RGOm

SYLLABUS (iv)

Hons)

Theory of Public Finance

COMPUTER

Issues from Indian Public Finance 40

APPLICATIONS

IN
BUSINESS

Semesler

4
R.P

(iin
 SYLLABUS
B.COM. (HONS.)
PUBLIC FINANCE
Credit: 6 Unit 1

a non-technical overview of government

Course Objective: This course is
finances with special reference to India. The course does not require
any prior Theory.of Public Finance
knowledge of economics, It will look into the efficiency and equity aspects of
taxation of the centre, states and the local governments and the issues of fiscal
federalism and decentralisation in India. The course will be useful for students
aiming towards careers in the government sector, policy analysis, business and .1. What do you understand by Public Finance? Explain scope of
public
journalism. Finance.
Ans. The State in modern times is called a welfare State. The activities
a of such
modern welfare State have vastly increased. For a smooth performance of these
Course Learning Outcomes: The mnodule aims to introduce students to the main
concepts in public finance, equip students with a thorough analytical grasp of functions the State needs finance. Public finance means the finances of
public
bodies-National, State or Local-for the performance of their functions. The
government taxes: direct and indirect taxes, and familiarise students with the term 'finance may also refer to financial management and administration. Public
main issues in government expenditure. At the end of the module the students finance thus means the administration of the financial
operations of the public
should be able to demonstrate their understanding of the economic concepts authorities. It refers to that branch of Economics which deals with the income
and
of public finances, use diagrammatic analysis to demonstrate and compare the expenditure of public bodies and the principles, problems and policies
to these matters. relating
economic welfare effects of various government policy options, and demonstrate "The science which deals with the activity of statesman in
their understanding of the usefulness and problems related to government obtaining and ayplying the
material means necessary for fulfillingthe proper functions
of the State." -Carl Plehn
revenues and expenditures. Scope of Public Finance:
(i) Public Revenues. Public revenue
refers to the total collection of income
COURSE CONTENTS by the government through various sources. The necessity of
revenue arises because to public expenditure. public
Public revenue is important
Unit 1:Theory of Public Finance component in the study of public finance.
(ii) Public Expenditure. Public
Overview of Fiscal Functions, Tools of Normative Analysis, Pareto expenditure is the reason of beginning and
Efficiency, Equity and the Social Welfare; Market Failure, Public Good and
end of the collection of revenues by the govermment. As pointed out
by
Plehn, "Public expenditure is the end and aim of collection of revenues
Externalities; Elementary Theories of Product and Factor Taxation (Excess and of other financial activities of the statesman".
Burden and Incidence). (ii) Public Debt. When public revenue falls short of public expenditure,
government borrows from the public to meet the gap. This the
Unit 2: Issues from India Public Finance is public debt.
(iv) Financial Administration. The aim of
financial administration is to
Working of Monetary and Fiscal Policies; Current Issues of India's Tax control processes and operations of public revenue, public
expenditure
System; Analysis of Budget and Deficits; Fiscal Federalism in India; State and public debt. The scope of financial administration includes the
collection, custody and disbursement of public money: the coordination
and Local Finances.
of expenditure according to a well-formulated plan; the management
of public debt and the general control of the financial operations
O000 of the
state. It also includes the preparation of the budget; its execution
and
above all auditing the finances of the state.

(iv)

Shiy Das DELHI UNIVERSITY SERIES
2 PUBLIC FINANCE
Finance a science or at or both?
Q.2. Explain nature of Public Finance. Is Public
Ans. Nature of Public Finance
• Whether it is science or art or both
any subjcct
• Public Finance is a science. Science is the systematic study of
Public finance is a systematic
which studies causal relationship between facts.
any subject which studies causal relationship between facts. The
study of
arguments could be:
() definite and limited field of human knowledge
(ii) systematic study of facts
(iii) scientific methods are used to study public finance
are empirical
(i) principles of public finance
•
Public Finance is an art. Art is the application of knowledge for achieving
objectives. Fiscal policy which is an important instrument of public finance makes
use of the knowledge of government's revenue and expenditure to achieve the
objectives of full enmployment, economic equality, economic development and
price stability.
Q. 3. Briefly explain the important of Public Finance.
MO4. Give the dissimilarities between public and private finance.
Ans. Dissimilarities between public and private finance:
Ans. Importance of Public Finance.
() Increasing the growth rate of Economy. The role of public expenditure
in economic development lies in increasing the growth rate of the
economy, providing more employment opportunities, raising incomes
and 'standard of living, reducing inequalities of income and wealth,
encouraging private initiative and enterprise and bringing about regional
balance in the economy. All these are achieved by spernding
on public
works, agriculture, industry, transport and communications, power,
financial and banking institutions, social services etc. The government is
able to increase public expenditure through a budget deficit.
(ii) Emergence of Social Services. The importance of public finance
as also
can
increased due to emergence of social services which be performed
more conveniently, efficiently and also at the minimumn cost as against
individual. Such services are education, health, social security- and
(in) Differences in Objectives. There is' a fundamental difference in the
protection from certain uncertainties. The need for such social services
is increasing day by day and with them is increasing the importance of
public finance.
(i) Reduction in Economic Inequalities. Public finance can play a vital role
in reducing economic inequalities which is the source of dissatisfaction,
class-struggles, poverty etc. The state can levy heavy taxes on richer
sections of the society and thereby spend the income so received on
"(iv) Nature of Expenditure. There are differences in the nature of expenditure
providing food, cheap housing, free medical aid etc. for the poorer
sections of the society. Similarly, heavy taxes can be imposed on the
use of harmful commodities, such as harmful drugs, wine, opium,
cigarettes etc.
(iv) Increases Employment. Public finance can play vital role in incréasing
employment which is a major problem of almost all the countries of the
world. The Governments these days establish, give grants, subsidies, gant
exemption from excise duty, sales tax etc. to encourage employment
UNIT 1:THEORY
OF
3
oriented cottage and small-scale industries.
an indispensable measure Unbalanced budget also
of increasing volurne of emplayment during
depression.
(v) Capital Formation. The economic
developrment, as is well
depends upon the rate of capital-formation in the country. Public known,
finance
can play a vital role in increasing the rate of
capital-formation in the
.economy. It can be managed in such a manner as
to step up the rate of
savings and investment in the econony. For example, the tax system can
be so managed as to discourage the consunption of non-essential goods
and thereby release the resources for being invested in more productive
industries. Further, the tax systern can be employed to increase the rate
of private saving which in turn, can be used as the basis for an increase
in public investment.
(vi) Industrial Development. The governments these days give subsidies and
grants to different industries to enable thern to increase the production of
essential goods in the country. These subsidies and grants have special place
in the government expenditure of underdeveloped and backward countries.
() Adjustment between Income and Expenditure. An individual determines
his expenditure on the basis of his income. He prepares his family
budget on his expected income during the month. On the other hand.
the government first estimates about its expenditure and then finds out
means. to raise the necessary income. As pointed out by Bastable, The
individual says, I can spend so much', the Finance Minister says, 'I have
to raise so much'.
(i) Elasticity of Finance. Public Finance is more elastic than private finance.
There is not much scope for changes in private finance while drastic
changes can be made in government finance. For example, a private
individual cannot effect any special increase in his income. As against
this the government can increase its income by imposing fresh taxes on
the people.
objective of private and public finance. The motive of private expenditure
is personal benefit whereas the objective of public expenditure is social
benefit. An individual always tries to save and a firm tries to earn profit.
But there are no such considerations on the part of the government,
except the public welfare. However, there are some public enterprises
which are run on profit that is utilised for public welfare.
between the two. An Individual's expenditure is governed by his habits,
customs, fashions etc.. On the other hand, government expenditure
depends on its economic and social policies, like removing unemployment
and poverty, reducing income inequalities, providing infrastructure
facilities, etc.
(v) Compulsion. There is compulsion in public finance. People have to pay
taxes. If they do not pay, they are punished by fine and imprisonment.

4 Shiv Das DELHI UNIVERSITY SERIES
to pay them money. The
An individual or a firm cannot force anybody
to lend
same is the case with loans. The government can force the people
any person
it during war or enmergency. But
an individual cannot compel
to lend him money.
his money
(vi) Law of Equi-marginal Utility. The private individual spends
on various items in such a manner as to secure equal marginal utilities
from them. It is only b equalizing the various marginal utilities that
he
can secure maximum utility out of his expenditure. The government
on
as a private
the contrary, does not give as much importance to this law
individual does. Modern governments sometimes incur certain types
of expenditure from which they do not derive any advantage, but they
often incur this expenditure to satisfy certain sections of the community
(vi) Present vs. Future. An individual is more concerned with his present
needs and tries to satisfy them. Life being uncertain and short, he has
his immediate gain or profit in view. On the other hand, government is
a permanent organisation. Only the ruling party changes and the ruling
party, the government is concerned not only with the welfare of present
generation but also it has concern for future generations. It therefore,
undertakes and spends on those activities which also benefit future
generations
(vii) ature of the Budget. A surplus budget is always good for a private
individual. But a surplus budget may not be good for the government.
It implies two things: () The government is levying more taxes on the
people than is necessary, (ii) The government is not spending as much on
the welfare of the public as it should. Keynes supported a deficit budget
to meet the situation created by depression. Further, the government
budget is passed by the parliament. The budget of an individual or firm
is a private affair without any controlling authority,
(ix) Nature of Borrowing. In case of an individual, there can be no internal
borrowing, An individual cannot borrow from himself. He can borrow
only from an external agency. The State, however, can borrow both from
internal as well as external sources. It borrows not only from its own
citizens, but also from foreigners.
Q. 5. Explain the role of Government in an economic system.
Ans. The basic economic problem of scarcity arises from the fact that on
account of qualitative as well as quantitative constraints, the resources available
to any society cannot produce all economic goods and services that its members
desire to have. Therefore, an economic system should exist to answer the basic
questions such as what, how and for whom to produce and how much resources
should be set apart to ensure growth of productive capacity. The modern society,
in general, offers three alternate eonomic systems through which the decisions
of resource reallocation may be made, namely- the market, the government and
a mixed system where both markets and governments simultaneously determine
resource allocation.
Adam Smith is often described as a bold advocate of free markets and minimal
governmental activity. However, he saw an important resource allocation role
UNIT 1:THEORY OF PUBLIC FINANCE 5
for government when he underlined the role of government in national defence,
maintenance of justice and the rule of law, establishment and maintenance of
ighly bneficial public institutions and public works which the market may
fail to produce on account of lack of sufficient profits. Since the 1930s, more
specifically as a consequence of the great depression, the state's role in the
economy has been distinctly gaining an importance and therefore, the traditional
functions of the state as described above, have been supplernented with what is
referred to as economic functions (also called fiscal functions or public finance
functions). While there are differences among different countries in respect to the
nature and extent of government intervention in economies, all governments are
still expected to playamajor role. This comes out of the belief that governent
intervention will invariably influence the performance of the economy in a
positive way.
Richard Musgrave, in his classic treatise The Theory of Public Finance (1959).
introduced the three branch taxonomy of the' role of government in a market
economy. He believed that, for conceptual purposes, the functions of government
are to be separated into three, namely, resource allocation (efficiency), income
redistribution (fairness) and macroeconomic stabilization. The allocation and
distribution functions are primarily microeconomic functions, while stabrlization
is a macroeconomic function. The allocation function aims to correct the sources
of
inefficiency in the economic system while the distribution role ensures that
the distribution of wealth and income is fair. Monetary and fiscal policy, the
problems of macroeconomic stability, maintenance of high levels of employment
and price stability etc. fall under the stabilization function.
LLO6. Discuss the fiscal function of the government in a developing economy.
Ans. There are three major fiscalfunctions of the government:
1. The Allocation Function. Resource allocatjon refers to the way in which the
available factors of production are allocated among the various uses to which
they might be put. It determines how much of the various kinds of goods and
services will actually be produced in an economy. One of the most important
functions of an economic system is the optimal or effcient allocation of scarce
resources so that the available resources are put to their best use and no wastages
are made.
The private sector resource allocation is characterized by market supply and
demand and price mechanism as determined by consumer sovereignty and
producer profit motives. The state's allocation, on the other hand, is accomplished
through the revenue and expenditure activities of governmental budgeting. In
the real world, resource allocation is both market determined and government
determined.
Efficient allocation of resources is assumed to take place only in perfectly
competitive markets. Irn reality, markets are never perfectly competitive. Market
failures which hold back the efficient allocation of resources occur mainly due to
the following reasons:
• Imperfect competition and presence of monopoly power in different
degrees leading to under-production and higher prices than would exist
 6 Shiv Das DELHI UNIVERSITY SERIES
available to
under conditions of competition. These distort the choices
consumers and reduce their welfare.
• Markets typically fail to provide collective goods which are, by their very
nature, consumed in common by all the people.
• Externalities which arise when the production and consumption of a good
or service affects people and they cannot influence through markets the
decision about how much of the good or service should be produced, e.g.
pollution.
Factor immobility which causes unemploymernt and inefficiency.
• Imperfect information,
•
and Inequalities in the distribution of income and wealth.
According to Musgrave, the state is the instrument by which the needs and
concerns of the citizens are fulfilled and therefore, public finance is connected
with economic mechanisms that should ideally lead to the effective and optimal
allocation of limited resources. This logic, in effect, makes it necessary for the
government to intervene in the market to bring about improvement in social
welfare. In the absence of appropriate government intervention, market failures
may occur and the resources are likely to be misallocated by too much production
of certain goods or too little production of certain other goods. The allocation
responsibility of the government involves suitable corrective action when private
mtkets fail to provide the right and desirable combination of goods and services.
Briefly put, market failures provide the rationale for government's allocative
function.
A variety of allocation instruments are available. by which governments can
influence resource allocation in the economy. For exanple,
government may directly produce the economic goods (for example,
electricity and public transportation services).
government, may influence private allocation through incentives and
disincentives (for example, tax concessions and subsidies may be given for
the production of goods that promote social welfare and higher taxes may
be imposed on goods such as cigarettes and alcohol).
•
government may influence allocation through its competition policies,
merger policies etc which will affect the structure of industry and
commerce (for example, the Competition
Act in India promotes competition
and prevents anti-competitive activities).
governments' regulatory activities such as licensing, controls, minimum
wages, and directives on location of industry
influence rèsource allocation.
• government sets legal
and administrative frameworks, and
• any of a mixture
of intermediate techniques may be adopted by governments.
Maximizing social welfare is one of the primary
and most commonly manifest
reaons for government intervention in the market.
However, it is also possible
that instead of eliminating market distortions,
sometimes governments may
contribute to generate them. The possible sources of,
this type of government
failures are inadequate information, conflicting
objectives and administrative
costs involved in government
intervention.
UNIT 1: THEORY OF PUBLIC FINANCE 7
2. Redistribution Function. The distributive function of budget
is related to
the basic question of for whom should an econorny produce goods and services.
As such, it is concerned with the adjustrnent of the distribution of income and
wealth so as to ensure distributive justice namely, equity and fairness. The
distribution function also relates the manner in which the effective demand
over the cconomic goods is divided among the various individual and farmily
spending units of the society. Effective demand is deternined by the level of
income of the households and this in turn deterrnines the distribution of real
output among the population.
The distribution function of the government aimns at:
redistribution of income to achieve an equitable distribution of societal
output among households.
• advancing the well-being of those members of the society who suffer from
deprivations of different types.
• providing equality in income, wealth and opportunities.
• providing security for people who have hardships, and
• enuring that everyone enjoys a minimal standard of living.
A few examples of the redistribution function (or market intervention for socio
economic reasons) perforned by governments are:
Taxation policies of the government whereby progressive taxatiorn of the
rich is combined with provision of subsidy to the poor households.
Proceeds from progressive taxes used for financing public services,
especially those, that benefit low income households (example, supply of
essential food grains at highly subsidized prices to BPL households).
• Employment reservations and preferences to protect certain segments of
the population.
• Regulation of the manufacture and sale of certain products to ensure the
health and well-being of consumers, and
• Special schemes for backward regions and for the vulnerable sections of
the population.
In modern times, most of the egalitarian welfare states provide free or
subsidized education and health care system, unemployment benefits, pensions
and such other social security measures. There is, nevertheless, an argument that
in exercising the redistributive function, there exists a conflict between efficiency
and eqeity. In other words, governments redistribution policies which interfere
with producer choices or consumer choices are likely to have efficiency costs
or deadweight losses. For example, greater equity can be achieved through high
rates of taxes on the rich; but high rates of taxes could also act as a disincentive
to work, and discourage people from savings and investments and risk taking.
This in turn will have negative consequences for productivity and growth of the
economy. Consequently, the potential tax revenue may be reduced and the scope
for government's welfare activities would get seriously limited. As such, an optimal
budgetary policy towards any distributional change should reconcile the conflicting
goals of efficiency and equity by exercising an appropriate trade off between them.
In other words, redistribution measures should be accomplished with minimal
efficiency costs by carefully balancing equity and efficiency objectives.
8 Shiv Das DELHI UNIVERSITY SERIES
3. Stabilization Function. The theoretical rationale for the stabilization
a
function the government is derived from the Keynesian proposition that
price
market economy does not automatically generate full employment and
stability and therefore the governments should
pursue deliberate stabilization
policies. Business cycles are natural phenomena in any economy and they tend to
occur periodically. The market system has inherent tendencies to create business
or to resolve
cycles. The market mechanism is limited in its capacity to prevent
the disruptions caused by the fluctuations in economic activity. In the absence
of appropriate corrective intervention by the government, the instabilities that
ocer in the economy in the form of recessions, inflation, etc. may be prolonged
for longer periods causing enormous hardships to people especially the poorer
sections of society. It is also possible that a situation of stagflation (a state of affairs
in which inflation and unemployment exist side by side) may set in and make
the problem more intricate. The stabilization issue also becomes more complex
as the increased international interdependence causes forces of instability to get
easily trarsmitted from one country to other countries, This is also known as
'contagion effect'.
The stabilization function is one of the key functions of fiscal policy and aims
at eliminating macroeconomic fluctuations arising from suboptimal allocation.
The stabilization function is concerned with the perfornance of the aggregate.
economy in terns,of:
() Labour employment and capital utilization,
(i) Overall output and income,
(iin) General price levels,
(iv) Balarnce of international payments, and
(o) the rate of economic growth.
Government's fiscal policy has two major components which are important in
stabilizing the economy:
() an overall effect generated by the balance between the resources the
government puts into the economy through expenditures' and the
resources it takes out through taxation, charges, borrowing etc.
(i) a microeconomic effect generated by the specifíc policies it adopts.
Government's stabilization intervention may be through monetary policy as
wellas fiscal policy. Monetary policy has a singular objective of controling the
size of money supply and interest rate in the economy which in turn would affect
consumption, investment and prices. Fiscal policy for stabilization purposes
attempts to direct the actions of individuals and organizations by means of its
expenditure and taxation decisions. On the expenditure side, Government can
chose to spend in such a way that it stimulates other economic activities. For
example, government expenditure on building infrastructure may initiate a series
of productive activities. Production decisions, investments, savings etc. carn be
influenced by its tax policies.
Q.7. Write short note on welfare economics.
Ans. Normative Economics or Normative Analysis or Welfare Economics. It is
the study of how the economy should work with a subjective representation of
what has occurred, what is happening, or what is expected to happen.
UNIT :THEORY OF PUBLIC FINANCE 9
1
(ii) Welfare economics refers to the branch of economic
theory concerned
with the social desirability of alternative economic states.
(ii) Welfare economics, is the branch of economic theory concerned with the
social desirability of alternative econornic states.
(iv) The thcory is' used to distinguish the circunstances under which markets
can be expected to perform well from those under which markets fail to
produce desirable results.
(v) Welfare economics relies on certain basic economic tools, particularly
indifference tools.
(vi) Normative economics often is accompanied by tools of positive analysis
by interpreting results of econometric models and then suggesting a
policy prescription to achieve some goal (ie, What should be done).
Q.8. Give the difference between positive and normative economics. Explain
the effects of resource use?
Ans. Positive economics is a scientific approach to analyse the cause and effect
relationship between economic variables. It is based on data or facts. For example,
the statement, "India is the second most populated country after China" is based on
census data which is verifiable. Positive economics helps governments to initiate
moves to deal with a particular problem. Looking at the above statement which is
based on data, the government will engage its departments to look into problems
of population. So Positive economics is objective in nature.
Normative economics on the other hand, is based on value judgments about
what is. desirable or what should be done to achieve the desired outcome. So,
unlike Positive economics, Normative economics is subjective in nature. It is
designed to formulate recommendations based on certain underlying values and
predetermined criteria so as to achieve a goal which should be accomnplished in
the best interest of the society. Consider the statement regarding population
"Higher growth of population is an obstacle to economic development" This statement
gives value judgment about population growth and indicates that excess
growth of population should be reduced to achieve economic development. In
order to verify such a proposition, the government will collect data not only
of total population but also of people who are poor and unable to get benefits
of development. Accordingly the government can formulate the best policy to
control population which is of course, a long-run problem.
Note that both Positive and Normative economics are complementary to each
other and help in achieving the desired goal through proper policy formulation.
Efficiency Criteria for Normative Evaluation. It is a well known fact that
human wants are unlimited but resources needed to satisfy them are limited.
Hence, resources must be used judiciously and efficiently so that they are utilised
in the best way without generating waste. Efficient use of resources among
others implies that their distribution among population is such that it generates
maximum social welfare. In a society where individuals are allowed to pursue
their own self interest, efficiency criteria aims at achieving a situation where no
one is harmed due to conflicting goals of different economic agents.
Analysing efficiency Criteria. Nornmative economics uses the concepts of
Microeconomics such as, relevant assumption, logic, mathematical tools etc.
 10 Shiv Das DELHI UNIVERSITY SERIES
UNIT 1: THEORY OF PUBLIC FINANCE
resource allocation, the 11
Continuing with the above mentioned problem of point E(point of intersection). Accordingly,
efficiency criteria requires that resources be allocated to the production of each efficient level of output as per efficiency corresponding to point E, Q* is the
over so that criteria of normative approach. Q*
good each period of output can guarantee maximun social welfare. level
=
Marginal Social Bencfit (MSB) Marginal Social Cost (MSC) In the lower panel of the diagrarm, TSB
called marginal conditions for efficient resource allocation. Let
us and TSC curves are shown. TSB curve
This increases slowly with increase in
concepts by using proper diagrammatic tool. quantity of good till a maximum point is
explain these reached, then it falls. TSC curve rises with increase
Às we know that production of goods and services provide benefits to the Social Benefit is reached at that level of quantity
in guantity of good. Maximum
society, but there is a cost involved to produce these goods as well. The Total of output which is determined
when the difference between TSB and TSC is
Social Benefit (TSB) is the total amount of satisfaction derived from production the maximum. In the diagram the
maximum difference between TSB and TSC occurs when
of certain given quantity of goods during a given period of time. the tangents drawn on
these curves become parallel to each other. In the lower
The Marginal Social Benefit (MSB) of a good is the extra benefit obtained parel, the tangent at
point A on the curve TSB and the tangent at point B on TSC curve are
by making one more unit of that good available for that period. MSB can be parallel to
each other indicating that the distance AB is the maximun between TSB
increased as the maximum amount of money given up by people to obtain the and TSC
which corresponds to output level Q*. It is to be noted that MSB and MSC are
extra unit of the good. MSB is assumed to decrease if more and more units of the
also defined as respective slopes of TSB and TSC as
good is made available. indicated by the respective
tangents on these curves. MSC = MSC happens at one point where
The Total Social Cost (TSC) of a good is the value of all resources necessary to these tarngents
become parallel to each other which takes place at point A
make a given quantity of the good during the given time period. The Marginal ard B respectively.
Hence the efficient level of output can be determined as
Social Cost (MSC) of the good is the minimum sum of money required to pay Q which corresponds
to quantity between MSB and MSC and maximum total benefit over total cost
for hiring the units of input needed to produce that extra unit of the good. The
level of technology is assumed to be given. It is assumed that MSC increases with according to efficiency criteria.
extra units of good produced. Q.9. What is production possibility curye? How can it be derived from the
Determination of efficient quantity of good. As stated above, the efficient production contract curve? [2003, 200s
Ans. The Production Possibility Curve (PPC) or transformation curve indicates
quantity of good required to maximise welfare is determined at that point where
MSB = MSC the various alternative combinations of goods and services that an economy can
This is given in the upper panel of the given diagram. produce when the resources are all fully employed. In other words, it tells us
about the technological choices open to an economy. PPC is derived by mapping
the production contract curve. Each point on the contract curve and PPC describes
MSC
an efficiently produced level of X and Y. The PPC, drawn in Diagram 1, shows
Panel
the various combinations of X and Y that an economy can produce by fully
Upper utilising all of its L and K (abour and capital) with the best technology availabl.

MSB
QuantityY pef Time Period
TSC
Price -TSB
panel

and Y

Lower Cost

Benefit,

X Xs
Good X
O Quantity per Time Period Production Possibility Curves
DIACRAM1
In the upper panel, MSB is given as a downward sloping curve since MSB
falls with additional quantity of good. The MSC curve is
upward sloping since The locus of points of tangency of the X and Y iso-quants is called the
cost of making additional output increases. Both MSB contract curve of production. On the aves, the given quantities of capital (K) and
and MSC are equal at
12 Shiv Das DELHI UNIVERSITY SERIES UNIT 1: THEORY OF PUBLIC FINANCE 13
X are plottcd
labour (L) are measured in Diagram 2. The iso-quants of conmodity
are plotted with origin
origin in the south-west corner and iso-quants of
Y
with
in the north-east corner.

L As
A1
A -B1
Consumer A Consumer B

E The indifference curves of A and B are downward sloping and convex to the
V 3 origin. The ratio of exchange between the goods X and Y for the consumers are
given by their respective marginal rate of substitution (MRS) which is the slope of
Ly their indifference curves. MRS shows that how much of good Y must be given up
Edgeworth Box Diagram and Contact Curve
to get one extra unit of good X. This is also interpreted as marginal willingness
DIAGRAM 2 to pay of the consumer. MRS =.Let the MRS of consumer A be denoted as

The curve is of particular importance as it is the locus of Pareto-efficient

MRS, and that of consumer B be MRS

Combinations of capital and labour between the firms. The trade between the consumers A and B and the economic efficiency of
We have labelled the points on the PPC to correspond to the points on the exchange can be shown in Edgeworth box diagram as shown here.
production contract curve. For instance, point A in Diagram 2, tells that given
the quantity of x2, the maximum quantity of y that can be próduced with given
is y. Similarly point B tells that given the quantity of x as x, the
factor K and I
maximum quantity of y that can be produced with given factor K and K is ys.
B
B

Production possibility curve is downward sloping because in order to produce Ag

more of good x eficiently, the economy must transfer the factors from the
production of good y, which results in lower production of goody. A downward
sloping curve can be a straight line, convex or concave to the origin. The difference
is that of slope. The slope of PPC is called Marginal Rate of Trarnsformation of x
for y (MRTxy). It measures the amount by which the economy must reduce its
output ofy in order to release enough L and K to produce one more unit of x.
Q. 10. Draw a contract curve for an economy which is inhabited by two
consumers who trade in two goods. Do you agree with the statement that since
all points on a contract eurve are efficient, they are all equally desirable from
a social point of view?
(2002
X
Edgetworth Bor Digram
The indifference maps of A and B have been juxtaposed in a manner such that
A's utility given by his indifference curves increases in the North-East direction
and B's utility given by indifference curves increases in South-West direction. This
obviouslý means that given the amount of X and Y, increase in A's consumption
has to be associated with decrease in B's consumption and vice-rersa.
In the Edgeworth box shown above A's indifference curves are given as Aj, Ag
and so on where A, > A, > Aj. On the other hand, B's indifference curves
A

and
Ans. To examine efficiency in allocation of goods among.consumers let us start from point O and are denoted as B,, B, and B, where B, > B, > B;
assume that can take
The joint consumption of goods X and Y by the consumers A and B
• there are two consumerS, A and B. are commn to indifference curves. These points
place at the points which their
• there are two goods, X and Y. are either points of intersection or points of tangency such as (M, N) or (D, E, F)
• both people have complete information about each other's preferences.
respectively.
• there are no transaction costs.
Efficiency in exchange. It can be proved that exchange of X and Y between the
The preference set of the consumers A and B given by their indifference consumers is efficient only at the tangency of their indifference curves. To prove
If consumers move
maps. this take the point of intersection M where B, intersects A,.
away from M to say E then consumer A's welfare is not affected.
14 Shiv Das DELHI UNIVERSITY SERIES UNIT 1
:THEORY OF PUBLIC FINANCE n 15
Both the points M and E
are on same indifference curve A2, but B's welfare
a It can also be stated that a situation in
on a higher indifference curve B,. Similarly which it is impossible to make any
increases at point E because this is consumer B. Note
one better-off without
making someone worse-off is said to make anyone
movement from M to F increases A's welfare without affecting off without making someone worse-off is better
indifference curves of A and B. It is also said to be Pareto-optirmal or
that E, F are points of tangency between efficient.
Pareto
E or F to point Mdecreases welfare
clear that the reverse movement from point For attaining a Pareto-efficient situation,
of one of the consumers
even if it may increase welfare of the other. the following three marzinal
as there is maximum welfare of both the conditions must be satisfied:
Hence, tangency points are efficient () Efficiency of distribution of commodities among consumers,
consumers jointly. These are also called Pareto optimal points of allocation. (efficiency in
consumers are equal which was exchange);
But at the points of tangency the MRS of both (i) Efficiency of the allocation of factors among firms (efficiency of
not the case at the intersection points so that there was scope for reallocation. production);
consumers A and B (ii) Efficiency in the allocation of factors among commodities (efficiency
Hence the condition for efficiency in exchange between the product-mix, or composition of output).
in the
=
is given by MRS,,A MRS,. Weaknesses. This criterion suffers from the following
we get
Joining the tangency points through the origins O and O', i.e., ODEF (0) This criterion can not
weaknesses:
evaluate a change that makes some individuals
the locus on which the MRS are equal. This is called "Edgeworth contract curve". better-off and others worse-off. Since most of the government
Hence trading on the Edgeworth contract curve will lead to efficiency in policies face
such situations, this criterion is of limited use in real-world situation.
exchange. (ii) A Pareto-optimal situation does not ensure the maximisation
Given the respective prices of X and Y as P, and P, in the market efficiency of the social
welfare. Pareto optimal state is a necessary but not a sufficient condition
P
implies that at the points of tangency the price ratio, i.e., is also same. for maximum social welfare.
Attainment of marginal conditions. For attaining Pareto-optimal state, three
*marginal conditions stated above must be satisfied. We can explain the satisfaction
of these conditions using Edgeworth box diagram based on 2 x 2 x 2 model.
B
This model is based on the following assunptions:
There are two commodities X and Y.
There are two consumers A and B.
- There are two factors labour (L) and capital (K).
There are two firms.
This is given in diagram where budget line JK is also tangent to indifference The goal of consumers is maximum satisfaction, and that of producers
curves of and B both at point-E. Given the initial allocation M, Movement maximum profit.
towards point E ensures efficiency finally at E There is perfect competition in commodity and factor markets.
where MRS A = MRS B = There is full employment of the factors of production.
1. Optinum distribution (exchange) of Commodities among
the consumers.
Pareto Optimality in exchange is achieved when allocation of commodities among
11. What is Pareto-optimality? (1996, 2002, 2004(E), 2005(E)
the consumers is suclh that it is not possible to increase the satisfaction of any person
Or
twithout reducing the satisfaction of someone else. This condition will be achieved
"A perfectly competitive economy results in an efficient distribution of
goods among consumers." Explain with the help of Edgeworth box diagram. when marginal rate of substitution between any two commodities is the same
for every consumer.
(1998, 1999
Ans. This criterion is named after the famous Italian In short:
economist-Vilfredo MRSA, = MRSy
Pareto.
According to this criterion any change that makes at least one We can show this' with the help of Edgeworth box diagram. In the diagram
individual
better-off and no one worse-off is an improvement in social CC is contract crve and points on this curve only satisy the Pareto-optimality
a change that makes no one
welfare. Conversely,
better-off and at least one worse-off is a decrease in condition.
social welfare.
 SERIES UNIT 1:THEORY OF
PUBLIC FINANCE D 17
16 Shiv Das DELHI UNIVERSITY Attainment of this condition can also be explained
with the help of Edgeworth
box diagram. In the diagrarm CC is contráct curve.
We know, only points on the
B contract curve fulfill Pareto Optimality Criterion.
B's Indifference Point H is inefficient, since a
B24 curves reallocation of the given K and L between the producers
of X and Y such as
A4 to reach any point from c to d inclusive
results in the increase of at least one
BA commodity without a reduction in the other.
3. Efficiency in the composition of output (product mix). This
condition states
that to optimise the social welfare in the Paretian sense the bundle of factors used
and
AOA goods produced in the economy be so organised that greater
A's Indifference satisfaction of one person is
Edgeworth Box of Exchange impossible without loss for another. The fulfillment of this condition
curves requires that
marginal rate of technical substitution (MRT) between the two products must be
Any other distribution off the contract curve is inefficient. For example, point equal to Marginal Rate of Substitution (MRS) between the two products for the
h is inefficient, since a redistribution of the commodities such
as to reach any
consumers (A and B). In short:
a and b increases the utility of both consumers. A movement to
a
point between
increases the utility of B without reducing the utility of A. MRPT,, = MRSA,, = MRSB,
Similarly, the distribution implied by b increases the utility of A without
reducing the utility of B. Thus, all the points from a to b represent improvements
in social welfare compared with the distribution at h. By reversing the argument M

it can be seen that a movement from a point on the contract curve to a point off it, B
results in a decrease in social welfare. Thus, the contract curve shows the locus of
Pareto-optimal or efficient distribution of goods between consumers. This curve
is formed from the points of tangency of the two consumers' indifference curves,
that is, points where the slopes of the indifference curves are equal.
In other words, at each point of the contract curve the following condition is
satisfied: Q. 12. Write a note on perfect competition and Pareto optimality. (2004(R)
MRSy ,= MRS°y Or
2. Optimum allocation of factors among the firms, This is the second condition "Perfect competition is economically efficient." Explain. (1997
of Pareto-optimality and is known as efficiency in production. It requires that. Ans. Perfectly competitive markets and Pareto optimality. The central
factors are allocated to the various commodities that it is not possible to increase the problems of any economy such as what, how, and for whom to produce arise
output of any commodity by re-allocating factors without causing decrease in the primarily due to scarcity of resources. If resources are not efficiently utilized or
production of another. This condition will be fulfilled when marginal rate of are being wasted, this implies that household's consumption is not as high as it
technical substitution (MRTS) between L and K is the same for both X and Y should be. If labour/capital is unemployed then their potential current output
produced by both the firms. That is: is lost. they are employed then obviously output will increase and everyone
MRTSLK= MRTSLK could be made better of.
However, it should be noted' that full employment or availability of resources
alone is not enough to ensure that they are efficiently utilized or are not being
wasted,
Y Isoquants
There are two possible sources of inefficiency:
(0) If industry's output is not produced at its lowest possible cost, then
resources are being wasted as are being used inefficiently. Because if less
costly methods are adopted, resources can be saved to produce other
goods. This relates to productive efficiency.
X Isoquants (i) If too much of one product and too little of another product is produced
Edgeworth Box of Production is
then resources are being used inefficiently. Because the good, which
 UNIVERSITY SERIES 1:
18 Shiv Das DELHI UNIT THEORY OF PUBLIC FINANCE 19
or negative
produced in large quantity, has its
marginal utility as zero The efficiency in exchange in such economy can be achieved
production is very by the following
good, whose
while the marginal utility of the other resources.
condition:
to allocative efficiency of
low, will be very high. This refers someone hurting someone MRS W .whereMRS Marginal Rate of Substitution between leisure
without
Inefficiency implies that we could help Cost of
and consumption or slope of the leisure
we can make one household better off at the -Consumption indifference curve
else. Efficiency implies that W Price of labour or slope of the budget line
worse off. This condition of efficiency is called Pareto
making another household The efficiency in production is achieved by the following condition:
great Italian economist Pareto.
efficiency or Pareto optimality in honour of
The Pareto optimality criterion is satisfied under the condition of perfect MP W
It has prodüctive
...where[MP Marginal Product of Labour or slope of production function
competition. It is known that perfect competition is efficient. Efficiency in both production and consumption simultaneously is achieved by
operates at the minimum point of long-run average cost,
efficiency since th firm the following condition:
efficiency because
thus minimising the cost of production. It has also allocative MRS = MP =W
equal to marginal cost so that as a result the consumer's
the equilibrium price is The indifference curve shows the individual's preference for good x and leisure.
and producer's surplus combined is maximised. The indifference curve is upward sloping with good x and labour because labour
two
In ageneral equilibrium framework with two individuals, two goods and. increases with decrease in leisure and accordingly good x also increases. The
factors of production, the Pareto optimality conditions, under the assumption of
slope of indifference curve is MRS showing the amount of leisure to be sacrificed
perfect competition both in commodity and factor markets and constant returns
to consume one unit more of good x.
to scale (since Long-run average cost is minimum) are given as follows:
() Efficiency in exchange. The condition for efficiency in exchange which Indifference curve
implies optimal allocation of goods among consumers is given by: good
Budget
MRS of person one is equal to MRS of the second person line
E
MRSperson 1 = MRSperson 2

Production
() Effciency in factor substitutionyproduction. This implies allocation of function
factors among two firms. The condition is given as: Profit= r

MRTS between the two factors is equal for all firms.

(ii) Efficiency in product mix. This implies optimal compositior of output in Labour
the economy and thus optimal allocation of resources. The condition for
this is given as: The budget line is defined as
MRS of both the persons is equal to MRT of both the goods: B=n+ WL

where B is the total revenue and total cost of the individual as producer and
..where MI
| = Rat of
Date of Substitution
Technical Substitution
MRTS income of the individual as consume.
MRT= Marginal Rate of Transformation
n is the profit in terms of good x. Some level of n, i.e., n* is always required for
Because in perfect competition, all three marginal conditions for Pareto optimal the individual when he does not work.
resources are satisfied, perfect competition is considered as an ideal market W is the wage rate in terms of good x which he must eam/pay to himself for
structure. This means scarce resources are used in mnost efficient way in perfect working or providing labour. WL = total wage billor earnings of the individual
competition. for supplying L units of labour.
Q. 13. If there is only one individual in society, how ecoomic efficiency in The slope of the budget line is W.
production and exchange (and maximum social welfare) is achieved? Explain The production function exhibits amount of good x to be produced by working
with the help of diagram. =
Ans. If there is only one individual in the society the individual will act as a
Or supplying labour. The slope of production function is MP, where MP
AL" 4
producer, supplier of factor and consumer. ie, change in quantity of good x happening due to extra unit of labour provided.
Let the individual supplies of labour be (L). Point E in the diagram is the point of tangency between budget line, indifference
Let the output he produces is x which he also consumes. curve and production function satisfying the condition
So this becomes 1 = W
x1 x1, i.e., one consumer, one factor and one good economy. MRS =MP
 SERIES
20 Shiv Das DELHI UNIVERSITY UNIT 1 : THEORY OF PUBLIC FINANCE
21
and consumption of good The equilibrium showing optimum anount of goods x
Accordingly, the optimum amount of production and y to be produced to
is L* at given wage and maximize revenue of the producer is attained when one iso-revenue
x is x* and optimum amount of labour to be provided is tangent to
pPC. Iso-revenue (R) is given as R = P + Py. This is a straight
prices. automatically lead to line with slope
Q. 14. Show how conditions of perfect competition So equilibrium of production of x and y requires that
Pareto optimality in product mix. Use diagrams and
state the underlying MRPT, = P, which
assumptions. happens at point E in the adjoining diagram 1.
Ans. Pareto optimality in product mix refers to efficiency in
consumption and
In the diagram 1, the is0-revenue curve R is tangent to PPC at E giving
production or factor substitution simultaneously. maximum of y = y1 and x X
quantities in the economy.
The assumptions of the model are as follows: Since the economy has two consumers A and B, the quantities and y1 will
say, A and B; I
() 2 x 2 x 2 economy, i.e., two individuals, have to be distributed among them giving their preferences and prices of goods,
two goods say x and y P, and Py Since the consumers aim to maximize their utilities, the condition for
and two factors of production, say L and
K.
P MRSB
r
(i) The prices of goods say P, and P, prices of factors, say and respectively
w this is given byMRS,= P,
and the technology are given.
(ii) The factors L and K are homogeneous and perfectly divisible and their
quantities are exogenously given.
(io) The preferences of consumers A and B have properties of ordinality,strict
convexity and diminishing marginal rate of substitution between two
goods x and y, non-satiation and continuity.
(v)There is absence of externalities in consumption and production. R2

(o) The goal of each consumer is to maximize his/her utility given the income R
PC
constraint.
DIAGRAM1
(vin) The goal of the producer is to maximize profit.
(viii) The factors are owned by corsumers. tir.
This equation means that the slopes of indifference curves of A and
B
(ix) There is perfect competition in both commodity and factor markets.
The Pareto optimality in product mix requires that the marginal rate of product respectively are equal to the ratio of prices of goods. This is given in the given
transformation between the two goods and y (MRPT,„) must be equal' to diagram 2.
In the diagram 2, the indifference curves of A and B touch each other at point
the marginal rate of substitution between the goods x, y (MRS,) for both the
consumers A and B. In symbolic form this is given as on the price line MN having slope
ewhich is located
MRPT,, = MRS = MRS
MRPTy gives the idea about maximizing the output combination of goods The indifference curves of A and B
move opposite to each other because, given
y
x and y by efficiently utilizing the factors, Labour (L) and Capital (K). Under y
the amount of x and in the
economy, higher the quantities of x and for A will
same for B and rice-ersa.
perfect competition the factor prices are given. be associated with lower quantities of the
The efficient use of factors to maximize output of x and y requires that the
marginal rate of technical substitution between factors L and K equal the ratio of M
their prices. This implies
MRTS LK= MRTSLK B.

This condition is satisfied when various iso-quants

of x and y are tangents to
one ánother showing a locus of combinations
of x and y output produced by
optimum utilization of L and K. The locus showing maximum
possible x and y
combinations is called Production Possibility Curve (PPC) as
given in Diagram 1 DLAGRAM2
MRPT,, is slope of PPC.
 SERIES UNIT 1:THEORY OF PUBLIC FINANCE 23
22 Shiv Das DELHI UNIVERSITY
and dCy = WdL, + rdky
MC, competition.
Now MRPT,y which is equal to MC, under perfect = =
On PPC, dL, -dy dk, -dK,
- MRSB MC, dC,
MRS^x.y
p MCy
= MRSB
Hence, MRPT,, = MRSA MC,
dC, dy
dz
MCy dC,
, we can combine the above two diagrams to show this in the
Through
MC WdL, + rdk, dy
MC, WdLy + ráky dr
diagram 3.
MC, WdL, + rdk, dy
MCy W-dL,) + (-dK)° dz

MC, dy
MCy
y1
MC, -dy = MRPTy
YA-R MCy dx
MC,

SlaiyDas
A PPC MRPTy = MCy
DIAGRAM3 MCL
But MCy
In the given diagram, the economy eficiently produces x and y, quantities of
z and y at point on PPC.where iso-revenue with slope P is tangent to it.
MRPT
Now x and y will be distributed among A and B at prices P, and P,
This takes place at point e' where the price line M has same slope as R (both Q. 15. What are the major sources of competitive market failures? In each
are parallel) and indifference curves of A and B also touch each other. case, explain briefly why the competitive market does not operate efficiently.
[1997, 1998, 1999, 2000, 2003
s
At e', A's share of x is Oxa and B's share xAX1.
Similarly A's share of y is OyA and the rest yAyi is B's share of y. Ans. It is true that there is an exact correspondence between perfectiy
The box Oyex, is the Edgeworth box such that A's share is measured from competitive equilibrium and Pareto optimality. In other words every perfecty
point O and B's share is mneasured from point e. Oe is the contract curve.
Both competitive equilibrium is Pareto optimal.
the equilibrium points e (for production) and (for consumption) lie on this Perfect competition leads to the following:
curve showing Pareto optimality e'
in product mix. () Pareto optimality in exchange.
The above result is possible under perfect competition because (i) Pareto optimality in production.
under perfect
competition MC, = P, MC, = (ii) Pareto optimality in production-cum-exchange.
P, so that MC, P.
Me. However, in the real world, perfect competition does not exist. In other words,
But it can also be proved in the real world, we find a situation of market failure.
that MC,
MC,
= MRPT,y
There are number of factors which are responsible for market failure. The
Proof. MRTPy = d, important factors are as follows:
1, Market power. There are many assumptions of perfect competition which
are not to be found in the real life. This situation of market failure leads to the

We
MC,
=, MC, =
di emergence of imperfect competition where due to less output and higher prices,
resources are mis-allocated.
knowthat C= WL + rK costs and benefits,
2. Externalities, There are many situations in real life when
dC, = WdL, + rdKy are to by the third parties, are not paid by them. Such
which supposed be paid
 UNIVERSITY SERIES
24 Shiv Das DELHI
can be of two
are called externalities. Externalities UNIT 1
:THEORY OF PUBLIC FINANCE 25
spill-over of costs or benefits of
the dccision consumption of it does not interfere with the consumption
economy and (b) external dis-economy. When of it by the other. A
types-(a) external it is a case of external good is non-cxcludable, once produced, people cannot
some firm benefits others for which the firm is not paid, be excluded from enjoying
$
are benefited). When the decision
or action of an its bencfits. There are many econornic implications
ecônomy for others (who of publíc goods like external
not pay, it is a case of external benefits (positive) and market failure (negative).
individual creates costs for others which they do a a
existence of externalities creates situation where there is 1. Efficiency and public goods. The
production of public goods clearly
dis-economy. The
cost. Therefore, in such a situation generates external benefits. The market will not provide
qifference between private cost and social the efficient or optimum
the private cost and amount of the public good. A public good is provided efficiently
market price will not reflect the real cost, it will reflect only when Marginal
cost.
Social Benefits (MSB) - Marginal Social Costs (MSC).
not the social
3. Incomplete information. Theoretically, assumed that price determination
it is In the given diagram, market dernand curve for a public good is
derived by
and consumer behaviour are based on the assumption that firms and households adding up marginal benefits enjoyed by two consumers A and B (MBA and
have complete information. However, in real life neither the households nor MBB) respectively. The MSB curve shows that society is
willing to pay price OP
the firms have the complete information. Because of this, prices are not what
for OQ, units of public good.
they ought to be. In other words, a situation of market failure exists. Because The efficient amount of output is given by point E, where MSB MSC. It shows
of this we often find that price of a commodity differs from seller to seller O0, is the efficient output level.
because consumers do not have the complete information about the market. Like
consumers, at times, firms also suffer because information available to them is
not adequate and complete.
4. Presence of public goods. Presence of publiccgoods is another source of
market failure. A public good is that which is non-rival and non-excludable. A good is
a non-rival in consumption when its consumption by the person is not interfered by some MBA
other person. Those produced goods, from which people can not be excluded from availing
of their benefits are called non-excludable goods. Output
Public goods being non-rival, their benefits accrue to all, but this not true
in the case of private goods. This is a case of market failure. The same analysis
holds good in the cae of non-excludable goods. Benefits of such goods are P:
available to all whether one pays for them or not. For example, a, lighthouse once
established, will benefit all the ships whether one pays for it on not. It is also a MBg
case of market failure.
X
16,What is a 'Public' good? What are the economic implications of Public 1 Output
goods? [2002, 2005(E) Y
Or
What is a Public Good? Explain why private markets
will fail to provide MSC
-MSB
public goods efficiently? PA +Pe) -Marginal Cost
(2008
Ans. Most of the goods we buy are produced by MSB
private firms and are called Vertical
private goods. A number of goods we consume are sum of MB
not produced by private
firms, but by public agencies. These are
called public goods. Output
For example, national defence,
pollution control, police, parks and fire protection.
A number of other goods have
both public and private characteristics. They are
known as quasi-public goods. 2. Public good and market failure. A free rider is an individual who receives
For example, public roads, benefits from a public good but does not pay for the benefits. Once the public
education and libraries. Public goods
characteristics -they are non-rival have two good is produced, it is non-exclusive. This problem leads to market failure. The
and non- excludable. A good is a
consumption when two persons can consume non-rival in presence of free riders makes it difficult or impossible for markets to
the same thing, i.e., one person's provide
public goods efficiently.
 UNIVERSITY SERIES UNIT 1:THEORY OF PUBLIC FINANCE
26 Shiv Das DELHI O 27
economy will not reach a point of Pareto
Even with perfect competition, the a simple
Suppose X is a public good in
efficiency when there are public goods.
efficiency in product mix is satisfied when
model. The third condition of Pareto
= MRS,A = MRS,B S
MRT,,
can both use each unit of public good X at -MEC
However, since individuals A and B
ensure maximum welfare (Marginal
the same time, the equilibrium condition which would Extreme Cost)
+ B. D
is MRT = MRS,,A MRS,
to Pareto inefficiency and market failure.
Thus, presence of public goods leads Quantity
3. Policy prescription. Since public goods
are non-excludable, the government
cost Let a certain commodity, say X, be produced by a
can subsidise the production of public goods. It will reduce the marginal competitive industry.
Dlagram, shows Industry Supply Curve S derived from horizontal
can also produce the public goods summation of
of producing these goods. The government individual firm's marginal cost curves. Where the cost of the firm is
revenues. comprising
where production is financed by tax private cost only. The industry demand for the commodity X is given by D.
a
Q. 17. What two characteristics define, public good? "External
costs are bad
Equilibrium price and output is determined at Po and Qo respectively at
External benefits, point
and government intervention to reduce them is justified. E. Let production of X involve external costs also in the form of, say, pollution,
however, are good, and there is no reason for government intervention in this
which is borne by the society but not by the firm. Then industry
case." Evaluate.. [2004(R) supply curve,
that includes both private and social costs, is given by S so that the difference
Ans. Public good has two following characteristics:
1. It is non-rival in consumption. This means that with a given level of S-S at E0, i.e., EE, is the measure.of Marginal Social/External Cost.
Now Pareto Optimality solution requires that equilibrium be at E" with D =S'
production, consumption by one person need not diminish the quantity consumed
by anyone else. In fact, non-rival consumption means potential simultaneous and price and quantity of X fixed at Pand Qrespectively so that the commodity
consumption of a good or service by the society or many households. price will reflect the full social cost of producing it. This can be achieved if the
2. The second characteristic of public good is non-exclusion. This means Government imposes an amount ofNT per unit corrective tax on the producers
that it is not possible to confine the benefits of a good once produced to only a of commodity X so that the 'supply curve S shifts up to S" and the equilibrium is
selected few in the society. That is, any person can benefit from prodúction of the achieved at E" where D = S" with the desired goal.
good regardless of whether the person has paid for it or not. It can also be shown that even in the presence of external benefits, the
External tosts refer to the situation when externalities are harmful for the government intervention is necessary in the form of providing subsidies to the
society. On the other hand, when externalities are berneficial then these are called producers of the said commodity in order to achieve Pareto efficiency. So it
external benefits. cannot be said that government intervention is not necessary in case of extermal
An example of external cost is air pollution accompanyig the production of, benefits which are good for the society. The reason is that in case of external
a commodity. On the other hand, an example of external benefit is the reduced benefits the competitive output may be too low because the marginal benefits of
chance of spreading a communicable disease when an individual is inoculated additional units of output may exceed the marginal costs of producing them. So
against it. the government must provide subsidy to the producer to stimulate production
Presence of external costs and benefits in both production beyond the market-determined level. This is shown in diagram.
and consumption
cause reduction in economic efficiency
and market failure so that Pareto optimal
situation cannot be achieved even under perfect competition.
The reason is that
in the presence of externalities private and social costs or benefits
differ. Eo\E
To make them equal in order to achieve efficiency,
Government must intervene
either through enacting property rights or through
imposition of tax in case of
external cost and provision of subsidy in case
of external benefits or both.
Let us take the case of external costs
and see how tax by government can tackle MEB
the issue by using given diagram.
 UNIVERSITY SERIES UNIT 1:THEORY
Shiv Das DELHI
OF
28 PUBLIC FINANCE 29
consumers
marginal benefits of the good to the case of external dis-cconomy. The existence of
Dis the demand curve reflecting constant there a difference externalities creates a
situation
S is the supply
curve (here it is assumed to be horizontal reflecting where between private cost and social
cost. Therefore, in
costs). Equilibrium price and output
are at Po and Q% respectively corresponding
MER
Wa situation market prICe will not reflect the
real cost, it will reflect only the
presence of external benefits shown by private cost and not the social cost
to equilibrium point E. Let there be presence external rlere are four causes of market failure. Externalities implies the cost or
curve. The demand curve in the of
(Marginal External Benefit) adding D and MEB Lonefit that arises due to the presence of external factors. the
is derived by vertically
benefit then becomes DB which to a exaple, external, benefit is construction of a wide
S is at E' and output increases
Now the new equilibrium with DB and to stimulate d
road around a factory
increased noise and air pollution due to increased traffic on that road is
output Q0- In order
Q which is greater than market determined government must.provide subsidy. external cost.
output so that it increases from Qo to Q the
curve shifts down toS and new equilibrium External costs refer to the situation when externalities are harmful for the
In this case due to subsidy, the supply
shifts to E" (D = S) and output increases
to Q, the subsidy amount E' E"= enciety. On the other hand, when externalities are beneficial then these are called
external benefits.
S -S. Free Rider problemn associated Presence of external costs and benefits in both production and consumption
Q. 18. What are public goods? Explain the cause reduction in economic efficiency and market failure. Due to externalities
with such goods.
and are called
Ans..Most of the goods we buy are produced by private firms Pareto optimal situation is never attained because private and social costs or
we consume are not produced by private benefits are different in the presence of externalities.
private goods. A number of goods
firms, but by public agencies. These are called public goods. Suppose X is an externality, thern the third condition of present efficiency in
For example, national defence, pollution control, police, parks and
fire protection. product mix is satisfied when
A number of other goods have both public and private c
characteristics. They are
MRT,y = MRSA =MRSB
known as quasi-public goods.
For example, public roads, education and libraries.
Public goods have two Since, both firms A and B can take benefits and may enjoy benefits of X
characteristics-they are non-rival and non- excludable. A good is à non-rival in externality at the same time without assuming costs, it would lead to Pareto
consumption when two persons can consumne the same thing, ie., one person's inefficiency and market failure.
the consumption of it by the other. The existernce of externalities creates a situation where there is a difference
consumption of it does not interfere with
once produced, people cannot be excluded from between private cost and social cost. Therefore, in this situation market price will
A good is non-excludable,
not reflect the real cost, it will reflect only the private cost not the public lost.
enjoying its benefits.
For exanple, Construction of a road around two factorñes facilitated workers
a

Free Rider problem. A free rider is

an individual who receives benefits from
is produced, to come easily, work more, increased distribution facilities and lead
to more
public good but does not pay for the benefits. Once the public good Hence, Pareto
it is non-exclusive, there is no
way to provide the service without benefiting prodúction, but it did not reflect social cost of road construction.
presence of free riders makes
everyone. The problem leads to market failure. The inefficiency and market failure.
efficiently. To make private and social costs and benefits equal,
the Government must
it difficult for the market to provide public goods
or of tax.
Q. 19. Why are externalities likely to lead
to an inefficient allocation of ntervene either through enacting property rights through imposition can
of externalities (external cost) see how successfully Government
resources just as public goods do? Can the effect Let us take the case. of external costs and
be corrected with the help of taxation? tackle the issue by using taxation.
life when costs and
Ans. Externalities. There are many situations in real
are not paid by
benefits, which are supposed to be paid by the third parties,
are externalities.
them. Such spillovers of costs or benefits called
Externalities can be of two types: S
Price

(a) external economy and MEC

(Marginal
(b) external dis-economy. Extreme Cost)
is not paid
When the decision of some firm benefits others for which the firm D
economy for others (who are benefited). When the decision
it is a case of external Quantity
or action of an individual creates costs for others which they do not pay, it is
 30 Shiv Das DELHI UNIVERSITY SERIES
UNIT 1: THEORY OF PUBLIC
industry FINANCE
Let a certain commodity, say X, be produced by 'a competitive
31
at tow the new equilibrium with DB
horizontal summation and S is at E and output
Diagram, shows Industry Supply Curve S derived from Lich is greater than market determined
output O, In order to increases to
individual firm's marginal cost curves. Where the cost of the firm is comprisino oo that
it increases trom Qo to the government must
stimulate output
private cost only.
e
due to subsidy, the supply curve provide subsidy. In this
shifts down to S and new
The industry demand for the commodity X is given by D. Equilibrium price Ahifts to E" (D=
5) and output increases to , the subsidy equilibrium
and output is determined at Po and Qo respectively at point Eo- Let production arnount is E" =
E
S'-S.20.
of X involve external costs also in the form of, say, pollution, which is borne by o Can the externality be internalized
with the help of taxation and
the society but not by the firm. Then industry supply curve, that includes both subsidies? (Use suitable diagrams).
(2003, 2004(E)
private and social costs, is given by S' so that the difference S'- S at Ep, i.e., EE Ans. Since externality causes market
failure, one solution to achieve competitive
is the measure of Marginal Social/ External Cost. cquilibrium is to internalize externality. This means
that in case of two firms,
Now Pareto Optimality solution requires that equilibrium be at E¢¢ with where one firm's production negatively affects the
production of the other firm
D =S and price and quantity of X fixed at P and Q respectively, so that through pollution, then both firms should be merged which
will ensure the surn
the commodity price will reflect the full social cost of producing it. This can be of the Marginal External Costs (MEC) of both the firms equal to zero
and the rew
achieved if the Government imposes an amount of NT per unit corrective tax on
management will minimise social costs of production rather
than private costs.
the producers of commodity X so that the supply curve S shifts up to S" and the This solution is applicable for both negative (as said) and positive
externalities.
equilibrium is achieved at E" where D = S" with the desired goal. In the latter case the solution is equalizing Marginal Social
Costs (MSC) with
It can also be shown that even in the presence of external benefits, the Marginal Social Benefits (MSB).
government intervention is necessary in the form of providing subsidies to In a real world situation, where merger is not always possible, the governmernt
the producers of the said commodity in order to achieve Pareto efficiency. So it takes action through taxation in case of negative externalities and subsidies in
case of positive externalities which can bring similar results the
cannot be said that government intervention is not necessary in case of external in following way:
We know that a competitive market has equilibrium when
benefits which are good for the society.
MC, = P, where x is output
The reason is that in case of external benefits the competitive output may be
too low because the marginal benefits of additional units of output may exceed MC = Marginal Cost (Private)
the marginal costs of producing them. So the government must provide subsidy
P= Price
Let production of x create pollution so that the society bears external cost.
to the producer to stimulate production beyond the market-determined level. Then MSC, = MC, + MEC
This is shown in given diagram. For competitive solution MSC, = P,
Then this implies that there is divergence between MSC, and MC, ie,
PA MSC, > MC, which can be bridged by taxation which is equal to MEC. In
Diagram 1, the private optimal output is X, where MC, - P, But MSC, > MC,
P So tax = TE, so that socially optimal output is at X, ie., P = MSC,
P In Diagram 2, due to positive externality MC > MSC so that the government
gives subsidy = Marginal External Benefits (MEB),
NE Accordingly output
increases to X1.
MEB

PeA MSC; MC
SC
Dis the demand curve reflecting marginal benefits of thegood to the consumers. MC,
Tax = MEC Subsidy =ME9
S is the supply curve (here it is assumed to be horizontal reflecting constant Po P
Ej
costs). Equilibrium price and output are at Po and Qo respectively corresponding
to equilibrium point E
Let there be presence of external benefits shown by MEB (Marginal External
Benefit) curve. The demand curve in the presence of external benefit then becomes X Xo Diayram 2
DB which is derived by vertically adding D and MEB. Dlagram 1
32 Shiv Das DELHI UNIVERSITY SERIES UNIT 1:THEORY
OF PUBLIC FINANCE
box 33
Q. 21. Show competitive equilibrium with the help of the,Edgeworth GoodY

diagram. (2 *2*2model). Y
a x 2 x 2 model.
Ans. Competitive equilibrium in 2
Assumptions of the 2 x 2 x 2
model:
A1. There are two factors labour and capital. They
are homogeneous and
perfectly divisible.
A2. There are two commodities. Production functions of the two commodities
are shown by two isoquants exhibiting DMRTS and CRS. The points on the PPC (A and
contract curve. The B) correspond to the points (A B) on
A3. There are two consumers with well behaved preferences. PPCis downward sloping and its slope and
is given by
A4. Consumers maximize their utility subject to their budget contraint. MRTXy = .,,the slope of PPC measures the marginal cost of producing
A5. Firms maximize profit subject to technological constraints. one good relative to the marginal cost
of producing the other good.
production are owned by consumers.
A6. Factors of
A7. There is full employment of factors of production and all income spent.
i Good YA
s
A8. There is perfect competition in factor and product market.

Competitive equilibrium exists when the consumers. maximize their utility

(ie, equilibrium in consumption), firms maximize their profit (ie., equilibrium MC
MRTY MCy
in production) simultaneously.
Equilibrium in production, In a two good economy, prouction equilibrium is
attained when [MRTS - MRTs > Good x

= = Py, we have
Since under perfect competition MC P and MGy
Contract curve
MRTxy =

x MX, which implies general equilibrium of production is reached

R P MCy
at a point where slope of PPC = ratio of prices of good X and Y.
Y-Isoquants
X-Isoquants Hence, the general equilibrium of production takes place at point E in the
Kx
figure given.
Y
X Y, Equilibrium in consumption. A consumer equilibrium is achieved when the
O
agent has maximizd utility subject to income constraint i.e., at a point where
Ly Ly
MRSxy =
Edgeworth contract curve as shown in the figure above is the locus of tangencies
of isoquants X and Y. Therefore at each point on this curve MRTS - MRTSLK
With the assumption of perfect competition only one point on this curve can
Consumption
be regarded as equilibrium in production which in the figure is a point where A. Contract curve
= MRIS
|MRISŠK B
A

From such equilibrium points we can draw a PPC (Production Possibility BA

B
B
Curve) which is derived by mapping the production contract curve from input X
space into output space. Each point on the PPC and the contract curve describes
an efficiently produced level of X and Y.
 SERIES UNIT 1
:THEORY OF PUBLIC FINANCE
34 Shiv Das DELHI UNIVERSITY 35
contract curve is locus of tangencies of indifferenco relative ability-to-pay. This approach focuses on
The Edgeworth consumption l welfare. The ability-to-pay the principle of maximum
cquilibrium condition
curves A and B. Therefore at cach point the following individuals - theory mentions the two broad
indices of
of potential points of equilibrium
are ability-to-pay of
is met: MRS =MRS. The number. (a) Objective Indices
one such equilibrium case exists, where
infinite but with perfect competition only (b) Subjective Indices.
= (o Objective Indices of Ability-to-Pay. The ability-to-pay
MRSY MRSY of the society as a
P whole is not an absolute quantity but it is variable and further
depends on itens
constitute listed on the expenditure budget of the government.
simultancous cquilibrium of Production and Consumption would
A

a general equilibrium in 2a x 2 x 2 economy. This requires that the marginal The objective indices are given as:
rate of transformation (MRT) between the two goods in production be equal to () Property. Property includes fixed assets such as land, building etc.
Private property belongs to individuals or farmilies and is protected by
the marginal rate of substitution (MRS) between the two goods in' tonsumption.
MRTxy = MRSXy at equilibrium
Law of Inheritance. The decisions to create property are taken by
private
MRS individuals, Corporate sectors, depending on how much they want to
MRT shows the rate at which a good can be transformed intiy production, save and invest. It is normally assumed that property has market value
consumers are willing to exchange one good for
shows the rate at which the or can create income for the owner. But some properties do not yieid
two ratioS are equal. Its
another. The entire system is in equilibrium when the any income. Taxing property may discourage savings and investment.
economic meaning is that the combination of outputs must be optimal from both
On the other hand, taxing properties which do not yield income will be
the consumer's and producer's point of view.
In the PPF figure below, PP,shows that every point on it corresponds to
regressive. Hence property is not a very good index of ability-to-pay, but
it cannot be ignored to distribute tax burden
equilibrium in production. Suppose that the output of X and Y produced in this
economy is given by point E on PPC as X, and
Y i) Income. Income is the most popular index of ability-to-pay. It is often
Then the Edgeworth boxO,Y,EX, Can be coristructed showing the exchange argued that people with higher income should be taxed more than the
possibilities for consumers A and B. Every point on the consumption contract
people with lower incóme. The base minimum income necessary to
survive should be totally exempted from tax. While dealing with income,
curve OPOp is a point of general equilibrium in exchange. However, this
economy will simultaneously be in equilibrium in production and consumption two sources of it must be considered. These are:
• Earned income
at point P. • Unearned income.
It is argued that Unearned income includes capital gains and
must
Good YA S
tax as compared to Earned income. There can be
P
be subject to heavy purpose. The
division of income into gross and net income for taxationcorrect
O
to get data on
major problem with income is that it is difficult
individual's level of income in developing countries. to conceal actual
economy the attempt
However with digitalization of
can not be used as index in indirect tax
x
•income has reduced. Also income
X
XP>Good due to the fact that
consumers in an economy can not be classifed
as one
to pay according to types of goods
At this point: homogeneous group with equal ability problems income remains as the
them. Despite
and services purchased by
MRSSy = MRSy = MRTXy of ability to pay.
most important index expenditure can be taken as
an
Consumption
() Consumption expenditure. consume luxury goods
At point P, consumer A gets X, of X
and Y, of Y and B gets X, (X- X) and pay. It is said that those who
Ihdex of ability to satisfaction and
possess higher standard of
Y, = (Y- Y,). derive higher necessary goods. So people
and services consumers
who consume less
Q. 22. Explain the Ability-to-Pay theory of distribution of tax burden?. 1ving than the is very high should
or whose consumption level
Ans. According to Ability-to-Pay theory, the distribution of tax burden Consuming luxury goods
amount than others.
among the members of the society should be on the criteria of justice and De taxed more or higher
equity. This in turn implies that the tax burden should be divided as per thelr
36 Shiv Das DELHI UNIVERSITY SERIES UNIT 1:THEORY
OF PUBLIC FINANCE B
Ane When a sales 37
However, the problem in this approach is that difficult to estimal.
it is tax is imposed,
the supply curve of the
thas upwards to the left by the anount of commodity shifts
consumption expenditure pertaining to given period. is argued
a It
onse in price the tax. This leads fall
indirect taxes like Excise Duty or Sales Tax can be taken as proxies for of the commodity. If the increase to in quantity and
in price is less than
tax purpose. But this criteria ie
Lnosed then the burden of tax is shared between the tax
estimate of consumption expenditure for buyers and sellers as per ratio
argue that af elasticity of supply (e.) and elasticity of demand (e,).
linited to people who consume such goods only. Some also
the part of income which is consumed should be taxed. This implies that
not be taken into account for tax purpose ie, ..where (BBuyer's burden, S-Seller's burden
saving and investnment should
In such a case, higher income people will plough back their income
To prove this, we iuse the following diagram:
earnings into investment and avoid tax. Hence, consumption expenditure The original equilibrium with demand D,
equal to supply S, is at point
cannot be the sole index of ability-to-pay. Equilibrium price is OPo and quantity is E
From the above, it can be concluded that index for Ability-to-Pay can be a O Let a sales tax of amount
imposed. Accordingly, supply S% shifts to S upwards by arnount t, -
t be
=
mixture of property, income and consumption expenditure but not any one of ie, S S, t.
New equilibrium with D, = S is at point E.
these variables alone. At new equilibrium point, tax = ET - So.
(b) Subjective Indices of Ability-to-Pay. The subjective indices of Ability-to -S
Pay include
() Assumptions about tax payer. According to subjective approach, the
Ability-to-Pay can be determined by assuming that a tax payer undergoes
hardships or sacrifices a lot while paying taxes. It can also be interpreted Po
as the tax payer does not feel better by paying taxes for welfare of society
or to sponsor state activities. Of course, sacrifice ofa tax payer depends
on his/her own tax liability: Dr
(in) Equity vs. Welfare. While determinin tax liability of individual the

principle of equity or welfare can be considered as an important criteria. Quantity

As per equity principle, the sacrifice of a tax payer is equally divided
among them. While prínciple of welfare says that the aggregate sacrifice At new price =
OP,quantity falls to OQ from OQ so that DQ-QQ.
by the tax payers be minimised. Now increase in Price= OP - OP,= PP = EN
(iin) Equal sacrifiçe. Equal sacrifice has three alternatives - Since tax = ET = EN + NT
• equal absolute sacrifice
The increase in price is less than tax. Hence both buyer and seller share the
• equal proportional sacrifice
burden of tax. Since increase in price is EN, the share of buyer is EN and the
• equal marginal sacrifice
=
rest amount NT is seller's burden. So
According to equal absolute sacrifice, each tax payer is made to sacrifice
the same amount of utility so that the difference between the aggregate To prove E'N we
have to find e, and e, separately.
utility from Income Before Tax and the utility of Income Aftei Tax is
that,
changed from E, to T
same for every tax payer. Now find e, along supply curve S, where point has
According to the principle of equal proportional sacrifice, no one 15
AQ P
exempt from sharing the tax burden. Each tax payer must sacrifice the
same proportion of total satisfaction as
desired from his/her income. .(Since P,P" = NT
Finally, according to the principle of equal
marginal sacrifice the ta NTOQ0
burden should be divided in such a way .that the marginal changed from
utility o Similarly, find
e on the demand curve Do where point has
income left after tax is the same
for all tax payers. Eg to E.
Q. 23. Prove that the burden of a sales tax
(or unit tax or specifi tax) on
commodity is shared between buyer and
seller on the basis of the rati0
elasticity of supply and elasticity of demand.
/1997, 1998
 UNIVERSITY SERIES UNTT 1: THEOKY
38 Shiv Das DELHI OF PUBLUCFINANCE 39
The supply curve 5, meets D at point
.(SinceP- tax S, shifts up to E, Equilibrium Price is
5; and at new equilibrium point E, price isOP After
E'N
eENOQ0 that increase in price P; OP; such
O EE, taz. Ouantity remains unchanged.
OQ0 E'N hich ie Buyer's burden E'N . The whole burden of tax is on buyer, because tax
Find NI
OQ O
NT Seller's burden NT
increase in price. Here

EN OQo
How the burden of a sales-tax is shared between buyer and seller in
0. 24. ic) lf e. =0, then price cannot rise after tax because supply curve is vertical at
(a) e, = ,
the following cases:
given downward sloping demand curve.
(b) e,=0, given upward sloping supply curve.
some quantity, which is constant.
So after tax, price and quantity
unchanged and the original equilibrium is also not disturbed. Sotemain
bears the whole burden of tax as shown in Diagam 3.
seller
(c) e, 0, given downward sloping demand curve.
() e, =,given upward sloping supply curve.
Sol. In case of a sales-tax, the burden between buyer and seller is shared on
PA

the basis of ca
Ey
,
(a) Ife, E, then =
the whole burden of tax is on buyer. Here increase in
price equals the amount of tax as shown in Diagram 1. D

Quantity
Diagran J

Po Since e, = 0, supply curve is vertical. The demand and supply equilibrium

does not change from E, even after tax. So price and quantity do nct
change. Hence, seller bears the whole burden of tax. Here
Quantity
Diagram 1
(d) If ea = ,
then demand curve is horizontal. This means that
pnce does
not change even after tax is imposed. So seller bears the whole burden.
When e=,Supply curve is horizonal. Original equilibrium is at with
E as shown in Diagram +.
D= S,. Price is OPo and quantity is OQ After
sales tax is imposed, S
shifts to S,, so that equilibrium shifts to point E' (D =
S). New price is PA
OP; quantity decreases to OQ,.
Here tax=S,-S= ET = PP, which is also the E -c
increase in price. P
Therefore, total tax burden is on the buyer.
(b) If e, =0, then dermand curve D is
vertical as shown in Diagram 2.

Quantity
Diagram

curve D is horizontal because e

= Original
E In the diagram, demand and quantity at Q
Price is at
equilibrium is at E, where D S.EquilibriumPpoint shifts to E, Quantity
=
toS,
After tax, S, shifts leftward
same at Tax = S - S EjTat
= new equlibrium
Quantity
Diaggam 2
falls to Q,. Price remains P
increase, the seller bears the whole burden of tax.
does not
E. Since price
 UNIT 2: ISSUES FROM
INDIAN PUBLIC FINANCE
41
gold and unencumbered apPproved securities
demand and time deposit equal to not less than 25 per cent of
their total liabilities. RBI has
two reasons: stepped up the liquidity
ratio for
Unit 2 higher liquidity ratio forces commercial
banks to maintain a larger
proportion of their resources in liquid form
and thus reduces their
Issues from Indian Public Finance capacity to grant loans and advances to
anti-inflationary.
business and industry
-thus it is
(h higher SLR was used to divert bank funds to finance govermmeat
expenditure. It may mentioned here that stepping up
statutory liquidity
requirements (SLR) and the cash reserve ratio (CRR) have the same effect,
viz., they reduce the capacity of commercial
banks to expand credit to
Q.1. Explain the role of fiscal and monetary policies in controlling inflation business and industry and thus are anti-inflationary.
in India. [2014, 2017 1. Bank Rate is basically the interest rate at which the
Central Bank borrows
Ans. In India, the Ministry of Finance and the RBI (Reserve Bank of India) from the other scheduled commercial banks. This rate is directly linked to the
always strive to control inflation. Eforts should be made to curtail demand and
interest rates charged in turn by all the commercial banks to its customers. All
improve supply management to control rising prices. Some of the measures to
these other interest rates on Homne loans, PerSOnal loans, etc. also increase with
control inflation are discussed as below. the increase in bank rate. Thus, by raising the Bank Rate and in turn all other
Monetary Policy. Monetary policy refers to the policy measures that affect the Interest Rates, the RBI makes borrowing money from banks a very costly affair.
economic variables, viz., oput, prices, etc, through changes in money supply. In
India, the RBI, being the central bank of the country formulates and implements People are thus discouraged to borrow more money and total amount of liquidity
decreases in the economy. In July end 2014, the RBI increased the Bank Rate from
the monetary policy with the objective of stabilizing prices and promoting growth
8.5% to 9.5%. Although the rise in interest rates initially makes life difficult for
generating forces in output and employment levels.
people who have taken loans on floating interest rates, it is a required step to
Quantitative controls are used to control the volume of credit and indirectly bring down inflation which is á larger evil. It might also be noted that RBI, by
to control inflationary and deflationary pressures caused by expansion and
contraction of credit. Quantitative controls are also known as general credit making the policy changes can control only one type of inflation, i.e., demand
'pull inflation. It cannot affect the other type of inflation, i.e., cost push inflation
controls and consist of CRR, Bank-Rate (REPO and Reverse-REPO), SLR, etc.
1. CRR (Cash Reserve Ratio) is the proportion of amount which is caused by rise in prices of raw materials and other factors of production.
which each
commercial bank has to maintain in the form of hard cash. All commercial banks That is why the rate of inflation is increasing continuously for the last six months
accept deposits from individuals and lend it to borrowers at a higher interest although the RBI is trying to control it.
rate. The difference between the interest rate which they collect from borrowers Fiscal Policy. Fiscal policy is budgetary policy in relation to taxation, public
and which they pay to their depositors is their profit. Naturally, each bank will borrowing, and public expenditure. Changes the total expenditure can be
try to lernd all the money they collect from depositors. However, banks cannot affected by fiscal measures. Price policy designed to promote economic growth
lend all the money they have. Under law, each bank has to maintain a certain includes measures for controlling the volume of public expenditure in general
any undue pressure on the
proportion of cash as reserve. This is known as CRR. For example, if the CRR is and fiscal deficit in particular. The aim is to reduce
consumer should be ready
5% and the bank collects 100 from its depositors.
Then it has to maintain 5 imited 'supply of consumption goods. Besides, the
as Reserve. It can lend the balance 795 to reasonable from the point of view of low income
its borrowers. RBI can decrease vast
amounts of liquidity circulating in the economy by raising the CRR. 0 Duy at the prices regarded
groups.
When RBI
increases the CRR, the bank's lending power decreases. Less measures would involve increase in taxation and
lending means less 10 combat inflation, fiscal
borrowing, this in turn means less money in the economy. the govermment is supposed
In July 2008, the RBI decrease in government spending. During inflation
increased the CRR from 8.75% to 9% to control private spending. A decline in public expenditure
0 cOunteract an increase
inflation. in
increase taxes to affect
-2. SLR (Statutory Liquidity Ratio) is also similar to must simultaneously
Government-Securities need to be maintained by the
CRR. But in case of SLR, One is not sufficient. Government to minimize intlationary pressures. Some
commercial banks instead d cut
in private expenditure-in order
of cash. All commercial banks have
maintain liquid assets in the form of cash, of the terms are explained below: disposable
more taxes are imposed, the size of the
Taxes. As we know, when given the available
40 inflationary gap diminishes,
One and the magnitude of the
 UNIT 2: 15UES
UNIVERSITY ERIES FROM INDIAN
42 Shiv Das DELHI PUBLIC FINANCE s
wcakene (u) Bank Rate. Itis the rate at 43
Inflationary pressure is significantly which the Reserve
supply of goods and services. an increase rodiscount bills of exchange or Bank is ready
by the simultaneous curtailment of
government expenditure and
is published under Section other cornnercial papers. to buy or
The Bank Rate
taxation due to a decline in disposable income with people. 49 of the Reserve
Bank of India Act,
of the central and the
sas This rate has been aligned 1934.
expenditure to the MF rate and,
2. Government expenditure. The automatically as and when therefore, changes
Governmen
governments which have grown enormously must be controlled, rate changes.
the MSF rate changes alorngside
policy repo
the size of th
must reduce its administrative expenditure by cutting down i) Cash Reserve Ratio (CRR).
non-productive expenditure The average daily balance
bloated government machinery. Non-essential and required to maintain with the Reserve that a bank
sector must be reduced and if possible eliminated. In this connection Bank as a share of such per
in the public its Net Demand and Time Liabilities cent of
on reduction of non-plan expernditure of the (NDTL)that
particular emphasis should be laid notify from time to time in the Gazetté India. the Reserve Bank may
government. Ultimately without government cutting down its expenditure it is of
(ni) Statutory Liquidity Ratio (SLR). The share of NDTL
not possible to control inflation: that a barnk
on required to maintain in safe and liquid assets, such as,
3. Subsidies. The massive amount of money that is used for subsidies
government securities, Cash and Gold. Changes in SLR unencumbered
food, fertilizers, etc,, must- be rationalized. Only those subsidies which realy the availability of resources in the banking system for
often irfluerce
help the poor and actually reach them and those which are crucial for country's lending to the
private sector.
development should be continued and all others must be abolished. The (ix) Open Market Operations (OMOs). These include
government should also avoid popular measures and pre-election doles to retain both, outright purchase
and sale of government securities, for injection and absorption of durable
'political power. Briefly, then, a reduction in public expenditure, and an increase
liquidity, respectively.
in taxes produces a cash surplus in the budget. () Market Stabilisation Scheme (MSS). This instrument for monetary
Q.2 Explain various instruments of monetary policy in India. [2019 (May) management was introduced in 2004. Surplus iquidity of a more
Ans. The Reserve Bank of India uses direct and ndirect instruments for enduring nature arising from large capital inflows is absorbed through
implementing the monetary policy: sale of short-dated goverrunent securities and treasury bills. The cash
() Repo Rate. The (fixed) interest rate at which the Reserve Bank provides sO mobilised is held in a separate government account witih the Reserve
overnight liquidity to banks against the collateral of government and Bank."
other approved securities under the Liquidity Adjustment Facility (LAF). Q.3. Explain various tools of fiscal policy in India. (2019 (May)
(n) Reverse Repo Rate. The (fixed) interest rate at which the Reserve Bank
Ans. Policies related to public revenue, public expernditure and public
absorbs liquidity, on an overnight basis, from banks against the collateral borrowing are collectively known as fiscal policy through which the government
of eligible government securities under the LAF. manages the economy. Hence the tools of fiscal policy are-Public Revenue,
(i) Liquidity Adjustment Facility (LAF). The LAF Consists of overnight Public Expenditure and public Borrowings. The Budget presented annually by
as well as term repo auctions. Progressively, the Reserve Bank has
the government is a statement of fiscal policy.
increased the proportion of liquidity injected under fine-tuning variable two heads-Revenue
) Public Revenue. Public Revenue is received under Revenue Receipts
rate repo auctions of range of tenors. The aim of term repo is to help (Current Account) Receipts and Capital Receipts.
develop the inter-bank term money market, which in turn can set market tax and non
include collection of tax in the form of direct and indirect
based bernchmarks for pricing of loans and deposits, and hernce improve income and wealth tax etc, whereas
tax revenues. Direct tax includes
transmission of monetary policy. The Reserve Bank also conducts variable Goods and Services Tax (GST), customs duty etc.
indirect tax includes
interest rate reverse repo auctions, as necessitated under the market fines collected by government
Non-tax revenues come from fees and
conditions. dividends earned by Public sector
administration, Postage, Profits and from disinvestment,
(iv) Marginal Standing Facility (MSF), A include funds raised
facility under which scheduled companies etc. Capital Receipts
commercial banks can borrow additional amount
of overnight money recovery of loans etc.
from the Reserve Barnk by dipping into their is of two types-Revenue
Statutory Liquidity Kato ") Public Expenditure. Public expenditure Expenditure includes
(SLR) portfolio up to a limit at a penal rate Expenditure. Revenue
of interest. This provides Expenditure and Capital assets while
safety valve against unanticipated liquidity Aid for creation of capital
(v) Corridor. The MSF rate and reverse
shocks to the banking system. lnterest Payments, Grants in expenditure on acquisition of assets, loans
repo' rate determine the corridor o Capital Expenditure includes
the daily movement in the weighted average
call money rate. and advances etc.
 UNIT 2: 155UES FROM INDIAN
44 Shiv Das DELHI UNIVERSITY SERIES PUBLIC FINANCE
governmens resources is the deficit financing. Since 45
When expenditure of the the launching of
(i) Public Borrowing/Public Debt. borrowing to India, the government has bcen utilizing seriously the Five Year Plans in
exceeds its receipts, then the government resorts to public
additional resources for plarns. this method of
meet the gap. Public debt is of two types- Internal Debt and Extemal obtain
programme of our plannedI economic
It occupies an financing to
important position
Debt. Internal debt includes Market Loans, 364 Days Treasury Bills, Gold development. in any
Deficit financing in India is said to occur
Bonds, Securities issued to RBI etc. External Debt includes loans from. when the Union
IME, World Bank and other external sources. budget deficit
bu
is covered by
the withdrawal of cash balancesGoverment's current
of the government
horrowing money trom the Reserve
Q. 4. What is a 'subsidy"? Explain how the benefit of a subsidy is split Bank of India. When
the governnent
draws its cash balances, these become active and come
between buyers and sellers a competitive market. government into circulation.
when the borrows from the RBI, Again,
Ans. Subsidy is a unilateral or transfer payment made by the government to currency. Thus, in
the latter gives loan by printing
additional boththe cases, 'new money comes
the firms to encourage production. Subsidy is aimed to reduce the prite of the to be remembered here that government iinto circulation.
commodity. borrowing from the public by
selling bonds is not to be considered as deficit financing
Subsidy leads to improvement in supply situation and shifts the supply curve Deicit financing may not necessarily be inflationary. There are
to the right. The price falls and quantity increases. The measure of subsidy is the certain
onditions under which deficit financing may not lead to inflation.
vertical distance between the two supply curves. With increase
in money supply due to defhcit financing prices do rise but in rise in prices will
Originally the market is at equilibrium at point E, where D = S;. Price is P, and only be temporary for about a period. As flow
guantity is Q,. After subsidy the supply curve shifts from S, to S, downwards of goods and services increase.
ndces will begin to fall. Deficit financing is an important device
(right side). for financing
development plans for underdeveloped countries and accelerate their rate of
Subsidy is equal to ED. economic development. But if deficit financing is not kept within limits it may
New price is P, and quantity is Q, at new equilibrium point E, where D = S,.
Here benefit to the consumer is the fall in price, ie, PP, - EN out of subsidy. given rise to prices. Distorted investment and unequal and unjust distribution of
income. Therefore it is essential that deficit financing is kept within limits and its
The rest, ie, ND is the benefit to the producer. Because of subsidy the supply
price would have droppéd to P, at point D on new supply curve S,. But since impact on prices and costs are softened through various controls.
equilibrium point is at E on S, producer gets price P, which is higher than P Prof. Minhas comments that the argument that deficit fnancing leads to the use
So benefit to producer is PP, = ND. of surplus labour for capital formation is also not applicable in India. According
to him, deficit financing in India has led to an increase in current expenditure
Q.5. Evaluate the role of deficit financing in mobilizing resources for Indian
and hs hardly served the purpose of investment. Therefore. the additional
plans. Do you think that the deficit financing has fuelled inflation in India?
expenditure attributed to deficit financing does not lead to additional output it
[2009; 2013; 2014; 2015
Ans. Deficit financing is the budgetary situation where expenditure is higher simply creates inflationary pressure. But this has not been a very strong relation
in the Indian context. Inflation in India primarily remains a supply side issue
than the revenue. It is a practice adopted for financing the excess expenditure
with food prices and oil predominantly dictating the trajectory of inflation. The
with outside resources. The expenditure-revenue gap is. financed by either
role of deficit financing has been somber.
printing of currency or through borrowing. Nowadays most governments both
the developed and developing world are having deficit budgets and these Q6. Discuss the main sources of financing Indian plans. In this context
examine role of deficit financing and its inflationary impact. [2017
deficits are often financed through borrowing. Hence the fiscal deficit
is the ideal sources available for financing plans in India,
indicator of deficit financing. Ans. There are three of finance
Deficit
Developing countries aim at achieving higher economic 0) Domestic Budgetary Sources, () Foreign Assistance, and ()
growth. A higher Financing.
economic growth requires finances. But private sector is shy of
making huge Data reveals that
expenditure. Therefore, the responsibility of drawing financial resources to 0) Domestic Budgetary Resources Including Taxation.
finance economic development rests on the government. Ong the three maior sources of plan financing
domestic budgetary resources
Taxes are one of such resources
instruments of raising resources. Being poor, these countries major portion. The contribution of domestic budgetary
the declined to
large resources through taxes. Thus, taxation has a narrow coverage
fail to mobilize touted
towards plan finance was 73 per cent during the First Plan and then since then the
poverty. A very little is saved by people because of poverty. due to mass per cent Second and Third Plan but
In order to collect and 59 per cent during the per cent, 78 per cent and
contribution maintained a steady level of 74 per cent,
S
financial resources, government relies on profits
of public sector enterprises. But
757 per cent Fifth, Sixth and Eighth
Plan respectively. Thus
these enterprises yield almost negative profit.
Further, there is a limit to public during the Fourth, contribution of domestic budgetary
borrowing. In view of this, an easy as well as a except for
Second and Third
Plan, the
shortcut method of marshalling resource, the between 73 to 82
per cent.
towards plan financing varied
 UNIT 2: ISSUES FROM
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46 Shiv Das DELHI UNIVERSITY SERIES PUBLIC FINANCE
Q.7. Explain the role of deficit financing 47
resources, taxation playsS a very importan resource
in
Among the domestic budgetary D
Ans. Role
of deficit
financing in resource mobilisation. (2011 (E)
First, Second, and Third
role mobilizing resources for plan. During the budgetary situation where expenditure mobilisation. Deficit financing is
additional taxation alone contributed nearly 12.7 per cent, 22.8 per cent and 34 the is higher than the revenue. It
practice adopted for financing the excess a

per cent of the public sector plan expenditure respectively. expenditure with outside resources. is
per cent, 37 pe. expenditure-revenue gap is financed The
The same additional taxation further contributed nearly.27 Nowadays most governments
by either printing of currency or through
Plan borrowing
cent, 22 per cent and 15 per cent during the Fourth, Fifth, Sixth and Seventh are having deficit budgets
both in the developed and developing
respectively. The importance of taxation in mobilising
resources for plan can ld and these deficits are often financed through
be visualized from the fact that tax revenue as a percentage of GNP gradually borrowing. Hence the fiscal deficit is the ideal indicator of deficit
financing.
increased from 7 per cent in 1950-51 to 20 per cent in 1987-88. Developing countries aim at achieving higher economic grOwth.
A higher
oconomic growth requires finances. But private sector is
Further, between direct and indirect taxes, the contribution of indirect taxes
is
shy of making huge
much higher than that of direct taxes and proceeds from direct taxes are nearly 5 expenditure. Therefore, the responsibility of drawing financial resources
to
per cent of national income. Further, the ratio of direct to indirect taxes declined Gnance economic development rests on the government. Taxes are one
of such
from 39 61 in 1950-51 to 14 : 86 in 1987-88.
:
instruments of raising resources. Being poor, these countries fail to mobilize
Besides taxation, the other sources of domestic budgetary resources such as Iarge resources through taxes. Thus, taxation has a narrow coverage due to mass
public borrowing, small savings and surpluses of public enterprises are also poverty. A very litle is saved by people because of poverty. In order to collect
contributing a good amount of resources for financing our plans. financial resources, government relies on profits of public sector enterprises. But
(ü) Foreign Assistance. Data further shows that the second important item these enterprises yield almost negative profit. Further, there is a limit to public
external foreign assistance also contributed a good portion towards financing borrowing. In view of this, an easy as well as a shortcut method of marshalling
plans in our country. The dependence on external assistance. which accounted resources is the deficit financing. Since the launching of the Five Year Plans in
for 10 per cent during the First Plan gradually increased to 24 and 28 per cent India, the government has been utilizing seriously this method of financing to
during the Second and Third Plan. Since then the dependence on foreign aid obtain additional resources for plans. It occupies an important position in any
declined to 13, 15, 8, 9 and 5 per cent during the Fourth, Fifth, Sixth, Seventh and programme of our planned economic development.
Eighth Plan. Thus excepting Second and Third Plan the dependence on foreign
Deficit financing in India is said to occur when the Union Government's current
assistance varied between 8 to 15 per cent.
budget deficit is covered by the withdrawal of cash balances of the government
(ii) Deficit Financing. The third important source of plan finance is the deficit
and by borrowing money from the Reserve Bank of India. When the government
fnancing. As taxation and borrowing have got their limits, thus deficit financing
draws its cash balances, these become active and come into circulation. Again,
has been considered as an important source of finance for planning in our
country. During the First and Second Plan 17 per cent and 20 per cent when the government borrows from the RBI, the latter gives loan by printing
of total additional currency. Thus, in both the cases, 'new money' comes into circulation.
plan resources respectively came from deficit financing.
During both the Third and Fourth Plan 13 per cent of total resources was covered lt is to be remembered here that government borrowing from the public by
out of deficit financing. But due to adverse consequence of deficit selling bonds is not to be considered as deficit finarncing.
financing a valuable instrument in
through inflationary rise in the price level, the extent of deficit financing was Deficit financing could be a helpful device and
an underdeveloped country in the initial
reduced to only 3 per cent during the Fifth Plan. Due to resource Promoting economic development in
extent of deficit financing again rose to 14 per cent constraints, the money (due to deficit financing) results
of total plan resources during Stages. The increase in the volume of
resources. As such, deficit financing is
the Sixth Plan (as against the original estimate of 5 per cent).
During the Seventh gher demand for labour and other a backward and developing economy.
and Eighth Plan also the extent of deficit financing again rose to
nearly 16 and 9 be advised
garded as a good tool to necessary t
per cent of the total plan resources. extreme caution is in, using deficit inancing for economic
Thus knowing fully the evils of deficit financing, inflationary in character, and hence, proper
planners are stillmaintaining development. For. it is intrinsically shows that
a high rate of deficit financing controls are of other countries clearly
in the absence of increased tax revenue
large scale tax evasion and negative due to hecessary. Besides, experience of currency notes
which will
contributions of public sector enterprises. deficit financing may to excessive printing
Considering the double-digit inflation lead
facing the country in recent years, is hign greatly reduce the value of money. are given below:
time that a total change in the system it financing too which
of plan financing be introduced where we re certain evil effects of deficit
should have more reliance on domestic to Fiscal deficit and
expansion in public debt and
budgetary resources and less on deficit Deficit Financing leads
financing and foreign assistance.
Also, Read the next question. other liabilities. prices.
to inflationary rise in
Deticit financing leads
 UNIVERSITY SERIES
UNIT 2 : ISSUES FROM
48 Shiv Das DELHI INDIAN PUBLIC
occurs as a result of deficit spending, consumption must Aidused to stabilise FINANCE 49
(ii) When inflation therefore savings become forced. food prices and import raw
of rise in prices and idutilised, a signincant proportion represented materials. Of the total
decline as a result investment and hence inv aid in kind or commodities,
changes the pattern of bulk of which has been utilized to import foodgrains the
(iv) Deficit financing pattern sought under the
ment due to inflation deviates from the are reinforced byincreased te in stabilising food-grain prices,
A part
which played a significant

created by deficit financing l aw materials or spare parts in short supply of the aid has been used to
import
() Inflationary forces banks, increase in Government spending without
a
in the economy and
this contributed
credit creation by ebstantially to increase the production in the 'country.
spending raises the bank deposits a Aidused for the enlargement
corresponding decrease in private of irrigation and power potential.
with central bank. The banks find their liquidity
increased and are External
assistance has contributed the productive capacity of agriculture
position to make extra advance. This adds to the intlationary pressUres way by enlarging the irrigation in a big
potential of the country. In the ield of dairy
which were started by deficit financing. and fishery, foreign aid has helped to modernize
the technique of production.
Q. 8. Discuss the role of foreign aid in financing India's five year plans. Eoreign aid has, in a big way, helped enlarge power
potential of the country. It
[2012 (R) has enabled the còuntry to import machinery and equipment
which has helped
Ans. Role of foreign aid. Foreign aid, from countries professing different to increase the installed capacity in' the country (from 2.3 million K.W.
ideologies as well as UN. and- other international institutions, has made a in 1950)
to (113 million K.W. in 1999-2000).
significant contribution to India's economic development. Besides helping ín the 4. Aid for improving transport. Transport absorbed
large proportion of total
exploitation of untapped natural resources and building up the infrastructure. utilized aid, i.e.f1A per cent, out of which 12 per cent has gone to the railways. It
aid has also played a crucial role in the allround industrial development of the has played an important role in the renovation and modernization of the railway
country. In fact, foreign aid contributes towards three things, which are: transport and it has helped to increase the rolling stock and locomotives.
(a) to make available additional supplies of foreign exchange; 5. Aid used for building up steel industry. Foreign aid has played an
(b) to supplement domestic savings; and important
(c) to facilitate transfer of technology.
role in the creation of capacity in such a basic line of production as steel in the
country. Over eighty per cent, of the amount. of aid utilized by mamufacturing
The extent to which the institutionat foreign- aid can contribute the
development of the productive capacity of the economy depends on the judicious industry has gone into the expansion and reation of capacity in the steel industry.
use of foreign aid, the effort and the total disposable resources The necessary aid was received from West Germany, erstwhile USSR and UK:
of the recipient
country. At the same time, its accuracy creates growth potential
far beyond the Q.9. Write a note on Centre-State financial relations. (2016
point where it is applied. Besides, the import of capital goods may release non Ans. Centre-State.financial relation. The Constitution of India makes a clear
aid resources for increasing the current consumption and division of fiscal powers between the union and the state governments. In India
also the aid in terms
of consumer goods, it may help release domestic resources the centre-state inancial relations may be explained as follows:
for capital formation.
Although the share of the net aid in the total plan expenditure Firstly, with fegard to taxes (like income-tax) are levied and collected by the
has been declining
after the Seventh Plan and has been less than 20 per cent Central Government. But proceeds of these taxes are shared among the Centre
gross disbursements of since the 8th Plan, the
aid have been increasing rapidly,
adding to the heavy and the States. Secondly, with regard to advancement of loans, the central
external debt-burden. The mounting debt-servicing It
obligations have put a severe gOvernment may, by the approval of Parliament, provide loans to the States.
strain on India's balance of payments for long and even may also guarantee loans to the States. Also, wvith regard to centre-state financial
Foreign aid acts as a helping hand during recent yeas;
but finally ultimate objective of Foreign ald Telations the President of India appoints the Comptroller and Auditor General
is to help the recipient country in powers in relation to State
attaining self-sustained and self-genera Or
India. He entrusts duties and confers him such
growth, without relying on foreign aid, a for every
we mention within a reasonable period of time. below dcCounts. The President of India also constitutes Finance Commission
the role that foreign aid uve years to review the allocation of certain tax proceeds and the principles of
has played over years:
1. Foreign aid
has helped to raise the level the our Constitution distributes powers between
investment has substantially of investment. The rate Srants-in aid to the States. Thus
increased States have been provided with
of
the nationalincomne at the beginning from the annual level of over 10 pee he Centre and States. Both the Centre and the
of the First Plan the authority to exercise their respective powers independently.
national income. With
this increase in the rate to nearly 25 per cent of principle adopted for the division of
outlay had also of investment the foreign Oistribution of Taxes or Resources. The
increased correspondingly
excf state governments is that taxes which
the country. Ever since 1972-73, which was beyond resources of L powers between the centre and the are
the country the exchange union, while those with a local base
crisis. But for the
foreign aid, it would has faced serious foreign ve an interstate base are levied by the
powers belong to the union. The union taxes
country to tide over have been well the levied by
this difficulty. nigh impossible for as
the states. The residuary Constitution of India
are:
laid in List I, Seventh schedule the
of
 SERIES
UNIT 2: 1S5UES FROM INDIAN PUBLIC FINANCE
UNIVERSITY
Shiv Das DELHI 51 n
50
income; Firstly, certain duties
which are levied by
• Taxes on income other
than agricultural by the union but are collected
appropriated the states. These mainly include stanp duties and
Corporation tax; not containcd DPedical preparations containing alcohol and narcotics. and excise duties
alcoholic liquor and narcotics
•
on Secondly, there are
• Excise duties except in certain taxes
which are levied and collected by the union
but the entire proceeds
medical or toilet preparations; hich are assigned to the states, in
proportion determined by the parliament.
These taxes include succession and estate duties, terrninal taxes
• Custom duties;
• Estate and succession duties
other than on agricultural land: passengers, taxes on railway freight and fares, taxes on in goods and
• Taxes on the capital value of assets,
except agricultural land of i transactions on stock
exchanges and futures markets and taxes on the sale and purchase of newspapers
viduals and companies; od advertisements. Thirdly, central tax on income and union excise duties
• Rates of stamp duties on financial
documents; nro levied and collected by the union but were shared by it with the sates a
• Taxes other than stamp duties on transaction in stock exchanges
and manner. in
prescribed
future markets; Grants-in-Aid. Since most of the important welfare and development
newspapers and on advertisements:
Taxes on sale or purchase of programmes are entrusted to the state governments, gaps between their
• Taxes on railways freight and fares;
expenditure and revenues usually take place and these gaps are corrected by
• Terminal taxes on goods or passengers carried by railways, sea or air: the centre by providing enough resources through transfer of resources from
and centre to states. This is done partly by arrangements for tax sharing. But grants
• Taxes on the sale or purchase of goods in the course of interstate trade in-aid by the union for specific purposes or general aid have come to occupy arn
Taxes within the jurisdiction of the states as given in the List 11 of the Seventh important place in centre-state financial relations in India. The grants also serve
schedule of the Constitution of India are: the purpose of correcting interstate disparities in resources.
• Land revenue; Q. 10. Suggest measures to improve Centre-State financial relations. [2013
• Taxes on the sale and purchase of goods, except newspapers; Ans. Meaisures to improve Centre-State fnancial relations. In India, the state
•
Taxes on agricultural income; of financial relations between the centre and the state governments has become a
• Taxes on land and building matter of serious controversy. The states have often voiced their concern at their
on the other hand.
• Succession and estate duties on 'agricultural land; increasing financial dependence on the centre. The centre,
• Excise on alcoholic liquors and narcotics; finds faults with the states for their lack of sense of responsibility and indiference
• Taxes on mineral rights; to the basic tenets of financial discipline and resource mobilization. Thus the centre
• Taxes on vehicles, animals and boats; state financial relations have often been marked by tensions and animosity.
between the Union and
• Stamp duties except those on financial documents; The general complaint against the financial relations
• Taxes on goods and passengers carried by board of inland waterways; the states concerns the division of resources. The states have a grievance that
• Taxes on luxuries including by and large the taxes with the Union
are quite elastic whereas those left with
entertainment, betting and gambling is also narrow. The states maintain
• Tolls; the states are inelastic and their tax base
to them the responsibility for development
• Taxes on professions, trades, callings that the Constitution has assigned
and employments; building of social overheads. Additionally,
Taxes on advertisements other than those contained in newspapers;
• Works, rural and social uplift and on
ie of law and order, the expenditure
•
Capitation taxes. tne responsibility for the maintenance are
gone up by leaps and bounds. Thus there
Allocation and Distribution of Central Revenne. The Indian Constituton Beneral administration has also
gaps between revenue' and expenditure. resources has
provides for the distribution or devolution of financial resources from the cenue states on the Union for financial
to the states as it felt that the allocation of financial resources 1he heavy dependence of the and initiative of the
did not correspo the jurisdiction, authority
with the assigned functions and that the resource gap in states in progressive erosion of defined spheres.
might widen States in their own constitutionally centre-state financial
the years. Specifically for this purpose, Article 280 of Constitution comprehensive review of
provides for the setting of a Finance Commission the Indian ence the solution lies in a political and tinancial autonomy for the states
by the President of India relations. In this regard, to see the centre, the
five years or earlier. The constitution apart ed
collected power and financial resources of the some state
by the states, had provided from the taxes levied and list
d
drastic restriction of the Commission and also
for the revenues union the Surkaria
to be allocated, partly or for certain taxes on the
wholly to the states. These various ral government appointedcommissions.
groups. provisions fall into 8Overnments constituted their
 UNIVERSITY SERIES UNIT 2: ISSUES FROM INDIAN
52 Shiv Das DELHI PUBLIC FINANCE
53
governnment of
its report to the India Problems of Indian tax system:
The Sarkaria Conmmission submitted
was necessary to preserve the unity 1 Lack
of adequacy. Despite generating
1988. According to the commission, it tho .hd
and
the tax collections are still inadequate increasing revenues every year,
the country and accordingly the commission rejected to meet the requirements
integrity of of
Indian economy. Every year the Central government of the
either to reduce the functions the centre or
suggestions made before it recommendations and reports to public borrowings to meet the expenditure.
increases deficit
made several with regard to
modify them. The commission
However, the central government did not accept
all 2. Lack of equity. Despite being progressive, the Indian tax system
its terms of reference. any case, the Sarkaria Commiect falls short of the criteria of equity and certainty still
recommendations of.the commission. In in complete sense. Lack
recommnendations are not the last word on the question of centre-state relaio of equity is visible in case of exemption granted to agricultural income.
any solution to the centre-state relation Similarly, unorganised sector is out of tax-net, thus giving rise to tax
The question is still wide open. Thus
ultimately depend on political will, the bargaining process between the
statoe havens in some pockets of the economy.
Commission 3. Regressive nature of indirect tax. Indirect taxes are levied on consumption
and the centre and the rules of engagement of the Finance
of goods. Since poor people and middle class have high propensity to
Q. 11. Give important features of Indian Tax system and discuss the problems consume than the rich, they pay more tax through expenditure on goods
faced by it? and services.
Ans. Features of Indian Tax System. 4. Uncertainty due to -change in policy. The taxation schemes in India
() Proper Distribution of tax power. Indiais a federation of states and have been considerably fluctuating over the years. This has resulted in
Union Territories. As per the Constitution of India, the area and sphere
frequent tarnpering with tax exemptions and concessiors thus giving to
of taxation are clearly demarcated between Centre and the States. For uncertainty. This is further damaged due to changes in goals of taxation
example, collection of Income tax comes under the purview of the centre.
in subsequent period or/and'when a new government assumes office.
In case of collection of Goods And Services Tax (GST), Centre collects 5. Complex law. Indian tax laws are complex due to the perceived level of
CGST and the States collect State Level GST i.e. SGST. difficulty in interpreting these laws and rules in the relevant jurisdictions.
(i) Multiple taxes, Both direct and indirect taxes are imposed by the India has tax administration index of 58.4 percent which percent.
is below the
government in India. Direct,taxes include income tax, wealth tax, capital average index for the entire Asia-pacific region at 60.3 The
investors to take risk and
gains tax, gift tax, corporate tax etc. Recently government of India brought higher Long-Term Capital Gain tax discourages
reforms in indirect tax by introducing one common Goods and Services provide jobs througth business.
Tax (GST). The main aim of GST is to curb the cascading effect of other tax, a direct tax, contributes
6. Low contribution of income tax. Income is
indirect taxes. revenue. The majority which
very, less, around 25 per cent to total tax reason being
tax. The main
(i) Larger share of indirect tax. The share of indirect taxes in the total tax a huge 75 per cent is contributed by indirect welfare
tax payment. From the
collection is very high in India. Indirect taxes account for more than 75% exemption of agriculture income from
falls on
of the total tax revenue. The share of direct tax is very low. incidence burden of indirect tax mostiy
angle it has been argued that goods in desired quantity.
(iv) Low tax GDP ratio. Tax GDP ratio in India falls
in the range of o consumers who could not consume their desired are
Dividends taxed twice–One,
percent. This is very low as compared to other developed countries. 7. Double taxation
on dividends.
government. A part
developed countries like Sweden, France, UK. USA etc. tax GDP raio tax and other taxes to the
companies pay corporationdistributed among shareholders in the form of
varies between 30 to 40 percent. tax is
of the net profit aftergovernment again taxes such dividends in the form
() Higher Burden on Urban Area. Incidence of taxatipn is higher in u dividend. Two, the as a high taxing country & less
India as compared to rural India. This is because of the fact that in rue personal income tax. This makes India
of
India income level is lower and complex
agricultural income exempted from business friendly. Corruption in public life,
Tax avoidance. rich
taxation.
6. Tax evasion
and of Shell companies of
(vi) Progressive nature. are to interpret, existence information,
Indian tax system is progressive in nature. It takes laws which
difficult
financing elections, lack of
into account the principle transparency and tax
of ability to pay. As tax base increases tax people, lack of resulted in tax evasion
rates also increases. So system ete in India have
richer people pay more tax than others. Similarly Complex political 2020-21?
luxury goods are taxed at government budget
higher rates. avoidance. structure and thrust areas of government budget?
(vi) Productivity. The Indian tax
system has exhibited buoyancy Give the given in the Indian government of
currently. The tax revenue good deal of with 2 2. the various concepts of deficit
of India. The
has been showing increasing trend plain Structure of the budget of Government
increase in national income.
Ans.
 UNIT 2: 1S5UES FROM
54 Shiv Das DELHI UNIVERSITY SERIES INDIAN PUBLIC
FINANCE
every year in the month of peficit on Capital account. The excess 55
India through finance ministry prescnts the budget 2. of capital expenditure over capital
February. The Finance Minister is responsible for presenting the budget in h receipts capital deficit
Budget Session of the Parliament.
Tdgetary deficit. The sum total of revenue
deficit and capital deficit
Normally the Budget consists of two major parts called Budgetary defiit. is
A. Revenue Budget which gives estimates of Revenue Receipts and Reven Budgetary deficit = Revenue
deficit + Capital deficit
Expenditure referring to the current year. Budgetary deficit is financed through
B. Capital Budget which gives estimates of Capital Receipts and Capital
the sale of 91-days adhoc Treasury
Bills and drawing down of Cash balances,
Expenditure. Eiscal deficit. This is also called gross fiscal
deficit. Fiscal deficit measures
Revenue receipts consist of () Tax revenue and (i) Non tax revenue which that portion of government expenditure which is financed
includes interest, non-interest and grants. by borrowings
including 91 days adhoc Treasury Bills and drawing down of
Capital Receipts consist of () Recoveries (ii) Borrowings other than 91 davs Cash
adhoc Treasury Bills, (i) Other net capital receipts and (iv) Sale of public assets. balances.
Eiscal deficit = Total exp. - (Revenue Receipts +
Total Receipts = Revenue Receipts + Capital Receipts = Borrowings, other than through 91
Recovertes Sale of Pubtic Assets)
Expenditure on Revenue Account or simply revenue expenditure includes days adhoc Treasury Bills + Sale of
(a) Interest payments, and (b) Non-interest expenditures public assets + Budgetary deficit.
Expenditure on Capital Account or simply the capital expenditure includes 5. Net Fiscal Deficit. It measures the difference between Fiscal deficit and
(a) Loans and Advances (b) Capital outlay.
Loans and advances on Capital account.
Total Expenditure = Revenue Expenditure + Capital E:xpenditure Net fiscal deficit = Fiscal deficit - Loans and Advances
The Budget also gives estimate of Borrowings through 91 days adhoc Treasury
6. Primary Deficit. It is also called Gross Primary Deficit.
Bills and drawing down of Cash balances.
Gross Primary Deficit = Fiscal Defcit - Net Interest Prments - Interest Recepts
Thrust Areas of the Budget 2020-21. The major thrust areas of the budget of
2020-21 were the following .where( Net Interest Payments Interest Paynents - Interest Receipts
7. Net Primary Deficit. This is obtained by subtracting Loans and Advances
1. Improving governance through
(a) Structural Reformms from primary deficit.
Net Primary Deficit =
I

(b) Digital Revolution

(c) Inclusive growth resources of local bodies in India?
Q13: Describe the various financial
2. Ease of living by focusing on can be divided into two broad
Ans. The financial resources of local bodies
() Aspirational India: categories- () tax revenue and (i) non-tax
revenue.
(a) Agriculture arid Rural India of the Taxation Enquiry
(b) Wellness, water and sanitation 1. Tax Revenue, Based on the recommendations
revenue bodies include the following
(c) Education and skill Commission the sources of tax for local
are very lucrative
Taxes on advertisements
Together these three comprise Aspirational 0) Tax on advertisements.
India sources of revenue for local bodies depending
on their size and location.
() Economic development, encouraging source can be very high in tourist areas, heavy
(a) Industry The collections from this
etc.
(b) Commerce and investment traffic junctions, crowded places enter a
(c) Infrastructure taxes. Octroi is a tax levy on goods which
") Octroi and terminal are in transit
(a) New economy tar is a tax on goods which
local aréa, whereas terninal states except for
(ifi) Caring society, been abolished in all
comprising
(a) Women and child through that area. Now octroi has
welfare Maharashtra.
(b) Culture and
tourism and on lands and building include both
(c) Environment Tax on Lands and Buildings. Taxes tax etc. as well as Service charges
and climae () as House or Property
3. Development of financial sector change Kinds of tax such water supply etc.
Concept of deficits as for Street lighting, scavenging Governments assign
Such charge on vehicles, State
1. Revenue Deficit.
It is defined an excess of on vehicles, In case of taxes
Laxes bodies.
revenue account. expenditure over receipts Vehicle tax to the local are existing
4 share of Motor
O

Taxes on animals and boats

Revenue deficit = Revenue boats.
expenditure - Revenue Receipt = on animals and because of their
unpopularity.
Revenue deficit (? 0) 1) Taxes hardly collected
on paper but ate
 UNIT 2 : ISSUES
56 Shiv Das DELHI UNIVERSITY SERIES FROM INDIAN
pandemic. This PUBLIC FINANCE
during the is less than 57
(v) Taxes on professions. Tax on professions is regressive in nature. The Commission for the period the 42%
share recommended
Finance
state assigns a share from this local bodies based on the income of 2015-2020.
The reason for by the 14th
of1% is to provide for the
newly formed this adjustment
assessees. Union Territories
Kashmir,and Ladakh from the resources of of Jammu'and
(vi) Other taxes. Some,other taxes include Entertainiment tax, Tax on sellers the Centre.
Estimates given by the 15th
in the pavement markets etc. Finance Commission
2. Non Tax Revernue of Local Bodies. This includes grants from State According to the 15th Finance Cormmission,
Government, carnings from public undertakings such as Water supply, Transport. 6-vear period are expected to the ross tax revenues
for
be 135.2 crore. After
earnings from Leasing of lands, buildings and plots. It also includes fees, fines and and surcharges and cost of collection, lakh deducting cesses
payments for certain services. Another non-tax revenue for local bodies consists the rernaining part as
Divisible Pool is estimated to be called the
of Loans and advances from the State Government or from Central Government. 103 lakh crore.
States' share at 41 per cent of divisible comes
Recently some urban local bodies have started opting for Market borrowings as pool to ?42.2 lakh crore for
2021-2026 period.
in case of Ahmadabad, Pune and Bengaluru etc.
Adding total grants of <10.33 lakh crore to
0. 14. What are the terms and references of 15th Finance Commission? Give the above mentioned share,
the major recommendations of 15th Finance commision. the aggregate transters to States are estimated to remain at
per cent of the Divisible around 50.9
Ans. The Finance Commission (FC) is a constitutional body formed by the Pol during 2021-2026 period.
Presidernt of India to give recommendations on Centre-State financial relátions. Total transfers (Devolution + Grants) constitute about 34 per
cent of
Since independence 15th Finance Commission have estimated Gross Revenue Receipts of the Union leaving adequate fiscal
been appointed. The
15th Finance Commission was appointed in 2017
under the CHairmanship of space for the Union to meet its resource requirements
and spending
Mr. N. K. Singh which was required to submit specific recommehdations obligations on national development priorities.
for the
financial year 2020-21 and general recommendations for the
five year period from Criteria for Devolution
2021 to 2026. The first report was tabled
in Parliament in February 2020 and the
second and final report was submitted on February 1, 2021.s The criteria adopted by the 15th Finance Commision for devolution purpose
Key recommendations in the report for 2021-2026 include:
As per the 27th November 2017 Gazette Notification
includes- Income Distance, Demographic Performance, Forest and Ecology and
Tax and Fiscal Efforts.
of the Governmeht of India,
the 15th Finance Commission shall make recommendations as • Income distance. Income distance is the distance of a State's incoma from
to the following
matters, namely:
the State with the highest income. Income of a State has been computed
() The distribution between the Union and the States' of as average per capita GSDP during the three-vear period between
the Net proceeds
of taxes under Chapter I, Part XI] of the Constitution 2016-17 and 2018-19. A State with lower per-capita income will have
and the allocation
between the States of the respective shares of
(ti) The principles which would govern
such proceeds; a higher share to maintain equity among States. The reference period
the Grants-in-aid of the revenues for computing Income distance and Tax efforts
is 2016-2019 for the
of the States out of the Consolidated Fund
of India apd the sums to recommendation period 2021-2026.
be paid to the States by way of Grants-in-aid Reference of the Commission
of their,revenues under
Article 275 of the Constitution for purposes Demographic performance. The Terms of
other than those specified in data of 2011 while making
the provisos to Clause 1 of that article; and required it to use the population criterion has been
(iii) The measures needed to augment
the Consolidated Fund of a State to Tecommendations. The Demographic performance
by States in controlling their
population.
supplement the resources of the Panchayats
and Municipalities in used to reward efforts made higher on this criterion.
the State on the basis of the recommendations will be scored
made by the Finance States with a lover fertility ratio arrived at by calculating the
Commission of the State. This criterion has been
Recommendations of the 15th Finance orest and ecology.forests of each State in the total
dense forests of all the
mentioned terms and references,
Commission. Based on the above Share of the dense
the recommendations of the 15th States. reward States with
Commission can be given as follows: Finance criterion has been used to average
x
and fiscal efforts. This s
the ratioof the
1. Share of States
in Central Taxes efficiency. It is measured during
5er ax collectionrevenue average per-capita State GDP
The share of States in the Central taxes own tax and the
to be 41%in order to maintain for the period 2021-2026 is Tcapita 2018-19,
predictability and stability resources,
of
recommended thethree years between 2016-17 and
especially
 UNIT 2: IS5UES FROM
SERIES INDIAN PUBLIC
Shiv Das DELHI UNIVERSITY FINANCE 59
58
to different criteria
.Crants to local bodies. The
total Grants to both
Table: Weights assigned local bodies taken
together will be 24.36 rural and urban
Commission
by the 15th Finance includes performance-linked lakh crore, part of
which
Grants.
14th Fintance 15th Finance be made available to all three tiers The Grants to local bodies will
Criteria of Panchayat-village, Block,
Commission Commission District. This Grant will also and
include Grant for health care
2015-20 2021-26 infrastructure. Grants to local bodies and health
(other tharn
distributed among states based on population health grants) will be
Income Distance 50.0 45.0 and area, with 90% and
10% weightage, respectively subject to
certain conditions.
15.0 15.0 (n) Disaster risk management.
Area The Commission recormrnended
the existing cost-sharing patterns between the Centre retaining
Population (1971) 17.5 and States for
Disaster management funds which is given as
Population (2011) 10.0 15.0 . 90:10 for
North-Eastern and Himalayan States, and
Demographic Performance 12.5 75:25 for all other States. State Disaster Managernent
funds will have
a corpus of
Forest Cover 7.5 1.6 lakh crore.
3. Fiscal Roadmap
Forest and Ecology 10.0
() The Commission šuggested that the Centre bring down fiscal deficit to
Tax and fiscal efforts 2.5 4% of GDP by 2025-26. For States, it recommended the fiscal deficit limit
Total 100 100 (as % of GSDP) of:
4% in 2021-22,
2. Grants. • 3.5% in 2022-23, and
• 3% during 2023-26.
As per the 15th Finance Commission's recommendations, the following grants
A State is allowed to avail ynutilized brrowings within the recommended
would be provided to States from the central resources over the period of
2021-2026: period if it is unable to utilize the funds.
(ii) States are granted an extra annual borrowing worth 0.5% of Gross
() Revenue deficit Grants. 17 States will receive Grants worth 2.9 lakh State Domestic Product (GSDP) during first four years (2021-2025) for
crore to eliminate revenue deficit.
(i) Sectorspecific Grants: Sector-specific Grants include: undertaking power sector reforms including:
• • reduction in operational losses,
health,
school education, reduction in revenue gap,
• higher education, reduction in payment of cash subsidy by adopting direct benefit
• implementation of agricultural
reforms, transfer, and
revenue.
• maintenance of PMGSY
roads, reduction in tariff subsidy as a percentage of
• judiciary, (ii) The Commission observed that the recommended path for fiscal deficit
will result in a reduction of total liabilities of
statistics, and for the Centre and States
• aspirational districts both Centre and the States.
and blocks. A part of these grants wil be grOup to
(0) It recommended forming. high-powered inter-goverrnmental (FRBMM).
a
performante-linked. It was recommended that
1.3 lakh crore will Responsibility and Budget Management Act
be given to States covering these eight sectors. review the Fiscal
the 15tn Finance
(i) State-specific Grants. The Commission recommended
State-specitic () To increase efficiency in revenue mobilization,asset-based taxation
and
Grants in the areas of: Commission recommended that income
implementation of various steps such
• social needs,
should be strengthened through
• administrative governance related to tax deduction and
and infrastructure, as expansion of coverage of provisions duty
• water and sanitation, Tapping the potentials of Stamp
collection at source (TDS/TCS), Integration of computerised
preservation of culture and historical at the State level,
monuments, and Registration fees Consideration
• high-cost
physical infrastructure, and records with the registration of transactions, and
• tourism. A Property governments should streamline the
total sum of 49,599 crore will be Or market value of
properties. State
earmarked for this.
methodology of property valuation.
60 Shiv Das DELHI UNIVERSITY
SERIES 2022 (MAY-JUNE)
nood
(vi) Regarding GST the Finance
Commission suggested that there is Name of the Paper
: Public Finance
to resolve the inverted duty structure between
intermediate inputs and Course B.Com. (Hons.)
rationalized and Revenue Name of the
be
final outputs. GST Rate structure should to step up field Semester IV
neutrality of GST rate should be restored.
States need minutes
ensuring compliarnce. Duration :3 hours 30
efforts for expanding the GST base and for The question paper is divided into Maximum marks: 75
(vii) The Finance Commission recommended for establishment of an tvo sections.
Attempt five questions in
all, sclecting three
to develop a comprehensive framework for from Sectin A
and
independent Fiscal Council Simple calculator is pernissible. tuo from Section B.

public financial management which includes preparation of standard

format for financial reporting, accuracy in macroeconomic forecasting
etc. The Council will play an advisory role and have powers to assess
records from the Centre as well as States.
(vii) States should amend their fiscal responsibility legislation to ensure
consistency with the Centre's legislation by forming an independent debt
management cell to manage their borrowing programmes efficiently.
Other recommendations of the 15th Finance Commnission.
() Regarding Health, the States should increas spending on health to
more than 8% of their budget by 2022. Primary healthcare expenditure
should be two-thirds of the total health expenditure by 2022 and All India
Medical and Health Service should be established.
(i) Regarding funding of Defence and internal security the Finance
Commission has recommended for constitution of a dedicated
non-lapsable fund called the Modernisation Fund with an estimated corpus
of 2.4 lakh crore to bridge the gap between budgetary requirements and
allocation for capital outlay in Defence and internal. security.
(ii) Finally, the Finance Commission has called for transparency in
management of Centrally-Sponsored Schemes (CSS). It has recommended
that third-party evaluatión of all Centrally Sponsored Schemes should
be completed within a stipulated time frame.
Section A
l) What is the importance of fiscal functions of the State
with respect
n allocation, distribution and stabilization? Explain.
t Discuss why imperfect competition may
lead to Pareto inefficiency
especially under monopoly market structure.
6
Ans. (a) Importance of fiscalfunctions of the State are:
() Resource allocation through collection of taxes, giving subsidies, making
policies through regulations and controls.
(i) Redistribution of income to bring about equity and reduce inequality.
(i) Stabilization of the economy to remove fluctuations in prices and output.
Above mentioned fiscal functions are important due to the following reasons:
(a) Fiscal function is necessary to achieve full employment of resources.
(b) Control of inflation and bringing about stability in prices.
() Fiscal functions can be used to remove poverty and inequality by
implementing redistribution measures and employment generation
schemes through mobilization of resources.
(a) Fiscal function ensure achieving targeted rate of economic growth.
(e) Fiscal functions can prevent market failure and ensure socially desirable
level of output to be produced.
() Through fiscal functions the government can maintain a healthy balance
of payment situation in the international market.
Also, See Q. 6, Unit I. [Page 5
(0) Imperfect competition may lead to Pareto inefficiency especially under
monopoly market, because in monopoly market power is concentrated with the
Single seller and price charged by single seller is higher than the Marginal Cost
as against that equal to MC charged by a competitive firm.
Pareto-efficiency requires that
MCx
MRPTx, Y = P and MRITx, Y= MCy
Py

Hence MRPTY y cannot be equal to p unless

MCxPx
MCy
P competition
which only in a competitive and
nmarket not in imperfect
is possible Pareto-inefficiency exists in a monopoly
and monopoly market. That is why
market.

MRTSXK MRTS K.

61
62 Shiv Das DELHI
UNIVERSITY SERIES

competition structure .. PUBLIC FINANCE-2022 (MAY-JUNE)

63
power of the scllers destroys the At output Q*, Total Social Benefit =a+ b + c
In sum, market failure.
poses as a potential
source of market
to market failure? and Total Social Cost b +c
are externalities? How do these ead to the soct
So, Total Social Surplus at output Q* = (a +
Q.2. (a) What a diagram, the gains and losses b+ )- (b+ c) = a
(b) Discuss with the help of Hence a movement from inefficient level of output
a efficie Q' to efficient level of
a inefficient level of output to socially output Q* in the presence of negative externality has caused the
from moving from socially Is a zero levpl ot social surplus
presence of negative externalities. to increase by an area equal to f. So is called dead
level of output in the f weight loss from being at
9
externality socially desirable? [Pages 28-29
optimal market level of production.
Ans. (a) See Q. 19, Unit
1.
Zero externality is not the correct answer or socially desirable. It is not possible
(b) A negative externality
occurs when the market interactions of others impoee to achieve zero externality except in the case of totally stopping
are adversely affected production itself.
cost on non-market participants. For exanple, non-smokers External cost will always be present, be it market level of output or optimal
smokers. So negative externality creates Social output level in the presence of externality. At the socially efficient level of output,
by the air pollution generated by
Cost over and above the Private Cost of production. the external cost can be reduced but not eliminated, which can be easily verified
+
Social Cost = Private Cost External Cost from the given diagram. At Q level of output which is inefficient level, the
or Marginal Social Cost (MSC) External Cost = b+e+f.
- Marginal Private Cost (MPC) + Marginal External Cost (MEC) At Socially Optimal or Efficient Level of output Q", External Cost = b+e.
Symbolically, MSC = MPC + MEC So external cost is not eliminated at all and zero externality is not desirable.
= + in
Let us see the social surplus and symbolically, MSC MPC MEC losses Only external cost can be reduced and optimally maintained.
the presence of negative externality. p Q. 3. (a) Many Government programs both redistribute income and correct
In the Diagram, the Demand Curve is shown MSC = MPC + MEC a market failure. What are the market failures associated with each of these
as MSB/MPB (Marginal Social/Private benefit) programs? 6
MPC
which is downward sloping. The Supply Curve in () Social security (i) Public elementary education
the absence of any negative externality is given as (6) "In dealing with a negative externality problem, Pigouvian Tax and
MPC Accordingly, the competitive equilibrium is Pigouvian Subsidy Schemes bring an equally efficient outcome with different
happening at point E where MSB = MPC, and the d MSB/MPB distributional consequences.' Discuss. Mention two problems associated with
output is Q. For output rate Q, the Total Private the Pigouvian Subsidy Program. 7+2
Benefit (TPB) at point E is equal to Ans. (a) () Social security and market failure. Welfare programmes such
a+b+c+ d +e.The Private Cost at point =c+d. E as social security schemes in the form of, say, insurance, creates moral hazard
Hence Total Market Surplus at point E without negative externality is equal to problem which causes market failure. Moral hazard refers to a situation where
Total Market Surplus = Total Benefit - Total Cost one side of the market cannot observe the actions of the other. For this reason it
= (a+ b + is also called a lidden action problem.
c+d+è)- (c+ d) A person avails social security scheme in order to be compensated for any
.Total Market Surplus = a
+b+e
When negative externality occurs, the society incurs external cost so that the unforeseen loss. For that person may also have to bear some cost or pay some
new supply curve is given as MSC = MPC+ MEC. price.
The new equilibrium point 15
E' where MSB = MSC. The new optimal level of output is Q*. By For example A person may buy insurance against theft of the motor bike but
moving ront
to Q', the market Surplus is reduced. there are many problems involved which affect both, the Buyer of insurance and
Thus At Q", Total Market Surplus = Benefit-Cost the Insurance company.
= (a + A Buyer of insurance may not take adequate care of the motor bike against
b+c) -c any possible theft just because he/she will be fully compensated if the bike is
a+b care. In case of
Now, Calculation of Social Surplus and Stolen. So, here moral hazard refers to lack of incentive to take
Loss: care of
Total Social Surplus = Total Social - Total Social Cost no insurance, the person has to bear lot of risk by taking On the other
Benefit
At output , Total Social Benefit Side, the seller of insurance or Insurance Company faces problem of estimating
=
a+ b + c+ d te on the probability of risk
and Total Social Cost b+ c+d + the actual care taken by an individual which depends
Hence Total Social etf to be undertaken and hence fixing the rate of premium to be charged for buying
Surplus
at (a + b+c+d+ e) - (b + c + d+e) Insurance. So, unlike a competitive market which produces quantity through
=a-f
 UNIVERSITY SERIES
64 Shiv Das DELHI PUBLIC FINANCE-2022 (MAY-JUNE)
65
equilibrium, a moral
interaction of demand and
supply and achieve hazard The output at point E or Market equilibrium is
equilibrium due to lack of
information about the does not reflect Marginal External Cost
Q
which is inefficient as it
problem cannot achieve market (MEC). With negative externality,
consumers as in the case of social security. Marginal Social Cost (MSC) is above MPC, Where MSC = MPC + the
actual behaviour of Public Elementary MEC
Education and market failure. Hence with negative externality the equilibrium is
(i) Public Elementary a source of market imperfection reached at point E where
as
causes market failure it is MSB = MSC.
Education
prove this:
Following arguments can be given to
MSC reflects the external cost by an amount =
There is presence of externality in the
provision of Public Elementary Pigouvian tax which is imposed to reflect the externalE'P MSC-MPC. This is
cost. ACcordingly, socially
co
Education. Education is vital to democracy, creates better optimal level of output, Q, will be achieved where MSB = MSC as at point
E.
Social benef
environment and key source of development. So, the Pigouvian Subsidy. Pigouvian Subsidy Scheme works in case of positive
education is far higher than the private benefit that market difficulty fe externality in which market interaction of others brings benefits to
non-market
market to produce optimum level. participants. When market does not reflect the actual social benefit, a Pigouvian
are children who do not a1. subsidy can be offered to adjust output so that total social benefit can increase
Recipients of Elementary Education
decisions with respect to attending school and receiving education. It causing increase in net social gain.
is the parents of the children who take decisions regarding spending
money on their children's education. So, amount of education to be made
P Net Gain
available depends on estimation of parental preference which makes it MPC
difficult for the market to function properly as preferences may differ
from person to person.
Uniform Price for education cannot be fixed if it is provided by Private MSB
Schools. Private schooling can be affordable for rich, but not for other Po- G
poor sections and backward classes of the society. So, Government must MPB
intervene to provide elementary education.
(b) Negative externality problem can be dealt effectively by imposing Pigouvian
Quantity
Tax so that socially optimal level of output can be achieved.
Working of Pigouvian tax: Pigouvian tax (a tax proposed by famous economist In the given diagram market equilibrium is achieved at point E initially with
Pigou) is imposed to reflect the external cost associated with negative externality. Marginal Private Benefit being equal to Marginal Private Cost or MPB = MPC.
If external cost is not taken into account, then there will be over-production which Equilibrium output is Q, and Price is P,. However, due to positive externality
is socially undesirable or inefficient, causing market failure. If
external costs are the Total Social Benefit is much more than Private Benefit. A Pigouvian Subsidy
covered by Pigouvian tax, then social cost will be more than private cost due to equal to EG can be offered to reflect the Total Social Benefit so the actual demand
addition of external cost and the resultant output level will curve becomes MSB and the new equilibrium will be at point E" and new output
be socially efficient
level of output as shown the diagram. will be higher at Q. At socially optimal Output. Q the shaded area NEE*
the net gain to society, Output, Q, Market Price is P, but consumers will only
P
pay P, which is equal to MPB and the difference P,P, or E'G is called Pigouvian
-MSC subsidy which will be borne by the Government.
Hence, Pigouvian tax and Pigouvian subsidy are meant to correct market
tax
Pigouvian
MPC failure and achieve socially optimal or efficient level of output.
Q. 4. (a) What is tax incidence? What are the various alternative concepts of
tax incidence? 7
introduction of a tax into a competitive
(b) Explain using diagrams how
MSB/MYO,Q pay and the price that
market creates a wedge between the price that buyers
tax.
sellers receive in the case of (i) Unit tax (i) Ad-valorem 8
In the given diagram,
incidence means the last burden of the tax. In case of Direct Tax,
E
where, MSB (Marginal the competitive market equilibrium achieved at point Ans. (a) Tax
is of tax (last burden of
Social/ Private Benefit) = Cost) Impact of tax means first burden of the tax and incidence
Or, MPB = MSB MPC(Marginal Private same person. in case of Indirect Tax impact of tax falls on
the tax) falls on the But

66 Shiv Das DELHI UNIVERSITY SERIES
on the consumers. In other
producers initially, but final or incidence of tax falls person
words, we can say that incidence of tax
or last burden of tax falls on that
who actually pays for it.
finally bear the
Thus, incidence of a tax is upon those economic units who
money burden of it and are not able to pass it on to others. Incidence lies upon
that final source from which the tax money comes.
All tvpes of Indirect Taxes like Excise Duty, GST etc. burden is borne by
different persons. First burden of indirect taxes is borne by the producer but the
incidence of tax is borne by the consumers. On the other hand, Direct taxes like
Income Tax, Gift Tax, House Tax etc. burden direct taxes is borne by the same
person who pays it and it cannot be shifted to the other person.
Theorics of Tax Shifting and Incidence
1. Earlier Theories: The earlier theories may be classified into:
(2) Concentration or Surplus theory: According to concentration theory, each
tax tends to concentrate on a particular class of people who happen to
enjoy surplus from their products.
(b) Diversion or Diffusion theory: The diffusion theory states that the tax
eventually gets diffused in the entire society. That is, the final placing of
tax is not one but multiple. The process of diffusion takes place through
shifting or through process of exchange.
PUBLIC FINANCE-2022 (MAY-[UNE)
67
Further, the Distributional aspect or Incidence of Taxation
aspect can be of
three types which are as follows:
1. Absolute Tax Incidence. It
examines the effect of a tax on the state of
income distribution when there is no change in
either other taxes or
public expenditure. Absolute incidence analysis does not consider
the use
tax revenue and considers only the burden of a
change in taxes.
2. Differential Tax Incidence. It examines
the difference in incidence when
one tax is replaced with another, holding the government budget constant.
other words, a differential incidence analysis considers the change in
distribution as one tax is replaced with another.
3. Budget Incidence. It takes into account the combined effects of change
tax and government spending financed by those taxes. The reason for
taking government spending into account is that distributional effect of
a tax depends on how government spends the money collected as tax
revenues which are usually not assigned for particular expenditures.
Therefore, budget incidence analyses change in distribution which results from
a simultaneous change in tax and expenditure policy.
(b) In a competitive market the introduction
of tax creates a gap or wedge betvween the price Price
Consumer Pays ç
that the buyer pays and the price that the seller P

2 Modern Theory: According to Modern theory, the concentration and receives in the case of unit tax and ad-valorem
diffusion theories are partially true. Actually there are both concentration and tax. P
diffusion of taxes according to the conditions present. The Modern theory seeks The wedge or gap shows that how much tax Price
to analyse the conditions which bring about concentration or diffusion. paid by the consumer and the revenue received Producer Receives
Alternatives concepts of Tax Incidence. Imnposition of tax leads to a series by producer, equals to the size of tax levied. Quantity
of wide ranging changes in the economy. For example, a tax is imposed on a
seller producing a product with many substitutes and seller tries to shift the () Per unit tax is a tax imposed on a particular
burden of the tax on buyers by raising the price. Since many substitutes are commodity, the Supply Curve (S) shifts
available, buyers may not bear the burden by shifting away from the market upward to S', Cost of Production P also
of taxed product to the market of other substitutes. The effect of taxation will increases by per unit tax to Point P and Per
t.
further trickle down to employment market as factors will shift from one market unit tax is represented by
to another depending upon the changes in productive activity due to changes in When unit tax is imposed in the short run,
as cost
demand for the products of two markets. This is only an indicative example
but price increases arnd quantity falls, the D
the point here is that effect of taxation is wide ranging. Depending upon increases. Thus this burden of tax is shared
these by the Consumers who pay
a higher price
effects of taxation on economy, the total QQ
change or total economic conequence who do not cover Quantity
can be said to have three aspects: and by the producers
run, some
Resource transfer impact: It involves transfer resources their average costs. In the long
of from private to the industry as a result supply decreases and
firms would start leaving on
public use as a result of taxation. nominal profit. Now, the whole burden will fall
Incidence of taxation. It is also known as losses convert into
distributional aspect includes.
resulting change in the distribution of income the consumers. tax like Sales Tax, VAT or MODVAT
a result of a tax.
available for private use as (i) Ad-Valorem tax–It is called Indirecttax is a fixed percentage of the price
(modified Value Added Tax). This tax, but
Output effect. It indicates a change in the level is quite similar to that of Unit
of output or real income of a commodity. The analysis collected from
as a result of a change in tax. assuming that tax is
is somewhat easier to explain by
consumers rather than the suppliers.
68 Shiv Das DELHI UNIVERSITY SERIES PUBLIC FINANCE-2022
(MAY-JUNE) 69
by the
When this Ad-Valorem tax is imposed, fraction of price paid
a (b)Utility Possibility Curve and Welfare
consumers is taken by the government and the price (net of tax) is received Maximisation. Utility Possibility
Curve is
by the producers.
the locus of points of maximum utility
for
In the given diagram, D is the Demand Curve
Good A for any other level of utility for
Good
before tax and OQo is quantity produced at
B. In the
given diagram point F where
Price OPo Welfare Curve is tangent to this Utility
When tax is imposed, the producers do not Possibility Curve is called Maximum Welfare
receive all that the consumer pays because D
Point. Alpoints which are below the point F W

now some fixed fraction of the price goes to are called non-Pareto Optimality. Ww
D' Thus point
the govermment. Now the Demand Curve F is the point of maximum social advantage. A's utility U,

shifts to D' which shows the price net of taxes
received by producers at P, and the price paid
by consumer is P',. The difference between P' - P; is the tax per unit.
Q.5. Write short notes on any twvO:
(a) Pareto optimal conditions for the provision of public and private goods
(use diagram).
(b) Uility Possibility Curve and Welfare Maximization.
(c) Role of coverage and time period in the distribution of tax burden.
Ans. (a) Pareto optimal conditions for the provision
of public good is such that cannot be altered in any
way so that at least one person would be made better
off without making anybody worse off.
We can explain it with the help of Utility Possibility
Set. Here equilibrium point E shows Pareto efficiency
or Optimality where IC is tangent to Utility Possibility
Curve.
Public good is that good which can be used by all
the community people because these goods have the
feature of non-rivalry and Non-excludability.
Efficiency in provision of Public goods. The
criterion for efficiernt provision of goods, whether
they are private goods or public goods, is the same.
It is the equality of Marginal Benefit (MB) derived
Quantity (c) Role of coverage and time period in
the distribution of tax burden. Coverage
and time period plays a very important role in the distribution of tax burden.
Time period is classified by Marshall. According to
him, time period may be very
slhort period, a short period and a long period.
In case the time period is short then the supply of a product cannot
or it is a case of inelastic supply. In this case the whole burden tax changed
be
7.5 of will be falls
7.5
on sellers or producers.
7.5 In case there is a long-time period, then the supply can be easily changed as
well as managed. In this case the whole burden of tax falls on consumers. In
India there is multiple taxation system so that each and every person is covered
under the taxation system. For example, at present Goods and Services Tax (GST)
is imposed on all the goods and services provided by the government or Others.
So the burden of tax falls on all the people, whether they are rich or poor.
Q. 6. (a) Write down the major fiscal functions of a government in an
economy. Do you think that these functions often overlap in practice?
(b) What are the instruments of stabilisation policy used by the Government?
Uility Possibility Set>X
O
Discuss. 6
Ans. (a) See Q. 6, Unit 1. [Page 5
(6) The inistruments of Stabilization policy used by the Government are Fiscal
and Monetary Policies.
For Monetary policy. See Q. 2, Unit 2. (Page 42
EMB = D,+ D2
For Fiscal policy. See Q. 3, Unit 2. [Page 43
D

from an additional unit to its MC that is, MB = MC Benefit Section B

Here we assume that there are two beneficiaries MC
Q.7. In the first half of the year 2020, when global crude oil prices remained
one with Demand D, and the
other with Demand Cost below $40 per barrel on average, India's retail prices of Petroleum, Oil and
D,. The demands represent the Lubricants (POL) products remained high. What were the reasons behind this?
marginal benefits
derived by the respective consumers. The aggregate How has the relative share of Central and State Governments in the revenue
MB is calculated through vertical space provided by POL products changes from 2011-12 to 2019-20 before and
summation of D, Quantity
and D,. Marginal Cost of Production after devolution of taxes? 15
being given,
the MC curve is Horizontal. Ans. Factors Leading to the 2020 Oil Price Drop.
It shows cost is fixed for all In 2020, worldwide demand for oil fell rapidly as governments closed
the units of the public good,
level of output of the public
good is determined at e, the
Efficient or Optimal businesses and restricted travel due to the COVID-19 pandemic.
MC and EMB. point of intersection of The COVID-19 pandemic triggered an unprecedented demand
shock
It is Q".
a collapse in oil prices. Demand for oil
in the oil industry, leading to
70 Shiv Das DELHI UNIVERSITY SERIES PUBLIC FINANCE-2022
When oil or crude come from (MAY-JUNE) 71
businesses, issucd
cratered as governments around the world shuttered firstly base price is taken, after
abroad or gulf countries,
in the price of crude oil
stay-at-home mandates and restricted travel. that
in March and State Government Sales Tax the Central Government Sales Tax (CGST)
• An oil price war between Russia and Saudi Arabia erupted (SGST) are included
in it. Apart from that
commission of the petrol pump owner
2020 when the two nations failed to reach a consensus on oil production and transportation cost are also included.
This way the price of POL increases
levels. which actually paid by the consumers.
In April, 2020 an oversupply of oil led to an unprecedented collapse in The whole burden of increase in price of
consumers. The government petroleum products is borne
by the
oil prices, forcing the contract futures price for West Texas Intermediate in 2019-20 increased the excise
a excise duty collection was 2.38 lakh crore duty on petrol. The
(WTI) to plummet from $18 a barrel to around -$37 barrel. which
• By the summer of 2020, oil prices began to rebound as nations emerged 2020-21.A major portion of Government's was inçreased to 3.84 lakh crore in
being provided by the increased
from lockdowns and the Organization of the Petroleum Exporting prices as due to COVID the commercial and
manufacturing activities had come
to a standstill.
Countries (OPEC) agreed to major cuts in crude oil production.
• By year-end, optimism about the planned rollout of multiple COVID-19 Q. 8. Discuss the gains from the implementation
of Goods and Services Tax
vaccines buoyed the market. In November 2020, Brent crude oil spot (GST). What are the distortions associated
with GST? 15
Ans. Goods and Services Tax (GST) is an indirect tax
prices increased to an average of $43 a barrel. (or Consumption tax)
WIIfinished 2020 at a price of $49 per barrel, while Brent crude finished used in India on the supply of goods and services. It is a comprehensive,
staged, destination-based tax: Comprehensive because it has subsumed multi
the year at a price of $51 per barrel. almost all
Global crude prices reached a trough of $21/barrel (bbl) in April 2020. Since the indirect taxes except a few state taxes. Multi-staged as, the GST
is imposed
then, these increased marginally but have remained below $40/bbl on average. at every step in the production process, but is meant to be refunded to all the
However, India's retail prices of Petroleum, Oil and Lubricant (POL) products parties in the various stages of production other than the final consumer. As a
have remained high during this period due to the impact of Central and State
destination-based tax, it is collected from point of Consumption and not from
taxes. This has given rise to the paradoxical and unexpected situation where point of origin like previous taxes.
low global crude prices have been accompanied by high retail prices of POL It is a boon for all due to the following reasons:
1. GST has mainly removed the cascading effect on the sale of goods
products in India. In fact, the Centre and States have competed to share the and
revenue space created by the lower global crude prices without passing on any services. Removal of this effect has impacted the cost of goods. GST has
benefit to the consumers and the users. The Central Government is in a position removed this cascading effect as the tax is calculated only on the value
to pre-emptively increase excise duties on POL products. It also has the option addition at each stage of the transfer of ownership.
2. In the case of Goods and Service Tax, there is a way to claim credit for
to increase either the basic excise duty which is shareable with states or special
additional excise duty or additional excise duty which are not shareable with the tax paid in acquiring input. What happens in this case is, the individual
states. who has paid a tax already can claim credit for this tax whern he submits
The dynamics of these changes have significant implications for the sharing his taxes.
3. Due to full and seamless credit, manufacturers or traders do not have to
of the revenue space between the Centre and the States. This trend was driven
by erosion of the buoyancy of Centre's gross tax revenues (GTRs) as also the. include taxes as a part of their cost of production, which is a big reason
weak revenues of the states in 2019-20 and in the subsequent years. With both that has contributed to a reduction in prices. Hence GST leads to decrease
in prices and helps price sensitive consumers.
the central and state governments increasing taxes on POL products under their 4. GST regime also brought a centralised system of way bills by the
respective control, their retail prices have increased in the recent months. This has
introduction of "E-way bills" for movement of goods inter-state and
the potential of impacting inflation through the cost side and may also eventually
intra-state on an invoice exceeding a prescribed limit for smooth and
hamper the growth momentum. barrier-free movement of goods.
In the first half of the year 2020, when global crude oil prices
remained below 5. Instead of maintaining bulky records, returns and reporting under
$40 per barrel on average, India's retail prices on Petroleum, Oil and Lubricants as the
(POL) products remained high. The reason behind different statutes, all assessees are more comfortable under GST,
this is imposition of Central simplifies the procedure of claiming
compliance cost is reduced. also
It
and State Government Taxes like (VAT). Sometimes POL price
increase due to input tax credit.
increase in World Crude Oil price but when global to return filing, indirect tax
then why in India POL Price remained high, its
price of crude oil is less, 6. With online GST processes, from registration
one of the key benefits of GST that
totally affected by government. compliance has been reduced. This is
taxation rule.
72 Shiv Das DELHI UNIVERSITY SERIES PUBLIC FINANCE–2022 (MAY-JUNE)
73
ease. The
carry out their business operations with The New GST system is still evolving, Every now
assists companies to
start-ups is that they do not have to are found and are being rectified. and then, whatever the faults
major benefit of GST registration for Also it will take a couple of years to
VAT, Service tax, excise, etc. make this
get involved in different registrations like system more effective and more convenient.
in India had to maintain
7. Pre GST administration, the logistics industry o.9. Consider the following information about an economy:
ensure current CST and state entrv
various warehouses across states to C= 100 + 0.5 (Y - T)

taxes were avoided on interstate movements. As a GST outcome, reduced

an revenue involved in the T= 100
logistics costs have led to increase in business
G= 200
supply of goods via transportation. I= 100
S. With transparent GST mechanism, unorganized sector
can be efficiently
like textiles and Where is the consumption function, G denotes government
C

regulated. Some particular industries in India expenditure,

With provision T is taxes and I is planned investment.
construction are highly unorganized and unregulated.
more () Find the equilibrium level of output (income) by way of calculation as
of online compliances and payments, the GST system has become
well as graphically. Also, find the government expenditure multiplier
accountable.
9. With the online facility to directly register, file returns, and make payments and the tax multiplier. 6
of taxes online, the whole tax mechanism has become transparent. The
(i) Define and derive the balanced budget multiplier. If the government
online system keeps a strict check on frauds and evasion without having increases its expenditure and taxes by 100 units each, what would be
to interact with tax authorities. The shift from traditional GST practices the impact on the equilibrium level of income? Caleulate. Will it
to online modes helps build acorruption-free tax administration and is a remain unchanged? Why or why not? 9
Ans. () As we Y =
ker merit of GST Registration. know, I+C+G
Distortions associated with GST. Y= 100 + 100 + 0.5 (Y- 100) + 20C AS =Y
1. Increases costs due to software purchase: Businesses are required to -C+G+I
update their existing accounting software to GST software to continue Y=400 + 0.5Y - 50 Expenditu
C+G
business operations and be GST compliant. This leads to increased cost of Y- 0.5Y = 350
software purchase and training company personnel to efficiently utilize Y(1 - 0.5) =350
the new billing software. 350
350
2. Higher Tax Burden of SMEs: Earlier Small and Medium Enterprises were 1-0.5 0.5 = 700
required to pay excise duty only on a turnover exceeding 1.50 Crore
every financial year. At present, businesses with a turnover exceeding .. Income
Equilibrium income, Y= 700
Z40 Lacs are liable to pay GST under the GST administration.
3. Increased Burden of Compliance: The new GST regime states
that .:.
Government expenditure multiplier 1
companies have to mandatorily get GST registered in all the states they =MPG05-2
operate their businesses in. This leads to an unnecessary
burden on -MPC
and Tax multiplier = 1- MPC
-0.5 =
-1
businesses for tedious paperwork, processes and compliance. 1-0.5
4. No GST charged on petroleum products: The GST
Council excludes petrol (i) Balanced budget multiplier. The balanced budget multiplier states that an
and petroleum products under its administration. These products attract increase in Government spending combined with a matching increase in taxes
other taxes such as Central Excise Duty and Value willraise output by exactly the increase in Government spending. Equivalently
Added Tax (VAT)
levied by states. one.
the multiplier for a balanced budget change in Government spending is
5. GST is an online taxation system: From
GST Registration to filing GS1 This is derived in the following manner:
Returns, the Government has made online
provisions for GST. While Let Y = Income and Output
businesses are gradually accelerating digital
are not well-versed solutions, small companies C =Consumption
with the evolving and advanced technologies I=
solutions. It can be challenging for many and Investment
businesses to adopt a GSl G = Government spending
structure.
6. Provision for TR = Transfers
punishnent and penalties: Because
troubles and initial flaws penalties are of some teething T =Taxes
levied which are not Disposable Income
justified. Yp =
 UNIVERSITY SERIES PUBLIC FINANCE-2022 (MAY-JUNE)
74 Shiv Das DELHI 75
(MPC) To solve the disputes or conflicts between
the Central and State governments,
c= Marginal Propensity to Consume Finance commission was set up by President our
= Autonomous consumption of country for every five years
who recommend that how allocation of funds or transfer of funds from
Let G,
I, TR andT also be autonomous (constant) Central
Government to State Government will bé done, so that
= Y+ TR their conflicts can be
Now Yp -T= - solved and to also help in regional development in India.
i.c. Disposable Income Income
and Output + Transfers Tax
In India there is a wide gap between some rich states
C = C + cYp
and poor states and
regional imbalances. To solve the problems of regional imbalances of allocation
i.c.Consumption = Autonomous Consumption
+ c(Disposable Income)
of funds, grants are given to the backward regional areas for their development.
cY + TR T) - C
= + -
(b) (i) Fiscal Deficit: Fiscal deficit is defined as excess of total budget expenditure
At equilibrium, over total budget receipts excluding borrowings during a fiscal year.
TR -
In simple words, it
or Y= C + c(Y + T)
+I+G is the amount of borrowing the government has to resort to, to meet its expenses.
Y=C+ |+G
Now G increases by AG and T increases by AT A large deficit means a large amount of borrowings. Fiscal deficit is a measure
A, ATR and Al are zero of how much the government needs to borrow from the market to meet its
- cAT
So AY = (AY - AT) + AG or AY = cAY + AG
expenditures when its resources are inadequate.
Since AT = AG Fiscal deficit = Total expenditure - Total receipts exchuding Borrouwings
So AY - cAY = 4G- cAG Primary Deficit: Primary deficit is defined as Fiscal deficit of current year
ninus Interest payments on previous borrowings.
or
AY (1 - ) =AG(1 - c)
AY = AG
or
c-1 Fiscal deficit indicates borrowing requirements inclusive of interest payment,
This implies that a fully tax
financed Goverfment's purchases increase income but Primary deficit indicates borrowing requírement exclusive of interest payment
(i.e., amount of loan).
by the same amount so that balanced budget multiplier is one.
It shows how much government borrowing is going to meet its expenses other
Now, Impact on equilibrium income:
than Interest payments. Zero primary deficit means that government has to resort
AG = AT = 100
.::
to borrowing only to make the interest payments.
1.
Since balanced budget multiplier is
Primary deficit = Fiscal deficit - Interest payments
AY = AG Difference between Primary Deficit and Fiscal Deficit
So, income will rise by 100.
Basis Primary Deficit Fiscal Deficit
Q. 10. (a) Discuss the role of Finance Commission towards cooperative
It is the difference between It is the excess of total expenditure
federalism and how it can remove the imbalance in regional development in 1. Meaning
India. 9 fiscal deficit and -interest over total receipts (excluding
(b) Explain the difference between: payment. borrowings).
() Fiscal deficit and primary deficit 2. Indicator It is the total borrowingIt indicates the total borrowing
(i) Revenue deficit and effective revenue deficit 3+3 requirements of the govern- requirements of the government
Ans. (a) The Finance Commission was set up in India under The Finance ment, (excluding interest) (including interest)
=
Commission (Miscellaneous Provisions) Act, 1951 of Indian constitution. In India 3. Formulae Primary deficit = Fiscal Fiscal Deficit Total Expenditure
Federal Government system is followed in which three types of governments are - - Total Receipts (excluding bor
deficit lnterest payment
included which are Central government, State government and Local government. rowings)
Functions of the finance comnission: Primary deficit is the part of It is broad or wide in scope.
4. Scope
1. Distribution of net proceeds of taxes between the Centre
and the States, fiscal deficit hence, narrowv
to be divided as per their respective contribution to
the taxes. in scope.
2. Determine factor governing Grants-in-Aid to
the States and the magnitud lt reflects the extent of bor- It retlects the extent of borrowings
of the same. 5. Reflection
rowings by the government| by the government when interest.
3. To make recommendations to President as to
the measures needed to when interest payment ispayment is
accounted for.
augment the fund of a State to supplement the resources of
the Panchayats not accounted for.
and Municipalities the States on the basis of recommendations made
by the Finance Comnission of the State from
time to time,
76 Shiv Das DELHIUNIVERSITY SERIES
6. Importance Primary deficit points to the High fiscal deficit (in terms of
need for borrowing even borrowings) points to the lack of
when interest payment on fiscal discipline in the country. It
the existing loan is ignored. is a hurdle in the process of GDP
It reflects continuous growth.
fiscal discipline in the
country.
() Effective Revenue Deficit is the Difference betwcen Revenue deficit and
Grants for the creation of capital assets by the Center to the States. The concept of
effective revenue deficit has been suggestcd by the Rangarajan Committee on
Public Expenditure.
Effectire Revenue Deficit = Revenue Deficit - Creation of Capital Assets
It is aimed to deduct the money used out of Borrowings to finance capital
expenditure. The concept has been introduced to ascertain the Actual deficit in
the Revenue account after adjusting for expenditure of Capital nature.
Focusing on this will help in reducing the consumptive component of Revenue
deficit and create space for increased Capital spending.
Effective Revenue deficit is a relatively new term which was introduced in the
Union Budget 2011-12. While Revenue Deficit is the difference between Revenue
Receipts and Revenue expenditure, the present accounting system includes all
Grants from the Union Government to the State governments/Union Territories/
other bodies as Revenue expenditure, even if they are used to create assets. Such
assets created by the sub-national governments/bodies are owned by them and
not by the Union Government. Nevertheless, they do result in the creation of
durable assets. According to the Finance Ministry, such Revenue expenditures
contribute to the growth in the economy and therefore, should not be treated as
Unproductive in nature. Grants for creation of capital assets, as a concept, was
introduced in the FRBM Act through the amendment in 2012.
Revenue Deficit: Revenue deficit is the exCess of Total revenue expenditure of
the government over its Total revenue receipts.
Revenue deficit = Total Revenue expenditure - Total Revenue receipts
Revenue deficit signifies that government's own earning is insufficient to meet
its normal functioning. Revenue deficit results in borrowing, The deficit is to be
met from capital receipts, i.e., through borrowing and sale of its assets. Given
the same level of fiscal deficit, a higher revenue deficit is worse than lower one
because it impliesa higher repayment burden in future not matched by benefits
via investrments.