Module 3

Principle of Sound Finance

Balanced Budget as a criterion, due to following reasons:
1. Balanced budget except during times of war as
Unbalanced Budget leads to:-
• Borrowing (in case of Deficit Budget).
• Inflation.
• Economic Uncertainty and promotes instability.
• Increase in burden of public debt on future generations (in case of Deficit Budget).
• Increases Rate of Interest which reduces investment in private sector.
2. Existence of Say’s Law (Supply creates its own demand)
3. Market mechanism
4. Invisible hand (dd & ss forces)
5. Full employment assumption
6. A strong belief that every public expenditure is bad - tax revenue collected must be equal to the
public expenditure.
They believed in the principle of individualism hence sound finance was appreciated.
But after Great Depression (1929) things have changed, the market failure (due to many reasons)
force the government to play an active role. (this leads us to Functional Finance)
Limitation of Sound Finance: Whether budget can be balanced (revenue=expenditure) depends
on the policy goals that are to met and economic setting in which the budget operates.
Functional Finance
• Today the Government is the friend, philosopher and guide, helping the people from the cradle
to the grave. Therefore, expenditure is ever increasing. Given the tax evasion there is the deficit
budget, hence, there is functional finance. Today world faces undesirable cyclical fluctuation in
the economy (hence A.P. Lerner used the term Functional Finance) Keynes also believed that
more than monetary policy the fiscal policy is better suited to stabilize the economy (especially
from depression). (Till 1929-36 monetary policy was given maximum importance because the
classical school believed in the minimum role of the government and free market economy
which could automatically solve all economic problems).
• Accordingly during depression and recession, the public expenditure should be increased. The
principle of functional finance is based on welfare state idea. Social objectives are the basis of
functional finance when countries suffer from inflation or deflation, the idea of functional
finance i.e. the government interfering and bringing stability becomes more relevant. So today
fiscal policy is most powerful instrument in the hands of government. This emphasizes the role
of functional finance.
How to reduce unproductive expenditure and divert resources to productive areas, play active role in case
of failure of the market, introduction of public goods, solving problems like inequality through a proper
redistribution of income, promote economic growth with stability, full employment is the main job of
modern Government.
 The 3 rules of functional finance- A.P. Lerner
1. The government shall maintain a reasonable level of demand at all times (by increasing/decreasing tax
rates and government spending).
2. Maintain rate of interest which induces the optimum amount of investment.
3. If either the first 2 rules conflicts with the principle of sound finance, balancing the budget or limiting the
national debt then government press shall print money that may nodded to carry out rule 1 and rule 2.
In particular, Lerner’s rules specifically ruled out worrying about the size of country’s budget deficit or
national debt. In fact what comes to be known as “Keynesian policy” for government intervention in
macroeconomic affairs of the country was basically an application of Lerner’s rules of functional finance.
Role of Govt. - Correcting market imperfections
1) Fiscal policy can be used to ensure efficient resource allocation. Taxes can be levied on goods
which cause external diseconomies and subsidies can be extended those goods whose production
causes external economies.
2) Strict regulatory measures can be taken to reduce diseconomies. For example effective
implementation of pollution control measures, traffic control measures etc. can promote social
welfare.
3) Dissemination of information enable people to make right decisions. Through this the problem
due to asymmetric information can be minimised.
4) When the private sector fails to produce adequate quantity of a good desired by the people, the
public sector should be encouraged to produce such goods to satisfy the demands of the public.
5) Suitable legislations can be passed and implemented to prevent unfair trade practices by
monopoly and oligopoly firms.
• All the above measures can ensure efficient allocation of resources and maximization of welfare.
Concept of Public Goods
• To understand the meaning of public goods clearly, one must first of
all divide goods into:
1) rival and non-rival
2) excludable and non-excludable
1) rival and non-rival
• rival good – if no 2 persons can consume the same unit.
• Non rival good – when 2 persons can consume the same thing i.e. 1
person’s consumption does not affect the consumption of that
product for other person. E.g. National Defense.
Excludable and non-excludable
• Excludable good – if people can be prevented from obtaining it.
• non-excludable good- when good once produced cannot be
prevented from consumption by anyone. E.g. Lighthouse, Police
Protection, flood control, etc.
• Public Good (Def): all non-rival and non-excludable goods are public
goods.
• Obviously, private sector will not provide these goods because it is
extremely difficult to protect property rights and use them to make
profits.
Significance of role of govt. – provision of
public goods
1. Overcoming the Free-Rider problem: Free rider problem says a rational person will not
contribute to the provision (pay for) of public goods because anyway he will be
benefitted. So, direct provision of a public good by the government to group of people
by charging nominal price (e.g. ration shops providing goods at lower price to those
having saffron colour card) or provide pure public goods to all (e.g. lighthouse,
defence), can help to overcome the free-rider problem.
2. Non rival Nature of Goods: The non rival nature of consumption provides a strong case
for the government rather than the market to provide and pay for public goods.
3. Efficient Provision of Goods: If the government provides public goods they may be able
to do so more efficiently because of economies of scale(reduction in cost due to large
scale production).
4. Social Welfare: State provision may help to prevent the under provision and under
consumption of public goods so that social welfare is improved.
 OBJECTIVES OF FISCAL POLICY
• Def: The policy of the government pertaining to public revenue, public expenditure and public debt is known as fiscal
policy.
• The fiscal policy is formulated with specific objectives in view. The objective in developed countries is to achieve economic
stability and maintain high aggregate demand.
• In developing countries the goal is to achieve economic growth and development
• Following are some of the objectives of fiscal policy.
1. Optimum Allocation of Resources: The most important function of fiscal policy is to determine how the country resources
will be allocated. What should be the share of different sectors of the economy in terms of resource allocation? This is
closely related to the government taxation and expenditure policies. Allocation of resources depends upon the collection of
taxes and size and composition of government expenditure. The national budget determine how funds are allocated to
different heads of expenses. The policy of public expenditure is used by the government to directly undertake resource
allocation for different sectors. On the other hand the government can use taxation and subsidies to indirectly influence
resource allocation. For example, tax incentive given to SEZ units will encourage investors to direct resources to those units.
2. Full Employment: The importance of fiscal policy as an economic tool gained significance during the Great Depression 1930s
when the developed countries were suffering from unemployment. Thus, the main objective of fiscal policy was defined as
achievement of full employment. For this the fiscal policy should be designed to keep the level of aggregate demand high.
In developing economies government expenditure on social and economic infrastructure is used to generate employment
opportunities.
• 3. Economic Stability: Stabilization of the economy is another important function of fiscal policy,
especially in developed economies that experience business cycles. The cyclical nature of the market in
these economies causes fluctuations in variables like income, output, investment and employment
causing hardships to the people. When growth periods end, they are followed by contraction in the
form of recession. Fiscal policy is meant to counter these fluctuations. This is known as counter cyclical
fiscal policy. A counter cyclical fiscal policy is adopted to counter the effects of recession and
depression by following a deficit budget. This brings about an increase in government expenditure to
generate employment and decrease in taxes to Induce consumption and investment On the other
hand, during inflation, government expenditure is lowered to reduce aggregate demand and prices. A
surplus budget is followed.

• 4. Increasing the Rate of Investment and Capital Formation: In developing countries the problem is of
mass and structural unemployment. Fiscal policy in such countries is aimed at Increasing the rate of
capital formation through Investment. This can be done by giving tax incentives and subsidies to
encourage private sector investment. Also, in many developing countries, the government directly
takes part in capital formation through investment in social and economic infrastructure.
• 5. Encouraging Socially Optimum Pattern of Investment: In developing countries fiscal policy can direct
investment in those fields that are most desirable from social point of view. For example, fiscal incentives to
small-scale industries and infrastructure development.

• 6. Reducing Income Inequalities: Fiscal policy can be effectively used to manipulate the distribution of national
income and resources. Taxation and public expenditure policies are used by the government to reduce
inequalities. Progressive direct taxes imposes heavier burden on the rich than the poor. Public expenditure on
social infrastructure and subsidies on food, housing, health and education help reduce income inequality.

• 7. Reducing Unemployment and Underemployment: Public expenditure can play an important role in this
regard. Public work programmes can be initiated to create employment and to absorb surplus labour from
areas of underemployment especially in developing countries.

• 8. Controlling Inflation: Developing countries need to resort to deficit financing in order to finance their
programmes of industrialization and infrastructure building. This creates inflationary conditions in the
economy as purchasing power is bound to rise with deficit financing. In order to control inflation, the ideal
fiscal response would be reduction of public expenditure. But this is unlikely to take place in a developing
country and hence the fiscal response should be in the form of encouraging supply of goods and services
though appropriate incentives. As supply increases, the inflationary pressure is likely to be on the decline.
Instruments of Fiscal Policy:
The tools of fiscal policy are taxes, expenditure, public debt and a nation’s budget. They consist of changes in government revenues
or rates of the tax structure so as to encourage or restrict private expenditures on consumption and investment.
Public expenditures include normal government expenditures, capital expenditures on public works, relief expenditures, subsidies of
various types, transfer payments and social security benefits.
Government expenditures are income-creating while taxes are primarily income-reducing. Management of public debt in most
countries has also become an important tool of fiscal policy. It aims at influencing aggregate spending through changes in the
holding of liquid assets.
During inflation, fiscal policy aims at controlling excessive aggregate spending, while during depression it aims at making up the
deficiency in effective demand for raising the economy from the depths of depression. The following considerations may be noted in
the adoption of proper policy instruments.
Taxation and Redistribution:
Income redistribution by the price-mechanism will normally tilt in favour of those whose labour  (by virtue of natural ability and acquired
education and skills) command high wages. This implies that without government intervention, some people in society who have less
ability due to low level of education and training received, the aged, those who were not able to accumulate or inherit large property
resources, and those who are physically and mentally handicapped will receive no income at all through the price system. Thus, the
market/price system promotes income inequalities thereby creating poverty and inequality amidst overall plenty in the economy.

Thus modern day governments intervene in the operation of the economy to correct unjust inequality of income through the
introduction of the taxation system, among other programmes, which is designed to take from the rich and less from the poor. Taxation
as a concept involves more than the mere imposition of the compulsory payment of sums of money by the government. Different taxes
contribute to the attainment of different objectives. Thus, some taxes would help in the redistribution of income and wealth more
equitably. However a tax which tries to reduce income inequalities might discourage saving and investment and thereby retard capital
accumulation and economic growth. It is, therefore, necessary that a judicious mixture of taxes be chosen so as to minimize their
possible ill effects and strengthen their beneficial effects for the economy.
• Anti-inflationary Nature of Taxation
• During inflation, surplus budget is followed. i.e. more taxation and less of public expenditure so as to control demand pull inflation.
• The more tax the government collects, the less net savings. On the other hand, in general, the higher the volume of voluntary
savings, the smaller the task that confronts taxation and other compulsory measures.

• There are a number of reasons why taxes are desirable, even as a mere replacement of savings. In waging fiscal war on inflation,
additional taxes can and must play a prominent part. In the withdrawal of excessive purchasing power taxes have three important
advantages over alternative measures.

• (i) Taxation reduces the need for costly administrative controls an inflation. 
• (ii) Taxes restrict the accumulation of public debt, and thus ease problem of debt management. By reducing the interest burden,
taxes give the Government greater fiscal freedom to cope with the economic problems.
• (iii) In a war situation taxes help prevent wartime inflation, and strike the roots of potential post-war inflation. If consumers,
especially those in the middle and lower income groups, accumulate great quantities of war bonds and other forms of savings,
there may be a dangerous surge of purchasing power immediately after the war.
TYPES OF FISCAL POLICY
• Based on their experiences of sound and functional finance policies, countries have evolved fiscal policies to suit
their own requirements. Most modern economies follow some version of functional finance in deciding on their
fiscal policy. In most developed economies the primary objective of fiscal policy is to counter the harmful effects
of economic fluctuations.
• Following are some of the types of fiscal policies used:
1. Automatic Stabilisers
• When the national income rises and the economy experiences prosperity and inflation takes place. During such
times, tax revenue automatically increases and government expenditure on social security like unemployment
benefits reduces as less people are unemployed. This keeps effective demand under control and slows down the
growth of aggregate demand preventing inflation.
• On the other hand, during recession public expenditure on unemployment benefits and other social security
measures automatically go up while tax revenue falls. Due to this the growth of aggregate demand increases
Production rises, unemployment falls and this prevents the economy from going into depression
• These changes in tax revenue and government expenditure take place automatically due to the built-in
flexibility in the fiscal system. This leads to automatic stabilization of the economy.
• Automatic stabilisers works only under certain conditions. They will be ineffective in case of cost push inflation
or inflation caused due to deficit financing. If the economy is affected by external factors like worldwide
recession, automatic stabilisers will not work. Also they are not applicable to developing economies where
built-in flexibility in the fiscal system is very limited.
2. Discretionary Fiscal Policy: In this type of fiscal policy, the government makes deliberate
changes in its taxation and expenditure policies in order to achieve some targets. Changes are
made in tax rates and structure, size and composition of public expenditure and debt.
Changes in tax rates addition or abolition of taxes, result in changing the disposable income of
people and bring about the desired changes in aggregate demand.
• Discretionary changes in government expenditure takes the form of expansion or reduction in
the size of expenditure, changing the composition and sources of financing, changes in
transfer payments like pensions, unemployment benefits etc., surplus or deficit in the budget
and methods of financing deficit. All these changes have an impact on aggregate demand
through consumption and investment expenditure.
• Discretionary fiscal policy is effective only when it is used for short run corrections in the
economy. For long run structural changes there should be effective automatic stabilisers.
Besides, time lags in recognising a particular problem and implementing the discretionary
policy measure reduce the impact of the policy.
3. Contracyclical Fiscal Policy or Compensatory Fiscal Policy: The main objective of contra-cyclical fiscal policy is
to achieve economic stability. The purpose is to counter the phases of business cycle and minimise their
negative impact on the economy. Such a fiscal policy is discretionary in nature and consists of deliberate
budgetary action taken to manipulate aggregate demand. The budget is the primary instrument of
compensatory fiscal policy .
A. Fiscal Policy during Recession and Depression
1. Pump- priming Here the government tries to revive economic activities in those sectors that are stagnant
and their revival is necessary to take the economy out of recession, done by government spending.
2. Compensatory spending This kind of spending is adopted to compensate the decline in private investment
during recession and depression.
B. Fiscal Policy during Inflation:
(i) Government expenditure: reduces
(ii) Taxation: increases
(iii) Public Borrowing is increased to control aggregate demand
❑CANONS OF TAXATION
•By canons of taxation we simply mean the characteristics or qualities which a good
tax system should possess. In fact, canons of taxation are related to the
administrative part of a tax. Adam Smith first devised the principles or canons of
taxation in 1776.
•Even in the 21st century, His canons of taxation are applied by the modern
governments while imposing and collecting taxes.

⮚Adam Smith the father of modern political economy gave us four principle of
taxation which he called the canons of taxation

1.Canon of equality or ability: All citizens should contribute to support government,

in proportion to their respective abilities. This canon is about economic justice. By
equality it means equality of sacrifice, i.e. the people should pay taxes in
proportion to their incomes. This principle supports/talks about progressive
taxation.
2.Canon of certainty: Taxpayers should not be subject to arbitrariness and
discretion of the tax officials. The form of payment, the manner of payment, the
quantity to be paid, all ought to be clear and plain to the contributor and to every
other person. If there is no certainty there is scope for a corrupt tax
administration.
3. Canon of convenience: Every tax ought to be levied at the
time or in the manner in which it is most likely to be
convenient for the contributor to pay it. The canon
recommends that unnecessary trouble to the tax payers
should be avoided.
4. Canon of economy: refers to cost of collection and that cost
should be minimum. Every tax should take out and to keep out
of the pockets of the people as little as possible, over and
above what it brings into the public treasury of the state. This
canon gives importance to productivity of taxes.

• Besides these canons there are some additional principles that

have been suggested given the character of the modern state.
5. Canon of diversity: The system of taxation should include a large number of
taxes, both direct and indirect. Variety in taxes is desirable from the point of
view of equity, yield and stability. However, too many taxes can violate the
canon of economy. If a single tax system is introduced, only a particular
sector will be asked to pay, leaving a large number of population untouched.
Obviously, incidence of such a tax system will be greatest on certain
taxpayers. 
6. Canon of elasticity: Also known as the canon of flexibility. The tax system
should be elastic such that when the government is in need of more funds it
should be able to increase its resources without additional cost of collection.
E.g. by raising the rates of taxation or their coverage(rational increase in no.
of people paying tax) to suit the changing requirements of the economy and
treasury.
7. Canon of functional efficiency: Tax policy should be efficient and objective.
The tax system should be easy to administer for the authority and it should
be implemented objectively.
8. Canon of productivity: Also known as the canon of fiscal adequacy.
According to a well-known classical economist in the field of public
finance, Charles F. Bastable, taxes must be productive or cost-
effective. This implies that the revenue yield from any tax must be a
sizable one. Further, this canon states that only those taxes should
be imposed that do not hamper productive effort of the community.
A tax is said to be a productive one only when it acts as an incentive
to production.
9. Canon of simplicity: The tax system should be simple to
understand. If it is complicated, it is difficult to administer and open
to differences of opinion, interpretation and consequently leads to
oppression, corruption and legal disputes
10. Canon of social objectives: Charging and collection of taxes should
be in line with the economic and social policy of the government.
• Thus, to conclude, taxation serves the following
purposes:
(i) To raise revenue for the government
(ii) To redistribute income and wealth from the rich to
the poor people
(iii) To protect domestic industries from foreign
competition
(iv) To promote social welfare.
Economic Effects of taxation
• Tax is an instrument of fiscal policy. The main purpose of tax is to collect revenue to meet the
government's expenditure Taxation as a policy instrument, however, has far-reaching implications
than what is apparently conceived, that is, raising revenue. We discuss below the effects of taxation
on various economic variables.
1. EFFECTS ON INCOME AND WEALTH
• Taxation has both favourable and unfavourable effects on the distribution of income and wealth.
Whether taxes reduce or increase income inequality depends on the nature of taxes. A steeply
progressive taxation system tends to reduce income inequality since the burden of such taxes falls
heavily on the richer persons.
• But a regressive tax system increases the inequality of income. Further, taxes imposed heavily on
luxuries and non-essential goods tend to have a favourable impact on income distribution. But
taxes imposed on necessary articles may have regressive effect on income distribution.
• However, we often find some conflicting role of taxes on output and distribution. A progressive
system of taxation has favourable effect on income distribution but it has disincentive effect on
output.
• A high dose of income tax will reduce inequalities but it will produce some unfavourable effects on
the ability to work, save, investment and finally, output. Both the goals - the equitable income
distribution and larger output - cannot be attained simultaneously.
• Realising the negative effects of steep rate of tax on income in India during 1970s and 1980s, the
government brought down the maximum of tax to 30 percent in 1990s.  At present tax rate varies
from 5 percent to 30 percent.
 EFFECTS ON CONSUMPTION
I. When taxes increase the price of the taxed good relative to the prices of untaxed or
lower taxed goods; it reduces consumption by affecting the taxpayer in two ways.
•1. Income Effect of taxation: The tax reduces the purchasing power or real income of
taxpayer. It takes resources away from the taxpayer and transfers them to the
government. This is often referred to as the direct burden of the tax.
• 
•2. Substitution (or Price) Effect of taxation: The tax creates an incentive for the
taxpayer to substitute less preferred but untaxed or lower-taxed goods in place of the
more preferred taxed good. The loss in consumer utility from this substitution is the
excess burden (or welfare cost) of the tax.

•Taxation influences the consumption; Such influence can be studied on the following
grounds:
II. When a tax influences the allocation of resources of individuals: Taxation reduces the
purchasing power of the people and it reduces their consumption. Every individual has
limited money income and allocates it to different uses. Taxation affects their
allocation directly or indirectly. For example, the income tax reduces the money
income of consumer and forces him to buy a smaller volume of goods and it reduces
the standard of living of the consumer.
3 Effects of Taxation on Consumption during Inflation and Depression: Taxation
has different effects in times of inflation and depression. During the time of
inflation the purchasing power of the people is reduced by a raise in the rates of
existing taxes or imposition of new taxes. This would control the consumption
and therefore, help in bringing in stability in prices.
• During the period of depression, taxation may be reduced. As a result of the
reduction on direct tax rates the people will have more disposable income and
higher purchasing power and a decrease in indirect taxes leads to the reduction
of selling prices. Both of them encourage the total consumption of the people
and thereby the economic activities are induced in the country.
• 4. Regulatory Effect of Taxation on Consumption: Taxation may be used to
regulate production and consumption. Consumption can be regulated by taxing
the production and use of certain commodities. For example, the objective of
some taxes may be to reduce the consumption of certain harmful commodities
such as alcohol, cigarettes etc.

• Since Y =C+S, any change in consumption will have its effect on savings, as S= Y-C.
Depending on the objective of fiscal policy taxation will be used to influence both
consumption and saving.
EFFECTS ON SAVINGS,
INVESTMENT AND PRODUCTION
• Taxation can influence production and growth. Such effects on production are analysed under
three heads:

1. Effects on the ability to work, save and invest

 
2 Effects on the willingness to work, save and invest
 
3, Effects on the allocation of resources

1. Effects on the Ability to Work, Save and Invest: Imposition of taxes results in the reduction of
disposable income of the taxpayers. This will reduce their expenditure on necessaries which are
required to be consumed for the sake of improving efficiency, As expenditures on necessities
suffers the ability to work declines. This ultimately adversely affect savings and investment. This
happens mainly in the case of the poor. The efficiency and ability to work of the rich are not
affected by taxes except, perhaps at a very high rate of taxation as it was the case in India when
the maximum income tax rate was 97.75% in the early 1970s.
• Not all taxes, however, have adverse effects on the ability to work. There are some harmful
goods, such as cigarettes and alcohol whose consumption has to be reduced to increase ability
to work. That is why high rate of taxes are often imposed on such harmful goods to curb their
consumption. But all taxes adversely affect ability to save. Since rich people save more than the
poor, progressive rate of taxation reduce savings potentiality. This means low level of
investment. Lower rate of investment negatively affects economic growth of a country Thus on
the whole, taxes have a disincentive effect on the ability to work save and invest.
2. Effects on the Willingness to Work Save and Invest: The effects of taxation on the willingness
to work, save and invest are partly the result of money burden of tax and partly the result of
psychological burden of tax.
• Taxes which are temporarily imposed to meet any emergency (example Kargil Tax imposed for
a year or so) or taxes imposed on windfall gain (e.g, lottery income) do not produce adverse
effects on the desire to work, save and invest. But if taxes are expected to continue in future,
it will reduce the willingness to work and save of taxpayers.
• Taxpayers have a feeling that every tax is a burden. This Psychological state of mind of the
taxpayers has a disincentive effect on the willingness to work. They feel that it is not worth
taking extra responsibility or putting in more hours because so much of their extra income
would be taken away by the Government in the form of taxes. However if taxpayers want to
maintain their existing standard of living they may not only continue to work in the midst of
payment of large taxes, they might put in extra efforts to make up for the income lost in tax.
• It is suggested that effects of taxes upon the willingness to work save and invest depends on
the income elasticity of demand.  Income elasticity of demand varies from individual to
individual.
• If the Income demand of an individual taxpayer is inelastic a cut in income consequent
upon the imposition of taxes will induce him to work more and to save more so that the lost
income is at least partially recovered. On the other hand, the desire to work and save of
those people whose demand for income is elastic will be comparatively less.
• Thus, we have conflicting views on the incentives to work. But it would seem logical that
there must be a disincentive effect of these taxes at some point.
3. Effects on the Allocation of Resources: By diverting resources to
the desired directions/sectors, taxation can influence the volume or
the size of production as well as the pattern of production in the
economy. It may, in the ultimate analysis produce some beneficial
effects on production. High taxation on harmful drugs and
commodities will reduce their consumptions.
• This will discourage production of these commodities and scarce
resources will now be diverted from their production to the other
products which are useful for economic growth. Similarly, tax
concessions on some products are given  in a region which is
considered as backward. Thus, taxation may promote balanced
regional development.
• However, not necessarily such beneficial effect will always be
reaped. There are some taxes which may produce some
unfavourable effects on production. Taxes imposed by local or state
governments on certain products may divert resources from one
region to another. Such unhealthy diversion may cause reduction of
consumption and production of these products.
4. REDISTRIBUTIVE EFFECTS 
• Income redistribution by the price mechanism will normally tilt in
favour of those whose labour (by virtue of natural ability and acquired
education and skills) command high wages. This implies that without
government intervention, some people in society who have less ability
due to low level of education and training received. the aged, those
who were not able to accumulate or inherit large property resources
will have less income and those who are physically and mentally
handicapped will receive no income at all through the price system.
Thus, the market/price system promotes income inequalities thereby
creating poverty and inequality amidst overall plenty in the economy.

• Thus modern day governments intervene in the operation of the

economy to correct unjust inequality of income through the
introduction of the taxation system, among other programmes which
is designed to take more from the rich and less from the poor.
Taxation as a concept involves more than the mere imposition of the
compulsory payment of sums of money by the government
• Different taxes contribute to the attainment of different objectives. Thus, some
taxes would help in the redistribution of income and wealth more equitably.
However a tax which tries to reduce income inequalities might discourage savings
and investment and thereby retard capital accumulation and economic growth. It
is, therefore, necessary that a judicious mixture of taxes be chosen so as to
minimize their possible ill effects and strengthen their beneficial effects for the
economy.

• India, at present is having different rates of tax on income, that is, 5, 20 and 30
percent plus surcharge. The indirect tax (GST) at different slabs to raise money
from the rich and spend it for the poor.

• However, it is necessary to keep in mind the negative effects of steep rate of

taxation on saving investment and production.

• Redistribution of income can also be achieved by offering incentives through tax

concession on investment to produce certain goods and services. Also, tax
holidays and tax rebates can be offered for Investing in economically backward
areas. Such investment may provide more employment and Income to the poor,
bringing down the inequality. Tax revenue spent on various schemes meant for the
poor also serve to reduce inequality.
5. ANTI-INFLATIONARY NATURE OF TAXATION
• Inflation is an universal phenomenon. Broadly inflation is the result of excess demand or
increase in cost. Taxation can check inflation by withdrawing excess purchasing power from
the economy, Tax on corporate profit, higher income, or luxury goods may check the
demand. Similarly, tax concession to produce essential goods will bring down the cost. It
may also provide incentive to increase the supply. Government through its tax policy should
manage to balance demand and supply.
• Tax reduction and concession may reduce the tax revenue, bringing down the government's
expenditure which in turn would decline the money supply and aggregate demand. Taxation
policy which controls inflation has other positive effect. Lower price level may encourage
exports bringing down trade deficit.
• Taxation which withdraws excessive purchasing power, beside controlling inflation has other
advantages too. They are
•It reduces the need for costly administrative controls.
• It reduces interest burden on public debt, if the government resorts to raise public debt to
reduce money supply. 
• In a war situation, taxes help to prevent war time inflation and strike at the root of potential
post war inflation, that is instead of taxes, if the government issues war bonds which can be
encashed during the post-war period, bringing more money in the economy aggravating the
post-war inflation.
Factors influencing incidence of taxation
• The following factors determine incidence and shifting of tax.
1.Elasticity of demand: if the taxed commodity had perfectly elastic demand price cannot be raised at all. The tax cannot be shifted
and hence the incidence will be wholly on the seller. In the other hand if the demand is perfectly inelastic, the incidence will be
wholly on the buyer. In between these two extremes, the burden of tax will be shared by the buyer and seller.
2. Elasticity of supply: when the taxed commodity had perfectly elastic supply the incidence of a tax will be fully on the buyer. When
the supply of a commodity is perfectly inelastic, the entire incidence will be on the seller.
3. Flexible price: price is the vehicle, which carries money burden of tax from the point of view of legal liability. If the tax is shifted
through a rise in price, it is called forward shifting. If the price cannot be raised, tax cannot be shifted. Price flexibility is the factor
that determines the shiftability of a tax.
4. Tax area: the nature of the area in which the tax is imposed also affects shifting of a tax. If the tax is imposed on a commodity, that
has a local market, it will be difficult to shift the tax by raising the price. Since people can avoid the tax by purchasing the commodity
from the neighbourhood market, where it's cheap.
5. Time period: in the short term supply is inelastic. Hence, during the period greater part of tax burden will be borne by the seller. In
the long-run, supply is more elastic: hence, there is greater scope to shifting the tax burden to buyers.
6. Coverage of tax: if the tax is general in character, falling on wide range of commodities, it is easy to shift the burden e.g. if the tax
levied on the tooth paste is general in nature- covering all brands and kinds, it will be readily get shifted. However, if a tax is imposed
on one brand of tooth paste, excluding the other brands, it is not possible to shift the tax burden. So we can say that shifting of a tax
is easier in the case of general taxes.
7. Availability of subsidiaries: taxes imposed on a commodity having no close substitutes, can be easily shifted to buyer. In the other
hand for commodity having close substitutes, shifting of tax on buyer is difficult.
8. Nature of demand for commodities: the nature of demand is different for commodities depending on whether they are necessaries,
comforts or luxuries. In case of necessary goods, demand is inelastic. Hence, the burden of tax is higher upon the buyer, than on seller.
In the case of comforts, demand is more elastic, hence burden of tax will be divided between buyer and seller. Coming to the case of
luxuries also, demand is elastic. Hence, the burden of tax is more on the seller. It cannot be easily shifted to the consumers.
9. Business conditions: shifting of a tax is influenced by the existing business condition in the economy. During periods of rising prices
and economic prosperity, taxes can be shifted more easily. However, during periods of depression, forward shifting of tax liability is very
difficult. Depression is a situation of falling prices.
10. Types of tax: shifting depends upon nature or type of tax imposed. If a tax is imposed on the excess profits of a firm under
monopoly or imperfect competition, the taxes will not be shifted. On the other hand, if the tax is levied on the output of the firm, a
part of burden can be shifted on to the consumers.
11. The policy of government: shiftability of a tax is determined by the laws and public policy. For example, sales tax legislation
stipulates that the burden of sales tax is to be borne by consumers. In the other hand, if prices are increased due to the attempt to
shift some taxes to be paid by the seller, awareness of tax laws helps the consumer to resist it.
12. Market conditions: shifting of tax is influenced by the conditions of market (perfect competition, monopoly, monopolistic
competition) for the product taxed.
Significance of public expenditure
• The term public expenditure refers to the expenses incurred by the public authorities - central, state and local governments for their own
maintenance and for the discharge of their duties towards the economy and the society as a whole. In recent years, it also includes the
expenditures incurred by the governments to help other countries.
• Significance:
• Social security contributions: Social security contributions are compulsory payments paid to the government that confer entitlement to
receive future social benefit. They include : unemployment insurance benefits and supplements, accident, injury and sickness benefits, old
-age, disability and survivors' pensions, family allowances, reimbursement for medical and hospital expenses or provisions of hospital or
medical services. Contributions may be levied on both employees and employers. Such payments are usually embarked to finance social
benefits and are often paid to those institutions of general government that provide such benefits. This indicator relates to government as a
whole (all government levels) and is measured in percentage both of GDP and of total taxation
• Generally, India's social security schemes cover the following types of social insurance:
1. Pension
2. Health insurance and medical benefit
3. Disability benefit 
4. Maternity benefit
5. Gratuity
• Unorganised sector employees may not be able to take advantage of these social security, the citizens of India employed and even
employed by foreign investors are entitled to coverage under the above schemes.
• Low income support: e.g. with health costs and free school meals support for people with less or no income could also take the form of
subsidies for food and fuel, low or no health care costs and food rations.
• Social insurance programmes: provides protection against various economic risk (e.g. loss of income due to sickness, old age, or
unemployment) and in which participation is compulsory. 
Types of Public expenditure
• Revenue expenditure: administration purpose (no returns in future)
• Capital expenditure: incurred on building durable assets (returns
in future are expected)
• Developmental expenditure and Non-Developmental expenditure:
Expenditure on irrigation projects, flood control measures,
transport and communication, capital formation in agricultural
and industrial sectors are de­scribed as developmental. On the
other hand, expenditure on defense, civil administration (i.e.,
police, jails and judiciary), interest on public debt etc., are put
into the category of non-development expenditure.
 Public Debt
• Public debt is one of the important source of income to the government in times of financial crisis,
emergencies like war, drought, etc.
• The act of borrowing by public authority creates a Public debt or Public borrowing.
Productive public expenditure
Encourages the ability to work, save and investment

Public debt is the total

- Debt incurred by central, state and local governments

Internal public debt is the debt incurred from within the country
-By Central, state and local governments from all sources.

Loans which the government promises to pay off at some

future date are called redeemable debts. 

Treasury Bills are extensively used as a means of short-term

(usually 90 days) borrowing by the government, generally,
for covering temporary deficits in the budgets.
Interest rates on such loans are generally low.
Public Debt and Fiscal Solvency
• Due to heavy public expenditure the fiscal deficit in Greece Rose to almost 13% of GDP much higher that they EU's 3% limit. The case of Greece
and some other European countries have brought to focus the question of fiscal sustainability of very large government budgets and the limit to
which the governments can borrow without harming the growth rate and solvency of the country.
• Fiscal solvency refers to the present ability of the government to spend to achieve public purposes. fiscal sustainability is the extend to which
patterns of current government spending do not undermine the capability of the government to continue to spend to achieve its public purposes.
• To understand the Fiscal sustainability of a government there are two basic measurements used public debt GDP ratio public debt export ratio.
• A literal lack of government's own currency can never undermine the capability of that government to continue to spend money to achieve its
public purposes. Inflation rather poses a problem and can put economy in inflationary cycle. It is in the context of the painful economic
adjustment associated with debt crises that it is essential to keep public debt within tolerable bounds and undertake public debt management.
• Public debt management: according to the World Bank Public debt management is a process of establishing and executing a strategy for
managing the government's debt in order to,
A. Raise the required amount of funding,
B. Achieve its risk and cost objectives
C. To meet any other sovereign debt management goals the government may have set, as developing and maintaining an efficient market for
government securities.
• Public debt generally involves the following
1.reduction in the primary deficit in the budget
2. reduction in the growth of current expenditure of the government
3. redemption of public debt.
 Burden of Public Debt
• Burden of Public Debt consist of the sacrifice that tax payer have to make for financial repayment of
principal amount and interest.
• Burden of Internal Public Debt
• Increases inequality: Purchasing power transfers from poor to rich.
• Adversely affects the ability and desire to work, save and invest
• Transfer purchasing power from young to older generation.
• Burden of unproductive debt: not self liquidating
• Burden of External Public Debt
• Direct money burden: The size of the burden would depends on the rate of interest and amount of the loan
incurred.
• Direct Real burden: It is measured in terms of loss of welfare suffered by people of the debtor of the country
due to repayment of debt.
• Indirect money burden and Indirect Real burden : This is measured in terms of effect on the production and
allocation of resources.
• Burden of unproductive foreign debt :The magnitude depends upon whether the debt is incurred for
productive purpose or unproductive purpose. If incurred for unproductive purpose it will create greater
burden on the community.
• Foreign currency burden increases
• Domination by creditor country
Types of Deficit