portion of the debt is external, or foreign-owned. While, under

normal conditions, this is not a serious concern, in a period of accelerated
repayment it would mean a sizable outflow of rupees from the India. Finally,
in order to pay off the public debt, a series of surplus budgets would be
needed.

However, as Keynes pointed out, a surplus budget has a contractionary

impact on the economy. While the debt was being paid off, economic activity
would decline. In short, the opportunity cost of lowering the national debt
would be a slowing down of the economic activities.

ROLE OF GOVERNMENT IN ECONOMIC DEVELOPMENT OF A COUNTRY

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In modern times, State participation in economic activity can hardly be a

matter of disagreement.

The free play of economic forces, even in highly developed capitalist

countries, has often meant large unemployment and instability of the
economic system.

In the advanced countries, State intervention has been invoked to ensure

economic stability and full employment of resources. State action is all the
more inevitable in under-developed economies which are struggling hard to
get rid of poverty and to attain higher living standards.

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Accordingly, Governments are playing a vital role in the development of

under-developed economies.

Their role is all the more remarkable in the following respects:

(i) Comprehensive Planning:
In an under-developed economy, there is a circular constellation of forces
tending to act and react upon one another in such a way as to keep a poor
country in a stationary state of under-development equilibrium. The vicious
circle of under-developed equilibrium can be broken only by a
comprehensive government planning of the process of economic
development. Planning Commissions have been set up and institutional
framework built up.

(ii) Institution of Controls:

A high rate of investment and growth of output cannot be attained, in an
under-developed country, simply as a result of the functioning of the market
forces. The operation of these forces is hindered by the existence of economic
rigidities and structural disequilibria. Economic development is not a
spontaneous or automatic affair.

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On the contrary, it is evident that there are automatic forces within the
system tending to keep it moored to a low level. Thus, if an underdeveloped
country does not wish to remain caught up in a vicious circle, the
Government must interfere with the market forces to break that circle. That
is why various controls have been instituted, e.g., price control, exchange
control, control of capital issues, industrial licensing.

(iii) Social and Economic Overheads:

In the initial phase, the process of development, in an under-developed
country, is held up primarily by the lack of basic social and economic
overheads such as schools, technical institutions and research institutes,
hospitals and railways, roads, ports, harbours and bridges, etc. To provide
them requires very large investments.

Such investments will lead to the creation of external economies, which in

their turn will provide incentives to the development of private enterprise in
the field of industry as well as of agriculture. The Governments, therefore,
go all out inbuilding up the infrastructure of the economy for initiating the
process of economic growth.

Private enterprise will not undertake investments in social overheads. The

reason is that the returns from them in the form of an increase in the supply
of technical skills and higher standards of education and health can be
realised only over a long period. Besides, these returns will accrue to the
whole society rather than to those entrepreneurs who incur the necessary
large expenditure on the creation of such costly social over-heads.

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Therefore, investment in them is not profitable from the standpoint of the

private entrepreneurs, howsoever productive it may be from the broader
interest of the society. This indicates the need for direct participation of the
government by way of investment in social overheads, so that the rate of
development is quickened.

Investments in economic overheads require huge outlays of capital which

are usually beyond the capacity of private enterprise. Besides, the returns
from such investments are quite uncertain and take very long to accrue.
Private enterprise is generally interested in quick returns and will be seldom
prepared to wait so long.

Nor can private enterprise easily mobilize resources for building up all these
overheads. The State is in a far better position to find the necessary
resources through taxation borrowing and deficit-financing sources not
open to private enterprise. Hence, private enterprise lacks the capacity to
undertake large-scale and comprehensive development. Not only that, it also
lacks the necessary approach to development.

Hence, it becomes the duty of the government to build up the necessary

infrastructure.

(iv) Institutional and Organisational Reforms:

It is felt that outmoded social institutions and defective organisation stand in
the way of economic progress. The Government, therefore, sets out to
introduce institutional and organisational reforms. We may mention here
abolition of zamindari, imposition of ceiling on land holdings, tenancy
reforms, introduction of co-operative farming, nationalisation of insurance
and banks reform of managing agency system and other reforms introduced
in India since planning was started.

(v) Setting up Financial Institutions:

In order to cope with the growing requirements for finance, special
institutions are set up for providing agricultural, industrial and export
finance. For instance, Industrial Finance Corporation, Industrial
Development Bank and Agricultural Refinance and Development
Corporation have been set up in India in recent years to provide the
necessary financial- resources.

(vi) Public Undertakings:

In order to fill up important gaps in the industrial structure of the country
and to start industries of strategic importance, Government actively enters
business and launches big enterprises, e.g., huge steel plants, machine-
making plants, heavy electrical work and heavy engineering works have
been set up in India.

(vii) Economic Planning:

The role of government in development is further highlighted by the fact
that under-developed countries suffer from a serious deficiency of all types
of resources and skills, while the need for them is so great. Under such
circumstances, what is needed is a wise and efficient allocation of limited
resources. This can only be done by the State. It can be done through central
planning.

What Is an Indirect Tax?

An indirect tax is collected by one entity in the supply chain (usually a
producer or retailer) and paid to the government, but it is passed on to the
consumer as part of the purchase price of a good or service. The consumer is
ultimately paying the tax by paying more for the product.

Volume 75%
 
1:06
Indirect Tax
Breaking Down Indirect Tax
Indirect taxes are defined by contrasting them with direct taxes. Indirect
taxes can be defined as taxation on an individual or entity, which is
ultimately paid for by another person. The body that collects the tax will
then remit it to the government. But in the case of direct taxes, the person
immediately paying the tax is the person that the government is seeking to
tax.

Import duties, fuel, liquor and cigarette taxes are all considered examples of

indirect taxes. By contrast, income tax is the clearest example of a direct tax,
since the person earning the income is the one immediately paying the tax.
Admission fees to a national park is another clear example of direct
taxation.

Some indirect taxes are also referred to as consumption taxes, such as

a value-added tax (VAT).  

Examples of Indirect Taxes

The most common example of an indirect tax is import duties. The duty is
paid by the importer of a good at the time it enters the country. If the
importer goes on to resell the good to a consumer, the cost of the duty, in
effect, is hidden in the price that the consumer pays. The consumer is likely
to be unaware of this, but he will nonetheless be indirectly paying the import
duty.
Essentially, any taxes or fees imposed by the government at the
manufacturing or production level is an indirect tax. In recent years, many
countries have imposed fees on carbon emissions to manufacturers. These
are indirect taxes since their costs are passed along to consumers.

Sales taxes can be direct or indirect. If they are imposed only on the final
supply to a consumer, they are direct. If they are imposed as value-added
taxes along the production process, then they are indirect.

Regressive Nature of Indirect Taxes

Indirect taxes are commonly used and imposed by the government in order
to generate revenue. They are essentially fees that are levied equally
upon taxpayers, no matter their income, so rich or poor, everyone has to pay
them. But many consider them to be regressive taxes as they can bear a
heavy burden on people with lower incomes who end up paying the same
amount of tax as those who make a higher income. For example, the import
duty on a television from Japan will be the same amount, no matter the
income of the consumer purchasing the television. And because this levy has
nothing to do with a person's income, that means someone who earns
$25,000 a year will have to pay the same duty on the same television as
someone who earns $150,000 — clearly, a bigger burden on the former. 

There are also concerns that indirect taxes can be used to further a
particular government policy by taxing certain industries and not others.
For this reason, some economists argue that indirect taxes lead to an
inefficient marketplace and alter market prices from their equilibrium
price.

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DISGUISED UNEMPLOYMENT

REVIEWED BY JULIA KAGAN

 

 Updated Jul 14, 2019

What Is Disguised Unemployment

Disguised unemployment exists where part of the labor force is either left
without work or is working in a redundant manner where worker
productivity is essentially zero. It is unemployment that does not affect
aggregate output. An economy demonstrates disguised unemployment
when productivity is low and too many workers are filling too few jobs.

Breaking Down Disguised Unemployment

Disguised unemployment exists frequently in developing countries whose
large populations create a surplus in the labor force. It can be characterized
by low productivity and frequently accompanies informal labor markets and
agricultural labor markets, which can absorb substantial quantities of labor.

Disguised, or hidden, unemployment can refer to any segment of the

population not employed at full capacity, but it is often not counted in
official unemployment statistics within the national economy. This can
include those working well below their capabilities, those whose positions
provide little overall value in terms of productivity, or any group that is not
currently looking for work but is able to perform work of value.

Another way to think about disguised unemployment is to say that people

are employed but not in a very efficient way. They have skills that are being
left on the table, are working jobs that do not fit their skills (possibly due to
an inefficiency in the market that fails to recognize their skills), or are
working but not as much as they would like.

The Underemployed
In certain circumstances, people doing part-time work may qualify if they
desire to obtain, and are capable of performing, full-time work. It also
includes those accepting employment well behind their skill set. In these
cases, disguised unemployment may also be referred to as the
underemployment, covering those who are working in some capacity but not
at their full capacity.

For example, a person with an MBA accepting a full-time cashier position

because he cannot find work in his field may be considered
underemployed, since he is working below his skill set for whatever reason.
Additionally, a person working part-time in his field but who wants to work
full time may also qualify as underemployed.
Illness and Disability
Another group that may be included is those who are ill or considered
partially disabled. While they may not be actively working, they may be
capable of being productive within the economy. At times, this form of
disguised unemployment is temporary in the case of illness, and categorized
when someone is receiving disability assistance. This means the person is
often not considered part of the unemployment statistics for a nation.

No Longer Looking for Work

Often, once a person stops looking for work, regardless of the reason, he is
no longer considered unemployed when it comes to calculating the
unemployment figures. Many nations require a person to be actively seeking
employment to be counted as unemployed. If a person gives up looking for
employment, whether on a short- or long-term basis, he is no longer counted
until the time he attempts to pursue employment options again. This can
count as underemployed when the person wants to find work but has
perhaps stopped due to being so dejected by a long search.

PRINCIPLES OF TAXATION | ECONOMICS

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In this article we will discuss about the principles of taxation.

The most important source of government revenue is tax. A tax is a

compulsory payment made by individuals and companies to the government
on the basis of certain well-established rules or criteria such as income
earned, property owned, capital gains made or expenditure incurred (money
spent) on domestic and imported articles.

Since many people object to paying taxes, taxation involves compulsion. The
taxpayers are required to make certain payments, regardless of their
individual wishes or desires in the matter. Because of this compulsion, the
collection of taxes may have very significant effects upon the behaviour of
individuals and the functioning of the economy, which must be taken into
consideration in selection of taxes if the tax structure is not to interfere with
the attainment of the economic goals of society. Furthermore, if the goals of
society are to be realised, the burden of the taxes must be distributed among
various persons in a manner consistent with these goals.

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No tax is ideal, but taxes are inevitable if the government is to obtain

revenue to pay for its expenditure. The government tries to satisfy most
taxpayers by ensuring that taxes are fair and reasonable.

The major objective of taxation is to raise revenues. But other objectives are
also important in the design of a tax system. The principle of taxation can be
chosen only in terms of the goals which are accepted as the appropriate
objectives of the economic system.

In a modern economy, four such goals are of considerable importance for

optimum economic welfare:
(1) Maximum freedom of choice, consistent with the welfare of others

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(2) Optimum standards of living in terms of available resources and tech-

niques and in the light of consumer and factor-owner preferences;

(3) An optimum rate of economic growth; and

(4) A distribution of income in conformity with the standards of equity

currently accepted by society.

In terms of these goals, three major principles or desirable characteristics of

the tax system have come to be generally accepted:
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1. Economic effects:
The tax structure must be established in such a way as to avoid interference
with the attainment of the optimum.

2. Equity:
The distribution of burden of the tax must conform with the pattern of
income distribution regarded as the optimum by the consensus of opinion in
a modern society.

3. Minimum costs of collections and compliance, consistent with effective

enforcement:
The rule requires that taxes be established in such a manner as to minimise
the real costs of collections, in terms of resources required as in terms of the
direct inconvenience caused to the taxpayers. In fact, different writers have
formulated the different theories, at different times, relating to the equitable
distribution of the burden of taxation among the people.

The principles of taxation, that is, the appropriate criteria to be employed in

the development and evaluation of the tax structure, have received attention
from the days of Adam Smith.

Adam Smith developed his four famous canons of taxation:

(1) Equity:
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The amount payable by taxpayers should be equal, by which he meant

proportional to income;

(2) Ability:
The taxpayer should know for certain how much he will have to pay;

(3) Convenience:
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There should be convenience of payment;

(4) Economy:
Taxes should not be imposed if their cost of collection is excessive.

The following are the most important principles of taxation:

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1. Neutrality:
Prima facie, a tax system should be designed to be neutral, i.e., it should
disturb the market forces as little as possible, unless there is a good reason to
the contrary.

As a general rule, people do not like tax payment. In fact, every tax provides
an incentive to do something to avoid it. Since the government is under
compulsion to collect taxes, it is not possible to guarantee complete
neutrality. The tax system must, therefore, seek to achieve neutrality, by
minimising the disturbance to the market that comes from taxation.

2. Non-neutrality:
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Sometimes it becomes essential to maintain non-neutrality for meeting
certain social objectives. These objectives can be secured by providing tax
incentives. This means that in some cases, it may be desirable to disturb the
private market.

For example, the government may impose tax on polluting activities, so as to

discourage firms to pollute the environment. Likewise, a tax on cigarettes
will serve a two-fold purpose: raising revenue and discouraging
consumption of this harmful item. In both the cases, the market is disturbed
but in a desirable way.

3. Equity:
Taxation involves compulsion. Therefore, it is important for the tax system
to be fair. On grounds of equity it has been suggested that a tax system
should be based on a principle of equal sacrifice or ability to pay. The latter
is determined by (a) income or wealth and (b) personal circumstances.

Richard Musgrave has argued that taxes are to be judged on two main
criteria: equity (Is the tax fair?) and efficiency (Does the tax interfere
unduly with the workings of the market economy?) It comes to us a surprise
that economists have been mostly concerned with the latter, while public dis-
cussions about tax proposals always focus on the former.

We may, therefore, start with the concept of equitable taxation:

(a) Horizontal Equity:
There are three distinct concepts of tax equity. The first is horizontal equity.
Horizontal equity is the notion that equally situated individuals should be
taxed equally. More specifically, persons of equal income should pay iden-
tical amounts in taxes. There is hardly any controversy about this principle.
But it is very difficult to apply the concept in practice.

Let us consider, for example, the personal income tax. Horizontal equity
calls for two families in the same income to pay the same tax. But what if one
family has eight children and the other has none? Or, what if one family has
unusually high medical expense, while the other has none (even if two
families have the same number of members)?

(b) Vertical Equity:

The second concept of fair taxation follows logically from the first. If equals
are to be treated equally, it logically follows that un-equals should be treated
unequally. This precept is known as vertical equity. This concept has been
translated into the ability to pay principle, according to which those most
able to pay should pay the maximum amount of taxes. Broadly, the principle
suggests that the fairest tax is one based on one’s financial ability to support
governmental activities through tax payments.

The ethical base of this principle rests on the assumption that one rupee paid
in taxes by a rich person represents less sacrifice than does the same rupee
tax paid by a poor man and that fairness demands equal sacrifice by both
rich and poor in support of government. Thus, a rich man must pay more
money in taxes than would a poor man for each to bear the same burden in
supporting services provided by the government.

Thus, horizontal equity suggests that people who are equal should pay equal
taxes: vertical equity suggest that, un-equals should be treated unequally.
Specifically, the rich should pay more taxes than the poor, since wealth is
considered an appropriate measure of one’s ability to pay taxes.

The Benefit Principle:

From the conceptual and practical points of view there is hardly any conflict
between the principles of horizontal and vertical equity. But there is a third
principle of fair taxation which may often violate commonly accepted
notions of vertical equity.

The principle recognises that the purpose of taxation is to pay for

government services. If taxes are imposed according to the benefit principle,
people pay taxes in proportion to the benefits they receive from government
spending.

Therefore, those who derive the maximum benefits from government

services such as roads, hospitals, public schools and colleges should pay the
maximum tax. However, if the benefit principle of taxation is followed, the
government will be required to estimate how much various individuals and
groups benefit, and set taxes accordingly.

According to the benefit principle of taxation those who reap the benefits
from government services should pay the taxes. The benefit principle holds
that people should be taxed in proportion to the benefits they receive from
goods and services provided by the government. This principle is based on
the feeling that one should pay for what one gets.

One clear example is road tax. Receipts from road taxes typically are set
aside for maintenance and construction of roads. Thus, those who drive on
the roads pay the tax. But one question remains unanswered: do those who
use the roads pay the tax roughly in proportion to the amount they use
them?
The principle also leads to an economically efficient solution to the questions
of how much government should provide and who should pay for it.
However, using the benefit principle has several practical difficulties that
render it impossible to apply it for many publicly supplied goods and
services.

When a good or service supplied by the government has the exclusive and
rival characteristics of a private good, benefits can be computed rather
easily and users can be charged accordingly. Examples include road tax, toll
tax and transit fees. When a publicly provided service is non-rival and non-
exclusive (a pure public good) the benefit principle is just a theoretical
concept because the benefits cannot be measured.

Problems:
In fact the necessity for different taxes generally makes benefit taxation
somewhat impractical for pure public goods. First, the public sector pro-
vides numerous public goods, and the cost of obtaining enough information
to permit levying appropriately different taxes may be very high.

Furthermore, most individual taxpayers often refuse to reveal their ‘true’

preferences because once the ‘public’ good is provided, individuals cannot
be excluded from enjoying the benefits whether they pay taxes or not. This
characteristic of public goods goes by the name ‘free riders’.

Let us suppose taxes are based on one’s reported assessment of the benefits
one receives from the good. In essence, taxation is voluntary. Some
taxpayers might assert that they want little or none of the public good (like a
road, or a public park or a bridge) in question.

Clever people might even assert that they are harmed by the public good.
So, they should receive subsidies from the government. Once other people
agree to buy some of the public good, free riders are able to enjoy the good
or service.

If most people want to enjoy the good or service free of cost (or, they
attempt to ‘free ride’), the public good may not be available at all.
Generally, it will be available in less than sufficient quantities. As a result of
the inability to ascertain people’s true preferences for public goods, the
benefit principle, while interesting analytically, is seldom used in practice.

So, it is not possible to implement the principle in practice. Most people will
enjoy the benefits of public expenditure but will be reluctant to pay taxes.
To overcome this problem, an alternative principle has been suggested, viz.,
the ability to pay principle.

This principle may now be discussed:

The Ability-to-Pay Principle:
If the objective of the government is to redistribute income, it should set
taxes according to the ability-to-pay principle. However, it is difficult to
measure ability. There are, in general, three measures of ability: income,
expenditure and property. But none is full-proof.

1. Income:
Income is said to be a better measure of ability than wealth. But here also
some difficulties are encountered. All work do not involve the same sacrifice.
A man earning Rs.500 through toil and trouble will not be a position to pay
taxes as one earning the same amount without any effort (from paternal
property) or gambling or through chance (lottery).

One with the same level of income as another may have more dependents
and more liability and thus lower ability to pay. Moreover, the marginal
utility of money differs from man to man. It is higher to a man with lower
income and vice versa. So, in the ultimate analysis, income is not a good test
of ability.

2. Expenditure:
According to Prof. N. Kaldor, expenditure is the best possible measure of
ability. He advocated an expenditure tax which was tried in India for
sometime but withdrawn subsequently. A poor man may spend more if he
has more dependants and if he has to look after his old parents. So, his
expenditure may be higher than his colleague belonging to the same income
bracket. But his expenditure does not reflect his true ability to pay.

3. Property:
Possession of wealth or property is a reflection of well- being, but to a
limited degree. For example, if two persons have the same amount of wealth,
they are not equally well-off. One may have some productive wealth like a
building which yields a steady income. Another may have unproductive
wealth (i.e., jewellery) of the same value. Naturally, their ability to pay taxes
will differ greatly.

Two basic indices (measures) of the ability to pay, viz., income and wealth
provide a justification for progressive personal taxes. If taxes are imposed
on the basis of the ability to pay principle, higher taxes will be paid by those
with greater ability to pay, as measured by income and/or wealth.
The measures of ability differ from tax to tax. For example, in income
taxation, the measure of ability is income; in wealth taxation, it is the value
of property (wealth).

A practical problem arises when we try to translate the idea (or notion) into
practice.

Let us consider the three alternative income tax plans listed in Table 3:

Under all three plans, families with higher incomes pay higher income taxes.
So, all these plans may be said to be operate on the ability to pay principle of
taxation. Yet they have different distributive consequences.

Plan 1 is a progressive tax: the average tax rate is higher for richer families.
Plan 2 is a proportional tax; every family pays 10% of its income. Plan 3 is
quite regressive: since tax payments rise more slowly than income, the tax
rate for richer families is lower than that for poorer families.
It appears that under plan 3 the principle of ‘fairness’ is violated. However,
the modern system of progressive personal income tax seems to be based on
the notion of vertical equity. Other things being equal, progressive taxes are
seen as ‘good’ taxes in some ethical sense while regressive taxes are seen as
-bad’. On these grounds, advocates of greater equality of income support
progressive income taxes and oppose sales taxes.

However, progressivity in taxation is not necessary for vertical equity. A

proportional income-tax system could well satisfy the equity principle.

Other Principles (Optional):

A few other principles of taxation have also been suggested from time to
time such as the following:
The Cost of Service Principle:
According to this principle, the tax to be paid by an individual should be
equal to the cost of services incurred by the government in rendering the
service to him. Thus, if the government spends Rs 50 for providing a
particular service to A, he should pay a tax of Rs 50.

The principle can be applied in the case of government services like

railways, postal services, etc. But the application of this principle in taxation
involves some difficulties. First, when the government spends some money
for the people at large, it does so in a general way.

So, the cost of services incurred for different individuals cannot be

separately calculated. Secondly, the application of this principle requires the
poor to pay taxes at higher rates than the rich as the government generally
spends more for the poor than for the rich.

Finally, if this principle be applied in the case of pension holders, the latter
would have to pay taxes more than the amount of pension to cover the
administrative expenses for giving such pension, but this would be absurd.

The Principle of Least-aggregate Sacrifice or Minimum Sacrifice Principle:

Some writers interpreted the ability to pay principle in terms of equal
sacrifice and minimum sacrifice. According to this principle, taxes should be
so designed as to cause the smallest possible real burden or the smallest
possible sacrifice to the community.

According to Pigou, the burden of taxation is to be distributed among the

people in such a way that the aggregate sacrifice of the community for
paying taxes should be the least, i.e., the minimum. This can be done by
taxing only the rich as the marginal utility of money to them is lower than
what it is to the poor.

But difficulties may arise in measuring the aggregate sacrifice of the

community owing to the difficulties in knowing the correct marginal utility
of money, which itself is a subjective phenomenon (only windfall gains
should be taxed at a high rate since they involve least sacrifice).

Conclusion:
In practice, the policy of a government can hardly be based solely on any of
the above principles. These principles set merely as guidelines to the gov-
ernment in framing its tax policy which is prepared having regard to
various considerations like the tax yield, equity, social and economic effects
and the requirements of the country.

At different times, certain principles of taxation have been suggested on the

basis of Smith’s four basic canons. According to the so-called benefit
principle, the amount a person should pay in taxes should be related to the
benefit he might expect to receive in return.

But this principle is difficult to apply in reality since, under this principle,
lower income groups would be called upon to pay most. Similar and equally
impracticable is the cost of service principle, according to which a person’s
tax liability would be based on the cost of the public services which he
enjoys.

WHAT IS A PUBLIC CORPORATION? EXPLAIN BRIEFLY ITS MERITS

AND LIMITATIONS.

JAN 2
Posted by Ranjay
PUBLIC CORPORATION
Public corporation is corporate body created by the Parliament or State
Legislature as the case may be, by a special Act which defines its powers.
Duties, functions, immunities and the pattern of management. Public
corporation is also known as statutory corporation. The capital is wholly
subscribed by the government. It is managed by the management committee
constituted according to the provisions of the Act. It is answerable to the
Parliament or State Legislature as the case may be. As stated by Roosevelt,
public corporation is an organisation which is clothed with the power of the
government but is possessed of the flexibility of private enterprise. Herbet
Morrison views a public corporation as a combination of public ownership,
public accountability and business management for public ends. Thus the
public corporation device is an attempt to combine public interest with the
flexibility of operation most prominently found in a company form of
organisation working in the private sector.
Merits
Public corporation strikes a mid-way between departmentally run public
undertakings and the privately owned and managed corporate bodies. It
absorbs some of the salient desirable features of both of them to fetch the
best of both forms. At the same time, it eliminates some of their major
weaknesses also. Let us discuss about the merits of a public’ corporation
form of organisation.
1 ) Initiative and flexibility: As it is an autonomous corporate body set up
under an Act of legislature, it manages its affairs independently with its own
initiative and flexibility. It experiments in new lines, exercises initiative in
business affairs and enjoys the operational flexibility as in private
enterprises.
2) Avoids red-tapism: The evils of red-tapism and bureaucracy associated
with departmental form of organisation are avoided. Business functions
cannot be carried out efficiently in a government set-up, which is marked by
rules, regulations and procedures. Compared with a departmental
organisation a public corporation can take
quick decisions and prompt actions on any matter affecting its business.
3) Easy to raise capital: Public corporations are government owned
statutory bodies.
They can easily raise required capital on their own whenever needed by
tloating bonds
at relatively lower rates of interest. Public also comes forward to subscribe
to such
bonds since they are safe.
4) Protects public interest: As you know, compared to a departmental
organisation, a
public corporation is relatively free from political interference,
parliamentary enquiryz
and departmental checks and controls. Although it has a considerable
degree of
administrative autonomy, its policies are subject to Parliamentary control.
Thus, it
ensures protection of public interests. Further, the Board of Directors of the
public
corporations consists of persons from various fields such as business experts
and the
representatives of special interests like labour, consumers, etc., who are
nominated by
the government. Thus, exploitation of any class at the cost of another is
r’uled out.
5) Works with service motive: Public corporation avoids the defects of
profiteering, exploitation, illegitimate speculation, etc., which are often
associated with private enterprises. A public corporation works primarily
with service motive and profit Forms of Organisation in earning is only a
secondary consideration. Though it works efficiently to show good Public
Enterprises results in the form of ‘surplus,’ such surplus must not be the
result of exploitation. The surpluses generated by the public corporations
are used for the good of the consumers and the community.
6) Secures working efficiency: It secures greater working efficiency by
providing better amenities and more attractive terms of service to its
employees which in turn; reduces the labour problems.
7) Secures benefits of large scale economies: Economies of large scale
operations are realised by the virtue of increased size and scale of the
business. Further, it is easy to reap considerable economies in management
by affecting the integration of several companies under this form. For
example, giant government undertakings organised as autonomous units
such as, banking, insurance, transport, etc., can secure better management
and staff with comparatively lesser costs.
Limitations
You have learnt about the merits of public corporation form of organisation.
This form of
organisation also suffers from certain limitations.
1) Less autonomy: Compared to departmental folm, public corporations
enjoy more autonomy. But, in practice, tlie autonomy of public corporation
is closely and systematically controlled by the government even in matters
where they are supposed to have freedom. For example, the Food
Corporation of India and the Electricity
Boards in various States (these are statutory corporations) are of important
to the government and to the public at large. But, the Central and State
Governments often find it difficult to allow them the freedom which they are
entitled to as per their Acts.
2) Inflexibility: A public corporation is set up by a special Act of legislature.
Any change in the objects and powers of the corporation requires an
amendment in the Act by the legislature. This tends to make a corporation
inflexible and insensitive to changing situations.
3) Clash amongst divergent interests: As you know, the corporations are
owned by the government and are managed by a Board of Directors
appointed by the govemment.
When the Board of Directors represent different interests there may be
clash of interests. This in turn, may hainper the smooth functioning of the
corporation.
Sometimes, the directors may abuse their autonomy and authority by
indulging in undesirable practices. This would defeat the social objectives of
public corporation.
4) Ignores commercial principles: Public corporations do not have to face
any competition. They are neither guided by profit motive nor haunted by
the fear of loss.
Therefore, there is a possibility of ignoring commercial principles in their
working.
This may ultimately lead to inefficiency and losses to the corporation. The
losses, thus arising are met by the govemment through subsidies.
5) Excessive public accountabili6: You know that the public corporations
work with the service motive rather than profit motive. This public
accountability of the corporation sometimes acts as a stumbling block in the
operational efficiency of the enterprise.

GROWTH OF PUBLIC EXPENDITURE: 16 FACTORS

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This article throws light upon the sixteen main factors responsible for the
growth of public expenditure. Some of the factors are: 1. The New Concept
of Welfare State 2. War and National Defence 3. Population
Growth 4. Growth of Democratic Institutions 5. Provision of Economic Over
Head 6. The Problem of Urbanization 7. Rising Trend in Price Level 8.
Adoption of Planning and Others.
Factor # 1. The New Concept of Welfare State:
The 19th century state was mainly and basically a ‘police state’ primarily
interested in the protection of the citizens from foreign aggression and in
maintaining law and order within the country.
Modern states are not police states, but welfare states. The belief of the
classical economists, in the efficacy of Laissez-fair capitalism in maintaining
full employment and economic stability has been falsified.

ADVERTISEMENTS:

On the other hand, Keynes and his followers with their penetrating analysis
has shown beyond any shadow of doubt that the state must intervene in the
economic system to secure economic stability in the developed countries and
to achieve accelerated growth with stability in under developed countries.
This led to the adoption of a welfare state concept by the Nations of the
world.

The main objective of the welfare state is to promote the economic, political
and social well-being of citizens. Modern governments spend huge amounts
on generation of employment, provision of basic service like educational
facility.

Health care facilities, social security measures, low cost housing to the poor,
protection of environment etc. These welfare functions require enormous
spending on the part of the government. This substantially contributed
towards increasing the volume of public expenditure over years.

Factor # 2. War and National Defence:

In most countries the heaviest increase in public expenditure has been on
account of cost of war and preparedness for war. The larger the country, the
greater the percentage of resources allocated to national defence.

ADVERTISEMENTS:

War and rumors of war between countries have forced them to be armed at
all time and to get prepared to face a war situation. The cost of defence has
phenomenally increased overtime, due to the use of new and sophisticated
equipment’s. The progresses of military arts and sciences have been so rapid
that the war equipment’s became extremely expensive and complex.

The progress in modernization of warfare and advancement in military arts

and sciences make the machines of war quickly out-dated and necessitate
speedy and costly replacement. With the emergence of electronic and
nuclear warfare, the nature and dimensions of war technology became much
costly.

Coupled with this, the provision of better living condition for defence
personal, provision of pension and other social security measures, interest
on war debt etc. positively helped to push the defence expenditure of almost
all countries.

Large amount of public expenditure is usually set apart for the defence
forces and local security forces like police, Territorial Army and border
security force, in the state of India.

Factor # 3. Population Growth:

ADVERTISEMENTS:

Another important factor responsible for increase in public expenditure is

the growth of population. Population growth and the consequent
concentration of people in towns have necessitated increased levels of many
governmental activities.

Along with growth in numbers, the responsibilities of government relating to

the provision of basic services have increased considerably. The state will
have to bear additional responsibility of solving problems like food, unem-
ployment, housing, sanitation, street lighting, drinking water, drainage etc.
Moreover, modern society is becoming complex with increasing needs such
as higher levels of education, growth of network of roads and railways and
other transport system and provision of public welfare. To check the growth
of population, again the government has to increase large amount for family
planning and welfare programmes.

Factor # 4. Growth of Democratic Institutions:

Today almost majority of nations have accepted the principle of democracy.
Democratic institutions exert structural compulsions on public expenditure.
The growth of democracy in the political system of any country requires
maintenance of political institutions like periodic elections, at different
layers of government, the legislatures, advisory council, local boards etc. and
other grass root level administrative units.

Democracy also requires formation of public opinion. A modern democratic

state has to maintain the ceremonial head of the state. Besides they had to
maintain diplomatic and consular relations with all parts of the world.

Many countries are members of international organizations like the U.N.O,

I.M.F, World Bank, W.T.O etc. This means besides annual subscription,
expenses on permanent delegates, annual conference and other committed
expenditures.

A modern government thus has been compelled by the democratic forces to

assume more and more functions. Under the shadow of democracy, state
activities have expanded and the functions of government have increased
both intensively and extensively. The government expenditure on account of
these institutions and activities has been on a continuous rise.

Factor # 5. Provision of Economic Over Head:

For the development of a nation, creation and maintenance of economic
overhead facilities is imperative. Provision of these facilities like well-
developed transport and communication, generation of electric power etc.
requires heavy capital investment.

Since these investments are not highly profit induced, the private sector will
be shy to invest in these areas. Hence government has to assume these re-
sponsibilities, to fulfill the basic requirements of development. Hence public
expenditure on account of economic infrastructure is huge in size in
developing countries.
Factor # 6. The Problem of Urbanization:
Population explosion leads to urbanization and resulted in the growth of
metropolitan centers throughout the world. Urbanization is creating major
hurdles to the all-round development of the economic system. Urban
settlements are creating a number of socio-economic problems to the state,
which need huge investment by the central, state and municipal bodies to
address these problems.

The size of cities is becoming larger and larger, while newer urban
habitations are springing up. The thickly populated urban centers have
necessitated the governments to initiate immediate steps to overcome some
of the major problems associated with education, public health, water
supply, pollution, environmental hazards, energy crisis, drainage and
sanitation, migration of rural people to cities etc. urbanization also leads to
concentration of industries in urban centers with all attended evils.

All these activities associated with rapid urbanization increases the

responsibility of state to provide huge public expenditure for taking care of
the problem of urban inhabitants. Urbanization necessitates a much larger
per capita expenditure on civic amenities of life.

Factor # 7. Rising Trend in Price Level:

Another factor pushing public expenditure ahead, at present, is the
inflationary trend in price level. Rise in price level affect government
expenditure in two ways.

Firstly as a purchaser, the government has to pay higher prices for all goods
and services it purchases.

Secondly government, which is the single largest provider of employment,

has to find out larger financial resources to meet its inflated administrative
expenditure. That is when prices rise, the salary and allowances of
government employees and other expenditures also increases
correspondingly.

Factor # 8. Adoption of Planning:

Almost all countries have now basically accepted the principle of planned
economic development. Economic planning is considered as a panacea for all
economic evils like poverty, deprivation, unemployment etc. planning is
considered as an instrument to achieve certain socio-economic objectives.

Planned economic development involves increasing state activities in many

spheres of socio-economic life of the community.
Eradication of poverty, equitable distribution of income and wealth,
provision of increased employment opportunities, development of backward
classes etc. are the major objectives of planned economic development. This
require large sum of money leading to a consistent increase in public
expenditure.

Factor # 9. Education and Human Capital Formation:

The overall development of a country depends on the quality of human
capital. In developing countries, responsibilities of human capital formation
are primarily on the government. This is due to the widespread poverty of
the people.

The government provides educational services, both general and technical

and training of manpower. These facilities are provided either free of charge
or at subsidized rate.

The development of trade and industry, necessitate specialization in dif-

ferent fields of technology and business administration. Government also
launched programmes to eradicate illiteracy. Large amounts of grants of
varying type are given to educational institutions at different levels.

Coupled with this the massive investments in the field of science and
technology, to cope with the advancement in the field also pushed up
government spending. The net result is a substantial increase in public
expenditure at different layers of government.

Factor # 10. Modernization of Agriculture:

Most of the developing countries are basically agrarian economics. Growth
of agriculture is necessary, not only to achieve self-sufficiency in food
production, but also to provide adequate support to agro-based industries
by providing required raw-materials.

The governments of most of these economics have realized the interdepen-

dence of agriculture and industry. The expansion of agricultural sector
provides impetus to industrialization by supplying raw-materials and wage
goods to industrial sectors. Increased income to farmers creates demand for
industrial goods.

Likewise industrial sector supplies various inputs and implements to

agriculture. Hence a systematic development of the agrarian sector is a vital
need for the rapid economic development of a country.
So modern government undertake ambitious programmes for the
modernization of agricultural sector. Hence in order to modernize
agriculture, the government has to undertake expensive programmes for
improving irrigation facilities, providing flood control methods, provision of
fertilizer and other scientific agricultural inputs.

Apart from this huge investment are done in research and soil conservation,
land reforms, subsidy to small and marginal farmers, export promotion
activities etc… All these modernization programmes involves huge public
expenditure.

Factor # 11. Industrial Development:

Industrialization leads to increase in national income and promotes the
standard of living of the people. However for rapid industrialization, the
involvement of the public sector is crucial. To industrialize the country the
government has to develop basic and key industries.

Government also offers various incentives and concessions to private sector

to attract industries in backward regions, and to ensure dispersal of
industries in backward regions, to keep balanced regional development.

The incentives are provided in the form of establishment of industrial

estates, provision of cheap credit, subsidized raw materials, tax holidays and
concessions, improved transport system and marketing facilities. Further
government takes measures to control monopolies and to provide consumer
goods and services at reduced price. All these resulted in an increase in
public expenditure.

Factor # 12. Provision of Public Goods and Utility Services:

Public goods are those, the consumption of which is externalized. It is
consumed equally by all. These goods have no private market. Defence, and
police service, justice, roads, irrigation, flood control projects, public parks
etc. are all examples of public goods.

They involve huge investments and have to be provided by the government

Moreover the provision of major public utilities like railways, post and
telegraph, electricity services etc. are coming under government sector. The
provision and maintenance of these public goods and general utility services
involve heavy expenditure.
Factor # 13. Servicing of Public Debt:
Public debt constitutes a substantial part of the government revenue; a
major part of mounting government expenditure is met from public
borrowing.

Hence the internal and external debt obligation of the government has
increased considerably during the last few decades. This leads to a
subsequent increase in public expenditure in the form of increasing cost of
debt servicing and repayment of loans.

Factor # 14. Protection from the Maladies of Market Mechanism:

In all welfare states, government is the ultimate custodian of public welfare.
It is bound to keep a constant vigil on the abuses of free market mechanism
like malpractices by dishonest traders, black marketing, hoarding,
monopoly practices and consumer exploitation.

Modem governments consider it a part of its duty to protect the economy

from the failures of market mechanism. Government adopts regulatory
measures to check the imperfections in-the market system.

Government usually makes arrangements for buffer stock creation, and

distribution of essential goods at reduced rates through a network of public
distribution system. Government makes earnest efforts to reduce the income
and wealth inequalities and to achieve social and economic justice. This
necessary involves huge government expenditure through budgetary
provisions.

Factor # 15. Economic Depression:

The worldwide depression of 1930’s stressed the need for using public
expenditure as a compensatory factor to overcome the deficiencies in trade
and employment caused by reduced private investment. Public expenditure
has been found as the best anti-dot to fight against and for preventing
economic depressions.

The government is expected to play an active role in maintaining the level of

trade and employment.

Depression of 1930 s proved that state has an active part to play, by making
a judicious planning of public expenditure in advance, to mitigate the
impact of depression in trade. Government expenditure on public works and
other projects directly provides employment to large numbers and by
increasing the effective demand for goods and services helps to raise the
level of business activity.
Government expenditure was considered as compensatory factors in
maintaining the level of trade and employment especially during economic
depression. This led to an increase in public expenditure after the world
wide depression of 1930’s.

Factor # 16. Maintenance of Law and Order:

In tune with the growth of population urbanization and complexities of
modern economic and socio-political life, law and order problem became
more complex. Terrorism has become an international and national
phenomenon threatening the law and order situations of nations across the
world.

The responsibilities of the government, to protect the people from internal

conflict and breach of peace by antisocial elements have now become a
crucial component of government activity. This requires large amount of
funds for maintaining the law and order machinery in constant vigil with
full preparedness to meet any adversities.

Apart from these the maintenance and preservation of historical places,

monuments and forest resources, populist policies adopted by the ruling
parties under pressure from democratic institutions and opinions and
lethargy of the bureaucracy also contribute towards increasing the nature
and volume of public expenditure in recent years.

PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE (WITH DIAGRAMMATIC

REPRESENTATION)
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Principle of Maximum Social Advantage (With Diagrammatic

Representation)!
The fiscal or budgetary operations of the state have manifold effects on the
economy. The revenue collected by the state through taxation and the
dispersal of public expenditures can have significant influence on the
consumption, production and distribution of the national income of the
country.
ADVERTISEMENTS:

The fiscal operations of the government resolve themselves into a series of

transfers of purchasing power from one section of the community to
another, along with the variations in the total incomes available in the
community. In fact, the fiscal activities of the state affect the allocation of
resources, the use of resources from one channel to another, hence, the level
of income, output and employment.

Hence, it is desirable that some standard or criterion should be laid down to

judge the appropriateness of a particular operation of public finance — the
government’s revenue and expenditures. In a modern welfare state, such a
criterion can obviously be nothing else but the economic welfare of the
people.

It follows, thus, that the particular financial activity of the state which leads
to an increase in economic welfare is considered as desirable. It may be
considered as undesirable if such an activity does not cause an increase in
the welfare or even sometimes, it may be the cause of a reduction in the
general economic welfare. The guiding principle of state policy has been
technically desirable as the Principle of Maximum Social Advantage by
Hugh Dalton.

According to Dalton, the principle of maximum social advantage is the most

fundamental principle lying at the root of public finance. Hence, the best
system of public finance is that which secures the maximum social
advantage from its fiscal operations. Maximum social advantage is the
maxim for the states. The optimum financial activities of a state should,
therefore, be determined by the principle of maximum social advantage.

ADVERTISEMENTS:

It is obvious that taxation by itself is a loss of utility to the people, while

public expenditure by itself is a gain of utility to the community. When the
state imposes taxes, some disutility or dissatisfaction is experienced in the
society. This disutility is in the form of sacrifice involved in the payment of
taxes — in parting with the purchasing power.

Similarly, when the state spends money, some utility is created in the society.
Some satisfaction is experienced by a group of people in the society on
whom, or for whom, the public expenditure is incurred by the state. This is
the social benefit of welfare of the public expenditure.

As such, the maximum social advantage is achieved when the state in its
financial activities maximise the surplus of social gain or utility (resulting
from public expenditure) over the social sacrifice or disutility (involved in
payment of taxes.) The principle of public finance, thus, requires the state to
compare the sacrifice and benefits of the society in its fiscal operations.

The principle of maximum social advantage implies that public expenditure

is subject to diminishing marginal social benefits and taxes are subject to
increasing marginal social costs. Thus, an equilibrium is reached when
social advantage is maximised, i.e., when the size of the budget is such that
marginal social benefits of public expenditures are equal to the marginal
social sacrifice of taxation.

ADVERTISEMENTS:

Dalton states, “Public expenditure in every direction should be carried just

so far, that the advantages to the community of a further small increase in
any direction is just counter-balanced by the disadvantage of a
corresponding small increase in taxation or in receipts from any other
sources of public expenditure and public income.”

Thus, a rational state seeks to maximise the net social advantage of its fiscal
operations. The social net advantage is maximum when the aggregate social
benefits resulting from public expenditure is maximum and the aggregate
social sacrifice involved in raising the public revenue is minimum.
According to the principle of maximum social advantage, thus, the public
expenditure should be carried on up to the marginal social sacrifice of the
last unit of rupee taxed.

Diagrammatic Representation:
In technical jargon, the maximum social net advantage is achieved when the
marginal social sacrifice (disutility) of taxation and the marginal social
benefit (utility) of public expenditure are equated. Thus, the point of
equality between the marginal social benefit and the marginal social
sacrifice is referred to as the point of aggregate maximum social advantage
or least aggregate social sacrifice.

The equilibrium point of maximum social advantage may as well be

illustrated by means of a diagram, as in Fig. 1.

ADVERTISEMENTS:

In Fig. 1, MSS is the marginal social sacrifice curve. It is an upward sloping

curve implying that the social sacrifice per unit of taxation goes on
increasing with every additional unit of money raised. MSB is the marginal
social benefit curve. It is a downward sloping curve implying that the social
benefits per unit diminishes as the public expenditure increases.

The curves MSS and MSB intersect at point P. This equality (P) of MSS and
MSB curves is regarded as the optimum limit of the state’s financial activity.
It is easy to see that so long as the MSB curve lies above the MSS curve, each
additional unit of revenue raised and spent by the state leads to an increase
in the net social advantage.

This beneficial process would then be continued till marginal social sacrifice
(MSS) becomes just equal to the marginal social benefit (MSB). Beyond this
point, a further increase in the state’s financial activity means the marginal
social sacrifice exceeding the marginal social benefit, hence the net social
loss.

ADVERTISEMENTS:

Thus, only under the condition of MSS = MSB, the maximum social
advantage is achieved. Diagrammatically, the shaded area APB (the area
between MSS and MSB curves, till both intersect each other) represents the
quantum of maximum social advantage. OQ is the optimum amount of
financial activities of the state.

Further, the ideal of maximum social advantage is attained by the state, if

the following principles of financial operation are followed in the budget.
1. Taxes should be distributed in such a way that the marginal utility of
money sacrificed by all the tax-payers is the same.

2. Public spending is done, such that benefits derived from the last unit of
money spent on each item becomes equal.

3. Marginal benefits and sacrifices must be equated.

To sum up, all fiscal operations, both as regards revenue and expenditure,
should be treated as a series of transfer of purchasing power that must
ultimately increase the economic welfare of the people. In this context,
Dalton enunciated the principle of maximum social advantage and asserted
that financial operations of the government must be in accordance with this
principle in a welfare state.