INTODUCTION TO PUBLIC FINANCE AND TAXATION

THEORY

Public Finance is the term, which has traditionally been used or

applied to the packages of those policy problems, which involve the
use of tax and expenditure measures. As a subject, public finance is a
study of public sector economics. It is about the revenue, expenditure
and debt operations of the government and the impact of these
measures to the society. Public Finance is, therefore, about fiscal
institutions, that is the tax systems, expenditure programs, and budget
procedures, stabilization instruments, debt issues, level of government
etc.

THE NEED FOR PUBLIC SECTOR:

From the economic point of view government, intervention is

necessary because of what is known as Market failure in such
functions as allocation of resources, distribution of income and
stabilization of the economy.

(a) Allocation Function:

The provision of social goods or the process by which total resources

used is divided between private and social goods and which chooses
the mix of social goods. This provision of social goods is what is
known as the allocation function. Market failure in the provision of
social goods is chosen. This provision of social goods is what is
known as the allocation function. Market failure in the provision of
social goods arises because of the presence of public goods. These are
goods we consume collectively and therefore one person who
purchased the good can exclude no one from the benefits arising from
consumption of such goods. To put id differently the benefits derived
by anyone consuming a social good are ‘exterilised’ in that they
become available to all others. Incase of private goods the benefits of
consumption are ‘internalized’ with a particular consumer whose
consumption excludes military defence, Law and Order (The Police),
Judiciary, Air clearing etc.

The market mechanism is well suited for the provision of private

goods. It is based on exchange, and exchange can occur only where
there is an exclusive title to the property, which is to be exchanged.
Application of the exclusion principle tends to be inefficient solution.
This is not the case for social goods, as it will be inefficient to exclude
anyone consumer from partaking in the benefits, when such
participation would not reduce consumption by anyone else. For
instance, you may cross the Salender Bridge as much as you can but
this does not reduce the possibility available to others to use the
bridge.

However, incases where benefits are available to all, consumers will

not voluntarily offer payments to supplier of social goods. Hence, no
voluntary payment is made especially where many consumers are
involved. The linkage between producer and consumer is broken and
the government must step in to provide for such goods.

 Distribution Function:

Again, the government has to intervene in order to adjust the

distribution of income and wealth to ensure conference with what
society considers a ‘fair’ or just state of distribution of income and
wealth to ensure conformance with what society considers a ‘fair’ or
just state of distribution. This fair or just distribution of income
cannot be achieved under the market mechanism. Under the market
mechanism, the distribution of income and wealth depends first of all
on the distribution of factor endowment and then determined by the
process of factor endowment and then determined by the process of
factor pricing, which in a competitive market, sets factor returns equal
to the value of marginal product. The distribution of income among
individuals thus depends on their factor supplies and the prices which
they fetch in the market.

Earning abilities differ, so does factor endowment, this distribution of

income may or may not be in line with what society considers fair and
just. It involves a substantive degree of inequality especially in the
distribution of capital income, and through views on distributional
income justice differ, most would agree that some adjustments are
required.
Among various fiscal devices, redistribution is implemented most
directly by:

 A tax scheme which combines progressive income taxation of

high income households with a subsidy to low income
households.
 Alternatively, redistribution may be implemented by progressive
income taxes used to finance public services especially those
such as public housing scheme, hospitals and other health care
schemes, education schemes etc which particularly benefit low
income households.
 A combination of taxes on goods purchased largely by high
income consumers with subsidies to other goods, which are
chiefly used by low-income earners.

1. Stabilization Function

Fiscal policy has to be designed by the government to maintain or

achieve the goals of high employment, a reasonable degree of price
level stability, soundness of foreign accounts and an acceptable rate of
economic growth. Fiscal policy is needed for stabilization of the
economy. Full employment and stability do not come about
automatically in a market economy but require public policy
guidance. Without it, the economy tends to be subject to substantial
fluctuations, and it may suffer firm sustained periods of
unemployment or/and inflation.
Sources of Government Revenue

To perform the aforementioned functions efficiently the government

must have resources or funds to finance the said activities. The
government raises much of its finance through taxation. Taxation is
the most preferred sources of revenue among governments’
worldwide. Apart from ensuring constant and uninterrupted flow of
revenue to government revenue, taxation serves other fiscal policy
objectives as well.

Other Sources of Government Revenue include:

 Borrowing:

The government may borrow funds from both internal and external
sources. Internal sources include all financial institutions such as
Banks, Insurance companies and social Security institutions.

External sources include bilateral (between governments) multilateral

sources such as IMF, World Bank etc.

 Grants and Aids:

Grants are funds given to the government for a specific purpose, e.g.
construction of road, purchase of rice etc. An aid is a general
monetary assistance given to the government with a donor country not
specifying its particular use.

 Dividends from its corporations:

The government may own shares in various corporations from which

it may receive cash dividend.

 User Charges:

These include port and airport services charges.

 Fines imposed as punishment or damages for contravening

various Laws enacted by the government. For instance driving a
defective motor vehicle may attract payment of a certain amount
of money to the government as fine.

 Licenses and other fees.

 Sale of government bonds and securities.

Non of these sources however can bypass taxation in terms of
bringing much revenue to the government. Most of these sources are
infact unstable and unreliable as they are subject to unpredictable
fluctuations and willingness of certain individuals or credit worth-
ness

Types Of Market Failures That Require

Government Intervention
This is part 1 of a 3-part series on the theoretical underpinnings
of governance and policymaking.
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09/02/2017 12:28 PM IST | Updated 10/02/2017 9:22 AM IST

RUPAK DE CHOWDHURI / REUTERS

"There are two things you don't want to see being made—sausage and
legislation. They're both messy. Often you have no idea what's in the end
product. And what goes into the process is, well, not for the faint-
hearted."— Otto Van Bismarck
Such sayings/idioms, even though amusing on the surface, betray an
undeniable and fundamental fault with how we as governments continue to
 create policies and govern. The problems facing our policymakers and the
potential solutions are well-known, although as they say, the devil lies in
the implementation; more often than not the real quagmire of all policy and
governance failures can be traced to the foundational issue of improper
implementation.

There are three fundamental questions to be asked before the process of

policymaking initiates:
1. When is government intervention needed?

2. How to navigate the terrain of political economy?

3. How to improve state capacity to execute policies and schemes?

When is government intervention needed?

The government is the entity that wields the maximum power to pursue
multiple objectives for the welfare of society. No one doubts the importance
of a well-oiled state machinery; however, unbridled state intervention raises
reasonable doubts on its need and requirement in the various situations
concerned.

Four market failure categories cover the areas where intervention by the government is required and the
provision of services and goods cannot be left to the forces of free markets.

In the realm of economics, there exists the concept of "laissez faire". In

plain speak, laissez faire is a system where the incentives of private
players to provide services are not shaped by government interventions
and all economic activities can take place without being encumbered by
coercive measures such as tariffs, subsidies and taxes. Laissez faire was
defined by the following three axioms that were proposed by economist Adam
Smith in 1776:
 The Invisible Hand: The notion that an individual's efforts to maximise her
own gains in a free market benefits society even when her ambitions have
no benevolent intentions.
 Advantage of Competition: Natural competition amongst private entities,
instead of closely controlled state companies and organisations, fosters
better and cheaper product development for the end consumer
 Dynamics of Supply and Demand: The producers of good in a free
market will produce enough to meet the demands of the consumers and
this potential equilibrium will rationalise and modulate the prices in an
economy.
The idea of laissez faire is a powerful one; one that injects innovation,
energy and dynamism into an economy for it prevents the meddlesome
state from resorting to desultory means of imposing and structuring
licensing paraphernalia, like the Fabianis-tic policies that India witnessed
during the license-raj era and which looks set to return with the inefficacious
demonetisation rollout. However, as beautiful a concept laissez faire is, its
limitations and failures in fostering crony capitalism and in imposing a
distinct lack of focus on the welfare of the underprivileged are
well documented and tested.
This then begs the fundamental question of when the state should react
and respond to these failures of the free market. These market failures can
be, summarily, divided into four categories:

1. Negative externalities identified by the exploitation of the commons

A negative externality is the cost borne by a tertiary player in the system due
to the actions of the primary and secondary players. Let us consider the
case of people suffering from respiratory diseases due to pollution spewing
vehicles on the roads:
 Assuming that all the people who are using vehicles to aid their
transportation process are within limits of plausible rationality; each person
then seeks to maximise her benefits associated with travelling in a private
vehicle. These benefits include: comfort, savings on account of time, status
in the society, among other things.
 Given that these people are rational beings, each person performs the
following mental calculation: Is the usage of a vehicle for the purposes of
transportation benefitting me?
 She generally has the following answers in mind: The positive component
is the array of benefits associated with usage of a vehicle; The negative
component is the pollution caused due to the vehicle.
 However, the person justifies her usage of a vehicle by way of the
argument that the negative externalities produced due to her actions are
shared amongst different stakeholders, whilst the positive benefits are
accrued by her only.
Such instances which involve exploitation of the commons require
immediate interventions by the state.

The road rationing experiment tried out by the Delhi government to reduce
air pollution is an example of a relatively successful state intervention.

2. Market forces of capitalism resulting in concentration of power

As described above, the single-minded pursuance of laissez faire often

gives rise to crony capitalism which is usually identified by monopolistic and
oligopolistic markets.
This gives rise to a system where there is a concentration of power among
a few instead of dispersion of power in the hands of many. This results in
distortions in the market economy, causing exploitation of the needy and
the poor.

This again requires intervention by the state to regulate markets by way of

rules, laws and policies which aim to safeguard the interests of the people.
ADNAN ABIDI / REUTERS

3. Asymmetry of information

Markets usually produce the end consumers with varied choices of

products and services, whose quality and/or reputation is hard to know, in
advance.

This results in information asymmetries where the consumer goes in blind,

oblivious to the quality of the service that he is utilising, argued George
Akerlof. Example: a patient visits a doctor for a routine examination, but he
has no knowledge of the reputation and credibility of his professional
medical practice
The government needs to remove these asymmetries and ensure proper
information dissemination to the citizens on the availability of cogent
information. Example: The government of India, through the Medical
Council of India (MCI) empanels doctors and medical institutions after a
rigorous vetting process, which signals the credibility of the practitioner
concerned to the citizen.
4. Provisos for non-rival and non-excludable goods

In the field of micro-economics, the following matrix of the categories of

service provided in a market is followed:

PRANAV JAIN

Thus, it is incumbent upon the government to provide for and intervene in

systems and market failures which involve non-rival and non-excludable
goods

***

With this we have answered our question of: When is government

intervention needed? These four market failure categories comprehensively
cover the areas where intervention by the government is required and the
provision of services and goods cannot be left to the forces of free markets.

The second article of this series will answer the questions of how to
navigate the terrain of political economy and how to improve state capacity
to execute policies and schemes. The third article will look at potential
solutions to simplify and strengthen the supply chain of ideation, policy
creation and its cogent implementation.

WHAT IS TAXATION

As a subject, taxation is a study of how the government imposes on

and collects taxes from, the income and wealth of individuals and
corporations to finance its social and regulatory activities. The study
of taxation usually covers the entire tax system which is made up of
Tax policy, law and administration.

The government, therefore, derives its revenue from taxes. A tax is

compulsory and mandatory contribution to the government from its
subjects. It is mandatory in the sense that there is a legal document
giving the government the mandate to collect such contribution:
However, if carefully analysed this definition may include such
payments as fines and penalties paid to the government. The most
dependable and reliable definition of what is a tax was given by Hugh
Dalton who defined a tax as “a compulsory contribution imposed by a
public authority, irrespective of the exact amount of services rendered
to the taxpayer in return, and not imposed as a penalty for any legal
offence”.

Imposition of a tax, therefore, creates a tax liability upon those liable

to pay the imposed tax. A tax liability is always expressed in
monetary terms, and it is worth noting here that any monetary liability
creates a burden. In other words imposition of a tax creates a tax
burden on taxpayers.

EQUITY:
In taxation, equity refers to fairness in the distribution of the tax
burden. For compliance purposes and to fend off public outcry the tax
burden should be apportioned in more equitable manner. Two
principals have long been developed as a guide to equity. These are:

 The Benefit Principle: This approach dictates that taxes are

apportioned to individuals according to the benefit they derive
from government activities and spending. Taxes therefore
should be treated as a payment for the goods and services
provided by the government.

 The ability to pay principle: This is concerned with the equitable

distribution of taxes according to the stated taxable capacity or
ability to pay of an individual or group. The emphasis in this
approach is put on redistribution of income, that, those with
higher incomes should sacrifice more so that there can be proper
and equitable redistribution of income.

Both principles are calling for equality, no one then will quarrel with
a saying that ‘those who are essentially equal should be taxed equally’
(Horizontal Equity), and if equals are to be taxed equally then the
reverse is also true, that unequal to be taxed unequally (Vertical
Equity)
To attain the much needed equally taxes are made to be proportional,
progressive or regressive depending upon whether they take from
high income earners the same fraction of income as tax than they take
from low income people.

However the general philosophy of Benefit or ability to pay alone

does not answer the question of best tax formula and hence the need
for political process. In practice all the principle are put into use.

TAX BASE AND TAX YIELD

To clearly understand the concept of tax base, we need to classify

taxes into two classes:

1. Direct Taxes
2. Indirect Taxes

Direct Taxes are levies directly on the income of individuals or

corporations. This includes income tax, Payroll levy, and other
withholding taxes. A tax base for direct taxes therefore is income. In
other words, direct taxes are tax based income. The amount of tax
revenue (tax yield) from direct taxes will therefore depend on income
of individuals and corporations.
 Indirect Taxes are levied on goods or services. The tax
base for indirect taxes is therefore the goods produced and services
rendered in a particular economy. Tax yield from indirect taxes will
therefore depend on goods produced and services rendered in the
economy. The amount of tax revenue collected from a particular tax
will therefore depend on, among other how wide the tax base or
coverage of that particular tax is.

Some advantage of Direct Taxes:

 They don’t have inflationary tendencies. Increase or decrease in

tax rates usually does not affect the general price level.
 When made progressive direct taxes tend to be highly equitable.

Disadvantages:

 In a cash economy like ours where general level of education of

taxpayers is low, it is difficult to determine taxable income of
taxpayers.
 Direct tax Laws are difficult to understand as a result the lead to
disputes.
 Direct taxes are unpopular as they directly affect the disposable
income.
 Progressiveness of direct taxes may be disincentive to hard
work, and therefore discourage savings and investment.
  They have a very narrow tax base
 Tax incidence cannot be shifted.

Advantages of Indirect Taxes:

 They are easy to collect

 They provide a wide tax base and hence revenue potential
 As taxes are included in the price of taxable goods and services,
the tax incidence is shifted to the last consumer.

Disadvantages:

 They tend to be regressive especially when imposed on goods

and services consumed by low income earners.
 They have inflationary tendencies. Increase in tax rates is likely
to disturb the general price level.

Principles of a Good Tax System:

Taxation being compulsory contributions from individuals, or

business entities to the government to defray the public expenditures
by the government has some effects in the economy as well as in the
social life of the society. The effect might be constructive to the
economy or might damage the economy. In order then to
avoid/minimize damage to the economy there are criteria/principles
for evaluating tax systems. These criteria are also called Canons of
Taxations.

Canons of Taxation

Equity: Equity entails that taxes should be levied in such a way that
they promote fairness. The concept of from each according to his
ability to pay or benefits received are really what the principle of
equity is all about a tax system that takes away proportionately more
income from higher income earners than from lower income earners
is the termed as a progressive tax system. In equity, a progressive rat
structure and the minimum exemption policy should characterize the
tax system. Thus, equals should be treated equally and unequal to be
treated unequally.

Simplicity: A tax system ought to be simple. Simplicity of the tax

system means the taxpayer should be able to understand the system
and the tax base should be known clearly. The taxpayer should be
able to compute his/her liability and the penalties involved for any
neglect or failure to comply with tax law. The amount should not be
the prerogative of the tax collector, as this will put the taxpayer to
disadvantage and at the mercy of the collector and may make tax
system arbitrary.
Economy: The administration of tax system should be least expensive
in terms of both manpower and material. The cost benefit analysis is
emphasized, as it does not make sense to spend more than the revenue
collected. Optimization of collection costs is called for to judge
whether a tax system is uneconomic or not, both pecuniary and non-
pecuniary costs should be taken into account.

Certain: The imposition of tax should yield the expected revenues in

order to assist government forward planning. Taxes on some
commodities are certain while on others are fairly uncertain. On the
other hand, this criterion advocates that the taxpayer ought to know
precisely and exactly as regards the time of payment, the manner of
payment and the amount to be paid.

Convenience: This calls for tax to be levied at the time and n the
manner in which it is most likely to be convenient to the taxpayer.
The system that allows the payment of tax at month end, immediately
after crop harvest seasons or provides for the payment of tax through
such devices as PAYE or other withholding arrangement can be
regarded as convenient to the tax-payers; while a tax system that
places heavy tax burden on tax-payers long after the income is
exhausted is an inconvenient one.

Elasticity of Tax to changes in the tax base: A good tax system

should be elastic to changes in the Tax base; the tax is elastic when
the amount of revenue it yields increases as fast or faster than the
growth of income or the economic or the economic activities. The
elastic tax system yields adequate revenue for planned projects.

What is the difference

between positive and
normative economics?
By Amy Fontinelle | Updated January 3, 2018 — 9:21 AM EST

SHARE

A:
The distinction between positive
economics and normative economics may seem simple, but it is not always
easy to differentiate between the two. Positive economics is objective and fact
based, while normative economics is subjective and value based. Positive
economic statements must be able to be tested and proved or disproved.
Normative economic statements are opinion based, so they cannot be proved
or disproved. In fact, many widely-accepted statements that people hold as
fact are actually value based.

For example, the statement, "government should provide basic healthcare to

all citizens" is a normative economic statement. There is no way to prove
whether government "should" provide healthcare; this statement is based on
opinions about the role of government in individuals' lives, the importance of
healthcare, and who should pay for it.
The statement, "government-provided healthcare increases public
expenditures" is a positive economic statement, as it can be proved or
disproved by examining healthcare spending data in countries like Canada
and Britain, where the government provides healthcare.

Disagreements over public policies typically revolve around normative

economic statements, and the disagreements persist because neither side
can prove that it is correct or that its opponent is incorrect. A clear
understanding of the difference between positive and normative economics
should lead to better policy making if policies are made based on facts
(positive economics), not opinions (normative economics). Nonetheless,
numerous policies on issues ranging from international trade to welfare are at
least partially based on normative economics

Read more: What is the difference between positive and normative

economics? https://www.investopedia.com/ask/answers/12/difference-between-
positive-normative-economics.asp#ixzz59GyA0J3e
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