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Public Finance

Year-II

INSTRUCTOR- :

NEELABH KUMAR

Year II | Public Finance 1

Unit 1

Concept of Public Finance


In order to provide a secure and peaceful environment to its citizens and in order to provide
certain goods and services to them, Governments need to incur expenditure on internal
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administration, internal security, internal law and order, a sound judicial system, external defense
of the country and on creating infrastructure of roads etc. These activities involve huge financial
investments and expenditure. Governments meet this expenditure partly by charging taxes on its
citizens and partly by raising loans. The financial operations of the Governments with regard to
raising and disbursement of finances are called Public Finance.
Public Finance is the study of the income and expenditure of the State. It deals only with the
finances of the Government. Public finance on the other hand refers to all activities of
government in generating and allocating (spending) revenue towards ensuring efficiency of the
state and the general well-being of the people, that is, financial operation of public treasury and
its implication.
Scope of Public Finance
Public Finance is the study of the income and expenditure of the State. It deals only with the
finances of the Government. Scope of Public Finance consists in the study of the collection of
funds and their allocation between various branches of state activities which are regarded as
essential duties or functions of the State.
There are four major scope of the Public finance
Keeping all these factors in view, Public Finance may be divided into following four parts:
(1) Public expenditure: It involves the judicious expenditure of public funds on the most
important and socially and economically relevant activities of the State.
(2) Public Revenue: Revenues includes all the income and receipts, irrespective of their source
and nature, which the Government obtains during any given period of time.
(3) Public Debt: Public debt is the loans raised by Governments and is a source of public finance
which carries with it the obligation of repayment to the individuals, along with interest, from
whom the debt was raised.
(4) Financial Administration: Financial administration consists of those operations the object of
which is to make funds available for the Governmental activities, and to ensure the lawful and
efficient use of these funds.
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Difference between Public Finance and Private Finance


S. No
1

Basis
Concept

Public Finance
Private Finance
Public finance studies the income-getting Private finance deals with the way a
and income-spending activities of the private person gets and spends his

public bodies or the state.


income.
Adjustment of The public authority generally adjusts its An individual
Income

and income to its expenditure.

Expenditure
Unit of Time

usually

adjusts

his

expenditure to his income.

The public authority balances its budget For an individual there is no period of
during a given period which is generally a time in the course of which the budget
year. The public authority however has to must

be

balanced.

The

individual

keep full records of its income and generally continues earning and spending
expenditure and the accounts are to be in without keeping any record of his budget
4

balance during the financial year.


by a particular date.
An individual The public authority, on the other hand, If at any time an individual is in need of
cannot borrow can borrow internally from its own people money, he cannot borrow from himself.
from himself

and externally from other nations.

He can raise the loan from other


individuals or can utilize his past savings,

Issue

but he cannot borrow internally.


of Government has full control over the issue If an individual does so, he will be put

Currency

of currency in the country. No other person behind the bars.

Purpose

except the state can print notes.


The purpose of public/government

The purpose of private finance is to

financing is the overall benefit of the maximize the benefit for the concerned
society trough development by investing in person/persons.
7
8

Disclosure

development programs
Details of public finance are published and The private financing details are kept

are easily available for the public


secret.
Provision for The government has to make a solid he individuals on the other hand are not
the Future:

provision for the future. It spends large generally liberal and far-sighted. They
amounts of the money on those projects discount the future at a higher rate and so
which the future generation is only to usually make inadequate provisional for
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benefit.

the future.

Public Revenue
In a broad sense, Public Revenues includes all the income and receipts, irrespective of their
source and nature, which the Government obtains during any given period of time. It will include
even the loans raised by the Government. In a narrow sense, it will include only those sources of
income of Government which are described as revenue resources.
Sources of Public Revenue
1. Taxes: The most common method of financing Government expenditure is by taking
resort to taxation. In every country, largest part of the public revenue is raised through
taxes. Taxes may be imposed on persons income or wealth or on both, they may be direct
or indirect, and they may be of different rates and nature. Tax is a compulsory
contribution imposed by a public authority, irrespective of the exact amount of service
rendered to the taxpayer in return, and not imposed as a fine for any legal offence.
2. Fees: The other important source of public revenue is the fees charged for rendering
certain services by the State. Fee is that revenue which is paid to the Government for the
special service rendered by it.
3. Price: The third important source of public revenue is the price. The Government sells
some services and goods and receives price in payment for them.
4. Fines and Penalties: Fines and penalties are payments made by citizens for
contravention of the laws of land. This is a major source of revenue of modern nation
states.
5. Gifts: A small portion of public revenue is generated through gifts made by individuals,
corporates and foreign Governments or agencies. Its significance as a source of public
revenue has been declining over the years.
6. Borrowings: It is a major source of public revenue to finance large projects or
programmes requiring large investments. Borrowings, besides being an important source
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for financing public expenditure, also help Governments to regulate money supply in the
economy.
7. Printing of Paper Money: The Governments, through their Central Banks, may resort to
printing of paper money to meet public expenditure. Governments have the ability to
create money and assign it legal tender qualities. Modern Governments, however, avoid
now using this source for financing public expenditure.

It is the normal practice of the government to classify the receipts into revenue receipts and
capital receipts.
Revenue receipts: are those items which are routine and earned ones. Example- tax receipts,
interest receipts, dividends and profits, grants, fees and fines etc. On the other hand the capital
receipts are those items which are basically of non repetitive in nature.
Revenue receipts are divided into tax and non tax revenue.
1. Tax revenue: it is divided into three sections
a. Tax on income and expenditure- this section covers all those taxes which are levied
on receipts of income and expenditures of taxpayers such as corporate tax, income
tax, interest tax, expenditure tax etc.
b. Taxes on property and capital transactions: this section covers taxes on specified
forms of wealth and its transfers such as wealth tax, gift tax, house tax, land revenue
etc.
c. Taxes on commodity and services: this section includes taxes on production, sale,
purchase, transport, storage, consumption of goods and services.
Alternatively, taxes may be divided into direct tax and indirect tax
2. Non tax revenue of the government may also be divided into three sections
a. Currency, coinage and mint: this source of non tax revenue is only available to the
GOI and not to the state government. It comprises of excess of face value of currency
created and sold to the RBI to be issued to the market over its cost of creation.
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b. Interest receipts, dividends and profits: this section comprises interest receipts on
loans by the government to other parties, dividends and profits from public sector
companies.
c. Other Non Tax revenue: this section covers revenue from various government
activities and services such as from administrative services, public service
commissions, police, jails, agricultural and allied services, industry, minerals,
education, housing, broadcasting, grants in aid and contributions etc.

Capital Receipts: capital receipts of the government assume several forms. The most important
one comprises fresh borrowings from the public. The next category of capital receipts covers
recovery of loans due from debtors to the government. Other category of capital receipts may
take the form of grants and donations and deposits and so on.

Taxation
Tax: it is a compulsory levy payable by a legal entity to the government without any
corresponding entitlement to receive any specified and equivalent benefits from the government.
Taxation: it is the inherent power of the state, acting through the legislature, to impose and
collect revenues to support the government and its recognized objects. Simply stated, taxation is
the power of the state to collect revenues for public purpose.
Nature of taxation
1.
2.
3.
4.
5.

It is an enforced contribution
It is generally payable in money.
It is proportionate in character, usually based on the ability to pay
It is levied on persons and property within the jurisdiction of the state
It is levied pursuant to legislative authority, the power to tax can only be exercised by the

law making body or congress


6. It is levied for public purpose
7. It is commonly required to be paid a regular intervals

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Purpose of Taxation
Primary purpose: is to provide funds or property with which the government discharges its
appropriate functions for the protection and general welfare of its citizens.
Non revenue Objectives
Aside from purely financing government operational expenditures, taxation is also utilized as a
tool to carry out the national objective of social and economic development.
1. To strengthen anemic enterprises by granting them tax exemptions or conditions or
2.
3.
4.
5.
6.

incentives for growth;


To protect local industries against foreign competition by increasing local import taxes;
As a bargaining tool in trade negotiations with other countries;
To counter the effects of inflation or depression;
To reduce inequalities in the distribution of wealth;
To promote science and invention, finance educational activities or maintain and improve

the efficiency of local police forces;


7. To implement police power and promote general welfare.
Canon of Taxation
A good system of taxation must satisfy certain general principles. Adam Smith laid down the
following four canons of taxation.
(1) Canon of Equality:
This is the most important canon of taxation. Equality or equity means that every ax payer
should contribute towards the support of the government according to his ability to pay. This
does not mean that all people rich or poor should pay equal tax or at equal rate. Equality means
equality of sacrifice. The equality of sacrifice can only be maintained when the rich are required
to pay tax at a greater rate than the poor people.
(2) Canon of certainty:
This canon says that everything about a tax should be definite and certain. According to this
canon there must be certainty about the time of payment, the manner of payment and the quantity

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to be paid. It will give greater confidence to the government about its estimates and that the tax
payer will also feel certain about his budget. Uncertainty encourages corruption.
(3) Canon of convenience:
This canon implies that every tax ought to be levied at the time or in the manner in which it is
likely to be most convenient for the contributor to pay it. If a tax is convenience, the payer will
pay it at the proper time without reminder. For example a person drawing a monthly salary likes
to pay at the time of receiving his salary every month.
(4) Canon of economy:
This canon implies two things. Firstly, the cost of collection of a tax should be small in
proportion to yield. Secondly, the tax must not obstruct in any manner the economic
development of the country. If a tax is contrary to these two principles it is regarded as costly and
uneconomical.
OTHER CANONS:
Besides these canons of taxation, there are four other important principles of taxation.

They

have been added by later economists. They are as follows:


(5) Canon of Productivity:
It means that taxes should yield sufficient revenue to the government. A few tax which are fairly
productive are much better than a large number of taxes which not so productive.
(6) Canon of elasticity:
This principles means that tax system should be capable of expansion and reduction according to
the requirements of the state. Taxes which in case of need can be conveniently increase in
amount without any additional cost of collection are considered to be good taxes. Income tax is a
very good example of an elastic tax.
(7) Canon of simplicity:

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The system of taxation should not be complicated and difficult to be understood by an average
person. The basis of tax and method of calculation should be simple, plain and intelligible.
(8) Canon of Diversity:
This principle says that a large variety taxes is always preferable to a small number. Every tax
has some defects. In a varied tax system, different taxes tend to cancel to each other. Variety is
also desirable from the point of view of yield, stability and justice.

Classification of taxes
Direct Tax
A Direct tax is a kind of charge, which is imposed directly on the taxpayer and paid directly to
the government by the persons (juristic or natural) on whom it is imposed. A direct tax is one that
cannot be shifted by the taxpayer to someone else.
1. Income Tax: Income Tax Act, 1961 imposes tax on the income of the individuals or Hindu
undivided families or firms or co-operative societies (other than companies) and trusts
(identified as bodies of individuals associations of persons) or every artificial juridical
person. The inclusion of a particular income in the total incomes of a person for income-tax
in India is based on his residential status. There are three residential status, viz., (i) Resident
& Ordinarily Residents (Residents) (ii) Resident but not Ordinarily Residents and (iii) Non
Residents. All residents are taxable for all their income, including income outside India. Non
residents are taxable only for the income received in India or Income accrued in India. Not
ordinarily residents are taxable in relation to income received in India or income accrued in
India and income from business or profession controlled from India.
2. Corporation Tax: The companies and business organizations in India are taxed on the income
from their worldwide transactions under the provision of Income Tax Act, 1961. A
corporation is deemed to be resident in India if it is incorporated in India or if its control and
management is situated entirely in India. In case of non resident corporations, tax is levied on
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the income which is earned from their business transactions in India or any other Indian
sources depending on bilateral agreement of that country.
3.
4. Property Tax: Property tax or 'house tax' is a local tax on buildings, along with appurtenant
land, and imposed on owners. The tax power is vested in the states and it is delegated by law
to the local bodies,

5. Inheritance (Estate) Tax: An inheritance tax (also known as an estate tax or death duty) is a
tax which arises on the death of an individual. It is a tax on the estate, or total value of the
money and property, of a person who has died. India enforced estate duty from 1953 to 1985.
6. Gift Tax: Gift tax in India is regulated by the Gift Tax Act which was constituted on 1st April,
1958. It came into effect in all parts of the country except Jammu and Kashmir. As per the
Gift Act 1958, all gifts in excess of Rs. 25,000, in the form of cash, draft, check or others,
received from one who doesn't have blood relations with the recipient, were taxable.
However, with effect from 1st October, 1998, gift tax got demolished. n 2004, the act was
again revived partially. A new provision was introduced in the Income Tax Act 1961 under
section 56 (2). According to it, the gifts received by any individual or Hindu Undivided
Family (HUF) in excess of Rs. 50,000 in a year would be taxable.

Indirect Tax:
An indirect tax is a tax collected by an intermediary (such as a retail store) from the person who
bears the ultimate economic burden of the tax (such as the customer). An indirect tax is one that
can be shifted by the taxpayer to someone else. An indirect tax may increase the price of a good
so that consumers are actually paying the tax by paying more for the products.
1. Customs Duty
Custom duty is a form of indirect tax. Standard English dictionary defines the term "custom"
as duties imposed on imported or less commonly exported goods. This term is usually
applied to those taxes which are payable upon goods or merchandise imported or exported. It
is also defined as tax imposed by the government on the import of items (goods). The
Customs Act was formulated in 1962 to prevent illegal imports and exports of goods.
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Besides, all imports are sought to be subject to a duty with a view to affording protection to
indigenous industries.
2. Excise Duty
The tax imposed by the government on the manufacturer or producer on the production of some
items is called excise duty. The liability to pay excise duty is always on the manufacturer or
producer of goods. The duty being a duty on manufacture of goods, it is normally added to the
cost of goods, and is collected by the manufacturer from the buyer of goods. Therefore it is
called an indirect tax. This duty is now termed as "Cenvat". There are three types of parties who
can be considered as manufacturers Those who personally manufacture the goods in question.
Those who get the goods manufactured by employing hired labor.
Those who get the goods manufactured by other parties.
In order to attract Excise duty liability, following four conditions must be fulfilled:
a) The duty is on "goods".
b) The goods must be "excisable"
c) The goods must be "manufactured" or produced.
d) Such manufacture or production must be "in India".
3. Sales Tax
Tax paid by the consumer on the purchase of some items is called the sales tax. Rates of sales tax
depend upon the nature of the goods purchased by the consumer.
4. VAT
VAT is the acronym for valued added tax. This tax which is in other words called consumption
tax can be defined as the amount charged by the government for every goods or services
purchased from time to time. This means it can only be paid when there is consumption of goods
or services (It forms part of the price paid for the good or service). Value Added Tax was
introduced in 1994 to replace sales tax which until now generated revenue for the state
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governments. VAT was designed broadly to be levied on imported goods, locally manufactured
goods, hotel service, bank transaction etc. It was to be federally-collected.
Characteristics of Value Added Tax
There are three main characteristic spelt out as follows:
1. It is a consumption Tax. This is that it can be paid when there is consumption of the
good or service.
2. Its incidence is borne by the final consumer
3. It is multi-stage tax. That is as additional value is created at each stage of production
the tax is paid by the consumer of the product at that stage. The total payments make
up the consumers price of the product.
Requirement of a good tax system
1. Fairness The tax system needs to ensure that all taxpayers share the tax burden equally.
People with similar financial circumstances should receive the same tax treatment. In other
words, all high-income earners, whether they are individuals or corporations, pay their fair
share of tax.
Equity: Two Kinds of Tax Fairness
When people discuss tax fairness, theyre talking about equity. Tax equity can be looked at
in two important ways: vertical equity and horizontal equity.
Vertical equity addresses how a tax affects different families from the bottom of the income
spectrum to the topfrom poor to rich. Three terms are used in measuring vertical equity:
a. Regressive tax systems require that low- and middle-income families pay a higher share
of their income in taxes than upper-income families. Sales taxes, excise taxes and
property taxes tend to be regressive.
b. Proportional or flat tax systems take the same share of income from all families.
c. Progressive tax systems require upper-income families to pay a larger share of their
incomes in taxes than those with lower incomes. Personal income taxes are usually
progressive.
Horizontal equity is a measure of whether taxpayers with similar circumstances in terms
of income, family structures, and age pay similar amounts of tax. For example, if one
family pays much higher taxes than a similar family next door, that violates horizontal
fairness.
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2. Fiscal Adequacy: means that the sources of revenues should be sufficient to meet the demand
of public expenditures.
3. Simplicity and compliance People will be more willing to comply with tax laws if the
system is simple and easy to understand.
4. Transparency: Tax legislation should be based on sound legislative procedures and careful
analysis. A good tax system requires informed taxpayers who understand how tax
assessment, collection, and compliance works. There should be open hearings and revenue
estimates should be fully explained and replicable.
5. Neutrality: The primary purpose of taxes is to raise needed revenue, not to micromanage the
economy. The tax system should not favor certain industries, activities, or products.
6. No Retroactivity: As a corollary to the principle of stability, taxpayers should rely with
confidence on the law as it exists when contracts are signed and transactions made. Changes
in tax law should not be retroactive. As a matter of fairness, taxpayers should rely with
confidence on the law as it exists when contracts are signed and transactions are made.
7. Economic growth As a corollary to the principle of neutrality, lawmakers should avoid
enacting targeted deductions, credits and exclusions. If such tax preferences are few,
substantial revenue can be raised with low tax rates. The tax system should encourage growth
through lower tax rates and a broader tax base.
8. Stability The federal government needs a stable and dependable source of tax revenue so it
can manage the countrys economy. The aim of tax reform is to make sure the federal
government can achieve its economic objectives.

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Unit 2

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Principle of Maximum Social Advantage


The 'Principle of Maximum Social Advantage' was introduced by British economist Hugh
Dalton. According to Hugh Dalton, "Public Finance" is concerned with income & expenditure of
public authorities and with the adjustment of one with the other.
Budgetary activities of the government results in transfer of purchasing power from some
individuals to others. Taxation causes transfer of purchasing power from tax payers to the public
authorities, while public expenditure results in transfers back from the public authorities to some
individuals, therefore financial operations of the government cause 'Sacrifice or Disutility' on one
hand and 'Benefits or Utility' on the other.
This results in changes in pattern of production, consumption & distribution of income and
wealth. So it is important to know whether those changes are socially advantageous or not.
If they are socially advantageous, then the financial operations are justified otherwise not.
According to Hugh Dalton, "The best system of public finance is that which secures the
maximum social advantage from the operations which it conducts."

Principle of Maximum Social Advantage (MSA)


The 'Principle of Maximum Social Advantage (MSA)' is the fundamental principle of Public
Finance. The Principle of Maximum Social Advantage states that public finance leads to
economic welfare when public expenditure & taxation are carried out up to that point where the
benefits derived from the MU (Marginal Utility) of expenditure is equal to (=) the Marginal
Disutility or the sacrifice imposed by taxation.
Hugh Dalton explains the principle of maximum social advantage with reference to :1. Marginal Social Sacrifice
2. Marginal Social Benefits

This principle is however based on the following assumptions:Year II | Public Finance 16

1. All taxes result in sacrifice and all public expenditures lead to benefits.
2. Public revenue consists of only taxes and no other sources of income to the government.
3. The government has no surplus or deficit budget but only balanced budget.
4. Public expenditure is subject to diminishing marginal social benefit and taxes are subject
to increasing marginal social sacrifice.

Marginal Social Sacrifice (MSS)


Marginal Social Sacrifice (MSS) refers to that amount of social sacrifice undergone by public
due to the imposition of an additional unit of tax. Every unit of tax imposed by the government
taxes result in loss of utility.
Dalton says that the additional burden (marginal sacrifice) resulting from additional units of
taxation goes on increasing i.e. the total social sacrifice increases at an increasing rate. This is
because, when taxes are imposed, the stock of money with the community diminishes. As a result
of diminishing stock of money, the marginal utility of money goes on increasing. Eventually
every additional unit of taxation creates greater amount of impact and greater amount of sacrifice
on the society. That is why the marginal social sacrifice goes on increasing.
The Marginal social sacrifice is illustrated in the following diagram:-

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The above diagram indicates that the Marginal Social Sacrifice (MSS) curve rises upwards from
left to right. This indicates that with each additional unit of taxation, the level of sacrifice also
increases. When the unit of taxation was OM 1, the marginal social sacrifice was OS 1, and with
the increase in taxation at OM2, the marginal social sacrifice rises to OS2.
Marginal Social Benefit (MSB)
While imposition of tax puts burden on the people, public expenditure confers benefits. The
benefit conferred on the society, by an additional unit of public expenditure is known as
Marginal Social Benefit (MSB).
Just as the marginal utility from a commodity to a consumer declines as more and more units of
the commodity are made available to him, the social benefit from each additional unit of public
expenditure declines as more and more units of public expenditure are spent. In the beginning,
the units of public expenditure are spent on the most essential social activities. Subsequent doses
of public expenditure are spent on less and less important social activities. As a result, the curve
of marginal social benefits slopes downward from left to right as shown in figure below.

In the above diagram, the marginal social benefit (MSB) curve slopes downward from left to
right. This indicates that the social benefit derived out of public expenditure is reducing at a
diminishing rate. When the public expenditure was OM1, the marginal social benefit was OB1,
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and when the public expenditure is OM2, the marginal social benefit is reduced at OB2.

The Point of Maximum Social Advantage


Social advantage is maximised at the point where marginal social sacrifice cuts the marginal
social benefits curve.
This is at the point P. At this point, the marginal disutility or social sacrifice is equal to the
marginal utility or social benefit. Beyond this point, the marginal disutility or social sacrifice will
be higher, and the marginal utility or social benefit will be lower.

At point P social advantage is maximum. Now consider Point P 1. At this point marginal social
benefit is P1Q1. This is greater than marginal social sacrifice S1Q1. Since the marginal social
sacrifice is lower than the marginal social benefit, it makes more sense to increase the level of
taxation and public expenditure. This is due to the reason that additional unit of revenue raised
and spent by the government leads to increase in the net social advantage. This situation of
increasing taxation and public expenditure continues, as long as the levels of taxation and
expenditure are towards the left of the point P.

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At point P, the level of taxation and public expenditure moves up to OQ. At this point, the
marginal utility or social benefit becomes equal to marginal disutility or social sacrifice.
Therefore at this point, the maximum social advantage is achieved.
At point P2, the marginal social sacrifice S2Q2 is greater than marginal social benefit P2Q2.
Therefore, beyond the point P, any further increase in the level of taxation and public expenditure
may bring down the social advantage. This is because; each subsequent unit of additional
taxation will increase the marginal disutility or social sacrifice, which will be more than marginal
utility or social benefit. This shows that maximum social advantage is attained only at point P &
this is the point where marginal social benefit of public expenditure is equal to the marginal
social sacrifice of taxation.
Conclusion
Maximum Social Advantage is achieved at the point where the marginal social benefit of public
expenditure and the marginal social sacrifice of taxation are equated, i.e. where MSB = MSS.
This shows that to obtain maximum social advantage, the public expenditure should be carried
up to the point where the marginal social benefit of the last rupee or dollar spent becomes equal
to the marginal social sacrifice of the last unit of rupee or dollar taxed.

Public Expenditure
Public Expenditure is the end and aim of the collection of State revenues. It involves the
judicious expenditure of public funds on the most important and socially and economically
relevant activities of the State. The term Public Expenditure refers to the expenses incurred by
the Government for its own maintenance and also for the preservation and welfare of society and
economy as a whole. It refers to the expenses of the public authorities, Central, State and Local
Governments, for protecting the citizens and for promoting their economic and social welfare.
Based on benefit accrued, public expenditure may be classified as:
1. Expenditure which confers common benefit on all: Public expenditure incurred on
general administration, legislatures, defence, education, transport, etc. benefits the entire
society in general.
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2. Expenditure which confers special benefit on some people: Public expenditure


incurred on providing police protection, justice, etc. provides security of life and property
to the entire community. However, comparatively greater benefit from these services
accrues to the weaker sections of the society who need the protection of police and justice
more than others. Thus, these services affect the entire community in general and some
groups in particular.
3. Expenditure which directly confers benefit on certain persons and indirectly on the
entire society: Social security, public welfare, unemployment relief, old age pension, etc.
are such items which are administered with the aim of directly helping the particular
sections of the society. Public expenditure incurred on these services directly benefits
certain persons while indirectly it benefits the whole society.
4. Expenditure which confers special benefit on some individuals: Some public
expenditure is incurred for the benefit of a particular group of society. Such expenditure
dies not confer advantages on the entire society or even on any group other than those for
whom it is intended by the Government. Subsidy given to particular industries or
individuals subsidized low cost housing provided to the poor is public expenditure of
such type.

Canons of Public Expenditure


Following are the important canons of public expenditure:
1. Canon of Benefit: Public Expenditure should bring with it important social advantages

such as increased production, preservation of social whole against external aggression


and internal disorder, and as far as possible reduction in income inequalities. In other
words, public funds must be spent in those directions which are most conducive to public
interest. Public expenditure must result in the achievement of maximum social advantage.
Public wealth should not normally be utilized for the benefit of a particular group, it
should rather equitably confer benefits on the whole community. Public expenditure in
every direction must be carried just so far that the advantage to the community of a
further small increase in any direction is just balanced by the disadvantage of a
corresponding small increase in taxation and from any other source of public income.
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2. Canon of Economy: Economy, here, does not mean miserliness or niggardliness rather it
means that wasteful extravagant expenditure should be avoided. The public authorities
should not waste the limited resources at their disposal. It is, therefore, necessary that the
Government incurs expenditure with greatest care and prudence. Only the minimum
necessary amount should be spent on any given head of expenditure. It should aim at
maximum benefit.
3. Canon of Sanction: There should be proper procedure of formulating the policy for
public expenditure with sufficient safeguards for avoiding arbitrariness and influence of
certain vested interests in the matter of public expenditure. The canon requires that there
should be in place a proper procedure for authority to incur expenditure out of public
funds and that accountability for expenditure should be inbuilt in the scheme of sanction
and incurring of expenditure. The spending authority should obtain proper sanction from
the authority vested with the power of sanction. The canon also envisages that there
should be adequate control and audit of public expenditure to ensure that expenditure is
as per sanction and likelihood of avoidable and unscrupulous expenditure and
misappropriation of funds is avoided.
4. Canon of Surplus: This canon enjoins that public expenditure should be, as far as
possible, met from current public revenues, without resorting to deficits or borrowings.
5. Canon of Elasticity: According to this canon, expenditure policy of the Government
should be such that it may be possible to change the size and direction of public
expenditure according to requirements of different circumstances.
6. Canon of Productivity: This canon implies that public expenditure should be such that
would encourage production and productive efficiency in the country.
7. Canon of Equitable Distribution: This canon is particularly important for the countries
where glaring inequalities of income and wealth are present.

Effects of Public Expenditure

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Public expenditure which is incurred by the Government according to sound principles of public
finance exerts its important healthy effect on the economy of any country.
1. Effects on Production and Employment: The beneficial effect of public expenditure is
in the form of greater production of output and more equitable distribution of wealth and
income in the society. Public expenditure on generalized social services like health,
education, public health, etc. tends to raise the efficiency of the nation. Consequently
such expenditure tends to increase the productivity of the nation leading to greater
prosperity of individuals. Public expenditure on infrastructure like roads, ports, railways,
etc. create tremendous employment avenues for the citizens, raising their income.
Increased income translates in higher consumption by citizens of goods and services,
resulting in increased demand with increase in industrial and other production. Increased
income of citizens also results in increase in savings by citizens which is likely to be
channeled in new production facilities through investment. Increased demand for goods
and services leads to increased employment and more avenues of increased income for
the citizens.
Public expenditure also exerts its effects on what regions or industries are to be provided
with abundant productive resources. While incurring public expenditure, the Government
has to choose the particular region or area and industry for incurring public expenditure
so that it maximizes national production and follows it with maximum community
welfare.
2. Effects on Distribution
Apart from affecting the level and composition of national output, public expenditure is
also most powerful fiscal instrument available to the Government to bring about an
equitable distribution of income and wealth in the country. While formulating its
expenditure policies, government takes into account as to which of the socio-economic
group in the country are being specially benefited by it. If greater those activities which
specially benefit the poor and weaker sections of the society, it will help bring about a
more equal distribution of income and wealth and the consequential removal of existing
disparities in peoples living standards in the society.
3. Effects on Economic Stability
Year II | Public Finance 23

Major Nation state economies are affected by business cycles whereby a cycle of growth
is generally followed by a cycle of stagnation or even negative growth. Increased public
expenditure during the stages or cycles of stagnation or negative growth reinvigorates the
economy and lessens some of the pain of stagnation.

4. Effect on Economic Growth


Public expenditure has a tremendous impact on economic growth. Public expenditure on
infrastructure like roads, ports, railways, electricity, shipping, etc. results in opening up of
more and more areas of the country, industrialization of backward areas and Philip to
both industrial and agricultural production. This type of expenditure makes it easier to
move surplus production to deficit areas of the country and even for export of surplus
production.

Public Debt
Public debt is the loans raised by Governments and is a source of public finance which carries
with it the obligation of repayment to the individuals, along with interest, from whom the debt
was raised.

Importance of Public Debt


The size of public debt has immensely increased all over the world, including in India, in recent
years. The main reasons are:

1. Financing Economic Development


An underdeveloped country is always faced with the shortage of funds. Taxation, as source of
public finance, has a limitation in as much as citizens in underdeveloped economies have limited
surplus to contribute to Governments taxation measures. Besides, taxes in an underdeveloped
economy have an adverse affect on consumption driven demand in the economy. However, the
Year II | Public Finance 24

need for finance is imperative in order to take the economy out of the vicious circle of poverty
and provide the citizens with minimum acceptable infrastructure. In such situation, public loans
are the only way out for Government to raise finances needed for development.
2. Unpopularity of Taxation
People generally do not like to pay taxes to the Government. The citizens generally oppose the
imposition of new taxes and enhancement of old taxes. To get over the public opposition,
Governments resort to the easy method of resorting to Public Debt.
3. Facing Natural Calamities
Sometimes Governments raise loans to meet the cost of repair of infrastructure and to provide
immediate succor to the people affected by natural calamities, like floods, earthquakes, etc. It
may not be possible to finance such expenditure from the current revenues of the Government.
4. Waging Wars for Defending the Nation
When country is engaged in war, the public exchequer is faced with a sudden and large demand
for funds to meet the equipment, manpower and other costs. Such expenditure is usually met
through public loans raised by Governments.
5. Covering Temporary Budget Deficit
Sometimes, the Government does not think it appropriate to meet its budget deficit by resorting
to additional taxation. In such a situation, the Government may resort to borrowing from the
public.
6. Fighting Depression
Business cycles affect all the economies. Cycles of rapid growth are generally followed by cycles
of depression, when due to lack of demand, industrial production comes down, employment is at
low level and there is an apprehension in the minds of people with surplus funds about avenues
of profitable investment. In such a situation Government borrows funds from people with surplus
funds and invests these funds to raise the level of aggregate demand in the economy. This
method of dealing the cycles of depression have been used effectively in USA and in Europe.
Year II | Public Finance 25

7. Controlling Inflation
By raising Public Debt, the Government can withdraw a large volume of money from the public
and thus prevent prices from rising. Since the monetary policy of Central Bank alone has not
been much successful, fiscal policy of which public debt policy constitutes an important part ,
has been attaining greater importance ever since the great war.

Classification of public debt


A. Internal and External Debt
Internal Debt:Government borrowings within the country are known as internal debt. Public loans floated
within the country are called internal debt. The various internal sources from which the
government borrows include individuals, banks, business firms and others. The various
instruments of internal debt include market loans, bonds, treasury bills, ways and means
advances etc. An internal debt may be either voluntary or compulsory.

External Debt:Borrowings by the government from abroad are known as external debt. The external debt
comprises of: - Multilateral borrowings, Bilateral borrowings, Loans from World Bank, Asian
Development Bank, etc. External loans help to take up various developmental programmes in
developing and underdeveloped countries. These loans are usually voluntary. Initially an external
loan involves a transfer of resources from foreign countries to domestic country but, when
interest and principal amount are being repaid a transfer of resources takes place in reverse
direction. These loans are repayable in foreign currencies.

B. Short Term. Medium Term and Long - Term Debt

Year II | Public Finance 26

Short Term Debt


Loans for a period of less than one year are known as short - term debt. For example The
treasury bills are issued by RBI on behalf of the government to raise funds for a period of 91
days and 182 days. Interest rates on such loans are very low. To cover the temporary deficits in
budget short - term loans are taken.

Medium - Term Debt


The period of medium term debt is normally for a period above one year and upto 5 years. One of
the main forms of medium term debt is by way of market loans. The interest rates on medium
term loans are reasonable. These are preferred to meet expenditure on health, education, relief
work etc.

Long - Term Debt


Loans for a period exceeding 5 years are called long - term debt. One of the main forms of long
term loans is by way of issue of bonds. Long term debt is required for the purpose of retirement
of debts and also for the purpose of development projects.

B. Productive and Unproductive Debt

Productive Debt
Public debt is said to be productive when it is raised for productive purposes and is used to add
to the productive capacity of the economy. These loans are normally long - term in nature. These
loans are utilised on development activities such as infrastructure development like roadways,
railways, airports, seaports, power generation, telecommunications etc. The productive debts are
self - liquidating in nature, this means the principal amount and interest are normally paid out of
the revenue generated from the projects to which the loans were utilised.
Year II | Public Finance 27

Unproductive Debt
An unproductive debt is one which does not yield any income. It does not add to the productive
assets of the country. For example debts utilised for transfer payments in form of subsidies, old
age pension, special incentives to weaker sections etc. Unproductive public loans are a net
burden on the community. The government will have to resort to additional taxation for their
servicing and repayment.

D. Compulsory and Voluntary Debt

Compulsory Debt
Normally, the government does not obtain funds through compulsory means. The government
may obtain such loans from banks, financial institutions and large corporate firms at time of war
or major disaster, only when it is not possible to obtain voluntary debt. In India, Compulsory
Deposit Scheme is an example of compulsory debt.

Voluntary Debt
Generally, public loans are voluntary in nature. The voluntary debt may be obtained in the form
of Market loans, bonds etc. People invest in voluntary debts from the point of view of liquidity
and profitability. The rate of interest is normally higher than that of compulsory debt.

E. Redeemable and Irredeemable Debt

Redeemable Debt
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Loans which government promises to pay off at some future date are called redeemable debts.
Their maturity period is fixed. The government has to make arrangements to repay the principal
and interest on due date. These loans are repaid out of revenue receipts of government or by
raising further loans.

Irredeemable Debt
Loans for which no promise is made by the government regarding their exact date of repayment
are called irredeemable debts. Such debt has no maturity period. The government may pay
interest regularly. Normally, government does not resort to such borrowings.

F. Funded and Unfunded Debts


Funded debt
Funded debt is repayable after a long period of time. The period may be 30 years or more.
Funded debt has an obligation to pay fixed sum of interest subject to an option to the government
to repay the principal. The government may repay it even before the maturity if market
conditions are favourable. Funded debt is Undertaken for meeting more permanent needs, say
building up economic & industrial infrastructure.The government usually establishes a separate
fund to repay this debt.

Unfunded debt
Unfunded debts are incurred to meet temporary needs of the governments. In such debts duration
is comparatively short say a year. The rate of interest on unfunded debt is very low. Unfunded
debt has an obligation to pay at due date with interest.There is no special fund created to repay
this debt.

Year II | Public Finance 29

Method of debt redemption

The various methods of public debt redemption are as follows.


1. Sinking fund method
The Government creates a fund called sinking fund by accumulating a part of the public revenue
every year for the repayment of debt. This is the most systematic and best method of debt
redemption. The burden of debt is spread evenly over the period of accumulation of the fund.
Sinking fund creates confidence among the lenders and increases the credit worthiness of the
government.
2. Capital levy
A capital levy is a tax on capital rather than income, and is collected once rather than
annually.A direct tax upon the capital of the tax payers is called capital levy. It will be generally
imposed in times of emergencies. Dalton recommended this method very strongly. It was
advocated as a method of liquidating the unproductive war debts. Debt redemption by imposing
a very heavy taxation on property has been advocated. However, this method has raised
objections as heavy taxes might lead to undesirable effects on the economy.
3. Conversion
Conversion of public debt implies changing the existing loans, before maturity, into new loans at
an advantage in servicing charges. In fact, the process of conversion consists generally, in
converting or altering a public debt from a higher to a lower rate of interest.
A government might have borrowed at a time when the rate of interest was high. Now, when the
rate of interest falls, it may convert the old loans into new ones at a lower rate, in order to
minimise the burden. Thus, the obvious advantage of such conversion is that it reduces the
burden of interest on the taxpayers. Furthermore, lower interest rates on public loans would mean
a less unequal distribution of income.
The success of conversion, however, depends upon:
Year II | Public Finance 30

(a) The creditworthiness of the government,


(b) The maintenance of adequate stock of securities,
(c) The efficiency in managing the public debt.
Furthermore, for a successful conversion, the government will have to offer new low-interest
bearing bonds at a discount rate and which will have to be redeemed at full value, causing
thereby a capital appreciation (which may be even free of income-tax).

Conversion is not repayment; it is only exchange of new debts for old. This may take place at the
time of maturity or before the time of maturity by the voluntary acceptance. The main advantage
of conversion is that it reduces the interest burden of the state and relieves tax payers. For this
purpose, the government had to maintain an adequate stock of securities for a smooth
functioning of this method.
4. Refunding
Refunding implies the issue of new bonds and securities by the government, to repay the matured
loans. The short term securities are replaced by long term securities. The owners of the old debt
have the option of subscribing to new debt or opt for cash. Under this method, the burden of
repayment of public debt is postponed to a future date.
5. Terminable annuities
The fiscal authority clears off a part of the public debt every year by issuing terminable annuities
to the bond holders which mature annually. It is a method of redeeming debts by instalment. The
burden of debt goes on diminishing annually and by time of maturity it is fully paid off.
6. Redemption by Purchase
In this case the government pays off debts by purchasing securities even before the maturity
whenever it has surplus budget. However, surplus budget is a rare phenomenon in modern times.
7. Additional Taxation
Year II | Public Finance 31

The government imposes new taxes to get revenue to repay the principal and interest of the loan.
This is the simplest method of debt redemption. If new taxes are levied to repay long term debts,
the burden is imposed on future generation. This method causes a redistribution of income from
the tax payers to the bond holders.
8. Surplus balance of payments
External debt redemption is possible only by accumulating foreign exchange reserves. Hence it is
necessary to create a trade surplus by increasing exports and reducing imports. External debt can
also be reduced by changing the terms of repayment. The loans raised must be used productively
so that they are self liquidating posing no real burden on the economy.

What is deficit financing?


When a government spends more than what it currently receives in the form of taxes and fees
during a fiscal year, it runs in to a deficit budget. When the budget deficit is financed by
borrowing from the public and banks, it is called deficit financing.
Deficit financing refers to the borrowing undertaken by the government to make up for the
revenue shortfall. It is the best stimulant for the economy in short term. However, in the long
term it becomes a drag on the economy and becomes the reason for rise in interest rate
There is no precise definition of the term deficit financing. It is a method used to finance the
overall or net budget deficit. Deficit financing is said to have been practiced when the
expenditure of the government both development and non- development exceeds its current
revenue and capital budget and the deficit is met through government borrowing.
Here are some of the problems of deficit financing.
1. Leads to inflation: Deficit financing may lead to inflation. Due to deficit financing money
supply increases & the purchasing power of the people also increase which increases the
aggregate demand and the prices also increases.

Year II | Public Finance 32

2. Adverse effect on saving: Deficit financing leads to inflation and inflation affects the
habit of voluntary saving adversely. Infect it is not possible for the people to maintain the
previous rate of saving in the state of rising prices.
3. Adverse effect on Investment: deficit financing effects investment adversely when there
is inflation in the economy trade unions make demand for higher wages for that they go
for strikes and lock outs which decreases the efficiency of Labor and creates uncertainty
in the business which a decreases the level of investment of the country.
4. Inequality: in case of deficit financing income distribution becomes unequal. During
deficit financing deflationary pressure can be seen on the economy which makes the rich
richer and the poor, poorer. The fix wage earners are badly affected and their standard of
living deteriorates thus no gap b/w rich & poor increases.
5. Problem of balance of payment: Deficit financing leads to inflation. A high price level as
compared to other countries will make the exports more expensive and thus they start
declining. On the other hand rise in domestic income and price may encourage people to
import more commodities from abroad. This will create a deficit in balance of payment
and the balance of payment will become unfavorable.
6. Increase in the cost of production: - When deficit financing leads to the rise in the price
level the cost of development projects also rises this means a larger dose of deficit
financing is required on the port of government for completion of these projects.
7. Change in the pattern of investment: Deficit financing leads to inflation. During inflation

prices rise and reach to a very high level in that case people instead of indulging into
productive activities they start doing speculative activities.

The main reasons for the use of deficit financing are:

Covering the Receipt-Expenditures Gap: the government receipts through taxes and other
sources are not adequate to finance the development expenditures. The government has not been
able to fill the gap between the total receipt and the total expenditure by levying new taxes or
increasing the rates of existing tax beyond a certain limits to avoid displeasure of the people, the
government has been choosing an easy path of deficit financing or creation of new currency.

Low Savings: The people in LDCs are consumption-oriented. Due to high propensity to
consume, the domestic saving rate as a percentage of GNP is very low. As such the

Year II | Public Finance 33

government is compelled to use deficit financing as an instrument of economic

development.
Inadequate Banking Facilities: the financial institutions which mobilize savings
particularly in the rural areas are inadequate. The government is therefore, not able to

mobilize resources to the desired extent.


Rapid Growth of Population: The rapid rate of population growth is swallowing up
whatever little economic progress is made. The government is anxious to speed up the
economic development in the shortest possible period of time and is using the method of

deficit financing.
Uncertainty in getting foreign assistance: Though the LDCs have been receiving
foreign assistance yet the amount of aid received has always remained uncertain. The
government for increasing the rate of investment and coming out of the vicious circle of
poverty has no other way but to resort to deficit financing.

Deficit Financing is a useful weapon for stimulating economic development in the country. The
main advantages claimed of deficit financing are:
1. Mobilizes additional resources for economic development: in LDCs the rate of capital
formation is very low due to the unavailability of resources. The rate of economic
development is very low. The capital is considered as life blood of the economy. Thus the
deficit financing is a source of capital formation.
2. Helps up in utilizing our unutilized or underutilized resources: the rate of economic
growth of the LDCs is slow because they cant utilize these resources fully due to the lack of
capital. Deficit financing creates additional purchasing power in the hands of government

with which the government can utilize the underutilized and unutilized resources.
3. Helps in building up infrastructure: the LDCs have very low infrastructure facilities
like highways, banks, education etc. a big sum is required by the government in
providing such facilities like construction of highways, provision of electricity, water &
gas, provision of health facilities. In such situations, when the revenue of the government
is low, deficit financing is the way to meet the needs of the government for providing
these facilities.
4. Ensuring
higher

level

of

employment

in

the

country:

in LDCs, the unemployment is a real problem. The number of unemployed people is


Year II | Public Finance 34

increasing day by day as the population increases and also due to the unavailability of
capital with the people and government.
5. Thus deficit financing is the way to increase the employment in the country. When the
revenue created through deficit financing is spent on different projects like construction
of roads, irrigation, hydro-electric generation etc. this will absorb the unemployed portion
of the people.

Year II | Public Finance 35

Unit 3

Financial relations between the Central Government, State Government and


Local Bodies
All political systems have people with differing and often conflicting demands and different
abilities to achieve them. Various groups of people in such systems have, however, common and
shared concerns. On the one hand, these groups of people have separate identities and would like
to retain their internal autonomy; on the other hand, their deeper socio-economic and cultural
interests get articulated through the participative political processes and institutions. The function
of government is to mediate between different interest groups within a legal and organizational
framework which binds them together. The distinctive feature of such a political system is that
Year II | Public Finance 36

public policy decision making and its implementation are divided between a multi-tier system
consisting of two governments, i.e., a central government and a set of unit governments. The
central government is known as the federal government and the unit governments are known as
the state governments. The political system which is characterized by multi-level governments is
known as a federation. Sir Robert Garron defined a federation as: "a form of government in
which sovereignty or political power is divided between the central and local government so that
each of them within its own sphere is independent of each other."
Basic Features of Federalism

Independence and Coordination


Conventional definitions of a federation usually lay emphasis on the fact that between the
two levels of government, there is a division of powers such that the central government
is given specified functions and the states enjoy the residual (non-specified) powers.
The central government is seen to be representing the nation and as being directly
responsible to the national electorate. On the other hand, the nation is the aggregate of the
units which comprise it. The electorate, the members of the central parliament, the
bureaucracy and politicians will tend to project demands and attitudes which originate
and relate to the units. In such a situation, the central government will serve as the
receptacle for the interaction of the interests of the units. In this process, there is bound to
be a conflict of interests, in some cases at least, between the central government and the
unit governments, or between the-different unit governments. The central government
has, therefore, to play a mediatory role as between the units. Institutional mechanisms
have to be created to resolve such conflicts particularly between the central government
and the state governments. The fundamental process of the formation of a federation is
guided by the dual consideration of self-interests of the units as also mutuality and
commonality of larger objectives which bind the federating units together. Thus the two
way process of guarding self-interest and yet reaching out beyond it for the realization of
common aspirations which may be rooted in culture, religion. race, language, internal or
external security of a shared history is continually at work. This makes for cooperation,

Year II | Public Finance 37

mutual accommodation and compromise. This is the essence of a functioning federation


which is characterized not so much by independence as by coordination.

Rationale for coming together


There is an inherent urge among the federating units to come together in a federation so
that the political and material interests of the units can be better safeguarded through the
nation that is brought into existence. This process usually takes place through two
opposite processes.
Federation by disaggregation, that is, by a process of decentralization a previously
existing state of a unitary character breaks up to form a federal state
Federation by aggregation, that is, by a process of centralization - a number of previously
independent units agree to come together to form a federal state in which they continue to
maintain their individualities. In most cases, federations have been brought about through
the aggregation principle, i.e., by a kind of compact between the units existing as
independent states before the formation of the federation.

Economic Determinants
Decentralization of powers and resources through federalism is regarded as a better
solution to achieve economic take-off, optimal resource use, removal of regional
economic disparities and strengthening of bargaining power in the global market. In
developing countries, it is possible to enhance allocation of resources on health,
education, poverty alleviation and social services. The objectives of equity and balanced
regional development may, however, not be served at least in the short run. Theoretically,
with the breaking down of barriers to trade and free movement of labour and capital
being allowed, the factors of production will move to regions where returns are the
highest.

Principles of Fiscal Federalism

Independence and Responsibility


The central facet of federations is the division of powers and functions between the
federal government and the state governments. The division of financial resources and
Year II | Public Finance 38

obligations as between the two levels of governments should correspond to the division
of powers and functions. Earnest efforts have to be made to ensure that each level of
government is financially self-sufficient and independent of each other to the maximum
extent possible. Political autonomy will be meaningless unless it is supported by financial
autonomy. No doubt, concerns which are of national character, or which transcend the
interests of one unit, should be entrusted to the central government. Functions of a purely
local character, confined to a unit in each instance, should generally be left to the Central
Government.

Adequacy and Elasticity


Financial independence also implies that central and unit governments should have
adequate financial powers to perform their exclusive functions. The correspondence
between revenues and functions should be understood in a dynamic sense. The sources of
revenue should be -elastic enough to. keep pace with the growth of responsibilities in the
specified spheres of activity. In order to implement a process of national development,
the central governments were made financially strong both in terms of powers and
resources.

Efficiency
The system of distribution of functions should conform to the requirements of efficiency
and economy. "No matter how well intentioned a scheme may be or how completely it
may harmonize with the abstract principles of justice, if the tax does not work
administratively, it is doomed to failure". Two factors determine the effectiveness of
different taxes, namely, nature of the tax and the character of administration.

Equity
Fiscal federation is viewed within the framework of welfare economics. Equitable
distribution of wealth and income of the community are the proper concerns of a welfare
state. Experts argue that the entire system of federal and state taxation and expenditure
should be so framed as to impose equal burdens and confer equal benefits upon similarly
placed persons irrespective of their residence.

Equalization Transfers
Year II | Public Finance 39

It does not usually happen that the revenues appropriate to federal and state exploitation
yield exactly the sums of money required for performing their respective functions. In
most federations, elastic sources of revenue are in the hands of the federal government
which has surplus resources. Through various means, federal governments have further
widened their sources of revenues. The resulting financial imbalance between the federal
and unit governments necessitates transfer of revenue to the unit governments in order to
enable them to perform their constitutional functions. In fact, there has been a major
extension in the functions of both the levels of governments. While the federal
governments have been able to mount the requisite mobilization efforts, the state
governments, mostly with inelastic Sources of revenue, which cannot be stretched
beyond a certain extent, have been hamstrung in their efforts to meet these expanding
demands, particularly those in the social services sector. Hence there is need for fiscal
equalization. Fiscal equalization has been defined as a systematic process of inter
governmental financial transfers directed towards equalization of the budget capacity or
economic performance. A fiscal equalization is intended to make it possible for the
governments to provide a standard range and quality of services for their citizens.

Conflict and Compromise


The rationale for the formation of federations comes from political, cultural, social,
historical, strategic and economic considerations. Administrative and political
considerations may often outweigh considerations of costs and benefits. The political
boundaries and the pattern of benefit distribution may not always match. When units
which happen to be the bigger beneficiaries are large and affluent, integration may be
promoted even though smaller units may nurse a grievance. In the reverse case of larger
gains going to small and poor units, the large and affluent units may frustrate the
integration process. Given the division of resources, it may not always be possible for the
states to pool together a level of resources that will be perceived to be adequate for
satisfying the developmental objectives and aspirations of people of the states concerned.
Policies and strategies for effecting credible equalizing fiscal transfers have turned out to
be extremely controversial exercises. While the state governments have been jealously
Year II | Public Finance 40

guarding their rights as provided for in the Constitution, they quite often find the federal
governments' encroachment on their jurisdiction irresistible.
The Constitutions generally provide for the creation of inter-governmental institutions to
act as the forum for the resolution of conflicts. In the ultimate analysis, however, it is the
perception of the federating units as regards their long-term interests being served
through the membership of the federation that helps resolve these tensions through
compromise, accommodation and perhaps some amount of coercion.

Evolution of Fiscal Federalism in India


Mobilization, sharing and utilization of financial resources play a very crucial role in all systems
of multi-tier government and can give rise to difficult problems of inter-governmental relations
unless handled in a spirit of mutual understanding and accommodation.
Growth of Fiscal Federalism: A highly centralized financial system came into being in India
with the take-over of the administration by the British Crown from the East India Company in
1858. The Governor-General-in-Council retained complete control over provincial resources as
well as expenditure. The provincial governments remained entirely dependent on annual
allotments by the Central Government for the maintenance of their administration. It was soon
realized that decentralization was necessary for governing a country of sub-continental
dimensions like India and the first step in this direction was taken in 1870. The fiscal history of
the next sixty years is very largely a process of gradual devolution of powers to the provinces
from the Central government. The Montague-Chelmsford Report which led to the passing of the
Government of India Act, 1919, recognized the necessity of separating the resources of the
central and provincial governments to support provincial enfranchisement.
Accordingly, under the devolution rules framed under the Act, customs, non-alcoholic excises
including salt, general stamp duties, income tax and receipts from railways and posts and
telegraphs, were assigned to the Government of India. Land revenue, irrigation charges,
alcoholic excises, forest receipts, court fees, stamp duties, registration fees and certain minor
Year II | Public Finance 41

sources of revenue were allotted to the provinces. This devolution scheme was criticized on the
ground that the resources assigned to the provinces did not have adequate growths potential and
were insufficient for their rapidly increasing needs, whereas the central revenues were capable of
expansion, although its needs were rel3tively stationary. The working of the financial relations,
was, therefore, reviewed by a number of expert committees, particularly, in early 1930's. The
provisions incorporated in the Government of India Act, 1935, were based on these reviews.
The Government of India Act, 1935: This Act constitutes the next landmark in the country's
financial administration. It divided the revenue sources into three categories:

Exclusively Federal.
Exclusively Provincial.
a) Taxes levied by the Federal government but shared with the provinces or
assigned to b) the taxes levied by the Federal Government but collected and
retained by the Provinces.

The scheme also envisaged grants-in-aid from the Centre to the provinces in need of assistance
as approved by the former. The Government of India Act, 1935, laid foundations for a system of
elaborate but flexible financial arrangements between the centre and the provinces. The long
history of the evolution of public finance in India shows very complex factors at work. However,
one clear discernible trend is that while it is wholly possible to divide the taxation powers and
allocate resources, it is difficult to establish a balance between need and resources. The various
stages of evolution helped confirm the maxims:

That no decentralized government can be established without allocating to it

sufficient financial powers.


That the central government is the appropriate authority to levy a tax where
uniform rate is important and locale is not a guide to its true incidence.

Financial Administration
Introduction
Finance is the fuel for the engine of Public administration. Mr. Lloyd George is reported to have
once remarked that Government is finance. This is quite correct, because almost everything the
Year II | Public Finance 42

Government does, require money. According to Kautilya, All undertakings depend upon
finance. Hence, foremost attention shall be paid to the treasury. Financial administration
consists of those operations the object of which is to make funds available for the Governmental
activities, and to ensure the lawful and efficient use of these funds. These operations are
performed by the following agencies:

The Executive, which needs funds;


The Legislature, which alone can grant funds;
The Finance Ministry which controls the expenditure; and
The Audit which sits in judgment over the way in which the funds have been spent.

Financial-administration is a dynamic process, which falls into five well defined divisions
namely:

Preparation of the budget, i.e., of the estimates of the revenue and expenditure for the

ensuing financial year,


Getting these estimates passed by the Legislature called Legislation of the Budget,
Execution of the budget, i.e., regulation of the expenditure and raising of revenue

according to it,
Treasury management, i.e., safe custody of the funds raised, and due arrangement for the

necessary payments to meet the liabilities; and


Rendering of the accounts by the executive and the audit of these accounts.

The term Financial Administration consists of two words viz. 'Finance' and 'Administration'. The
word 'administration' refers to organisation and management of collective human efforts in the
pursuit of a conscious objective. The word 'Finance' refers to monetary (money) resource.
Financial Administration refers to that set of activities which are related to making available
money to the various branches of an office, or an organisation to enable it to carrying out its
objectives.
Nature of Financial Administration
There are two different views regarding the nature of financial administration. These are i)
Traditional view; ii) Modern view.
Year II | Public Finance 43

1. Traditional View
Advocates of this view conceive financial administration as a sum total of activities undertaken
in pursuit of generation, regulation and distribution of monetary resources needed for the
sustenance and growth of public organisations. They emphasize upon that set of administrative
functions in a public organisation which relate to an arrangement of flow of funds as well as to
regulating mechanisms and processes which ensure proper and productive utilization of these
funds. When one looks at this view from systems perspective, it represents an integral subsystem of supportive system. A financial administrator shoulders responsibility for ensuring
adequate financial backing for running public organisation in the most efficient manner. His job
is to plan, programme, organize and direct all financial activities in public organisations so as to
achieve efficient implementation of public policy. The participants of this system are considered
as financial managers and they discharge managerial functions of financial nature.

2. Modem view
The modem view considers financial administration as an-integral part of the overall
management process of public organisations rather than one of raising and disbursing public
funds. It includes all the activities of all persons engaged in public administration, for quite
obviously almost every public official takes decisions which are bound to have some direct or
indirect consequences of financial nature. According to this view financial administration has the
following roles.

Equalizing Role: Under this role financial administration seeks to demolish the
inequalities of wealth. It seeks, through fiscal policies, to transfer income from the

affluent to the poor.


Functional Role: Under normal circumstances the economy cannot function on its own.
Under this role, financial administration seeks to ensure, through taxation, public
expenditure and public debt, and proper functioning of the economy. It evolves policy

instruments to maintain high economic growth and full employment.


Activating Role: Under this role financial administration involves the study of such steps
that will facilitate a smooth and rapid flow of investment and its optimal allocation to
increase the volume of national income.
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Stabilizing Role: Under this role, the objective of financial administration is the
stabilization of price level and inflationary trends through fiscal as well as monetary

policies.
Participatory Role: According to this view, financial administration involves
formulation and execution of policies for making the state a producer of both public and
private goods with the objective of maximizing social welfare of the community. It also
seeks to promote economic development through direct and indirect participation of the
State.

Scope of Financial Administration

Financial Planning: planning, in a broad sense; includes the concerns in terms of whole
range of government policy and it demands a time frame and a perception of the inter
relationships among policies. It looks at a policy in the framework of long-term economic
consequences. There is a need to coordinate planning and budgeting. Financial
Administration, under this phase, should consider the sources and forms of finance,

forecasting expenditure needs, desirable fund flow patterns and so on.


Budgeting: This area is the core of financial administration. It includes examination and
formulation of such important aspects as fiscal policy, equity and social justice. It also
deals with principles and practices associated with refinement of budgetary system and its

operative processes.
Resource Mobilization: Imposition of taxes, collection of rates and taxes etc. are
associated with resource mobilization effort. Due to the ever increasing commitments of
government, budgetary deficits have become regular feature of government finance. In
this context deficit financing assumes greater importance. Another challenge faced by
administration is tax evasion and growth of parallel economy. Finally public debt
constitutes yet another element of state resources. The proceeds of debt mobilization

effort should be used only for capital financing.


Investment decisions: Financial and socio-economic appraisal of capital expenditure
constitutes what has come to be known as project appraisal. Since massive investments
have been made in the public sector a thorough knowledge of the concepts, techniques
and methodology of project appraisal is indispensable for a financial administrator.

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Expenditure control: Finances of the modem governments are becoming quite inelastic.
Almost every government is suffering from resource crunch. Further, the society cannot
be taxed beyond a certain point without doing a great damage to the economy as a whole.
Thus, there is an imperative need for careful utilization of resources. Executive control is
a process aimed at achieving this ideal. Legislative control is aimed at the protection of
the individual tax payers interest as well as public interest. There is also the need to
ensure the accountability of the executive to the legislature.

Objectives of Financial Administration


1) Management of finances of Public Household: Just as in an individual household, the public
authorities are concerned with the satisfaction of human wants and their major problem is to
ensure the best application of limited means to secure given ends. In this context, a financial
manager focuses his/her attention on mobilization of resources and their rational deployment, in
conformity with the rising expectations of the people.
2) Implementation of projects and programmes: A welcome development in financial
administration is related to ensuring optimal public investment decisions through project
formulation, appraisal and implementation. The emphasis has shifted from expenditure control to
the implementation of projects within the stipulated time schedule and expenditure ceiling.
3) Provision for public goods and social services: Since the benefits from public goods and
social goods are available to one and all notwithstanding one's contribution to public exchequer,
no one will offer payments for the supply of such goods. Provision of public goods like public
parks, social services like public health, sanitation cannot be left to the private sector which is
motivated by profit rather than service to the people. Budgetary support for such services
becomes a legitimate concern for fiscal policy makers.
4) Growth, Employment and Price Stability: Modem governments are expected to focus
attention on socially desired rate of economic growth, high employment and a reasonable degree
of price level stability and a positive balance of payments position. Achievement of these
objectives cannot come about automatically. There is need for policy initiatives on the part of
public authorities.
5) Capital Formation: Economic development of a nation, to a great extent, depends upon the
capital formation through increased savings. No amount of State's coercive power can achieve
Year II | Public Finance 46

this objective. Appropriate financial and fiscal measures such as discriminatory taxation and
monetary policy instruments may be employed to accomplish this objective.
6) Productive deployment of funds: A major problem of under-developed countries is the
allocation of investible funds between competing projects and programmes. The entrepreneurs
may prefer 'risk free' and 'quick yielding' investment rather than those which are essential in
national interest. In order to ensure flow of investible funds into desirable channels, Planning
Commission lays down guidelines regarding priorities for different types of investment for both
public as well as private sector. The finance ministry takes up the task of ensuring adherence to
national priorities both in the public sector and the private sector.
7) Facilitating smooth flow of parliamentary processes: The basic tenet of representative
governments throughout the world is the supremacy of the representative institutions and their
control over executive branch of the government. One of the most important dimensions of this
is the control of legislature over use of public funds. Financial administration through its
budgetary process and audit function enables and ensures the supremacy of the legislative body
over the executive.
8) Achievement of equity and equality: Financial administration, through its fiscal policies,
such -as progressive taxation; grants, subsidies etc. can help movement towards greater equality
of wealth and opportunities.
Principle of Financial Administration

The principle of stability and balance: It is a known fact that the financial
administration is characterized by technical expertise and hence cannot be handled by
unskilled and non-trained personnel. Therefore, this principle calls upon financial
organisations to develop capacity to withstand losses of specific trained personnel
without serious consequences to effectiveness, and efficiency. For this purpose, there is
need for effective-manpower planning together with a good programme for human

resource development.
The principle' of simplicity and flexibility: In a democratic era electorate functions as
the fountain of all authority. Therefore, it is very essential that the financial system and its
Year II | Public Finance 47

procedures should be simplified in such a manner as to become intelligible to the layman.


The principle of flexibility implies that the financial organisation should develop capacity

to adjust itself. to fluctuations on work flows, human compositions and physical facilities.
The principle of conduct, discipline and regularity: The principle of conduct implies
that the officials of public financial organisations should act ethically and set high ethical
standards and styles to the people. The principle of discipline implies that the objectives,
rules and regulations, the policies, procedures and programmes must be honored by each
participant of public financial organisation. The principle of regularity implies that no

public organisation, including financial organisation, can afford to function at intervals.


The principle of Public Trust and Accountability: Financial administration collects
and disburses public funds as a public trust. But, it is quite vulnerable and can lead to
misuse of these funds for personal interest. Financial administration has therefore to be
held publicly answerable for proper use of funds at several levels such as political, legal,
administrative, organizational, professional, moral and aspirational. Here accountability

implies answerability for one's responsibility and for trust reposed in an official.
The Principle of Correspondence: This principle implies that there should be a causal
relationship between the objectives of financial administration and the functions, the
human and material resources necessary to accomplish such objectives. In other words,
the type of functions, the personnel required to handle them and the physical facilities

necessary for the purpose should have a rational mutual interrelationship.


The principle of primacy of public interest, public choice and public policy: Public
interest can be interpreted in various ways such as the common good, the general welfare,
and the overall quality of life of contemporary and subsequent generations, the collective
realization of social values, rights and privileges. For, fiscal policy and administration, it
is imperative to concentrate on those types of activities which make a definite and
justifiable contribution to the accomplishment of public interest and public satisfaction as
expressed in public policies. It is quite essential to realize that fiscal policy is expected to
sub serve the broad aims as spelt out in public policies. One should be clear about the
meaning of public choice. Some erroneously try to identify the public choice with the
choice of the greatest number or the aggregation of individual and group interests. Public
choice is a choice which encompasses common life and is shared by all.

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Financial Administration in India

Regulation and control of fiscal deficit: Development efforts in India are characterized
by an order of investment much higher than the available domestic resources. The gap
should have been met from favorable balance of payments and external remittances. But
Indian policy framers met this gap by creation of credit on excessive dosage of money
supply. Deficit financing was used as an alternative to resource mobilization including
taxation. The annual average rate of deficit financing began, to rise year after year. The
government had to take a number of measures for overcoming this crisis. The main

objective .was to control fiscal deficit and bring it down to 5 percent of G.D.P.
Cutback on non-development expenditure: A substantial portion of Indian resources
are frittered away in non-development expenditure which is an unproductive channel.
There has been a tremendous increase in non-development expenditure. A significant
amount of this expenditure is associated with extravagance, inefficiency and infructuous

public policies and activities.


Development of zero base perspective: Budgetary decisions in India have been
characterized by incrementalist approach. Though no whole scale installation of zero base
budgeting was attempted, expenditure policy that evolved during the last five years took
into account the basic premises of this new budgetary concept. No area of government

spending was sought to be exempted from scrutiny.


Non-bureaucratic delivery of public goods and services: Following public choice
theorists, the government is thinking in terms of providing public goods and services
competitively to avoid the pitfalls of public monopoly. The government, for instance, is
seriously thinking in terms of involving private sector in power generation and

distribution, electronic media and telecommunications, roads etc.


Towards deregulation and liberalization: Union Government m an effort to provide
full freedom to market mechanism so as to maximize productive potential of enterprising
business people is moving towards a free market economy. Industrial policy has been
suitably amended to accommodate genuine requirements of private sector and foreign

direct investment.
Focus on decentralized responsibility for financing development plans: Union
Government has had the responsibility for plan formulation as well as plan financing. The
Year II | Public Finance 49

state governments could execute centrally sponsored schemes rather than the schemes
supported by their budgetary provisions. This tendency on the part of the State led to a
lack of concern for resource mobilization. This syndrome is evident from increasing
emphasis of the state governments on populist measures. As a back-up to economic
reforms the Union Government has veered round to the concept of "indicative planning".
The Union Government is now promoting cooperative federalism and is therefore,
seeking an active role for the state government in resource mobilization.

The Finance Commission


Finance Commission and Planning Commission are the two important bodies through which
fiscal transfers between the centre and states are effected. The functions of the Finance
Commission are to make recommendations to the President in respect of:
1) the distribution of net proceeds of taxes to be shared between the Union and the States
and the allocation of shares of such proceeds among the States
2) the principles which should govern the payment of the Union grants-in-aid of the revenue
of the States
3) Any other matter concerning financial relations between the Union and the States.

The Finance Commission is a quasi-judicial body and it acts independent of the centre and the
states. The specific terms of reference of each Finance Commission are drafted by the Ministry
of Finance at the Centre. The state governments are not consulted in the matter.
According to the Constitution, the Finance Commission should consist of a Chairman and four
other members. According to the Finance Act, 1951, the Chairman shall be a person with
experience in public affairs. The four members should have been or be qualified to be appointed
as Judge of the High Court, or should have specialized knowledge of economics, financial
matters or finance and accounts of the government.
The principles generally observed by the Finance Commission are that the resource transfers
from the union should not cause undue strain on its resource base; that their distribution among
Year II | Public Finance 50

the states should follow uniform criteria and, the scheme of distribution should attempt to lessen
the inequalities between the states. The need to protect national interests, preserve the autonomy
of states and promote fiscal discipline among the union and the states are other important criteria.
State's share of Income Tax and Excise Duties have been successively increased by the Finance
Commissions.
As regards grants-in-aid, the principles generally followed in making recommendations are:
budgetary needs, tax efforts, economy in expenditure, standard of social services and special
obligations. Though the Finance Commissions have functioned under various constraints, they
have earned high regard of the union and the states because of their status, quasi-judicial
approach and expert recommendations.

Introduction to Budget
A budget is a financial plan summarizing the financial experience of the past stating current plan
and projecting it over a specified period of time in future.
Budgeting involves:
(1) Preparation of the estimates,
(2) Collection and custody of funds,
(3) Disbursement and control of expenditure,
(4) Recording of all the transactions whose legality and regularity are duly verified and reported
to the Legislature by an independent audit.
Principles of Budget
1. Executive Programming: Budget, being the programme of the Chief Executive, goes
hand in hand with programming and consequently must be under the direct supervision of
the Chief Executive.
2. Executive Responsibility: The Chief Executive must see that the departmental
programmes fulfill the intent of the legislature and due economy is observed in the
execution of the programme.

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3. Reporting: Budgetary process like preparation of estimates, legislative action and the
budget execution must be based on full financial and operating reports coming from all
levels of administration.
4. Adequate Tools: The Chief Executive must have an adequately equipped budget office
attached to him, and an authority to earmark monthly or quarterly allotment of
appropriations.
5. Multiple Procedures: The method of budgeting may vary according to the nature of
operations. Thus, the budgeting of quasi-commercial activities may be different from that
of purely administrative activities.
6. Executive Direction: Appropriations should be made for broadly defined functions of the
department allowing, thereby, sufficient discretion to the executive to choose means of
operation to realize the main purpose.
7. Flexibility in Timing: Budget should have provisions to accommodate necessary changes
in the light of changing economic situation.
8. Two-Way Budget Organisation; Efficient budgeting depends upon the active cooperation
of all departments and their sub-divisions.
Utility of Budget: Budget today has become one of the primary tools of financial as well as
developmental administration. It is a management tool and sets out programmes and projects for
socio-economic development. The utilities of budget are as follows:
(a) As a Tool of Financial Control: It is through the budget that a balance is tried to be
maintained between scarce resources and limitless demands. Financial control through
budget is exercised at various stages from the preparation of estimates to expenditure
making, the subordinate agencies within a department are involved in the initiation of the
estimates.
(b) As a Tool of Administration: It embraces all the activities of Government departments
as well as public corporations and Government aided agencies. An approved budget gives
the administrator a summary of the financial environment within which he has to work. It
makes readily available to him information on varied features of his departments plan
and prospects which need to be taken into account in considering any change in policy.
(c) As an instrument of Public Policy: The budget is vital, because it is the device where
by plans and policies are put into action. It converts broad ideas into concrete activities
Year II | Public Finance 52

and resources. In doing so, the budget serves as the final determinant of the degree to
which legislatively enunciated policy will be translated into reality. The budget as an
instrument of fiscal policy, i.e., as a fiscal tool for consciously influencing the operations
and directions of an economy, is one of its most important aspects. It is through budget
that the Government tries to influence the size and direction of private investment
expenditure by declaring concessions and incentives.
(d) As a Tool of Accountability : The objective is to ensure the financial and legal
accountability of the executive Government to the Legislature, and, within the executive
Government, to ensure a similar accountability on the part of each subordinate authority
to the one immediately above in the hierarchy of delegation.
(e) Budget and Planning: The planning application has always been latent in the budgetary
process. Planning attempts to translate long term goals into medium term operational
objectives and make allocation of human, physical and financial resources to programmes
designed to achieve these objectives most effectively at the least cost.
(f) Informative Role: The budget document contains valuable information for various
sections. The functional classification of budget gives a clearer picture of the
Governments effort in each field. The budget contains a lot of data on various economic
indicators such as national income, consumption, expenditure, capital investment, deficit
financing, etc.
(g) Role in Performance Evaluation: The budgetary data could provide information about
the overall performance and the specific data indicate the performance of a project,
programme of a particular department. Unit performance from year to year can be
compared. Cost benefit analysis can help in restructuring, reallocating or changing the
objectives or activities.
Budgetary Process
The budgetary responsibilities of a modern Government are vast and grave. Article 112 of the
Constitution of India refers to the laying of an Annual Financial Statement, which is a statement
of the estimated receipts and expenditure, of the Government of India for the ensuing financial
year.
The Annual Financial Statement consists of
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(a) Statement of Revenue,


(b) Statement of Expenditure, and
(c) An overall statement.
This Annual Financial Statement shows the sums charged on the Consolidated Fund of India and
the money required to meet other expenditures.
The budgetary process in India involves the following operations:
(1) Preparation of the budget
(2) Legislative authorization of the enactment of the budget
(3) Execution of the budget
(4) Accounting
(5) Audit

Preparation of the budget


There is no single budget for the entire country; States have their own budgets, the Constitution
being federal. Even at the Union level, there are two budgets (i) the General Budget and (ii)
the Railway Budget. The Railway budget was separated from the General budget in 1921. The
advantages of this arrangement are, first, that a business approach to the railway policy is
facilitated, and, secondly, the railways after paying a fixed annual contribution to the general
revenue of the country, can keep their profit for their own development.
Formulation of the budget involves, in India, the following operations which follow in the order
given below:
(1) Preparation of the preliminary estimates by the heads of offices.
(2) The scrutiny and review of those estimates by the controlling officers.
(3) Scrutiny and review of the revised estimates by the Accountant-General and the
administrative department.
(4) Scrutiny and review of the revised estimates by the Finance Ministry.
(5) The final consideration of the consolidated estimates by the Cabinet.

Year II | Public Finance 54

In India, budget preparation formally begins on the receipt of a circular from the Ministry of
Finance sometime during September/October, that is, about six months before the budget
presentation. The circular prescribes the time-schedule for sending final estimates separately for
plan and non-plan, and the guidelines to be followed in the examination of budget estimates to be
prepared by the department concerned. The general rule is that the person who spends money
should also prepare the budget estimates. Budget proposals normally contain the following
information:
I.
II.
III.
IV.
V.

Accounts classification
Budget estimates of the current year
Revised estimates of the current year
Actuals for the previous year; and
Proposed estimates for the next financial year (which is the budget proper).

Budget estimates normally involve:


a. Standing charges or committed expenditure on the existing level of service. This can
easily be provided for in the budget, as it is more or less based on a projection of the
existing trends.
b. New expenditure which may be due to:
I.
expansion of programmes involving expenditure in addition to an existing
II.

service or facility; and


New service for which provision has not been previously included in the grants.

While b (I) can be estimated with reference to progress made and the likely expenditure during
the next financial year, budget provision for b (I) and (II) cannot be made unless the scheme
relating to it is finally approved.
The budget estimates prepared by the ministries/departments according to budget and accounts
classification are scrutinized by the Financial Advisors concerned. The plan items of the Central
Budget are finalized in consultation with the Planning Commission and are based on the Annual
Plan.

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Legislation of Budget
Enactment of the budget: Once the budget is prepared, it goes to the parliament for enactment
and legislation. The budget has to pass through the following stages:

The finance minister presents the budget in the Lok Sabha. He makes his budget in the
lok sabha. Simultaneously, the copy of the budget is laid on the table of the Rajya Sabha.
Printed copies of the budget are distributed among the members of the parliament to go

through the details of the budgetary provisions.


The finance bill is presented to the parliament immediately after the presentation of the
budget. Finance Bill relates to the proposals regarding the imposition of new taxes,

modification on the existing taxes or the abolition of the old taxes.


The proposals on revenue and expenditure are discussed in the parliament. Members of

the parliament actively take part in the discussion.


Demands for grants are presented to the parliament along with budget statement. These
demands for grants show that the estimates of the expenditure for various departments

and they need to be voted by the parliament.


After the demands for grants are voted by the parliament, the Appropriation Bill is
introduced, considered and passed by the appropriation of the parliament. It provides the
legal authority for withdrawal of funds of what is known as the Consolidated Fund of

India.
After the passing of the appropriation bill, finance bill is discussed and passed. At this
stage, the members of the parliament can suggest and make some amendments which the

finance minister can approve or reject.


Appropriation bill and Finance bill are sent to Rajya Sabha. The Rajya Sabha is required
to send bank these bills to the Lok Sabha within fourteen days with or without

amendments. However, Lok Sabha may or may not accept the bill.
Finance bill is sent to the President for his assent. The bill becomes the statue after
presidents sign. The president does not have the power to reject the bill.

Execution of the budget


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Once the finance and appropriation bill are passed, execution of the budget starts. The executive
departments get a green signal to collect the revenue ad start spending money on approved
schemes. Revenue Department of the ministry of finance is entrusted with the responsibility of
collection of revenue. Various ministries are authorized to draw the necessary amounts and spend
them. For this purpose, the Secretary of ministers acts as the chief accounting authority. The
accounts of the various ministers are prepared as per the laid down procedures in this regard.
These accounts are audited by the Comptroller and Auditor general of India.
The execution of the budget is the responsibility of the executive government. The procedures
for execution of the budget depend on the distribution and delegation of powers to the various
operating levels. As soon as the Appropriation Act is passed, the Ministry of Finance advises
spending Ministries / Departments about their respective allocation of funds. The controlling
officers in each ministry department then allocate and advise the various disbursing officers. The
expenditure is monitored to ensure that the amounts placed at the disposal of the spending
authorities are not exceeded without additional funds being obtained in time. Thus the financial
system broadly consists of the following levels :
a. controlling officers; normally the head of the ministry/department acts as the controlling
officer;
b. a system of competent authorities who issue financial sanction;
c. a system of drawing and disbursing officers; and
d. a system of payments, receipts and accounts.
The Department of Revenue in the Ministry of Finance is in overall control and supervision over
the machinery charged with the collection of direct and indirect taxes. Such control is exercised
through the Central Board of Direct Taxes and the Central Board of Indirect Taxes. These Boards
exercise supervision and control over the various operational levels which implement different
taxation laws. The Reserve Bank of India is the central banker of the government. The
nationalized banks and the network of treasuries are also performing the service of collection
(receipts) and disbursement of funds.

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Unit 4

State and Local Finance

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Local Government means the management of local affairs by the representatives of the locality
itself. It deals with the problems, chiefly of local concern. It plays an important role in solving
the local problems of the people. It provides the foundation on which the democratic structure of
a country stands. At the local level, India is governed by two different sets of institutions,
namely, the Rural Governments and the Urban Local Governments.

Municipal Government: Sources of Revenue

1. Tax-Revenue: The major proportion of income of urban governments flows from taxes.
It ranges between two-fifths and three-fourths of total income. The main taxes are:
Octroi or terminal tax
House tax
Tax on trades, professions,
Tax on dogs
Tax on advertisements other than those published in the newspaper
Bazar tax
Tax on vehicles
Tax on theatres
Toll tax.
2. Non-Tax Revenue: It includes receipts from rents of municipal property, interest on
investments, profit from public utility undertakings like-water supply, passenger
transport, electricity, supply, fee for issuing licences or permits, fines realised for offences
against municipal bye-laws, rules, regulations etc.
3. Grants-in Aid: It is another important source of income of urban governments in India.
Grants represent subsidies given by the state government in aid of certain services
rendered by urban governments. Grants can broadly be divided into two categories,
namely, recurring and non-recurring. The former are provided by the State Government
to meet the gap in their recurring expenditure. The latter are given to municipalities to
meet the initial cost of some specific projects such as water supply, school buildings,
health centre etc. The amount of grant is determined on the basis of the matching
formula, per capita income and expenditure etc.

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4. Loans: Urban governments also meet their needs of capital expenditure such as purchase
of land, heavy machinery and long-term projects by raising loans. Borrowings are
regulated by the central law known as Local Authorities Loans Act, 1914. Loans are
raised with prior sanction from the state government. In certain cases, the permission of
the central government is also needed. The urban governments are permitted to borrow
loans from banks, Life Insurance Corporation and other financial institutions. All
proposals concerning loans from open market or LIC are required to be cleared, by the
Reserve Bank of India. For all practical purposes, urban governments except municipal
corporations have to depend largely upon loans from their respective state governments.
Every loan has its own rate of interest, term, mode of repayment, measures of utilization
etc.
Municipal Government: Expenditure

1. General Administration, Establishment and Collection Charges: This expenditure


includes charges like salaries of employees, maintenance of the office, charges for the
collection and construction of office building and octroi. The other charges which fall
under this head also include litigation expenditure such as lawyer's fee, court and witness
fee, election expenses for preparing voters list, ballot papers, audit fee for auditing
accounts etc.
2. Public Education: The responsibility of providing free and compulsory education for
children until they complete the age of fourteen years is as a matter of fact to be borne by
the state governments. (Article 45 of the Constitution of India). The expenditure on
public education falls under two heads, viz., (1) running schools, and (2) setting up and
operating public libraries and reading rooms.

3. Medical and Public Health: Protection of public health is one of the primary functions of

urban governments. The public health activities are divided into two parts:
Provision for medical relief and administration of preventive. medicines and
Maintenance of public health.
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4. Water Supply: Pure drinking water is essential for good health. The provision of pure,
clean and adequate water supply is, therefore, an important function of urban
governments. Expenditure on this head is usually quite heavy because tanks, reservoirs,
engines, pipes, taps and other works may have to be constructed and maintained.
5. Municipal Works: It is one of the important items of the municipal budget. Under this
head, the urban government's maintenance of roads, bridges, markets, slaughter-houses,
lanes and bye-lanes and any such other works concerning with the physical beautification
and development of the city or a town, are covered.
6. Maintenance and Reserve for Unforeseen Emergency Maintenance expenditure covers
property repairs, dismantling unauthorized structures etc. Reserve for unforeseen
emergency includes expenditure on public safety such as fire services, protecting public
against stray and dangerous dogs, and any such other emergency which is unpredictable.
State control and Supervision over Urban Local Finance
Urban local bodies are not sovereign bodies. As mentioned earlier, local government is a state
subject and as such state government is empowered to legislate on various aspects of local
bodies. It determines their structure, powers, functions, financial resources etc. In fact, urban
local bodies are regularly controlled, supervised, directed and occasionally penalized by the State
Government for their acts of omission and commission.
Government control over the finances of urban governments may be grouped under the
following heads:

Control over Taxation: The government is empowered to exempt any person or property
from the payment of any tax. Every resolution of a municipality increasing or decreasing
or abolishing an existing tax requires the approval of the state government and in certain
cases, of central government as well.
Besides, the state government can direct a municipal body to impose octroi on a
particular item at a particular rate.
Year II | Public Finance 61

State government may allow urban bodies to add supplementary rates to the existing
government taxes.

Control over Municipal Expenditure and Fund: The state government is empowered
to regulate municipal expenditure by fixing limits on expenditure to be incurred on
various items, laying down regulations and procedures for incurring expenditure. If the
work involved exceeds a particular limit of expenditure, the urban bodies are required to
obtain administrative and technical sanction from the competent authorities as determined
by the state government. It can also require a municipal body to pay for any service.

Control over Budget: The urban bodies are required to prepare their budgets in the
manner and form as determined by the state government from time to time. The budget
approved by the municipality cannot be executed without the prior sanction of the state
government which in turn has the power to make alterations in budgetary proposals. As
mentioned in the preceding section if municipality does not agree with the modifications
made, the decision of the state government is final and binding on the municipality.

Control over Loans: As mentioned earlier, the borrowing powers of urban bodies are
regulated by the central law known as the Local Authorities Loans Act, 1914. Before
approving any proposal to borrow, the state government thoroughly examines the
scheme, reviews the entire financial position of the urban local body, fixes the period of
repayment, determines the mode of borrowing etc.

Deficit Financing in India


Deficit financing refers to means of financing the deliberate excess of expenditure over income
through printing of currency notes or through borrowings. The term is also generally used to
refer to the financing of a planned deficit whether operated by a government in its domestic
affairs or with reference to balance of payment deficit.
But according to Indian budgetary documents government resorting to borrowing from the public
and the commercial banks does not come under deficit financing. These are included under the
head of 'Market Borrowings' and government spending to the extent of its market borrowings
does not result in or lead to deficit financing. In the Indian context, public expenditure, which is
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financed by borrowing from the public, commercial banks are excluded from deficit financing.
While borrowing from the central bank of the country, withdrawal of accumulated cash balances
and issue of new currency are included within its purview.
Deficit financing in Indian context occurs when there 'are budgetary deficits. Let us now discuss
the meaning of budgetary deficit. Budgetary deficit refers to the excess of total expenditure (both
revenue and capital) over total receipts (both revenue and capital).
Role of deficit financing as an aid to financing economic development
Deficit financing has been resorted to during three different situations in which objectives and
impact of deficit financing are quite different. These three situations are war, depression and
economic development.

Deficit financing during war


Deficit financing has its historical origin in wlr finance. At the time of war, almost every
government has to spend more than its revenue receipts from taxes and borrowings. Government
has to create new money (printed notes or borrowing from the Central Bank) in order to meet the
requirements of war finance. Deficit financing during war is always inflationary because
monetary incomes and demand for consumption goods rise but usually there is shortage of
supply of consumption goods.
Deficit financing during depression
It was advocated that during depression, government should resort to construction of public
works wherein purchasing power would go into the hands of people and thereby demand would
be stimulated. This will help in fuller utilization of already existing but temporarily idle plants
and machinery. Deficit spending by the government during depression helps to start the stagnant
wheels of productive machinery and thus promotes prosperity.
Deficit financing and economic development

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When government resorts to deficit financing for development, large sums are invested in basic
heavy industries with long gestation periods and in economic and social overheads. This leads to
immediate rise in monetary incomes while production of consumption goods cannot be increased
immediately with the result that prices go up. It is also called the inflationary way of financing
development. However, it helps rapid capital formation for economic development.
Advantages of Deficit Financing in India
Up till now, we have seen that deficit financing is inflationary and it destroys its own purpose of
aiding economic development. But it is not always so. Secondly inflation is not always harmful
for economic development. On the contrary, to a certain extent inflation is conducive to
economic development and hence deficit financing is beneficial.
During the process of development, increase in national production is bound to give rise to the
demand for increased money supply for transactions. This can be met by injecting new money in
the economy through deficit financing. If deficit financing is resorted to for productive purposes
especially for the production of consumer goods and that too for quick results then deficit
financing is not that inflationary.
Deficit financing will be non-inflationary if the government is able to mop up the additional
money incomes, created by deficit financing, through taxation and saving schemes. Properly
controlled and efficiently managed programme of deficit financing may help the process of
economic development.

Limitations of Deficit Financing


The major evil of deficit financing is the inflationary rise of prices. Deficit financing leads to
increase in money supply and, therefore increase in demand for goods and services.

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